Dividend arrears

What Is Dividend Arrears?

Dividend arrears refer to the accumulated unpaid dividends on preferred stock, specifically for shares with a cumulative feature, that a company has failed to pay to its shareholders on schedule. This concept is central to corporate finance, as it highlights a company's ongoing obligation to its preferred shareholders even when facing financial constraints. For dividend arrears to exist, the preferred stock must be "cumulative," meaning that any missed dividend payments do not expire but instead accrue and must be paid before any dividends can be distributed to common stock holders.¹⁴, ¹⁵

History and Origin

The concept of dividend arrears is intrinsically linked to the development of different classes of equity, particularly preferred stock, which emerged to offer investors a hybrid security with characteristics of both debt and equity. The "cumulative" feature on preferred stock was introduced to provide an added layer of protection to preferred shareholders, ensuring they would eventually receive all promised dividends, even if the company faced temporary financial difficulties.¹³ This mechanism serves to protect the income stream of preferred shareholders by formalizing their entitlement to missed payments, which helps make preferred stock an attractive financing tool for companies.¹¹, ¹² For instance, companies like CIT Group have historically navigated periods involving unpaid preferred dividends, which they later addressed.¹⁰

Key Takeaways

Dividend arrears represent missed dividend payments on cumulative preferred stock that accumulate over time.
These accumulated unpaid dividends must be settled by the company before any dividends can be paid to common shareholders.
The existence of dividend arrears often signals financial strain or strategic cash preservation within a company.
Preferred stockholders with cumulative rights maintain a priority claim to these unpaid dividends.
Dividend arrears impact a company's balance sheet as a liability and affect its cash flow planning.

Formula and Calculation

Dividend arrears are not calculated using a complex formula, but rather as the simple sum of all previously missed dividend payments on cumulative preferred stock. The calculation involves:

\text{Total Dividend Arrears} = \sum_{i=1}^{n} (\text{Dividend per share} \times \text{Number of preferred shares outstanding})_{i}

Where:

(\text{Dividend per share}) = The stated dividend rate per preferred share for a specific period.
(\text{Number of preferred shares outstanding}) = The total number of preferred shares subject to the dividend payment for that period.
(i) = Each period (e.g., quarter, year) in which a dividend payment was missed.
(n) = The total number of periods for which dividends have been missed.

For an investor, calculating the dividend arrears owed on their shares would involve multiplying the fixed dividend rate per share by the number of periods the dividend was not paid.

Interpreting Dividend Arrears

The presence of dividend arrears provides critical insights into a company's financial health and its corporate governance practices. When a company accumulates dividend arrears, it typically indicates that the company has experienced significant financial challenges, such as insufficient retained earnings or liquidity issues, preventing it from meeting its dividend obligations.⁹

For potential investors, especially those considering preferred stock, the existence of arrears signals a higher risk profile for the company. While cumulative preferred shareholders have a legal claim to these unpaid dividends, the delay in payment suggests a need for careful evaluation of the company's prospects for recovery and its ability to resume regular dividend payments. Conversely, for a company that clears its dividend arrears, it often signals an improvement in financial stability and a renewed commitment to its shareholders.

Hypothetical Example

Consider "Alpha Corp," which has 1 million shares of cumulative preferred stock outstanding, each with a stated annual dividend of $2.00, payable quarterly ($0.50 per share).

In 2023, due to unexpected market downturns and significant investment in new projects, Alpha Corp's board of directors decided not to declare or pay any dividends for the last two quarters.

Quarter 3, 2023 missed dividend: $0.50 per share x 1,000,000 shares = $500,000
Quarter 4, 2023 missed dividend: $0.50 per share x 1,000,000 shares = $500,000

By the end of 2023, Alpha Corp had accumulated $1,000,000 in dividend arrears. This amount would be recorded as a liability on Alpha Corp's balance sheet.

In 2024, Alpha Corp's financial situation improves. Before paying any dividends to its common stock shareholders, Alpha Corp must first pay the full $1,000,000 in dividend arrears to its preferred shareholders, in addition to any current preferred dividends declared for 2024.

Practical Applications

Dividend arrears are a critical consideration in various financial contexts:

Investor Analysis: Investors analyze dividend arrears when assessing the risk and potential return of cumulative preferred stock. A company's history of managing or accumulating dividend arrears can be a key indicator of its financial resilience and management's commitment to its obligations. The Securities and Exchange Commission (SEC) provides resources explaining how preferred stock works, including features like cumulative dividends.⁸
Corporate Restructuring: During periods of financial distress or corporate restructuring, addressing dividend arrears is often a primary concern. Companies may negotiate with preferred shareholders to restructure these obligations, sometimes offering a combination of cash, new preferred shares, or common stock in settlement.⁷ This forms part of the company's overall capital structure management.
Mergers and Acquisitions (M&A): In M&A scenarios, the acquiring company must account for any existing dividend arrears of the target company. These arrears represent a significant liability that must be settled or negotiated as part of the acquisition agreement.
Credit Ratings and Lending: Lenders and credit rating agencies closely monitor dividend arrears as an indicator of a company's financial stress. Accumulating arrears can negatively impact a company's creditworthiness, making it harder or more expensive to obtain future financing. Financial institutions, such as those discussed by the Federal Reserve Bank of San Francisco, consider preferred stock and its features when assessing a company's financing needs.⁶
Regulatory Compliance: Publicly traded companies must disclose their financial obligations, including dividend arrears, in their financial statements and SEC filings, providing transparency to the market.⁵

Limitations and Criticisms

While designed to protect preferred shareholders, the concept of dividend arrears has certain limitations and can draw criticism:

Impact on Common Shareholders: The accumulation of dividend arrears directly affects common stock shareholders. They cannot receive any dividend payments until all preferred dividend arrears are fully paid. This can lead to prolonged periods without dividends for common shareholders, impacting their investment returns and potentially their patience.
Prolonged Financial Strain: While dividend arrears provide flexibility for a company to conserve cash during tough times, the growing liability can become a significant burden, prolonging the period of financial distress and making it harder for the company to return to profitability or attract new equity investment.
Market Perception: The existence of substantial dividend arrears can create a negative perception of the company in the stock market. It signals underlying financial issues, which can depress the company's share price for both preferred and common stock and erode investor confidence. The Financial Times has reported on how such features influence preferred share valuations.⁴
Liquidation Priority: Although preferred shareholders have priority for dividend arrears over common shareholders, their claim for repayment is still subordinate to that of debt holders in the event of liquidation. If a company faces bankruptcy, preferred shareholders might not recover the full amount of their arrears or even their initial investment.

Dividend Arrears vs. Cumulative Preferred Stock

The terms "dividend arrears" and "cumulative preferred stock" are closely related but refer to distinct concepts. Cumulative preferred stock is a type of preferred stock that carries a specific feature: if the company misses a dividend payment, that payment accumulates and must be paid in the future. The cumulative feature is a contractual right embedded within the terms of the preferred shares. Dividend arrears, on the other hand, are the result of this cumulative feature when dividend payments are indeed missed. They represent the actual dollar amount of those accumulated, unpaid dividends. Without cumulative preferred stock, dividend arrears cannot exist, as missed dividends on non-cumulative preferred stock are simply forfeited and do not accrue.³

FAQs

Q1: Do all preferred stocks accrue dividend arrears?

No, only cumulative preferred stocks accrue dividend arrears. If a preferred stock is non-cumulative, any missed dividends are simply forfeited and do not accumulate.²

Q2: What happens if a company cannot pay its dividend arrears?

If a company cannot pay its dividend arrears, these unpaid amounts continue to accumulate. The company is legally obligated to pay these arrears before it can distribute any dividend to common stock holders. Failure to resolve significant arrears can signal severe financial distress and may lead to further financial restructuring or, in extreme cases, liquidation.

Q3: Are dividend arrears considered a debt?

While dividend arrears represent an obligation, they are typically not considered "debt" in the same way as bonds or bank loans. They are a liability owed to preferred shareholders, but they usually do not carry the same legal enforcement mechanisms or consequences (like default leading to bankruptcy) as traditional debt. However, they are a significant financial obligation that must be settled.

Q4: How do dividend arrears affect a company's financial statements?

Dividend arrears are typically disclosed in the notes to a company's financial statements or as a separate line item if material. They are usually treated as an appropriation of retained earnings when declared and paid, or as a contingent liability when they accumulate but remain undeclared.

Q5: Can a company pay common stock dividends if it has dividend arrears?

No. A fundamental rule of corporate finance is that all dividend arrears on cumulative preferred stock must be fully paid before a company can declare or pay any dividends to its common stock shareholders. This payment priority protects preferred shareholders.¹