Convertible Preferred Stock

Investor.gov describes the two main kinds of stock as common stock and preferred stock. It states that preferred stockholders usually do not have voting rights but receive dividend payments before common stockholders do. It also states that preferred stockholders have priority over common stockholders if the company goes bankrupt and its assets are liquidated, and that the company's bondholders will be paid first, then holders of preferred stock.

The Conversion Feature Under Delaware Law

Section 151 of the Delaware General Corporation Law is the Delaware statute on classes and series of stock. Section 151(a) provides that a corporation may issue one or more classes of stock, or one or more series of stock within any class, which may have such voting powers, full or limited, or no voting powers, and such designations, preferences and relative, participating, optional or other special rights, and qualifications, limitations or restrictions, as are stated and expressed in the certificate of incorporation or in the resolution or resolutions providing for the issue of the stock adopted by the board of directors pursuant to authority expressly vested in it by the certificate of incorporation.

Section 151(e) addresses conversion directly. It provides that any stock of any class or of any series may be made convertible into, or exchangeable for, at the option of either the holder or the corporation or upon the happening of a specified event, shares of any other class or classes or any other series of the same or any other class or classes of stock of the corporation, at such price or prices or at such rate or rates of exchange and with such adjustments as shall be stated and expressed or provided for in the certificate of incorporation or in the resolution or resolutions providing for the issue of the stock adopted by the board of directors. Section 151(g) refers to a certificate of designations setting forth a copy of the resolution or resolutions.

Three points appear in the statute's text. The option to convert can belong to the holder, to the corporation, or can arise on a specified event. The price or rate of exchange, and the adjustments to it, are whatever the certificate or the board resolution states. The stock into which the conversion is made can be any other class or series of the corporation's stock.

How the Terms Appear in a Prospectus Supplement

A prospectus supplement filed with the SEC shows how the conversion terms are written for a real security. On January 24, 2008, Bank of America Corporation filed a prospectus supplement under Rule 424(b)(5) for 6,000,000 shares of 7.25% Non-Cumulative Perpetual Convertible Preferred Stock, Series L. The supplement states a liquidation preference of one thousand dollars per share, with a liquidating distribution of that amount plus any declared and unpaid dividends.

On conversion, the supplement states that each share may be converted at any time, at the option of the holder, into 20 shares of the issuer's common stock, which reflects an initial conversion price of fifty dollars per share. It refers to that rate, or the adjusted rate, as the conversion rate, and it states that the conversion rate may be adjusted in the event of, among other things, stock dividend distributions and subdivisions, splits and combinations of the issuer's common stock.

This is one issuer's security. The terms of any convertible preferred stock are those stated in its own certificate or resolution.

Conversion Price and Conversion Rate

The supplement states the conversion in two ways. It gives a number of common shares for each share of preferred stock, which is 20, and it gives an initial conversion price of fifty dollars per share, which the 20 shares reflect.

Investor.gov states that in a conventional convertible security financing the conversion formula is generally fixed. It contrasts this with market price based formulas, in which the conversion ratio may be based on fluctuating market prices to determine the number of shares.

Who Holds the Option to Convert

Section 151(e) allows the option to belong to the holder, to the corporation, or to arise on a specified event. The Series L supplement shows the holder's option and the issuer's option in one security.

The holder may convert at any time. The supplement also gives the issuer a conversion right at its option on or after January 30, 2013. The issuer may exercise it if, for 20 trading days during any period of 30 consecutive trading days, the closing price of its common stock exceeds 130 percent of the then-applicable conversion price of the preferred stock.

Whichever side holds the option, the statute provides that the terms are stated in the certificate or the board resolution.

Dividends

Section 151(c) provides that holders of preferred or special stock are entitled to receive dividends at such rates, on such conditions and at such times as are stated in the certificate of incorporation or in the board resolution, payable in preference to, or in such relation to, the dividends payable on any other class or series, and cumulative or noncumulative as stated and expressed. The statute leaves the choice between cumulative and noncumulative to the certificate or resolution. It does not state that preferred stock is cumulative by default.

The Series L supplement describes noncumulative dividends. It states that dividends on the preferred stock will not be cumulative, and that the issuer will pay dividends, when, as, and if declared by its board of directors, quarterly at 7.25 percent per annum. It also states that dividends on the preferred stock cease to accrue after conversion.

Section 151(c) adds a priority rule: when dividends on the preferred stock, to the extent of the preference to which the stock is entitled, have been paid or declared and set apart for payment, a dividend on the remaining class or classes or series of stock may then be paid out of the remaining assets of the corporation available for dividends.

Ranking and Liquidation

The SEC's glossary defines a liquidation preference as a right that an investor may have to be paid before other investors upon a liquidation event, such as the sale of the company. It states that preferred stockholders typically receive a liquidation preference over common stockholders, that liquidation preferences are often expressed as a multiple of the initial investment, such as 1X or 2X, plus accrued but unpaid dividends, and that the preference may vary by class of stock and may be negotiated during each funding round.

The Series L supplement states that the preferred stock ranks, as to payment of dividends and distribution of assets upon liquidation, dissolution or winding up, equally with the issuer's 7% Cumulative Redeemable Preferred and senior to its common stock.

Investor.gov states the priority in a bankruptcy: bondholders are paid first, then holders of preferred stock, with priority over common stockholders.

Voting Rights

Investor.gov states that preferred stockholders usually do not have voting rights. The SEC's glossary lists limited voting rights, such as electing designated directors or approving major transactions, as a right of preferred stock. Section 151(a) allows the certificate or resolution to give a class voting powers, full or limited, or none.

The Series L supplement states that holders of the preferred stock do not have voting rights generally. It provides limited rights: holders may vote for the election of two additional directors to the board if dividends are unpaid for the equivalent of six or more quarterly dividend periods, and holders vote as required by Delaware law.

Redemption and Maturity

Section 151(b) provides that stock may be made subject to redemption by the corporation at its option or at the option of the holders. Whether a convertible preferred stock is redeemable therefore depends on its terms. The Series L supplement states that the preferred stock is not redeemable by the issuer at any time. The word perpetual appears in the name of the Series L security.

Dilution

The SEC's glossary describes dilution as what occurs when a company issues new shares of stock, leaving the existing stockholders with a smaller percentage ownership interest in the company.

Investor.gov addresses the risk in connection with market price based convertible securities. It describes deals in which the company issues convertible securities that allow the holders to convert their securities to common stock at a discount to the market price at the time of conversion, and states that this means the lower the stock price, the more shares the company must issue on conversion. It states that the greater the dilution, the greater the potential that the stock price per share will fall, and that the more the stock price falls, the greater the number of shares the company may have to issue in future conversions and the harder it might be for the company to obtain other financing. Investor.gov cautions that market price based convertible security deals can affect the company and possibly lower the value of its securities. It advises investors to understand the terms of a convertible security financing arrangement, including how the conversion formula works.

Price Behavior and Risk

The Series L supplement states, as a risk, that the market price of the preferred stock will be directly affected by the market price of the issuer's common stock, which may be volatile, and that this may result in greater volatility in the market price of the preferred stock than would be expected for nonconvertible preferred stock.

The supplement states that holders of the preferred stock will have no rights with respect to the common stock until they acquire the common stock. It also states that the preferred stock is unsecured and is not a savings account, deposit, or other obligation of a bank, and is not insured by the Federal Deposit Insurance Corporation or any other governmental agency. Those statements describe this issuer's security.

Convertible Preferred Stock and Convertible Bonds

Investor.gov states that a convertible security is usually a bond or a preferred stock. The two hold different places in the capital structure. Investor.gov states that in a bankruptcy bondholders are paid first, then holders of preferred stock. The SEC's glossary describes preferred stock as an ownership interest, or equity.

FINRA's Securities Industry Essentials content outline lists convertible features in two places: under equity securities, and under debt instruments as callable and convertible features.

The SEC's glossary also describes the convertible note, a loan made by an investor to a company that can be converted into a different security. It states that a convertible note is often used during seed rounds, and that typically the note will automatically convert from debt into preferred stock of the company upon the closing of the next funding round or other agreed upon conditions. A convertible note is a loan that may convert into preferred stock, while convertible preferred stock is already stock.

Treatment Under the Securities Laws

Section 3(a)(11) of the Securities Exchange Act of 1934 defines the term equity security to mean any stock or similar security; or any security future on any such security; or any security convertible, with or without consideration, into such a security; or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any other security which the Commission shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security. The definition covers stock and securities convertible into stock.

Rule 13d-3 under the Exchange Act addresses beneficial ownership for the purposes of sections 13(d) and 13(g). Under paragraph (d)(1)(i), subject to paragraph (b), a person is deemed to be the beneficial owner of a security if that person has the right to acquire beneficial ownership of the security within sixty days, including a right to acquire it through the conversion of a security. The rule provides that securities not outstanding which are subject to conversion privileges are deemed outstanding for the purpose of computing the percentage of the class owned by that person, but not for computing the percentage owned by any other person.

Resale of the Common Stock Received on Conversion

Rule 144 addresses the holding period of securities received on conversion. Paragraph (d)(3)(ii), titled conversions and exchanges, provides that if the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities are deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the surrendered securities were not convertible or exchangeable by their terms. The note to that paragraph addresses surrendered securities that originally did not provide for cashless conversion or exchange. Where the holder provided consideration, other than solely securities of the same issuer, in connection with an amendment to permit cashless conversion or exchange, the newly acquired securities are deemed acquired at the time of the amendment, so long as the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer.

Common stock received on conversion by an affiliate of the issuer is control stock, and the entry on control stock sets out the conditions of Rule 144 for its resale.

Convertible Preferred Stock in FINRA's Examination Outline

FINRA's Securities Industry Essentials examination content outline carries a 2025 copyright. Under Section 2, Understanding Products and Their Risks, the equity securities topic lists preferred stock among the types of equities, and its list of items to know includes convertible. Under the debt instruments topic, the outline lists callable and convertible features. Candidates should check the current outline before the examination.

Common Misunderstandings

One misunderstanding is that a convertible preferred stock must convert at the holder's option. Section 151(e) allows the option to belong to the holder or the corporation, or to arise on a specified event.

A second misunderstanding is that preferred stock is always cumulative. Section 151(c) allows the certificate or resolution to state that the dividends are cumulative or noncumulative.

A third misunderstanding is that convertible preferred stock is redeemable. Section 151(b) allows redemption, and the terms of each stock decide. The Series L supplement states the preferred stock is not redeemable.

A fourth misunderstanding is that convertible preferred stock is debt. The SEC's glossary describes preferred stock as an ownership interest, or equity, and Investor.gov states that bondholders are paid before preferred stockholders in bankruptcy.

A fifth misunderstanding is that a holder has the rights of a common stockholder before converting. The Series L supplement states that holders will have no rights with respect to the common stock until they acquire the common stock.

A sixth misunderstanding is that convertible preferred stock trades like straight preferred stock. The Series L supplement states that the price of the preferred stock will be directly affected by the market price of the common stock, which may result in greater volatility than would be expected for nonconvertible preferred stock.

A seventh misunderstanding is that the conversion formula is always fixed. Investor.gov states that the formula in a conventional financing is generally fixed, and that some formulas are based on fluctuating market prices.

An eighth misunderstanding is that a convertible security is always a bond. Investor.gov states that it is usually a bond or a preferred stock.

A ninth misunderstanding is that conversion starts a new holding period for resale. Rule 144 paragraph (d)(3)(ii) provides that, where the conditions are met, the newly acquired securities are deemed acquired at the same time as the securities surrendered.

A tenth misunderstanding is that a holder who has not yet converted has no ownership for beneficial ownership reporting. Rule 13d-3 deems a person with the right to acquire a security within sixty days through conversion to be its beneficial owner.

Key Points

Convertible preferred stock is preferred stock that can be converted into another class of the issuer's stock, usually common stock. Investor.gov describes a convertible security as usually a bond or a preferred stock.

Section 151(e) of the Delaware General Corporation Law lets stock be made convertible at the option of the holder or the corporation or upon a specified event, at the price or rate of exchange and with the adjustments stated in the certificate or board resolution.

Preferred stock usually has no voting rights, receives dividends before common stockholders, and has priority over common stockholders in a liquidation, according to Investor.gov. Dividends may be cumulative or noncumulative as the terms state.

The SEC's glossary describes dilution as a company issuing new shares and leaving existing stockholders with a smaller percentage ownership interest. Investor.gov warns that market price based formulas can require more shares to be issued as the stock price falls.

A convertible preferred stock's price is affected by the market price of the common stock, according to the Series L supplement.

An equity security under the Exchange Act includes any security convertible into stock, and Rule 144 treats securities received on conversion as acquired when the surrendered securities were acquired, where the rule's conditions are met.