2012-10-30 11:47:51
January 02 2010| Filed Under Investing Basics
Say you just bought stock in Disney (NYSE:DIS). As a part owner of the company
does this mean you and the family can hit Disneyland for free this summer? Why
is it that Anheuser-Busch (NYSE:BUD) shareholders don't get a case of beer each
quarter? (Forget the dividends!) Although these perks are highly unlikely, they
do raise a good question: what rights and privileges do shareholders have?
While they may not be entitled to free rides and beer, many investors are
unaware of their rights as shareowners. In this article, we discuss what
privileges come with being a shareholder and which do not. (To learn more about
shareholder rights and responsibilities, see also Proxy Voting Gives Fund
Shareholders A Say.)
Levels of Ownership Rights
Before getting into the nitty-gritty of shareholder rights, let's first look at
a company's pecking order. Every company has a hierarchical structure of rights
that accompany the three main classes of securities that companies issue:
bonds, preferred stock and common stock (To learn more, see our Stocks Basics
Tutorial.)
The priority of each security is best understood by looking at what happens
when a company goes bankrupt. You may think that as an owner you'd be first in
line for getting a portion of the company's assets if it went belly up. After
all, you did pay for them. In reality, as a common shareholder you are at the
very bottom of the corporate food chain when a company liquidates; you are the
corporate equivalent of a hyena that eats only after the lions have eaten their
share. During insolvency proceedings, it is the creditors who first get dibs on
the company's assets to settle their outstanding debts, then the bondholders
get first crack at those leftovers, followed by preferred shareholders and
finally the common shareholders. This hierarchy forms according to the
principle of absolute priority.
In addition to the rules of absolute priority, there are other rights that
differ with each class of security. For example, usually a company's charter
states that only the common stockholders have voting privileges and preferred
stockholders must receive dividends before common stockholders. The rights of
bondholders are determined differently because a bond agreement, or indenture,
represents a contract between the issuer and the bondholder. The payments and
privileges the bondholder receives are governed by the indenture (tenets of the
contract).
Risks and Rewards
Sounds pretty bad for common shareholders, doesn't it? Don't be fooled, common
shareholders are still the part owners of the business and if the business is
able to turn a profit, then common shareholders gain. The liquidation
preference we described makes logical sense: shareholders take on a greater
risk (they receive next to nothing if the firm goes bankrupt) but they also
have a greater reward potential through exposure to share price appreciation
when the company succeeds, whereas there are usually fewer preferred stocks
held by a select few. As such, preferred stocks generally experience less price
fluctuation.
Common Shareholders' Six Main Rights
Voting Power on Major Issues
This includes electing directors and proposals for fundamental changes
affecting the company such as mergers or liquidation. Voting takes place at the
company's annual meeting. If you can't attend, you can do so by proxy and mail
in your vote. (see The Purpose and Importance of Proxy Voting)
Ownership in a Portion of the Company
Previously we discussed the event of a corporate liquidation where bondholders
and preferred shareholders are paid first. However, when business thrives,
common shareholders own a piece of something that has value. Said another way,
they have a claim on a portion of the assets owned by the company. As these
assets generate profits, and as the profits are reinvested in additional
assets, shareholders see a return in the form of increased share value as stock
prices rise.
The Right to Transfer Ownership
Right to transfer ownership means shareholders are allowed to trade their stock
on an exchange. The right to transfer ownership might seem mundane, but the
liquidity provided by stock exchanges is extremely important. Liquidity is one
of the key factors that differentiates stocks from an investment like real
estate. If you own property, it can take months to convert your investment into
cash. Because stocks are so liquid, you can move your money into other places
almost instantaneously.
An Entitlement to Dividends
Along with a claim on assets, you also receive a claim on any profits a company
pays out in the form of a dividend. Management of a company essentially has two
options with profits: they can be reinvested back into the firm (hopefully
increasing the company's overall value) or paid out in the form of a dividend.
You don't have a say in what percentage of profits should be paid out - this is
decided by the board of directors. However, whenever dividends are declared,
common shareholders are entitled to receive their share. (To continue reading,
see How and Why Do Companies Pay Dividends?)
Opportunity to Inspect Corporate Books and Records
This opportunity is provided through a company's public filings, including its
annual report. Nowadays, this isn't such a big deal as public companies are
required to make their financials public. It can be more important for private
companies.
The Right to Sue for Wrongful Acts
Suing a company usually takes the form of a shareholder class-action lawsuit. A
good example of this type of suit occurred in the wake of the accounting
scandal that rocked WorldCom in 2002, after it was discovered that the company
had grossly overstated earnings, giving shareholders and investors an erroneous
view of its financial health. The telecom giant faced a firestorm of
shareholder class-action suits as a result. (Want to read more about frauds?
See The Biggest Stock Scams of All Time.)
Shareholder rights vary from state to state, and country to country, so it is
important to check with your local authorities and public watchdog groups. In
North America, however, shareholders rights tend to be more developed than
other nations and are standard for the purchase of any common stock. These
rights are crucial for the protection of shareholders against poor management.
Corporate Governance
In addition to the six basic rights of common shareholders, it is vital that
you thoroughly research the corporate governance policies of a company. These
policies are often crucial in determining how a company treats and informs its
shareholders. (For a detailed look at the importance of corporate governance to
shareholders and prospective investors as well as where to find a company's
record or policy, see Governance Pays.)
Shareholder Rights Plan
Despite its name, this plan differs from the standard shareholder rights
outlined by the government (the six rights we touched on). Shareholder rights
plans outline the rights of a shareholder in a specific corporation. A
company's shareholder rights plan, it is usually accessible in the investor's
relations section of its corporate website or by contacting the company
directly.
In most cases, these plans are designed to give the company's board of
directors the power to protect shareholder interests in the event of an attempt
by an outsider to acquire the company. To prevent a hostile takeover, the
company will have a shareholder rights plan that can be exercised when another
person or firm acquires a certain percentage of outstanding shares.
The way a shareholder rights plan may work can be best demonstrated with an
example: let's say Cory's Tequila Co. notices that its competitor, Joe's
Tequila Co., has purchased more than 20% of its common shares. A shareholder
rights plan might then stipulate that existing common shareholders have the
opportunity to buy shares at a discount to the current market price (usually a
10-20% discount). This maneuver is sometimes referred to as a "flip-in poison
pill". By being able to purchase more shares at a lower price, investors get
instant profits and more importantly, they dilute the shares held by the
competitor, whose takeover attempt is now more difficult and expensive. There
are numerous techniques like this that companies can put into place to defend
themselves against a hostile takeover. (see The Wacky World of M & A)
Sometimes There are Little Extras
Are you still looking for other perks? Although free beer may be a little
far-fetched there are companies that offer shareholders little extras. For
instance, Anheuser-Busch does offer its shareholders discounted rates to some
of the company's entertainment parks, among other things. Other companies have
been known to give their shareholders small tokens of their appreciation along
with their annual reports. For example, AT&T (NYSE:ATT) has given shareholders
a 10-minute phone card with its annual report, McDonald's (NYSE:MCD) included a
voucher for free fries and Starbucks (Nasdaq:SBUX) was gracious enough to give
shareholders a free cup of coffee.
Conclusion
Buying a stock means ownership in a company and ownership gives you certain
rights. While common shareholders might be at the bottom of the ladder when it
comes to liquidation, this is balanced by other opportunities like share price
appreciation. As a shareholder, knowing your rights is an essential part of
being an informed investor - ignorance is not a defense. Although the
Securities and Exchange Commission and other regulatory bodies attempt to
enforce a certain degree of shareholder rights, a well-informed investor who
fully understands his or her rights is much less susceptible to additional
risks.