Basic securities
Introduction to fundamental facts about types of securities
This section should hopefully be primarily a review, but we need to make sure we understand how the basics works, as that is a lot of what we are likely to be supervising.
Equity and debt
In simplest terms, stocks and bonds. Equity is ownership. The owner of an equity security, has some form of ownership claim on the issuer of the security. The specific claim can get a little complicated. Common stock and preferred stock are the most used forms of equity, with common stock being the most common (no pun intended).
Debt is loaning the company money, and they are now a debtor to you, the creditor, and they, the company, will pay interest on the loan to you and eventually repay the loaned principal, if able. Bonds and debentures are the most used forms of debt. A debenture is unsecured - it’s backed only by the issuer’s general creditworthiness - while a secured bond is backed by specific collateral, such as property or equipment.
Derivatives
We will be going into far more detail in their own sections on options, but derivatives are a type of investment category we need to understand. The term derivative is used, because these are securities that derive their value, from the underlying security. In many cases, we can think of these types of securities as a “bet”, betting if the price will go up, betting if the price will go down, betting the price will stay the same, or far more complicated bets are possible. In practice, they are a contract between 2 parties.
Rights and warrants
Rights and warrants are issued by the issuing company, when certain events happen. Puts and calls, covered below, are different: an option is written (sold) by another market participant, not by the company whose stock it covers.
Rights are issued when a currently listed company, one that has already had an IPO, and has common stock outstanding, issues additional shares. This could be in an additional public offering (APO), subsequent public offering (SPO), or follow-up/follow-on offering. When an issuer whose charter grants preemptive rights issues additional shares, it has to give its current common stock shareholders rights to maintain proportional ownership. They do this through issuing preemptive rights, or just rights. These allow the holder of them to buy the shares, to keep their proportional ownership, at a discount from the current market price. They would be able to sell them on the secondary markets if they choose. Rights though, are short term: 30-45 days is usual, and they generally expire within one to three months of the offering being announced.
Warrants are issued as a sweetener, to make a deal more attractive. Typically warrants are issued with a bond, but they could also be issued with preferred stock. The idea is that the issuing company, doesn’t want to pay as high an interest rate, so they have to offer something else to “sweeten the deal”, if they want to pay a lower rate than their company otherwise should based on the risks. The idea is that a warrant allows the owner, to buy the stock of the issuer, at a price higher than it currently is at the issue of the warrant, but unlike rights, warrants have a very long expiration period. Warrants usually are 3-5 years at least, with some warrants being perpetual or forever warrants. The summary use being, if you think the company is a good company, and you like their bonds, would you be willing to accept a slightly lower interest rate when you loan them money, in exchange for the ability to buy their stock at a stated price for 5 years? If you think the company will go up, then that capital gain potential, would be worth a lot more than that extra income would be.
Options: puts and calls
Usually, everyone’s favorite topic. We will go into more details in their own section, especially on the supervision as that is what is most often tested.
For now, think of them as a bet, they are contracts, but they function as a bet, someone is betting that the underlying investment is going to go up (buying a call), the other person therefore is “taking the bet”, and saying “it’s not going to go up”. The other situation has someone betting that the underlying investment is going to go down (buying a put), and the person “taking the bet”, is saying “it is not going to go down”.
An options quote would look something like “2 ABC Jan 40 call at 5”. That is stating there are 2 call contracts being discussed, these are call contracts that will expire the third Friday of January. They have a strike price of 40, meaning the person buying this believes it will go above 40, and the person selling it believes it will not go above 40, all by the third Friday in January. The option costs $5 per share, and each contract is for 100 shares, so each contract costs $500, 2 contracts, $1,000 for buying this quote.
Options with 9 months or less until expiration must be paid for in full, so they cannot be bought on margin or used as collateral. Listed options with more than 9 months until expiration can be bought on margin, with a requirement of 75% of their market value.
Almost all options questions will be tested on the Series 9, but there could be some questions, especially about the non-marginal nature, that could be seen on the Series 10.
Variable annuities
Again, most of this should likely be review. These are an insurance product, most suitable for investors wanting a stream of income for life, likely for a long life, and have a reasonably long period of time to grow the money, or a lump sum to invest in them. If a client withdraws money from any annuity prior to 59.5 years old, the taxable portion of the withdrawal will have the 10% retirement penalty, unless an exception such as death or disability applies.
Annuity earning grow tax deferred, meaning you are not paying taxes each year on growth in the account.
Representatives must have an understanding of the client’s investment objectives, time horizon, liquid net worth, and similar information before recommending these products.
There are severe liquidity issues, with potentially very high surrender charges for the first few years. Remember as well, this like all FINRA exams, will focus on the vanilla annuities, not the riders we know and love. Do not assume there are annual step-up or lock-ins, no guaranteed minimum income benefit, or any other riders. The one guarantee to know is the death benefit: if the owner dies before the insurer starts making payments, the beneficiary is guaranteed a set amount, typically at least the purchase payments, even if the account is worth less. That protects what heirs receive, not the owner’s own account value, which rises and falls with the market, so a variable annuity is not a capital preservation investment.
When replacing annuities, the surrender charge of the old annuity needs to be taken into consideration. It doesn’t really matter the benefits of the new annuity over the old annuity, if the client is going to lose 5-6% or more of their money due to surrender charges or other contractual limitations. If the old annuity is out of surrender charges, then it might be useful to consider, and the 1035 exchange means it would be tax-free, the deferral of the taxes would remain and carry over. There certainly are times when the annuity can be exchanged during a surrender period, but the key must still be that the new annuity is clearly better than the old product, with the additional benefits outweighing the fees/costs associated with terminating the old product. If there are no fees/costs with the old, it is even easier to justify.
Registered reps must be insurance and securities licensed in each state they wish to sell these, and supervisors must be registered in both securities and insurance, in each state they supervise reps in these products.
One of the trickier things to never forget about annuities is that regardless of the type of annuity, if taxes are owed, they are always ordinary income. If the annuity has been annuitized, the exclusion ratio determines how much of each payment is tax-free: it’s the client’s cost basis (the amount invested in the contract) divided by the expected total return over the payout period, based on life expectancy tables. For example, if a client invested $50,000 into a contract with an expected total return of $150,000 over the payout period, the exclusion ratio is $50,000 ÷ $150,000 = 1/3, so 1/3 of each payment is excluded from tax and the remaining 2/3 is taxable as ordinary income.
Qualified vs non-qualified
Like in all areas with these words, it comes down to qualified means tax deductible and tax deferred, non-qualified means not those, not deductible, and not deferred. When it comes to annuities, all of which are deferred, the only difference than means qualified has not been taxed yet, tax deductible, and nonqualified means it has been taxed, investors have already paid the tax on their investment, it creates a cost basis, and is non-deductible.
Qualified annuities are held inside a qualified retirement arrangement, such as a 403(b) plan (offered by schools, hospitals, churches, and other 501(c)(3) organizations), a 401(k), or an IRA. It has not been taxed yet, so 100% of the withdrawals will be taxable as ordinary income.
Nonqualified annuities are available through insurance/brokerage companies. They are after-tax meaning only the gain is taxable, as you won’t be double taxed. Annuities must use LIFO accounting, meaning the withdrawals are 100% taxable as ordinary income, until all growth has been removed.
This chapter covers the core equity, debt, and annuity products you’ll supervise most often. Direct participation programs and other pooled, complex structures follow in the next chapter, More complex securities; municipal securities supervision is covered later, in the MSRB rules chapters.