Offering safe alternatives for companies and investors to carry out investments and raise funds is undoubtedly crucial in fostering Brazil's economic activity and capital markets, especially in a crisis scenario.
An instrument widely used in day-to-day operations of Brazilian companies are the preferred shares. In addition to allowing greater flexibility in defining the capital structure without a loss of corporate control, preferred shares may offer a wide range of rights to investors, thereby attracting those investors who have no interest in participating in the management of the company.
Since they do not usually grant voting rights to their holders, but rather award them, in exchange, with preferences that often resemble the economic advantages inherent to debt instruments, preferred shares are usually considered as hybrid instruments. This fact was taken into account in the analysis of financial statements, but did not result, until 2010, in the obligation to account for certain preferred shares as financial liabilities.
Since 2010, when large Brazilian companies and enterprises began to adopt the Brazilian Accounting Board - CPC Rule No. 39 - "Financial Instruments: Presentation", drafted based on the IAS 32 - Financial Instruments: Presentation (IASB) (CPC 39), even shares, which by their nature represent a portion of capital stock, can be considered as financial liabilities. That is, regardless of the legal form, analysis of the essential characteristics of a given instrument is fundamental for properly classifying it as a liability or an asset.
The application of IAS 32 and CPC 39 has raised and continues to raise many questions and controversies at the international and national levels. Some foreign and local studies argue that preferred shares, regardless of their characteristics, should be classified as a financial liability. These analyses also show that the application of IAS 32 would have resulted in the disuse of preferred shares in certain countries, such as the Netherlands.
Given the great practical importance of its guidelines and the significant impacts of classifying them as assets or liabilities in the capital structure of a company, CPC 39 remains a topic of debate in the market and its implementation often presents a challenge for companies.
In this context, we have analyzed the circumstances that would allow for classification of preferred shares as financial liabilities based on the legal instruments of the Brazilian Corporation Law and the guidelines set forth in CPC 39.
Pursuant to Article 17 of the Brazilian Corporation Law, preferred shares may have the following advantages: (i) priority in the distribution of dividends, whether minimum or fixed; (ii) priority in the reimbursement of capital, with or without a premium; and/or (iii) accumulation of the foregoing preferences.
Priority in capital reimbursement, with or without premium, is a right that can easily be classified within the concept of equity, since it addresses a residual interest in the assets of the company. Meanwhile, priority in the distribution of dividends, whether fixed or minimum, is a right that more closely resembles the concept of a liability.
A liability can be defined as: (i) a contractual obligation to deliver, or exchange under unfavorable circumstances, cash or financial assets with another person, or (ii) a present obligation arising from past events, the settlement of which is expected to result in the outflow of funds from an entity capable of generating economic benefits.
For example, fixed dividends and prefixed interest are similar in the sense that such disbursements can be fixed on a predetermined basis, often related to the invested capital itself. However, despite the similarity, it seems incorrect to classify preferred shares as financial liabilities based solely on this characteristic. This is because the distribution is conditioned to the future generation of profits. That is to say, the company does not, per se, have a present obligation to pay in this case.
Therefore, in principle, we understand that preferred shares, in essence, should be classified within the concept of assets. It so happens that various other rights may be linked to the preferred shares and provided for in the company's bylaws, such as (i) partial or full rights of redemption of the investment and/or (ii) rights that affect the company's discretion in the distribution of dividends.
CPC 39 expressly provides that preferred shares are considered financial liabilities whenever they grant a right of redemption to be exercised on a determined date or at the discretion of the holder, regardless of the potential inability of the company to redeem such shares. On the other hand, when redemption is at the discretion of the company, such preferred shares do not represent a present obligation and, therefore, do not meet the requirements of a financial liability.
In addition to redemption, CPC 39 also indicates that preferred shares with priority in dividend distributions, whether or not cumulative, will be considered assets, provided that distributions can be made at the issuer's discretion. That is, if there is any obligation of distribution on the part of the issuer, such shares, on the contrary, should be considered as financial liabilities.
CPC 39 gives no other concrete examples; it establishes that all other rights conferred by a certain preferred share should be analyzed to identify whether it has fundamental characteristics of an asset or a financial liability.
Because CPC 39 is not exhaustive, the correct classification of preferred shares should reflect the essence of the rights granted thereby within the concepts of liabilities and assets. Often, this makes classification complex, especially in unconventional fundraising structures with various nuances.
Companies should evaluate, as soon as possible, the substance of the rights linked to preferred shares under the Brazilian Corporation Law and CPC 39 in order to avoid any surprises or questions regarding the accounting of such investment.
If the accounting is different from the initial intent, the impacts may be material in what concerns to financial covenants, which may lead to acceleration of debt and cross-default on financial agreements. In addition, considering the different tax treatment of dividend income and debt instruments (interest), incorrect classification may result in tax liabilities for both the holders and the company.
The correct classification of preferred shares is fundamental for the financial standings of a company to be properly reflected in its financial statements, thereby avoiding asymmetries of information within the market which could harm creditors and investors.