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2.5. Negotiable instruments representing equity

2.5.1. Introduction

Negotiable instruments representing equity are not derivatives of equities, but instruments that represent the right to equities, and they are tradable instruments in their own right. They are as follows:

• Letters of allocation.

• Certified transfer deeds.

• Share transfer receipts.

• Balance receipts.

• Warrants.

2.5.2. Letters of allocation

Letters of allocation (also called letter of rights and nil-paid letters) are a form of option on specific equities. In terms of the company statute, when a company requires further capital in the form of the issue of ordinary shares, it is obliged to offer the additional equity to existing ordinary shareholders in proportion to their existing holding. The company is said to be making a rights offer or a rights issue of additional equity.

The company makes the offer by the issue of a letter of allocation. The letter specifies the subscription price and the expiration time of the offer (which is usually short - a few weeks - from the issue date of the letter). Thus the shareholder has the right to buy the shares offered, but is not obliged to take up the offer. The shareholder does not pay for the letter (option), but the letter has a value, depending on the price specified in the letter relative to the market price, as well as expectations of the future price of the share. These letters are listed by, and traded on, the share exchange.

The take-up of the offer is a function of the price of the offer relative to the market price of the share. If the rights offer price is below the market price, the offer is usually taken up and the shares held or sold.

2.5.3. Certified transfer deeds

A securities transfer deed (STD) is the instrument prescribed by the statute relating to companies for the transfer of securities from one name to another. In many countries there are two types, distinguished by color; here we assume white and blue.

The white STD is used for the normal transferring of shareholding from one beneficial owner to another. The blue STD is issued by companies (or their Transfer Secretaries - TS) under certain circumstances. For example, if a broker requests a TS to split a LCC10 million par value Company ABC share certificate, and this cannot be effected immediately, the TS will complete 10 blue STDs for say LCC1 million each and stamp them with an official stamp. The STD is now (usually) called a certified securities transfer deed (CSTD) and may be traded as bearer equity.

It will be evident that under a dematerialized system, where an electronic entry in a register/s represents evidence of ownership, this instrument will become extinct.

2.5.4. Share transfer receipts

Another alternative to the share certificate is the share transfer receipt (STR). When shares are lodged for transfer and this cannot be immediately given effect, the TS may issue STRs in the denominations required. When accompanied by a STD the STRs are negotiable.

As in the case of the certified transfer deed, under a dematerialized system, where an electronic entry represents evidence of ownership, this instrument will disappear.

2.5.5. Balance receipts

A balance receipt, as the wording depicts, is a receipt showing the balance of shares. For example, if an equity deal for LCC1 million is transacted, and the seller only has a LCC10 million denomination certificate, this will be lodged with the TS together with a STD for LCC1 million.

If the transfer cannot be given effect immediately, and the seller wishes to trade the balance of LCC9 million, the TS will issue a balance receipt for LCC9 million. This receipt is tradable when accompanied by a STD.

It will be apparent (as in the above cases) that this instrument will die out under a dematerialized system.

2.5.6. Warrants

The warrant, being similar to an option, should perhaps be discussed under derivatives. However, because it is only a call option (in most cases) and represents a call on new equity (also in most cases), we regard it a negotiable instrument representing equity.

Warrants are call options issued by a company to purchase a specified number of shares in the company at a specified price before a specified date in the future. The main differences of warrants compared with traded options are:

• They are written by the issuing company.

• They have a longer lifespan that traded options (usually two to three years).

• They involve new equity issues by the company upon exercise.

The above describes the standard warrant, i.e. single equity warrant, which is a call warrant on new shares. Internationally, there are deviations from the standard warrant. Examples are:

• Covered warrant - where a banker (that operates in this market) acquires the underlying shares for the express purpose of issuing the warrant.

• Low exercise price warrants.

• Capped warrants - low exercise price warrants where the upside gain is capped.

• Installment warrants - where the shares are purchased in installments.

• Endowment warrants.

• Capital plus warrants.

South Africa boasts a substantial warrant market.10 However, the warrants in this market are not standard warrants, but retail options. Thus they belong under the heading of derivatives. The South African call "warrants" are not tied in with new issues of shares. Both call and put warrants (options) are available on specific shares and indices, and all are settled in cash. There are also basket warrants (options) available, which are warrants (options) written on the shares of a group of different companies that are involved in a similar sector.

To confuse the matter further, there exists (internationally) a discount warrant, which is a hybrid of the common / real warrant and the South African retail option. With this hybrid the holder receives either cash or the underlying share upon exercise, and this depends on the market / closing price of the underlying share on expiry:

• Closing price > is pre-specified target level: the holder obtains a cash settlement.

• Closing price < the target level: the holder receives the underlying share.

In summary, there are three types of warrants:

• Common warrants (tied to the issue of new shares).

• Warrants which are retail options (not tied to the issue of new shares).

• Discount warrants (tied to the issue of new shares under certain circumstances).

2.6. Summary

Ordinary shares are the essence of the equity market. The majority have a par value (and most a share premium if listed). They stand last in the waterfall of claims on the company, but have voting rights and share in profits to an unlimited extent.

Preference shares have preference to dividends over ordinary shares, but profit sharing (in most cases) is limited to the coupon. There are many different types of preference shares, which include characteristics such as participating, cumulative and convertible.

There are a number of negotiable instruments representing equity, the best known of which is the letter of allocation (rights issue).

2.7. Bibliography

Blake, D, 2000. Financial market analysis. New York: John Wiley & Sons Limited.

Faure, AP, 2007. The equity market. Cape Town: Quoin Institute (Pty) Limited.

Mayo, HB, 2003. Investments: an introduction. Mason, Ohio: Thomson South Western.

McInnes, TH, 2000. Capital markets: a global perspective. Oxford: Blackwell Publishers.

Mishkin, FS and Eakins, SG, 2000. Financial markets and institutions. Reading, Massachusetts: Addison Wesley Longman.

Pilbeam, K, 1998. Finance and financial markets. London: Macmillan Press.

Reilly, FK and Brown, KC, 2003. Investment analysis and portfolio management. Mason, Ohio: Thomson South Western.

Reilly, FK and Norton, EA, 2003. Investments. Mason, Ohio: Thomson South Western.

Rose, PS, 2000. Money and capital markets (international edition). Boston: McGraw-Hill Higher Education.

Santomero, AM and Babbel, DF, 2001. Financial markets, instruments and institutions (second edition). Boston: McGraw-Hill/Irwin.

Saunders, A and Cornett, MM, 2001. Financial markets and institutions (international edition). Boston: McGraw-Hill Higher Education.

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