SECTION ARTICLE III. RIGHTS OF PREFERRED SHAREHOLDERS. 2262. Right to preferential dividends dependsupon contract. 2263. Such a contract may consist of a by-law. 2264. Preferred stock gives a right to interest chargeable upon prof its. 2265. Entitles the holders to dividends 2267. Illustration. 2269. Interpretation: dividends on 2271. Right of the preferred stock- 2272. Circumstances under which dividend on preferred stock may be paid, although capital impaired. SECTION 2273. Right to pass the dividend in case of changes of ownership. 2274. Effect of a guaranty of dividends: whether absolute or conditioned on their net earnings. 2275. Doctrine that such a guaranty is a guaranty only in case there are profits. 2276. Such a guaranty may make the right to dividends cumulative. 2277. Whether a preferential certifi cate is of stock or indebtedness. 2278. Preferred stockholders not entitled to priority over credit ors. 2279. Illustration. 2280. Nor over other shareholders. 2283. Interpretation of the phrase 2285. Right to dividends on preferred 2286. Rights of preferred shareholders against schemes of "arrangement" under English Railway Companies Act. § 2262. Right to Preferential Dividends Depends upon Contract. It is next proposed to consider the rights of preferred shareholders; and the chief question with which we are concerned consists of their right to dividends. It must be borne in mind that the right to dividends on preferred stock springs out of contract, from which it follows that the right to such dividends depends upon different principles from those relating to dividends of common stock. Controversies in respect to dividends on preferred stock must be determined in each case by the terms of the contract creating the preference. A § 2263. Such a Contract may Consist of a By-Law. by-law providing for the payment of dividends on the preferred stock of a company establishes a contract between the company and its preferred stockholders. And it may be added, with the most entire confidence, that whether the stock is issued in pursuance of a by-law, or of a resolution of the board of directors, or of a resolution passed at a general meeting of stockholders (always assuming that the act is valid), the person who receives the preferred shares in pursuance of it, acquires a right resting in contract and enforceable on the theory of contract. This is assumed in all the cases on the subject and is nowhere disputed. § 2264. Preferred Stock Gives a Right to Interest Chargeable Upon Profits. The view of some of the English courts that a preferred and guaranteed dividend authorized by an act of parliament is substantially interest, chargeable exclusively upon profits," has been adopted in this country, and the conclusion thus expressed has been reached: "The guarantee of a dividend by a railway company is construed by the courts mean nothing more than a pledge of the funds legally applicable to the purposes of a dividend; that, in short, it is a dividend, and not a debt, which is thus preferred and guaranteed." 3 to § 2265. Entitles the Holders to Dividends only in Case They are Earned. The ordinary species of preferred stock entitles the holders to a dividend of a certain per centum out of the profits of each particular year, in preference to any dividends on the common stock. It amounts merely to an engagement to divide earnings among the preferred stockholders in preference 1 Belfast &c. R. Co. v. Belfast, 77 Me. 445; Hazeltine v. Belfast &c. R. Co., 79 Me. 411; s. c. 1 Am. St. Rep. 330. 2 Henry v. Great Northern R. Co., 3 Jur. (N. s.), part I, 1133; s. c. 1 De Gex & J. 606. See also Crawford v. Northeastern R. Co., 3 Jur. (N. s.), part I, p. 1093; Matthews v. Great Northern R. Co., 5 Jur. (N. s.), part I, p. 284. 3 Taft v. Hartford &c. R. Co., 8 R. I. 310; s. c. 5 Am. Rep. 575. to those who are not preferred. If there are no earnings in a particular year, they get no dividend in that year. Whether there are earnings in a particular year, which can be divided among the preferred stockholders, is a matter for the directors to determine in the first instance in the exercise of a sound and honest business discretion, and subject to the control of the courts in case their discretion is abused, as hereafter shown.1 Such a claim makes the holder of the share certificate a stockholder, and not a creditor.2 If a dividend were guaranteed, or if the promise were to pay interest on the shares absolutely and in any event, he would, to that extent at least, be a creditor. Where the corporation guarantees (as is sometimes the case) not only interest on the stock, but also agrees to receive back or otherwise liquidate the principal of the shares at par, at a date named, then the certificate becomes substantially an interestbearing bond of the corporation, and the holder to the fullest extent a creditor, although he may also have rights pertaining to a shareholder, such as the right to vote at corporate meetings. It has been pointed out that under some schemes, what has been called "preferred stock" is really an interest-bearing debenture of the corporation, which creates the relation of debtor and creditor between the corporation and the so-called shareholder.3 When, therefore, no profits have been earned out of which a preferred dividend can be paid, the holder of preferred shares on which a dividend is guaranteed at a certain rate per annum "before any dividends shall be paid on other stock of said company," cannot maintain an action of assumpsit for the recovery of the annual dividend thus guaranteed.* 1 New York &c. R. Co. v. Nickals, 119 U. S. 296; s. c. 7 Sup. Ct. Rep. 209. 2 Under an act empowering certain counties to subscribe for preferred stock of a certain railroad, to bear seven per cent. interest, it was held that a county was not to be a creditor, but a stockholder, and that their stock was to be preferred over the common stock by being entitled to seven per cent. interest out of the dividends in advance of the others. An expression in the certificate "prior and in prefer ence to any dividend upon the capital stock of the company" was objectionable as implying that the county was not a stockholder. State v. Cheraw &c. R. Co., 16 S. C. 524. 3 Such was the case in West Chester &c. R. Co. v. Jackson, 77 Pa. St. 321; in Burt v. Rattle, 31 Oh. St. 116; and in Williams v. Parker, 136 Mass. 204. 4 Taft v. Hartford &c. R. Co., 8 R. I. 310; s. c. 5 Am. Rep. 575. § 2266. Right to Dividends Not Absolute, but Subject to Just Discretion of Directors.- Under such a scheme as that named in the preceding section, the right of the holders of preferred shares is not an absolute right to a dividend in any event, but it is a qualified right to a dividend, to the extent named in case there are profits which can appropriately be divided. It is not enough that there may be net earnings; because the corporation may, from its nature, have public duties to perform, as in the case of a railroad company, whose duties require it to expend its net earnings in keeping up its properties so that it can serve the public severally and individually. "A different view," said the Supreme Court of the United States, speaking through Mr. Justice Harlan, "would lead to results which sound policy would seem to forbid, and which, therefore, it is not to be supposed were contemplated by the parties. For, if preferred stockholders become entitled to dividends upon a mere ascertainment of profits for a particular year, the duty of the company to maintain its track and cars in such condition as to accommodate the public and provide for the safe transportation of passengers and freight would be subordinate to their right to payment out of the funds remaining on hand after meeting current expenses and fixed charges." 1 And whether there are net earnings which can properly be distributed as a dividend on preferred shares must, in the first instance, be left to the decision of the directors, subject, of course, to judicial superintendence where the evidence shows that there are profits which can appropriately be so applied. In other words, to quote again from the language of the court in the same case, the preferred shareholders" are not entitled, of right, to dividends, payable out of the net profits accruing in any particular year, unless the directors of the company formally declare, or ought to declare, a dividend payable out of such profits; and whether a dividend should be declared in any year is a matter belonging in the first instance to the directors to determine, with reference to the condition of the company's property and affairs as a whole." 2 § 2267. Illustration.- This is well illustrated by a case in the Supreme Court of the United States, where it appeared that pending 1 New York &c. R. Co. v. Nickals, 119 U. S. 296, 306. 2 Ibid. 307. an action to foreclose mortgages upon the property of a railway company, an agreement was entered into, by holders of common and preferred shares of its stock and its creditors, for co-operation in the foreclosure and sale under one of the mortgages, the purchase of the property and franchises, and the organization of a new corporation to take and hold them, by one article of which it was agreed that preferred stock should be issued to an amount equal to the preferred stock of the company then outstanding, "entitling the holders to non-cumulative dividends, at the rate of 6 per cent. per annum, in preference to the payment of any dividend on the common stock, but dependent on the profit of each particular year, as declared by the board of directors." The agreement was carried out, its provisions being set out in the articles of association of the new company, and preferred stock was issued by it, as agreed. Subsequently the directors made a report of the operations of the new company for a particular year, showing a net profit of a large amount which had been applied to improvements of the property of the company. The court held that a suit by holders of preferred shares to compel the company to declare and pay a dividend to them out of the profits of that year could not be maintained. The agreement was not intended to confer upon preferred shareholders an absolute right to a dividend in any particular year, dependent alone on the fact, or the official ascertainment of the fact, that there were net profits in that year, unless the directors should formally declare or ought to declare a dividend payable out of such profits, and whether a dividend should be declared in any year was matter belonging, in the first instance, to the directors to determine, with reference to the condition of the company's property and affairs as whole.1 * § 2268. What are "Net Earnings" to be Appropriated in Dividends on Preferred Shares. This question has been answered thus by Sir George Jessel, M. R.: "That means this, that the preferred shareholders only take a dividend if there are profits of the year sufficient to pay their dividend. They are co-adventurers for each particular year, and can only look to the profits of that year. If they are lost for that year, they are lost forever. Profits for the year mean the surplus receipts, after paying the expenses and restoring the capital to the position it was in on the first day of January of that year."' 2 The same view is thus expressed by a modern writer of reputa 1 New York &c. R. Co. v. Nickals, 119 U. S. 296. 2 Dent v. London Tramway Co., L. R. 16 Ch. 344. |