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As we have seen, a company can raise funds by selling ownership in itself to investors.These funds would form the equity portion of a companys capital structure. In return,the investors would receive shares in the company, representing their degree of owner-ship. Their investment would be tied directly to the fortunes of the company. As the companyearned profits and retained some or all of them, its equity value would grow. This increases thenet asset value of each common share and makes them more attractive to investors. Growingprofits could also mean an increase in dividends paid out to shareholders, which would alsoenhance the appeal of the shares. As the companys shares became attractive to new investors,they would be bid up in price, providing a potential gain to existing shareholders.

Conversely, a series of losses could eat away at retained earnings and thereby reduce the equityvalue of the shares. A company without profits would be unlikely to increase its dividends. Itwould be more inclined to cut them to conserve cash. These events would probably cause adecline in the share price and in the value of the shareholders investment.

All corporations, whether public or private, listed or unlisted, issue common shares. In addition,some companies issue preferred shares. A common share is entitled to a proportion of a compa-nys equity relative to the total number of common shares. It will have a varying equity worth asthe companys equity and number of outstanding shares varies.

A preferred share is entitled to a fixed amount of equity, determined when the share is firstissued. A series of profitable years will increase the equity value of common shares, as retainedearnings and therefore common equity grow, but will have no effect on the equity value of pre-ferred shares. The two types of shares appeal to two distinct types of investors. Common sharesare bought by those looking to profit from the ongoing success of the issuer. Preferred sharesappeal to those wanting steady dividend income and a place in line ahead of the common share-holders should the company dissolve.

The stock market is a leading indicator of the direction of the business cycle. Exchanges andother financial institutions create indexes to track the movement of these markets. These indexesare discussed at the end of this chapter.

A. COMMON SHARESCommon shareholders are the owners of a company and initially provide the equity capital tostart the business.

If the venture prospers, the shareholders benefit from the growth in value of their originalinvestment and the flow of dividend income. The prospect of a small investment growing tomany times its original value attracts many investors to common shares.

On the other hand, if the business fails, the common shareholders may lose their entire invest-ment. This possibility of total loss explains why common share capital is sometimes referred toas venture or risk capital.

Although part owner of the business, the common shareholder is in a relatively weak position, assenior creditors (such as banks), bond and debenture holders and preferred shareholders all haveprior claims on the earnings and assets of the company. Unlike debt interest, dividends are

Chapter 6

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CSI Global Education Inc. (2005)

PRE-TEST

payable at the discretion of the Board of Directors. In many companies dividend pay-ments are a routine matter and can be regularly anticipated by shareholders. For compa-nies in cyclical industries, there is less certainty. Some companies reinvest all earnings inthe business; others lack sufficient earnings to pay dividends.

For many years, a purchaser of common shares was given a certificate with the companyname and number of shares engraved on it. Some of these certificates were quite elabo-rately done, with an illustration relating to the companys business. For the most part,the securities industry has moved away from a paper-based system of ownership.Instead, street certificates are registered in the name of a securities firm rather than theowner of the shares. This procedure is often followed because, like a bond in bearerform, a share certificate in street name is negotiable, that is, readily transferable to a newowner.

The Canadian Depository for Securities Limited offers computer-based systems toreplace certificates as evidence of ownership in securities transactions. This systemalmost eliminates the need to handle securities physically.

B. RIGHTS AND ADVANTAGES OF COMMON SHARE OWNERSHIP

The following are some of the benefits of owning common shares:

Potential for capital appreciation;

The right to receive any common share dividends paid by the company;

Voting privileges including the right to elect directors, to approve financial state-ments, and auditors reports, and vote on other important issues;

Favourable tax treatment in Canada of dividend income and capital gains;

Marketability shareholdings can easily be increased, decreased or sold for mostpublic companies;

The right to receive copies of the annual and quarterly reports, and other mandato-ry information pertaining to the companys affairs;

The right to examine certain company documents such as the by-laws and registerof shareholders at specified times;

The right to question management at shareholders meetings; and

Limited liability.

1. Capital Appreciation

For many investors the prospect of capital appreciation is the main attraction of com-mon shares. Stocks have proven over time that such an attraction is justified, althoughnot all common shares fulfil this expectation, and even those that do will not necessarilyincrease in value every year.

As companies earn profits year after year, whatever money is not paid out to sharehold-ers in the form of dividends will remain in the company as retained earnings. Sinceretained earnings form part of common equity, a growth in retained earnings will add tothe value of shareholders equity. Assuming a fairly constant number of shares outstand-ing, the amount of equity that belongs to each share will increase. Since investors relatethe price they are willing to pay to a shares equity or book value, a higher equity pershare value will lead to a willingness on the part of investors to pay more to acquirethese shares.

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6-2 CSI Global Education Inc. (2005)

Annual growth in the size of a companys profits also makes its shares attractive toinvestors. Anticipation that this growth will continue will increase the earnings multiple(i.e., the price/earnings ratio) that investors will be willing to pay for the stock.Increased earnings can lead also to an increase in the dividend rate. Since yield is anoth-er factor that investors take into account when evaluating stocks, dividend growth canlead to stock price increases.

There are many other factors, both within the company and externally, that can affect acompanys stock price, and careful analysis and selection are required to ensure a prof-itable investment. Analysis of these factors is covered in Chapter 8.

2. Dividends

A companys net earnings after the payment of preferred dividends are available:

For distribution as common share dividends;

As funds to be kept by the company as retained earnings and reinvested in the busi-ness; or

As a combination of the preceding.

Companies vary widely in the percentage of earnings they pay to common shareholders.Payout ratios vary greatly from one industry to another. Mature companies, such asbanks, may pay out a substantial percentage of their earnings as dividends to sharehold-ers. While growing companies such as those in the technology field may need to keep ahigh proportion of earnings within the company to fund the large amount of researchand development that are crucial to their success. Dividend policy is determined by theBoard of Directors who are guided primarily by the goals set for the company.

To maintain its operations and finance future growth opportunities, most companieswill retain a portion of earnings each year. In the long run this policy may work to thebenefit of shareholders if it results in increased earnings.

Reductions or omissions of dividends do occur, particularly in poor economic times,and, although they may be temporary, they do emphasize the risks of common shareinvestment.

Restrictions in the trust deed of outstanding bond issues or preferred covenants oftenrequire that working capital be maintained at a certain level before dividends can bepaid on the common shares.

a) Regular and Extra Dividends

Some companies paying common share dividends designate a specified amount that willbe paid each year as a regular dividend. The term regular indicates to investors that pay-ments will be maintained barring a major collapse in earnings.

Some companies may also pay an extra dividend on the common shares, usually at theend of the companys fiscal year. The extra is a bonus paid in addition to the regularpayout but the term extra cautions investors not to assume that the payment will berepeated the following year. If the companys earnings are maintained, the extra may berepeated. However, directors can omit the extra at their discretion just as they can withregular dividends.

In calculating an indicated annual yield for a common stock, it is accepted practice toinclude extra dividends if there is strong evidence that the extra dividend will be paidagain. However, when factors such as declining earnings suggest the extra will not berepeated, then the indicated yield is best calculated on the regular indicated dividend.

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b) Declaring and Claiming Dividends

Unlike interest on debt, dividends on common shares are not a contractual obligation.The Board of Directors decides whether to pay a dividend, the amount and paymentdate. An announcement is made in advance of the payment date. Companies may paydividends quarterly, semi-annually or annually.

If the shares are registered in the name of the owner, dividend payment cheques aremailed directly to the owner. For shares registered in street certificate form, dividendpayments are made to the securities firm whose name appears on the certificate. Thedividends are then credited to the accounts of the firms clients who own the shares.

c) Ex-Dividend/Cum Dividend

Many companies place advertisements in financial newspapers announcing the declara-tion of a dividend. Exhibit 6.1shows a typical dividend announcement.

EXHIBIT 6.1

Notice of Dividend

NOTICE is hereby given that a dividend has been declared on the capital stock of the Company as follows:

Common Shares . . . . . . . . . . . . .$1.50 per share

The dividend will be payable July 2, 20** to shareholders of record at the close of business on the13th day of June, 20**.The transfer books will not be closed. Payment will be made in Canadian funds:

By Order of the Board

K. C. JONESSecretary.

Vancouver, June 2, 20**

The purpose of the interval between June 13 and July 2 is to give the company time toprepare the dividend cheques for mailing to recorded shareholders. During this intervala purchaser of these shares will not receive the dividend that has just been declared andthe stock is said to be ex-dividend.

When a stock is actively traded, the record of shareholders is continually changing. Forconvenience, the company names a date known as the dividend record date. All share-holders, recorded as of this date will be entitled to the dividend. The dividend recorddate is usually two to four weeks in advance of the payment date in order to allow timefor cheque preparation.

To determine whether the seller or the buyer is entitled to the dividend when a saletakes place around the time of the dividend payment, the stock exchange names an ex-dividend date. On and after this date, the stock sells ex dividend; that is, the sellerretains the dividend and the buyer is not entitled to it. The ex dividend date is set at thesecond business day before the dividend record date. Since trades settle on the third busi-ness day after a trade, a purchaser of shares two days before the record date would nothave the trade settle until the day after the record date, and would therefore not be ashareholder of record for purposes of receiving the dividend. Exhibit 6.2 provides anexample of how the shares trade.

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EXHIBIT 6.2

Trading Ex- and Cum Dividend

Using the dates in Exhibit 6.1, and assuming that all are business days, the shares wouldtrade as follows:

Date Traded Date Settled Ex- or Cum Dividend

June 9 June 12 Cum Dividend

June 10 June 13 Cum Dividend

June 11 June 16 Ex-dividend




The major Canadian stock exchanges publish dividend announcements in their dailyreleases to securities firms in the following form:

Share- ExWhen Holders Dividend

Payment Payable of Record* Date

A Company .25 June 15 May 14 May 12

B Company .50 August 5 July 15 July 13

*or Dividend Record Date

Stocks going ex dividend sometimes start trading at a price reduced by the exact amountof the dividend. Securities firms holding open orders to buy or open stop orders to sellautomatically reduce such orders by the amount of the dividend when the stock starts totrade ex dividend (unless otherwise advised). Open sell orders and open stop orders tobuy are not reduced. An open order is a type of order that is usually entered at a speci-fied price to buy or sell a security and is held open until executed or cancelled. Adjustingopen orders is a standard approach used within the securities industry.

These same general principles apply when a security is quoted ex-rights (explained inChapter 7).

The person who buys the stock on the day that it goes ex dividend does not get thedeclared dividend, but will of course receive subsequent dividends as long as the sharesare held.

The expression cum dividend means the reverse. Trades during this period result in thepurchasers receiving the declared dividend. The last day a stock trades cum dividend isthe third business day before the dividend record date; in other words, it is the daybefore the first ex dividend date.

d) Dividend Reinvestment Plans

Some major companies give their preferred and common shareholders the option ofparticipating in an automatic dividend reinvestment plan. In such a plan, the companydiverts the shareholders dividends to the purchase of additional shares of the company.Reinvested dividends are taxable to the shareholder as ordinary cash dividends eventhough the dividends are not received as cash.

Share purchases in most dividend reinvestment plans are made on the open marketunder the direction of a trustee. Participating shareholders are periodically sent a state-

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ment showing the number of shares, including fractional shares in some cases, boughtunder the plan and at what price. BCE Inc. and Enerplus Resources Fund are examplesof major companies offering dividend reinvestment plans.

Since under a reinvestment plan the company uses authorized dividends to purchaseadditional shares in bulk, a saving in commission is achieved. An individual shareholdertrying to buy the same small number of shares would normally pay a higher commis-sion, particularly if odd lots were involved.

In effect, a dividend reinvestment plan is an automatic savings plan which solves theproblem of reinvesting small amounts of cash. Participating shareholders acquire a gradu-ally increasing share position in the company and because purchases by the plan aremade regularly, the advantages of dollar cost averaging are obtained. The provision insome plans for crediting participating shareholders with applicable fractions of shares isunique. Normally fractions of shares cannot be purchased in the market by a shareholder.

Some companies offer variations on this type of reinvestment plan and permit share-holders to make additional cash contributions to the plan, perhaps up to a fixed amount(e.g., $1,000 to $3,000 per quarter). Another variation is to apply the funds for rein-vestment to the purchase of unissued treasury shares at a specified discount from theprevailing open market price.

e) Stock Dividends

Sometimes the dividend may be in the form of additional stock rather than cash. Oftensuch dividends are paid from time to time by a rapidly growing company that needs toretain a high degree of earnings to finance future growth. The advantage to the compa-ny is that cash is conserved for expansion purposes while shareholders receive additionalshares, which can be sold if they require the cash. These stock dividends would berecorded on the Statement of Retained Earnings in the same fashion as cash dividends.

Since stock dividends are treated as regular cash dividends for tax purposes, manyinvestors, given the option, elect to receive dividends in cash.

3. Voting Privileges

Voting rights are an important feature of common shares. Through the right to vote atthe annual meeting and at special or general meetings, shareholders exercise their rightsas owners to control the destiny of the corporation. They elect the directors who guideand control the business operations of the corporation through its officers. Many mat-ters of an unusual, non-recurring nature, such as the sale, merger or liquidation of thebusiness and the amendment of the charter must receive shareholder approval beforeaction is taken.

However, many companies have two or even three different types of shares, often desig-nated as Class A or B. Because all classes may not have voting rights and may differ inother respects such as dividend entitlement, it is important to know their respective fea-tures.

a) Restricted Shares

Restricted shares are shares which have the right to participate to an unlimited degreein the earnings of a company and in its assets on liquidation, but do not have full vot-ing rights. There are three categories of restricted or special shares:

Non-voting shares which have no right to vote, except perhaps in certain limitedcircumstances;

Subordinate voting shares which carry a right to vote, where there is another classof shares outstanding that carry a greater voting right on a per share basis; and

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Restricted voting shares which carry a right to vote, subject to a limit or restrictionon the number or percentage of shares that may be voted by a person, company orgroup.

Beginning in 2004, the Toronto Stock Exchange and TSX Venture Exchange beganidentifying stock listings by the type of non-conventional voting structure that eachsecurity offers. These voting structures are:

NV non-voting shares.

SV subordinate-voting shares.

RV restricted-voting shares.

For example: Power Corporation currently has an issue of subordinated common sharesoutstanding. These shares are listed under the symbol POW.SV on the TSX.

In recent years the number of companies issuing restricted shares has increased substan-tially. Some investors have become concerned and have resisted reorganizations whichinvolve the creation of restricted shares.

Canadian securities regulators have introduced policies regarding these shares. InOntario, for example, the details of these policies are set out in Ontario SecuritiesCommission Policy 1.3. Investment Advisors should be able to identify restricted sharesand understand the implications of the differences in the voting rights of such shares inorder to advise their clients properly.

b) Rights and Benefits of Restricted Shares

Like common shares, restricted shares participate in the earnings of a company and in itsassets on winding up or liquidation. While being subject to the same risks as holders ofcommon shares, holders of restricted shares may have little or no voice in the affairs ofthe company. Many of the rights and remedies available to shareholders under corporateand securities law are conditional upon the shares carrying voting rights. Under corporatelaw, these rights include requisitioning of shareholders meetings and initiation of share-holder proposals, election of directors, approval of financial statements, confirmation ofby-law amendments, and, in many circumstances, prior approval of fundamental changesin the business, operations or capital of the company. Examples of fundamental changesinclude the sale of substantially all the assets and increases in the authorized capital.

Reference should be made to a companys charter, the notes to financial statements inthe annual report and the governing corporate statute to determine the rights and bene-fits attached to particular classes of restricted shares.

c) Stock Exchange Regulations Regarding Restricted Shares

The stock exchanges have urged companies having or issuing restricted shares to put inplace provisions to ensure that the holders of restricted shares are treated fairly.

Some of the regulations published by the stock exchanges and securities commissions are:

Restricted shares must be identified by the appropriate restricted share term;

Disclosure documents such as information circulars, annual reports and financialstatements which are sent to voting shareholders must be sent to holders of restrict-ed shares and must describe the restrictions on the voting rights of the restrictedshares;

Restricted shares must be identified in the financial press with a code;

Dealer and advisor literature must properly describe restricted shares;

Trade confirmations must identify restricted shares as such;

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Holders of restricted shares must be given notice of, be invited to attend and bepermitted to speak at shareholders meetings; and

Minority approval is required for any corporate action, which would result in thecreation of new restricted shares.

Advisors should be aware of the protection offered to restricted shareholders, as theextent of such protection may vary.

4. Tax Treatment

The tax system in Canada provides some benefits to investors holding common shares.

A dividend tax credit is available that makes the purchase of dividend-paying sharesof taxable Canadian companies relatively attractive compared to interest payingsecurities;

The current exemption from tax of 50% of capital gains provides investors with atax inducement to buy shares; and

Stock savings plans entitle residents of some provinces to deduct up to specifiedannual amounts from (or obtain a tax credit for) the cost of certain stocks pur-chased in their respective provinces during the year.

a) Dividends from Taxable Canadian Corporations

Although greater risk is involved in owning common and preferred shares compared toowning debt securities, the pre-tax yield from common and preferred shares is normallybelow the yields available from debt investments. This is due to the tax treatment ofinterest received versus dividends received.

When a company pays interest on its debt, the interest is paid with the companys pre-tax dollars because interest is considered a tax-deductible cost of doing business. Whenbond or debenture holders receive interest, it is treated as taxable income in their hands.

When a company pays dividends on its shares, the dividends are paid with after-tax dol-lars because dividends, being a share of a companys profits, are not considered a tax-deductible cost of doing business. When shareholders receive dividends, the dollarsinvolved have already been subject to tax in the companys hands prior to payout. Toalleviate double taxation, shareholders of Canadian companies receive tax relief throughthe dividend tax credit.

This procedure is applicable to dividends received from resident taxable Canadian cor-porations. No similar preferential treatment is applicable to interest income, foreign div-idends or dividends from nontaxable Canadian corporations. The taxpayer is required togross-up the amount of the dividend by 25%. For example, if an individual receives a$160 dividend, it would be reported for tax purposes as $200 (125% of $160) in netincome. The additional $40 is referred to as the gross-up and the $200 is known as thetaxable amount of dividend.

The taxpayer calculates net income using the $200 amount, and can then claim a creditin the amount of:

13.33% of the taxable amount of dividend

or

13.33% x $200 = $27

All provinces and territories provide a dividend tax credit as well. Examples of this cal-culation are shown in greater detail in Chapter 13, Financial Planning and Taxation.

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b) Minimizing Taxable Income on After-Tax Yield of Investments

Dividends from taxable Canadian corporations (but not foreign corporations) are sub-ject to less tax than interest. At the lower tax brackets, these dividends are more taxeffective. Accordingly, a shift of investments from interest paying investments into divi-dend-paying Canadian stocks may reduce taxes and improve after-tax yield.

c) Tax on Foreign Dividends

Individuals who receive dividends from non-Canadian sources usually receive a netamount from these sources, as taxes are usually deducted at source. Such investors maybe allowed a deduction from the Canadian income tax otherwise payable. The allowablecredit is essentially the lesser of the foreign tax paid and the Canadian tax payable onthe foreign income, subject to certain adjustments. Details on foreign tax deductions areavailable from the Canada Revenue Agency (CRA).

d) Capital Gains and Losses

Investors are taxed on any capital gains or losses earned from their investments.Basically, a capital gain arises from the sale (or the deemed sale) of a capital property formore than its cost. A capital loss arises from the sale of a capital property for less thanits cost. Any capital gains earned must be reported and 50% of the gain must be includ-ed in income for that year and taxed at the investors marginal tax rate. Capital lossescan be used to reduce any capital gains that have been earned, but generally cannot beused to reduce any other income. The taxation of capital gains and losses are covered inmore detail in Chapter 13.

5. Marketability

The right to buy or sell common shares in the open market at any time is an attractivefeature and a relatively simple matter with few legal formalities.

When a company first sells its shares to investors, the proceeds from the sale go to thecompany. When these outstanding shares are subsequently sold by their holders, theselling price is paid to the seller of the shares and not to the corporation. Shares, there-fore, may be transferred from one owner to another without affecting the operations ofthe company or its finances. From the companys point of view, the effect of a sale issimply that a new name appears on its list of shareholders.

6. Stock Splits and Consolidations

a) Stock Splits

The common shares of a prospering corporation can rise substantially in price overtime. Most companies believe it is good corporate strategy to keep the market price oftheir shares in a popular price range, say $10 $20, and use a stock split or subdivisionto bring a high-priced stock into this range.

The mechanics of a stock split are straightforward. First, the companys directors passand submit a by-law for approval by a vote of the voting common shareholders at a spe-cial meeting. Depending on the current market price of the shares, the split could be onany basis such as two new shares for one old share; or three new for one old; or even tenfor one.

When a split becomes effective, the market price of the new shares reflects the basis ofthe split. For example, in a four-for-one split, the market price of shares selling at $100(pre-split basis) will sell somewhere in the $25 range after the split. An investor whoowned 1,000 shares of the company would now own 4,000 shares.

When a split is first announced, the initial effect on the market price of the stock maybe bullish. There can be a modest surge in the price of the shares on increased volume.

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Dividend increases, often announced at the same time, contribute to the initial bullishimpact. The effect of a split on the shares market price after the initial flurry dependson several important factors such as the companys earnings trend and the stage of theequity cycle (described later).

Although investor aversion to purchases of odd-lots of high-priced shares is usually citedas the main reason for splits, commissions on odd-lot trading may also be a factor. Thelonger-term results of a split may be to broaden the distribution of a companys shares,increase marketability and, thus, facilitate equity financing if required in the future.

While stock splits are associated with active and buoyant stock markets and are general-ly viewed in a positive light, the split itself does not affect the dollar value of a compa-nys equity, nor the value of a shareholders stake. Equity per share would be reduced, asthe total number of shares outstanding would increase; but the equity section of the bal-ance sheet would remain unchanged. Each individual shareholder would own moreshares, but there would be a greater number of total shares outstanding, so proportion-ate ownership would stay the same. Exhibit 6.3 illustrates the impact a stock split hason the financial structure of the company and its shareholders.

EXHIBIT 6.3

Effect of Stock SplitA company announces a 4 for 1 stock split.

Before the stock split After the stock split

# of shares outstanding 1,000,000 4,000,000

Approximate market price per share $100 $25

Capitalization of company $100,000,000 $100,000,000

# of shares owned by investor 50,000 200,000

Dollar value of Shares owned by Investor A $ 5,000,000 $ 5,000,000

Investor As proportionate ownership in company 5% 5%

b) Reverse Splits or Consolidations

Reverse stock splits or consolidations can occur with the result that each shareholderstotal shareholdings in a company are reduced. If a reverse split of one new share for fourold was implemented after shareholder approval, a shareholder owning 100 shares ofstock would own only 25 new shares after the split. The total dollar value of the hold-ings should theoretically not be affected. If the shares were selling at $0.25 before thesplit, the new shares would probably trade near $1.00 per share.

Reverse splits occur most frequently when a companys shares have fallen in value to alevel that is unattractive to investors with large amounts of capital. They are utilizedwhen a company is in danger of being delisted by a stock exchange as the companysshare price has fallen below the exchanges minimum share price rule.

For example, in March 2003, the price of the common shares of Aventura Energy Inc.had fallen to $0.41. This price level was so low that it discouraged purchases by institu-tional investors who had policies of avoiding shares with low prices. The companyresponded by implementing a 1 for 10 reverse split that raised the price to more than$4.00 per share.

A reverse split raises the market price of the new shares and can put the company in abetter position to raise new capital.

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7. Reading Stock Quotations

In the financial press, stocks are listed in alphabetical order. Quotes sometimes appear intwo separate sections: high, low and closing prices for stocks that traded during the dayunder review and bid and ask quotations for stocks that didnt trade.

There are two kinds of stocks traded during the day under review: those that are listedand thus traded on the stock exchanges, and the unlisted stocks that trade on the over-the-counter market.

A typical quotation for stocks traded in Canada during the day under review is shownhere:

52 weeks

High Low Stock Div. High Low Close Change Volume12.55 9.25 BEC .50 10.65 10.25 10.35 +.50 6,000

This type of quotation is complex but very useful and may vary in format among finan-cial newspaper quotation sections. This quotation means that:

BEC common has traded as high as $12.55 per share and as low as $9.25 duringthe last 52 weeks;

BEC common has paid dividends totalling $0.50 per share during the last 52 weeks(sometimes an indicated dividend rate may be shown if the company pays regulardividends and has recently increased a dividend payment). Unlisted stocks tend notto pay dividends, therefore this column is omitted from TSX Venture Exchange andUnlisted tables; and

During the day under review, BEC common shares traded as high as $10.65 and aslow as $10.25. The last trade of the day in this stock was made at $10.35 and theclosing trade price was $0.50 higher than the previous trading days closing tradeprice. A total of 6,000 BEC common shares traded that day.

Some financial publications give additional information about the stock, including theyield, price earnings ratio and the earnings per share.

Market prices used in stock quotations apply to trades in board lot sizes of the stockand exclude commission expense for trades in listed stocks. Financial publications gen-erally provide information on how to read their quotations. To understand a stock quo-tation, note any code or symbol attached to a quotation and read the appropriate expla-nation of the code or symbol.

Quotations for stocks that didnt trade during the day under review might read as fol-lows:

Issue Bid Ask LastXYZ 11.45 12 11.45

This quotation means that the best bid (the highest price a prospective buyer was will-ing to pay) was $11.45 and the best asking price (the lowest price a potential selleroffered to accept) was $12 for each XYZ common share. The most recent trade in XYZcommon shares took place at $11.45. Bear in mind that the bid and ask figures do notrepresent actual trade prices, since no trades took place during the day.

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POST-TEST

C. PREFERRED SHARESShares can have a number of designations including common, ordinary, subordinated,Class A, and preferred. In recent years the name given to shares has become less helpfulin determining the attributes attached to the shares. It is necessary to go beyond thename to determine the true characteristics of a companys shares. The notes to a compa-nys audited financial statements can be useful in this regard.

In this chapter, references to preferred shares apply to all shares not classified as com-mon or restricted shares.

1. The Preferreds Position

Typically the preferred shareholder occupies a position between that of the companyscreditors and that of the common shareholder. Preferred shareholders are usually enti-tled to a fixed dividend payable out of retained earnings, subject to the discretion of theBoard of Directors.

If a companys ability to pay interest and dividends deteriorates because of lower earn-ings, the preferred shareholder is in the middle. The investor is better protected thanthe common shareholders but junior to the claims of the debtholders. It is important tokeep in mind that bond and debenture holders are creditors, while preferred sharehold-ers rank afterwards and are part owners along with common shareholders.

Some companies issue more than one class of preferred stock and when this occurs eachclass is separately identified. (Note that in this example, and the ones that follow, refer-ence is sometimes made to preference shares. These shares generally hold the same mean-ing as preferred shares, but can rank ahead of the different classes of preferred sharesthat a company has outstanding.)

Example: Argus Corporation Limited has four preferred share issues outstanding: a$2.50 Series Class A Preference; a $2.60 Series Class A Preference; a 1962 Series Class BPreference; and a Class C Participating Preference.

If various outstanding preferred share issues rank equally as to asset and dividend enti-tlement, the shares are described as ranking pari passu.

Example: TELUS Communications Inc. has one class of 6% Preference Shares and 8classes of preferred shares outstanding. The 6% Preference Shares have priority as toasset and dividend entitlement ahead of the 8 classes of preferred shares. However, the 8classes of preferred shares rank pari passu as to asset and dividend entitlement after the6% Preference Shares.

2. Preference as to Assets

Preferred shares are usually given a prior claim to assets ahead of the common shares inthe event of winding up or dissolution of a company. Claims of creditors and debthold-ers rank ahead of preferred shareholder claims and the common shareholder has to becontent with anything that is left after all creditor, debtholder and preferred shareholderclaims have been met.

This preference as to assets clause is found in most preferred share issues. Since preferredshareholders usually have no claim on earnings beyond the fixed dividend, it is fair thattheir position is buttressed by a prior claim on assets ahead of the common shares.

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In the event of the winding up or dissolution of the issuing company, preferred share-holders are entitled to funds up to a stated amount after creditors and debtholders havebeen paid in full.

Example: Dofasco Inc.s Class A Preferred Shares Series A are entitled in the event of liq-uidation, dissolution, winding up, etc., if voluntary, to $101; or, if involuntary, to $100;in each case plus accrued and unpaid dividends.

3. Preference as to Dividends

Preferred shares are usually entitled to a fixed dividend expressed either as a percentageof the par or stated value, or as a stated amount of dollars and cents.

Example: TransCanada Pipelines Limiteds 5.6% First Preferred shares pay a fixed annualdividend of $2.80 per share.

Dividends are paid from earnings current or past. However, unlike interest on a debtsecurity, dividends are not obligatory and are payable only if declared by the Board ofDirectors. If the Board omits the payment of a preferred dividend, there is very little thepreferred shareholders can do about it. However, the charters of some companies pro-vide that no dividends are paid to common shareholders until preferred shareholdershave received full payment of dividends to which they are entitled.

While directors have the right to defer the declaration of preferred dividends indefinite-ly, in practice dividends are paid if justified by earnings. Failure to declare an anticipatedpreferred dividend has unfavourable repercussions. Besides weakening investor confi-dence, the general credit and future borrowing power of the company suffer.

Since most preferred shares can be considered fixed income securities, they do not offer,from an investment standpoint, the same potential for capital gain that common sharesprovide. Should interest rates decline, the preferred will increase in price, much like abond; but good corporate earnings will have no effect on the dividend rate or equityallocation. Thus, the dividend rate is of prime importance to the preferred shareholder.

4. Features Of Preferred Shares

a) Introduction

While the description of the rights of a debtholder is found in the trust deed or inden-ture, those of a preferred shareholder are found in the charter of the company. A com-pany wishing to issue preferred shares must apply to make the necessary changes to itscharter, unless the existing charter provides for issuance of preferred shares at the discre-tion of the directors.

After deciding to issue preferred shares, the directors meet with the companys under-writers to determine the type of preferred to issue and the specific features to include.The features described in this section could be built into any of the types of preferredshares just described. Some features strengthen the issuers position, others protect thepurchasers position. The final selection represents a compromise in that the new issuewill offer safeguards to the buyer without unduly restricting the issuer.

b) Cumulative and Non-cumulative

Most Canadian preferred shares have a cumulative dividend feature built into their terms.

Cumulative Feature

With a cumulative feature, if a companys Board of Directors votes not to pay one ormore preferred dividends when due, the unpaid dividends accumulate or pile up inwhat is known as arrears. All arrears of cumulative preferred dividends must be paidbefore common dividends are paid or before the preferred shares are redeemed.

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If a companys financial condition weakens because of a decline in earnings, the direc-tors may reluctantly decide to omit a preferred dividend. This will likely cause a declinein the preferreds market price. If the dividend is cumulative, the shares assume a specu-lative aspect which will become more pronounced if subsequent dividends are passed,causing the dollar amount of the arrears to grow. Later, if the companys earningsimprove or if losses change to profit, some investors may buy the preferred on specula-tion that dividends will resume. If a partial or complete repayment of arrears material-izes, payment is made to the preferred shareholders owning shares at the time of repay-ment. No payments are made to preferred shareholders who previously sold their stock,and no interest is paid on arrears.

Non-cumulative Feature

On non-cumulative preferreds, the shareholder is entitled to payment of a specified divi-dend in any year, only when declared.

When a non-cumulative preferred dividend is passed, arrears do not accrue and the pre-ferred shareholder is not entitled to catch-up payments if dividends resume. For thisreason the dividend position of non-cumulative preferred shares is very weak.

Investors should determine if a cumulative feature is present before purchasing a preferred.

c) Callable and Non-callable

Callable or Redeemable Feature

Issuers of preferred shares frequently reserve the right to call or redeem preferred issuesat a stated time and at a stated price. A call feature is a convenience to the issuer, ratherthan to the purchaser.

As with callable corporate debt, callable preferreds usually provide for payment of asmall premium above the amount of per share asset entitlement fixed by the charter, ascompensation to the investor whose shares are being called in.

The company will typically try to buy shares for cancellation on the open market orthrough invitations for tenders addressed to all holders. The price paid under these cir-cumstances generally must not exceed the par value of the preferred shares plus the pre-mium provided for redemption by call.

Non-callable Feature

Non-callable preferred shares cannot be called or redeemed as long as the issuing com-pany is in existence. This feature is restrictive from the issuers standpoint, in that itfreezes a part of the capital structure for the life of the company. The feature is, there-fore, rarely built into the terms of Canadian preferreds. It is advantageous to the pur-chaser since the investment cannot be redeemed.

d) Voting Privileges

Virtually all preferred shares are non-voting so long as preferred dividends are paid onschedule. However, once a stated number of preferred dividends have been omitted, it iscommon practice to assign voting privileges to the preferred.

Issuing companies may consider a non-voting feature advantageous since it ensures thepreferred shareholders have no say in running the companys affairs so long as dividendrequirements are met.

However, preferred shareholders are usually given a vote on matters affecting the qualityof their security. For example, if the company intended to increase the amount of pre-ferred stock authorized, the preferred shareholders would have to approve the new issue.

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Sometimes, the approval of holders of a stated percentage of the preferred shares out-standing must be obtained before funded debt is created.

e) Purchase Funds and Sinking Funds

Purchase and Sinking Funds

Many redeemable Canadian preferred shares have a purchase fund or a sinking fundbuilt into their terms. These features are similar to those found in bonds and debenturesdiscussed in Chapter 5. A purchase fund is advantageous to preferred shareholdersbecause it means that if the price of the shares declines in the market to or below a stip-ulated price, the fund will make every effort to buy specified amounts of shares forredemption. Consequently, a preferred share issue with a purchase fund has potentialbuilt-in market support through the funds purchasing efforts each year.

Example: Domtars cumulative preferred Series B shares include a purchase fund whichstipulates that beginning in April 1992, the company will make all reasonable efforts toannually purchase 1% of the outstanding shares in that year at a maximum price of $25per share.

As a preferred share purchase or sinking fund operates, the total of outstanding pre-ferred shares of a particular issue gradually decreases. As shares become scarcer, mar-ketability becomes thinner. However, the market price of the preferred will show firm-ness or improvement as the purchase or sinking fund bids for shares up to the stipulatedprice. Over time, as the funds gradually reduce the total number of preferred shares out-standing, the position of the remaining shareholders is strengthened. Annual preferreddividend requirements are reduced, allowing more net earnings for the common shares.

5. Special Protective Provisions

Underwriters encourage companies creating new preferreds to build in specified protec-tive provisions to safeguard the position of the preferred shareholder and make the issuemore saleable. A description of several protective provisions follows:

a) Restrictions on Common Dividends

To protect the preferred shareholders, specific provisions can be created to restrict thecircumstances under which common dividends are paid. A working capital clause isdesigned to ensure that the companys financial position will not be seriously weakenedif dividends are paid on the common shares. For example, the working capital clause ofone company is worded as follows:

No dividends shall at any time be declared or paid or set apart for the common shares or anyshares or any part thereof when the payment of such dividends would reduce the workingcapital of the company as herein defined after such dividend has been paid to an amount lessthan $500,000.

Terms can specify that no dividends will be paid to common shareholders if preferredshare purchase or sinking fund payments are in arrears.

b) Right to Vote in Event of Arrears

Many Canadian preferreds have a protective provision whereby preferred shareholdersare entitled to vote when preferred dividends and/or purchase or sinking fund paymentsare a stated number of payments in arrears.

Since the number of preferred shares outstanding is usually far less than the number ofcommon shares outstanding, any voting privileges given to the preferred shareholdersrarely affect control of the company. To ensure that the preferred shareholders have at

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least one seat on the board of directors, some companies specify the number of directorswho shall be elected by the preferred shareholders as a group.

c) Restrictions on Further Preferred Issues

This clause restricts future issues of preferred shares that are senior or equal to the pre-ferred shares presently outstanding. Issuance of such shares is usually prohibited withoutthe prior approval of the preferred shareholders. However, in most cases, approval neednot be obtained if certain conditions are met. The most common requirement is thatnet earnings over a stated period of time (usually the previous 12 months) must cover(usually at least two times) the annual dividend requirements on the issued and pro-posed-to-be-issued preferreds.

d) Restrictions on Sale of Assets

Sometimes the affirmative vote of two-thirds of the preferred shares outstanding isrequired before a company is allowed to sell, transfer or lease its property, or consolidateor merge with another corporation where securities rank prior to or in parity with theexisting companys preferred shares.

e) Restrictions on Change of Terms

The provisions and terms included in preferred share covenants are typically written in away that makes it very difficult for a company to change them. Usually clear preferredshareholder approval is required before a proposed change is implemented.

6. Why Do Companies Issue Preferred Shares?

In comparison with debt, preferred shares are usually more expensive for a companybecause dividends paid are not a tax-deductible expense. However, when all considera-tions are weighed, there may be sufficient advantages to justify a new preferred shareissue.

a) Preferred Issue or Debt Issue?

From a companys viewpoint, preferreds do not create the demands that a debt issue cre-ates. Preferreds do not usually have a maturity date, which may come at a financiallyawkward time, although some may have a purchase fund. If a preferred dividend pay-ment is omitted, no assets are seized by preferred shareholders.

Because of the stringent legalities involved, a company will go to great lengths to avoidmissing an interest or principal payment. However, the company has flexibility in decid-ing whether or not to declare a preferred dividend. Dividends are never omitted withoutgood reason. But to preserve working capital in an emergency, a companys directorsmay decide to omit a preferred dividend without jeopardizing the companys solvency.

A corporation will choose to issue preferreds rather than debt if:

It is not feasible for it to market a new debt issue. Existing assets may already beheavily mortgaged;

Market conditions are temporarily unreceptive to new debt issues;

The company has enough short and long-term debt outstanding, i.e., its debt/equi-ty ratio is high. Preferreds will increase the equity component;

The directors are reluctant to assume the legal obligations to pay interest and prin-cipal; or

The directors decide that paying preferred dividends will not be onerously expen-sive. The company has a low apparent tax rate, which means it is less of a burden topay dividends from after-tax profits.

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b) Preferred Shares vs. Common Shares

When a company has decided it will not or cannot issue bonds or debentures, it mayfind conditions are not favourable for selling common shares. The stock market may befalling or inactive, or business prospects may be uncertain. However, in such circum-stances preferred shares might be marketed as a compromise acceptable to both the issu-ing company and investors. Preferreds also offer the advantage of avoiding the dilutionof equity that results from a new issue of common shares.

7. Who Buys Preferred Shares?

Preferred shares are bought largely by income-oriented investors. Today, conservativeindividual investors, seeking income, purchase preferred shares to take advantage of thepreviously mentioned dividend tax credit. Institutional investors are attracted to thepreferential tax treatment of preferreds as well. If the institutional investor is not con-cerned with taxes, such as a pension fund, they will typically invest in bonds.

Canadian companies also purchase preferred shares as an income investment. Dividendspaid by one resident taxable Canadian company to a similar company are not taxable inthe hands of the receiving company. This is not the case with debt interest. WhenCanadian Company One purchases a debt issue of Canadian Company Two, the inter-est received by Company One is fully taxable in Company Ones hands.

D. TYPES OF PREFERREDS1. Fixed Rate (or Straight) Preferreds

These are preferred shares with normal preferences as to asset and dividend entitlementahead of the common shares. Straight preferreds may have any or all of the featuresdescribed previously. Since straight preferreds pay a fixed dividend rate, the shares tradein the market on a yield basis. As with the market price of bonds and debentures, ifinterest rates rise, the market price of straight preferreds will fall, and if interest ratesdecline the market price of straight preferreds will rise.

From the standpoint of the purchaser, straight preferred shares provide:

Greater safety than common shares through preference to dividend and asset enti-tlements;

A tax advantage to individuals through the dividend tax credit and to public corpo-rations which receive preferred dividends from taxable Canadian companies on atax-exempt basis;

Less safety than a debt investment since dividends are not a legal obligation;

A fixed dividend rate which will not be increased;

No voting privileges (unless a stated number of dividend payments are in arrears);

No maturity date, unlike a debt investment;

Poorer marketability than common shares because there are usually fewer preferredshares than common outstanding; and

Limited appreciation potential compared to common shares. The price at which thepreferred could be redeemed by the issuer will limit any appreciation that mightoccur as a result of a decline in interest rates.

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2. Convertible Preferreds

a) General Description

Convertible preferreds are similar to convertible bonds and debentures because theyenable the holder to convert the preferred into some other class of shares (usually com-mon) at a predetermined price(s) and for a stated period of time. More recently, pre-ferred shares have been issued where both the holder and the issuer have conversionprivileges.

Conversion terms are set when the preferred is created and normally specify the numberof common shares into which each preferred is convertible. The preferred price is set ata modest premium (perhaps 10% 15%) above its converted value. The purpose of thepremium is to discourage an early conversion, which would defeat the purpose of theconvertible offering. Virtually all conversion privileges expire after a stated period oftime, usually five to 12 years from the date of issue.

Example: Power Financial Corporation, 4.70% Non-Cumulative Preferred Shares, SeriesJ are convertible by the holder on a minimum of 65 days notice beginning July 31, 2013and on the last day of January, April, July and October of each year into commonshares. The conversion rate is determined by dividing $25, plus declared and unpaiddividends to the date of conversion, by the greater of (i) $3 and (ii) 95% of the weight-ed average trading price of the common shares on the TSX for the 20 trading days end-ing on the last trading day occurring on or before the fourth day immediately prior tothe date of conversion. These shares are also convertible by the company beginningApril 30, 2009 under various terms.

Usually the convertible preferred will sell at a premium above the price it might beexpected to sell at, based on the conversion terms. This premium can be expressed as adollar amount or as a percentage. Expressing the premium as a percentage makes com-parisons between preferreds easier. The premium on the preferred shares is usually offsetby their higher yield compared to the underlying common shares. Over a period ofyears, the preferreds higher yield will pay back to the investor the premium requiredto purchase it.

Table 6.1 illustrates a hypothetical example of a convertible preferred share. As the priceof the common shares approaches the preferreds current conversion price the marketprice of the convertible preferred will rise accordingly. When the price of the commonshares rises above the conversion price, the preferred is selling off the common stockand the market action of the preferred will reflect the market action of the common.

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TABLE 6.1

Example of Conversion Cost Premium and PaybackPreferred Market Price Pre-tax Yield Conversion Cost Years to RepayIssue Preferred Common Preferred Common Difference Premium Premium

ABC Corp.Cumulative Redeemable Convertible $62.50 $18.50 3.2% 1.5% +1.70 12.61% 7.42 yearsClass A Preferred, Series 2 (Div. $0.2775)(Each Series 2 preferred is convertible into 3 common shares at any time.)

Sample calculation (excluding commission) of a conversion cost premium using ABC Corp.

1. To buy one ABC Corp. Series 2 preferred share that could be converted into 3 common shares costs $62.50

2. To buy 3 common shares would cost $55.50 (3 x $18.50)

3. Therefore, the conversion cost dollar premium is $62.50 $55.50 = $7.00.As a percent of the common share price, the premium is:

4. Years to pay back premium from the convertibles higher dividend stream:

b) Selecting Convertible Preferreds

Generally speaking, investors look for convertible preferreds with low premiums andshort payback periods. However, it is necessary to go beyond the simple numbers incomparing these preferreds. A low premium may signal that the prospects for the under-lying common are poor. In that case, the conversion feature of the preferred would noteven be worth its low premium. A high premium is a result of popularity with investors,who have bid up the preferreds price. Is their optimism justified? If the common sharesdo well, the preferred will turn out to be a good investment despite its premium.

Most convertible preferreds are redeemable, which gives the issuer the power to force aconversion into the underlying shares when the market price of the preferred rises abovethe redemption price. To force a conversion, management announces the redemption ofthe preferred at the call price as at a certain date. Convertible preferred shareholdersconvert their shares into common to avoid having them redeemed for less than theircurrent value. A forced conversion is implemented only if management decides there isan advantage to retiring the preferred by issuing new common shares.

Once a convertible preferred is exercised it is not possible to convert back. No commis-sion is charged on conversion and no capital gain or capital loss is incurred until thesubsequent sale(s) of shares received from the conversion.

If the underlying common shares are split, the conversion terms are adjusted automati-cally on the basis of the larger number of new underlying shares.

Convertible preferreds are issued either in markets where a straight preferred is difficultto sell or in a situation where a high level of dividend coverage is lacking. Because of theadded benefit of a conversion feature, the dividend on a convertible is often less thanthat of a comparable straight preferred.

% .. .

. premiumconvertible yield common yield

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3 20 1 5012 6611 70

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. %7 0055 50

100 12 61 =

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c) Implications for Investors

From the standpoint of the purchaser, convertible preferred shares:

Provide a two-way security. The holder is in a more secure position than the com-mon shareholder and yet can realize a capital gain if the market price of the com-mon rises sufficiently;

Usually provide a higher yield than the underlying common shares;

Provide the right to obtain common shares through conversion without paying acommission;

Usually provide a lower yield than a comparable straight preferred;

Are vulnerable to a decline in price if selling off the common and the price of thecommon declines;

Sometimes convert into less (or more) than a board lot of common shares which inturn may be a little more difficult to sell than a board lot; and

Revert to a straight preferred when the conversion period expires if conversion hasnot taken place.

3. Retractable Preferreds


While most preferred shares are redeemable, there is no assurance that redemption willoccur because the call privilege rests with the company. A retractable preferred share-holder, on the other hand, can force the company to buy back the retractable preferredon a specified date(s) and at a specified price(s). Some are issued with two or moreretraction dates. The principle of retraction or pulling back is identical to that describedin Chapter 5 for retractable bonds and debentures. The holder of a retractable preferredcan create a maturity date for the preferred by exercising the retraction privilege andtendering the shares to the issuer for redemption. The term soft retractable preferredrefers to those retractables where the redemption value may be paid in cash or in com-mon shares, generally at the election of the issuer.

Example: Brascan Corp., Series 5, floating rate Preference Shares are retractable on thefirst of each March, June, September, and December at $25 per share.

b) Implications for Investors

From the standpoint of the purchaser, retractable preferred shares:

Provide a predetermined date(s) and price(s) to tender shares for retraction. Theshorter the time interval to the retraction date, the less vulnerable is the stocks mar-ket price to increases in interest rates. Whereas a straight preferred will decline inprice if interest rates rise, a retractable preferred will not fall significantly below itsretraction price as the retraction date approaches;

Provide a capital gain if purchased at a discount from the retraction price and sub-sequently tendered at the retraction price;

Will sell above the retraction price and at least as high as the call price if interestrates decline sufficiently;

Do not retract automatically. The retraction privilege will expire, if no action istaken by the holder during the election period(s); and

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Become straight preferred shares if not retracted when the election period(s) expires.If this occurs in a period of high or rising interest rates, the stocks market value willdecline. The shares will sell on a straight yield basis after the retraction privilegeexpires.

c) How to Calculate Annual Pre-Tax Yield for A Retractable Preferred

If a preferred can be purchased below its retraction price, a capital gain will occur if thepreferred is later retracted. Alternatively, if a preferred is purchased above its retractionprice, a capital loss will occur if the preferred is later retracted (which is a less likely situ-ation). The pre-tax yield should factor in this gain or loss, much as a bond yield calcula-tion factors in the difference between a bonds purchase price and its redemption ormaturity value. The approximate yield to maturity calculation given for bonds inChapter 5 can therefore be used here. The after-tax yield will vary, depending on the taxrates of the province.

Example: Suppose a 7% $100 p.v. retractable preferred is purchased at $98.75 and isretractable at the holders option at $100 in 4 years and 2 months time.

Numerator: annual dividend income ($7.00) + [annualized capital gain (100 98.75) 4.17]

Denominator: (98.75 + 100) 2

4. Variable or Floating Rate Preferreds


Identical in concept to variable or floating rate debentures, variable rate preferreds paydividends in amounts that fluctuate to reflect changes in interest rates. If interest ratesrise, so will dividend payments and vice versa.

Example: The Thompson Corp. Variable Rate Cumulative Redeemable, Series II areentitled to cumulative preferential cash dividends. The annual dividend rate is 70% ofthe prime rate. The dividend rate is set on the last business day of the preceding month.

Variable rate preferreds are issued:

During periods in the market when a straight preferred is hard to sell and the issuerhas rejected making the issue convertible (because of potential dilution of equity) orretractable (because holders could force redemption on a specified date);

When the issuer believes interest rates will not go much higher than they are at thedate of issuance of the new issue. The company, in any event, is prepared to pay ahigher dividend if interest rates rise. Of course, if interest rates decline, the issuerwill pay a smaller dividend (subject in most cases to a guaranteed minimum rate);and

When the issuer may be trying to match the nature of the firms assets.

Some preferred shares may have delayed variable rate features. Known as delayedfloaters, fixed-reset or fixed floaters, these shares entitle the holder to a fixed dividendfor a predetermined period of time after which the dividend becomes variable.

Example: Extendicare Inc., Floating Rate Cumulative, Redeemable Class 1 Preference,Series 2. The issue pays 71% of the prime rate.

7 3099 375

100 7 35..

. % =

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b) Implications for Investors

From the standpoint of the purchaser, variable rate preferreds provide:

Higher income if interest rates rise, but lower income if interest rates fall;

A variable amount of annual income that is difficult to predict accurately but whichwill reflect prevailing interest rate levels; and

An investment with a market price less responsive to changes in interest rates com-pared to the market prices of straight preferred shares. The dividend payout of avariable rate preferred is tied to changes in interest rates on a predetermined basis.Accordingly the preferreds market price is less sensitive to changes in interest rates.

5. Foreign-pay Preferreds

Most Canadian preferreds pay dividends in Canadian funds. However, it is possible fora company to create and issue preferreds with dividends and certain other featurespayable in or related to foreign funds. These are known as foreign-pay preferreds.

Example: Bank of Montreal 5.95% Non-cumulative Class B Preferred, Series 10 sharespay an annual dividend of US$1.4875.

The key factor to selecting a foreign-pay preferred is the desirability of receiving divi-dends in a currency other than Canadian funds. There is additional risk in the form offoreign currency risk. If the foreign currency increases in value compared to theCanadian dollar, your dividend will increase. If, however, the Canadian dollar increasesin value compared to the foreign currency, your dividend will decrease in value whenyou convert it to Canadian funds.

One of the advantages of this type of preferred share is that, although the dividend isreceived in a foreign currency, because it is paid by a Canadian company, the dividend iseligible for the dividend tax credit.

Typically, it is the sophisticated investors, wishing to diversify the currencies received intheir portfolios, who are the logical buyers of foreign-pay preferreds. Another type ofinvestor who may benefit a foreign-pay preferred is the person who maintains a resi-dence in another country and wants to receive a cash flow in the currency of that coun-try (for example, a Canadian who spends part of the year in Florida).

6. Canadian Originated Preferred Securities (COPrS)

Canadian Originated Preferred Securities (COPrS) were introduced to the Canadianmarket in March 1999 (they are a trademark of Merrill Lynch). COPrS are long-termjunior subordinated debt instruments issued by Canadian corporations. These hybridsecurities offer features that resemble both long-term corporate bonds (debt), and pre-ferred shares (equity). Similar to debt instruments, COPrS quarterly distributions aretreated as regular interest income for taxation purposes. Similar to preferred shares,COPrS trade cum dividend (an ex-date is declared) in that accrued interest is notadded to the market price. COPrS rank ahead of common and preferred shares and jun-ior to senior and other subordinated debt of the corporation. COPrS trade on listedstock exchanges and trade like preferred shares.

On most issues, the COPrS issuer has the right to defer payment for up to 20 consecu-tive quarterly periods. Deferred interest will accrue, but not compound. Most issues areredeemable by the issuer at a redemption price equal to 100% of the principal amountof the securities to be redeemed plus accrued and unpaid interest. Yields tend to bemuch higher on COPrS than on comparable fixed income instruments.

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Because payments from COPrS are treated as interest income, for tax purposes, the pay-ments do not receive the preferential dividend tax treatment. This makes them particu-larly suitable for inclusion in non-taxable accounts, such as an RRSP.

Example: Shaw Communications Inc. 8.875% COPrS, due September 28, 2049redeemable on and after October 17, 2005 on minimum 30 and maximum 60 daysnotice at $25 per share. The company has the right to defer, at any time and from timeto time, subject to certain conditions payments of interest on the securities by extendingthe interest payment period on the securities for a period of up to 20 consecutive quar-terly periods.

7. Other Types of Preferreds

New products are constantly being introduced to the marketplace. Many of these newproducts are custom made for the issuer or the buyer (usually institutional). There areother types of preferreds that are not as common as those mentioned above but dotrade, such as participating preferreds, or deferred preferreds. The investor and the advi-sor must always investigate the security, in order to confirm the features of that particu-lar issue.

Many preferreds may have special designations in their description, such as Class A orClass B, Series I or Series II. These designations could mean only that the two pre-ferreds were issued at different times, but in all other respects, the issues are identical.The term Class A shares may be used to identify a special class of preferred share withdifferent characteristics from other outstanding preferred shares from the same issuer,such as:

Voting rights;

Example: Dofasco Inc.s Class A preferred shares are non-voting but rank ahead of allother outstanding classes of non-voting preferred shares as to asset and dividend entitle-ment.

To distinguish shares which may receive a cash dividend from Class B shares whichmay receive a stock dividend; and

To identify restricted shares.

a) Participating Preferreds

Participating preferred shares have certain rights to a share in the earnings of the com-pany over and above their specified dividend rate.

Example: Argus Corporation Limited Class C Participating Preferred Shares participateequally with the common shares in any dividends paid in any fiscal year, after $0.30 pershare has been paid on each preferred and common share. The shareholder can also par-ticipate in any distribution of assets.

b) Preferred Issues with Warrants

The addition of a bonus or sweetener of common share warrants, as part of a new pre-ferred issue, is another method of improving the issues saleability. The two securitiestogether are called a unit. In some cases, the warrants are readily detachable, enablingthe preferred shareholder to sell part or all of the warrants and retain the preferredshares. A variation is to defer issuing the warrants to preferred shareholders until a speci-fied date in the future. This in turn encourages retention of the shares.

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c) Auction Preferreds

Auction preferreds offer a dividend rate determined by an auction between the holderand the issuer. The rate may be based on the number of orders to hold, sell or buy andtypically offer a reset minimum and maximum dividend rate.

d) Deferred Preferreds

Deferred preferred shares pay no dividend until a future preset maturity date. On thematurity date, the holder is paid a cumulative amount equal to the dividends thatwould have been received had the investor purchased a preferred share that paid a regu-lar annual dividend. If held to redemption, the accrued dividends are fully taxable asinterest income. If sold prior to redemption, the income is treated as a capital gain (orloss). This feature allows investors to defer taxes paid on income earned until a laterdate. These preferreds are attractive to investors who do not have an immediate need forregular income. The shares are also attractive for investors who want to receive com-pounded growth in a registered account, such as an RRSP, as taxes are deferred to a laterperiod.

e) Split Shares

Split shares (also known as structured preferreds or equity dividend shares) are com-mon shares that have been structured to create two classes of securities which are splitinto an equity component (preferred shares) and a capital component (capital shares).The preferred shareholders receive only the dividends from the underlying commonshares, while the capital shareholders have the potential to generate capital gains fromthe underlying common shares.

The equity dividend shares trade like bonds and preferreds, based on yields, but theycan benefit from increases in dividends paid on the underlying common stock. Thematurity values of these shares are dependent upon the value of the underlying commonshares. It is possible, therefore, to lose a portion of ones principal at maturity if thecommon shares decline substantially in price. Most structured preferreds areredeemable. If the shares are redeemed early, the investor will lose the stream of divi-dend income.

Example: TD Split Shares. The preferred shareholders receive quarterly dividend pay-ments that are funded from the dividends received on Toronto-Dominion Bank com-mon shares and, if necessary, with proceeds from the sale of TD Bank shares. The capi-tal shares provide holders with a leveraged investment, whereby the value of the invest-ment is linked to changes in the market price of the Toronto-Dominion Bank commonshares. Both the preferred and capital shares are listed and publicly trade on the TSX.

E. CASH AND MARGIN ACCOUNTS1. Cash Accounts

A securities transaction through a member firm must be made in either a cash accountor a margin account.

Cash Accounts: Clients with regular cash accounts are expected to make full paymentfor purchases or full delivery for sales on or before the settlement date which is pre-scribed by industry rules and specified in the contract. The normal settlement dateis prescribed as the following business days after the transaction date:

Government of Canada Treasury bills Same day as the transaction takes place;

Most debt securities maturing up to 3 years (see Table 5.10 in Chapter 5 forexceptions) Two business days after; and

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POST-TEST

PRE-TEST

All other securities Three business days after.

Margin Accounts: In contrast, margin accounts are for clients who wish to buyand/or sell securities on credit and initially pay only part of the full price of thetransaction. In such cases, the member firm lends the remainder of the transactionprice to the client, charging interest on the loan.

It is important to recognize the difference between cash accounts and margin accounts.When a client opens a cash account, the member does not grant credit and the explicitunderstanding is that the client will settle on the settlement date. On the other hand,when a client opens a margin account, it is on the explicit understanding that the mem-ber is granting credit based on the market value and quality of the securities held longand/or short in the account. A long position represents actual ownership in a security.For example, an investor who is long 100 shares of Bell Canada owns 100 shares of BellCanadas stock. In contrast, a short position is created when an investor sells a securitythat he or she does not own.

a) Cash Account Rules Summary

In most cases, a firms computerized accounting system will flag settlement dates forclients transactions. The computer will also keep track of the dates when accountsbecome overdue and the amounts of capital that must be maintained by the member tocarry these overdue accounts. At a certain point, the account will become restricted andtrading activity will no longer be permitted until the account is settled.

Members may adopt more stringent rules to minimize the amount of capital being un-profitably tied up in carrying delinquent cash accounts. IAs must know industry andtheir own firms requirements as well as acceptable methods of settling both normal cashaccount transactions and those where restrictions have later been imposed.

b) Free Credit Balances

Free credit balances are uninvested funds held in client accounts that the member firmmay use as a financing source for its business. These funds are, however, payable ondemand to their clients. The exchanges and the IDA require that every statement ofaccount given or sent to a customer by a member contain the following written notice:

Any free credit balances represent funds payable on demand which, although properly record-ed in our books, are not segregated and may be used in the conduct of our business.

2. Margin Accounts

The word margin refers to the amount of funds the investor must personally provide.The margin plus the amount provided by the member firm together make up the totalamount required to complete the transaction. There are two different types of marginpositions:

A long margin position allows the investor to partially finance the purchase of secu-rities by borrowing money from the dealer.

A short margin position allows the investor to sell securities short by arranging forthe dealer to borrow securities to cover the short position.

Not every investment firm allows margin accounts, and those that do are required toobtain an authorized Margin Account Agreement Form from a potential margin clientbefore business is transacted.

Interest on the margin loan is calculated daily on the debit balance in the account andcharged monthly. Member firms usually charge margin clients interest based on therates members are charged on loans made to them by the chartered banks.

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a) Long Margin Accounts

The amount of credit which a member may extend to customers on the purchase ofsecurities (both listed and unlisted) is strictly regulated and enforced. Examiners con-duct spot checks in addition to regular field examinations to ensure that members keepclients accounts properly margined.

Table 6.2 shows the maximum loan values which IDA member firms may extend forlong positions in equity securities listed on any recognized exchange in Canada or theU.S., the Tokyo Stock Exchange (First Section) or the London Stock Exchange.

TABLE 6.2

Maximum Loan Values

On listed equities selling: Maximum Loan Values

Securities Eligible for Reduced Margin 70% of market value

at $2.00 and over 50% of market value

at $1.75 to $1.99 40% of market value

at $1.50 to $1.74 20% of market value

under $1.50 No loan value

Securities that meet specific price risk and liquidity risk measures at each calendar quar-ter-end will be eligible for reduced margin. Each quarter, the IDA will publish a List ofSecurities Eligible for Reduced Margin.

The maximum loan values of 40% and 20% on listed securities selling between $1.99and $1.50 (which means the client is required to put up margin of at least 60% and80% respectively, and more if the price has dropped since the initial transaction) aredesigned to reduce the scale of additional margin calls in a falling market.

Clients with margin accounts should avoid the practice of margining close to prevailingprice limits (i.e., keeping a minimum amount of margin on deposit in the account).Where additional funds or securities with excess loan value are on deposit, a cushion ofprotection is provided against the inconvenience of having to respond to a margin callafter a minor adverse price fluctuation. It also reduces the possibility that the dealer willbe forced to sell out (or buy in) the margin account in the event of a drastically adverseprice fluctuation.

The exchanges prohibit one member from accepting transfers from another member ofany under-margined account, unless that member holds sufficient funds or collateral tothe credit of the account to margin it when it is taken over.

b) Margining Long Positions in Listed Equities

When a long position is established on margin, sufficient funds (or securities with excessloan value) must be in the account to cover the purchase. The member firm lends someof these funds to the client, with the client being responsible for the balance. Thus,margin is the amount put up by the client (not the amount borrowed or loaned), andthe minimum margin required equals the initial cost of the transaction minus the mem-bers loan. The following are some examples of margin transactions; in all cases, com-missions are excluded from the calculations.

Equities


Example of a Margin Transaction in a Listed Equity(which is not eligible for reduced margin)

Assume a client buys 1,000 shares of listed ABC Company on margin when it sells for $1.95 per share:

Total cost to buy ABC shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,950 (A)

Less: Member's maximum loan(40% of $1.95 x 1,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 780

Equals: Margin (which is put up by the client) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,170 (B)

(i) Example of a Margin CallAssume the price of ABCs shares declines to $1.60

Original cost of ABC shares (A above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,950

Less: Member's revised maximum loan(20% of $1.60 x 1,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 320

Equals: Gross margin requirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,630

Less: Clients original margin deposit (B above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,170

Equals: Net margin deficiency(for which a margin call is issued to the client) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 460

(ii) Example of Excess Margin in AccountAssume this time the price of ABCs shares instead of declining from $1.95 to $1.60 had increased from $1.95 to $2.25

Original cost of ABC shares (A above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,950

Less: Member's revised maximum loan(50% of $2.25 x 1,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,125

Equals: Gross margin requirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 825

Less: Clients original margin deposit (B above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,170

Equals: Excess margin in account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 345

The $345 can be used as margin toward the purchase of another security, or withdrawnfrom the account. It is not, however, an idle amount of cash that can be removed with-out consequence. The client is still borrowing money from the member firm, on whichinterest will be charged. If the excess margin is left in the account, the amount bor-rowed would still be (1,950 $1,170) the $780 lent initially by the dealer. What haschanged is the amount of money the dealer is willing to lend: because the collateralvalue of the shares has increased, the member will now lend $1,125 instead of $780. Bywithdrawing the $345 margin surplus, the client will be borrowing (and paying intereston) this larger amount.

F. SHORT SELLING OF EQUITIES 1. What is Short Selling?

Short selling is defined as the sale of securities that the seller does not own.

Profits are made whenever the initial sale price exceeds the subsequent purchase cost.With long positions, an investor purchases a security and then holds it in the hope ofselling it later at a higher price. With short selling, the order of the transactions isreversed. The investor sells the security first, and then waits in the hope of buying itback later at a lower price. Since the seller does not own the securities sold, the seller ineffect creates a deficit or short position where he or she owes securities, and the subse-quent purchase covers or repays this deficit.

Short selling is generally carried out in the belief that the price of a stock is going to fall.

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The short seller feels bearish towards a particular security and sells it short, hoping tobuy it back later at a lower price. If the sale is made at a higher price than the subse-quent purchase, the investor has made a profit.

However, short selling is not done only by speculators in anticipation of a price drop. Itis also done by arbitrageurs and hedgers, as well as by strategists using combinations ofsecurities positions such as convertibles and various derivatives products, such as putand call options, together with short positions.

2. How is Short Selling Done?

A client wishing to short a security would first contact his or her IA and declare theintention to sell short. The IAs firm would then lend the securities to be shorted to theclient, and the client would sell them into the market in the same manner as a longposition would be sold. The proceeds of the short sale are then deposited in the clientsaccount, and the client is required to deposit enough margin into the account, in addi-tion to the sale proceeds, to bring the account balance up to the required minimum.

As an example, if an investor sells a stock short at $10.00 per share, the investor wouldhave to put up margin of $5.00 per share. Since the investor is putting up less moneythan the full value of the securities being sold, the element of leverage exists for all shortsales. In fact, short selling is the mirror image of purchasing shares on margin.Therefore, short selling can be somewhat more risky than purchasing an outright longposition, and such basic precautions as stop buy orders (see Part H) should be consid-ered.

After the short position is established, the investor then waits for an opportune momentto cover the sale with a purchase at a lower price. Of course, since the price could alsorise and lead to losses, regular monitoring of the position is advisable. A client maydecide to enter a stop buy order to reduce the risk of loss.

When the short seller finally purchases the stock originally sold short, the stock isreturned to the lender. Alternatively, the ultimate lender of the shorted security may askthat the security be returned. If no other lender can be found, the seller will be forcedto buy back the security at whatever the current price is, regardless of whether thei

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