Ch 3: Equity Sec Flashcards
2 primary types of equity sec
- common
2. preferred
each share of common stock entitles owner to…
portion of the co’s profits and dividends and an equal vote on directors
BOD
they oversee co’s biz
Ways to classify common stock
authorized
issues
outstanding
treasury
authorized stock
founders of the biz decide number of shares the co is authorized to issue
if a co wants to issue more shares than authorized, the charter must be amended thru a stockholder vote
issued stock
authorized stock that has been sold to investors.
authorized but unissued stock do NOT carry rights and privileges of issued shares and is not considered in determining a co’s total capitalization.
when a corp issues/sells fewer shares than the total # authorized, it normally reserves the unissued shares for future needs, including
- raising new capital for expansion
- paying stock dividends
- OR exchanging common stock for outstanding convertible bonds/preferred stock
outstanding stock
any shares that a co has issued and are in the hands of investors. If co. gets back its shares, that stock is no longer outstanding.
treasury stock
stock a corp has issued and subsequently reacquired.
Treasury stock does NOT carry the rights of outstanding common shares, such as voting rights and the right to receive dividends.
limited liability
stockh can’t lose more than the amt they invested/bought the stock of
residual claims to assets
residual right to claim assets
if corp is liquidated, common stockh have residual rights to claim corporate assets. (meaning all debts and other sec holders have been satisfied). But common stock is the most junior sec.
stock splits
high mkt price scaring away investors? co declares aa stock split to make the stock price attractive to more investors.
forward stock split increases number of shares.
stock dividends
paying common stockh a dividend in additional shares of stock.
Like stock split, there is no real change to the overall value. The market price of the stock drops.
transferability
shares of stock are freely transferrable (aka shareh do not need the permission of anyone to sell the stock in the open mkt)
1 exception is restricted stock, where sales depend on meeting the requirements of SEC Rule 144.
voting takes place at the co’s annual meeting and could include topics like…
- issuance of convertible sec or additional common stock
- substantial changes in corp’s biz (ie M&A)
- declaration of stock splits (forward and reverse)
proxies
stockh often find it difficult to attend the annual stockh’s meeting, so most vote on co matters by means of a PROXY (form of an absentee ballot).
After the proxy is returned to co, aa proxy can be auto canceled if stockh attends the meeting, authorizes a subsequent proxy, or dies.
stockh may revoke a proxy at any time before co. tabulates the final vote at its annual meeting.
nonvoting common stock
Class A vs B
Issuing nonvoting stock allows a co to raise more capital while maintaining mgmt control and continuity without diluting voting power.
preemptive rights
anti-dilution provision when issuing new shares; stockh have right to purchase enough newly issues shares to maintain their proportionate ownership in the corp.
inspection rights
right to receive annual fin statem and obtain lists of stockh.
inspection rights do not include the right to examine detailed fin records or the minutes of BOD meetings.
Preferred Stock
reps ownership in corp; NO VOTING RIGHTS; does NOT offer appreciation potential associated with common stock.
preferred stock - always issued with a FIXED rate of return. That fixed return is a fixed dividend that’s being paid.
- which is why these are usually purchased for INCOME
- SOME preferred stock is issued with variable dividend payout (known asa adjustable-rate preferred stock)
preferred stock prices tend to move inversely with interest rates. they typically do not have growth potential like common stock, making it subject to inflation risk.
Adv of Preferred Stock
- when BOD declares dividends, owners of preferred stock must receive their stated dividend in full before common stockh may receive a dividend
- if a corp goes bankrupt, preferred stockh have a priority clim over common stockh on the. remaining after creditors have been paid
bc of this, preferred stock appeals to investors looking for income and safety.
Fixed rate of return
Preferred stocks’ fixed dividend is a key attraction for income-oriented investors.
% of par value
Important point about these dividends is that, just as with common stock, there is NO OBLIGATION FOR THEM TO BE PAID. It’s NOT a debt security where interest paym are required.
- takes a vote of BOD for dividend to be declared; it IS true that the dividend is fixed and must be paid BEFORE common tho
states rate of dividend payments for preferred stock causes…
market price of preferred stock to move OPPOSITE changes in int rates
*** preferred stock reps ownership in a co like common stock, but…
its price is sensitive to int rates just like price of a bond!)
altho it’s aa fixed-income investm, preferred stock (unlike bonds) have no preset date at which it matures and no scheduled redemption/maturity value/date.
straight preferred
no special features beyond the stated dividend paym
Divid does NOT have to be made-up in future if co. can’t pay divid this yr.
Cumulative preferred
any dividends skipped must be paid before paying common dividend (aka dividends in arrears)
for anyone seeking income, cumulative is safer than straight. That is why the dividend rate is somewhat lower.
convertible preferred
gives the owner the right to exchange each preferred share for common stock shares
conversion rate is fixed at time of issue; conversion feature also results in shares with lower dividend rate
par/conv price = # of shares of common
participating preferred
fixed dividend
stock is eligible for a % of common dividend
max % is stated when stock is issued; before the participating dividend can be paid, a common dividend must be declared.
callable preferred/redeemable preferred
co can buy back the stock from investors at a stated price on the call date/any day after. the call feature would most likely be used when int rates decline. They could issue a new preferred with a lower dividend and use that money to call in the old stock.
Similar to refinancing loan when int rates go down.
Risk: issuer may decide to redeem it. That ends dividend payments.
Adj Rate Preferred
int rates on US gov T bills is one frequently used. Adjustm done quarterly.
Adv to an adjustable-rate preferred stock: it does not have the int rate risk of other fixed-income securities.
Preemptive Rights/Stock Rights
proportionate ownership in a co.
rights offering allows stockh to purchase common stock below current market price.
altho referred to as an equity security, these rights are NOT ownership. ONLY when it’s exercised does hte investor have more shares. Just like any other shares, they have voting and dividend rights.
Rights themselves do NOT pay dividends + do not vote.
stockh who receives stock rights may…
ex the rights to buy stock by sending the rights certificate and a check for the required amt fo the rights agent
sell the rights and profit from their MV (rights certificates are negotiable sec), or
let the rights expire and lose their value
subscription rights
certificate rep the privilege to buy additional shares of a corp. Corp sends this certificate to each common shareholder.
This certificate grants 1 right for each share of common stock they own. These rights have a short lifespan.
Most rights expire within 30-45 days of issue.
Terms of the Offering
terms of the offering are described in the subscription right certificate.
Terms include number of new sh a stockh may buy and the subscription (exercise) price.
Final date for exercising the rights is shown and the date for when the new shares will be issued.
Stand By Underwriter
When it comes to a rights offering, BD serve a special role as an underwrite of the offering, known as a STAND BY UNDERWRITER.
When a co’s current stockh don’t exercise their preemptive rights in an additional offering, a corp has an underwriter standing by to purchase what4ever shares remain unsold as a result of rights expiring.
This is also a firm commitment bc the underwriter unconditionally agrees to buy all shares that current stock do not subscript to.
warrants
certificate granting owner the right to buy sec from issuer at x price.
UNLIKE A RIGHT, warrant is always a LT instrument. There is NO standard length, but usually have na expiration date at least 2 yrs after issue.
Unlike rights, the purchase price is always higher than the current market price on the date of issue of the warrant.
Warrants are NOT ownership. They are ONLY when they’re exercised. Warrants themselves also don’t pay dividends or vote.
Warrants started as SWEETENERS to bonds/pref stock. It’s a chance to benefit from an increase in price of co’s stock. This enables the issuer to reduce the interest cost of debt/fixed dividend of preferred stock. These are known as bundled UNITS.
AFTER issuance, warrants are detachable and may trade separately from the bond/pref stock.
ADRs
ADRs - sec that trade on the US sec markets; they trade in US dollaars
receipt for shares of a foreign stock deposited with a custodian; similar to a stock certificate
ADR shows ownership in the deposited security. Each ADR reps a specific # of shares in a foreign co. held by a custodian. That custodian is usually a domestic bank in the US.
Rights of ADR Owners
like common stockh, they have right to receive dividends when declared; most important, those dividends are in US dollars.
ADRs do NOT have voting right.
Delivery of Foreign Sec
ADR owners have the right to exchange their ADR certificates for foreign shares they rep by returning ADRs tot he depository banks, which cancel the ADRs and deliver the underlying stock.
Rarely done, but the option is available.
Taxes on ADRs
In most countries, a withholding tax on dividends is taken.
Cases where investors hold ADRs - there would be a foreign income tax, which may be taken as a credit against any US income taxes owed by the investor.
currency risk
ADR investors are subject to this risk. Foreign co is pay8ing dividends in LOCAL currency. If that currency drops in value compared to the US dollar, the investor receives LESS money, even if the dividend stays level.
Stock’s price can go up in the local market, but if the value of that currency falls, the ADR investor’s value can go down!
Custodian holding the actual shares receives dividends in…
foreign currency! It then converts them to US dollars, which leads to currency risk and political risk.
Registered Owner
ADRs are registered on the books of the US banks responsible for them. Individual investors in ADRs are NOT considered the stock’s registered owners.
ADRs are registered on the books of US banks, so dividends are sent to custodian banks as registered owners. Bank collects payments and converts them into US dollars.
Sponsored ADRs
all exchange-listed ADRs are sponsored (aka the foreign co sponsors the issue to increase its ownership base).
Sponsored ADRs are sometimes known as ADS (Am Depositary Shares). Nonsponsored ADRs are issued by banks without assistance and participation of the issuer.
examples of 2-way auction process exchanges
- NYSE
- NYSE American LLC (American Stock Exchange - AMEX)
- CBOE
- NASDAQ
Other trades are OTC markets
exchange market
listed securities are traded; listed security is any security that’s bought and sold on an exchange.
Each stock exchange requires corps to meet certain standards before it’ll allow their stock to be listed for trading on that exchange.
NYSE has most stringent requirements.
blue-chip stocks
common-stock of well-known companies with histor of growth and dividend payments
NASDAQ
electronic stock exchange
how many stock exchanges are there?
21 registered as national stock exchanges with the SEC
***auction market
stock exchanges historically operated as auction markets! Floor brokers competed to execute trades at the most favorable prices.
The designated market maker, DMM, formerly called the specialist, conducts the auction.
OTC market
largest in the US (most # of sec)
unlike NYSE, OTC market has no central marketplace. Now, it’s on an interdealer network. OTC market has market makers. Market maker chooses to “deal” in selected OTC stocks. Market maker can select stocks in its inventory.
OTC market is a NEGOTIATED market
OTC market functions as an interdealer market in which UNLISTED SEC (sec not listed on any exchange) trade.
OTC Bulletin Board
where stocks that don’t qualify for listing on the exchanges are traded
OTC Link
Pink Sheets; quotes are printed on pink colored paper.
OTC Link stocks don’t trade very often (thinly traded). They’re registered with the SEC, but tend to be on the highly speculative side.
ECN
electronic communications network (ECN) where BD can send an order through instead of going through a market maker.
ECN is an electronic trading system that auto matches buy and sell orders at specifies prices. ECNs are SEC-sanctioned alternative trading systems (ATS); open 24 hours a day.
No inventory; ECN matches buy and sell orders as agents, NOT as principles.
ECNs make it easy for both institutional and individual investors to trade anytime.
Dark pools of Liquiduity
trading vol that occurs that is NOT openly available to the public.
Bulk of this vol reps large trades engaged in institutional traders and trading desks away from exchange markets.
These large volume transactions occur on ECNs; orders are matched electronically without routing the order to marketplace where last sale price and volume info is displayed.
Institutions using dark pools are able to execute LARGE BLOCK ORDERS WITHOUT AFFECTING PUBLIC QUOTES/PRICES. They don’t reveal investm strategy.
Dark pools account for about __% of the trading vol int eh US stock market.
17%
Portfolio Income
includes dividends, int, net capital gains derived from sale os sed
No matter the source of income, it’s taxed in the year in which it’s earned.
dividends
preferred stock always paid dividends in cash. Dividends on common stock may be paid in cash or as additional shares of stock, (stock dividend)
Cash dividend
most of cash dividends will be QUALIFIED. If dividend qualifies, the tax rates are lower than if nonqualified.
If dividend is NONqualified, ordinary income tax rates apply. For the exam, assume that any dividend from a US corp (MF, etc) is qualified unless question states otherwise.
***tax rate is __ than ordinary income rate applied to nonqualified dividends
lower
when a corp pays a stock dividend, it…
pays out shares of common stock rather than cash. There’s no monetary change to investor’s account.
There’s no monetary change to investor’s account. More shares but lower price per share.
Capital gains/losses
any sec sold within 12 mo of purchase, holding period is ST.
net capital losses
when net position is a capital gain: ST gains are taxed at ordinary income rates and LT gains at 15% (unless in the highest tax brackets); makes no difference if that gain is $100 or $1M, all is taxable.
For net LOSSES, capital losses that exceed capital gains are deductible against earned income. Annual max is $3,000/yr. If greater than that, the excess may be carried forward indefinitely as a deduction to offset capital gains in future yrs. If losses carried forward as ST, they keep that in status.
penny stock risks
penny stocks: shares worth < $5/share and is NOT listed on major exchanges (ie NYSE, NASDAQ)
lack of transparency for penny stocks
penny stocks trade on OTC and OTC Link; the requirements for trading there are less stringent than the major exchanges.
lack of liquidity
penny stocks may trade infrequently (thinly traded); Thinly traded sec usually have a large spread between buy and sell price though!
no track record
many penny stock cos are new. Some have little or no operating history. SEC warns that investors in penny stocks should be prepared to lose all of their investment.
Pump and Dump
fraud activity
unscrupulous firms or investors spread rumors in an attempt to “pump” up the stock’s price. If enough investors bite price raises and the promoters then “dump” their big loss.
Penny Stock Rules
15g rules
Risk Disclosure Doc
Disclosure of Quotes
Disclosure of Compensation
Risk Disclosure Doc for Penny Stocks
requires that customers BEFORE any initial transaction in a penny stock, be given a copy of Risk Disclosure Doc! The member firm must receive a signed and dated acknowledgment from customer that the doc has been received
SEC requires the firm to wait __
at least 2 biz days after sending statement before executing the 1st trade. This is to give clients time to carefully consider their trade.
Disclosure of Quotes (BC)
requires members to provide penny stock purchases with a current bid and asked quote on the stock to prevent prices of quoting prices that are way from current mkt to customers.
Quote must be provided to customer ORALLY or in writing before effecting any transaction with the customer for the purchase of sale of any penny stock.
Disclosure of Comepnsation
requires members to provide penny stock purchasers with info on the compensation to be earned by both the member and RR as the result of the transaction. This prevents EXCESSIVE MARKUPS.
Freq of Customer Acct Statemetns
requires members to provide penny stock purchasers with MONTHLY STATEMENTS and they can get normal statement frequency is quarterly.
Customer Suitability Determination
rule requires members who are soliciting new customers to make a suitability determination. Member must inquire as to the prospective customers’ income, net work, obj and risk tolerance.
Suitability statem is prepared using this info. It shows WHY the proposed penny stock is suitable for the customer. Member firm sends the statement to the customer for a signature, returned, then trade stocks.
established customer EXCEPTION
a member may solicit an established customer without having to prep a suitability statement IF the established customer is 1 who has:
1) effected a nonpenny stock transaction or made a deposit of funds or sec in an acct more than 1 yr before proposed penny stock trade
2) made 3 unsolicited purchases of stock stocks, on 3 separate days, involving 3 separate issues. Once a customer buys 3 different penny stocks, he’s no longer covered by suitability statem requirement.
Suitability statement for these follow ons
suitability statement does NTO apply to any customer turning in an unsolicited order to trade a penny stocks.
5% policy
adopted to ensure that investing public receives fair treatment and is charged reasonable rates for brokerage services.
Application of 5th Policy
applies to equity transactions
applies in both OTC and exchange markets. It applies when customers buy/sell sec. It does NOT apply to prospectus offerings.
If member must give a customer a prospectus, that transaction is outside the scope of the 5% policy (new issues, MFs, variable annuities, and DPPs)
***In the case of new issues, the document used to disclose the pertinent info is the…
prospectus
*** 5% policy applies to…
both principal (dealer) and agency (broker) transactions. It applies to markups, markdowns, commissions, but NOT to sec sold by prospectus tho.
