Equity Securities

Common Stock

Common stock represents an ownership interest in a corporation. When you buy shares of common stock, you become a part-owner (shareholder) of that company. Common stockholders are the last in line to receive assets if the company is liquidated, but they also have unlimited upside potential if the company grows. Understanding the characteristics and rights of common stock is fundamental to the SIE exam.

Ownership Rights

As a common stockholder, you generally receive the following rights:

• Voting rights: The right to vote on major corporate matters, including the election of the board of directors, mergers and acquisitions, and stock splits. Each share typically carries one vote.
• Dividend rights: The right to receive dividends when declared by the board of directors. However, dividends are not guaranteed; the board decides whether to pay them and how much.
• Preemptive rights: In some companies, existing shareholders have the right to purchase new shares before they are offered to the public, maintaining their proportional ownership.
• Right to inspect books and records: Shareholders can inspect certain corporate records.
• Residual claim on assets: In liquidation, common stockholders receive whatever is left after all creditors, bondholders, and preferred stockholders have been paid (often nothing).
• Limited liability: A shareholder's maximum loss is limited to the amount invested. Personal assets cannot be seized to pay corporate debts.

Voting Methods: Statutory vs. Cumulative

There are two methods of voting for directors:

Statutory (Regular) Voting: Each share gets one vote per director position being elected. If you own 100 shares and 3 directors are being elected, you cast up to 100 votes for each of the 3 seats (but cannot give more than 100 to any one candidate). This method favors majority shareholders.

Cumulative Voting: Each share gets one vote multiplied by the number of directors being elected, and these votes can be distributed in any way the shareholder chooses. With 100 shares and 3 positions, you have 300 total votes. You could give all 300 to one candidate if you wish. This method benefits minority shareholders by allowing them to concentrate their votes on a single candidate.

Dividends and Key Dates

Dividends are distributions of a company's profits to shareholders. The board of directors declares dividends, and they are typically paid in cash (though stock dividends are also possible). There are four important dates in the dividend process:

1. Declaration Date: The date the board of directors announces the dividend. At this point, a liability is created on the company's books.
2. Ex-Dividend Date (Ex-Date): Set by FINRA, this is one business day before the record date. If you purchase a stock on or after the ex-date, you will NOT receive the upcoming dividend. The stock price typically drops by approximately the dividend amount on this date.
3. Record Date: The date on which you must be a "holder of record" (listed in the company's shareholder records) to receive the dividend. Set by the corporation.
4. Payment (Payable) Date: The date the dividend is actually paid to shareholders of record.

Market Capitalization

Market capitalization (market cap) is the total market value of a company's outstanding shares. It is calculated as:

Market Cap = Share Price x Number of Outstanding Shares

Companies are commonly categorized by market cap: Large-cap (over $10 billion), Mid-cap ($2-$10 billion), Small-cap ($300 million-$2 billion), and Micro-cap (under $300 million). Larger companies tend to be more stable but may have slower growth potential, while smaller companies may offer higher growth potential with greater risk.

Preferred Stock

Preferred stock is a hybrid security that has characteristics of both equity (stock) and debt (bonds). Like common stock, it represents ownership in a company. Like bonds, it typically pays a fixed dividend. Preferred stockholders have priority over common stockholders for dividends and assets in liquidation, but they are subordinate to all creditors and bondholders.

Types of Preferred Stock

• Cumulative Preferred: If the company misses a dividend payment, the unpaid dividends accumulate as "dividends in arrears." ALL cumulative preferred dividends in arrears must be paid before any dividends can be paid to common stockholders. This is the most common type of preferred stock.
• Non-Cumulative Preferred: Missed dividends do not accumulate. If the board skips a dividend, it is lost forever. Common dividends can resume without catching up on non-cumulative preferred dividends.
• Convertible Preferred: Can be converted into a fixed number of common shares at the holder's option. This feature provides upside potential if the common stock price rises significantly.
• Callable Preferred: The issuing company can "call" (repurchase) the shares at a predetermined price after a specified date. Companies typically call preferred stock when interest rates decline, allowing them to reissue at a lower dividend rate.
• Participating Preferred: In addition to the fixed dividend, holders may receive extra dividends if the company's earnings exceed a certain level. In liquidation, they may also share in excess assets beyond par value.

Liquidation Priority

In the event of a corporate liquidation (bankruptcy), the order of claims on assets is:

1. Secured creditors (bondholders with collateral)
2. Unsecured creditors / general creditors (debenture holders)
3. Subordinated debt holders
4. Preferred stockholders
5. Common stockholders (last in line)

Stock Splits and Dividends

Corporations sometimes adjust the number of shares outstanding through stock splits or stock dividends. These corporate actions change the number of shares and the price per share, but they do not change the total value of an investor's holdings or the company's market capitalization.

Forward Stock Splits

In a forward stock split, a company increases the number of shares outstanding and proportionally decreases the price per share. The total market value remains the same.

Common forward split ratios include 2:1 (each share becomes 2), 3:1 (each share becomes 3), and 3:2 (each share becomes 1.5). Companies typically split their stock to make shares more affordable and increase trading liquidity.

Reverse Stock Splits

In a reverse stock split, a company decreases the number of shares outstanding and proportionally increases the price per share. For example, in a 1:5 reverse split, every 5 shares become 1 share at 5 times the price. Companies may execute reverse splits to increase their stock price above exchange minimum listing requirements or to appear more institutional-grade.

Stock Dividends

A stock dividend is a distribution of additional shares to existing shareholders rather than cash. For example, a 10% stock dividend gives one additional share for every 10 shares owned. Like splits, stock dividends increase the number of shares outstanding without changing total value. The price per share adjusts downward accordingly.

From a tax perspective, stock dividends are generally not taxable when received. Instead, the cost basis per share is adjusted downward. Taxes are deferred until the shares are sold.

American Depositary Receipts (ADRs)

American Depositary Receipts (ADRs) allow U.S. investors to invest in foreign companies without dealing directly with foreign stock exchanges or foreign currencies. An ADR represents shares of a foreign company held on deposit by a U.S. bank. ADRs trade on U.S. exchanges in U.S. dollars, making international investing more accessible.

How ADRs Work

A U.S. depositary bank purchases shares of the foreign company and holds them in custody. It then issues receipts (ADRs) representing those shares, which trade on U.S. exchanges like any domestic stock. One ADR may represent one share, a fraction of a share, or multiple shares of the foreign company.

Sponsored vs. Unsponsored ADRs

• Sponsored ADRs: Created with the cooperation of the foreign company. The company has a direct relationship with the depositary bank and provides financial information. Sponsored ADRs are listed on major U.S. exchanges and must comply with SEC reporting requirements. There are three levels: Level I (OTC only, least disclosure), Level II (listed on exchange, more disclosure), and Level III (listed + can raise capital through new share issuance, most disclosure).
• Unsponsored ADRs: Created by a depositary bank without the cooperation or participation of the foreign company. They typically trade OTC and may have multiple depositary banks issuing receipts for the same foreign company. Unsponsored ADRs provide less investor protection.

Risks of ADR Investing

• Currency risk: Since the underlying shares are denominated in a foreign currency, changes in exchange rates affect the ADR's value. Even if the foreign stock price stays the same, a weakening foreign currency will reduce the ADR's value in dollar terms.
• Political/country risk: Foreign governments may impose regulations, tax changes, or restrictions that affect the investment.
• Tax implications: Foreign governments may withhold taxes on dividends. U.S. investors may be able to claim a foreign tax credit on their U.S. tax return to avoid double taxation.

Rights and Warrants

Rights and warrants are both securities that give the holder the ability to purchase common stock at a specified price. However, they differ significantly in their origin, duration, and purpose.

Preemptive Rights (Stock Rights)

Preemptive rights (also called "subscription rights") allow existing shareholders to maintain their proportional ownership when a company issues additional shares. When a company announces a rights offering, each existing shareholder receives rights based on the number of shares they own.

Rights are short-term instruments, typically expiring in 30 to 45 days. They allow the holder to purchase new shares at a subscription price that is below the current market price, providing built-in value to compensate shareholders for the dilution that occurs when new shares are issued.

Theoretical Value of a Right (Cum-Rights):

Value = (Market Price - Subscription Price) / (Number of Rights Needed + 1)

Theoretical Value of a Right (Ex-Rights):

Value = (Market Price - Subscription Price) / Number of Rights Needed

Warrants

Warrants are long-term instruments that give the holder the right to buy common stock at a fixed price (the exercise price). Key characteristics of warrants:

• Typically issued as a "sweetener" attached to a bond or preferred stock offering to make the issue more attractive
• Exercise price is usually set above the current market price at the time of issuance
• Long-term duration: often 2 to 10 years, sometimes perpetual
• Warrants trade separately on exchanges and can be bought and sold independently
• Warrants do NOT carry voting rights or dividend rights until exercised
• Most of a warrant's value is time value (since the exercise price is above the market price at issuance)