Chapter 11 - Solution Manual

The issue of whether mandatorily redeemable preferred

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The issue of whether mandatorily redeemable preferred stock is a liability hinges on determining whether the entity has little or no discretion to avoid the future sacrifice. First, mandatorily redeemable preferred stock is senior to all other stock of the enterprise. This seniority prohibits declaration or payment of dividends to other stock unless the full cumulative dividend has been declared and set aside for holders of redeemable preferred stock. Redemption is not optional on the part of either the issuer or the holder of the stock. Hence, the holder of redeemable preferred shares has a contractual right to receive cash at the specified time and to enforce a contractual provision not to pay dividends on other issues of stock if the preferred dividends have not been paid. And, at redemption, the holder has the right to receive the redemption price, which typically includes unpaid dividends. That right normally becomes a creditor’s interest at the redemption date. If the company were to declare bankruptcy, the holder of mandatorily redeemable preferred stock may be a member of the creditors’ committee that petitions a court for involuntary bankruptcy or reorganization of the debtor. However, the redemption value would not be included in determining insolvency, nor would the holder be able, by themselves, to place the issuer in involuntary bankruptcy. Thus it appears that owners of mandatorily redeemable preferred stock have essentially the same legal rights as creditors as long as the issuer is solvent and some of the same legal rights as creditors when the issuer is insolvent. Thus, it is argued that the mandatorily redeemable provisions converts what otherwise would be an equity instrument into a liability because the essence of a liability is the obligation to transfer assets to another party. As such, this debt instrument imposes a duty to sacrifice assets that the enterprise has little discretion to avoid. The obligation is virtually unavoidable because the only way it can be avoided is for the company to become financially incapable of paying a return to its owners. Team 2 Argue for presenting redeemable preferred stock as equity Redeemable preferred stock is characterized for legal purposes as “stock.” All financial instruments that are characterized for legal purposes as “stock” are therefore subject to restrictions on distributions to shareholders that stem from corporate law rather than contract. Hence, these securities should be considered equity instruments even when the issuer has a contractual obligation to redeem them. Whether the issuer can be required to satisfy its obligation to redeem depends on the adequacy of the assets and equity as defined by applicable legal provisions. The issuer may avoid the contractually required sacrifice of assets if the applicable legal requirements for a distribution to owners are not met.
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