Financial innovations and excesses revisited: the case of auction rate preferred stock - Security Design Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Michael J. Alderson, Donald R. Fraser

The surge in financial innovation that occurred during the 1980s produced a family of securities that were designed to lower the cost of preferred stock financing by widening the availability of the Internal Revenue Code Section 246(c) dividends-received deduction. Consistent with the properties of optimal security design developed by Allen and Gale |2~, the objective of this effort was to enhance the marketability of preferred equities to the tax clientele that values them most, corporate purchasers. In a competitive market, the tax advantage of preferred equity to those purchasers is reflected in a lower pre-tax dividend yield, causing the cost of preferred equity to fall below the cost of debt financing for companies with low marginal tax rates.

Central to the success of this effort was the development of a feature that reduced share price volatility so that variable rate preferred could effectively serve as a substitute for money market investments. The first generation product to obtain acceptance was adjustable rate preferred stock, a security with a dividend rate that is adjusted quarterly to reflect changes in money market yields. Although it enjoyed a high degree of popularity early on, investor demand for adjustable rate preferred stock weakened when experience revealed that the shares retained a degree of price volatility that was incompatible with the objectives of corporate cash managers (Winger et al |13~).

The disappointing experience of adjustable rate preferred shares led to the development of improved dividend adjustment features in a second-generation product, auction rate preferred stock.(1) In addition to resetting the dividend more frequently (usually every 49 days), the refinements to the dividend adjustment procedure for auction rate preferred provide for the dividend yield to be determined in a dutch auction, thereby allowing it to fully adjust to movements in interest rates and to adapt to changes in credit risk premia within a limited range.

The dutch auction process begins when the auction agent takes orders from both existing holders and from potential holders through designated broker-dealers. The supply of available shares at a particular auction is determined by the number of shares offered for sale by existing shareholders; the new dividend yield is established by identifying the lowest rate at which those shares can be sold. This dividend rate serves a dual purpose; it restores the market value of the shares to the auction exchange price (the liquidation preference amount) and represents the cost of preferred equity to the issuer over the next seven weeks.

Existing shareholders who wish to retain their shares may choose to do so on a noncompetitive basis at the new dividend yield or may bid a rate at or above which they are willing to hold their shares. In the event that all holders elect to retain their shares, the dividend yield is automatically set at a prespecified floor that usually equals 58% of the 60-day AA commercial paper rate.(2) Current holders who place a bid must nevertheless sell their shares if the new dividend yield falls below the rate which they specified.

Bids from potential purchasers are not accepted if they exceed a prespecified maximum dividend rate which typically ranges between 110% and 150% of the 60-day AA commercial paper rate. As a consequence, existing shareholders who elect to sell their shares will be able to divest completely only if the number of acceptable bids is sufficient to cover the number of available shares. If the number of shares demanded is insufficient, the new dividend yield is set at the maximum dividend rate. In that event, the auction is said to have failed, and existing holders electing to sell will only be allowed a partial divestiture at the auction on a pro rata basis, to the extent that demand allows.

The cost of preferred equity following an auction failure is defined by the prespecified maximum dividend rate. Because the maximum dividend rate is less than the market clearing dividend yield, the market value of a failed auction rate issue is less than the auction exchange price. The holder suffers a capital loss on the auction rate shares, because the dividend yield cannot rise by the amount necessary to restore the market value to the liquidation preference amount. This condition highlights an important characteristic of auction rate preferred stock: existing holders who wish to divest have no recourse to the issuer in the event that the number of shares demanded at a dividend yield below the stated maximum rate is insufficient to cover the available supply.(3)

Initial growth of the auction rate preferred stock market was so rapid that the total dollar value of new auction rate issues exceeded the amount of convertible preferred stock and fixed rate preferred issued in 1987 (Houston and Houston |6~). This growth occurred in apparent response to the significant financing advantage to auction rate issues, which typically carry a lower dividend yield than comparable fixed rate shares. In spite of this apparent yield advantage, however, the total dollar amount of auction rate preferred stock outstanding peaked in 1988 and has declined since.