In what way does a proxy give significant power to a corporation’s management?
A proxy is a combination absentee ballot and assignment of vote. Proxies are solicited by management prior to a corporation’s annual meeting. One reason is to ensure that a majority of shares are represented at the annual meeting, either in person or by proxy, thus constituting a quorum and permitting the meeting to take place. However, in a widely-held company, it is normal for only a small percentage of stockholders to attend the annual meeting; the vast majority of shares are represented by proxies. This gives power to management in two ways.
First, the proxy form is usually printed to favor management. For yes-no-abstain votes, the proxy typically identifies management’s preferred outcomes, often in large bold type.
For the election of directors, the typical proxy only gives shareholders two choices:
(1) vote for all of management’s preferred candidates, or
(2) vote for all of management’s preferred candidates except those whose names the shareholder writes into a small space on the proxy. With these limited, awkward alternatives, it is difficult for management’s candidates to lose.
Second, collecting proxies permits management to cast a majority of the votes on any issue not listed on the proxy that comes before the meeting. Management has total control of these issues and while dissenting shareholders may speak out, they cannot change management’s position.
Is there any advantage to having preemptive rights as a stockholder? Is there any disadvantage?
There are two advantages to a corporation’s stockholders of having preemptive rights. The primary advantage is the ability to maintain a proportional ownership of the corporation should it issue additional shares of common stock in order to maintain control. In addition, it is less costly to issue new shares to existing shareholders than to new shareholders since the services of an investment banker are not required. This lowers the company’s cost of equity, and hence its cost of capital, increasing the firm’s value. Management can keep this extra value within the company or can distribute it to shareholders in the form of a discounted price on the newly issued shares (in which case the rights may be used or sold to other investors for their cash value). There is no particular disadvantage to preemptive rights other than that a stockholder who elects to use them to purchase additional shares must come up with the necessary amount of cash.
If a stockholder could literally inspect the company’s books, a company’s competitors could buy a few shares and use their new relationship as a stockholder to obtain confidential competitive information. Also, a constant stream of stockholders passing through a company’s offices and going through its records could create quite a disruption to its business. Instead, stockholders are entitled to regular financial reports according to standard accounting formats, an obligation discharged through the formal annual report and 10K form (the non-glossy annual report required to be filed with the Securities and Exchange Commission).
When would a stockholder be willing to purchase a class of common stock that did not have full shareholders’ rights?
Not all shareholders’ rights are of equal value to all shareholders. Some shareholders value one or more of the rights of ownership so highly that they are willing to give up other shareholder rights to secure the ones they value most.
- For example, when venture capitalists invest in a startup business, the company’s managers often get stock with control but limited income (“founder’s shares”) while the venture capitalists get shares with income but limited control.
Also, some shareholders are prohibited by law or regulation from owning one or more of the traditional shareholder rights.
- For example, a charity or foundation which owns a substantial amount of the stock of any one company will attract the scrutiny of the IRS which will wonder whether it was set up to evade taxes while maintaining control of the company.
Such a charity or foundation might prefer stock with all the income and residual value rights but with limited or no voting power to avoid threatening its tax-exempt status.
Why is preferred stock often called a hybrid between bonds and common stock?
Preferred stock is often considered a hybrid between bonds and common stock because it contains a mixture of many of the characteristics of each. Among the examples given in the chapter:
(1) Like a bond: preferred stock has a face or maturity or par value, it pays its holder a fixed amount each year, it normally has no voting privileges, it has priority above common stock in liquidation, it may contain a call feature or be convertible to common stock, the issue may require a sinking fund for its retirement, and it may contain indenture provisions.
(2) Like common stock: preferred stock normally does not have a fixed maturity, it pays a dividend, it may contain voting power, it has priority after all debt in liquidation, and dividends may adjust with the company’s income.
Companies issue warrants for at least three reasons:
(1) as the mechanism for conveying preemptive rights to their shareholders (“stock subscription warrants”),
(2) as incentive compensation for employees (“employee stock options”), and
(3) as extra compensation for lenders and preferred stockholders (“sweeteners,” “kickers”).
Is there any difference in value between cumulative and non-cumulative preferred stock? Why, or why not?
While the difference is minimal in financially healthy companies, there is a significant difference in companies in financial distress. A company with outstanding cumulative preferred stock cannot pay dividends on its common stock unless all past dividends on the preferred issue have been fully paid. Financially healthy companies routinely pay all preferred dividends; to the preferred shareholders of these firms, the cumulative feature adds little value to the issue because it is highly unlikely that it will ever be invoked. However, companies in financial distress often are cash poor and elect to suspend preferred dividends in order to conserve their cash. To the preferred shareholders of these firms, the cumulative feature is critical to maintaining any value to the preferred shares at all.
Companies issue convertible bonds for at least four reasons:
(1) to minimize the interest rate on their debt since the conversion feature forms part of the lenders’ value,
(2) to raise funds in a poor stock market that will eventually become equity at a much better share price,
(3) to create financial leverage for a period of time which then disappears upon the bonds’ conversion, and
(4) to use and then automatically free up debt capacity.
What is the relationship of a warrant and a convertible bond to a call option?
Both a warrant and a convertible bond contain a call option. A warrant is a call option. The holder of the warrant can force the company to deliver a specified number of shares of its stock to be paid for with cash. Warrants differ from other call options only in that they are issued by the company whose stock can be called. A convertible bond is the combination of a bond and a call option. The bond’s owner can force the company to deliver a specified number of shares of its stock to be paid for with the bond. And, like a warrant, the option is granted by the company whose stock can be called.
Under what circumstances can a company successfully force conversion of a convertible bond? Under what circumstances will the company fail?
Since holders of convertible bonds generally have no reason ever to convert the bonds to stock, companies often use a call feature to force conversion. Bondholders will convert their bonds in response to a call if the value of the stock to be received upon conversion exceeds the proceeds from the call. This will be the case if the stock has risen sufficiently since the bond was issued. On the other hand, if the company’s stock price has not increased very much so that the value to be received upon conversion is less than the proceeds from the call, bondholders will simply submit to the call and the company will find itself paying out cash instead of issuing new stock.