Preferred stocks pay shareholders dividends before common stockholders receive their returns. Unlike interest on a security, dividends do not fluctuate. Investors who buy preferred shares typically want income but do not seek to profit from the long-term success of the issuing company. According to FINRA, preferred stock presents less risk than common stock but has a lesser chance of earning significant returns over time.
What is Preferred Stock?
Preferred stocks are stocks that function more like bonds. You may also see preferred stocks referred to as “preferred equity” or “preferreds.”
Callable Preferred Stocks
Preferred stocks are typically long-term and do not come with maturity dates. They may, however, be callable after a set number of years, usually five or ten. An issuer may “call” a preferred stock -i.e., cancel the investment and return the par value to the investors – in the event they no longer wish to pay dividends.
Investors should know that issuers are more likely to recall secured securities when interest rates rise, at which point investors will have to start over if they want to find a replacement fixed-income investment.
Brokerage Firm Allegedly Failed to Disclose Callable Nature of Preferred Stocks
In 2023, FINRA fined TD Ameritrade for its self-reported lack of disclosure regarding preferred stocks. According to the Acceptance, Waiver, and Consent (AWC) agreement – the agreement that allows firms to settle with FINRA without denying or admitting the regulator’s findings – TD Ameritrade allegedly did not disclose that certain preferred securities were callable. Investors need to know that they are callable because this reduces the investor’s yield.
As part of the terms of the AWC, TD Ameritrade consented to a $500,000 fine.
What is Preferred Equity?
“Preferred equity” is another way of referring to preferred stocks. “Equity” refers to a company’s stocks’ value.
How Does Preferred Equity Work?
Like bonds, preferred stocks have a face value, also known as a “par value.” The dividends are calculated as a percentage of the par value. Preferred shares may come with a dividend that continues indefinitely. The fixed dividend does not increase as the stock’s value increases. On the plus side, the value of preferred shares does not decline with the price of the common stock shares.
- Depending on the issuer, investors may be able to convert preferred shares to common shares. Investors should be sure to know if they have this option because preferred stocks often do not have maturity dates.
- Dividends on preferred stocks are typically taxed at a lower rate than income – another feature that might make them attractive to investors.
Preferred Stocks Basics
Investors should know the following before they decide to invest in preferred stocks:
- Shares of preferred stocks can be bought and sold on the public exchange.
- Preferred stocks usually pay reliable dividends of 6% to 7%, which are desirable rates compared to other fixed-income investments.
- To calculate the dividend payout, companies refer to the par value of the preferred stock. The par value does not fluctuate, unlike the value of stocks. The par value for preferred securities is typically $25 per share.
- If a preferred stock issuer liquidates, preferred stockholders get paid before common stockholders. (Investors should note, however, that bondholders and other debt security holders will get paid before preferred stockholders.)
- These securities offer investors the opportunity to own equity in a company but unlike common stock owners, preferred shareholders typically do not have the right to vote on company matters.
Are Preferred Stocks Better Than Common Stocks?
Preferred stocks do not necessarily offer better returns than common stocks. The Wall Street Journal reported in 2020 that preferred stocks have underperformed the returns offered by the S&P 500 and U.S. long-term bonds. Nevertheless, investors who are more interested in regular income may be tempted by the dividends.
Can I Recover from Preferred Stock Losses?
Even if you did not lose money on a preferred stock, it still may not be the right product for you. Certain investments come with an opportunity cost—money you lose by not investing your money in a security with better returns. Brokers should only recommend investments that fit your financial goals. If you want to make more money in the long run, preferred stock is probably not the best choice, and your brokerage firm could be liable for your losses if your broker misrepresented preferred shares.
Debt Security Vs Equity Security
Equity securities are securities like stocks that allow investors to profit from a company’s earnings. Debt securities are investments in debt instruments. A common example of a debt security is a bond.
There are two types of preferred securities: Preferred debt securities and equity preferred stocks.
- Debt securities are also known as “baby bonds.” Debt securities receive their dividends before preferred equity securities. These may be referred to as “preferred bonds,” although this is not the most accurate term.
- Preferred equity securities are traditional preferred stocks. These receive their payments after preferred debt security holders but before common stockholders.
Is Preferred Stock Debt or Equity?
Preferred stock is a type of equity, just like common stock. Its only similarity to debt security is its regular payments. Investors should know that while preferred stocks receive payment before common stockholders, companies pay their debt securities before they pay preferred stockholders.
Different Types of Preferred Stocks
Preferred stocks can come with a variety of features. Brokers should thoroughly explain all the options before investors sign the dotted line.
Convertible
Investors may choose convertible preferred stock in order to take advantage of both a fixed-income security and capital appreciation. These types of securities are convertible after a certain date or after a fixed period of time.
Contingent Convertible
If an issuer does not meet specific capital requirements, these preferred stocks convert into equity or are “written down,” meaning that their value is reduced.
Floating Rate
For floating rate preferreds, the dividend is reset at specific intervals. These types of preferred stocks are usually callable after 5 to 10 years.
Fixed-to-Floating Rate
If not called by the issuer, fixed-to-floating rate preferred securities become floating rate securities after 5 to 10 years. Their interest rates change depending on a predetermined benchmark.
Cumulative Preferred Stock
These stocks come with a guarantee that if there are any missed payments, cumulative preferred stockholders will receive their missed payments before other preferred stockholders.
Noncumulative Preferred Stock
Noncumulative preferred shares come with somewhat more risk than cumulative preferred stock.
Participating Preferred Stock
In the event of liquidation, participating preferred stockholders receive their initial investment as well as part of the payout that common stockholders also receive.
Perpetual Preferred Stock
Many preferred stocks are perpetual preferred stocks, meaning that they do not mature. They will pay dividends indefinitely but will not appreciate over time like a common stock.
Preferred Stock Voting Rights
Investors who purchase preferred stock usually settle for a hands-off relationship with the issuing company. Shareholders in common stock can get more involved in the company’s management. Voting rights allow common stock investors to vote on company issues, like whether the company should acquire another business.
Risks of Preferred Shares of Stock
Preferred shares are actually “callable,” which means that the issuer can redeem them after a predetermined period. It may be in the issuer’s best interest to call back the shares in order to stop paying dividends.
Interest Rates
When interest rates rise, investors might regret missing out on the stronger returns offered by common stock. Rising interest rates make the value of the preferred shares decline. Calls are less likely when interest rates rise.
Issuers may want to call the preferred shares if interest rates have declined, making it possible for companies to issue preferred shares at lower interest rates.
Creditworthiness of Issuer
The issuers’ creditworthiness may affect the preferred shares’ value. Be aware that higher yields are generally offered by riskier issuers.
Preferred stock does not always come with a maturity date. If an investor wants to get their principal back, they will have to try to sell their shares on a secondary market.
Suspended Dividends
In April 2023, First Republic Bank suspended dividends on its preferred stock after the bank’s shares fell nearly 90% over the course of about a month following the failure of Silicon Valley Bank. Like Silicon Valley Bank, First Republic Bank had uninsured deposits that put it at risk for collapse. Because the preferred shares were non-cumulative, the bank had no obligation to catch up on payments if it had resumed payments.
When is Preferred Stock a Risky Investment?
Preferred stocks are not all created equally. Brokerage firms should carefully research the issuing company and the specific terms of a preferred stock.
The following are examples of brokerage firms and brokers who have faced regulatory action following allegations that they recommended preferred stocks that were not in their investors’ best interests.
RBC Capital Markets Allegations
On April 14, 2023, RBC Capital Markets entered into an Acceptance, Waiver, and Consent agreement (AWC) in which the firm consented to the findings that they failed to supervise recommendations involving preferred stocks. FINRA Rule 3110 requires brokerage firms to supervise brokers when they make recommendations to ensure they adhere to securities rules and regulations.
According to the AWC, RBC Capital Markets recommended short-term trading involving preferred stocks. Preferred stocks are designed for long-term investments and impose up-front sales charges. FINRA alleges that brokers made these recommendations in order to secure higher commissions for themselves.
As part of the terms of the AWC, RBC Capital Markets consented to a $300,000 fine.
Alleged Failure to Disclose Compensation Related to Preferred Securities
Preferred securities can come with compensation for the brokerage firm. The Exchange Act (and now Regulation Best Interest) requires firms to disclose this information. According to an Acceptance, Waiver, and Consent agreement dated June 25, 2020, a firm called Moors & Cabot failed to disclose $7.5 million in compensation it received for 11,500 preferred securities trades in customers’ accounts.
Preferred Stock Investments in Allegedly Risky Companies
FINRA fined a broker after she recommended preferred shares of a distressed energy company that specifically stated in their prospectus that any money raised from preferred stocks would go toward paying off debt. In fact, a credit rating company had rated this investment as speculative. This high-risk investment did not suit the investor’s financial needs, and the broker was fined $10,000 and had to requalify as a broker by taking the Series 7 exam.
Alleged Due Diligence Failure by Brokerage Firms
FINRA alleged in an Acceptance, Waiver, and Consent agreement that brokerage firm Capital City had failed to perform its due diligence before they recommended preferred shares of a high-risk private placement. According to the AWC, FINRA’s due diligence consisted solely of a link to the private placements’ Edgar filing. Anyone can access an Edgar filing — investors should be able to rely on their brokers to provide more sophisticated insights.
Preferred Shares Stopped Paying Dividends
In another Acceptance, Waiver, and Consent agreement, FINRA fined a broker after attempting to resolve a dispute with an investor over preferred shares. The preferred shares had stopped distributing dividends, and to placate the investor, the broker tried to pay the investor themselves, which goes against FINRA regulations.
Preferred Stock Fraud
Contact an investment lawyer if you believe your preferred stock shares did not perform as expected. Investors typically rely on their broker to evaluate their suitability. These can be difficult for investors to evaluate given the different types of preferred stocks and their variations in call provisions and tax treatments.
It is your broker’s duty to research preferred stocks and verify they suit your financial goals before making a recommendation. Brokers should only recommend preferred shares if the investor indicated they wanted a long-term investment. Brokerage firms also have a duty to research the preferred stock issuer’s creditworthiness and to determine if bonds would offer better diversification. In the event that stock market prices fall, The Wall Street Journal reports that bonds may offer better protection against portfolio losses than preferred stocks.
If the brokerage firm did not perform its due diligence, or your broker did not consider your best interests, our attorneys can help you recover your losses through FINRA arbitration. Contact our experienced investment fraud attorneys for a free case evaluation – call (877) 600-0098 or email info@kurtalawfirm.com.