Law of Capital Markets Fall 2024 PDF

Sultan Qaboos University College of Law Law of Capital Markets Fall 2024 Chapter I - Securities Dr. Moufid El Khoury Chapter I: Securities Section 1: Definition of Securities A- Negative Definition of Securities: What is not a security? B- Positive Definition of Securi...

Sultan Qaboos University College of Law Law of Capital Markets Fall 2024 Chapter I - Securities Dr. Moufid El Khoury Chapter I: Securities Section 1: Definition of Securities A- Negative Definition of Securities: What is not a security? B- Positive Definition of Securities: What is a security? – the Legislative definition 1) The Legal Definition of Securities under Omani Law 2) Non-exhaustive enumeration of securities under Omani Law Section 2: Types of Securities A- Debt & Equity Securities 1) Difference between Debt and Equity securities 2) Specific examples of securities a) Bonds a) Promissory note b) Sukuk c) Depository Receipts i) BDRs ii) GDRs B- Derivatives 1) Futures a) Concept of Futures b) Futures Contract Example 2) Options C- Hybrid securities 1) Preference shares 2) Convertible debt securities 2 Chapter I: Securities The term “securities” has a flexible meaning. Depending of the context, it can mean security interests or guarantees (such as mortgages and charges). The term “securities” can also refer to “transferable financial investments”. The latter meaning is used when we refer to the capital markets as “securities markets”.1 Section 1: Definition of Securities A- Negative Definition of Securities: What is not a security? Financial instruments or securities are not a commercial paper such as cheque or bill of exchange. If commercial papers are negotiable instruments between merchants, financial instruments are traded on the capital markets. What is the difference between commercial papers and securities? The Commercial Code in Oman does not define commercial papers. From a comparative law perspective, Article 509 of UAE Commercial Transaction Code defines commercial papers as: “Commercial papers are written instruments in such forms defined by the law that represents a right which subject is a specified amount of money falling due at sight, or after a specific term, or can be specified. Commercial papers are negotiable in the commercial ways. It is established in the custom that commercial papers are accepted as a means of payment in lieu of money.”2 Commercial papers include bills of exchange, cheques and other instruments drawn for the purpose of carrying on commercial activity and recognized in commercial practice as acceptable forms of payment for transactions. Put simply, commercial papers are recognized and used in commerce as a substitute for money. In general, commercial papers can be considered as a short-term, unsecured, negotiable commercial instruments. 1 Geoffrrey Fuller, The Law and Practice of International Capital Markets, Lexis Nexis, Butterworths, 2007, p. 5. 2 Federal Decree-Law No. 50/2022 Issuing the Commercial Transactions Law Commercial Code. https://www.moec.gov.ae/documents/20121/0/DecreeLaw_50_2022_pdf.pdf/d34d9209-b407-6e73-9acb- 3b01522e94e6?t=1673496808487 3 1) Unsecured: The obligation to pay is usually not backed by a collateral. 2) Short-term: Commercial papers are usually short-term means of payment and issued as a substitute for cash. In general, the maturity period of commercial papers does not exceed one year. 3) Negotiable: What does it mean for commercial papers to be negotiable? In other words, what does it mean to “sell” a commercial paper? In practice, they can be transferred or “sold” at a discounted value and redeemed later by the last holder at its “par value.” B- Positive Definition of Securities: What is a security? 1) The Legal Definition of Securities under Omani Law: The Law defines Securities as follows: Royal Decree 46/2022 Article 1(c) “Securities: Any financial contracts, property rights, or debt instruments that are tradeable and fungible such as stocks, bonds, sukuk, and any other instruments stipulated in this law or determined by the board.” Put simply, a security is financial instrument (financial asset) that can be traded on the financial market (open market). 2) Non-exhaustive enumeration of securities under Omani Law: Chapter 4 of RD 46/2022 is denominated “Securities” and directly regulates them. Article 27 does not define what is a security but enumerates examples of what might be a security. Article 27 reads the following: “Securities include, in particular, the following: (a) Stocks. (b) Bonds, promissory notes, any other type of debt instruments. (c) Sukuk. (d) Depository receipts. (e) Derivative contracts listed on the securities exchange, such as immediate and future settlement contracts, buy or sale option contracts, futures based on the value or value differential of one or 4 more securities, commodities, currencies, interest rates, returns, energy, financial indexes, credit rating, or any contract or principles approved by the board. (f) Securities issued by the government or public authorities and establishments. (g) Convertible depository receipts issued by depositories accredited by the authority, and whose amount, kind, and the quality and grade of commodity kept against such receipt, are determined. (h) Rights and products connected to the security. (i) Part or all of the contract of a collective investment fund. (j) Any other securities determined by the board.” Section 2: Types of Securities A- Debt & Equity Securities 1) Difference between Debt and Equity Securities A debt security may be issued by any type of issuer whether or not it is a company. The relationship between issuer and holder is contractual: the issuer owes a debt toward the holder. The holder is therefore a creditor of the issuer and is entitled to payment of the principal and interest on the due dates and the benefit of such other covenants as may be included in the terms. An equity security, however, is a type of ownership interest in an economic venture, and therefore may only be issued by a commercial company, taken in its broad sense. Not all equity securities are shares. In general, equity securities are the “ordinary shares” referred to as “common shares” or “common stock” as distinct from shares having preferred or postponed rights. Precise definitions of debt or equity will vary from one jurisdiction to another, but there are two principal features which determine which label is appropriate: ▪ The ranking in a liquidation of the issuer: Shareholders invariably rank behind creditors in a liquidation. ▪ A debt security does not entitle the holder to be treated as a member of the issuer. This has two principal consequences: a) Whereas a shareholder and a creditor both have rights against the issuer arising under a contract (Articles of Association vs. Debt contract), the shareholder has a property right in the issuer. 5  b) Shareholders participate in the decision-making of the issuer as they have rights to vote at company meetings, whereas creditors do not. Creditors can generally exercise control over the issuer only through covenants in the debt contract. The other differences between debt and equity include: c) The income on debt securities takes usually the form of an “interest”, and the income on equity securities takes usually the form of “dividends”. Dividends are only payable if there are sufficient distributable profits, and thus will vary with the performance of the issuer’s business, whereas interest is usually payable irrespective of profits. d) Debt securities usually provide for repayment (or redemption) on a specified date (bullet redemption) or a series of dates (instalment redemption), whereas equity securities usually have no specified repayment date.3 2) Specific examples of securities a) Bonds A bond is fixed-income instrument which represents a loan made by an investor to a borrower (private sector or public sector). Typically, corporations and governments issue bonds for investors. Bonds include the maturity date when the principal of the loan is due to be paid and usually include variable or fixed interest payments made by the borrower. https://www.youtube.com/watch?v=-0HQltcbglw Watch Now: What Is a Bond? b) Promissory note A promissory note is a debt instrument. In general, a promissory note is a writing containing an unconditional undertaking signed by the borrower to pay a certain sum of money only to, or to the order to a specific person or to the bearer of the promissory note. c) Sukuk Sukuk or Islamic trust certificates were first seen in the international capital markets in 2002. The first issue being a $600m global sukuk issue by the Federation of Malaysia.4 Sukuk provide a form of Sharia’a compatible capital markets financing that meets the economic expectation of conventional capital investors. Sukuk are, in essence, trust certificates backed by Sharia’a-acceptable assets. The form of documentation and the marketing and issue processes are 3 Geoffrrey Fuller, The Law and Practice of International Capital Markets, Lexis Nexis, Butterworths, 2007, p. 9-10. 4 Ibid., p. 60 6 similar to those for a conventional issue of international debt securities: however, the instrument, rather than being a debt obligation of the issuer, confers rights as beneficiaries under a trust of the relevant assets backing the deal. It is thus akin, in legal terms to a depository receipt. Sukuk can be structured in a variety of ways. The most common are structures backed by ijara or mosharaka. A typical sukuk would have the following principal features: The issuer of sukuk would usually be a special purpose vehicle (SPV) company, which purchases the relevant assets from the existing owner (The Vendor), which is the ultimate recipient of the financing, for a purchase price equal to the proceeds of issue of the sukuk. The SPV would then enter into an Islamic finance contract (such as ijara, mosharaka) or series of contracts, with the Vendor in relation to the assets. The payments due to the SPV from the Vendor would be reset periodically by reference to LIBOR5 plus a margin, and would match the periodic distributions due to investors under the sukuk. Funds to pay the principal of the sukuk at maturity would be generated by a sale of the assets back to the Vendor. The Vendor would thus agree in advance to repurchase the assets on the scheduled maturity date of the sukuk, or if earlier, on the occurrence of a default with respect to the sukuk.6 d) Depository Receipts Depository receipts is a tradeable security issued by a bank or other financial institution (a Depositary) conferring on the holders beneficial ownership of assets held by the Depository on trust for the holders of the depository receipts. In very broad terms, there are two main types of depository receipts in the international capital markets: those in which the underlying assets are debt claims (often referred to as “bearer depository receipts”, or BDRs); and those in which the underlying assets are shares (often referred to as “global depository receipts” or GDRs). i) BDRs Bearer Depository Receipts are used where a direct bond issue by the ultimate borrower is not possible or is not financially attractive. This may be because of taxation issues or public issues by the ultimate borrower are not permitted. Instead of the ultimate borrower issuing bonds to the market, it issues the bonds to the Depository or enters into a loan agreement or deposit agreement with the Depository. The Depository issues the BDRs to the market, and passes the issue proceeds to the ultimate borrower. The Depository holds the bonds on trust for the holders, and the holders are entitled to principal and interest to the extent principal and interest are received by the Depository on the underling bonds. 5 London Inter-Bank Offered Rate 6 Idem, p. 60-61 7  ii) GDRs Global Depository Receipts are most often used as a way of facilitating international investment in shares of companies in emerging markets. As with BDRs, the issue proceeds are used to subscribe for or purchase the shares. The underlying assets here are shares in the case of GDRs, which are then held by or on behalf of the Depository on trust for the holders of the GDRs. The voting rights attaching to the shares are exercisable by the Depository. However, to the extent permitted by the law applicable to the shares, the GDRs usually set out provisions entitling the GDR holders to direct the Depository as to how to vote. B- Derivatives Derivatives are financial instruments whose value is based on or derived from other assets or variables. The value of a derivative security depends on the value of another underlying asset (e.g., a barrel of oil). With derivative securities, both parties involved in the contract are essentially “betting” on the underlying asset's value changing in opposite ways. 7 The underlying asset can really be anything. Generally, the underlying asset can be one of three categories: § A commodity (gold, silver, coffee, sugar, electricity, natural gas, oil, etc.) § A financial asset (stocks, bonds, currencies, interest rates, etc.) § An Event (snow, sand storm, rainfall, temperature, natural catastrophes, etc.) Examples of Derivatives include futures, forwards, swaps, and options. Today, financial futures or options markets span the globe. The underlying asset may be a bond issued by a major government, equity in a firm or an index of a leading stock market. These markets have a long pedigree. Futures markets began hundreds of years ago, giving famers and traders firm prices for crops well before harvest. US futures exchanges opened in the mid-1800s. Options markets appeared in Europe and America in 1700s, but not until the early 1900s was an exchange- like association set up. The Chicago Board Options Exchange opened the first options exchange in 1973.8 7 MasterClass, Guide to Securities: 4 Types of Financial Securities, 2021, available at: https://www.masterclass.com/articles/what-are-securities 8 Hals Scott & Anna Gelpern, International Finance: Law and Regulation, Third Edition, Sweet & Maxwell, 2012, p. 807. 8  1) Futures a) Concept of Futures A futures contract is an agreement to buy or sell an asset at a set time in the future for a set price. No cash is paid at the time the contract is entered into. Futures exist for many different types of assets. For example, there are futures contracts on wheat, on Treasury Bills, stock indices such as the S&P5009 or FTSE 10010, shares of individual companies and even other derivatives. Hedges and speculators are the two basic types of investors in futures. Hedgers are people who use futures contracts to offset their risks with regard to a particular asset. Speculators, on the other hand, buy and sell futures contracts with the sole goal of earning a profit. They usually base their decisions on their perceived sense of price movement of the underlying asset in the contract. b) Futures Contract Example11 Suppose that Ahmed’s coffee shop currently purchases coffee beans at a price of OR 4/Kg. At this price, Ahmed is able to maintain profitable margins on the sale of coffee beverages. However, Ahmed reads in the newspaper that sand storm season is coming up and this may threaten to destroy coffee plantations. He is worried that this will lead to an increase in the price of coffee beans, and thus reduces his margins. Coffee futures that expire six months from now (in March 2025) can be bought for OR 40 per contract. Ahmed buys 1000 of these coffee bean futures contracts (where one contract = 10 Kg of coffee), for a total cost of OR 40,000 for 10,000 Kg (OR 4/Kg). Coffee industry analysts predict that if there are no sand storm, advancements in technology will enable coffee producers to supply the industry with more coffee. Scenario 1 – Storm destroys plantations 9 The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. 10 The Financial Times Stock Exchange 100 Index, also called the FTSE 100 Index, FTSE 100, FTSE, or, informally, the "Footsie", is a share index of the 100 companies listed on the London Stock Exchange with the highest market capitalization. 11 Example edited and extracted from: https://corporatefinanceinstitute.com/resources/knowledge/finance/futures- forwards/ 9 The following week, a massive storm devastates plantations and causes the price of March 2025 coffee futures to spike to $60 per contract. Since coffee futures are derivatives that derive their values from the values of coffee, we can infer that the price of coffee has also gone up. In this scenario, Ahmed has made a $20,000 capital gain since his futures contracts are now worth $60,000. Ahmed can decide to sell his futures. Scenario 2 – Storm does not destroy plantations Coffee industry analyst predictions were correct, and the coffee industry is flooded with more beans than usual. Thus, the price of coffee futures drops to $20 per contract. In this scenario, Ahmed has incurred a OR 20,000 capital loss since his futures contracts are now worth only OR 20,000 (down from OR 40,000). 2) Options An Option is a contract, the option agreement between two parties. The beneficiary or the recipient of the option right is called Option buyer or Option holder. The predetermined price of the asset can be called Strike. The price of the Option is called a Premium. Option term or duration: Period of time during which the option buyer can exercise The party giving the right and taking upon itself the obligation can be called “Originator”, Option writer, or Option seller. Two types of options exist. § A call option gives the holder the right to buy an asset by or at a set date for a set price. A call option confers the right to buy an asset at an agreed exercise or strike price by or at a set time in the future. § A put option gives the holder the right to sell an asset by or at a set date for a set price. A put option confers the right to sell at the strike price by or at a set time in the future. Options provide the buyer of the contracts the right, but not the obligation, to purchase or sell the underlying asset at a predetermined price within a predetermined time frame.12 Watch: What are Options? https://www.youtube.com/watch?v=CRhGikRHSu8 12 Andrew Loo, Derivatives, available at: https://corporatefinanceinstitute.com/resources/knowledge/trading- investing/derivatives/ 10  C- Hybrid securities 13 A hybrid security is one which combines some features of a debt security with others of an equity security. It may either be structured to have a mix of the legal and economic features of each, or it may merely be convertible from one to the other. Hybrid securities are called “Hybrid” because they contain elements of both equity securities and debt securities. The main types of hybrid securities include the following: 1) Preference shares In some jurisdictions, these are referred to as “preferred shares” or “preferred stock”. They are shares, that under the issuing company’s constitution, rank ahead of the ordinary shares. The holders are thus members of the issuing company, and will rank behind creditors in its liquidation, but the shares carry a number of ‘quasi-debt’ features, including: - A fixed preferential dividend payable in priority to dividends on the ordinary equity. - A preferential right to a return of capital on a liquidation of the issuer ahead of the holders of the ordinary equity – though still ranking behind the creditors. - Limited voting rights. Preferred shares under Omani Law: § Equality of rights as a Principle Under Article 121 Omani Commercial Companies Law, shares shall enjoy equal and inherent rights in the ownership thereof. The most important of these rights are namely, the right to receive dividends declared by the general meeting, the preferential right of subscription for new shares, disposal of the shares, obtaining a copy of the financial statements, perusal of the shareholders’ register, attending the general meetings and voting on the items of their agendas and perusal of their minutes, the right to apply for suspension or invalidation of any resolution adopted by the general meeting or the board of directors which is contrary to the law, the articles of association or the internal regulations of the company, the right to take legal actions against members of the board of directors and the auditor in his/her own name or on behalf of the shareholders or the company and the right to participate in the distribution of the company’s assets upon its liquidation. 13 Geoffrrey Fuller, The Law and Practice of International Capital Markets, Lexis Nexis, Butterworths, 2007, p. 11- 12. 11  § Preference as an Exception Under Article 122 Omani Commercial Companies Law, the articles of association of a company may establish certain privileges for some of the shares with respect to voting, dividends or proceeds of liquidation or such other rights. Legal Restriction: the shares of the same class shall have equal rights, privileges and limitations and the rights, privileges and limitations related to any class of shares shall not be amended except by a resolution of the extraordinary general meeting and with the approval of two thirds of the owners of such class of shares. Is this legal restriction on the exception of preferential treatment an indirect restoration of the principle of equality? Article 45 & 46 of Decision No. 27/2021 Issuing the Regulation for Public Joint Stock Companies The articles of association of the company may provide for certain preferences for shares in voting or dividends or the proceeds of liquidation or other rights. Such shares shall be called preferred shares and shall be issued in different classes as per the preference they bear provided the preference shall be the same for the same class of shares even in different issues. The Public Joint Stock Company may issue preferred shares on the following terms and conditions: 1. The articles of association of the company permits issuance of such shares. 2. Obtain the approval of the extraordinary general meeting. 3. The ratio of preference shares shall not exceed 20 % of the total capital. 2) Convertible debt securities Convertible debt securities carry the normal rights of debt securities to periodic interest payments and repayment of principal on maturity, but have a hybrid quality in that they also entitle the holders to convert the debt into equity of the issuer. The attraction to an investor is the flexibility. If the issuer performs well, the holder can convert into equity and share in the “upside”. Prior to conversion, however, he receives a fixed income, and if the issuer does not perform well, he need never convert. Until he converts, the holder is a creditor, and the convertible debt will rank ahead of the equity. 12