Equity Securities

Common Stock

Common stock represents an ownership interest (equity) in a corporation. When an investor purchases shares of common stock, they become a part-owner of the company, entitled to a proportional share of the corporation's profits (when distributed as dividends) and residual assets in the event of liquidation. For the Series 7 exam, you must understand the rights, characteristics, and regulatory aspects of common stock in substantially more detail than the SIE exam requires.

Rights of Common Stockholders

Common stockholders possess several fundamental rights that distinguish equity ownership from debt instruments:

• Voting rights: Common shareholders vote on major corporate matters, including the election of the board of directors, approval of mergers and acquisitions, changes to the corporate charter, and authorization of additional shares. Each share typically carries one vote. Voting can occur in person at annual meetings or by proxy.
• Dividend rights: When the board of directors declares dividends, common stockholders are entitled to receive them. Dividends are not guaranteed and are paid at the board's discretion from retained earnings. Dividends may be paid in cash, stock, or (rarely) property.
• Preemptive rights: Where the corporate charter provides for them, existing shareholders have the right to purchase newly issued shares before they are offered to the general public. This allows shareholders to maintain their proportional ownership (anti-dilution protection). Not all corporations grant preemptive rights.
• Right to transfer ownership: Shares of publicly traded common stock can be freely bought and sold on the open market, subject to applicable securities regulations.
• Right to inspect books and records: Shareholders may inspect corporate minutes, shareholder lists, and other records for proper purposes.
• Residual claim on assets: In liquidation, common stockholders receive whatever remains after all debts, taxes, and preferred stock claims have been satisfied. In practice, common shareholders frequently receive nothing in bankruptcy.
• Limited liability: A shareholder's maximum loss is limited to the amount invested. Creditors cannot pursue a shareholder's personal assets to satisfy corporate obligations.

Voting Methods

There are two principal methods for electing directors:

Statutory (Regular) Voting: Each share receives one vote per director seat. An investor with 100 shares voting for 5 director positions may cast up to 100 votes for each seat but cannot give more than 100 votes to any single candidate. This method favors majority shareholders who can sweep every board seat.

Cumulative Voting: The total number of votes equals shares owned multiplied by the number of directors being elected. These votes may be distributed in any combination. An investor with 100 shares and 5 positions has 500 total votes that can all be cast for a single candidate. Cumulative voting benefits minority shareholders by allowing them to concentrate votes to guarantee at least one board seat.

Dividend Key Dates

The dividend process involves four critical dates that Series 7 candidates must know:

1. Declaration Date: The board of directors formally announces the dividend, the amount per share, the record date, and the payment date. A liability is created on the company's balance sheet.
2. Ex-Dividend Date: Set by FINRA (not the corporation), this falls one business day before the record date. Buyers who purchase the stock on or after the ex-date do NOT receive the dividend. The stock price typically drops by approximately the dividend amount on the ex-date.
3. Record Date: Set by the corporation. Shareholders of record as of this date receive the dividend. With T+1 settlement, an investor must purchase shares at least one business day before the record date (i.e., before the ex-date) to be the holder of record.
4. Payment Date: The date the dividend is actually distributed to shareholders of record.

Restricted Stock, Control Stock, and Rule 144

The Series 7 exam tests in-depth knowledge of the resale restrictions on certain types of stock. Two categories of stock face resale limitations: restricted stock and control stock.

Restricted Stock (Unregistered Stock)

Restricted stock is acquired through private placements (Regulation D offerings), employee compensation plans, or other non-public transactions. Because these shares were not registered with the SEC and not sold through a public offering, they carry a restrictive legend on the certificate and cannot be freely resold on the open market.

Restricted stock is subject to a holding period before it can be sold. Under current rules, the required holding period is:

• 6 months for restricted securities of SEC-reporting companies (companies that file 10-Ks, 10-Qs, etc.)
• 12 months for restricted securities of non-reporting companies

Control Stock

Control stock is held by affiliates (insiders) of the issuing corporation, including officers, directors, and anyone owning 10% or more of the outstanding shares. Control stock may have been acquired through public purchases on the open market (and therefore is not restricted), but it is still subject to resale limitations because of the seller's insider status.

Rule 144: Resale of Restricted and Control Stock

SEC Rule 144 provides a safe harbor that allows restricted and control stock to be sold in the public market if specific conditions are met:

1. Holding period: Restricted stock must be held for at least 6 months (reporting company) or 12 months (non-reporting company). Control stock that is NOT restricted has no holding period requirement.
2. Current public information: The issuer must be current in its SEC filings (for reporting companies) or have adequate public information available (for non-reporting companies).
3. Volume limitations: Within any 90-day period, the seller may sell the greater of: (a) 1% of the total outstanding shares, or (b) the average weekly trading volume over the preceding four weeks. This applies to both restricted stock (during the first year for reporting companies) and control stock (always).
4. Manner of sale: Shares must be sold in routine, unsolicited brokers' transactions. The seller cannot actively solicit buyers.
5. Filing Form 144: If the sale exceeds 5,000 shares or $50,000 in any 3-month period, a Form 144 must be filed with the SEC concurrently with placing the sell order. The form is valid for 90 days.

Rule 144A: Resale to Qualified Institutional Buyers (QIBs)

Rule 144A provides a separate exemption that permits the resale of restricted securities to Qualified Institutional Buyers (QIBs) without registration. Key features:

• QIBs are institutional investors (insurance companies, investment companies, pension funds, etc.) that own and invest at least $100 million in securities on a discretionary basis. Registered broker-dealers qualify at $10 million.
• There is no holding period requirement under Rule 144A.
• Securities can be resold immediately to other QIBs.
• Rule 144A does not apply to securities of the same class as those listed on a U.S. exchange (i.e., it is for privately placed securities).
• The rule greatly enhances the liquidity of private placements and is heavily used in the institutional bond market.

Preferred Stock Types

Preferred stock is a hybrid security combining equity ownership characteristics with fixed-income features. Preferred stockholders receive a stated (fixed) dividend and have priority over common stockholders in both dividend payments and liquidation, but they are subordinate to all debt holders. The Series 7 exam requires detailed knowledge of the various types of preferred stock and their unique features.

Cumulative Preferred

Cumulative preferred stock provides the strongest dividend protection for preferred shareholders. If the corporation fails to pay the stated dividend in any period, the unpaid amount accumulates as dividends in arrears. All accumulated dividends in arrears, plus the current preferred dividend, must be paid before any dividends can be distributed to common stockholders. Most preferred stock issued in the market is cumulative.

Non-Cumulative Preferred

Non-cumulative preferred stock does not accumulate unpaid dividends. If the board skips a dividend, it is permanently lost. Common stockholders can receive dividends even if non-cumulative preferred dividends were skipped in prior periods, as long as the current preferred dividend is paid first. Non-cumulative preferred is less attractive to investors and therefore typically offers a higher dividend yield.

Convertible Preferred

Convertible preferred stock can be exchanged for a fixed number of common shares at the holder's option. The conversion feature provides upside potential if the common stock price rises significantly. Key concepts:

• Conversion ratio: The number of common shares received per preferred share upon conversion (e.g., each preferred share converts into 4 shares of common stock).
• Conversion price: Par value of preferred stock divided by the conversion ratio. If a $100 par preferred converts into 4 common shares, the conversion price is $25.
• Parity price: The common stock price at which the conversion value of the preferred equals the preferred's market price. If the preferred trades at $120 and the conversion ratio is 4, parity is $120 / 4 = $30 per common share.

Because the conversion feature adds value, convertible preferred typically pays a lower dividend than non-convertible (straight) preferred of the same issuer.

Callable Preferred

Callable preferred stock gives the issuing corporation the right to redeem (repurchase) the shares at a specified call price after a set date. The call price is typically at or slightly above par value. Companies exercise the call when interest rates decline, allowing them to retire the higher-dividend preferred and potentially reissue new preferred at a lower rate. Callable preferred generally offers a higher dividend to compensate investors for call risk.

Adjustable-Rate Preferred

Adjustable-rate (floating-rate) preferred stock has a dividend rate that resets periodically based on a benchmark interest rate, such as the Treasury bill rate. This reduces interest rate risk because the dividend adjusts with market rates. As a result, the market price of adjustable-rate preferred tends to be more stable than fixed-rate preferred, trading closer to par value.

Participating Preferred

Participating preferred stock provides additional dividend income beyond the stated rate if the company's earnings exceed a specified level. In liquidation, participating preferred shareholders may also share in excess assets beyond par value after all other claims are satisfied. This type is rare but offers enhanced upside potential.

American Depositary Receipts (ADRs)

An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank representing shares of a foreign company held in custody at a foreign branch or correspondent bank. ADRs enable U.S. investors to invest in foreign companies through a familiar mechanism: they trade on U.S. exchanges or OTC markets, are denominated in U.S. dollars, and settle through the standard U.S. clearing system.

ADR Structure and Levels

Sponsored ADRs (created with the cooperation of the foreign issuer) come in three levels:

• Level I: Trades OTC only (not listed on NYSE or Nasdaq). Minimal SEC reporting requirements. The foreign company does not need to comply with U.S. GAAP. Used to establish a U.S. trading presence with the least regulatory burden.
• Level II: Listed on a major U.S. exchange (NYSE, Nasdaq, or AMEX). Requires SEC registration (Form 20-F) and compliance with exchange listing standards. Greater visibility and liquidity but more costly compliance.
• Level III: Listed on a U.S. exchange AND the foreign company can raise new capital in the U.S. through a public offering of new shares. Requires full SEC registration (Form F-1) and compliance with U.S. GAAP or IFRS with reconciliation. This level provides the most access to U.S. capital markets.

Unsponsored ADRs are created by a depositary bank without the foreign company's involvement. Multiple banks may issue unsponsored ADRs for the same foreign company. These trade OTC and carry greater risk due to less reliable information flow.

Key ADR Risks

• Currency (exchange rate) risk: The primary additional risk. ADR values fluctuate with both the foreign stock price and the exchange rate between the foreign currency and the U.S. dollar.
• Political/sovereign risk: Changes in foreign government policies, regulations, or stability can impact the underlying investment.
• Dividend withholding: Foreign governments often withhold taxes on dividends. U.S. investors may claim a foreign tax credit to avoid double taxation.
• Liquidity risk: Some ADRs (especially Level I) may have limited trading volume.

Rights Offerings and Warrants

Both rights and warrants give holders the ability to purchase common stock at a specified price, but they differ fundamentally in their origin, purpose, duration, and pricing relative to market value.

Preemptive Rights (Subscription Rights)

When a corporation with preemptive rights provisions in its charter issues additional common shares, existing shareholders receive subscription rights that allow them to purchase new shares in proportion to their current holdings. This prevents dilution of ownership percentage.

Rights are short-term instruments, typically expiring within 30 to 45 days. The subscription (exercise) price is set below the current market price, giving each right immediate intrinsic value.

Rights Valuation Formulas:

Cum-Rights (rights-on) Value:
Value = (Market Price - Subscription Price) / (Number of Rights Required + 1)

Ex-Rights Value:
Value = (Market Price - Subscription Price) / Number of Rights Required

Warrants

Warrants are long-term securities giving holders the right to purchase common stock at a specified exercise price. Unlike rights, warrants are typically issued as sweeteners attached to bond or preferred stock offerings to make them more marketable.

• Duration: Typically 2 to 10 years, sometimes perpetual. Much longer than rights.
• Exercise price: Set above the current market price at the time of issuance (out of the money at inception).
• Value composition: Primarily time value at issuance since they are out of the money. They gain intrinsic value only if the stock rises above the exercise price.
• Detachable vs. non-detachable: Most warrants are detachable, meaning they can be separated from the bond or preferred stock and traded independently on an exchange.
• No voting or dividend rights: Warrants carry no ownership rights until exercised.
• Dilutive effect: When warrants are exercised, new shares are issued, diluting existing shareholders.

Stock Splits and Stock Dividends

Stock splits and stock dividends are corporate actions that change the number of shares outstanding and the price per share without altering the total market value of an investor's position or the company's market capitalization.

Forward Stock Splits

In a forward split, the company increases shares outstanding and proportionally decreases the price per share. Common ratios include 2:1, 3:1, and 3:2. The purpose is typically to make shares more affordable and increase liquidity.

Adjustment formulas:

• New shares = Old shares x Split ratio (e.g., 100 shares x 2 = 200 shares in a 2:1 split)
• New price = Old price / Split ratio (e.g., $80 / 2 = $40 per share)
• Total value is unchanged: 200 x $40 = $8,000 = 100 x $80

Reverse Stock Splits

In a reverse split, the company decreases shares outstanding and proportionally increases the price per share. Example: In a 1:10 reverse split, 1,000 shares at $2 become 100 shares at $20. Companies use reverse splits to raise the stock price above exchange minimum listing requirements (typically $1.00 for Nasdaq, for example).

Stock Dividends

A stock dividend distributes additional shares to shareholders rather than cash. A 20% stock dividend gives 1 additional share for every 5 owned. The cost basis per share is adjusted downward, and stock dividends are not taxable when received. Taxes are deferred until the shares are eventually sold.