Securities - Update 3

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4 Chiswell Street

London

EC1Y 4UP

Tel: 0845 072 7620

Fax: 020 7496 8607

Email: [email protected]

www.7city.com

Securities & Investment Institute

Level 3 Certificate in Investments

Unit 2 – Securities

Unit 4 – SFD

Update Supplement

This supplement should be used if

your examination is on or after

19/11/07

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Copyright 7city Learning Limited 2007

All rights reserved. No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording or otherwise) without the prior permission of the copyright owner. Any person who does any

unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages.

While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by 7city Learning Limited.

Edition 5 (01/04/2004)

Edition 5 (1/4/04)

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Dear Delegate

In order to give you a more rounded view of the syllabus, we have made some updates to the study material.

A summary of the changes follows this page. Where new content has been added, updated subject(s) appear towards

end of the supplement. These changes are also reflected in 7C-online where content and questions are constantly

updated from the database.

The majority of the amendments made to the material are aimed at tightening up the existing content and better defining

examinable areas. If you have any concerns about this update, feel free to call the number below and speak to myself or

another 7city Certificates tutor.

Kind regards and good luck with your study.

Andy Bennett

Head of Securities and Investment Institute Certificates

7city Learning

4 Chiswell Street

London

EC1Y 4UP

Tel: 0845 072 7620

Fax: 020 7496 8607

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SUMMARY OF CHANGES

CHAPTER 1 – EQUITIES: TYPES AND FEATURES

Subject 1 - Equites types and features: introduction

• Question weighting – content updated.

• Learning outcomes – content updated.

Subject 3 – Ordinary and preference shares

• Partly paid shares and calls – new subject added.

• Preference shares – content updated.

Subject 5 – Dividend payments

• New subject added

Subject 6 – Ownership and title documents

• SDRT – new topic added

Subject 8 – American and Global Depository Receipts

• ADRs: features – content updated

Subject 9 – Equities types and features: summary

• Key concepts – new content added

CHAPTER 2 – ISSUING EQUITIES

Subject 1 – Issuing Equities: introduction

• Learning outcomes – content updated.

Subject 2 – Equities: methods of issue

• The origination team – content updated.

• Pricing offers for subscription and offers for sale – content updated.

Subject 3 –London Stock Exchange: Official List and AIM

• Introduction – content updated.

• The Official List and the UK Listing Authority (UKLA) – content updated

• Listing application – content updated

• Sponsors and advisors – content updated

• Official List: Continuing obligations – new topic added

• AIM: continuing obligations – topic updated

Subject 4 –Underwriting and stabilisation

• Underwriting – content updated

• Stabilisation – content updated

Subject 5 –Issuing equites: summary

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CHAPTER 3 – EQUITY MARKETS

Subject 1 – Equity Markets: introduction

• Question weighting – content updated.

• Learning outcomes – content updated.

Subject 3 – London Stock Exchange: an overview

• LSE: the different securities traded – content updated and new content added

Subject 4 –SETS

• SETS: introduction – content updated

• SETS: trading day – content updated and new content added

• SETSqx – new topic added

Subject 5 – LSE’s central counterparty service (CCP)

• New subject added

Subject 12 – Virt-x

• Content updated and new content added

Subject 13 – PLUS

• Content

updated

Subject 15 –Settlement

• New subject added

Subject 17 –Equity markets: summary

• Content updated and new content added

CHAPTER 4 – WARRANTS

Subject 1 – Warrants: introduction

• Question weighting – content updated.

• Leaning outcomes – new content added

Subject 4 – Warrant value: introduction

• New subject added

CHAPTER 6 – DEBT TYPES AND FEATURES

Subject 1 – Debt types and features: introduction

• Question weighting – content updated.

Subject 3 – Government bonds: features

• Index linked gilts – content updated

Subject 4 – Corporate bonds: features

• Corporate bonds: security – content updated and new content added

• Impact of security – content updated

• Local authority loans – content updated

Subject 5 – Domestic and overseas bonds: features

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CHAPTER 7 – ISSUING DEBT

Subject 1 – Issuing debt: introduction

• Question weighting – content updated.

Subject 3 – Corporate and overseas bonds: issue

• Corporate bonds: issue – content updated

Subject 4 – Other bond issuers

• Content

updated

CHAPTER 8 – DEBT VALUATION

Subject 1 –Debt valuation: introduction

• Learning outcomes – content updated.

Subject 2 –Debt valuation: prices and yields

• Bond yield calculations – content updated.

• Spread analysis – new content added.

• Clean vs. dirty prices – new content added.

Subject 3 –Debt valuation: factors affecting prices

• Bond prices: bond futures – new topic added

• Convexity – content updated

• Credit enhancements – new topic added.

Subject 5 –Debt valuation: factors affecting prices

• Key concepts – content updated.

CHAPTER 9 – DEBT MARKETS

Subject 1 –Debt markets: introduction

• Question weighting – content updated.

Subject 2 –Government bonds: trading

• UK government gilts: trading – content updated

Subject 3 –Corporate bonds: trading

• Corporate bonds: introduction – content updated and new content added

• Corporate bonds: dealing and reporting on LSE – content updated

• Corporate bonds: dealing off exchange – content updated

Subject 4 –International debt markets

• Diagram

updated

Subject 5 –Eurobonds: trading

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CHAPTER 10 – FOREIGN EXCHANGE

Subject 1 –Foreign Exchange: Introduction

• Learning outcomes – content updated and new content added

Subject 4 –FX: forward markets

• Forward FX rates - new content added

Subject 5 –Foreign exchange: summary

• Key concepts – content updated

CHAPTER 12 – REGULATION

Subject 2 –Markets in Financial Instruments Directive (MiFID)

• Client categorisation – content updated

• Order execution policy – content updated and new content added

CHAPTER 13 – Company accounts

Subject 1 –Financial statements

• Chapter overview – content updated

• Learning outcomes – content updated

Subject 3 –Financial statements: regulatory framework

• Companies Act 2006 (CA06) – content updated

• Accounting standards – content updated

• Accounts: summary – diagram updated

Subject 5 –Income statements

• Cost of sales and operating costs – content updated

• Exceptionals – content updated

• Extraordinary items – content updated

• Interest and tax – content updated

• Dividends – content updated

• FRS 3: reporting financial performance – content updated

Subject 6 –Cashflow: FRS1

• Subject

deleted

CHAPTER 14 – Ratio analysis

Subject 1 –Ratio analysis: introduction

• Chapter overview – content updated

CHAPTER 15 – Investment planning

Subject 1 –Investment planning: introduction

• Question weighting – content updated

• Chapter overview – content updated

Subject 3 –Private client investment advice

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CHAPTER 16 – Companies Act 2006

Subject 1 –Companies Act: introduction

• Chapter overview – content updated

Subject 2 –Notifiable interests

• Notifiable interests: background – content updated

• Disclosure of material interests – content updated

• Company investigations: enquiry notices (S793 CA ’06) – content updated

• Statutory rights of shareholders – topic moved from chapter one and content updated

Subject 4 –Memorandum and Articles of Association

• Articles – content updated

Subject 5 –Share buy-backs

• Share buy-backs: background – content updated and new content added

Subject 6 –Companies Act: Summary

• Key concepts – content updated and new content added

CHAPTER 17 – Regulation on takeovers and mergers

Subject 1 –Regulation on takeovers and mergers: introduction

• Question weighting – content updated

Subject 2 –Stake Building

• Subject

moved

• Stake building: Background – new content added

• Summary – new content added

Subject 5 –City Code

• City Code: background – content updated

Subject 6 –Regulation on takeovers and mergers: summary

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1 CHAPTER Equities: types and features

Equities: types and

features

Chapter 1

Time Allocation: 1hr Approx Question Weight: 7-9

1 Equities types and features: introduction

Chapter overview

Shares are issued by companies in order to raise long-term capital. Investors who buy shares are called shareholders.

This chapter starts by explaining the concept of incorporation and the distinction between the ownership of a company (shareholders) and its management (directors).

There are two main types of share a company can issue; ORDINARY and PREFERENCE shares.

Ordinary shareholders are otherwise called EQUITY shareholders as they have an ownership stake in the company. Ordinary shareholders have the right to receive a share in the company's profits, known as a DIVIDEND, the size of which will depend on the company's profitability. Ordinary shareholders also have the right to attend and vote in company meetings on matters such as the appointment (and removal) of directors, approving the financial statements or agreeing to a takeover or merger. On the other hand, preference shares do not attract voting rights, but, to

compensate for this, they pay a fixed rate dividend which is not dependant on the company's profitability.

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Ordinary and preference shares are examples of REGISTERED securities, which means that owners’ names are recorded on central registers. This is unlike some other forms of investments which are held in BEARER form. This means that physical possession is proof of legal title, and no central register of owners exists. This chapter provides further details of the differences between registered and bearer securities.

You will learn about AMERICAN DEPOSITORY RECEIPTS (ADRs). ADRs are attractive to US investors who may otherwise be reluctant to buy shares in a non-US company as it means having to pay for the shares (and receive dividends) in foreign currencies. As you will see, ADRs are a way of overcoming these problems. Finally we introduce the different rates of stamp duty and stamp duty reserve tax (SDRT) which are charged on share transfers, creation of bearer shares and the transfer of shares into depositary receipts (ADRs, GDRs). You will also learn which transfers are exempt.

Learning outcomes

On completion of this chapter you will:

Limited companies

Know the process of incorporation.

Know the distinction between ownership and management. Know the distinction between authorised and issued share capital.

Ordinary and preference shares

Know the basic rights of ordinary shareholders.

Know how the rights of preference shareholders differ from ordinary shareholders.

Quotation of share prices and dividends

Be able to distinguish between nominal value and share price.

Know the rate of tax suffered by holders of UK shares on dividend distributions.

Dividend Payments

Know the purpose of the ex-dividend date and the record date Know when special bargains can be struck

Understand how clains can be generated

Title documents

Know the difference between registered and bearer form securities. Be able to identify examples of registered and bearer form securities. Know the difference between temporary and permanent documents of title.

Stamp Duty

Know the situations in which stamp duty is payable. Identify exempt transfers for stamp duty purposes.

American and Global Depository Receipts (ADRs)

Know the key features of an ADR.

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Right to a surplus on winding up

In the event of the winding up of a company, ordinary shareholders are entitled to a share of the remaining (i.e. surplus) assets of the company, but only after ALL other liabilities have been paid. This may result in ordinary shareholders receiving more than their nominal, or face, value.

Special types of ordinary shares

'A' shares

'A' shares provide the holder with NO voting rights.

Holders of 'A' shares, however, participate in profits and dividends in the normal way.

Founder shares

Founder shares are shares issued to the SUBSCRIBERS of the company.

Deferred shares

Deferred shares are often issued to the founders of a company, and only pay a dividend once all other ordinary dividends have been paid.

Alternatively, deferred shares may pay a reduced dividend for a number of years before ranking equally with other classes of share.

Partly paid shares and calls

On occasion a company will issue shares to shareholders but only request for them to paid in part. In this way shareholders are permitted to pay the full value of the share at a later date. This is an obvious advantage to the shareholder, but the company also benefits in that more investors would wish to take the opportunity to buy the shares leading to a full subscription.

Later the company will make a call on the issued shares, and the current shareholders will need to pay the balance of what is owed to the company.

Preference shares

Background

Preference shares do not normally carry the right to vote in general meetings. However, unlike ordinary shares, preference shares carry an expectation of a FIXED RATE dividend. This dividend is payable AFTER interest but BEFORE ordinary dividends. Like all dividends, this dividend is payable at the discretion of the directors.

A company cannot pay ordinary dividends without paying off any preference dividends due.

Some companies issue preference shares that are redeemable by the company at a future date. Other types may give the investor the right to convert into ordinary shares. These, and other rights, will be stated in the company's Articles of Association.

Cumulative preference shares

A cumulative dividend means that, should the company not pay a dividend, (because, for example, of a lack of profitability) the right to receive that dividend is ROLLED OVER into the next period.

This is in contrast to ordinary shareholders who will lose the right to receive an annual dividend if the directors do not declare one.

Ordinary dividends cannot be paid until all ARREARS of cumulative preference dividends have been satisfied.

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The Articles of Association will usually specify that, should a cumulative preference dividend not be paid then the preference shareholders will be entitled to vote at the next Annual General Meeting. The most common period for non-payment which invokes the right to vote is 3 years, but this may vary from company to company. This is referred to as enfranchisement.

The holders of ZERO DIVIDEND preference shares are also normally afforded voting rights.

Participating preference shares

Most preference shares are only entitled to a fixed rate dividend. For example, a 5% £1 preference share will entitle the shareholder to 5p dividend each year for every share held.

However, the Articles may confer PARTICIPATING RIGHTS. This means that additional dividends may be paid, over and above the fixed rate, should the company be particularly profitable.

Participating preference dividends will often be calculated according to a profit related formula.

Convertible preference shares

A preference share with conversion rights allow the preference share to be converted into ordinary shares in the future,

Redeemable preference shares

Most shares have an indefinite life, however, when issued in a redeemable format they carry a specified redemption date when the company will refund the nominal value.

4 Quotation of share prices and dividends

Share prices

Shares are described with a NOMINAL (or FACE or PAR) value. For example, a 50p ordinary share, or a £1 ordinary share, or a 25p preference share.

The nominal value is shown on the face of the share certificate. The nominal value does NOT represent the market value of the share.

The market value is the PRICE of the share (i.e. its worth). Should a company issue shares at a value above nominal, the excess is called the SHARE PREMIUM. The total MARKET CAPITALISATION of a company is calculated by multiplying the number of shares in issue by the market value/price of each share.

Dividends

Dividends, both ordinary and preference, are quoted (and paid) NET of a 10% tax credit.

Consequently, when a shareholder receives a dividend, he or she is deemed to have already paid 10% income tax at source.

This tax credit is taken into account when an individual's income tax bill is calculated for the year.

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Example:

An investor receives a dividend of 10p:

Gross dividend = 10 x 100/90 = 11.1p Tax credit =1.1p

5 Dividend payments

Background

As we have seen, ordinary shares tend to pay a dividend to shareholders based on the profits of a company. These dividends are price sensitive information, and as we will see in the next chapter, all price sensitive information needs to be disclosed to the market via a primary information provider. Once announced, the share will be trading cum-dividend, or WITH dividend, which will give it extra value on the market. Once the dividend has been paid, the share will trade ex-dividend, or WITHOUT dividend, causing it to drop in value.

The ideas around the share moving from cum- to ex-dividend are discussed below.

The buyer of the security will be entitled to receive the next dividend payment

The buyer of the security will NOT be entitled to the next dividend payment.

Entitlement to the next dividend payment remains with the seller

E X -D I V D A T E

CUM-DIV PERIOD EX-DIV PERIOD

Ex-dividend date

The EX-DIVIDEND (or EX-DIV) date is the date from which all transfers of the security are contracted WITHOUT the right to receive the dividend. The period from the ex-div date is called the ex-div period. The period before the ex-div date is called the cum-div period.

Any transfers of the security during the cum-div period are contracted WITH the right to receive the next dividend payment.

The LSE usually declares the ex-div date as the WEDNESDAY FOLLOWING the day on which the dividend is announced.

The LSE usually requires 3 clear business days between the dividend declared date and the ex-div date. Therefore, when a dividend announcement falls on a Friday, the ex-div date is TWO Wednesdays later.

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Record date (Friday) E X -D I V D A T E

(Usually a Wednesday) Company proposes a

dividend

Record date

The RECORD DATE is the date on which a company inspects the register of members in order to establish which shareholders will be sent the dividend. The record date (or REGISTER DATE or BOOKS CLOSED DATE) is usually the Friday after the ex-div date.

The company chooses this date as the record date because a purchaser in the cum-div period would normally be expected to settle on or before this date (T+3). Therefore, the purchaser's name would be expected to appear on the shareholders' register by this date.

Special ex date

The SPECIAL EX DATE is the first date in the cum-div period from which SPECIAL EX transactions can be agreed.

A special ex-bargain is a transaction carried out in the cum-div period, but contracted ex-div. The buyer will not receive the next dividend.

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(Wednesday) Company proposes a dividend Record date (Friday) Special ex date (XD – 10 business days) E X -D I V D A T E

Dividend payment

date

SPECIAL-CUM PERIOD

Ex-div deals may be struck in the cum-div period 10 business days before the ex-div date. Such deals are known as ‘special ex-div’ bargains.

Special cum bargains

It is permissible for the buyer to buy shares cum div even within the ex-div period. Such transactions are called SPECIAL CUM DIV bargains.

Such special cum-div bargains can be entered into right up to the day before the dividend payment date.

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(Wednesday) Company proposes a dividend Record date (Friday) Special ex date (XD – 10 business days) E X -D I V D A T E

Dividend payment

date

SPECIAL-CUM PERIOD

Cum-div deals may be struck in the ex-div period right up to the day before the dividend payment date. Such deals are called ‘special cum’ bargains.

How a dividend claim may arise

Consider an investor who buys a share one day before the ex-div date, but who has agreed to settle the deal in 25 business days time, the latest the LSE will allow. The deal is therefore in the cum-div period. It follows that the buyer is entitled to receive the dividend payment from the company.

However, because the trade is to be settled T+25, the buyers name will NOT be on the register by the books closed date.

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The buyer’s name will not be on the register of members by the record date. The company will therefore pay the dividend to the seller, even though it was sold cum-div. A claim between the brokers is therefore necessary. (Wednesday) Company proposes a dividend Record date (Friday) Special ex date (XD – 10 business days) E X -D I V D A T E

Dividend payment

date Trade date

T +25

On the dividend payment date, the company will pay the dividend to the selling investor instead of the buyer, as it will use the name of the registered holder on the record date to determine the recipient of the dividend.

The buyer's broker will have to claim the dividend amount from the seller's broker. The buyer's broker will have to claim the dividend amount from the seller's broker.

6 Ownership and title documents

Title documents: background

A DOCUMENT OF TITLE is evidence that an investor has legal ownership of an asset, e.g. land, real estate or financial securities.

The title document may be held in different forms as described below.

Registered securities

A registered security is one whose ownership is recorded on a central register. This is the same as for cars and real estate, where the asset is registered in the owner's name. Registration denotes LEGAL ownership.

A company maintains a register of shareholders which is updated whenever there is a change of ownership.

A quoted company usually appoints an independent registrar to manage these shareholder records.

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Stamp duty

Stamp duty is charged at 0.5% of the amount paid for the securities (i.e. ad valorem). If nothing is charged (i.e. the shares are gifted) no stamp duty is due. The tax legislation refers to the rate as '£5 per £1,000 of consideration or any part thereof'. This means that stamp duty is always ROUNDED UP to the next £5.

SDRT

SDRT is also charged at 0.5% of the amount paid for the securities. The major difference is that it is rounded to the NEAREST PENNY.

8 American and Global Depository Receipts

ADRs: background

American Depository Receipts (ADRs) are used by non-US companies in order to encourage US investors to buy an equity stake. An ADR represents a shareholding in a non-US company, although the instrument itself is DENOMINATED IN DOLLARS.

The problem non-US companies face, is that US investors like to buy dollar denominated shares and to receive dollar dividends. Therefore, unless a non-US company issues dollar denominated shares, it may lose out on the potential US investor base.

An ADR issue is a way around this problem.

ADRs: features

The following description explains how a fictional UK company, Brit plc, issues ADRs on the back of sterling denominated shares.

Step 1: Brit plc issues sterling shares to a UK branch of an American bank. The bank will pay Brit plc for these shares in sterling.

Step 2: The bank will keep the sterling shares in a safe place by acting as a depository.

Step 3: The bank then issues ADRs, denominated in dollars, to US investors. Usually, one ADR represents several underlying securities. For example, one ADR may represent 100 shares in Brit plc.

ADR holders receive most privileges of the underlying shares, including voting rights and dividends. Dividends will, however, be paid in dollars. Holders of ADRs are generally NOT granted pre-emptive rights in a rights issue. Instead, they receive the NIL PAID price (i.e. the value of the right) instead.

Although the underlying shares in Brit plc are registered in the name of the bank acting as depository, the ADRs themselves trade as bearer documents. Nevertheless, as the depository receipt must be registered in the name of the depository, they are not considered pure bearer documents.

US investors do not pay stamp duty when purchasing ADRs. However, the depository pays a one-off stamp duty charge of 1.5% on the creation of the ADRs themselves.

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ADRs can be issued and traded BEFORE the underlying shares have been issued; these are known as PRE-RELEASE ADRs.

ADRs can only trade in pre-release form for 3 months, and, during that period, cash from the sale of the ADRs (COLLATERAL) must be deposited with the depository. Cash is the only acceptable form of collateral.

ADRs are freely transferable securities and standard settlement is T+3.

ADRs are not restricted to trading in the US, they can also be traded in the UK and elsewhere.

Should the investor wish to, these instruments can be converted back into the underlying shares by returning the ADR to the depository.

Global Depositary Receipts (GDRs) work in the same way and are likely to be created for distribution across several countries.

ADRs: a summary

BANK A

BRIT PLC

ADRs

$$$$s

££££s

SHARES

USA

UK

Brit Plc will pay dividends in sterling to Bank A. Bank A will convert them into US dollars and pass them on to the ADR holder.

American Investor

9 Equities types and features: summary

Key concepts

Limited companies

The process of incorporation.

The distinction between ownership and management. The distinction between issued and authorised share capital.

Ordinary and preference shares

The basic rights of ordinary shareholders.

How the rights of preference shareholders differ from ordinary shareholders.

Quotation of share prices and dividends

The distinction between share price and nominal value.

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Dividend Payments

The purpose of the ex-dividend date and the record date When special bargains can be struck

How clains can be generated

Title documents

The difference between registered and bearer form securities. Examples of registered and bearer form securities.

The difference between temporary and permanent documents of title.

Stamp Duty

The situations in which stamp duty is payable. Exempt transfers for stamp duty purposes.

The rate of stamp duty and the distinction between stamp duty and stamp duty reserve tax (SDRT).

American and Global Depository Receipts

The key features of an ADR.

Why a US investor might use an ADR rather than invest directly in an overseas company.

The key features of a pre-release ADR.

Now you have finished this chapter you should attempt the chapter

questions.

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2 CHAPTER Issuing equities

Issuing equities

Chapter 2

Time Allocation: 2hrs Approx Question Weight: 8-10

1 Issuing equities: introduction

Chapter overview

Companies issue shares to raise cash or CAPITAL.

This chapter starts by explaining the two markets in which shares are traded; the PRIMARY and SECONDARY markets. Issues into the primary market occur when a company is seeking to raise long-term capital from investors - new shares are therefore issued by the company in return for finance from investors. Secondary market trading, however, is the market in 'second-hand' shares. In the secondary market, no new finance is raised by the company as the trading is done directly between investors.

Despite the general idea that shares are issued to raise capital, this chapter also identifies limited situations where shares are issued FREE. This does not raise any new money for the company but can have the effect of making shares more attractive to investors by reducing the share price and encouraging trading. Finally, the chapter moves on to describe the procedures a company is required to follow in order to have its shares traded on the London Stock Exchange. The LSE manages two separate markets: the larger is known as the Official List and contains well-known companies such as BP Amoco and British Airways, the smaller is known as the Alternative Investment Market (AIM) and is a market for shares in smaller, younger companies.

Learning outcomes

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Equities: methods of issue

Know the principal characteristics and differences between primary and secondary markets.

Know the role of the origination team. Know the members of an origination team.

Know and explain the different issue methods used in the primary market, including: Offer for subscription.

Offer for sale Placing

Intermediaries offer.

Be able to calculate the dilutive effect on share price of share issues.

London Stock Exchange: Official List and AIM

Know the criteria for entry to the Official List.

Know the participants involved in gaining entry to the official list. Know the continuing obligations of listed companies.

Know the methods of disclosure for official list companies. Know the criteria for entry to AIM.

Know the participants involved in gaining entry to AIM. Know the continuing obligations for AIM companies.

Underwriting and stabilisation

Understand the methods and purposes of underwriting. Know the purpose of stabilisation.

2 Equities: methods of issue

The primary market

The PRIMARY MARKET is the market on which securities are sold for the first time. Companies use the primary market as a means of RAISING new long-term

CAPITAL (for both equity and debt).

The SECONDARY MARKET, on the other hand, is the market on which existing securities are traded. The secondary market exists to support the primary market. It provides subscribers to shares in the primary market with a place to sell them on again and also acts as a benchmark for primary market pricing decisions. Secondary market activity does NOT raise new capital for the company.

Many international stock exchanges, including the London Stock Exchange, fulfil the role of both primary and secondary markets.

An initial public offer (IPO) is the first sale of stock by a private company to the public. In an IPO, the issuer obtains the assistance of an underwriting firm (typically an investment bank), which helps it determine what type of security to issue, best offering price and time to bring it to the market and acts as sponsor.

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The origination team

The origination team consists of a number of specialised advisers including the sponsor, legal advisors, public relations consultants, accountants and a corporate broker. They all work with the underwriting firm which holds ultimate responsibility. Once a company has made the decision to raise capital via an IPO and has produced a prospectus, it is ready to issue shares on the primary market. The following illustrations describe the various means by which a company can issue shares in the primary market.

Company A

SHARES

Investor

£

Offer for subscription

An offer for subscription involves a company issuing shares directly to the general public. COMPANY ISSUING HOUSE £ £ £ £ £ £ SHARES SHARES INVESTOR

Offer for sale

An offer for sale is similar to an offer for subscription. However, in this case, the issuing house (or LEAD MANAGER) initially buys up new shares from the issuing company before re-selling them to the investing community.

An offer for sale is not restricted to the issue of new securities. It can also be used for a large shareholding being sold into the market place, e.g. government

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Pricing offers for subscription and offers for sale

It can be difficult to ascertain a price for offers and this can be addressed in three ways:

Fixed price offer

A fair price is established based on the price of a similar company's security that is already trading in the market. An offer is then made to the public, with purchasers stating the number of shares they wish to buy at the fixed price. In the event of oversubscription, allocations are dealt with on a pro rata basis.

Fixed price offers are often at an offer price which is artificially low, to generate goodwill amongst purchasers. Investors who purchase shares to profit from an immediate increase in price due to underpricing, and who plan to sell as soon as this happens are known as STAGS.

Tender offer

Where interested investors make bids and the issuing house then selects the applications with the highest bids. Note that once an acceptable price has been determined from the bids, successful applicants actually pay a COMMON STRIKE PRICE.

Bookbuilding

The issuing house assesses interest from investor relations presentations and constructs a demand curve to ascertain possible offer prices. The level of interest from institutional investors (the number who wish to be on the issuing house's 'book') then determines whether the final price is set at the higher or lower end of the demand curve.

A bookrunner or lead manager is the main underwriter in equity and debt issues and, in a particularly large issue, will usually syndicate the new issue with other firms of underwriters in order to lower its risk.

If the size of the issue is large enough, there can be several lead managers, known as co-lead managers. Each of the co-lead managers would be responsible for issuing the shares in a certain geographical region. The bookrunner is listed first among all the underwriters participating in the new issue.

Placing

A placing is similar to an offer for sale, however the lead manager does NOT offer to resell the shares to the investing community at large. Instead, the shares are only offered to selected investors such as pension funds and wealthy individuals. For this reason, a placing is sometimes referred to as SELECTIVE MARKETING.

Small investors would NOT be offered shares in a placing

Wealthy individuals

Institutions and wealthy individuals would be offered shares in a placing

£

3

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3 London Stock Exchange: Official List and AIM

Introduction

Block 7 of the FSA Handbook, “Listing, Prospectus and Disclosure” consists of three rule books:

Listing Rules. Prospectus Rules. Disclosure Rules.

The Prospectus Rules affect all publicly traded companies whether they trade on the main market or AIM, whereas the Listing Rules do not apply to AIM or other similar securities. Both sets of rules are discussed in detail below.

The Disclosure Rules apply to shares traded on a regulated market in the UK and help prevent insider dealing and market abuse.

Once a company's shares are on the LSE, the company will find themselves bound by three sets of regulation:

The Companies Act FSA rules

The LSE's own rules for members

Official List and AIM: background

The London Stock Exchange provides a market place for the trading of company stocks. Companies enable trading of their shares by a process called FLOTATION. The London Stock Exchange manages and administers two markets, a main market, called the Official List, and a junior market called the Alternative Investments Market (AIM).

A flotation can go hand in hand with an issue of new shares (i.e. as part of a marketing operation) or by way of an introduction.

Flotation: pros and cons

Pros

Acquisitions and mergers

The ability to issue paper securities with a market price as an acquisition currency can increase the potential of corporate growth by way of acquisition.

Public profile and prestige

Exposure on a public market will usually bring about an increase in press coverage, resulting in a heightening of public awareness about the company and its products and services.

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Cons

Regulation and cost

A publicly quoted company is more accountable to regulators. It therefore entails a much higher level of disclosure and reporting than is required by non-quoted companies. This, in turn, will lead to additional costs.

Market conditions

A company's share price is susceptible to volatile market conditions. This may result in a lack of liquidity in the company's shares that is beyond the control of the company's directors.

Investor power

Where shares are held by large institutional investors there is a risk that the founders could lose control of what they perceive to be their business.

The Official List and the UK Listing Authority (UKLA)

The main market of the Stock Exchange is known as The Official List. There are currently more than 2,000 companies, foreign and domestic, traded on the Official List.

In order to obtain a listing on the main market, a company must apply to the UK Listing Authority (UKLA). Successful companies are referred to as LISTED companies.

The Listing Principles

Listing principles are designed to ensure adherence to the spirit as well as the letter of the rules and thus promote a fair and orderly market. In line with the FSA’s own approach to regulation, these principles place an emphasis on having adequate controls and systems in place.

The Principles

Principle 1

A listed company must take reasonable steps to enable its directors to understand their responsibilities and obligations as directors.

Principle 2

A listed company must take reasonable steps to establish and maintain adequate procedures, systems and controls to enable it to comply with its obligations. Principle 3

A listed company must act with integrity towards holders and potential holders of its listed equity securities.

Principle 4

A listed company must communicate information to holders and potential holders of its listed equity securities in such a way as to avoid the creation or continuation of a false market in such listed equity securities.

Principle 5

A listed company must ensure that it treats all holders of the same class of its listed equity securities that are in the same position equally in respect of the rights attaching to such listed equity securities.

Principle 6

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Pre-emption rights

Any subsequent issue of shares for cash (e.g. a rights issue) must contain a pre-emption right. Although shareholders may vote to waive their pre-pre-emption rights, the maximum waiver is 5 years.

Controlling shareholdings

The existence of controlling shareholders could lead to the application for listing being rejected unless the company can demonstrate to the UKLA that conflicts of interest will be controlled.

A controlling shareholder is any person (or persons acting jointly) who is entitled to exercise, or to control the exercise of, 30% or more of the rights to vote at the AGM.

Warrants

The issue of warrants or options to subscribe for equity shares must not be greater than 20% of the company's issued share capital at the time of the issue of the warrants or the options.

Settlement

The shares must be eligible for electronic settlement.

Listing application

A company must submit listing documents accompanied by the fee to the FSA for approval before a listing on the Exchange is granted.

These documents consist of the prospectus (where new securities are issued along with listing) or the listing particulars (if this is an introduction), and the completed admission form.

Full documentation must be made available 48 hours prior to the hearing of the application to obtain a listing.

Advertising

Once the UKLA has approved the listing particulars, a formal notice must be published in at least one national newspaper.

Sponsors and advisors

Appointment of a sponsor

A company seeking a listing must appoint a sponsor. A sponsor will normally be a corporate broker or investment bank but may also be another type of professional advisor, e.g. accountant or lawyer.

The sponsor is also responsible for seeking the FSA's approval of the listing particulars and prospectus. The 48-HOUR RULE requires that the documentation be submitted at least 48 hours prior to the hearing of the application to obtain a listing.

The role of the sponsor is to:

Ensure the issuer meets the requirements for a listing.

Ensure the issuer is guided and advised as to the application or interpretation of the listing rules.

Provide the UKLA with all information requested by them or required under the rules.

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Appointment of advisors

The sponsor will also appoint and co-ordinate the activities of other advisors in relation to a listing. The other advisors and their roles are as follows:

Reporting accountants: reporting accountants give an independent view of the past, present and future performance of the issuer. They summarise their findings in a LONG FORM REPORT, which is delivered to the sponsor, accompanied by a WORKING CAPITAL STATEMENT to support the sponsor's report to the UKLA on the issuer's working capital position.

Lawyers: ensure the listing process is carried out in accordance with the appropriate regulations.

Underwriters: underwriting syndicates guarantee to buy any unsold shares under the issue.

Bookrunners/global coordinators: help determine the price of issue, where shares are being placed with financial institutions.

PR consultants: enhance the attractiveness of the issue by ensuring it is marketed effectively.

Official list: Continuing obligations

If a company wishes to list on an exchange, there are certain obligations that they must fufil. These include:

Corporate governance - ensuring that the directors are responsible and

accountable for the running of the firm. It also ensures that the responsibilities are shared and that too much influence is not placed with one person.

Reporting - ensuring that all shareholders are given an equal opportunity to access price sensitive information. More on this is discussed below.

Regulatory Information Service (RIS) and Primary

Information Provider (PIPs)

One of the main principles of the Listing Rules is that unpublished price sensitive information must be disclosed to the market as a whole without delay. A listed company must notify the market of all relevant information which is not public knowledge concerning a change in the company's financial condition, the performance of its business or in its expectations as to its performance. Price sensitive information may not normally be disclosed to anyone else before it has been notified to an RIS (Regulatory Information Service) or PIPS (Primary Information Provider Service). A key principle of the Listing Rules is to maintain a balance between ensuring the existence of a level playing field amongst investors on the one hand and ensuring efficient and orderly markets on the other. The longest standing PIP is the LSEs Regulatory News Service (RNS).

Regulatory News Service (RNS)

RNS is both a regulatory and financial communications channel for companies to communicate with the professional investor. RNS provides certainty in delivering communications consistent with local regulatory regime. Using their secure website or easy to use PC tool RNS Submit (TM), investors choose the regulators whose requirements need to be met and attach their announcement.

Secondary Information Providers (SIPs)

The Primary Information Providers are responsible for distributing listed company announcements to the newswire services or Secondary Information Providers. These include Bloomberg and Reuters. These SIPS disseminate the information provided by the PIPS to the general public.

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AIM: continuing obligations

Disclosure requirements

The same rules apply as for companies on the Official List, including the rules on corporate governance.

Financial information

The company is required to publish audited annual accounts within 6 months of the financial year end and half yearly reports within 3 months of the period to which they relate.

AIM vs. Official List: main differences in entry

requirements

Note that for AIM applicants there is NO: Minimum shares in the hands of the public. Trading record requirement.

Shareholder approval needed. Minimum market capitalisation.

4 Underwriting and stabilisation

Underwriting

In its most basic sense, underwriting is a means of guaranteeing a minimum level of proceeds from a share issue. The cost of the guarantee is a fee, payable to the underwriter (normally an investment bank).

In the event that demand is insufficient to generate the minimum level of proceeds, the underwriter agrees to take up any shortfall, paying cash for the unwanted stock. The underwriter will usually agree to a ‘firm’ underwriting, whereby the proceeds of the issue are guaranteed (for a fee). Alternatively, they market the issue on a best efforts basis, meaning that they will do their best to sell the securities at a certain price, but that there is no guarantee and the issuer bears the risk. The process whereby a firm of underwriters attempts to generate a book of investor demand for an IPO is known as book-building.

In these bought deals, the issuing company usually allows the underwriters an option to increase the size of the offering by up to 15% in certain circumstances, known as 'greenshoe' or 'overallotment' option. This option may be used if the demand for the new shares is in excess of the base number of shares that the company planned to issue. Where there is no greenshoe option, it would be referred to as a base deal.

Alternatively, an issue can be marketed on a best efforts basis, meaning that the underwriter will do their best to sell the securities at a certain price but that there is no guarantee and the issuer bears the risk.

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A bookrunner or lead manager is the main underwriter in equity and debt issues and will usually syndicate the new issue with other firms of underwriters in order to lower its risk. If the size of the issue is large enough, there can be several lead managers with each of the co-lead managers being responsible for a certain geographic region. The bookrunner is listed first among all the underwriters participating in the new issue.

Underwriting is used in all situations where share issues are generating proceeds, e.g. offers, placings and rights issues. It is not necessary for bonus issues and introductions, which are not marketing operations (i.e. no new capital is being raised).

There is no limit to the number of underwriters who can participate in the purchase of shares in an underwriting syndicate.

Stabilisation

Stabilisation is the process where a lead manager in an issue purchases stock in the secondary market in order to support the price of the issue.

The market is made aware that stabilisation is taking place by the letter 'S' being displayed on trading screens.

The Financial Services and Markets Act 2000 (FSMA 2000) has permitted the FSA to create rules governing standardisation.

FSA may permit investment banks to stabilise an issue, provided that: The offer is for cash;

The offer is public on a qualifying exchange; The offer is for a limited period;

Adequate prior disclosure was given;

Information on stabilisation activities will be provided to the issuer.

The FSA's stabilisation rules provide a 'safe harbour' to the offence of Market Abuse.

The FSA's Conduct of Business rules state that a firm may only recommend a security whose price has been affected by stabilisation to a private customer where ALL of the following conditions are satisfied:

The customer has been given a verbal or written explanation of stabilisation. Where it is permitted by any existing customer agreement.

The firm drew the customer's attention to the fact that the market price of the security might be temporarily higher than usual at the time of the transaction.

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5 Issuing equities: summary

Key concepts

Equities: methods of issue

The role of the origination team

The members of an origination team

The principal characteristics and differences between primary and secondary markets.

Issue methods used in the primary market, including: Offer for subscription.

Offer for sale Placing

Intermediaries offer.

Calculation of the dilutive effect on share price of share issues.

Calculation of the dilutive effect on share price of follow on share issues.

London Stock Exchange: Official List and AIM

Know the criteria for entry to the Official List.

Know the participants involved in gaining entry to the official list. Know the continuing obligations of listed companies.

Know the methods of disclosure for official list companies. Know the criteria for entry to AIM.

Know the participants involved in gaining entry to AIM. Know the continuing obligations for AIM companies.

Underwriting and stabilisation

Understand the methods of underwriting. Know the purpose of stabilisation.

Now you have finished this chapter you should attempt the chapter

questions.

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3 CHAPTER Equity markets

Equity markets

Chapter 3

Time Allocation: 5hrs Approx Question Weight: 13-15

1 Equity markets: introduction

Chapter overview

This chapter explains the purpose and role of stock exchanges in general as well as the role of the London Stock Exchange in providing a trading platform for the securities market. As you will see, it is not only shares that are traded on the Exchange, but also corporate bonds, UK Government bonds (gilts), American Depositary Receipts, warrants and a selection of other

Importantly, you will learn each of the different trading systems the LSE operates. For example, the system used to trade shares in large UK companies is the Stock Exchange Electronic Trading Service (or SETS). You will be taken through the details of each different trading system including the types of trades and how they are executed.

You will understand different roles played by London Stock Exchange member firms and identify alternative markets for the trading of shares, e.g. virt-x, a market for Pan-European stocks and a direct competitor of the London Stock Exchange. The chapter finishes introducing you to the main services provided by prime brokers including securities lending and borrowing, leverage trade execution, cash

management, core settlement and custody. You will also learn about the main sources of equity financing.

This is a detailed chapter with lots of information to absorb and is very important for your exam.

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Learning outcomes

On completion of this module, you will:

Stock Exchanges

Know the purpose and role of a stock exchange.

London Stock Exchange: an overview

Know the securities covered by Rule 3000.

Know the right of the London Stock Exchange under Rule 3040.

Be able to identify the different parties trading on the London Stock Exchange.

SETS

Know the securities traded on SETS.

Know the features of a standard trading day on SETS. Understand the operation of a SETS screen.

Be able to distinguish between different types of SETS orders. Know the definition and uses of a Worked Principal Agreement.

SETSqx

Know the securities traded on SETSqx

Know the key features of the operation of SETSqx

Inter-dealer brokers (IDBs)

Know details of the service offered to other market participants by IDBs. Know the motivation for trading via an IDB.

Stock borrowing and lending

Understand the role of SBLIs in the equity markets.

Virt-x

Know the role of virt-x as a direct competitor of the London Stock Exchange in the equity markets.

Know basic details of trading on virt-x.

Know the reporting and publication requirements for virt-x trades. Be able to identify the role LCH.Clearnet for virt-x trades.

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PLUS

Know the status of PLUS as defined by the FSA. Be able to outline features of trading on PLUS.

Overseas equity markets

Be able to identify basic features of trading and settlement in the main overseas equity markets.

Prime brokerage and equity finance

Know the main services provided by an equity and fixed income prime broker Know the use of the main sources of equity financing

2 Stock Exchanges: an overview

Purpose and role

A stock exchange is a corporation or mutual organization which provides facilities for its members to trade company stocks and other securities. Members of the exchange can be acting as brokers or dealers. Brokers are qualified and regulated professional who buy and sell securities on behalf of investors. Brokers may also offer investment advice to their clients. Dealers execute trades for their own account. They may also buy or sell securities directly from/to clients.

Stock exchanges also provide facilities for the issue and redemption of securities as well as other financial instruments. The securities traded on a stock exchange include: shares issued by companies, unit trusts and other pooled investment products and bonds. The initial offering of stocks and bonds to investors is done in the primary market and subsequent trading is done in the secondary market.

Stock exchanges provide liquidity to existing and potential investors allowing them to sell and buy securities more easily. The concentration of buy and sell orders (supply and demand) in an organized market enables a price formation process which leads to a market price at all times.

Today, stock exchanges usually have a central location at least for recordkeeping, but trade is less and less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of speed and cost of

transactions. Historically, stock exchanges were physical locations where brokers and dealers (members) met to trade face to face. They would shout and/or hand signal to transfer information about buy and sell orders (open outcry).

3 London Stock Exchange: an overview

LSE: introduction

The LSE's origins go back to the 17th century, when people wishing to invest in joint-stock companies met in coffee houses to strike deals.

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The headquarters are now at Paternoster Square, next to St Paul's Cathedral, and the LSE has grown into one of the major stock exchanges of the world. The LSE provides a marketplace where over 3,000 company securities, domestic and international, are traded.

However, equities are not the only products that can be bought and sold on the LSE.

LSE: the different securities traded

LSE rules 3000 and 3040 combine to govern the securities traded on the exchange. Rule 3000 defines a transaction as a deal that involves AT LEAST ONE member firm in any of the securities listed below.

Rule 3040 gives the LSE the right to prohibit dealings in any of these securities, at any time, for any reason.

The list of securities is as follows:

UK equities

Ordinary shares issued by UK companies. These are traded on the SETS order book or SETSqx.

International equities

Ordinary shares issued by non-UK companies traded on the International Order Book, the International Bulletin Board and the International Retail Service.

AIM securities

Shares and corporate debt of smaller young and growing companies. Most AIM stockshave recently been moved onto SETS, and the remainder trade on SETSqx.

UK gilts

UK Government bonds, traded principally over the telephone by GEMMs - Gilt-Edged Market Makers.

Sterling bonds

Issued by companies and local authorities. These are quoted on the SEAQ system.

Warrants

Issued by companies giving the right to buy new shares. These are traded on the covered warrant order book.

Covered warrants

Covered warrants are issued by a person other than the issuer of the underlying asset. These are traded on the covered warrant order book or the covered warrant request for quote system.

Depositary receipts

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Other instruments

Corporate Eurobonds and traditional options are traded on SEAQ.

The LSE has created a new system to support its range of trading platforms called TradElect.

Tradable instrument structure

The London Stock Exchange provides a wide range of platforms, which are summarised below. The platforms that will be tested in detail in this exam are SETS, SETSqx, SEAQ, IOB, ITBB and IRS. However, we have included the other systems for completeness.

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Table 3: TradElect trading services

Optional No None Reporting only Debt Fixed interest market Mandatory No None Reporting only UK gov’t debt Gilt-edged market Mandatory No None Quote book Equities in DI form International Retail Service Optional No Continuous Order book Equities International Bulletin Board No No Continuous / Periodic Order book Depositary receipts International Order Book No No None Reporting only Equities European Trade Reporting Optional No None Quote book Equities European Quoting Service Optional Yes Continuous Order book Equities EUROSETS Mandatory No None Quote book Debt SEAQ Optional varies Periodic Order book & Quote book Equities SETSqx Mandatory No Continuous Order book & Reporting only Structured Products Modified SETS Optional Yes Continuous Order book Equities SETS Market makers CCP for TradElect executions TradElect execution Type Securities Name

Description

Trading

Service

LSE: the different parties trading

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A broker/dealer can trade in one (or both) of two ways: buy and sell securities on behalf of clients (act as AGENT), and/or buy and sell securities for their own account (act as PRINCIPAL).

The ability to act as agent and/or principal is described as DUAL CAPACITY. Broker/dealers can gain other labels in the marketplace, depending on the activities in which they engage. Examples include:

Market makers.

Stock borrowing and lending intermediaries. Inter-dealer brokers.

GEMMs: Gilt-edged market makers.

IGEMMs: Index linked gilt-edged market makers.

However, despite differing terminology, they are essentially all broker/dealers acting in one (or both) of their permitted capacities: agent and/or principal.

4 SETS

SETS: introduction

The Stock Exchange Electronic Trading Service - SETS is the central trading mechanism for the constituents of the FTSE All share index and some Euro denominated Irish securities. It is also the platform used for the trading of ETFs - Exchange Traded Funds, and ETCs - Exchange Traded Commodities.

Only member firms authorised to use SETS can place orders on the SETS order book, either for their own account or on behalf of clients. However, anybody is able to view the order book to see the orders being placed.

Once an order has been placed on the order book, it will automatically be matched against a corresponding order. If there is no such corresponding order to match against, the order will either stay on the order book for future execution or will be returned (in full or in part) to the member who originally entered the order.

SETS: trading day

SETS has a trading day running from 7.15am until 5.15pm. The automatic trading in SETS securities runs from 8.00am to 4.30pm each business day ('normal market hours'). The system is open before and after the automatic trading period for reporting and auction periods.

The opening of the market is preceded each day by a 10 minute AUCTION CALL PERIOD, running from 7.50am to 8.00am. This allows member firms to enter orders onto the order book without automatic execution taking place.

At 8.00am a matching algorithm is run by the system which calculates the opening price of the security. Normal trading activity then continues until 4.30pm.

When trading stops at 4.30pm, there is a 5 minute closing auction call period, similar to the opening one, which establishes the closing price of the security.

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Example

FILL OR KILL:

Buy 2,000 at 215 limit fill or kill

Tesco TSCO Currency GBX 11,000 208 - 215 1,000 11,000 208 3,000 207 2,000 206 215 1,000 216 7,000 217 6,000 218 1,000

Tesco TSCO Currency GBX 11,000 208 - 215 1,000 11,000 208 3,000 207 2,000 206 215 1,000 216 7,000 217 6,000 218 1,000 Order cannot be executed, order book remains unaltered. Example

Iceberg order

ICEBERG orders were introduced in September 2003 and are available on SETS, the International Order Book and SETSmm.

Previously, market participants with large orders to execute would have been reluctant to route these through the order book because of the potentially adverse market impact.

An iceberg order manages this problem by allowing the order to be partially hidden from the market view.

Upon entry of the order, the participant specifies the total order size and the visible ''peak'' size. The peak size is the maximum volume that will be shown to the market at any time. Matching orders will exhaust the total iceberg volume before executing orders further down the price queue.

Named Orders

SETS has recently combined with SETSmm to provide market maker support to all securities traded on the order book. These are done through named orders. Named orders are buy and sell orders placed on the order book by market making firms and allow traders to call these firms to buy or sell shares, rather than place an order on the order book. Named orders are also referred to as commited principal (CP) orders.

Market makers are member firms who have volunteered to provide buy and sell prices during a fixed period of time called a mandatory quote period (MPQ). The mandatory quote period runs from 08:00 to 16:35.

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3 CHAPTER Equity markets 1.0p W 1000p or more 0.5p H 500p – 999p 0.25p Q 10p – 499p 0.01p J Less than 10p Tick value Price format code

Price range

Interruptions to trading

The following are interruptions to SETS trading that may be declared by the Exchange:

Pause

In order book securities, this acts like an auction call, although no indicative uncrossing price is disseminated. Orders can continue to be entered and deleted.

Trading halts

Trading halts are triggered due to rapid movements in the trading price. Halts protect against erroneous trades and provide the market with time to respond to price movements in an orderly manner.

This will happen if the price of one automatic trade is +/- 5% from the price of the last automatic trade.

When a trading halt is declared, automatic execution in that security is halted, however, members are permitted to trade away from the order book. Members may also continue to submit/delete orders to/from the order book during a trading halt. Trading halts last 5 minutes and, once the halt has been lifted, the auction process is run and trading may commence.

Suspension of trading

If a security's listing is suspended, member firms CANNOT TRADE in that security (without the permission of the Market Supervision Division of the Exchange). All orders in that security are REMOVED from the order book.

Halt and Close

This freezes and disseminates a closing price, so is designed to be used where there is little likelihood of returning to trading that day. No orders or quotes can be entered or deleted during this period.