Clearing, Settlement and Custody

Chapter 4

Equity clearing and settlement

Introduction

When an investor purchases a share in a company they have acquired

a stake in the equity of that company. Through the share purchase

they are buying partial ownership in the issuing company. The

number of shares owned by the investor in proportion to the total

number of shares outstanding determines the extent of the ownership

an investor has in a company. For the private investor this is likely to

be a very small percentage, but the larger funds can often have

reasonably significant holdings. Not all equity-related instruments

give the buyer ownership and it is very important to understand not

only the equity shares characteristics but also those of the various

other types of instruments.

A share may offer the following ‘rights’ to investors:

䊏 The right to vote in company matters.

䊏 The right to have access to company books and records

(accounting and record keeping).

䊏 The pre-emptive right (or right of first refusal). This means

that if the company issues new securities, the current holders may

have the right to purchase additional shares to maintain their

proportional ownership of the company. This offer to the original

holder is generally given before the offer is made to the public.

䊏 The right to share in the company’s profits through dividend

payments.

These basic rights are important in terms of settlement as they will

have actions associated with them, for instance corporate actions in

respect of rights issues, dividends, etc. Within the realm of equity

securities are various classes of equity instruments such as ordinary

shares, preference shares, etc. Foreign markets will support equities,

which may be similar to some of the above but with different

terminology. For example:

USA – Common Stock/Preferred Stock

France – Action Ordinaire (Ordinary Share)

Germany – Stamm-Aktie (Ordinary Share)

Japan – Futsu Kabushiki (Ordinary Share)

We need to consider the different characteristics of each of the classes

of equity instruments, starting with the most common type, the

ordinary share, as shown in Table 4.1.

Issuing and trading equities

When a corporate entity offers its shares to the public for the first

time, it is said to be going public. This ‘Offer for Sale’ (or Initial

Public Offering – IPO) will be underwritten by investment banks or

brokers. A prospectus containing information on the issuer, the terms

of the issue, the management structure and any other important

aspects of the issuer is prepared. The issue itself will either be placed

among clients of the brokers (institutional investors) or advertised to

the general public through the publication of mini-prospectuses and

application forms in the financial press and elsewhere.

Any shares which are not bought by the public will be taken up by the

underwriters who will take the shares onto their own books or sell

them on to their own clients. On the other hand, issues that are

initially oversubscribed will be distributed on a scaled-down basis.

One of the consequences of an oversubscription is that the share price

will rise to a premium over the issue price when it starts trading in the

secondary market.

Clearing, Settlement and Custody54

Table 4.1 Classes of equities

Class Characteristics

Ordinary

shares

Ordinary shares represent partial ownership in a

corporation. Characteristically shareholders will have the

right to vote in the election of the board of directors.

They will also have the pre-emptive right to purchase any

additional shares sold by the company and to receive a

dividend, but only if the directors decide to issue a

dividend.

This dividend payment will generally be received when a

dividend is declared but only after preferred shareholders

have been paid.

In addition, if the company is liquidated, (un)secured

creditors, bondholders, and preferred shareholders have a

prior claim to the company’s assets before the common

shareholders.

Preference

shares

Preference shares also represent ownership in a

corporation. Characteristically shareholders will:

䊏 Generally have no voting rights.

䊏 Generally receive dividends before the ordinary

shareholders.

The dividend is frequently fixed as a percentage of the

share’s stated value. However, the dividend is not

guaranteed. If the company does not post strong earnings,

the directors can omit the preferred dividend.

A cumulative feature may be attached to a preference

share, which states that all dividends in arrears must be

paid to holders at some point in time prior to any

dividends paid to common shareholders.

Participating preference shares may benefit from an

increased level of dividends if the company does well.

Redeemable preference shares have a fixed repayment

date and may be entitled to more than their nominal

capital amount (face value).

Equity clearing and settlement 55