Section 3 Function 3: Investment Products, Recommendations & Records

Equity securities

59 min read · Lesson 1 of 19

About This Lesson

Welcome to the products module, the biggest block of the course and of the exam itself. It opens with the security everything else is measured against: common stock. The chapter runs on a handful of mechanical skills, computing outstanding shares, allocating cumulative votes, valuing a right, adjusting basis after a stock dividend, plus the vocabulary of preferred stock, ADRs, and the venues where equities trade. Every formula here gets reused later in the course, so it pays to get them down now.

What you'll cover

common stock: the share taxonomy (authorized, issued, treasury, outstanding), voting mechanics, and shareholder rights
preferred stock and the liquidation priority stack, plus rights, warrants, standby underwriting, and ADRs
corporate actions and cost basis, then the marketplaces (exchanges, OTC, ECNs, dark pools), short selling, and penny stock rules

This is the first chapter of the products module.

In this chapter

59 min · 13 concept checks

§1

Common Stock Fundamentals

Rights, Warrants & ADRs

Equity Markets & Trading Risks

~9 min · 4 checks

Summary

Exam Essentials & Traps

Exam-day review

Section 1 of 5 ~10 min · 1 concept check

Common Stock Fundamentals

Common Stock: Rights and Characteristics

Common stock represents an ownership interest in a corporation. Shareholders are the residual claimants — they receive whatever remains after all creditors, bondholders, and preferred shareholders have been paid. In exchange for this subordinated position, they have the greatest upside potential and certain shareholder rights.

Voting rights

One vote per share. Statutory and cumulative voting methods are detailed below.

Governance

Preemptive rights

The right to maintain proportional ownership by purchasing new shares before they are offered to the public. Exercised via a rights offering.

Anti-dilution

Residual claim

Last in line at liquidation — after secured creditors, unsecured creditors, and preferred shareholders. May receive nothing in bankruptcy.

Highest risk

Inspection rights

The right to inspect corporate books and records, attend annual meetings, and vote on major corporate actions (mergers, charter amendments).

Oversight

Limited liability

Maximum loss is the amount invested. Shareholders are not personally liable for corporate debts beyond their equity investment.

Protection

Dividends on common stock are declared by the board of directors and are not guaranteed. Four dates govern the dividend timeline:

Declaration date: Board announces the dividend
Ex-dividend date: First day a buyer will not receive the declared dividend (T+1 from record date under standard settlement)
Record date: Shareholders of record on this date receive the dividend
Payment date: Dividend is actually distributed

Share Taxonomy: Authorized, Issued, Outstanding, Treasury

Corporations count their shares four different ways, and the exam's favorite move here is to hand you three of the numbers and ask for the fourth. Learn what each category measures and the arithmetic takes care of itself:

Authorized Shares

The maximum number of shares the corporate charter permits the company to issue. Increasing this ceiling requires a shareholder vote. Acts as the upper bound on all share categories below.

Issued Shares

Shares the company has actually sold (or distributed) to investors. Always less than or equal to authorized. Once issued, shares remain "issued" even if subsequently bought back by the company.

Treasury Shares

Issued shares the company has repurchased and currently holds. Treasury shares pay no dividends, carry no voting rights, and are not counted in EPS calculations. Held by the company itself.

Outstanding Shares

Shares currently held by investors. The active voting and dividend-receiving share count. Computed as: Issued minus Treasury = Outstanding.

Worked example: MNO Company has 3,000,000 shares authorized. It issued 70% of those shares one year ago, then later repurchased 600,000 shares for treasury.

Step 1 — Authorized: 3,000,000
Step 2 — Issued: 70% × 3,000,000 = 2,100,000
Step 3 — Treasury: 600,000
Step 4 — Outstanding: Issued − Treasury = 2,100,000 − 600,000 = 1,500,000

The exam shortcut: outstanding shares are what matter, for voting, for dividends, and for EPS. When a question gives you authorized, issued, and treasury figures, run Issued minus Treasury and you have the outstanding count, which is almost certainly the number being asked for.

Voting Rights: Statutory vs. Cumulative

Common shareholders elect the board and vote on the big corporate decisions, and the exam cares most about the mechanics: when several board seats are open at once, how do the votes get allocated? Two methods exist, and which one a company uses decides how much a small shareholder matters.

Statutory Voting

One vote per share per open seat

A shareholder owning 100 shares with three board seats up for election casts 100 votes for each seat — 100 votes per candidate, with no ability to concentrate votes on one favored candidate. Benefits larger shareholders who already command majority blocks.

Cumulative Voting

Votes can be combined

A shareholder owning 100 shares with three board seats up for election may cast all 300 votes (100 × 3) for a single candidate, or split them as desired. Benefits smaller shareholders by allowing them to concentrate influence on board representation.

What Shareholders DO and DO NOT Vote On

Shareholders DO Vote On	Shareholders DO NOT Vote On
Election of board members	When dividends are declared (BOD decides)
Stock splits	The dollar amount of dividends
Issuance of additional equity-related securities	Day-to-day operating decisions
Major corporate actions (merger, dissolution)	Hiring or firing of company officers (BOD decides)

Special Voting Structures

Supervoting stock: A class of shares with multiple votes per share — commonly used by founders to retain control after a public offering. Class A might have 1 vote per share while Class B held by founders has 10 votes per share.
Nonvoting common stock: A separate class with all economic rights of common stock but no voting rights. Used to raise capital without diluting founder control.
Proxy voting: Shareholders unable to attend the annual meeting may delegate their votes to another party (typically management) by completing a written proxy. Proxies must comply with SEC disclosure rules.

Cumulative Voting vs. Statutory Voting: The Minority Shareholder Trap

The exam describes a minority shareholder and asks which voting method protects them better. The answer is always cumulative voting, and the arithmetic shows why.

Under statutory (straight) voting, a shareholder votes their shares once per director seat. A holder with 100 shares casts 100 votes for each of 5 directors, and a majority bloc can outvote them every time on every seat.

Under cumulative voting, that same holder has 500 total votes (100 × 5 seats) and can stack all 500 on a single candidate. That concentration is what lets a minority shareholder seat at least one board member without controlling a majority of shares.

Concept Check

MNO Company has authorized 3 million shares of common stock. It issued 70% of those shares one year ago. The company has since repurchased 600,000 shares for treasury. How many shares of MNO common stock are currently outstanding?

Outstanding shares are computed as issued shares minus treasury shares. MNO issued 70% of 3,000,000 authorized = 2,100,000 shares. The company then repurchased 600,000 shares for treasury, leaving 2,100,000 minus 600,000 = 1,500,000 outstanding. Outstanding shares are what investors currently hold and what counts for voting, dividends, and EPS calculations. Treasury shares pay no dividends and carry no voting rights despite still being technically issued. The 2,100,000 distractor reports issued shares without subtracting treasury. The 3,000,000 distractor reports the authorized ceiling, the maximum permitted by the corporate charter.

Section 2 of 5 ~7 min · 2 concept checks

Preferred Stock

Common Stock vs. Preferred Stock

Common stock

Voting equity — highest upside, most risk

Dividends Discretionary — board may cut or eliminate

Voting Yes — one vote per share (statutory)

Liquidation Last — residual claim after all creditors and preferred

Price sensitivity Moves with company earnings and market sentiment

Upside Unlimited — participates in all earnings growth

Preferred stock

Fixed income hybrid — income focus, limited upside

Dividends Fixed rate — stated as % of par or dollar amount

Voting Generally none — sometimes granted if dividends are in arrears

Liquidation Before common shareholders, after all creditors

Price sensitivity Moves inversely with interest rates (like a bond)

Upside Limited — capped at par unless participating feature

Preferred Stock: Four Key Subtypes

The exam tests preferred stock features by asking what happens in specific scenarios. Know what each feature adds to basic preferred.

Cumulative preferred

If dividends are skipped, the unpaid amounts accumulate as "dividends in arrears." All arrears must be paid in full before common shareholders receive any dividend.

Most protective for investor

Participating preferred

After receiving the fixed dividend, participating preferred shareholders also receive a share of any additional dividends paid to common shareholders — they participate in excess profits.

Rare — adds upside

Convertible preferred

Holder may convert each preferred share into a fixed number of common shares at a predetermined conversion ratio. Attractive when the common stock rises significantly above the conversion price.

Equity upside option

Callable preferred

The issuer may redeem (call) the shares at a preset call price, typically at par or a small premium. Usually called when interest rates fall so the company can reissue at a lower dividend rate.

Reinvestment risk for holder

Adjustable-rate preferred (ARP): A fifth subtype sometimes tested — the dividend rate floats with a reference rate (such as T-bill yields) rather than being fixed. This reduces interest rate risk for the holder but makes future income less predictable.

Liquidation Priority: The Stack

When a corporation is liquidated, assets go out in strict priority order, and no tier sees a dollar until every senior tier is paid in full:

1. Secured creditors (mortgage bondholders, secured lenders): first in line
2. Unsecured creditors (debenture holders, trade creditors)
3. Subordinated debenture holders
4. Preferred shareholders: fixed liquidation preference
5. Common shareholders: last, the residual claimants

The stack explains the whole risk hierarchy: bonds are safer than preferred, preferred is safer than common, and common keeps the highest potential return precisely because it stands last in line.

Concept Check

A corporation skips its preferred stock dividend for three consecutive years. The following year, the company earns sufficient profits and declares a common stock dividend. Under which type of preferred stock must all three years of unpaid dividends be distributed before common shareholders receive anything?

Cumulative preferred stock requires that any skipped (unpaid) dividends accumulate as dividends in arrears. All accumulated arrears must be paid to cumulative preferred shareholders in full before common shareholders can receive any dividend. This is the defining feature of cumulative preferred and its primary investor protection. Non-cumulative preferred holders lose skipped dividends permanently.

Concept Check

The board of directors of DDC Corporation omitted dividends in 2021 on their $100 par 6% NONCUMULATIVE preferred stock. In 2022, the board paid only $2 of the preferred dividend. The board now wants to pay a common stock dividend in 2023. How much must be paid per preferred share before any common dividend is permitted in 2023?

Noncumulative preferred stock requires only the current year stated dividend to be paid before any common dividend is declared. Prior years’ omitted dividends do not accumulate as obligations — they simply lapse. The 2021 omission and the partial 2022 payment do not create arrears that must be cleared. For 2023, the company must pay the stated 6% on $100 par = $6 per share, after which a common dividend may be declared. Cumulative preferred would require all unpaid dividends to be made up before common payments. The exam tests recognition of this distinction between cumulative and noncumulative obligations.

Section 3 of 5 ~7 min · 2 concept checks

Rights, Warrants, and ADRs

Rights and Warrants: Preemptive and Long-Term Equity Options

Rights (subscription rights)

Short-term • Existing shareholders only

Issued to existing shareholders to maintain their proportional ownership

Exercise price is set below the current market price (intrinsic value at issuance)

Short life — typically expire within 30 to 45 days

Can be sold (traded) in the secondary market if the holder doesn't exercise

Warrants

Long-term • Sweetener on bond or preferred offerings

Issued by the company as a sweetener attached to bonds or preferred stock

Exercise price is set above the current market price (out-of-the-money at issuance)

Long life — typically 5 to 10 years, sometimes perpetual

Trade separately in the secondary market after detachment from the host security

Key distinction: Rights have intrinsic value at issuance (exercise price below market) because they protect existing shareholders from dilution. Warrants are issued out-of-the-money (exercise price above market) as an incentive — they only become valuable if the stock appreciates significantly.

Preemptive Rights: Maintaining Proportionate Ownership

Preemptive rights let an existing shareholder buy into a new issuance in proportion to what they already own, a right but never an obligation, so a new equity sale cannot dilute their percentage stake without their consent.

Theoretical Value of a Right

Rights carry real value because they let the holder buy below market, and the exam tests two formulas. Which one applies depends on whether the stock currently trades cum-rights (rights still attached) or ex-rights (rights split off and trading separately).

Cum-Rights (with rights)

Stock still trades with rights attached

Value = (MP − SP) ÷ (N + 1)

Ex-Rights (without rights)

Stock trades after rights detached

Value = (MP − SP) ÷ N

Where: MP = current market price of stock; SP = subscription (exercise) price for the new shares; N = number of rights required to buy one share.

Worked example (cum-rights): Stock trades at $40, the subscription price is $35, and 4 rights are needed to buy one share.
Value = ($40 − $35) ÷ (4 + 1) = $5 ÷ 5 = $1.00 per right

Memorization shortcut: the "+1" appears only while the rights are still attached. Cum-rights means "with," so include the +1 in the denominator; ex-rights means "without," so drop it. The question always tells you which condition applies; your only job is picking the right formula.

Standby Underwriter

One more player completes the rights offering. Not every shareholder exercises, so the issuer engages a standby underwriter, an investment bank committed to buying any unsubscribed shares at the subscription price. The standby commitment guarantees the issuer raises its intended capital no matter how many shareholders participate.

American Depositary Receipts (ADRs)

An ADR is how a U.S. investor buys a foreign company without leaving home: no foreign market, no foreign currency at the brokerage level, no foreign settlement. Five mechanics cover what the exam asks:

Structure: A U.S. depositary bank holds shares of the foreign company in a foreign custodian bank and issues ADRs to U.S. investors representing those underlying shares
Currency: ADRs are priced and trade in U.S. dollars. Dividends are received in dollars (the depositary bank converts the foreign currency). However, currency risk still exists — the underlying value of the foreign shares fluctuates with the exchange rate
Ratio: One ADR may represent one, a fraction of, or multiple underlying foreign shares depending on the ADR ratio set at issuance
Sponsored vs. unsponsored: Sponsored ADRs are created with the cooperation of the foreign issuer and are listed on major exchanges. Unsponsored ADRs are created by a depositary bank without the issuer's involvement and trade on OTC markets
Levels: Level I ADRs trade OTC and have minimal SEC reporting. Level II and III ADRs trade on exchanges and require full SEC registration and reporting — Level III allows capital-raising in the U.S.

Concept Check

Which of the following best describes the difference between a subscription right and a warrant?

Rights are short-term instruments (30–45 days) issued to existing shareholders to maintain their proportional ownership in a new offering. The exercise price is below market price, giving them immediate intrinsic value. Warrants are long-term (5–10 years), issued above market price as sweeteners on bond or preferred offerings. They become valuable only if the stock appreciates significantly above the exercise price.

Concept Check

A U.S. investor buys an ADR representing shares of a Japanese technology company. The investor is exposed to which of the following risks that would NOT be present if buying a domestic U.S. stock?

ADRs are priced in U.S. dollars, but the underlying shares are denominated in a foreign currency (in this case, Japanese yen). If the yen weakens against the dollar, the dollar value of the investment falls even if the stock price in Japan is unchanged. This currency (exchange rate) risk is the unique risk of investing in foreign securities that does not apply to purely domestic investments. ADRs do trade on U.S. exchanges and are liquid.

Section 4 of 5 ~6 min · 4 concept checks

Corporate Actions

Stock Splits and Stock Dividends

Both stock splits and stock dividends increase the number of shares outstanding without changing total shareholder equity. The critical exam concept is that they do not create or destroy value — they simply redistribute it across more shares.

Forward stock split (e.g., 2-for-1)

Shares outstanding increase; price per share decreases proportionally. Total market cap unchanged.

Before: 100 shares × $80 = $8,000
After 2-for-1: 200 shares × $40 = $8,000

Reverse stock split (e.g., 1-for-4)

Shares outstanding decrease; price per share increases proportionally. Often used to avoid delisting when price falls below exchange minimum.

Before: 400 shares × $2 = $800
After 1-for-4: 100 shares × $8 = $800

Stock dividends follow the same math: a 10% stock dividend means a shareholder with 100 shares receives 10 additional shares. The share price adjusts downward by the same proportion. As with splits, total portfolio value is unchanged immediately after the dividend. Options contracts are adjusted for stock splits and stock dividends to maintain their economic value.

Stock Dividends and Cost Basis Adjustments

A stock dividend hands the shareholder more shares with no immediate tax bill, but two adjustments follow, and the exam tests both: the per-share cost basis drops to spread the same total over more shares, and the new shares borrow the holding period of the original purchase.

Worked example (KC 2.4 pattern): Florence buys 100 shares of YXC common stock at $22 per share on February 12, 2022. Total cost = $2,200.

On May 18, 2023, she receives a 10% stock dividend (10 additional shares). Total shares now: 110.
New cost basis per share: $2,200 ÷ 110 = $20.00

In June 2023 she sells all 110 shares at $25 per share. Total proceeds: $2,750.
Total gain: $2,750 − $2,200 = $550
Holding period: All 110 shares acquired 2/12/2022 — long-term (held more than one year). Stock-dividend shares inherit the holding period of the underlying original purchase.
Tax treatment: $550 long-term capital gain.

Two key rules: stock-dividend shares (1) take a pro-rata slice of the original cost basis, lowering the per-share number without changing the total, and (2) inherit the holding period of the underlying shares. A share you received yesterday can be long-term, as long as the original purchase was.

Cash Dividends: Qualified vs. Nonqualified

Cash dividends split into two tax categories:

Qualified dividends are taxed at preferential long-term capital gains rates. To qualify, the holding-period requirement is generally that the investor held the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.
Nonqualified (ordinary) dividends are taxed at the investor’s marginal ordinary income tax rate — typically higher than qualified rates.

The exam does not push into the holding-period arithmetic. What you need is the rate distinction: qualified dividends ride the preferential long-term capital gains rates, while ordinary dividends are taxed like wages.

Concept Check

A company completes a 3-for-1 stock split. Before the split, an investor held 200 shares priced at $90 per share. Immediately after the split, the investor holds:

In a 3-for-1 forward stock split, each existing share becomes 3 shares and the price per share is divided by 3. The investor's 200 shares become 600 shares (200 x 3), and the price adjusts from $90 to $30 ($90 ÷ 3). Total portfolio value is unchanged: 600 x $30 = $18,000, same as the original 200 x $90 = $18,000. Stock splits do not create or destroy value.

Concept Check

A company with 10 million shares outstanding declares a 3-for-2 stock split. After the split, the stock price was $60 before the split. What is the new share count and approximate price per share after the split?

In a 3-for-2 stock split, every 2 shares becomes 3 shares. Shares outstanding: 10M x (3/2) = 15 million. The price adjusts inversely: $60 x (2/3) = $40 per share. Total market cap remains unchanged (15M x $40 = $600M, same as 10M x $60). Stock splits are cosmetic — they do not change shareholder wealth or company value, just the number of shares and price per share. A 2-for-1 split would yield 20 million shares at $30.

Concept Check

An investor owning 400 shares of XYZ common stock notices that the company will execute a 3-for-2 forward stock split. As a result of the split, the investor will receive how many additional shares?

A 3-for-2 stock split delivers 3 new shares for every 2 old shares. The investor with 400 shares ends up with 400 × (3 ÷ 2) = 600 total shares. The number of additional shares received is 600 minus 400 = 200. Per-share price drops correspondingly to maintain the same total market value: a $30 share before the split becomes $20 after. The 400-additional-share distractor would represent a 2-for-1 split. The 600-additional-share distractor reports the new total holdings rather than the additional shares received. The 100-share distractor reflects no recognizable split ratio with the original 400-share position.

Concept Check

Florence purchases 100 shares of YXC common stock at $22 per share on February 12, 2022. On May 18, 2023, she receives a 10% stock dividend (10 additional shares). She sells all 110 shares at $25 per share in June 2023. The tax consequences of her transactions are

Stock dividend shares inherit the holding period of the underlying shares from which they were derived. Florence’s 100 original shares and the 10 stock-dividend shares all share the February 12, 2022 acquisition date for tax purposes. By June 2023, the holding period exceeds one year, qualifying for long-term capital gain treatment. New per-share basis after the stock dividend: $2,200 cost ÷ 110 shares = $20.00. Total proceeds: 110 × $25 = $2,750. Total gain: $2,750 minus $2,200 = $550, all long-term. The split-treatment distractors incorrectly assume the stock-dividend shares have a new holding period.

Section 5 of 5 ~9 min · 4 concept checks

Equity Markets & Trading Risks

Equity Marketplaces: Where Stocks Trade

The IPO from Chapter 2 was the primary market; everything after it happens in the secondary market, and the Series 7 expects you to know the four venues where that trading lives:

Stock Exchanges

Auction markets where buyers and sellers bid and offer continuously through a centralized order book. NYSE and Nasdaq are the two largest U.S. exchanges. Designated market makers and electronic systems match orders at the best available prices.

Over-the-Counter (OTC)

A negotiated market where buyers and sellers arrive at an agreed-upon price by bargaining. No centralized exchange. Dealers maintain bid and ask quotes; trades are negotiated bilaterally. Most non-listed stocks (including penny stocks) trade OTC.

ECN

An Electronic Communications Network is an alternative trading system that trades listed stocks. ECNs must register with the SEC as broker-dealers. They match buy and sell orders electronically, providing direct access without exchange specialists.

Dark Pools

Private alternative trading venues where institutional investors execute large block trades anonymously. Pre-trade order details are not displayed publicly, reducing the market-impact cost of large transactions. Trade reports become public after execution.

Auction vs. negotiated: exchanges are auction markets, continuous bids and offers meeting in one public order book. The OTC market is a negotiated market, dealers bargaining bilaterally with counterparties. The exam tests that vocabulary pair again and again.

Interactive: Short Selling Mechanics

Scenario:

Borrow and short sell

The investor borrows 100 shares from the broker and sells them into the market at the current price. The proceeds are held by the broker as collateral — the investor cannot use them freely.

Shares sold at$50.00 Proceeds (held by broker)$5,000 ObligationReturn 100 shares

Stock price falls

The investment thesis plays out — the stock declines. The investor's short position is now profitable because they can buy the shares back at a lower price than they sold them for.

Original sale price$50.00 Current market price$35.00 Unrealized gain per share+$15.00

Cover the short — profit

The investor buys 100 shares at the lower price and returns them to the broker. The difference between sale price and repurchase price is the profit, minus any dividends paid or borrowing fees incurred while short.

Sold at$5,000 Bought back at$3,500 Gross profit+$1,500 Maximum lossUnlimited (no price ceiling)

Penny Stock Rules: Definition and Customer Protection

Penny stocks sit at the speculative bottom of the equity market, and the SEC built a special rulebook to slow their sale to retail customers. The exam tests the definition first and the paperwork second.

Definition

The Series 7 simplified definition: an equity security trading at less than $5 per share that is not listed on a major exchange (NYSE, Nasdaq Stock Market). Stocks priced at $1 to $4 on the OTC markets typically qualify as penny stocks. Major-exchange- listed stocks are excluded regardless of price because exchange listing imposes substantial transparency and quality requirements.

Why Penny Stocks Are Risky

Lack of transparency: OTC trading requirements are less stringent than exchanges; analyst coverage is sparse.
Lack of liquidity: Thin trading volume makes positions difficult to sell at fair value.
No track record: Many issuers are early-stage with limited operating history.
Pump-and-dump schemes: Coordinated promotion temporarily inflates prices that promoters sell into, leaving retail buyers with losses.

Penny Stock Rule Requirements (SEC Rule 15g)

Brokers recommending penny stocks owe a stack of disclosures and sign-offs under SEC Rule 15g, each one designed to slow the sale down and make the risks unavoidable:

Risk Disclosure Document: A standardized document explaining penny stock risks must be provided to the customer, who must sign and return it before the trade.

Suitability Determination: The broker must determine that penny stocks are suitable for the customer in writing before recommending them. Customer signs and returns this written suitability statement.

Disclosure of Quotations and Compensation: Current bid/ask must be disclosed, and the broker’s compensation must be itemized.

Monthly Account Statements: Customers holding penny stocks receive account statements at least monthly showing the market value of each penny stock position.

Established customer exception: the written suitability determination is not required for "established customers": anyone who has held an account at the firm for more than one year, or who has made three penny stock purchases of different issuers on different days. Prior experience substitutes for the paperwork.

Concept Check

An investor short sells 100 shares of a stock at $60. The stock later rises to $85 and the investor covers the short. What is the investor's profit or loss, and what is the theoretical maximum loss on a short sale?

The investor sold at $60 and had to buy back at $85, a loss of $25 per share x 100 shares = $2,500. Short selling profits when the stock falls and loses when it rises. The maximum loss is theoretically unlimited because there is no ceiling on how high a stock price can rise. Contrast with a long position, where the maximum loss is capped at the amount invested (if the stock goes to zero).

Concept Check

The over-the-counter (OTC) market is described as a negotiated market. This characterization is best understood as meaning that buyers and sellers

A negotiated market is one in which buyers and sellers reach an agreed-upon price through direct bilateral bargaining — not through a centralized auction. OTC dealers maintain bid and ask quotes, but the actual transaction price often results from negotiation between the dealer and the counterparty. Stock exchanges by contrast are auction markets where orders meet in a continuous public order book with prices set by the bid-ask interaction. Customers are not forced to accept dealer quotes — they can negotiate or seek a competing quote.

Concept Check

A type of alternative trading system that trades listed stocks electronically and is required to register with the SEC as a broker-dealer is best described as

Electronic Communications Networks (ECNs) are alternative trading systems that trade listed stocks and must register with the SEC as broker-dealers. ECNs match buy and sell orders electronically, providing direct market access without traditional exchange specialists. The fourth market refers more broadly to direct trades between institutions, often through ECNs but encompassing other venues. Dark pools are private alternative trading venues focused on anonymous large-block trades by institutions; pre-trade quotes are not publicly displayed. ETNs are debt instruments tracking an index, unrelated to trading-system classification.

Concept Check

Under SEC rules, an unlisted common stock trading on the OTC markets avoids being defined as a penny stock as long as the market price is at least

The Series 7 simplified definition of a penny stock is an equity security trading below $5 per share that is not listed on a major exchange. A stock on the OTC markets at $5 or higher avoids the penny stock classification and the corresponding regulatory requirements. Major-exchange-listed stocks (NYSE, Nasdaq) are excluded from penny stock rules regardless of price because exchange listing standards impose substantial transparency requirements. The $1.00, $2.00, and $2.50 distractors all fall below the $5 threshold and would still classify the stock as a penny stock. The cutoff is specifically $5.

Summary Exam-day review · 2 essentials blocks

Chapter Summary — Exam Essentials

Ch 8 Exam Essentials — Equity Securities

Common vs. preferred priority: In liquidation: secured creditors → unsecured creditors → preferred stockholders → common stockholders. Common gets the residual; preferred gets a fixed claim first.
Preferred stock features: Cumulative = missed dividends accumulate (arrears must be paid before common dividends). Participating = shares in extra dividends. Convertible = can convert to common at a set ratio. Callable = issuer can redeem at a set price.
Rights and warrants: Rights — short-term (weeks), allow existing shareholders to buy new shares at a discount before the public offering (preemptive right). Warrants — long-term (years), typically attached to bonds as a sweetener, exercise price above market.
ADR taxation: ADR dividends are subject to a foreign withholding tax at the source country level. Investors can claim a foreign tax credit on their U.S. return.
Short selling mechanics: Borrow stock, sell it, hope to buy back cheaper. Profit = sale price − repurchase price − borrowing costs. Unlimited risk (stock can rise indefinitely). Requires a margin account.

Equity Securities Exam Traps — Consolidated

Twelve places the exam likes to set its equity traps. Give this list a final pass the night before; every item maps to a question pattern that has actually appeared:

1. Outstanding = Issued − Treasury. Authorized is the maximum allowed; issued is what was sold; treasury is what was bought back; outstanding is what investors hold today.

2. Treasury shares pay no dividends and have no votes. They sit on the company’s balance sheet, not in investor portfolios. Not counted in EPS calculations.

3. Cumulative voting benefits small shareholders; statutory voting benefits large blocks. Cumulative lets a small holder concentrate all votes on one preferred candidate.

4. Shareholders DO NOT vote on dividend declarations. Dividends are declared by the board of directors. Shareholders DO vote on stock splits, board elections, and major corporate actions.

5. Cum-rights formula: (MP − SP) / (N + 1). Ex-rights formula: (MP − SP) / N. The "+1" is what changes; "with rights" includes the additional new share in the denominator.

6. Standby underwriter guarantees the offering. Buys any unsubscribed shares at the subscription price, ensuring the issuer raises the targeted capital regardless of shareholder uptake.

7. OTC is a negotiated market; exchanges are auction markets. OTC dealers bargain bilaterally; exchanges feature continuous bid/offer in a centralized order book.

8. ECNs trade listed stocks and register as broker-dealers. Dark pools are private trading venues for institutional block trades; pre- trade quotes are not publicly displayed.

9. Stock dividends adjust per-share basis pro rata. Total basis stays the same; new shares inherit the original holding period. A stock-dividend share received yesterday can be long-term if the underlying purchase was long-term.

10. Penny stock = under $5 per share + not on a major exchange. Major-exchange listing exempts a stock regardless of price. The OTC location is essential to the penny stock classification.

11. Penny stock suitability determination must be in writing, signed by customer. Established customers are exempt: account holders for over one year, or three different penny stock purchases on different days.

12. Qualified dividends taxed at LTCG rates; nonqualified at ordinary income. Holding-period requirement (over 60 days in the 121-day window around ex-dividend) makes a dividend qualified. Candidates do not need to memorize the day count, only the rate distinction.

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