Equity Securities

Common stock

Share terminology, and the arithmetic the exam asks for: authorized shares are the maximum the charter permits; issued shares are those actually sold at some point; treasury stock is issued stock the company has bought back, which carries no vote and no dividend; and outstanding shares are issued minus treasury.

The rights of a common shareholder: a pro rata share of dividends when declared; a vote on directors, mergers and charter changes; a preemptive right to maintain proportional ownership in a new issue, if the charter provides one; limited access to the corporate books; a residual claim in liquidation; and limited liability.

The liquidation order runs: secured creditors, then unpaid wages and taxes, then general creditors including debenture holders, then subordinated debt, then preferred shareholders, then common. Everyone who lent is paid before anyone who owned.

Voting comes in two forms. Statutory voting allows up to the number of shares owned to be cast for each open seat, with no concentration. Cumulative voting gives shares times seats as a pool that may be concentrated on one candidate, which benefits minority shareholders.

Dividends have four dates: declaration, ex-dividend, record and payable. Under the current T+1 settlement cycle, the ex-dividend date is the same business day as the record date, so a buyer must purchase at least one business day before the record date to receive the dividend.

Stock splits and stock dividends are not taxable events. They spread the same total basis over more shares, so basis per share falls proportionally and the holding period of the new shares tacks onto the old.

Preferred stock

Preferred stock is equity with a fixed dividend, stated as a percentage of par — conventionally $100 — or as a dollar amount. It ranks ahead of common for dividends and in liquidation, and behind every creditor. It usually carries no vote.

The feature types:

Cumulative — unpaid dividends accumulate in arrears and must be paid in full before any common dividend. Non-cumulative loses a skipped dividend permanently.

Participating — shares in additional distributions beyond the stated rate.

Convertible — exchangeable for common at a stated ratio, which is par divided by the conversion price. Because the conversion privilege has value, a convertible preferred pays a lower dividend than an otherwise identical straight issue.

Callable — redeemable by the issuer, usually after a protection period. Because callability disadvantages the holder, a callable issue pays a higher dividend.

Adjustable rate — the dividend resets against a benchmark, which keeps the price stable and makes it the least volatile preferred in a changing rate environment.

A straight preferred pays a fixed amount forever with no maturity, so it behaves like a perpetual bond: its price moves inversely with interest rates and it is highly rate-sensitive.

Rights, warrants and ADRs

A subscription right is a short-lived privilege distributed to existing shareholders, letting them buy new shares below the market price. One right per share owned, a life of weeks, and a subscription price set below market — so a right has value immediately and trades in the secondary market.

A warrant is long-term, with an exercise price set above the market at issue, so it starts with no intrinsic value at all. Warrants are typically attached to a bond or preferred issue as a sweetener to let the issuer pay a lower coupon, and they detach and trade separately.

Neither pays a dividend or carries a vote, and both are issued by the company — so exercising either creates new shares and dilutes existing holders, which is not true of a listed call option.

An American Depositary Receipt is a negotiable receipt issued by a US depositary bank for shares of a foreign company held abroad. It trades in the United States in US dollars and settles domestically, which is its whole purpose. Dividends are converted into dollars, net of the depositary's fee and any foreign withholding. The risks specific to it are currency risk, political and economic risk in the home country, and differing accounting standards. ADR holders generally do not have the full voting rights of a direct shareholder.

Restricted and control securities

Two different problems that SEC Rule 144 addresses together.

Restricted securities are unregistered securities acquired from the issuer or an affiliate in a transaction not involving a public offering — a private placement, a Regulation D offering, an employee award.

Control securities are securities held by an affiliate: an officer, a director, or a large enough holder to exert control. The shares themselves may be ordinary registered stock; what is restricted is who is selling.

Rule 144 sets the conditions under which a resale is not treated as a distribution. For restricted securities of a reporting issuer, at least six months must elapse between acquisition and resale; for a non-reporting issuer, one year. An affiliate's sales are additionally limited in volume — in any three-month period, no more than the greater of one percent of the shares of the class outstanding or the average weekly reported trading volume over the preceding four calendar weeks — must be made as brokers' transactions, and require a Form 144 notice if the amount sold in three months exceeds 5,000 shares or $50,000.