All copyrights and content belongs to Barrons and Leonore Briloff. I do not own this article. Please ask the authors permission to republish.
Barron’s
December 26, 1977
By Abraham Briloff
So called senior equity
needs scrutiny, so “gadfly of accountants” avers. In view of mandatory
retirement, sinking fund provisions, he calls such securities— issued lately by
Eastern Air Lines, National Distillers, Reliance Insurance— tantamount to
debentures. Adjusting the capital ratios.
Eastern Air Lines last month strengthened its finances with the
successful sale of two million shares of a $2.69 cumulative preferred issue.
The offering, underwritten by a group headed by Lazard Freres and Merill Lynch,
netted the airlines $47.5 million. A week earlier, National Distillers and
Chemical Corp. announced a proposed takeover of Emery Industries Inc. This
transaction will involve the swap of Emery common for some $225 million of new
National $25 preference stock, with cumulative dividends of $2.08 a share.
What’s significant about both transactions is the preferred stock
involved, which differs from the run of the mill preferred stocks with which
most investors are familiar. That’s because these particular senior equity
issues embrace features which assure their eventual retirement some years down
the road. Thus, unlike equity capital—both the common and the preferred kinds—
which generally is thought of as permanent, the new breed of preferred will be
available to the corporation for only a limited period of time.
Hidden Leverage?
What’s more, a review of recent filing with the New York Stock Exchange shows
that these are not merely isolated cases. Indeed, the trend seems to be
spreading fast. If unchecked (and thus far my colleagues in the accounting
profession have not done so) it could reach epidemic proportions with, I
submit, eventual dire consequences. For preferred stock with “special features”—that is,
mandatory retirement and, typically, sinking fund provisions – is really debt
dressed up on corporate balance sheets as stock holder’s equity. To my mind,
where companies use such securities, their debt to equity ratios— which denote
the extent of their leverage, and implicitly, the degree of risk assumed by
shareholders as well as creditors –may prove deceptive.
Actually, I first observed this phenomenon when researching an
article on Reliance Group Inc. (then known as Leasco Corp.), which appeared in
Barron’s on Dec. 18 1972. Contrary to the usual presumption surrounding
preferred stock, the Reliance issue, I found, did not represent investments by
shareholders committed to the entity of perpetuity, thereby, to my mind, entitled to be classified
as true residual equity. Instead, these shares called for a sinking fund and
mandatory redemption at certain fixed dates. I maintained in that price –
headlined “The $200 Million Question” – that preferred stock with such
characteristics was little different from debenture bonds, and should be
accounted for as such.
Shortly thereafter, the corporation moved to provide fuller exposure
in a footnote (and later, though an exchange offer, Reliance reduced the
redemption burden to $116 million). As a result of prodding from the Securities
& Exchange Commission, Reliance now shows this preferred stock in the
balance sheet at the ultimate $116 million redemption amount, instead of a mere
$ 4 million (i.e., the par value).
At any rate, the Reliance Group catalog of preferred securities has
expanded to include three more issues— all with mandatory redemption and
sinking fund requirements. Included is a Reliance Group Series “C” (used in the
recapitalization of part of the old “B” shares involved in the 1972 article);
an issue of $30 million by Reliance Insurance Co. (a wholly owned subsidiary of
the Group), used to acquire from Provident National Corp. (a bank holding
company) the stock of Commonwealth Land Title Insurance Co; and most recently,
Reliance Insurance Co. (97% owned by Reliance Financials) sold $50 million of
this type of “special feature” preferred to the public.
The $30 million in preferred issued to Provident National was
discussed in another Barron’s article, “Whose Deep Pocket?”, published on July
19, 1987. I there commented that Financial’s new preferred stock was none
existent; it was debt thinly disguised. That’s because, starting October 1980,
Reliance Financial Services must redeem annually one fifteenth of the shares
issued to Provident. Just as Financial, I said, will have a sinking fund
commitment to redeem $5 million of its debenture bonds in each of the 10 years
beginning with 1983, so it will have to fund at least $2 million annually from
1980 through 1994 to buy back the preferred. I went on: “There may be a sematic
distinction between the two; it may also be that Provident gets a tax break,
since 85% of the $3 million in annual dividends received on the preferred is
tax free. But when it comes to the ultimate economic realities, the distinction
between such preferred stock and debt is a distinction without a difference.”
There may be an advantage to this type of security from a corporate
(or institutional) investor’s vantage point. Under prevailing accounting field
rules, corporations may be required to mark equity securities down to market
values. However, since these investments have specified maturities and
redemption values, they fall in to the same exclusions as bonds— thereby
obviating the need for adjusting books to reflect changes in market values.
Most recently, as noted, a growing roster of corporations seems
attracted— from their point of view, with good reason—to this hybrid equity
issue. There was a time, to be sure, when it seemed that the accounting
profession would face up to the implications. In August 1975, the Accounting
Standards Executive Committee (“AsSEC”) of the American Institute of Certified
Public Accountants wrote to the Financial Accounting Standards Board, alerting
it to what AsSEC called the “Emerging Practice Problems – Classification of
Preferred Stock.” In its presentation, AsSEC state that it “has identified as a
problem in need of current resolution the question of appropriate balance sheet
classification of preferred stock issues that have a temporary life.”
Possible Motive?
The committee observed: “In some instances,
the motivation for issuance of preferred stock instead of debt lies in the
existing debt to equity ratio of the issuer. As that ratio weakens because of
increasing debt, an issuance of preferred stock is often motivated by a desire
to improve upon that ratio.”
The AcSEC submission suggested three possible alternative solutions:
(1)
Classify such “temporary life”
preferred stock as a liability;
(2) Create a new section on the
balance sheet, between the liabilities and the shareholders’ equity; or
(3) Permit this stock to remain in
the shareholders’ equity section, but have it set out as to be distinguishable
from equity committed “in perpetuity.”
Mirabile dictu (Wonderful to relate), the FASB demonstrated its
capability of tackling a substantive critical challenge expeditiously. Thus, on
Nov, 19, 1975, the FASB proclaimed that it had added to its “technical agenda”
a “project on long term debt and fixed maturity preferred stocks.” And it promised
to proceed with dispatch: “Based on recommendations made to the Board and
advice of the screening committee, the Board concluded that these problems
require early resolution. Hence, the board does not expect to issue discussion
memoranda but may hold public hearings and will issue an exposure draft for
public comment… before issuing final Statements of Financial Accounting
Standards.” But alas, after almost two years, the FASB last June announce that
is was abandoning the effort.
Has the problem gone away? To the contrary, only within the past
several months there has been a proliferation of these “limited life”
preferred stock issues. The roster of issuers includes not only Eastern Air Lines
and the proposed issue by National Distillers, but also Continental Group,
Itel, Occidental, Tenneco, and TWA. And others are getting into the act.
Bankers Trust New York Corp., a bank holding company, recently floated a $75
million issue; Time inc. swapped 1,370,982 shares of a new “sinking fund”
preferred for a majority of shares of the Book of the Month Club; and, only last
week, Outlet Co., a Rhode Island based retailer and broadcaster, obtained an
$11 million cash infusion from a Dutch concern via a preferred, which if it
isn’t eventually converted, must start being retired 10 years hence. Come
January, furthermore, El Paso Natural Gas Co. a subsidiary of El Paso Co.,
plans to market, via White, Weld, two million “depositary preferred shares” to
raise $50 million (before deducting underwriting commissions).
Let’s look at Tenneco Corp., which in September announced that it
was prepared to issue almost $200 million of a new preferred stock in order to
acquire the remaining 76% of Philadelphia Life Insurance Co. (it already owns
24%.) This new preferred, according to The
Wall Street Journal, "would be nonredeemable for 10 years,” but “thereafter
it would be subject to a sinking-fund which would retire the issue by the end
of the 20th year.”
Tax Free Exchange
The use of preferred stock has tax free implications. Assuming this
takeover ultimately is consummated on the basis as indicated, it would be deemed a tax
free exchange. Consequently the Philadelphia Life shareholders who tender their
shares would have no immediate tax consequence. On the other hand, Tenneco, for its part,
takes on an added cost burden, since it cannot step up the tax basis of the
underlying Philadelphia Life assets by reference to the higher cost of its
investment in the life company. And, of
course, there’s the fact that dividends on the preferred are paid out of
after-tax earnings.
Similarly, on June 29, 1977, Continental Group Corp, listed on the
Big Board 7,000,000 (maximum) additional shares of common stock and 8,800,000
(maximum) shares of a $2 cumulative convertible preference stock. Series A, These shares were eventually issued
in connection with merger of Richmond Corp., the big Virginia insurance holding
company, into Continental.
Continental has an obligation to redeem each year, starting in 1983,
2½%
of the preferred stock originally issued.
The redemption price: $25 a share.
Consequently, unless these preferred shares are converted in the years
between 1983 and 2023, Continental will
have to pay out as much as $220 million to buy up the stock.
The listing application also provided a pro-forma balance sheet,
assuming that 100% of the Richmond shares are exchanged in the merger and 8.6
million preferred shares are presumed to be involved. It showed that $8.6 million (the par value)
would be credited to the new cumulative convertible preference stock. Series A, and that $213.60 million would be
earmarked “Excess of fair value at date of issuance over par value” – for a
total credit to shareholders’ equity of $222.2 million,
Pro-Forma Approach
Elsewhere in the document, we find a pro-forma statement of
Continental’s capitalization. This tabulation reflects the credit side of the
balance sheet (excluding the liabilities incurred in the ordinary operations of
the corporation) and may be summarized as follows (in $ millions):
Long and short term debt $450.6
Stockholders’ equity
(including the new preference shares at
the $222.2 million referred to above) $1,299.6
For a total of $1,750.2
What this produces in a relatively low debt-to-shareholders’-equity
ratio of 1-to-2.9. But if we were to
shift the $222.2 million new preferred credit from stockholders’ equity into
the debt area, the $1,750.20 million aggregate capitalization would be divided
as follows: Debt $672.8 million. Stockholders’ Equity $1,077.40 million. The ratio would them stand as a less
flattering 1-to-1.6.
This was the kind of “emerging problem” AcSEC sought to bring to
FASB’s attention – and which the latter brushed aside. However, it should be noted that as with
Tenneco’s contemplated offering for Philadelphia Life and that by National
Distillers for Emery, as well as Time Inc, for Book-of-the-Month Club,
Continental’s issuance of preferred stock (rather than a debt instrument). May have been motivated more by the need to
provide a tax-free swap for the Richmond shareholders. This rationale would not, however, apply to
the multi-million-dollar issues of Bankers Trust, TWA, Occidental Petroleum,
Itel or Eastern Air Lines, which raised fresh funds.
In the case of TWA, last June it raised $95 million by selling five
million shares of Series B $1.9 Cumulative Preferred Stock, and 1,250,000 additional
shares of common stock (as units, consisting of a share of preferred and a
quarter share of common for $19 apiece).
According to the TWA listing application, TWA is schedule to redeem
(or to purchase) and retire, “subject to appropriate annual action to be taken
by and at the discretion of its Board of Directors, an aggregate of 200,000
shares of Series B Preferred Stock on or prior to June 30, 1983, and on or
prior to each June 30 thereafter, until all the shares of Series B Preferred
Stock shall have been redeemed and retired or purchased and retired… The
noncumulative annual scheduled redemptions have been calculated to retire all
of the Series B Preferred Stock by 2007….”
This scheduled TWA redemption of 200,000 shares annually begins in
1983. When allocating the $94,550,000
anticipated net proceeds between the common and preferred shares in the
financing package, the airline attributed $11,523,000 to be common stock and
the remaining $83,027,000 went to the new preferred stock account – all to be
included in Shareholders’ Equity. As a
consequence, when detailing its capitalization, after giving effect to the new
issue, TWA came up with the following aggregates
(in $ thousands)
Total debt
(including that of subsidiaries) $722,989
Total Shareholders’ Equity
423,943
Total capitalization $1,146, 932
This works out to about $1.7 of creditors’ money to cash dollar
provided-by share-holders. Now let’s see
what happens should we exclude from shareholders’ equity the $83,027,000 of
preferred stock credit and include the $100 million ultimate aggregate
redemption value in the debt ambit. The
capitalization would then become $823 million in aggregate debt. $341 million
in shareholders’ equity, for total capitalization of $1,164 million. The debt share then factors out to $2.4, as
compared to each dollar provided by true shareholders.
Next we turn to four million shares of a $2,125 cumulative preferred
stock sold last July by Occidental Petroleum Corp. These shares were priced at $25 each, yielding
met proceeds of $95.2 million. Again,
this new issue carried the “special feature” of a sinking fund, thus: “As a
sinking fund to provide for the retirement of all the Preferred Stock by July
1, 2020, Occidental on July 1, 2002, Occidental on July 1 in each year
commencing in 1983 will be required to redeem 200,000 shares of Preferred
Stock. The obligation to redeem shares
of the Preferred Stock under this mandatory sinking fund is cumulative. The sinking fund redemption price will be $25
per share...”
Short and Long
Oxy allocated the net proceeds to be preferred stock account in the
amount of $4 million (the par value) and to additional paid-in capital, the
$91.2 million remainder. As a
consequence, the capitalization schedule included in the prospectus showed ($
thousands): Aggregate short and
long-term debt and minority interest of $1,277,394; total shareholders’ equity
of $1,540,331; and total capitalization, $2,817,725.
This would produce a debt to shareholders’ equity ratio of 1-to 1.2
or $1.20 of shareholders’ investment underlying each $1 of indebtedness). Now see what happens when we reflect the new
preferred stock as debt. The revised
tabulation (in $ thousand) follows; Aggregate obligations (including this new
$100 million preferred stock issue at its redemption amount), $1,377,394;
shareholders’ equity (excluding the $95.2 million credited for the new
issue). $1,445,131; for a total
capitalization of $2,822,525.
This revised presentation brings the debt-to-equity ratio to
1-to 1.05 – whereby the margin is dramatically reduced, and the leverage
considerably increased. But there is
more to the Oxy mystique: Thus, the
corporation had two issues of preferred stock with “special features” even
before this latest $100 million offering.
According to its Dec 31, 1976, balance sheet, there were
“nonconvertible preferred stocks, subject to mandatory redemption through
sinking fund requirements (aggregate… mandatory redemption value $92,500,000). “This obligation is included in the balance
sheet numbers in an intriguing fashion; $3,175,000 (the par value) is on the
preferred stock line, with another $73,343,000 included in additional paid-in
capital, (designated as the amount thereof “allowable to nonconvertible preferred
stocks”).
The total of these two credits.
$76,518,000 is, we note, $15,982,000 short of the ultimate redemption
value. That difference represents the
spread between the proceeds from these two earlier preferred issues and the
amount ultimately payable, to the extent it had not been amortized through Dec
31, 1976. (Each year between 1976 and
the eventual redemption, part of this remaining spread will be
And credited to additional paid in capital. Do be assured, dear reader, that debits
invariably equal credits.)
If, then, we were also to adjust Oxy’s capitalization schedule by
deleting this $76,518,000 aggregate from shareholders’ equity and put the
$92,500,000 obligation where I believe it belongs, we get (in $ thousands):
Aggregate debt as adjusted $1,469,894
Shareholders’ equity 1,368,507
Total capitalization $2,838,507
As can be seen, these further adjustments trigger a “tilt” – the
shareholders’ equity is now slightly less than half of the total
capitalization. Or, as against every $1
of borrowing, there is only 93 cents of equity.
Proceeding with a corresponding calculus for Itel offering of 3.5
million shares with a $52.5 million maturity value, the debt-to-equity ratio
would move from $1.55 to $1.00 or $2.71 of debt for each dollar of equity. For Eastern Air Lines, the charge would be
from $1.55 of debt to each $1 of equity, to $1.93 of debt to each equity
dollar.
The Mind Boggles
According to the El Paso Natural Gas “red herring,” upon the
completion of its offering. Its total
debt would stand at $1,166.6 million, vs equity of $725.7 million, a ratio of
$1.61 to $1. Shift the $50 million from
the latter to the former and the ratio becomes $1.8 of debt per dollar of
equity.
What I also find mind-boggling is the inordinately high cost
implicit, in financing by use of preferred stock with special features. Year-to-year expenses involved in the Eastern
Air Lines, liet, Occidental, Reliance Insurance and TWA issues (Continental is
excluded, since these shares were not issued for new money) is summarized in
the accompanying table.
Preferred Offerings
Company
|
Net Proceeds
|
Annual Dividend
|
Current Cost %
|
Eastern Air Lines
|
$47,500,000
|
$5,380,000
|
11.3
|
Itel
|
49,700,700
|
5,040,000
|
10.1
|
Occidental
|
95,200,000
|
8,500,000
|
8.9
|
Reliance Insurance
|
46,987,000
|
5,402,000
|
11.5
|
TWA
|
83,027,000
|
9,500,000
|
11.4
|
In as much as there “borrowing” costs are met-after-tax costs, since
they are not tax-deductible, it follows that the current cost percentages are
equivalent on a presumptive pre-tax basis (i.e. if the cost were deductible as
interest) to almost 17% for Occidental, and 22% for Eastern, Reliance and TWA.
And at least one banker has shown a proclivity for this kind of
“high-cost” security. On Nov 2, Bankers
Trust New York sold 1,500,000 shares of a new $4,225 (per $50 share) preferred
stock series, for which it got $72,375,000 (after deducting $2,625,000 for
discounts and expenses). These shares
call for a sinking fund beginning in 1988 to retire 4% of the shares annually,
so that over the ensuring quarter century, the holding company will be
constrained to pay back the full $75 million.
But this is only half the Bankers Trust story. Five years ago, it issued three million shares
of a preferred stock paying a dividend of $2.5 on each $25 share to raise $75
million; this issue calls for sinking fund redemptions, also over a quarter
century, starting in 1986. Hence,
starting in 1988, Bankers Trust will be called upon to generate $6 million
annually for two decades to pay off the bulk of this $150 million aggregate
obligation.
If the $150 million were added to the debt sector, where I feel it
rightfully belongs, it would shrink Bankers Trust stockholders’ equity, as
stated in the November prospectus, by 18%.
The annual cost of the new Bankers Trust borrowing by the use of this
preferred works out to 8.75% of the proceeds.
But since this cot is on a non-tax-deductible basis, the annual cost
would be the equivalent of almost 17% deductible interest.
Where, then, does this analysis lead? As noted, I am of the view
that preferred stock with the “special features” here involved is little more
than thinly disguised debt – and that it is the independent auditor’s
responsibility to strip the financial statement of the façade currently given
such securities.
The argument advanced by pro-sinking fund preferred forces for
treating these securities as equity goes something like this; Preferred is a
proper stockholders’ equity security, in accordance with GAAP and financial
practices generally. If a preferred
stock dividend is passed, the consequences are far different than if interest
on debt is not met. Also preferred
dividends, and the right of holders of such securities, are subordinate to all
creditors. But as support for my position that we are, in fact, dealing with a
liability, I cite the Financial Accounting Standard Board’s December 1976
Discussion Memorandum relating to its Conceptual Framework project.
Bearing and Risks
In paragraph numbered 150, the memorandum asserts; “Most definitions
of liabilities identify liabilities with a business enterprise obligation or
responsibilities to transfer economic resources to other entities (including
individuals)….” Who can question that
the preferred stock issues cited here do impose on the respective issuers the
obligation and responsibility to transfer resources to others?
Correspondingly, paragraph 187 of the same FASB Memorandum as the
initial paragraph under “Owners’ equity or capital,” tells us what such equity
is supposed to be, to wit: “The owners’ or stockholders’ interest in a business
enterprise is a residual interest. It is
the interest in the enterprise’s assets that remains after deducing the claims
of others.” It is the interest, in other
words, of those who bear the ultimate risks and uncertainties, and who receive
the ultimate benefits of operations.
Most assuredly, the preferred stockholders involved in our sagas are
not “residual risk-takers.” Excepting
for an occasional convertible privilege, they have a limited set of
expectations – a fixed annual return and a return of a fixed principal amount
at a certain date in the future. If
that’s not an undertaking requiring the obligor to transfer resources to
another entity or individual, nothing is.
All this, to me leads to one conclusion: The special-feature preferred stock does not
belong in the shareholders’ equity section of the balance sheet – even if the
corporation is willing to show the amount thereof at the ultimate redemption
value.
I maintain that this kind of security properly belongs grouped with
any debenture bonds which a corporation may have outstanding. By the same token, any discount and/or costs
incurred on the issuance of these securities should be treated as though they
were sustained on a debenture offering – and amortized against income
accordingly. And the dividends paid on
such preferred should be included along with interest as an expense, thereby
reducing the corporate “bottom line.”
Dr. Briloff is Emanuel Saxe Distinguished Professor of Accountancy
of Baruch College. City University of
New York.
No comments:
Post a Comment