Is a Company Required to Pay Preferred Dividends?
Uncover whether companies are truly obligated to pay preferred dividends. Explore the factors and stock terms that define payment requirements.
When a company issues preferred stock, investors often wonder about the regularity and certainty of dividend payments. Preferred stock represents a unique class of ownership, distinct from common stock, which typically offers a fixed dividend payment. Understanding the nature of these dividends and the factors influencing their payment is important for anyone assessing this type of investment.
Understanding Preferred Dividends
Preferred dividends are cash distributions a company pays to its preferred shareholders. These dividends are typically fixed, often expressed as a percentage of the stock’s par value or a set dollar amount per share, and are usually paid quarterly or annually. This fixed nature contrasts with common stock dividends, which are variable and depend directly on a company’s profitability and the discretion of its board of directors.
A significant characteristic of preferred dividends is their priority over common stock dividends. If a company declares dividends, preferred shareholders must receive their payments in full before any dividends can be distributed to common shareholders. However, unlike interest payments on debt, preferred dividends are not a mandatory contractual obligation that can lead to default if missed, unless they are formally declared by the company’s board.
When Companies Declare Preferred Dividends
The decision to declare preferred dividends rests with a company’s board of directors. The board evaluates several factors before authorizing these payments, including the company’s overall financial performance and available cash flow. Companies that are consistently profitable and maintain a stable financial position are more likely to declare dividends for their preferred shareholders.
Legal restrictions and existing financial agreements also influence the board’s decision. Companies must often pass solvency tests, ensuring they can meet their liabilities as they become due and that their assets exceed liabilities after the dividend payment. Furthermore, loan agreements with lenders frequently include negative covenants that restrict or limit dividend payments to shareholders, aiming to protect the company’s ability to repay its debts.
How Preferred Stock Terms Affect Payment
The terms embedded within preferred stock agreements significantly impact the obligation to pay dividends. Two primary types define this dynamic: cumulative preferred stock and non-cumulative preferred stock.
For cumulative preferred stock, any dividends that the company fails to pay accumulate as “arrearages.” These missed payments must be fully paid to cumulative preferred shareholders before any dividends can be distributed to common shareholders. This feature provides a layer of security for investors, ensuring that unpaid dividends are not simply lost but are carried forward as a liability until paid.
In contrast, non-cumulative preferred stock does not accrue missed dividends. If the company’s board decides not to declare a dividend for a non-cumulative preferred stock in a given period, that payment is permanently lost. The company has no future obligation to make up for the skipped dividend. This type of preferred stock offers less certainty regarding dividend income compared to its cumulative counterpart.
What Happens When Dividends Are Not Paid
When a company does not declare or pay preferred dividends, the consequences vary depending on the specific terms of the preferred stock. For cumulative preferred stock, unpaid dividends accumulate as arrearages on the company’s books. These accumulated dividends represent a financial obligation that must be satisfied before any common stock dividends can be paid. This can effectively prevent common shareholders from receiving dividends for an extended period if arrearages are substantial.
Beyond this financial obligation, non-payment can trigger other provisions outlined in the preferred stock agreement. Some agreements may grant preferred shareholders temporary voting rights if a certain number of dividend payments are missed, allowing them to exert influence in corporate decisions until the arrearages are cleared. Consistently missing preferred dividend payments can also damage a company’s reputation and its ability to raise capital in the future, as investors may perceive it as financially unstable.