Unit 3 - Equity Securities

Preemptive rights give investors

the right to maintain a proportionate interstate's in a company's stock

The value of one right is found as follows:

(Market price - subscription price) / (Number of rights to purchase 1 share + 1)

ex-rights formula is:

(Market price - subscription price) / (Number of rights to purchase 1 share)

forward stock split

A forward stock split increases the number of shares and reduces the price without affect- ing the total market value of shares outstanding; an investor will receive more shares, but the value of each share is reduced. The total market value of the ownership interest is the same before and after the split.

Convertible Preferred

A preferred stock is convertible if the owner can exchange each preferred share for shares of common stock. The price at which the investor can convert is a preset amount and is noted on the stock certificate. Because the value of a convertible preferred stock is linked to the value of the issuer's common stock, the convertible preferred's price fluctuates in line with the common. Convertible preferred is often issued with a lower stated dividend rate than nonconvertible preferred because the investor may have the opportunity to convert to common shares and enjoy capital gains. In addition, the conversion of preferred stock into shares of common increases the total number of common shares outstanding, which decreases earnings per com- mon share and may decrease the common stock's market value. When the underlying com- mon stock has the same value as the convertible preferred, it is said to be at its parity price.

reverse split

A reverse split has the opposite effect on the number and price of shares. After a reverse split, investors own fewer shares worth more per share.

Subscription Right Certificate

A subscription right is a certificate representing a short-term (typically 30 to 45 days) privilege to buy additional shares of a corporation. One right is issued for each common stock share outstanding.

warrant

A warrant is a certificate granting its owner the right to purchase securities from the issuer at a specified price (normally higher than the current market price) as of the date of issue of the warrant. Warrants represent the right to purchase shares but, in and of themselves, do not represent ownership. Therefore, warrant holders do not have voting rights like shareholders do until they exercise the warrants and become shareholders. Unlike a right, a warrant is usu- ally a long-term instrument, giving the investor the choice of buying shares at a later date at the exercise price.

Rights of ADR Owners

ADR owners have most of the rights common stockholders normally hold. These include the right to receive dividends when declared. Generally, ADRs do not have voting rights, though some ADR issuers will pass on voting rights to the holders of ADRs. As for preemp- tive rights, the issuing bank sells off the rights and distributes the proceeds pro rata to holders.

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 depository banks, which cancel the ADRs and deliver the underlying stock.

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.

Sponsored ADRs

All exchange-listed ADRs are sponsored—that is, the foreign company sponsors the issue to increase its ownership base. Issuers that sponsor ADRs provide holders with financial state- ments in English. Sponsored ADRs are sometimes referred to as American depositary shares (ADSs). Nonsponsored ADRs are issued by banks without the assistance and participation of the issuer.

STOCK SPLITS

Although investors and executives are generally delighted to see a company's stock price rise, a high market price may inhibit trading of the stock. To make the stock price attractive to a wider base of investors—that is, retail versus institutional investors—the company can declare a stock split.

Growth

An increase in the market price of shares is known as capital appreciation. Historically, owning common stock has provided investors with high real returns.

Authorized Stock

Authorized stock refers to a specific number of shares the company has authorization to issue or sell. This is laid out in the company's original charter. Often, a company sells only a portion of the authorized shares to raise enough capital for its foreseeable needs. The company may sell the remaining authorized shares in the future or use them for other purposes. Should the company decide to sell more shares than are authorized, the charter must be amended through a stockholder vote. Authorized but unissued stock does not carry the rights and privileges of issued shares and is not considered in determining a company's total capitalization.

Cumulative Preferred

Buyers of preferred stock expect fixed dividend payments. The directors of a company in financial difficulty can reduce or suspend dividend payments to both common and preferred stockholders. With cumulative preferred, any dividends in arrears must be paid before paying a common dividend. Any special feature attached to preferred, such as a cumulative feature, has a price. The cost for such a benefit is less dividend income. Cumulative preferred typically has a lower stated dividend than straight preferred (less risk equals less reward). All dividends due to cumulative preferred shareholders accumulate on the com- pany's books until the corporation can pay them. When the company can resume full payment of dividends, cumulative preferred stockholders receive their current dividends plus the total accumulated dividends—dividends in arrears—before any dividends may be distributed to common or other straight preferred stockholders. Therefore, cumulative preferred stock is safer than straight preferred stock.

Voting Rights

Common stockholders use their voting rights to exercise control of a corporation by elect- ing a board of directors and by voting on important corporate policy matters at annual meet- ings, such as: ■ issuance of convertible securities (dilutive to current stockholders) or additional common stock; ■ substantial changes in the corporation's business, such as mergers or acquisitions; and ■ declarations of stock splits (forward and reverse). Stockholders have the right to vote on the issuance of convertible securities because they will dilute current stockholders' proportionate ownership when converted (changed into shares of common).

Nonvoting Common Stock

Companies may issue both voting and nonvoting (or limited voting) common stock, nor- mally differentiating the issues as Class A and Class B, respectively. Issuing nonvoting stock allows a company to raise additional capital while maintaining management control and con- tinuity without diluting voting power.

equity securities

Corporations issue equity (and debt) securities as a means of raising capital in order to implement ideas such as expanding operations or funding a merger or acquisition. Investing in equity securities is perhaps the most visible and accessible means of creating wealth. Individual investors become owners of a publicly traded company by buying stock in that company. In doing so, they can participate in the company's success over time. They also share in the risk of operating a business; they can lose their investment. Equity securities are more risky for investors compared with bonds because once you pay for a security, the issuer is under no obligation to ever give you any of your money back.

Common Stock

Corporations may issue two types of stock: common and preferred. When speaking of stocks, people generally refer to common stock. Preferred stock represents equity ownership in a corporation, but it usually does not have the same voting rights or appreciation potential as common stock. Preferred stock normally pays a fixed, semiannual dividend and has priority claims over common stock; that is, the preferred is paid first if a company declares bankruptcy.

Callable Preferred

Corporations often issue callable, or redeemable, preferred, which a company can buy back from investors at a stated price on the call date or any date thereafter. The right to call the stock allows the company to replace a relatively high fixed dividend obligation with a lower one should interest rates decline. When a corporation calls a preferred stock, dividend payments and conversion rights cease on the call date. In return for the call privilege, the corporation usually pays a premium exceeding the stock's par value at the call, such as $103 for a $100 par value stock.

Cumulative voting

Cumulative voting allows stockholders to allocate their total votes in any manner they choose. Benefits the smaller investor

Established Customers

Established customers are exempt from the suitability statement requirement but not from the disclosure requirements. An established customer is someone who: ■ has held an account with the broker-dealer for at least one year (and has made a deposit of funds or securities), or ■ has made at least three penny stock purchases of different issuers on different days.

AMERICAN DEPOSITORY RECEIPTS (ADRs)

Foreign branches of large commercial U.S. banks issue ADRs. A custodian, typically a bank in the issuer's country, holds the shares of foreign stock that the ADRs represent. The stock must remain on deposit as long as the ADRs are outstanding because the ADRs are the depository bank's guarantee that it holds the stock.

RESIDUAL CLAIMS TO ASSETS

If a corporation is liquidated, the common stockholder (as owner) has a residual right to claim corporate assets after all debts and other security holders have been satisfied. The com- mon stockholder is at the bottom of the liquidation priority list.

Participating Preferred

In addition to fixed dividends, participating preferred stock offers owners a share of cor- porate profits that remain after all dividends and interest due other securities are paid. The percentage to which participating preferred stock participates is noted on the stock certificate. Before the participating dividend can be paid, a common dividend must be declared.

Currency Risk

In addition to the normal risks associated with stock ownership, ADR investors are sub- ject to currency risk, the possibility that an investment denominated in one currency could decline if the value of that currency declines in its exchange rate with the U.S. dollar. Currency exchange rates are an important consideration because ADRs represent shares of stock in companies located in foreign countries.

Taxes on ADRs

In most countries, a withholding tax on dividends is taken at the source. In the case of investors holding ADRs this would be a foreign income tax. The foreign income tax may be taken as a credit against any U.S. income taxes owed by the investor.

Issued Stock

Issued stock has been authorized and distributed to investors. When a corporation issues, or sells, fewer shares than the total number authorized, it normally reserves the unissued shares for future needs, including: ■ raising new capital for expansion; ■ paying stock dividends; ■ providing stock purchase plans for employees or stock options for corporate officers; ■ exchanging common stock for outstanding convertible bonds or preferred stock; or ■ satisfying the exercise of outstanding stock purchase warrants.

Income

Many corporations pay regular quarterly cash dividends to stockholders, but dividends are not considered to be fixed like the dividend stated on preferred stock. A company's dividends may increase over time as profitability increases. Dividends, which can be a significant source of income for investors, are a major reason many people invest in stocks. Issuers may also pay stock dividends (additional shares in the issuing company) or property dividends (shares in a subsidiary company or a product sample).

Outstanding Stock

Outstanding stock includes any shares that a company has issued but has not repurchased—that is, stock that is investor owned. issued stock - treasury stock = outstanding stock

Preferred stock

Preferred stock is an equity security because it represents ownership in the corporation. However, it does not normally offer the appreciation potential associated with common stock. Not all corporations issue preferred stock. Like a bond, a preferred stock is issued with a fixed (stated) rate of return. In the case of the preferred stock, it is a dividend rather than interest that is being paid. As such, these securities are generally purchased for income. Although the dividend of most preferred stocks is fixed, some are issued with a variable dividend payout known as adjustable-rate preferred stock. Like other fixed-income assets such as bonds, preferred stock prices tend to move inversely with interest rates. Most preferred stock is nonvoting. Preferred stock does not typically have the same growth potential as common stock and therefore is subject to inflation risk.

FIXED RATE OF RETURN

Preferred stock's fixed dividend is a key attraction for income-oriented investors. Normally, a preferred stock is identified by its annual dividend payment stated as a percentage of its par value, which is usually $100 on the Series 7 exam. (A preferred stock's par value is meaningful to the investor, unlike that of common stock.) A preferred stock with a par value of $100 that pays $6 in annual dividends is known as a 6% preferred. The dividend of preferred stock with par value other than $100 is stated in a dollar amount, such as a $6 preferred. The stated rate of dividend payment causes the price of preferred stock to act like the price of a bond: prices and interest rates have an inverse relationship.

CATEGORIES OF PREFERRED STOCK

Separate categories of preferred stock may differ in the dividend rate, profit participation privileges, or other ways. All, however, maintain a degree of preference over common stock. One or several of the features described next may characterize issues of preferred stock.

Adjustable-Rate Preferred

Some preferred stocks are issued with adjustable, or variable, dividend rates. Such divi- dends are usually tied to the rates of other interest rate benchmarks, such as Treasury bill and money market rates, and can be adjusted as often as semiannually.

Statutory voting

Statutory voting allows a stockholder to cast one vote per share owned for each item on a ballot, such as candidates for the BOD. A board candidate needs a simple majority to be elected. Benefits larger shareholders

Limited liability

Stockholders cannot lose more than the amount they have paid for a corporation's stock. Limited liability protects stockholders from having to pay a corporation's debts in bankruptcy.

INSPECTION OF CORPORATE BOOKS

Stockholders have the right to receive annual financial statements and obtain lists of stockholders. Inspection rights do not include the right to examine detailed financial records or the minutes of board of director's meetings.

PROXIES

Stockholders often find it difficult to attend the annual stockholders' meeting, so most vote on company matters by means of a proxy, a form of absentee ballot. After it has been returned to the company, a proxy can be automatically canceled if the stockholder attends the meeting, authorizes a subsequent proxy, or dies. When a company sends proxies to sharehold- ers, usually for a specific meeting, it is known as a proxy solicitation.

Straight (Noncumulative)

Straight preferred has no special features beyond the stated dividend payment. Missed dividends are not paid to the holder. The year's stated dividend must be paid on straight pre- ferred if any dividend is to be paid to common shareholders. Preferred stock with no special features is known as straight preferred.

PENNY STOCKS

The SEC adopted the penny stock cold-calling rules to prevent certain abusive sales prac- tices involving high-risk securities sold to unsophisticated investors. These rules involve the solicitation of non-Nasdaq equity securities traded in the over-the-counter (OTC) market for less than $5 per share. These equity securities are frequently called penny stocks and are considered highly speculative.

Terms of the Offering

The terms of a rights offering are stipulated on the subscription right certificates mailed to stockholders. The terms describe how many new shares a stockholder may buy, the price, the date the new stock will be issued, and the final date for exercising the rights.

TYPES AND CHARACTERISTICS OF EQUITY SECURITIES

There are many different types of equity securities. The two primary types of equity securi- ties most investors are familiar with are common and preferred stocks. These are considered ownership positions in a corporation. All corporations issue common stock. Each share of common stock entitles its owner to a portion of the company's profits and dividends and an equal vote on directors and other important matters. Most corporations are organized in such a way that their stockholders regularly vote for and elect candidates to a board of directors (BOD) to oversee the company's business. By electing a BOD, stockholders have some say in the company's management but are not involved with the day-to-day details of its operations.

Treasury Stock

Treasury stock is stock a corporation has issued and subsequently repurchased from the public. The corporation can hold this stock indefinitely or can reissue or retire it. A corpora- tion could reissue its treasury stock to fund employee bonus plans, distribute it to stockholders as a stock dividend, or under certain circumstances, redistribute it to the public in an addi- tional offering. Treasury stock does not carry the rights of outstanding common shares, such as voting rights and the right to receive dividends. By buying its own shares in the open market, the corporation reduces the number of shares outstanding. If fewer shares are outstanding and operating income remains the same, earnings per share increase. treasury stock = issued shares - outstanding shares

antidilution provision

When a corporation raises capital through the sale of additional common stock, it may be required by law or its corporate charter to offer the securities to its common stockholders before the general public. This is known as an antidilution provision.

Regardless of activity, if the account holds penny stocks,

broker-dealers must provide a monthly statement of account to the customer. This must indicate the market value and num- ber of shares for each penny stock held in the account, as well as the issuer's name.

it is assumed an investor buys or owns shares of stock with the intent of selling them at a higher price in the future

buy low, sell high later. An investor who buys shares is considered long the stock.

shareholders do NOT vote on

dividend-related matters such as when they are declared and how much they will be

These rules state that when a broker-dealer's representative contacts a potential customer to purchase penny stocks, the representative must

first determine suitability on the basis of information about the buyer's financial situation and objectives. The customer must sign and date this suitability statement before the penny stock trades can be affected. In addition, the broker-dealer must disclose: ■ the name of the penny stock, ■ the number of shares to be purchased, ■ a current quotation, and ■ the amount of commission that the firm and the representative received.

Dividends are declared in the

foreign currency but are payable in US dollars lending to currency risk

Existing stockholders have preemptive rights or stock rights that entitle them to

maintain their proportionate ownership in a company by buying newly issued shares before the company offers them to the general public. A rights offering allows stockholders to purchase common stock below the current market price. The rights are valued separately from the stock and trade in the secondary market during the subscription period.

Callable preferred stock is unique because

of the risk that the issuer may buy it back and end dividend payments. Because of this risk, callable preferred has a higher stated rate of dividend payment than straight, noncallable preferred. Issuers are likely to call securities when interest rates are falling. An issuer would prefer to pay a lower rate for money. Issuers call securities with high rates and replace them with securities that have lower fixed-rate obligations.

The provision of the penny stock rules apply

only to solicited transactions. Transactions not recommended by the BD are exempt.

Stockholders then have a preemptive right to

purchase enough newly issued shares to maintain their proportionate ownership in the corporation.

Stock is traded cum rights until the ex-date. An investor who buys stock cum rights

receives the right. An investor who buys stock ex-rights does not.

If a proxy vote could change control of a company (a proxy contest), all persons involved in the contest must

register with the SEC as participants or face criminal penalties. This registration requirement includes anyone providing unsolicited advice to stockholders about how to vote. However, brokers who advise customers who request advice are not considered to be participants. A stockholder may revoke a proxy at any time before the company tabulates the final vote at its annual meeting.

An investor may also sell shares before he owns them, with the intent of buying them back at a lower price in the future

sell high, buy low later. Such a transaction, known as a short sale, involves borrowing shares to sell that the investor must eventually replace. An investor who sells borrowed shares is considered short the stock until he buys and returns the shares to the lender. People generally expect to receive financial growth, income, or both from common stock investments.

Preferred stock represents ownership in a company like common stock, but its price is

sensitive to interest rates - just like the price of a bond No Maturity Date or Set Maturity Value. Although it is a fixed-income investment, preferred stock, unlike bonds, has no preset date at which it matures and no scheduled redemption date or maturity value.

shareholders vote on

stock splits, board members, and issuance of additional equity-related securities such as common stock, preferred stock, and convertible securities.

Companies that solicit proxies must

supply detailed and accurate information to the share- holders about the proposals to be voted on. Before making a proxy solicitation, companies must submit the information to the Securities and Exchange Commission (SEC) for review.

Warrants are usually offered to the public as

sweeteners, or inducements, in connection with other securities, such as bonds or preferred stock, to make those securities more attrac- tive. The issuer is able to reduce the cost of debt or the fixed dividend of preferred stock because of the added benefit to investors that allows them to exercise the warrant. Such offer- ings are often bundled as units. After issuance, the warrants are detachable and trade separately from the bond or pre- ferred stock. When first issued, a warrant's exercise price is set well above the stock's market price. If the stock's price increases above the exercise price, the owner can exercise the warrant and buy the stock below the market price or sell the warrant in the market.

preferred stockholders generally have two advantages over common stockholders.

■ When the board of directors declares dividends, owners of preferred stock must receive their stated dividend in full before common stockholders may be paid a dividend. ■ If a corporation goes bankrupt, preferred stockholders have a priority claim over common stockholders on the assets remaining after creditors have been paid. Because of these features, preferred stock appeals to investors seeking income and safety.

Common stock can be classified as:

■ authorized, ■ issued, ■ outstanding, and ■ treasury.

A stockholder who receives rights may:

■ exercise the rights to buy stock by sending the rights certificates and a check for the required amount to the rights agent; ■ sell the rights and profit from their market value (rights certificates are negotiable securi- ties); or ■ let the rights expire and lose their value.

A corporation buys back its stock for a number of reasons, such as to:

■ increase earnings per share; ■ have an inventory of stock available to distribute as stock options, fund an employee pen- sion plan, and so on; or ■ use for future acquisitions.