Equity Securities

Question 1

Types of Securities

Answer 1

Options, rights, warrants, ETFs/ETNs, Real estate investment trusts, CMOs

Question 2

Authorized Stock

Answer 2

Authorized stock is the maximum number of shares that a company may sell to the investing public in an effort to raise cash to meet the organization’s goals. The number of authorized shares is arbitrarily determined and is set at the time of incorporation. A corporation may sell all or part of its authorized stock. If the corporation wants to sell more shares than it’s authorized to sell, the shareholders must approve an increase in the number of authorized shares.

Question 3

Issued Stock

Answer 3

Stock that has been authorized for sale and that has actually been sold to the investing public. The total number of authorized shares typically exceeds the total number of issued shares so that the corporation may sell additional shares in the future to meet its needs. Once shares have been sold to the investing public, they will always be counted as issued shares, regardless of their ownership or subsequent repurchase by the corporation. It’s important to note that the total number of issued shares may never exceed the total number of authorized shares. Additional shares may be issued in the future for any of the following reasons: pay a stock dividend, expand current operations, exchange common shares for convertible preferred or convertible bonds, to satisfy obligations under employee stock options or purchase plans.

Question 4

Treasury Stock

Answer 4

Treasury stock is stock that has been sold to the investing public, which has subsequently been repurchased by the corporation. The corporation may elect to reissue the shares or it may retire the shares that it holds in treasury stock. Treasury stock does not receive dividends, nor does it vote. A corporation may elect to repurchase its own shares for any of the following reasons: to maintain control of the company, to increase eps, to fund employee stock purchase plans, to use shares to pay for a merger or acquisition.

Question 5

Formula to Determine Amount of Treasury Stock

Answer 5

Issued stock - outstanding stock = treasury stock

Question 6

Book Value

Answer 6

The theoretical liquidation value of the company. The book value is found by taking all of the company’s tangible assets and subtracting all of its liabilities. This will give you the total book value. To determine the book values per share, divide the total book value by the total number of outstanding common shares.

Question 7

Preemptive Rights

Answer 7

As a stockholder, an investor has the right to maintain their percentage interest in the company. This is known as a preemptive right. Should the company wish to sell additional shares to raise new capital, they must first offer the new shares to existing shareholders. If the existing shareholders decide not to purchase the new shares, then the shares may be offered to the general public. When a corporation decides to conduct a rights offering, the board of directors must approve the issuance of the additional shares. If the number of shares that are to be issued under the rights offering would cause the total number of outstanding shares to exceed the total number of authorized shares, then shareholder approval will be required. Existing shareholders will have to approve an increase in the number of authorized shares before the rights offering can proceed.

Question 8

Three Possible Outcomes of a Right

Answer 8

Exercised: the investor decides to purchase the additional shares and sends in the money, along with the rights to receive the additional shares. Sold: The rights have value and if the investor does not want to purchase the additional shares, they may be sold to another investor who would like to purchase the shares. Expire: The rights will expire when no one wants to purchase the stock. This will only occur when the market price of the share has fallen below the subscription price of the right and the 45 days has elapsed.

Question 9

Trading Cum Rights

Answer 9

When the company’s stock is trading with the rights attached. Will trade Cum Rights between the declaration and the ex date.

Question 10

Trading Ex Rights

Answer 10

After the ex date, the stock will trade without the rights or will trade ex rights.

Question 11

Cum Rights Formula

Answer 11

(Stock Price - Subscription Price) / (the number of rights required to purchase one share + 1)

Question 12

Voting

Answer 12

As a common stockholder, you have the right to vote on the major issues facing the corporation. You are a part owner of the company and, as a result, you have a right to say how the company is run. The biggest emphasis is placed on the election of the board of directors. Common stockholders may also vote on: issuance of bonds or additional common shares, stock splits, mergers and acquisitions, major changes in corporate policy.

Question 13

The Statutory Voting Method

Answer 13

Requires that votes must be distributed evenly among the candidates for whom the investor wishes to vote.

Question 14

The Cumulative Voting Method

Answer 14

Allows the shareholder to cast all of their votes in favor of one candidate, if they so choose. The cumulative method is said to favor smaller investors for this reason.

Question 15

Freely Transferable

Answer 15

Common stock and most other securities are freely transferable. This means that one investor may sell their shares to another investor without limitation and without requiring the approval of the issuer. The transfer of a security’s ownership, in most cases, is facilitated through a broker dealer. The transfer of ownership is executed in the secondary market on either an exchange or in the over-the-counter market. Ownership of common stock is evidenced by a stock certificate which identifies the: name of the issuing company, number of shares owed, name of the owner of record, CUSIP number. In order to transfer or sell the shares, the owner must endorse the stock certificate or sign the power of substitution known as a stock or bond power. Signing the certificate or a stock or bond power makes the securities transferable into the new buyer’s name.

Question 16

The Transfer Agent

Answer 16

The transfer agent is the company that is in charge of transferring the record of ownership from one party to another. The transfer agent: cancels old certificates registered to the seller, issues new certificates to the buyer, maintains and records a list of stockholders, ensures that shares are issued to the correct owner, locates lost or stolen certificates, issues new certificates in the event of destruction, may authenticate a mutilated certificate.

Question 17

The Registrar

Answer 17

The registrar is the company responsible for auditing the transfer agent to ensure that the transfer agent does not erroneously issue more shares than are authorized by the company. In the case of a bond issue, the registrar will certify that the bond is a legally binding debt of the company. The function of the transfer agent and the registrar may not be performed by a single department of any one company. A bank or a trust company usually performs the functions of the transfer agent and the registrar.

Question 18

CUSIP Numbers

Answer 18

The Committee on Uniform Securities Identification Procedures issues CUSIP numbers that are printed on the stock or bond certificates to help identify the security. CUSIP numbers must also appear on trade confirmations.

Question 19

Trade Date

Answer 19

The trade date is the day when your order is actually executed. Although an order has been placed with a broker, it may not be executed on the same day. There are certain types of orders that may take several days or even longer to execute, depending on the type of order. A market order will be executed immediately (as soon as it is presented to the market), making the trade date the same day the order was entered.

Question 20

Settlement Date

Answer 20

The buyer of a security actually becomes the owner of record on the settlement date. When an investor buys a security from another investor, the selling investor’s name is removed from the security and the buyer’s name is recorded as the new owner. Settlement date is two business days after the trade date. This is known as T+2 for all regular-way transactions in common stock, preferred stock, corporate bonds, and municipal bonds. Government bonds and options all settle the next business day following the trade date.

Question 21

Payment Date

Answer 21

The payment date is the day when the buyer of the security has to have the money in to the brokerage firm to pay for the purchase. Under industry rules, the payment date for common and preferred stock and corporate and municipal bonds bonds is four business days after the trade date or T+4. Payment dates are regulated by the Federal Reserve Board under Regulation T of the Securities Exchange Act of 1934. Although many brokerage firms require their customers to have their money in to pay for their purchases sooner than the rules state, the customer has up to four business days to pay for the trade.

Question 22

Violation

Answer 22

If the customer fails to pay for the purchase within the four business days allowed, the customer is in violation of Regulation T. As a result, the brokerage firm will ‘sell out’ and freeze the customer’s account. On the fifth business day following the trade date, the brokerage firm will sell out the securities for which the customer failed to pay. The customer is responsible for any loss that may occur as a result of the sell out and the brokerage firm may sell out shares of another security in the investor’s account in order to cover the loss. The brokerage firm then will freeze the customer’s account, which means that the customer must deposit money up front for any purchases they want to make in the next 90 days. After the 90 days have expired, the customer is considered to have reestablished good credit and then may conduct business in the regular way and take up to four business days to pay for their trades.

Question 23

Straight/Non Cumulative Preferred Stock

Answer 23

Has no additional features. The holder is entitled to the stated dividend rate and nothing else. If the corporation is unable to pay the dividend, it is not owed to the investor.

Question 24

Cumulative Preferred

Answer 24

A cumulative feature protects the investor in cases when a corporation is having financial difficulties and cannot pay the dividend. Dividends on cumulative preferred stock accumulate in arrears until the corporation is able to pay them. If the dividend on a cumulative preferred stock is missed, it is still owed to the holder. Dividends in arrears on cumulative issues are always the first dividends to be paid. If the company wants to pay a dividend to common shareholders, they must first pay the dividends in arrears, as well as the stated preferred dividend, before common holders receive anything.

Question 25

Participating Preferred

Answer 25

Holders of participating preferred stock are entitled to receive the stated preferred rate as well as additional common dividends. The holder of participating preferred receives the dividend payable to the common stockholders over and above the stated preferred dividend.

Question 26

Convertible Preferred

Answer 26

A convertible feature allows the preferred stockholder to convert or exchange their preferred shares for common shares at a fixed price known as the conversion price.

Question 27

Callable Preferred

Answer 27

A call feature is the only feature that benefits the company and not the investor. A call feature allows the corporation to call in or redeem the preferred shares at their discretion or after some period of time has expired. Most callable preferred stock may not be called in during the first few years after its issuance. This feature, which does not allow the stock to be called in its early years is known as call protection. Many callable preferred shares will be called at a premium price above par. For example, a $100 par preferred stock may be called at $103. The main reasons a company would call in their preferred shares would be to eliminate the fixed dividend payment or to sell a new preferred stock with a lower dividend rate when interest rates decline. Preferred stock is more likely to be called by the corporation when interest rates decline.

Question 28

Stock Dividend

Answer 28

A corporation that wants to reward its shareholders – but also want to conserve cash for other business purposes – may elect to pay a stock dividend to their shareholders. Each investor will receive an additional number of shares based on the number of shares that they own. The market price of the stock will decline after the stock dividend has been distributed to reflect the fact that there are now more shares outstanding, but the total market value of the company will remain the same.

Question 29

Property/Product Dividend

Answer 29

This is the least likely way in which a corporation would pay a dividend, but it is a permissible dividend distribution. A corporation may send out to its shareholders samples of its products or portions of its property.

Question 30

Taxation of Dividends

Answer 30

All qualified dividends received by investors are taxed at a rate of 15% for ordinary income earners and at a set rate of 20% for high-income earners. A key to determine which rate applies will be the investor’s marginal tax rate. If a question asks you about an investor who is in a high tax bracket such as 39%, the 20% rate will apply for the year the dividend is received. The tax rate for dividends is a hotly debated topic and may be subject to change. It is important to note that stock dividends received by investors are not taxed until the investor sells the shares.

Question 31

Warrants

Answer 31

A warrant is a security that gives the holder the opportunity to purchase common stock. Like a right, the warrant has a subscription price. However, the subscription price on a warrant is always above the current market value of the common stock when the warrant is originally issued. A warrant has a much longer life than a right and the holder of a warrant may have up to 10 years to purchase the stock at the subscription price. The long life is what makes the warrant valuable, even though the subscription price is higher than the market price of the common stock when the warrant is issued.

Question 32

Units (Warrants)

Answer 32

Many times, companies will issue warrants to people who have purchased their common stock when it was originally sold to the public during its initial public offering. A common share that comes with a warrant attached to purchase an additional common share is known as a unit.

Question 33

Attached to Bonds (Warrants)

Answer 33

Many times, companies will attach warrants to their bond offerings as a ‘sweetener’ to help market the bond offering. The warrant to purchase the common stock makes the bond more attractive to the investor and may allow the company to issue the bonds with a lower coupon rate.

Question 34

Secondary Market

Answer 34

Warrants often will trade in the secondary market just like the common stock. An investor who wishes to participate in the potential price appreciation of the common stock may elect to purchase the corporation’s warrant instead of its common shares.

Question 35

Global Depositary Receipts

Answer 35

A global depositary receipt or GDR is similar to American depository receipt. However, the GDR is issued by an international depository and allows the underlying shares to trade globally in many different countries and markets. Global depositary receipts do not trade in the United States.

Question 36

Real Estate Investment Trusts/REITs

Answer 36

A real estate investment trust is a special type of equity security. REITs are organized for the specific purpose of buying, developing, or managing a portfolio of real estate. REITs are organized as a corporation or as a trust and publicly traded REITs will trade on the exchanges or in the OTC market just like other stocks. A real estate investment trust is organized as a conduit for the investment income generated by the portfolio of real estate. REITs are entitled to special tax treatment under Internal Revenue Code Subchapter M. A REIT will not pay taxes at the corporate level as long as: it receives 75% of its income from real estate, it distributes at least 90% of its taxable income to shareholders.

Question 37

Limited Partnerships

Answer 37

A limited partnership is an entity that allows all of the economic events of the partnership to flow through to the partners. These economic events are: income, gains, losses, tax credits, deductions. There are two types of partners in a limited partnership. They are the limited partners and the general partner.

Question 38

Limited Partners

Answer 38

The limited partners: put up the capital, losses are limited to their investment, receive the benefits from the corporation, may not exercise management over the operation, may vote to change the objective of the partnership, may vote to switch or remove the general partner, may sue the general partner, if the general partner does not act in the best interest of the partnership. A limited may never exercise any management or control over the limited partnership. Doing so would jeopardize their limited status and they may be considered a general partner. It is important to note that there are no tax consequences at the partnership level. In order to qualify for the preferential tax treatment, a DPP or LP must avoid at least two of the six characteristics of a corporation. These characteristics are: continuity of life, profit motive, central management, limited liability, associates, freely transferable interest. Several characteristics cannot be avoided, such as associates and a profit motive. The easiest two characteristics of a corporation to avoid are continuity of life and freely transferable interest. The LP can put a termination date on the partnership and substitute limited partners may not be accepted or may only be accepted once the general partner has agreed.

Question 39

General Partners

Answer 39

The general partner is the person or corporation that manages the business and has unlimited liability for the obligations of the partnership business. The general partner may also: buy and sell property for the partnership, receive compensation for managing the partnership, enter into legally binding contracts for the partnership. The general partner also must maintain a financial interest in the partnership of at least 1%. The general partner may not: commingle funds of the general partner with the funds of the partnership, compete against the partnership, borrow from the partnership.

Question 40

Partnership Tax Considerations

Answer 40

If a limited partnership has used up all of its deductions and has a gain on the sale of a depreciated asset, the sale above the asset’s depreciated cost basis may subject the limited partners to a taxable recapture. There are two types of loans that a partnership may take out: a nonrecourse loan and a recourse loan. With a nonrecourse loan if the partnership defaults, the lender has no recourse to the limited partners. With a recourse loan, in the event of the partnership’s default, the lender can go after the limited partners for payment. A recourse loan can increase the investor’s cost base. Partners must monitor their cost base and adjust it for: cash or property contributions to the partnership, recourse loans, any cash or property received from the partnership. Investors are responsible for any gain on the sale of their partnership interest in excess of their cost basis.