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Difficulty: HardEquity Securities and Characteristics

A publicly traded corporation with both common stock and 5% cumulative preferred stock outstanding enters voluntary liquidation following a corporate reorganization. The company suspended dividend distributions in each of the prior two fiscal years. After all secured debt, unsecured claims, and legal costs are fully satisfied, funds remain available for distribution to equity owners. Which of the following statements correctly describes the distribution entitlements of the cumulative preferred stockholders relative to the common stockholders?

  1. Cumulative preferred stockholders must receive all unpaid dividend arrears from the prior two years plus their full liquidation preference before any assets may be distributed to common stockholders.Answer
  2. B
    Cumulative preferred stockholders receive priority payment only for the par value of their shares, as dividend arrears are forfeited if dividends were never formally declared by the board.
  3. C
    Preferred stockholders and common stockholders share remaining proceeds on a pro-rata basis because corporate liquidation automatically grants equal voting and distribution rights to all share classes.
  4. D
    Common stockholders take distribution priority over preferred stockholders because common shares represent true voting ownership and residual rights in the corporate enterprise.

Answer

Cumulative preferred stockholders must receive all unpaid dividend arrears from the prior two years plus their full liquidation preference before any assets may be distributed to common stockholders.
Cumulative preferred stock grants holders priority over common stockholders for both ongoing dividend distributions and liquidation preferences. When dividend payments are skipped on cumulative preferred stock, they accrue as dividends in arrears. Upon corporate liquidation, once all creditor claims are resolved, cumulative preferred shareholders must receive 100% of their accumulated dividend arrears plus their par value liquidation preference before common stockholders are eligible for any distribution.

Step-by-Step Solution

1
Analyze the corporate liquidation priority hierarchy for equity holders.
Creditors are paid first, followed by preferred stockholders, and finally common stockholders.
Common stock represents residual ownership and is junior to all debt and preferred equity claims.
2
Evaluate the contractual feature of 'cumulative' preferred stock.
Omitted dividends on cumulative preferred shares accumulate as dividends in arrears.
Unlike non-cumulative preferred stock, missed payments remain an obligation that must be satisfied before common equity distributions.
3
Apply the cumulative dividend requirement to the liquidation event.
The preferred holders are entitled to both total accumulated arrears and full par value liquidation preference prior to any payout to common holders.
Full satisfaction of senior equity claims is mandatory before junior equity claims receive funds.

Key Concept

Cumulative Preferred Stock Liquidation Hierarchy and Dividend Arrears Rights
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Topics

Equity Securities and Characteristics

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