Dividends in arrears occur when a company fails to turn a substantial enough profit to pay the dividends guaranteed to its preferred shareholders. For dividends to be paid to common shareholders, any dividends in arrears due to the owners of preference shares must be paid first.
Common Vs. Preference Shares
Common, or ordinary, shares of stock are what most people think about when they look at the stock market. The majority of the buying and selling of stock involves common shares. Common stockholders have an ownership stake in the issuing company commensurate with the amount of stock they own.
If a single shareholder owns 1,000 of the total 5,000 shares outstanding, then they own 20% of the company. This also means that common shareholders have voting rights and get to participate in large business decisions, such as the election of board members.
Preference shares are a slightly different matter, because they share some characteristics of common shares and bonds. Though preferred shareholders also have an ownership stake in the issuing company, they generally do not have voting rights. However, preferred shareholders do have a higher claim on company assets in the event of bankruptcy than common shareholders. Preference shares tend to be more expensive than common shares, primarily because of the dividend benefits of ownership. Like bonds, preference shares carry fixed dividend rates, making them particularly appealing to more risk-averse investors.
Though both types of shares can pay dividends, only certain types of preference shares are guaranteed to pay fixed amounts each year. Of course, if the company falls on hard times, its board of directors can elect to suspend dividend payments. However, any dividends that are due to preferred shareholders must be paid prior to the issuance of any common dividends. Overdue dividends are called dividends in arrears.
Assume that company ABC has 5 million ordinary shares and 1 million preference shares outstanding. The company pays dividends to common shareholders every other year, but preferred shareholders are guaranteed a $3 dividend per share. At a minimum, ABC must pay out $3 million in dividends each year.
Due to a failing economy and some legal issues with one of its directors, ABC's profits take a huge dive, leaving it with just enough to pay the bills. The board elects to suspend dividend payments until revenues pick up. However, three years later, ABC is still floundering. At the end of these three years, ABC owes preferred shareholders $9 million in unpaid dividends.
With the launch of a revolutionary new product, ABC finally sees its profits pick up. However, due to the strain of operating with so little income for so long, ABC is still unable to pay preferred dividends, as there are more pressing financial obligations to attend to.
Five full years after its near collapse, ABC is more profitable than ever thanks to some much-needed corporate restructuring. To thank its stalwart investors, ABC pays the $15 million in dividend arrears owed to preferred shareholders and issues a $2 dividend to common shareholders as well.
The Fine Print
In general, preference shares are assumed to carry a guaranteed dividend that can accrue over time if left unpaid, as in the example above. However, only cumulative dividends carry this benefit. Companies have the option of issuing non-cumulative dividends, meaning that shareholders do not have a claim on any dividends left unpaid due to a drop in profits. Luckily, these types of dividends are far less common.
Though companies want to reward shareholders for investment, they are not generally in the business of giving away more money than they have to. Some companies seek to limit their liability by issuing callable shares. This type of preference share can be repurchased by the company, at its discretion, for a predetermined price on a given date. Preference share dividends are, like bond coupon rates, largely influenced by prevailing national interest rates set by the Fed. Companies that issue callable shares can elect to repurchase existing preference shares and reissue them with a lower dividend rate when interest rates fall.