Preferred Stock

Discussion

Preferred stock is an equity security, but has certain features that liken it to debt instruments such as fixed dividend payments, seniority of claims to regular common stock and, in many cases, no voting rights (except on matters that affect the seniority of preferred stock as a class). The terms of blank check preferred stock give a company's board the power to issue shares of preferred stock at its discretion, with voting, conversion, distribution, and other rights to be determined by the board at the time of issue.

Blank check preferred stock can be used for sound corporate purposes such as raising capital or making acquisitions. In these cases, "blank check" implies flexibility in meeting the company's broad finance needs. By not establishing the terms of preferred stock at the time the class of stock is created, companies maintain the flexibility to tailor their preferred stock offerings to prevailing market conditions.

Uses of Blank Check Preferred Stock

In most instances, blank check preferred stock is used responsibly. Private placements of preferred stock are often used by companies that are experiencing a cash shortage and cannot afford to go through the months-long process of registering securities for sale through the SEC.

White Squire Placements

Nevertheless, blank check preferred stock is also suited for use as an entrenchment device. A large number of companies, including many members of the S&P 500, obtained shareholder approval to issue blank check preferred stock amid a wave of hostile takeover activity in the mid-1980s.

One powerful takeover defense at the time was the placement of large blocks of corporate securities, or blank check preferred stock, with friendly third parties- the white knight rescue. This practice was followed by a series of placements done before a tender offer was threatened-the white squire placement-either to a private investor, a company's ESOP, another company or to an investment fund. Such a defense is particularly effective with the use of blank check preferred stock because the particular attributes of the shares (e.g., voting power, conversion rights, liquidation rights) are unspecified and they can be issued at the board's discretion. From the perspective of management, these placements not only preclude most takeover attempts, but also provide a pool of "patient capital" that helps managers focus on long-term planning. While there is a lot to be said for patient capital, these placements also can dilute existing shareholders' equity and voting positions.

Shareholder Response to White Squire Placements

Shareholders interested in protecting their voting positions in such situations devised a simple remedy. In 1990, the nation's largest private pension system, the Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), sponsored the first shareholder proposal (at Pfizer Inc.) asking that existing shareholders be allowed to vote on placements representing ten percent or more of existing equity. Other proposals have asked corporations to adopt a policy of seeking shareholder approval before placing blank check preferred stock (stock without predefined voting and dividend rights) with any person or group, except in cases when such placement of shares is for the purpose of raising capital or making acquisitions in the normal course of business. Such proposals provide shareholders with some power to stop wasteful white squire placements and should be supported.

Blank Check Preferred Stock As An Entrenchment Device

Since the 1980s, the use of white squire rescues has become rare. Many companies have armed themselves with a host of other antitakeover techniques, such as poison pills, classified boards, and supermajority voting requirements on mergers, all of which serve as effective deterrents to unsolicited takeover bids. Moreover, the use of blank check stock as a takeover defense has also declined due to shareholder and SEC opposition to dual-class voting schemes.

Despite this, shareholders approving a proposal to authorize blank check issues may ultimately be haunted by their decision in the event of a new wave of hostile takeovers. Moreover, while boards frequently stress the need for flexibility to tailor issues of preferred stock to market conditions, ISS has never received an explanation as to why voting and conversion rights cannot be limited in order to protect the investment of other shareholders. Furthermore, blank check preferred stock would not be as objectionable to shareholders if a company stated in writing that such shares would not be used to thwart a potential takeover ("declawed"). IBM Corp. adopted this approach when it sought authorization of blank check preferred stock. Shareholders should approve blank check proposals that clearly state that the shares will not be issued as a takeover defense mechanism without prior shareholder approval.

Evaluating Blank Check Preferred Authorizations

As with proposals to increase the number of authorized common shares, shareholders voting on proposals to increase preferred stock authorization should examine the number of preferred shares outstanding and reserved as a percentage of the total number of preferred shares currently authorized for issuance. ISS recognizes that patterns of utilization of preferred shares vary from industry to industry. However, a company with few shares available-because most of the current authorization is outstanding or reserved for issuance-is afforded a larger allowable increase. The allowable increase represents the maximum permitted number of shares that can be added to the current share authorization.

Additionally, shareholders should examine company-specific performance. ISS has compiled data on preferred stock authorization proposals and classified companies into one of ten peer groups. An 11th peer group is designated for rapidly growing companies whose shares have recently become publicly traded. Each company's performance is measured on the basis of three-year total shareholder returns. Companies that have posted superior total shareholder returns should be given more latitude with respect to capital stock increases than lesser-performing companies.

An "allowable increase" for a company is set after examining shares outstanding and reserved as a percentage of the total number of shares currently authorized for issuance and company performance. ISS recommends votes against proposals to increase the number of authorized preferred shares when the proposed increase exceeds the allowable increase. Proposals to increase authorized preferred shares are supported when the proposed increase falls within the allowable increase.