Definition of a Preference Share
Preference shares are shares that rank above other share types and classes in terms of dividends or capital but have restricted voting rights. They are almost always fixed-income securities. The specifics of preference shares are usually set out in the company’s articles of association or shareholder agreements[1].
Key features of a preference share:
- First right to dividend pay-outs
Preference shares allow shareholders to receive dividend pay-outs when other shareholders may receive dividends later or may not be receiving dividends. Typically, they have a fixed rate of dividend which is paid out before the other types of shares. In other words, they take precedence over ordinary shares (and other share classes) in terms of the payment of any dividends.
- Return of capital
Another feature of preference shares is that, in the event of the company being wound up, holders of preference shares are entitled to be repaid their capital contribution before ordinary shareholders. However, priority is still given to creditors over shareholders – preference or otherwise.
- No voting rights
In general, this class of shares do not come with any automatic voting rights, unlike most ordinary shares[2].
- Conversion
Preference shares can typically be converted into ordinary shares. Some preference shares inform investors that they can be converted beyond a specific date, while others may require permission and approval from the company’s board of directors to be converted.
Accounting treatment of preference shares
The classification of preference shares in financial reporting based on International Financial Reporting Standards (IFRS) varies depending on the rights of the preference shareholders and the obligations of the issuing entity. Some preference shares are classified as equity while some are classified as liability instruments, while others are considered compound instruments with both equity and liability components.
Preference shares are likely to be recognised as a liability when:
- they carry fixed dividend rights where there is a contractual obligation to deliver cash
- they provide for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date
- they give the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount[3].
The absence of terms stated above is likely to indicate that preference shares may be classified as equity.
Types of preference shares
Convertible Preference Shares
Convertible preference shares are those shares that can be easily converted into equity shares.
Non-Convertible Preference Shares
Non-Convertible preference shares are those shares that cannot be converted into equity shares.
Redeemable Preference Shares
Redeemable preference shares are those shares that can be repurchased or redeemed by the issuing company at a fixed rate and date. These types of shares help the company by providing a cushion during times of inflation.
Non-Redeemable Preference Shares
Non-redeemable preference shares are those shares that cannot be redeemed or repurchased by the issuing company at a fixed date.
Participating Preference Shares
Participating preference shares help shareholders demand a part in the company’s surplus profit at the time of the company’s liquidation after the dividends have been paid to other shareholders. However, these shareholders receive fixed dividends and get part of the surplus profit of the company along with equity shareholders.
Non-Participating Preference Shares
These shares do not grant preference shareholders the additional option of earning dividends from the surplus profits earned by the company, but they receive fixed dividends offered by the company.
Cumulative Preference Shares
Cumulative preference shares are those type of shares that gives shareholders the right to enjoy cumulative dividend pay-out by the company even if they are not making any profit. These dividends will be counted as arrears in years when the company is not earning profit and will be paid on a cumulative basis the next year when the business generates profits.
Non – Cumulative Preference Shares
These shares do not collect dividends in the form of arrears. The dividend pay-out takes place from the profits made by the company in the current year. So if a company does not make any profit in a single year, then the shareholders will not receive any dividends for that year. Also, they cannot claim dividends in any future profit or year.
Adjustable Preference Shares
In the case of adjustable preference shares, the dividend rate is not fixed and is influenced by market rates.
Shariah Issues in Preference Shares
From a Shariah perspective, the nature of a product depends on the contractual elements of it. Irrespective of the name and cash flows, the contractual obligations in one contract can skew the fundamentals of the product, thereby transforming the product into something else altogether. This does not apply to scenarios where there are multiple contracts with independent executions. Yes, there are some scenarios which are prohibited on the basis of Shubhat al-Riba (suspicion of Riba), which warrants another write-up.
Equity investments in Shariah demand the following:
- Capital be at risk and is not guaranteed by the investee company.
- Dividends are calculated based on a percentage of profit.
- Dividends are a result of business performance and not simply an obligation to repay.
- All parties have an equal ranking and be on the same tier to receive dividends in any distribution.
- Loss is proportionate to investment capital for all partners without any one party bearing more risk.
- All parties bear risk at the same tier and level, without one partner being made to absorb investment risk primarily before another partner.
- There is no obligation on one party to pay another, rather returns are based on asset-based income generation, or the supply of services to third parties or the trading activity of a business.
Considering the above, the Shariah non-compliant elements of preference shares are as follows:
- Dividends are calculated in relation to capital. As such, dividends are not reflective of enterprise performance, but of capital contribution. It is a fixed dividend payment as a consequence. Having a fixed dividend is at odds with the principles of partnership in Shariah. Of course, preference shares do not guarantee payment of any dividend to their holders if there have not been sufficient profits. As the dividends from preference shares are fixed, a preference shareholder does not typically benefit from any upside in a company’s profits, however, they have some level of protection from the downside if a company’s profits fall. This s how the risk/return profile of preference shares is weighed up.
- Preferential return of capital is another breach of Shariah principles. In the event of the company being wound up, holders of preference shares are entitled to be repaid their capital contribution before ordinary shareholders. This preference goes against the Shariah principle of all investment partners having equal ranking when it comes to access to residual assets upon liquidation.
- Preferential dividend payment in preference shares is another Shariah contravention. Preference shares take precedence over ordinary shares and other shares classes in terms of payments of any dividend. This feature essentially provides a higher degree of security and protection for preference shareholders, at least in terms of receiving a return on their investment.
- Some preference shares, although not so common, have a fixed redemption date. This is called a ‘call option’ and it allows the issuer to repurchase the instrument at par on a certain date. This is also a Shariah breach as it provides the investor a level of protection in their investment capital from the investee company.
Considering the above, preference shares are not Shariah compliant instruments. The above factors would have to be removed for such shares to be acceptable from a Shariah perspective.
A preference share is a voidable agreement (Fāsid) from a Shariah perspective. A voidable investment agreement is regarded as sinful and a violation of Shariah principles. With a voidable term in the investment contract, the investment must be terminated and reperformed without the voidable elements. If the investment was not terminated, the parties in such an investment are only entitled to profit in proportionate to the percentage of their overall capital contribution. Any additional return will be unlawful for the preference shareholder.
[1] https://crestlegal.com/ordinary-shares-vs-preference-shares/
[2] https://www.qualitycompanyformations.co.uk/blog/what-are-preference-shares/are
[3] https://library.croneri.co.uk/cch_uk/iast/ias32-200312
