Equities Unit 3

Question 1

What is the standby underwriter?

Answer 1

What happens when some of the shareholders fail to exercise their subscription rights? Perhaps they let
them lapse, or maybe they didn’t understand what the right was about. Maybe they just didn’t have the money to exercise, or maybe they just ignored the mail carrying the notice.
In Unit 20, we will discuss the various methods of bringing a new issue to the public. Part of the discussion is the role of the investment banker or underwriter who assists the issuer. When
it comes to a rights offering, there is a special role that is played by the broker-dealer serving as the underwriter of the offering. That is the role of the stand by underwriter.
When a company’s current stockholders do not exercise their preemptive rights in an additional offering, a corporation has an underwriter standing by to purchase whatever shares remain unsold as a result of rights expiring.
Because the standby underwriter unconditionally agrees to buy all shares that current stockholders do not subscribe to at the subscription price, the offering is a firm commitment.

Question 2

What is a Warrant?

Answer 2

 A warrant is a certificate granting its owner the right to purchase securities from the issuer at
a specified price. Warrants are sometimes confused with rights. We’ll take a look at some of the differences and similarities.
Unlike a right, a warrant is always a long-term instrument. There is no standard length, but they generally have an expiration date at least two years after issue. A more typical length is five years. In some cases, the expiration date is much longer than that. In fact, years ago, a few companies issued perpetual warrants. Those never expire.
Unlike rights, the purchase price is always higher than the current market price on the date of issue of the warrant.

Question 3

What is an American Depositary Receipts (ADRs)?

Answer 3

American Depositary Receipts (ADRs) An American depositary receipt (ADR) is simply a receipt for shares of a foreign stock deposited with a custodian. In that respect, it is similar to a stock certificate. The stock certificate shows ownership in a company’s stock. The ADR shows ownership in the deposited security. Each ADR represents a specific number of shares in a foreign company held by a custodian. That custodian is typically a bank in that company’s country. The stock must remain on deposit as long as the ADRs are outstanding. That is because the ADRs are the depositary bank’s guarantee that it holds the stock.
ADRs are securities that trade on the U.S. securities markets. ADRs are in English and trade in U.S. dollars.

Question 4

An ADR represents A. a U.S. security trading in a foreign market. B. a foreign security trading in the United States. C. a U.S. security trading in both the United States and a foreign market. D. a foreign security trading in both the United States and a foreign market.

Answer 4

Answer: B. ADR stands for American depositary receipt. ADRs are receipts issued by U.S. banks. They represent ownership of a foreign security and trade in the U.S. securities markets.

Question 5

How can the owner of an ADR receive the actual shares of the foreign company’s stock?

Answer 5

Delivery of Foreign Security
ADR owners have the right to exchange their ADR certificates for the foreign shares they represent. They can do this by returning the ADRs to the depositary banks, which cancel the ADRs and deliver the underlying stock. This is rarely done, but is an option available for the ADR holder.

Question 6

Who is the registered owner of an ADR?

Answer 6

Registered Owner
ADRs are registered on the books of the U.S. banks responsible for them. The individual investors in the ADRs are not considered the stock’s registered owners. ADRs are registered on the books of U.S. banks, so dividends are sent to the custodian banks as registered owners. The banks collect the payments and convert them into U.S. dollars.

Question 7

What are the two markets for trading equity securities?

Answer 7

There are two terms used to describe the marketplace for securities. The primary market is the market in which the proceeds of sales go to the issuer of the securities sold. That is generally called the new issues market and will be covered in Unit 20. The secondary market is where previously issued securities are bought and sold.

Question 8

Which of the two markets does the Securities Act of 1933 regulate?

Answer 8

the primary market

Question 9

Which of the two markets does the Securities Exchange Act of 1934 regulate?

Answer 9

the secondary market.

Question 10

Who thru their powers granted in the Exchange Act, aims to protect investors by regulating the exchanges, the over-the-counter market, the extension of credit by the Federal Reserve Board, broker-dealers and their registered representative, insider transactions, trading      

Answer 10

SEC, under the powers granted in the Exchange Act

Question 11

How many exchanges (stock exchanges) are on record for registration with the SEC?

Answer 11

21

Question 12

Where are the largest amount of stock traded?

Answer 12

OTC

Question 13

How does the OTC market function?

Answer 13

The OTC market functions as an interdealer market in which unlisted securities—that is, securities not listed on any exchange—trade.

Question 14

How are stocks traded on the OTC market?

Answer 14

computers and telephones connect securities dealers across the country.

Question 15

What kinds of securities are traded in the OTC market?

Answer 15

Thousands of securities are traded OTC, including stocks, corporate bonds, and all municipal and U.S. government securities.

Question 16

What is one of the best known OTC markets?

Answer 16

One of the best known of the OTC markets is the OTC Bulletin Board where stocks that do not qualify for listing on the exchanges are traded.

Question 17

What is the OTC Link?

Answer 17

Another is the OTC Link, which for many years was known as the Pink Sheets because the quotes were printed on pink colored paper. In general, the OTC Link stocks do not trade very often. We say they are thinly traded stocks. Like securities traded on the exchange, these are registered with the SEC, but tend to be on the highly speculative side.

Question 18

What is different about the marketplace of the OTC?

Answer 18

Unlike the NYSE, the OTC market has no central marketplace. Trading takes place over the phone, over computer networks, and in trading rooms across the country. The OTC market is an interdealer network.

Question 19

While the NYSE has the DMM to facilitate trading on the floor, the OTC market has what?

Answer 19

While the NYSE has the DMM to facilitate trading on the floor, the OTC market has market makers. A market maker chooses to “deal” in selected OTC stocks. This is similar in concept to an auto dealer choosing to deal in certain brands.

Question 20

How do Market Makers function in the OTC market?

Answer 20

A market maker chooses to “deal” in selected OTC stocks. This is similar in concept to an auto dealer choosing to deal in certain brands. Just as the auto dealer maintains an inventory of that brand to sell, the market maker has its selected stocks in its inventory. Just as auto dealers are willing to buy your old car, market makers are ready to buy shares of those stocks. Just as auto dealers compete to advertise the best prices, market makers compete to post the best prices at which they are ready to buy or sell those stocks. We will cover the details of how they work in Unit 17. The correct answer to a possible test question is that the OTC market is a negotiated market.

Question 21

What is an ECN?

Answer 21

Electronic Communications Network (ECN)
Technology has made many advances in the securities industry. One area of the OTC market is the electronic system known as an electronic communications network (ECN). Broker-dealers can send an order through an ECN instead of going through a market maker. An ECN is an electronic trading system that automatically matches buy and sell orders at specified prices. ECNs are SEC-sanctioned alternative trading systems (ATS). They are open 24 hours a day. There is no inventory; the ECN matches buy and sell orders as agents, not as principals. Extended hours orders are handled by ECNs.
Throughout the history of trading securities in the United States, the NYSE set the stan dards. Normal trading times were from 9:30 am until 4:00 pm ET Monday–Friday. However, in the latter part of the 20th century, the demand for after-hours trad ing grew. Now, after the closing bell, ECNs make it easy for both institutional and individual investors to trade anytime.

Question 22

What are Dark Pools?

Answer 22

Dark Pools Dark pools, sometimes referred to as dark pools of liquidity, is trading volume that occurs that is not openly available to the public. The bulk of this volume represents large trades engaged in by institutional traders and trading desks away from the exchange markets. Generally, these large volume transactions occur on ECNs. The orders are matched electronically for execution without routing the order to marketplace where last sale price and volume information is displayed.
Institutions choosing to use dark pools are able to execute large block orders without affecting public quotes or prices. In this way, they do not reveal their investment strategy. The public does not see what they are buying or selling. Indeed, orders can be placed anonymously so that the identity of the entity placing the order is unknown to the general investing public along with the volume and price for the transaction. The concern with dark pools is that some market participants are left disadvantaged because they cannot see the trades, volume, or prices agreed upon within the pools. This lack of transparency is why they are called dark pools.
Dark pools account for about 17% of the trading volume in the U.S. stock market.

Question 23

How are dividends on Preferred stocks paid?

Answer 23

Dividends on preferred stock are always paid in cash. (Never in additional shares of stock?).

Question 24

How are dividends paid on common stocks?

Answer 24

Dividends on common stock may be paid in cash or as additional shares of stock (stock dividend).

Question 25

What is the tax rate difference between qualified and nonqualified dividends?

Answer 25

If the dividend qualifies, the tax rates are lower than if nonqualified.
If the dividend is qualified, the tax rate is generally a maximum of 15%. It can be as high as 20% or more for taxpayers in the highest brackets, but that is unlikely to be tested. If the dividend is nonqualified, ordinary income tax rates apply. For test purposes, assume that any dividend from a U.S. corporation, including mutual funds, is qualified unless the question states otherwise.

Question 26

How are capital losses handled in relation to annual income?

Answer 26

Capital losses that exceed capital gains are deductible against earned income. The annual maximum is $3,000 per year. What if the losses are greater than $3,000? The excess over $3,000 may be carried forward indefinitely as a deduction to offset capital gains in future years. If the losses carried forward are short-term, they keep that status.

(See OneNote: Net capital gains).

Question 27

What is the annual maximum deduction from income for capital losses?

Answer 27

$3,000 per year indefinitely.
Capital losses that exceed capital gains are deductible against earned income. The annual maximum is $3,000 per year. What if the losses are greater than $3,000? The excess over $3,000 may be carried forward indefinitely as a deduction to offset capital gains in future years. If the losses carried forward are short-term, they keep that status.

Question 28

What is the definition of a Penny stock?

Answer 28

If the stock trades for less than $5 per share and is not listed on a major exchange such as the NYSE or the Nasdaq Stock Market, it is a penny stock.
Many penny stocks do trade for pennies, but you can find some trading at $3 or $4 per share.

Question 29

What are the risks unique to penny stocks? What are risks related to transparancy?

Answer 29

Penny stocks are highly speculative securities.
Lack of Transparency Penny stocks trade on the OTC Bulletin Board and the OTC Link. The requirements for trading there are less stringent than the major exchanges. Coverage by analysts is spotty, so getting information is more difficult than with listed stock.

Question 30

What does Rule 15g-2 have to do with penny stocks?

Answer 30

Risk Disclosure Document Rule 15g-2 requires that customers, before their initial transaction in a penny stock, be given
a copy of the Risk Disclosure Document. The member firm must receive a signed and dated acknowledgment from the customer that the document has been received. In addition to obtaining the client’s signature, the SEC requires the firm to wait at least two business days after sending the statement before executing the first trade. This is to give clients time to carefully consider their trade. Not surprisingly, the document describes penny stocks in less than flattering terms.

Question 31

What does Rule 15g-3 have to do with penny stocks?

Answer 31

Disclosure of Quotations Rule 15g-3 requires members to provide penny stock purchasers with a current bid and asked quote on the stock to prevent the practice of quoting prices that are away from the current market to customers. The quote information must be provided to the customer orally or in writing before effecting any transaction with the customer for the purchase or sale of any penny stock. This information is also sent in writing with the trade confirmation.

Question 32

What do Rule 15g-4 and 15g-5 have to do with penny stocks?

Answer 32

Disclosure of Compensation Rules 15g-4 and 15g-5 require members to provide penny stock purchasers with infor mation
on the compensation to be earned by both the member and the registered repre sentative as the result of the transaction. This is to prevent excessive markups.

Question 33

What does Rule 15g-6 have to do with penny stocks?

Answer 33

Frequency of Customer Account Statements
Rule 15g-6 requires members to provide penny stock purchasers with monthly state ments showing the estimated market value of each penny stock purchased. As we will learn in Unit 15, the normal statement frequency is quarterly.

Question 34

What does Rule 15g-9 have to do with penny stocks?

Answer 34

Customer Suitability Determination
Rule 15g-9 addresses sales practices to curb abusive sales practices. This rule requires members who are soliciting new customers to make a suitability determination. The member must inquire as to the prospective customer’s income, net worth, objectives, and risk tolerance. A suitability statement is prepared using this information. This suitability statement shows why the proposed penny stock trade is suitable for the customer. The member firm sends the statement to the customer for a signature. Once returned, trading in penny stocks may take place.

Question 35

What is the Established Customer Exception as regards penny stocks?

Answer 35

Established Customer Exception
A member may solicit an established customer without having to prepare a suitability statement. An established customer is one who has
 effected a nonpenny stock transaction or made a deposit of funds or securities in an account more than one year before the proposed penny stock trade; or
 made three unsolicited purchases of penny stocks, on three separate days, involving three separate issues. Once a customer buys three different penny stocks, he is no longer covered by the suitability statement requirement.
In addition, the suitability statement does not apply to any customer turning in an unsolicited order to trade a penny stock. These customers initiate the trade without the firm making a penny stock recommendation.

Question 36

Under SEC ri;es. fpr am im;osted mpm-Nasdaq stock to avoid being defined as a penny stock, it must have a market price oaf at least?

Answer 36

$5 per share.

Question 37

What is Rule 2121, also known as the 5% policy?

Answer 37

Rule 2121, also known as the 5% policy, was adopted to ensure that the investing public receives fair treatment and is charged reasonable rates for brokerage services. It is considered a guideline—not a firm rule. Test questions try to trap students into thinking that the rule mandates markups or commissions of 5% or less. That is not true. Charges of more than 5% can be reasonable. This would be the case with the thinly traded securities we have discussed. On the other hand, there are cases where a charge of less than 5% would be unfair. The point is, disregard the number 5%—it is simply the name of the policy.

Question 38

How is the Application of the 5% Policy carried out?

Answer 38

Application of the 5% Policy
The policy applies to transactions in equity securities. It applies in both the OTC and the exchange markets. It applies when customers buy or sell securities. It does not apply to prospectus offerings. If a member must give a customer a prospectus in any transaction, that transaction is outside the scope of the 5% policy (e.g., new issues, mutual funds, variable annuities, and DPPs). In Unit 13, we will cover the nuts and bolts of the policy.
The 5% policy applies to both principal (dealer) and agency (broker) transactions. It applies to markups, markdowns, and commissions, but not to securities sold by prospectus.