Understanding preference shares

Preference shares can be a flexible and effective source of quasi debt funding for early stage or distressed businesses.  They can also be used for many other purposes, for example to provide key staff with an equity interest in the business without affecting its ownership or control.

Recently, preference shares made headlines when Nufarm (an Australian agricultural chemicals maker) was ‘bailed out’ by its largest shareholder, Sumitomo, with a near $100 million capital injection via preference shares.

However, despite the advantages of issuing preference shares, it is critical to ensure that they are in fact ‘preferred’.

In this edition of Corporate Insights, we explain why a solid understanding of the legal nature of ‘preference’ is essential to achieve the right commercial outcome.

What is a preference share?

It’s generally understood that a preference share is ‘preferred’ in some way over other shares in the company.  The Corporations Act states that a company can issue preference shares if the following matters are set out in the company’s constitution or approved by special resolution of the company:

• Repayment of capital;
• Participation in surplus assets and profits;
• Cumulative and non-cumulative dividends;
• Voting;
• Priority of payments of capital and dividends in relation to other shares or classes of preference shares.

Weinstock v Beck

The complex and long-running Weinstock litigation[i] considered some of the key characteristics of preference shares.

Weinstock involved a deceased estate dispute as to whether eight preference shares in a family furniture business could be ‘redeemed’, i.e. purchased back by the company for $1.00 each.  The share terms stated that, on a winding up or capital reduction, the shareholder would receive a return of their share capital in priority to all other shares of the company.  However, the shares did not receive any preference as to dividend.

Because the Corporations Act states that only redeemable ‘preference’ shares can be redeemed, the case turned on whether these shares were preferred.  If the shares were preferred then they were also redeemable, meaning the company was able to purchase them back for $1.00 each.  If not, then the shares would have been valued at millions of dollars on winding up of the company.

Interestingly, the company in question had not issued any ordinary shares, although its constitution did provide for ordinary shares to be issued.  The Supreme Court of New South Wales (the Supreme Court) had to consider two key questions:

• Did the company need to actually issue (other) ordinary shares in itself for these shares to be ‘preferred’; and
• Can shares be ‘preference’ shares without having priority over other shares for both dividends and distributions (on a winding up)?

Dividend or distribution?

The Supreme Court found that it was not necessary for a share to have preferential rights for both dividends and distributions.  Priority in one of these matters was sufficient for the share to be ‘preferred’.  This finding was not contested during subsequent appeals.

Do ordinary shares need to be issued?

Initially the Supreme Court ruled that shares could not be ‘preference’ shares unless the company had also issued ‘ordinary’ shares, as they had no priority over any issued ordinary shares.

This decision was set aside by majority in the New South Wales Court of Appeal (Court of Appeal), and the shares were deemed to be preference shares that could be validly redeemed. On appeal the High Court affirmed the decision of the Court of Appeal, unanimously agreeing that preference shares could exist, despite the fact that no ordinary shares had been issued.

Takeaways

A solid understanding of the legal nature of ‘preference’ is essential to achieve the right commercial outcome.  This is particularly important where a share is expressed to be ‘redeemable’, as is often the case for shares issued by early stage businesses to senior employees or other key staff.

Such shares will also often be ‘convertible’, i.e. convertible into ordinary shares.  If all goes well with the business, the shares may be converted into ordinaries, for example if the business achieves scale and proceeds to IPO or trade sale.  Otherwise, the shares may be redeemed, usually for a nominal amount.  These alternative outcomes can result in a difference of millions of dollars for the holder of the shares.

As the Weinstock litigation shows, achieving the right legal outcome is critical to ensure the company and shareholder achieve the agreed commercial result and to avoid dispute.

[i] Weinstock v Beck [2011] NSWCA 228; on appeal Weinstock v Beck [2013] HCA 15.