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II-A Registrars to an Issue and Share Transfer Agents – Corporate NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Workbook for NISM-Series-II-A: Registrars to an Issue and Share Transfer Agents - Corporate Certification Examination National Institute of Securities Markets www.nism.ac.in Page 1 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Certification Examination for Registrars to an Issue and Share Transfer Agents -Corporate. Workbook Version: February 20241 Published by: National Institute of Securities Markets © National Institute of Securities Markets, 2024 Plot 82, Sector 17, Vashi Navi Mumbai – 400 703, India National Institute of Securities Markets Patalganga Campus Plot IS-1 & IS-2, Patalganga Industrial Area Village Mohopada (Wasambe) Taluka-Khalapur District Raigad-410222 Website: www.nism.ac.in All rights reserved. Reproduction of this publication in any form without prior permission of the publishers is strictly prohibited. 1 This version of the workbook is for candidates appearing for NISM-Series-II-A: Registrars to an Issue and Share Transfer Agents - Corporate Certification Examination on or after April 13, 2024. Page 2 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Disclaimer The contents of this publication do not necessarily constitute or imply its endorsement, recommendation, or favoring by the National Institute of Securities Markets (NISM) or the Securities and Exchange Board of India (SEBI). This publication is meant for general reading and educational purpose only. The statements/explanations/concepts are of general nature and may not have taken into account the particular objective/ move/ aim/ need/ circumstances of individual user/ reader/ organization/ institute. Thus NISM and SEBI do not assume any responsibility for any wrong move or action taken based on the information available in this publication. Therefore, before acting on or following the steps suggested on any theme or before following any recommendation given in this publication user/reader should consider/seek professional advice. The publication contains information, statements, opinions, statistics and materials that have been obtained from sources believed to be reliable and the publishers of this title have made best efforts to avoid any errors. However, publishers of this material offer no guarantees and warranties of any kind to the readers/users of the information contained in this publication. Since the work and research is still going on in all these knowledge streams, NISM and SEBI do not warrant the totality and absolute accuracy, adequacy or completeness of this information and material and expressly disclaim any liability for errors or omissions in this information and material herein. NISM and SEBI do not accept any legal liability what so ever based on any information contained herein. While the NISM Certification examination will be largely based on material in this workbook, NISM does not guarantee that all questions in the examination will be from material covered herein. Page 3 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Foreword NISM is a leading provider of high end professional education, certifications, training and research in financial markets. NISM engages in capacity building among stakeholders in the securities markets through professional education, financial literacy, enhancing governance standards and fostering policy research. NISM works closely with all financial sector regulators in the area of financial education. NISM Certification programs aim to enhance the quality and standards of professionals employed in various segments of the financial services sector. NISM’s School for Certification of Intermediaries (SCI) develops and conducts certification examinations and Continuing Professional Education (CPE) programs that aim to ensure that professionals meet the defined minimum common knowledge benchmark for various critical market functions. NISM certification examinations and educational programs cater to different segments of intermediaries focusing on varied product lines and functional areas. NISM Certifications have established knowledge benchmarks for various market products and functions such as Equities, Mutual Funds, Derivatives, Compliance, Operations, Advisory and Research. NISM certification examinations and training programs provide a structured learning plan and career path to students and job aspirants who wish to make a professional career in the Securities markets. Till March 2023, NISM has issued more than 17 lakh certificates through its Certification Examinations and CPE Programs. NISM supports candidates by providing lucid and focused workbooks that assist them in understanding the subject and preparing for NISM Examinations. This book covers all important aspects of the functioning of the Registrars and Transfer Agents related to dealing, collecting or processing applications for listed companies; handling matters relating to corporate actions, refunds or redemptions, repurchase of securities, transfers and transmissions etc. This book will be useful to understand the overall RTA-Corporate role and the regulatory environment in which they operate in India. Director Page 4 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Acknowledgement This workbook has been developed and reviewed by the Certification Team of NISM in co-ordination with its Resource Person – Mr. Haresh Hinduja. NISM gratefully acknowledges the contribution of Registrars and Transfer Agent Association of India (RAIN) and the Examination Committee for Registrar and Transfer Agent Examination consisting of nominated representatives from the RAIN. Page 5 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination About NISM Certifications The School for Certification of Intermediaries (SCI) at NISM is engaged in developing and administering Certification Examinations and CPE Programs for professionals employed in various segments of the Indian securities markets. These Certifications and CPE Programs are being developed and administered by NISM as mandated under Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007. The skills, expertise and ethics of professionals in the securities markets are crucial in providing effective intermediation to investors and in increasing the investor confidence in market systems and processes. The School for Certification of Intermediaries (SCI) seeks to ensure that market intermediaries meet defined minimum common benchmark of required functional knowledge through Certification Examinations and Continuing Professional Education Programmes on Mutual Funds, Equities, Derivatives Securities Operations, Compliance, Research Analysis, Investment Advice and many more. Certification creates quality market professionals and catalyzes greater investor participation in the markets. Certification also provides structured career paths to students and job aspirants in the securities markets. Page 6 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination About the Certification Examination for Registrars to an Issue and Share Transfer Agents – Corporate The examination seeks to create a common minimum knowledge benchmark for associated persons working in Registrars to an Issue and Share Transfer Agents (R&T agent) organizations performing any of the following functions for listed companies: dealing or interacting with the investors or issuers; dealing, collecting or processing applications from the applicants; dealing with matters relating to corporate actions, refunds or redemptions, repurchase of securities, etc; handling redressal of investors’ grievances; responsible for internal control and risk management; responsible for any compliance of securities laws; responsible for any other activity performed under the Securities and Exchange Board of India (Registrars to an Issue and Share Transfer Agents) Regulations, 1993. Examination Objectives On successful completion of the examination the candidate should: Know the basics of securities and securities markets Understand broadly the role and functions of the R&T Agents in the corporate securities issuance and transaction process. Know the regulatory environment in which the R&T Agents operate in India. Assessment Structure The examination consists of 100 questions of 1 mark each and should be completed in 2 hours. The passing score for the examination is 50%. There shall be negative marking of 25% of the marks assigned to a question. Examination Structure The exam covers knowledge competencies related to the basics of securities and markets and those related to the processing of corporate offerings and subsequent operations. How to register and take the examination To find out more and register for the examination, please visit www.nism.ac.in Page 7 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Important Please note that the Test Centre workstations are equipped with either Microsoft Excel or OpenOffice Calc. Therefore, candidates are advised to be well versed with both of these softwares for computation of numericals. The sample caselets and multiple choice questions illustrated in the book are for reference purposes only. The level of difficulty may vary in the actual examination. Page 8 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Table of Contents CHAPTER 1: INTRODUCTION TO SECURITIES…………………………………………………..13 1.1 Introduction to Equity and Debt................................................................... 13 1.2 Features of Equity Capital and Benefits to Equity Investors........................ 14 1.3 Features of Debt Capital and Benefits to Debt Investors............................. 16 1.4 Hybrid Structures.......................................................................................... 17 CHAPTER 2: CHARACTERISTICS OF EQUITY SHARES………………………………………..19 2.1 Investors in Equity Shares............................................................................. 19 2.2 Rights of a Shareholder................................................................................. 21 2.3 Risks in Equity Investing................................................................................ 22 2.4 Equity Terminology....................................................................................... 23 2.5 Corporate Actions......................................................................................... 26 2.6 Reduction of Share Capital............................................................................ 28 2.7 Preference Shares......................................................................................... 28 2.8 Rights Issue of Shares.................................................................................... 29 2.9 Preferential Issue.......................................................................................... 30 CHAPTER 3: CHARACTERISTICS OF DEBT SECURITIES………………………………………32 3.1 Features of a Debt Security........................................................................... 32 3.2 Market Value of a Debt security................................................................... 33 3.3 Yield from Debt Instruments......................................................................... 33 3.4 Types of Debt Securities................................................................................ 34 3.5 Classification of Debt Market........................................................................ 36 3.6 Credit Rating.................................................................................................. 37 3.7 Money Market Instruments.......................................................................... 40 CHPATER 4: CHARACTERISTICS OF OTHER SECURITIES…………………………………….43 4.1 Warrants...................................................................................................... 43 4.2 Convertible Debentures................................................................................ 44 4.3 Depository Receipts...................................................................................... 44 4.4 Foreign Currency Convertible Bonds............................................................ 46 4.5 Exchange Traded Funds and Index Funds..................................................... 46 4.6 Investment Trusts......................................................................................... 47 4.7 Alternate Investment Funds (AIFs)............................................................... 48 4.8 Corporate Fixed Deposits.............................................................................. 48 CHPTER 5: BASICS OF MUTUAL FUNDS…………………………………………………………..50 5.1. Introduction to Mutual Funds...................................................................... 50 5.2. Advantages of Mutual Funds....................................................................... 53 5.3. Open Ended and Close Ended Mutual Funds............................................... 54 5.4. Assets under Management (AUM).............................................................. 55 5.5. Net Assets.................................................................................................... 57 CHAPTER 6: SEBI - ROLE AND REGULATIONS…………………………………………………..61 6.1. Securities and Exchange Board of India Act, 1992 and Role of SEBI........... 62 6.2. SEBI Regulations specifically aimed at Investor Protection......................... 64 6.2.1 SEBI (PROHIBITION OF INSIDER TRADING) REGULATIONS, 2015............................... 64 Page 9 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination 6.2.2 SEBI (PROHIBITION OF FRAUDULENT AND UNFAIR TRADE PRACTICES RELATING TO SECURITIES MARKET) REGULATIONS, 2003..................................................................... 65 6.3. Investor Education and Protection Fund (IEPF) Authority........................... 65 6.4. SEBI Regulations for Registrars and Transfer Agents.................................. 69 6.4.1 SEBI (REGISTRARS TO AN ISSUE AND SHARE TRANSFER AGENTS) REGULATIONS, 1993... 69 6.4.2 SEBI (INTERMEDIARIES) REGULATIONS, 2008......................................................... 78 6.4.3 SEBI (DEPOSITORIES AND PARTICIPANTS) REGULATIONS, 2018.................................. 79 CHAPTER 7: PUBLIC OFFER OF SECURITIES……………………………………………………..82 7.1 Issuing Equity Capital.................................................................................... 82 7.2 Public Offer of Shares.................................................................................... 83 7.3 Reservations.................................................................................................. 84 7.4 Initial Public Offer......................................................................................... 85 7.5 Eligibility for Initial Public Offer of Shares.................................................... 86 7.6 Further Public Offer...................................................................................... 87 7.7 Buy Back of Securities................................................................................... 87 CHAPTER 8: MODES OF ALLOTMENT OF SHARES OTHER THAN PUBLIC OFFERS93 8.1. Private Placement of Shares........................................................................ 94 8.2. Qualified Institutions Placement................................................................. 94 8.3. Rights Issue................................................................................................... 95 8.4. Employee Stock Options (ESOPs)................................................................. 96 8.5. Conversion of Convertible Debentures/Bonds into shares......................... 97 CHAPTER 9: PROCESSES RELATED TO PUBLIC OFFERING OF SHARES……………….99 9.1 Pre-Issue Work.............................................................................................. 99 9.2 Post-Issue Work.......................................................................................... 100 9.3 Terms and Concepts in Public Issue of Shares............................................ 101 9.4 Prospectus................................................................................................... 103 9.5 Red Herring Prospectus.............................................................................. 103 9.6 Underwriting............................................................................................... 103 9.7 Green Shoe Option...................................................................................... 104 9.8 Methods of Making a Public Issue of Shares.............................................. 105 9.9 Initial Public Offer (IPO) by Small and Medium Enterprises (SME)............ 108 CHAPTER 10: ROLES AND RESPONSIBILITIES IN A PUBLIC ISSUE……………………111 10.1 Registrar and Transfer Agents.................................................................. 111 10.2 Sponsor Bank............................................................................................ 114 10.3 Bankers to the Issue.................................................................................. 114 10.4 Brokers to the Issue/Syndicate Members/ Designated Intermediaries... 120 CHAPTER 11: DEPOSITORY SERVICES……………………………………………………………122 11.1 Dematerialisation...................................................................................... 122 11.2 Constituents of the Depository System.................................................... 123 11.3 Investor’s Interface with the Depository.................................................. 125 CHAPTER 12: PROCESSES RELATED TO DEPOSITORIES…………………………………..128 12.1 Dematerialisation of Securities................................................................. 128 12.2 Rematerialisation of Securities................................................................. 130 12.3 Trading and Settlement............................................................................ 131 Page 10 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination 12.4 Beneficial Owner Reporting...................................................................... 134 12.5 Corporate Actions..................................................................................... 135 12.6 Reconciliation............................................................................................ 137 12.7 Crediting shares to IEPF Account.............................................................. 142 CHAPTER 13: INVESTOR INTERFACE WITH THE R&T AGENT………………………….146 13.1 Transfer of Securities................................................................................ 148 13.2 Recording Change in Investor Information............................................... 149 13.3 Issue of Duplicate Certificate for Securities.............................................. 153 13.4 Stop Transfers........................................................................................... 154 13.5 Transmission............................................................................................. 155 13.6 Timelines pertaining to investor services provided by RTA...................... 156 13.7 Online processing of investor service requests and complaints by RTAs: 157 13.8 Annual General Meeting........................................................................... 158 13.9 E Voting..................................................................................................... 159 13.10 Responsibilities of RTA during Annual General Meetings (AGM)........... 160 Annexure 13.1: Standard Operating Procedure for Change of Address............. 161 Annexure 13.2: Standard Operating Procedure for Issuance of Duplicate Share Certificate............................................................................................................. 164 Annexure 13.3: Standard Operating Procedure for Transmission of securities.. 166 Annexure 13.4: Format for registering or updating PAN, KYC details................. 168 CHAPTER 14: SECONDARY MARKET TRANSACTIONS…………………………………….173 14.1 Stock Markets........................................................................................... 174 14.2 Participants in the Stock Markets............................................................. 175 14.3 Listing of Securities................................................................................... 177 14.4 SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 (LODR).................................................................................................................. 179 CHAPTER 15: CLIENT SERVICING…………………………………………………………………..189 15.1 Investor in context of RTA organisation................................................... 189 15.2 First Time Right (FTR)................................................................................ 189 15.3 Principles of Client Servicing..................................................................... 190 15.4 Service etiquettes of RTA organisations in Client Servicing..................... 191 LIST OF ABBREVIATIONS………………………………………………………………………………198 LIST OF IMPORTANT WEBSITES…………………………………………………………………….199 Page 11 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Syllabus Outline and Weightages Chapter No. Chapter Name Weightage (%) Chapter 1 Introduction to Securities 3 Chapter 2 Characteristic of Equity Shares 6 Chapter 3 Characteristics of Debt Securities 6 Chapter 4 Characteristics of Other Securities 3 Chapter 5 Basics of Mutual Funds 3 Chapter 6 SEBI- Role and Regulations 14 Chapter 7 Public Offer of Securities 5 Chapter 8 Modes of allotment of shares other than Public 2 Offers Chapter 9 Processes related to Public Offering of shares 8 Chapter 10 Roles and Responsibilities in a Public Issue 6 Chapter 11 Depository Services 6 Chapter 12 Processes related to Depositories 16 Chapter 13 Investor interface with the R&T Agent 10 Chapter 14 Secondary Market Transactions 5 Chapter 15 Client Servicing 7 Page 12 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination CHAPTER 1: INTRODUCTION TO SECURITIES LEARNING OBJECTIVES: After studying this chapter, you should know about: Concept of Equity and Debt Features and Benefits of Equity Capital Features and Benefits of Debt Capital Features of Hybrid Instruments 1.1 Introduction to Equity and Debt A firm that requires money to conduct its operations can fund its requirements through: - Contribution by owners (either in form of loan or equity) - Contribution from outsiders (either in form of loan or equity) Businesses are typically created by promoters, who bring in the initial funds, to start and nurture a business. Later as the business grows in size, the need for money can be met by additional funds brought in by the owner(s) or contributions from outsiders (public). Similarly, an investor has a choice of owning a business by contributing to equity capital or lending to a business as debt capital. Capital used in running a business can be primarily classified based on: - The contributors of funds - The period for which money is contributed - The cost of the funds to the firm - The rights that accrue to the contributors of the funds Contributors Fund brought in by promoters and owners of the business is called equity capital. Equity capital can be brought in at the start of a business or at a later date as the business grows. Equity capital also can be contributed by outside investors. To enable such contribution, the business offers equity shares to outside investors, who become shareholders. Funds brought in as loan is called debt capital. Those that contribute debt capital are called as lenders to the business. Lenders can be individuals or institutions including banks. To enable such lending, a business issues debt instruments to investors, or obtains term loans by mortgaging the assets of the company. Time Period Page 13 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination The period for which capital is brought in may vary. Equity capital cannot be taken out of the firm unless the firm is liquidated. Such capital is for perpetuity. Debt has to be repaid by the company after a certain period. The period of repayment may be short-term (less than one year) or long-term (more than one year and may go up to even 30 years or more) and is decided at the time such funds are brought in. Cost of Capital The business has to pay a price for using equity or debt capital. The cost may be fixed at the time the money is brought in and may constitute an obligation for the company. Debt instruments usually pay a periodic interest. The rate of interest may be pre-determined or the method by which the rate will be determined, as in the case of floating rate bonds and inflation indexed bonds, will be described upfront. The cost of capital may vary depending on the earnings of the company, as is the case with equity capital. Both debt and equity are reflected in the liability side of the balance sheet indicating “source of funds”. A company must carefully decide the mix of debt and equity to be used in the business. Rights of the Contributors The contributors of capital enjoy certain rights and obligations depending upon the type of capital that they have brought in. Equity investors enjoy rights such as ownership and voting rights and rights to share the profits of the company. Debt investors have the right to receive periodic interest and return of the capital on the expiry of the fixed period. The contributors of debt capital may have their rights secured against the assets of the company. 1.2 Features of Equity Capital and Benefits to Equity Investors Those who contribute equity capital to the company, buy equity shares, when they are issued by the company. They are called equity shareholders of the company. Page 14 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Limited Liability Equity capital is issued with limited liability. This means, if the creditors to a business are not able to recover their dues, equity shareholders will not be asked to pay up. The liability of equity shareholders in a company is limited to their contribution made to its equity capital, or on any amount unpaid which they have agreed to pay. Ownership Rights Equity represents ownership of the company. Equity shareholders are owners of the company in portion of the shares held. For example, if a company has an issued and paid-up capital of Rs.10 crore made up of 1 crore shares of Rs.10 each, and an investor owns 10 lakh equity shares, such investor owns 10 percent of the company. Equity shareholders have the right to participate in the management of the company. They can do this through voting rights. Each equity share carries one vote. Major decisions of the company require resolutions to be passed, which have to be voted by a majority. Equity capital entitles its contributors to participate in the residual profits of the company. After meeting all expenses and provisions, profit that remains in the books belongs to equity shareholders. This is generally distributed to the shareholders in the form of dividends. Liquidity Equity shares are first issued by a company to the public through a process called the Initial Public Offer (IPO). IPOs are made in primary market. The money raised in an IPO is used by the company for its business activities and reflected in the balance sheet of the company. After IPO, the shares are listed on the stock exchanges, where they can be traded between one investor to another. This is called the secondary market. Such transactions do not result in change in the capital structure of the company. Secondary market provides liquidity to the investors. Page 15 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Perpetuity Equity capital is for perpetuity. It cannot be redeemed and the company does not have an obligation to repay it. In special situations, a company may buy-back its own shares from the shareholders. Such shares shall be extinguished by the company. Uncertain Pay-outs Shareholders enjoy return in the form of dividends paid by the company and may also benefit by the appreciation in share price. The investors can book capital gains by selling their shares in secondary market at a price higher than the acquisition price. If share price goes down, this may result in capital loss. However, there is no guarantee of dividends or capital appreciation on equity capital. Thus, the returns from equity are uncertain. 1.3 Features of Debt Capital and Benefits to Debt Investors Debt capital refers to the borrowings of a company. Those that contribute debt capital are lenders or creditors of the company. Debt capital implies regular return and security for the investor. For the company there is an obligation to make periodic interest payments and to repay the capital on maturity. Debt is raised by companies either by issuing securities such as debentures, bonds and commercial papers to the lenders or by taking a loan from a bank or financial institution. The terms at which the borrowing is being made, are mentioned in the document (or certificate) that represents the debt. Debt is raised by the company for a fixed period after which it has to be repaid. The period of borrowing will vary depending upon the need of the company. The interest rate or coupon rate of a bond/ debenture depends on the risk of default associated with the company issuing such securities. Thus credit rating of the debt security by SEBI registered Credit Rating Agency forms an important factor while investing in such securities. Debt securities/ loans have differential rights such as secured or unsecured. A secured loan is one where lenders have a right against the assets of the company if the company fails to pay interest and/or return the principal amount borrowed. Unsecured loan is one where such rights do not exist. Debt instruments may be listed on a stock exchange. A bond or debenture will be defined by: Page 16 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Face value Interest rate (also called coupon rate) and Frequency of interest payment Date of Maturity/ Redemption Other Rights of Bondholders (secured / unsecured) A loan from a Bank or Financial Institution will be defined by: Amount of the Loan Interest Rate and Frequency of Payment Nature of Loan (Term Loan, overdraft limit, bill discounting etc.) Repayment Conditions and Time Line (As Negotiated between Borrower and Lender) Other Rights of Lender (secured / unsecured) 1.4 Hybrid Structures Companies may raise capital in a form that combines the features of both debt and equity. These are called hybrid instruments. Convertible Debentures Convertible debentures pay interest like any other debt instrument till the date of maturity. On maturity, the debt is converted into equity shares. The terms of conversion, such as the number of equity shares that each debenture will be converted into and the price at which the conversion will take place are mentioned at the time of the issue of the debt instrument. They are beneficial to a company as there is no cash outflow on maturity. The lender is benefitted if the conversion is below the prevailing market price of the share. Preference Shares Preference shares resemble debt instruments because they offer pre-determined rate of dividend. However, they do not have a fixed maturity period or a right over the assets of the company. They have a preference in the payment of dividend over ordinary equity shares and in the return of capital, if the company is wound up. Page 17 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Chapter 1: Sample Questions 1. _______ capital is for perpetuity from the point of view of the company. a. Debt b. Equity c. Both debt and equity d. None of the above 2. Equity capital gives returns to the investors in the form of: a. Dividend b. Capital Appreciation c. Both Dividend and Capital appreciation 3. The interest that a company will have to pay on the debt raised will depend upon its_______. a. Default Risk b. Market Risk c. Liquidity Risk 4. Debt capital is always raised for short-term periods. State whether True or False. a. TRUE b. FALSE 5. Which of the following is a hybrid security? a. Equity shares b. Preference shares c. Non-convertible debentures d. All the options above Page 18 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination CHAPTER 2: CHARACTERISTICS OF EQUITY SHARES LEARNING OBJECTIVES: After studying this chapter, you should know about: Investors in equity shares Rights of a Shareholder Risks in Equity Investing Equity related terminology Corporate Actions Preference Shares, Rights Issue and Preferential Issue 2.1 Investors in Equity Shares A company raises equity capital to meet its need for long-term funds for expansion or continuing operations of the company. Equity capital does not impose any liability on the company in terms of returns or repayment. However, when a company issues equity capital, the investors also get proportionate control and ownership. A company can raise capital from different categories of investors. Different categories of investors have different requirements in terms of returns, risk and management control. a. Promoters Promoters are the group of investors who set up the company and bring in the initial capital required to start the business. This is the risk capital. At the initial stage the entire control of the company is with the promoters. They may bring in additional capital as and when required. As the capital needs of the business grow, promoters may invite other investors. These may include both institutions and retail public investors. Promoters usually retain the majority shareholding in the company so that they can continue to control its affairs even after their stakes are diluted. The stage at which the promoters bring in the initial capital is the riskiest. Further, it is generally assumed that the promoter knows the business the best. Thus, the promoter / owner is the logical manager of the business. However, ownership and management may be in separate hands. Page 19 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination b. Institutional Investors Institutional investors include financial institutions, venture capital companies, mutual funds, foreign financial institutions and banks among others. These are professional investors who have the ability to evaluate the business proposition, the risks associated with it and the expected returns. The company may allot shares to such investors through a private placement or preferential issue of shares. The risks and returns depend upon the stage at which the institutional investors bring in capital. Some like venture capital firms may be willing to bring in capital for companies in the start-up stage while others like financial institutions invest in more established firms. Institutional investors such as venture capital firms may be actively involved in the management of the company while others like mutual funds may be more passive investors. To strike a balance between being a passive and active investor, SEBI has issued guidelines for mutual funds and alternative investment funds to ensure better corporate governance in listed companies where the funds have invested.2 Apart from the attractiveness of the business proposition, institutional investors would also be interested in factors such as exit options, since many of them may hold a significant proportion of the equity capital. Many institutional investors like venture capitalists, encourage a company to offer its shares to the public investors as an exit option for themselves. c. Public Investors When the equity shares are held by promoters and a few investors, it is said to be a closely held company. Such companies may also be private companies, which are not required to disclose too much of information about themselves to the public or the regulators. When a company offers its equity shares to the public at large and lists its shares on a stock exchange, it moves from being a privately held or closely held company, to a publicly held company, which agrees to disclose periodic information about its operations and business to the public. Investors, other than promoters, participate in the equity of a company when a company comes out with a public issue of shares (IPO). A public issue of shares 2 SEBI Circular No.: CIR/CFD/CMD1/168/2019 on Stewardship Code for all Mutual Funds and all categories of AIFs, in relation to their investment in listed equities dated December 24, 2019. Page 20 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination requires regulatory compliance with SEBI’s guidelines and regulations governing listing of the shares on a stock exchange. Public investors in shares may be retail investors, high networth individuals (HNI), non-institutional investors or institutional investors. Retail investors, and to a great extent HNIs, are more interested in the returns that they can generate from their investment from capital appreciation in the value of the shares and dividend, rather than in the control and management of the company. Large stake holders and institutional shareholders actively participate in the affairs of the company. Some large institutional investors may be given a seat on the board of the company. Regulations require extensive and timely disclosures of all information that affects the interests of the public investors in a company. 2.2 Rights of a Shareholder Equity share capital has distinct features which define its risk and return. These features determine the suitability of raising equity capital for the company over other sources of financing such as debt. The equity shareholders have specific rights and privileges in the company as compared to debt holders. Some of the rights of common shareholders are discussed below: Ownership Rights Issuing ordinary equity capital implies that the company is giving ownership rights to the shareholders. Investors are given voting rights which allow them to vote on important decisions taken by the company. The voting rights are in proportion to the number of shares held by the investor and allow them to express their views by voting ‘For’ or ‘Against’ a proposal. The General Body Meeting of shareholders is the highest decision making authority in a corporate setup. Typically, a company will call a meeting of the shareholders once a year. This meeting is known as the Annual General Meeting (AGM). Shareholders have a right to attend the AGM of the company and participate in the proceedings. Shareholders have a right to express opinions on various aspects of the company working and vote on the various proposals put forth in the AGM. Right to Dividend Ownership rights in a company also mean that the investors who hold equity shares are entitled to participate in the profits of the company. This participation will be in the form of dividends that are periodically declared by the company. Page 21 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Ownership Transfer Rights A company is not required to return the equity capital to the investor as it is perpetual in nature. However, investors can sell their shares to other investors who may want to buy the shares. Other Rights Shareholders have other rights such as right to inspect documents related to company workings, right to legal recourse in case of mis-management or wrong disclosure. Also shareholders are sometimes provided with certain special rights such as Anti- dilution rights. Anti-dilution provision gives an investor the right to maintain the same percentage ownership in a company by purchasing a proportional amount of shares in future when securities are issued. 2.3 Risks in Equity Investing Investment in equity shares also involves certain risks to the investors. They are explained as follows: No Fixed Return The return in the form of dividend from equity is not pre-defined either in terms of the percentage of dividend or the date on which the payment will be made. Dividend is paid if the company makes sufficient profits and the management of the company feels it is appropriate for some of the profits to be distributed among the shareholders. In case the company makes losses or the profits made by the company is ploughed back for the expansion and other operations of the company, the shareholders may not get a dividend. The other source of return for the holder of equity shares is the appreciation in the price of the share in the secondary market. This constitutes the major portion of the return for the equity investor. If the company’s performance is bad or if the stock markets are going through a downturn, the value of the shares may actually depreciate leading to a loss for the investor. There is no guarantee that the principal amount invested in equity shares will remain intact. No Fixed Tenor Equity shares are issued for perpetuity. This means that there is no period of maturity after which the money will be returned to the shareholders. Investors Page 22 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination who want to exit their investments may do so by selling the shares on the stock exchange to other investors. Liquidity Risk A shareholder has the right to sell his shares to other investors. However, there may be a difference between the price expected by the seller and the price offered by the potential buyer. This is referred to as “bid ask spread” or liquidity risk. The risk to the shareholder arises if the shares are illiquid and not easily sold at its market value or if the shares are unlisted. The investor’s investment may get stuck without an exit option or they may sell their shares at lower than fair value resulting in loss. No Collateral Security Equity capital is not secured by the assets of the company. The cash and assets of the company are first applied to settle the claims of the lenders and creditors. The claims of the equity shareholders always rank last in order of preference. During the normal course of operations of the company, dividends are payable to the equity shareholders only after the expenses, interest and taxes are provided for. In the event of liquidation of the company, the equity shareholders are only entitled to a refund of capital after the claims of all the other creditors are satisfied from the sale of the company’s assets. 2.4 Equity Terminology i. Face Value The total equity capital required by a company is divided into smaller denomination called the face value or par value of the equity shares. Face value of a share represents the book value of the share and always remains fixed. Face value of a share helps in calculating the dividend pay-out to the investors when dividends are declared by the company. Example 1: If a company wishes to raise Rs. 10,00,000 (ten lakh), this can be denominated as: one lakh shares with a face value of Rs. 10; or two lakh shares with a face value of Rs. 5; or ten lakh shares with a face value of Re. 1. Page 23 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination ii. Share Premium Companies issue shares at face value or at prices higher than the face value depending on the future prospects of the company. The excess amount received by the company over the face value is called the share premium. Example 2: A company issues 1 lakh equity shares of face value of Rs. 10 each, to the public at Rs. 50 per share, i.e. Face Value of each share is Rs. 10 (par value) and Share Premium on each share is Rs. 40 (Rs. 50 – Rs. 10). iii. Authorised Capital The maximum amount of equity capital that a company will have is defined in the Memorandum of Association (MoA) of the company and is called its authorised capital. iv. Issued Capital The company may issue a portion of its authorised capital as and when it requires capital. The capital may be issued to the promoters, public or to specified investors. The portion of authorised capital that has been issued to investors is called issued capital. The capital may be issued by the company either at its face value or at a premium (higher than the face value). In special cases shares may be issued at a discount (lower than the face value). v. Paid-up Capital When investors subscribe to the capital issued by a company, they may be required to pay the entire price at the time of issue or in tranches (instalments). The portion of the issued capital that has been fully paid-up by the shareholders is the paid-up capital of the company. vi. Outstanding shares Outstanding shares refer to the total number of shares issued by the company to its investors (including retail and institutions). Page 24 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Example 3: A company decides that the maximum equity capital it needs is Rs.20 crore. In the initial stages, the need is Rs.10 crore. It issues equity shares of Rs.10 face value, at par. Investors are required to pay Rs.5 per share with application and Rs.5 after 6 months. What is the authorised, issued and paid-up capital of the company, before the issue, after allotment and after 6 months? What is the number of outstanding shares of the company? Before the issue: Authorised capital: Rs. 20 Crore After allotment: Authorised capital: Rs.20 Crore Issued capital: Rs.10 Crore Paid up capital: Rs.5 Crore After 6 months: Authorised capital: Rs. 20 Crore Issued capital: Rs.10 Crore Paid up capital: Rs.10 Crore Number of Outstanding Shares: 1 crore (i.e. Rs. 10 crore/ Rs. 10) One may remember that: Paid up capital is always less than or equal to issued capital; Issued capital is always less than or equal to authorised capital. Authorised capital is the maximum amount that can be issued or paid up. vii. Fully Paid up Shares Fully paid shares are those, of which entire face value amount is collected from shareholders upfront. Shareholder is not liable for any amount. viii. Partly Paid up Shares Partly paid-up shares are those on which entire face value amount is not collected from shareholders upfront. That means, company can make call for balance unpaid portion and the shareholder will be liable to pay such call money. If the Page 25 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination shareholder does not pay the call money as per schedule, the shares can be forfeited, including the amount already paid thereon, by company. 2.5 Corporate Actions A corporate action is an event initiated by a public company that will bring an actual change to the securities—equity or debt—issued by the company. Corporate actions are typically agreed upon by a company's board of directors and authorized by the shareholders. a. Dividend The most common corporate action is payment of dividend. Equity shareholders are entitled to share in the profits of the company. One way to do this is through the dividend that the company may periodically declare. Dividend declared by a company is not pre-fixed in terms of the percentage of the dividend or the period when it will be declared. Dividends are declared by the company when there is sufficient profit that can be distributed among the shareholders. The board of directors of the company will take a decision on the dividend to be declared. Shareholders approve such dividend in an annual general meeting. Dividend is computed as a percentage of the face value of the shares. A 40 percent dividend declared by a company will translate into a dividend of Rs. 4 for a share with a face or par value of Rs. 10 (i.e. 10*40/100), Rs. 2 for a share with a face value of Rs. 5 (i.e. 5*40/100). To ensure clarity for investors, SEBI has mandated that listed companies declare the dividend in terms of rupee per share. Dividend for a company is usually declared at the end of a year which is called the final dividend. However, companies may also declare dividends during the year, called the interim dividend. Many companies have now made a regular practice of quarterly dividends. The dividend declared by a company is a percentage of the face value of its shares. When the dividend received by an investor is compared to the market price of the share, it is called the dividend yield of the share. Example 4: A company declares a dividend of 60 percent on its shares which have a face value of Rs. 2. The market price of the share is Rs. 80. In this case, the dividend amount is Rs. 1.20 per share. The dividend yield is 1.5 percent (i.e. 1.2/80*100) Page 26 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination b. Buyback of shares Buy-back of shares refers to repurchase of shares by the company from its existing shareholders. During the buy-back, the company usually offers a higher price to the shareholders. However, participation in a share buyback is voluntary. The shares acquired by a company in buyback are extinguished and this results in reduction of share capital. Buyback of securities are governed by SEBI (Buy-Back of Securities) Regulations, 2018. c. Bonus issue A company may issue additional shares to existing shareholders without any capital contribution from the shareholders based on the number of shares an investor holds. This is known as a bonus issue. The bonus is issued against accumulated profit of the company. Bonus issue results in increase in number of outstanding shares of the company. Example 5: ABC Company Ltd. declares a bonus issue in the ratio 1:2. This means that ABC Company Ltd. will issue 1 bonus share for every 2 shares held by the shareholder. d. Stock split and Consolidation A company may decide to change the face value of its shares. This is done through stock split or consolidation methods. These methods change the number of outstanding shares. However, in both the cases, the value of the shares held by a shareholder remains unchanged. When a higher face value of a share is reduced to a lower face value, it is called a stock split. It increases the number of shares in the hands of an investor, but reduces the face value of each share. Example 6: Mr. P holds 100 shares of face value Rs. 10 of ABC Ltd. The company decides to divide each share into 2 shares with face value of Rs. 5 each. Before Stock Split: Value of Mr. P’s holdings is Rs. 1000 (i.e. Rs. 10 x 100) After Stock Split: Mr. P will now hold 200 shares of face value Rs. 5. Therefore, value of Mr. P’s holdings is Rs. 1000 (i.e. Rs. 5 x 200). A consolidation refers to increasing the face value of a share from lower amount to higher amount. This reduces the number of shares held by an investor, but increases the face value of each share. Page 27 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Example 7: Mr. S holds 100 shares of face value Rs. 2 of XYZ Ltd. The company decides to club 5 shares into 1 share with face value of Rs. 10 each. Before Stock Consolidation: Value of Mr. S’s holdings is Rs. 200 (i.e. Rs. 2 x 100) After Stock Consolidation: Mr. S will now hold 20 shares of face value Rs. 10. Therefore, value of Mr. S’s holdings is Rs. 200 (i.e. Rs. 10 x 20). 2.6 Reduction of Share Capital The company may reduce its share capital in the following ways: Extinguishment of shares through buyback of shares. Forfeiture of shares in case of partly paid shares, where the balance call money remains unpaid after sufficient reminders for making the balance payment. This proposed reduction in the capital must be approved by special resolution passed by the company. If the capital of a company is reduced, it results in alteration of its memorandum by reducing the amount of its share capital and outstanding shares accordingly. In case the company is in arrears in the repayment of any deposits accepted by it or the interest payable, then reduction of capital cannot be made. 2.7 Preference Shares When we talk of shares of a company we usually refer to the ordinary shares of a company. A company may also raise equity capital with varying rights and entitlements. These are called preference shares because they may offer certain special features or benefits to the investor. Some benefits that investors in ordinary equity capital have, such as, voting rights, may instead not be available to preference shareholders. Preference shares are usually given preference over equity shares in the payment of dividends and the repayment of capital, if the company is wound up. Dividend is paid to the preference shareholder at a fixed rate mentioned at the time of the issue of the shares. The terms of issue may allow the preference shareholders to participate in the residual profits too in some defined ratio. These are called participating preference shares. Preference shareholders are paid dividend only if the company has sufficient profits. The unpaid dividend may be carried forward to the following year(s) and paid if there are profits to pay the dividends, if the terms of issue of the shares so allow. Such shares are called cumulative preference shares. Page 28 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination The returns for the preference shares are primarily from the dividend the company pays. Non-convertible preference shares issued through a public issue or private placement may be listed on a stock exchange, provided the issue meets the terms laid down by SEBI in its regulations. The scope for capital appreciation in these types of shares may be limited because they do not participate in the profits of the company. Their value is not affected by the over-performance or under- performance of the company. Though preference shares are similar to debentures, they differ on the following points: - A preference shareholder is a shareholder of the company. A debenture holder is a creditor of the company. - A debenture is usually secured on the assets of the company. A preference share is not secured since it is not a borrowing. - The coupon interest on the debenture is an expense to be paid by the company before calculating the profits on which tax has to be paid. Dividends on preference shares are paid from the residual profits of the company after all external liabilities, including tax, have been paid. 2.8 Rights Issue of Shares A company may raise equity capital from its investors at various times. Whenever a company makes a fresh issue of shares, it has an impact on the existing shareholders since their proportionate holding in the shares of the company gets diluted. For example, a company may have 10 lakh outstanding shares of Rs.10 each, amounting to an issued and paid-up capital of Rs. 1 crore. If it issues another 10 lakh shares, to increase its capital, the proportion held by existing shareholders will come down by half, as the issued and paid up capital has doubled. This is called as dilution of holdings. To prevent this, Companies Act requires that a company which wants to raise more capital through an issue of shares must first offer them to the existing shareholders. An existing shareholder has a right to proportionate participation in all capital raising activity. Thus the term Rights issue. A rights issue is subject to various SEBI regulations. The rights shares are offered to the existing investors in a proportion as approved by the Board of the company. For example, the company may choose to issue rights at 1 for 1, to double its capital. This means each existing shareholders will get one equity share for every one equity share that they already hold. The issued and paid up capital will double, but proportionate holdings of each shareholder will not change. The ratio and price of the rights issue is proposed by the Board of the company, however the participation in a rights issue is voluntary. Page 29 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination 2.9 Preferential Issue A company may issue shares to a strategic investor or collaborator at a pre- negotiated price. The pricing for such an issue is determined under various SEBI guidelines. A preferential issue dilutes (reduces) the proportionate rights of existing shareholders and thus requires approval of existing shareholders. Page 30 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Chapter 2: Sample Questions 1. _____ rights give the equity investor a say in the management of the company. a. Voting b. Dividend c. Both voting and dividend 2. A 20 percent dividend declared on face value of Rs. 10 and market price of Rs. 120 translates into a dividend payout of _____. a. Rs. 2.00 b. Rs. 24.00 c. Rs. 20.00 d. Rs. 12.00 3. Preference shareholders get preference over debenture holders in the payment of dividend. State whether True or False. a. TRUE b. FALSE 4. Which of the following is/are examples of corporate actions? a. Dividend b. Bonus issue c. Stock split d. All the options given 5. A company may issue additional shares to existing shareholders without any capital contribution from the shareholders based on the number of shares an investor holds. This is known as _______. a. Bonus issue b. Rights issue c. Preferential issue Page 31 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination CHAPTER 3: CHARACTERISTICS OF DEBT SECURITIES LEARNING OBJECTIVES: After studying this chapter, you should know about: Features of Debt Security Market value of debt securities Yield to Maturity of debt instruments Types of Bonds Features of Fixed and Floating Rate Bonds Credit Rating Money Market instruments 3.1 Features of a Debt Security A debt security denotes a contract between the issuer (company) and the lender (investor) which allows the issuer to borrow a sum of money at pre-determined terms. These terms are referred to as the features of a bond and include the principal, coupon (interest rate) and the maturity date of the bond. In Indian securities markets, a debt instrument denoting the borrowing of a government or public sector organizations is called a bond and the borrowings by the private corporate sector is called debenture. The terms bonds and debentures are used interchangeably. The principal is the amount which is being borrowed by the issuer. The face value or par value of the debenture is the amount of the principal that is due on each debenture at maturity. The face value of a debenture is usually Rs. 100 or Rs. 1,000. The coupon is the rate of interest to be paid by the borrower to the lender. This is a percentage that is applied to the face value or par value of the bond. The periodicity of interest payment (annual, semi-annual, quarterly or monthly) is also specified. The maturity date of a bond refers to the date on which the contract requires the borrower to repay the principal amount. Different combinations of each of these features can be used to create instruments that meet the specific requirements of the borrower or the lender. It may, therefore, be emphasised that the debt securities have distinct characteristics in contrast to equities. Page 32 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination The debt holders are lenders to the company, while equity-holders are owners of the company; The debt securities have fixed maturity period while equities are perpetual in nature; The return to debt holders are fixed at the time of issuance, whereas the equity-holders are entitled to residual profit, but not guaranteed; The debt holders enjoy preference over equity-holders in receiving back payments in case of winding up of the company. 3.2 Market Value of a Debt security As stated earlier, the face value or par value of a debt instrument is its book value that represents the principal amount of the borrowing which is to be repaid to the investor at the time of maturity. If the debt instrument is traded in the market before its maturity, the value at which such trade is executed is called the market value of the debt instrument. Market value may be higher or lower than the face value of the debt instrument. Market value fluctuates due to market dynamics such as demand-supply condition, market interest rate scenario etc. 3.3 Yield from Debt Instruments The returns to an investor in bonds, is primarily made up of the coupon payments. However, if the investor acquires or sells the bond at a price that is different from the par value it generates capital gains or loss, as the case may be. The returns to the investor in such a case can vary from the coupon. Therefore, the coupon rate of the bond is not an indicator of the returns on the bond, but merely helps in computing what cash flows would accrue periodically, to the investor. The term ‘yield’, rather than ‘coupon rate’, is used to denote the returns to the investor. Current Yield Current yield simply compares the coupon of a bond with its market price. For example, if a bond paying an annual coupon of 12 percent is trading in the market for Rs. 109.50, then the current yield is: 12/109.5*100 =10.96 percent Page 33 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Yield to Maturity (YTM) Yield to maturity (YTM) is a popular and extensively used method for computing the return on a bond investment. Every bond is made up of a set of cash flows that accrue at various points in time, from the time the bond is acquired, until it is sold or redeemed. Therefore, using the principle of finance to value the bond, the price at which the series of future cash flows should sell is the sum of the discounted value of these cash flows. The rate which equates the discounted value of the cash flows with the price of the bond is the yield to maturity of the bond. 3.4 Types of Debt Securities i. Convertible Debt Securities As already discussed in Chapter 1, convertible debt securities are hybrid instruments with features both of debt and equity. These securities pay the pre- determined coupon payments to the holders and on maturity the same is converted into equity based on pre-defined terms. The convertible debt securities are more suitable for low credit rating companies and companies with high growth potentials. Advantage to Issuers: It is a low cost financing compared to other financing means, issuers pay lower coupons to the lenders and also on maturity, repayment of principal amount need not be made as the security is converted into equity. Advantage to Investors: Though the investors are paid a lower coupon rate, compared to other debt securities, the potential to earn capital appreciation on the converted security (equity) compensates the receipt of lower interest rate. However, there involves a risk of dilution of stake of the existing shareholders in the company on conversion of the debt securities. ii. Zero Coupon Bond In such a bond, no coupons are paid or specified. The bond is issued at a discount to its face value. There are no intermittent payments of interest. When such a bond is issued for a very long tenor, the issue price is at a steep discount to the redemption value. Such a zero coupon bond is also called a deep discount bond. The effective or implied interest earned by the buyer is the difference between the face value and the discounted price at which the bond is bought. There are Page 34 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination also instances of zero coupon bonds being issued at par, and redeemed with interest at a premium. The essential feature of this type of bonds is the absence of periodic interest payments. They are suitable for financing projects with long gestation periods. iii. Fixed Rate Bonds Fixed rate bonds pay a pre-defined interest that are payable at specified intervals. Such bonds are also called as the plain vanilla bonds. A plain vanilla bond will have a fixed term to maturity with coupon being paid at pre-defined periods and the principal amount is repaid on maturity. The bond is usually issued at its face value and redeemed at par. The simple variations to this structure could be a slightly varied issue price, higher or lower than par and a slightly altered redemption price, higher or lower than par. In some cases, the frequency of the interest payment could vary, from monthly, to quarterly and annual. All these variations still come under the plain vanilla definition of a bond, where the interest is paid at a fixed rate periodically, and principal returned when the bond is retired. iv. Floating Rate Bonds Instead of a pre-determined rate at which coupons are paid, it is possible to structure bonds, where the rate of interest is reset periodically, based on a benchmark rate such as RBI Repo Rate. Such bonds whose coupon rate is not fixed, but reset with reference to a benchmark rate, are called floating rate bonds. For example, a company can issue a 5-year floating rate bond, with the rates being reset semi-annually with reference to the 1-year yield on central government securities and a 50 basis point mark-up. In this bond, the coupon rate is reset every six months based on the 1-year benchmark rate on government securities. The other names, by which floating rate bonds are known, are variable rate bonds and adjustable rate bonds. These terms are generally used in the case of bonds whose coupon rates are reset at longer time intervals of a year and above. These bonds are common in the housing loan markets. v. Inflation Indexed Bonds Inflation Indexed Bonds (IIB) are a category of floating rate bonds where the benchmark is the inflation rate. Such instruments are generally government Page 35 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination securities issued by the RBI which provides inflation protected returns to the investors. vi. Amortising Bonds The structure of some bonds may be such that the principal is not repaid at the end/maturity, but over the life of the bond. A bond in which payments that are made by the borrower includes both interest and principal, is called an amortising bond. Auto loans, consumer loans and home loans are examples of amortising bonds. The maturity of the amortising bond refers only to the last payment in the amortising schedule, because the principal is repaid over time i.e. redemption in more than one instalment. vii. Asset-backed Securities Asset backed securities represent a class of fixed income products, created out of pooling together assets, and creating bonds that represent participation in the cash flows from the asset pool. For example, select housing loans of a loan originator (say, a housing finance company) can be pooled, and bonds can be created, which represent a claim on the repayments made by home loan borrowers. Such bonds are called mortgage–backed securities. In some markets like India, these bonds are known as structured obligations (SO). Assets with regular streams of cash flows are ideally suited for creating asset-backed securities. viii. Other types of bonds Some of other structures are: (a) deferred interest bonds, where the borrower could defer the payment of coupons in the initial 1 to 3 year period; (b) Step-up bonds, where the coupon is stepped up periodically, so that the interest burden in the initial years is lower, and increases over time. 3.5 Classification of Debt Market There are two broad ways in which bond markets can be segmented. Based on the type of borrower, we can segment the market between the bonds issued by governments, and those issued by non-government agencies like banks, corporations and other such entities. Based on the tenor of the instrument, we can segment the bond markets as short-term, medium term and long term. Page 36 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination These are not mutually exclusive segments. The government issues bonds to meet its requirements for various periods as does the private sector. Each issued bond has an issuer and a tenor. Government Securities comprises the central government bonds, and quasi- government bonds issued by local governments, state governments and municipal bodies. Government securities do not have credit or default risk. Corporate bond markets comprise pre-dominantly of short-term commercial papers and long-term bonds. Another segment comprises of short term paper issued by banks, in the form of certificates of deposit. The rate at which the non- government segment borrows depends upon the credit quality of the borrower. The credit or default risk of the borrower is defined by the credit rating of the bond. Higher the credit rating, lower is the risk of default. 3.6 Credit Rating The biggest risk faced by investors in debt securities is the possibility of the borrower not honouring their commitment on payment of interest on the borrowing and repayment of the principal on maturity of the instruments. The ability of the borrower to meet its obligation will depend upon factors internal and external to the business. Lenders therefore evaluate these factors associated with the borrower before entering into the transaction. The decision of a lender on whether or not to lend to a borrower and at what cost would be determined by the risk associated with the borrower. This risk of the possibility of a default on obligations by the borrower is called the credit risk of the borrower. The credit risk of a borrower is evaluated by credit rating agencies. Credit rating agencies have to be registered with SEBI and abide by the regulations laid down in SEBI (Credit Rating Agencies) Regulations, 1999 in the conduct of such evaluations. The credit rating agencies consider all the qualitative and quantitative factors that impact the business of the borrower and consequently their ability to meet their financial obligations. The appraisal is done by industry experts and the information collected not only from the borrower but from other sources as well. Based on their appraisal, the rating committee of the credit rating agency will assign a rating to the borrowing. Rating is therefore an exercise that converts the ability and willingness of the company to service the instrument proposed to be issued into a symbol. Page 37 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination The credit rating assigned to an instrument is not static but is dynamic. This means that the credit risk associated with a borrowing may change over time. Credit rating agencies are required by SEBI to constantly monitor factors that affect the status of the instrument and to reassign a rating if the credit quality of the instrument improves or deteriorates. Recently, SEBI issued detailed guidelines on provisional ratings assigned by Credit Rating Agencies to debt instruments.3 A rating will be considered as provisional, and not final, in cases where certain compliances that are crucial to the assignment of credit rating are yet to be complied with or certain documentations remain to be executed at the time of rating. All provisional ratings ('long term' or 'short term') for debt instruments need to be prefixed as 'provisional' before the rating symbol in all communications-- rating letter, press release and rating rationale. SEBI has standardized the rating symbols used by the credit rating agencies so that investors are able to easily gauge the level of credit risk assigned to an instrument. The rating symbols and their definitions are reproduced below.4 I. Rating Symbols and Definitions for Long Term Debt Instruments Long term debt instruments: The instruments with original maturity exceeding one year Rating symbols should have CRA’s first name as prefix AAA - Instruments with this rating are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk. AA - Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk. A - Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such instruments carry low credit risk. BBB - Instruments with this rating are considered to have moderate degree of safety regarding timely servicing of financial obligations. Such instruments carry moderate credit risk. BB - Instruments with this rating are considered to have moderate risk of default regarding timely servicing of financial obligations. B - Instruments with this rating are considered to have high risk of default regarding timely servicing of financial obligations. C - Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligations. D - Instruments with this rating are in default or are expected to be in default soon. Modifiers {"+" (plus) / "-"(minus)} can be used with the rating symbols for the categories AA to C. The modifiers reflect the comparative standing within the category. II. Rating Symbols and Definitions for Short Term Debt instruments Short term debt instruments: The instruments with original maturity of upto one year Rating symbols should have CRA’s first name as prefix A1 – Instruments with this rating are considered to have very strong degree of safety regarding timely payment of financial obligations. Such instruments carry lowest credit risk. 3 SEBI Circular No.: SEBI/HO/MIRSD_CRADT/P/CIR/2021/554 dated April 27, 2021 4 SEBI Circular No.: CIR/MIRSD/4/2011 dated June 15, 2011 Page 38 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination A2 - Instruments with this rating are considered to have strong degree of safety regarding timely payment of financial obligations. Such instruments carry low credit risk. A3 - Instruments with this rating are considered to have moderate degree of safety regarding timely payment of financial obligations. Such instruments carry higher credit risk as compared to instruments rated in the two higher categories. A4- Instruments with this rating are considered to have minimal degree of safety regarding timely payment of financial obligations. Such instruments carry very high credit risk and are susceptible to default. D - Instruments with this rating are in default or expected to be in default on maturity. Modifier {"+" (plus)} can be used with the rating symbols for the categories A1 to A4. The modifier reflects the comparative standing within the category. III. Rating Symbols and Definitions for Long Term Debt Mutual Fund Schemes Long term debt mutual fund schemes: The debt mutual fund schemes that have an original maturity exceeding one year Rating symbols should have CRA’s first name as prefix AAAmfs - Schemes with this rating are considered to have the highest degree of safety regarding timely receipt of payments from the investments that they have made. AAmfs– Schemes with this rating are considered to have the high degree of safety regarding timely receipt of payments from the investments that they have made. Amfs - Schemes with this rating are considered to have the adequate degree of safety regarding timely receipt of payments from the investments that they have made. BBBmfs- Schemes with this rating are considered to have the moderate degree of safety regarding timely receipt of payments from the investments that they have made. BBmfs - Schemes with this rating are considered to have moderate risk of default regarding timely receipt of payments from the investments that they have made. Bmfs - Schemes with this rating are considered to have high risk of default regarding timely receipt of timely receipt of payments from the investments that they have made. Cmfs - Schemes with this rating are considered to have very high risk of default regarding timely receipt of timely receipt of payments from the investments that they have made. Modifiers {"+" (plus) / "-"(minus)} can be used with the rating symbols for the categories AAmfs to Cmfs. The modifiers reflect the comparative standing within the category. IV. Rating Symbols and Definitions for Short Term Debt Mutual Fund Schemes Short term debt mutual fund schemes: The debt mutual fund schemes that have an original maturity of upto one year Rating symbols should have CRA’s first name as prefix A1mfs - Schemes with this rating are considered to have very strong degree of safety regarding timely receipt of payments from the investments that they have made. A2mfs– Schemes with this rating are considered to have moderate degree of safety regarding timely receipt of payments from the investments that they have made. A3mfs - Schemes with this rating are considered to have the adequate degree of safety regarding timely receipt of payments from the investments that they have made. A4mfs- Schemes with this rating are considered to have minimal degree of safety regarding timely receipt of payments from the investments that they have made. Modifiers {"+" (plus)} can be used with the rating symbols for the categories A1mfs to A4mfs. The modifier reflects the comparative standing within the category. Page 39 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Further to the above, the credit rating agencies suffix ‘CE’ i.e. Credit Enhancement, to the rating of instruments having explicit credit enhancement.5 In addition to this, SEBI has introduced Expected Loss based Rating Scale for rating of projects/ instruments associated with infrastructure sector.6 3.6.1 Unrated Bonds Bonds that do not have any current or valid rating by an external rating agency are unrated bonds. Since unrated instruments are more illiquid than rated instruments, the yield of such unrated instruments is higher. SEBI has provided guidelines for mutual funds on investments in unrated debt instruments.7 3.7 Money Market Instruments Money market refers to the market where instruments with a maturity of less than one year are issued and traded. Money market participants are generally commercial banks and the central bank. The money market is the platform for banks and government to finance their short term capital requirements. It is a wholesale market with large volumes. It is considered the most liquid of all financial markets with borrowing and lending transactions done for shorter periods such as one day. Instruments in money markets include Commercial papers, Certificates of deposit, Treasury Bills etc. that are due to mature within 365 days, and long term government debt. 3.7.1 Commercial Paper Commercial Paper (CP), an unsecured money market instrument issued in the form of a promissory note, was introduced in India in 1990 with a view to enable highly rated corporate borrowers to diversify their sources of short-term borrowings and provide an additional instrument to the investors. Subsequently, primary dealers (PDs) and all-India financial institutions (FIs) were also permitted to issue CP to enable them to meet their short-term funding requirements. The aggregate amount of CP that can be issued by an issuer shall at all times be within the limit as approved by its Board of Directors or the quantum indicated by the Credit Rating Agency (CRA) for the specified rating, whichever is lower. Individuals, banks, other corporate bodies (registered or incorporated in India) and unincorporated bodies, Non-Resident Indians and Foreign Portfolio Investors (FPIs) shall be eligible to invest in CPs. FPIs shall be eligible to invest in CPs subject to (i) such conditions as may be set for them by SEBI and (ii) compliance with the provisions of the Foreign Exchange Management Act, 1999, the Foreign Exchange 5 SEBI Circular No.: SEBI/HO/MIRSD/DOS3/CIR/P/2019/70 dated June 13, 2019. 6 SEBI Circular No.: SEBI/HO/MIRSD/MIRSD_CRADT/P/CIR/2021/594 dated July 16, 2021. Page 40 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination (Deposit) Regulations, 2000 and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000, as amended from time to time. Commercial paper has emerged as an effective instrument for all corporate companies to avail the short-term funds from the money market within the shortest possible time limit by avoiding the hassles of direct negotiation with the commercial banks for availing the short-term loans. 3.7.2 Certificate of Deposit Certificate of Deposit (CD) is a negotiable money market instrument and issued in dematerialised form or as a Usance Promissory Note against funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are presently governed by various directives issued by the Reserve Bank of India (RBI), as amended from time to time. CDs can be issued by (i) scheduled commercial banks (excluding Regional Rural Banks and Local Area Banks); and (ii) select All-India Financial Institutions (FIs) that have been permitted by RBI to raise short-term resources within the umbrella limit. Minimum amount of a CD should be Rs.1 lakh, i.e., the minimum deposit that could be accepted from a single subscriber should not be less than Rs.1 lakh, and in multiples of Rs. 1 lakh thereafter. CDs can be issued to individuals, corporations, companies (including banks and PDs), trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs, but only on non-repatriable basis, which should be clearly stated on the Certificate. Such CDs cannot be endorsed to another NRI in the secondary market. The maturity period of CDs issued by banks should not be less than 7 days and not more than one year, from the date of issue. The FIs can issue CDs for a period not less than 1 year and not exceeding 3 years from the date of issue. 3.7.3 Treasury Bills Treasury bills or T-bills, which are money market instruments, are short term debt instruments issued by the Government of India and are presently issued in three tenors, namely, 91 day, 182 day and 364 day. Treasury bills are zero coupon securities and pay no interest. Instead, they are issued at a discount and redeemed at the face value at maturity. For example, a 91 day Treasury bill of Rs. 100/- (face value) may be issued at say Rs. 98.20, that is, at a discount of Rs. 1.80 (i.e. 100- 98.20) and would be redeemed at the face value of Rs. 100/-. The return to the investors is the difference between the maturity value or the face value (i.e. Rs. 100) and the issue price (i.e. Rs. 98.20). Page 41 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination Chapter 3: Sample Questions 1. _________ of a bond refers to the interest payable on a bond. a. Coupon b. Inflation rate on Principal c. Market Price d. Face Value 2. A bond with a higher credit rating will pay _______ interest rates. a. Higher b. Lower c. Unrelated 3. The prices of bonds are ________ related to interest rate movements. a. Directly b. Inversely c. Not 4. A zero coupon bond is always issued at a premium. State whether True or False. a. TRUE b. FALSE 5. The YTM of a bond is the yield that investors will earn on holding a bond to maturity. State whether True or False. a. TRUE b. FALSE Page 42 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination CHPATER 4: CHARACTERISTICS OF OTHER SECURITIES Learning Objectives: After studying this chapter, you should know about other types of securities such as: Warrants Convertible Debentures (CDs) Depository Receipts (DRs) Foreign Currency Convertible Bonds (FCCBs) Exchange Traded Funds (ETFs) and Index Funds Real Estate Investment Trusts (REITs) Infrastructure Investment Trusts (InvITs) Companies raise capital using equity and debt instruments. The basic features of these instruments can be modified to suit the specific requirements of the borrowers or lenders. Such modifications bring advantages such as wider participation, better management of cash flows and better return prospects. 4.1 Warrants Warrants give the investors the right to buy shares of the company in the future. The number of shares that the warrant entitles the holder to subscribe to at a pre- determined date and price are specified at the time of issue. Conversion/ exercise of the warrants results in increase in share capital. Warrants may be traded on the stock exchange as a security separate from the debenture with which it was issued. Warrants usually have a longer lifetime as compared to options contracts which they closely resemble.8 Warrants will be exercised if the share price at the time of exercise is higher than the price at which the investors have the right/ option to buy the shares. For example, assume a warrant enables an investor to buy an equity share of a company at Rs.100. The warrant will be exercised: (a) when it is due to be exercised, (b) if the price of the share in the market is more than Rs.100. If the market price is less than Rs.100, the investor can always buy from the market, rather than use the option to buy the same share at a higher price. Warrants may be used by promoters to increase their stake in the company. Issue of warrants is subject to SEBI guidelines and shareholders’ approval. The regulations include an upfront payment and a lock in on conversion. 8 Options refer to a type of derivatives contract that gives buyer the right to exercise the option to buy or sell the underlying security at a pre-defined date and price. Page 43 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination 4.2 Convertible Debentures Convertible debentures are debt instruments that can be converted into equity shares of the company at a future date. The security has features of both debt and equity. It pays periodic coupon interest till the date of redemption/ conversion into equity shares, just like any other debt instrument. At the time of redemption of the debenture, the investors can choose to receive shares of the company instead of cash redemption The issuer specifies the details of the conversion at the time of making the issue. This will include: - The date on which the conversion will be made. - The ratio of conversion i.e. the number of shares that the investor will be eligible to get for each debenture. - The price at which the shares will be allotted to the investor on conversion. Usually this is at a discount to the market price. - The proportion (full or part) of the debenture that will be converted into equity shares. Accordingly, the debenture may be referred to as Fully Convertible Debenture (FCD) or Partly Convertible Debenture (PCD) or Non-Convertible Debenture (NCD). As already discussed in Chapter 3, the advantage to the issuer of convertible debenture lies in the fact that convertible debentures usually have a lower coupon rate than pure debt instruments. This is because the yield to the investor in such debenture is not only from the coupon alone but also the possibility of capital appreciation in the investment once the debentures are converted into equity. Moreover, the issuer does not have to repay the debt on maturity since shares are issued in lieu of repayment, thus saving cash outflow. The shareholding percentage of the existing shareholders gets diluted when fresh shares are issued on conversion. Thus convertible debentures are normally issued on rights basis or with specific approval of existing shareholders. Issue of convertible debentures is governed by SEBI Regulations. 4.3 Depository Receipts Depository receipts (DRs) are financial instruments that represent shares of a local company but are listed and traded on a stock exchange outside the country. DRs are issued in foreign currency, usually in US Dollars. DRs allow overseas investors to easily invest in a company. Page 44 of 199 NISM Series II-A: Registrars to an Issue and Share Transfer Agents – Corporate Certification Examination To issue a DR, a specific quantity underlying equity shares of a company are lodged with a custodian bank, which authorises the issue of depository receipts against the shares. Depending on the country of issue and conditions of issue, the DRs can be converted into equity shares. DRs are called American Depository Receipts (ADRs) if they are listed on a stock exchange in the USA such as the New York Stock Exchange or NASDAQ. If the DRs are listed on a stock exchange outside the US, they are called Global Depository Receipts (GDRs). The listing requirements of stock exchanges can be different in terms of size of the company, state of its finances, shareholding pattern and disclosure requirements. When DRs are issued in India and listed on stock exchanges in India with foreign company stocks as underlying shares, these are called Indian Depository Receipts (IDRs). The company, whose shares are traded as DRs, gets a wider investor base from the international markets. Investors in international markets get easy access to invest in shares of an overseas company. Holding DRs, gives investors the right to dividends and capital appreciation from the underlying shares, but not voting rights. The steps in issuing DRs are the following: - The company has to comply with the listing requirements of the stock exchange and market regulator where they propose to get the DRs listed. - The company appoints a depository bank which will hold the stock and issue DRs against it. - If it is a sponsored issue, the stocks from existing shareholders are acquired and delivered to the lo

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