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Overview of Stock Ownership - Module 1 of 5

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Module 1-Overview of Stock Ownership

Tens of millions of Americans are directly or indirectly invested in the stock market, often relying on some form of stock ownership to save for retirement and to build wealth.[1] Still, many do not understand the basic nature of stock ownership. Unfortunately, people lacking this basic knowledge are less able to make competent decisions about saving, investing and wealth building. This course will provide the viewer with an overview of stocks and stock ownership.

In our first module, we will provide an in-depth overview of the legal concepts associated with stock ownership. We’ll first discuss how shares of stock are defined as a type of security. Next, we’ll distinguish certificated and uncertificated shares of stock and distinguish between the different classes of shares. Finally, we’ll introduce the state and federal regulatory framework that governs the sale and ownership of stocks.

Stock Certificates

A share of stock is a form of intangible personal property. Each share held by a stockholder represents the stockholder’s ownership interest in a company, usually a corporation.[2] While a stockholder has an ownership interest in the corporation, stock ownership alone doesn’t represent title to the corporation’s property. Instead, the stockholder is entitled to a fractional part of the property, profits and proceeds of the corporation.[3] For the stockholder, ownership of shares of stock represent a distinct bundle of rights flowing from the corporation to the stockholder.[4]

Stock can be represented and held in a variety of ways, including: 

(1)  certificate form;
(2)  direct registration system form; or
(3)  street-registration form.[5]

 Let’s begin by looking at holding stocks in certificate form. Unlike furniture or clothing, stocks are intangible. Because stocks cannot be touched or grasped, they can be represented by tangible and documented proof of ownership. Historically, stockholders would have a stock certificates to show ownership. The certificate is like a deed to a house in that it holds no value itself but serves as tangible documentary evidence of ownership of the underlying property being represented. A stockholder who has physical possession of the stock certificate also has an easier time transferring the shares or pledging them as collateral for a loan.[6]

Today, publicly traded companies don’t typically issue shares of stock in certificate form because of the sheer volume and costs of printing and storing physical certificates. A company that does issue shares in certificate form must include the following information on them:

  •        the name of the issuing corporation, stating that the corporation is organized under the law of the particular state
  •        the name of the person to whom the shares are issued;
  •        the number of shares the certificate represents;[7] and
  •        a summary of the shareholder’s rights and privileges for each represented class of shares, if the corporation issues different classes of shares or different series within a class.

To be effective, each certificate must be executed in accordance with applicable law. For example, a state may require that the issued certificate must be signed by two officers designated in the issuing corporation’s bylaws or by the board of directors[8]  
Under Kentucky law, for example, a share certificate must be executed by two officers designated in the bylaws or by the board of directors.[9]

The disadvantages in holding stock in certificate form are both administrative and legal in nature. Administratively, the process of issuing shares in certificate form makes it difficult for issuers to manage the volume of paper certificates. Legally, because anyone can assume physical possession of a stock certificate, stock certificates present custody and transfer issues. This is especially true if the certificate is lost or stolen.[10] 

This is best illustrated by the chaos that happened in the 1960s, when stock ownership was purely paper based. This time is referred to as the “paperwork crisis” of Wall Street. At a 1971 U.S. Senate hearing, U.S. Attorney General John N. Mitchell testified that during the crisis an estimated $400 million dollars’ worth of securities had been stolen by organized crime syndicates.[11] Once these stock certificates were in the hands of the trafficking rings, they were often sold to innocent purchasers or used as collateral to secure loans from innocent creditors. To make matters worse, if the original owner failed to report the shares stolen before they were registered by the innocent purchaser or creditor, he lost claim to his shares forever.[12] 

If a stockholder reports that his stock certificate is lost, stolen, or destroyed, he should also request that a “stop transfer” notation be attached to the missing shares. The stop transfer designation prevents unauthorized transfer of the shares represented by the missing certificate. Once the certificate is reported as missing, the stockholder’s brokerage firm, bank, transfer agent or the corporation itself must report the missing security to the Securities and Exchange Commission’s Lost and Stolen Security Program.[13]
Replacing a missing stock certificate is a costly, multi-step process. First, the stockholder must pay a replacement fee.[14] Second, he must purchase an indemnity bond to protect the corporation and, if applicable, the transfer agent, against any claims that may be brought by an innocent purchaser of the missing shares. This bond functions as insurance for the issuing company and can be costly. Generally, an indemnity bond costs between two or five percent of the current market value of the shares represented by the missing certificate.[15] 

Registration forms that do not require paper certificates, of course, bypass many of these potential problems. 

Direct Registered and Street-Name Registered Stock

To hold shares in “registered form” means that the shares are either registered directly on books by the issuer in a direct registration system or the shares are registered on the books of a security intermediary such as a broker-dealer in street-name form.[16] A broker-dealer is someone who buys and sells securities and is usually associated with a brokerage firm, such as Fidelity or Charles Schwab. However, some broker-dealers operate their own brokerage firms rather than working for a larger firm. During the Great Recession of 2007-2009, it was discovered that some broker-dealers were using their positions to defraud investors of millions or even billions of dollars, Bernard Madoff being the most infamous example.[17] This prevalence of securities fraud resulted in a massive overhaul of the regulation of broker-dealers, which we’ll discuss a bit later. 

Let’s first discuss the Direct Registration System, through which shares are registered directly on the books of the issuer and in the stockholder’s name. This means that the company issuing the stock maintains the records detailing the owners of its stock.[18] If the company’s stocks are publicly traded, it can elect to use a transfer agent to manage its stock records. A transfer agent is a third-party administrator that acts as an intermediary between the stock holder and the company. Transfer agents can also issue and cancel shares on behalf of the company and process claims for lost, stolen or damaged certificates.[19] When shares are registered in direct form, account statements, dividends, and annual reports are mailed directly from the issuer or transfer agent to the stockholder.[20] 

One advantage for a shareholder with shares in a direct registration system is that he won’t have to safeguard a paper certificate, decreasing the likelihood that it will be lost or stolen. Additionally, the shareholder will receive mailings related to his stock ownership directly from the issuer.[21] Finally, the shareholder can easily sell his shares electronically. The electronic movement of shares is usually facilitated through post-settlement services offered by the Depository Trust Corporation,[22] which is a centralized system where custody of more than 1.3 million active securities are stored.

Despite these advantages, one shortcoming may arise in the form of restrictions on when an account owner can sell her shares. Companies may, in restrictions outlined in the company’s disclosure documents, restrict the purchaser’s ability to buy or sell shares at a specific market price or at a specific time.[23] Registration in “street-name” form means registration registered under the name of the brokerage firm of the shareholder’s broker-dealer rather than under the name of the stockholder. Rather, the stockholder is listed as a beneficial owner of the shares.[24] 

The advantage in holding shares in street-registration form is that the shares are safeguarded and managed by a brokerage firm.[25] Also, the stockholder will have access to professional advice regarding his current and future investments and so may be better able to manage the stock.[26]

The disadvantage associated with holding shares in street-registration form is that since the stockholder is not listed as the owner on the books of the issuer, important corporate communications will not be mailed to the stockholder. Instead, mailings will be sent to the brokerage firm. Also, since dividend and interest payments are sent to the brokerage firm instead of directly to the stockholder, there may be a delay in the stockholder’s receipt of these payments.[27]

Classes of Stock

A corporation may issue two or more classes of stock. Two of the most common classes of stock are common stock and preferred stock.

Unless a corporation’s articles of incorporation or bylaws provide otherwise, all issued stock is common stock.[28] Owners of common stock are entitled to enjoy basic rights and privileges such as a pro rata share in the corporation’s dividends, the corporation’s assets upon dissolution and the power to vote on matters involving the management of the corporation’s affairs.

However, a corporation can restrict or limit the rights and privileges of common stock owners. For example, a corporation can decide to deny voting rights to common stock owners, so that voting power can remain concentrated with a certain group of stockholders. For example, a company may issue “A” and “B” classes of common stock and designate “A” common stock as non-voting shares as a way to concentrate voting rights to “B” common stockholders.[29] A common stock owner’s rights and privileges may also be superseded if a corporation grants preferred stock with rights that are superior to those of the holders of common stock.[30]    

The other major type of stock class is preferred stock.[31] To effectively create a class of preferred stock, the rights and privileges of preferred stock owners must be distinguishable from those of the owners of other classes of stock and must be expressly stated in the corporation’s articles of incorporation.[32] Simply designating stock as “preferred” does not make it superior, as their superiority is derived from the rights under the articles of incorporation and extends only as far as is dictated in them. 

Still, a preferred stock owner’s rights are usually superior to those of a common stock shareholder in at least some area. For example, a preferred stock owner may be entitled to priority over other classes in the right to receive dividends or a preferred stock owner may have superior voting rights. Preferred stock may also carry special voting rights, such as the ability to vote more than once per share. 

Preferred stock owner may have additional privileges relating to the management of the corporation’s affairs, such as the right to elect a majority of the directors of the corporation or the right to guaranteed dividends (which are usually distributed only at the discretion of the board of directors).[33]

Regulation of Stocks

Before the stock market crash of 1929, federal oversight of the securities market was virtually non-existent. In many stages since 1933, Congress has enacted sweeping legislation, which has put the regulation of publicly offered securities under  federal oversight.[34] 

Federal Oversight and Regulation

The Securities and Exchange Commission, also referred to as the SEC, is a federal agency that has broad powers to administer and enforce federal U.S. securities laws. The SEC is an independent agency consisting of five commissioners who are appointed by the President and confirmed by the Senate.[35] To ensure that the SEC is a non-partisan agency, by law, no more than three of the five commissioners can belong to the same political party.[36] 

The SEC has 11 regional offices, through which the SEC conducts most of its enforcement activities. Each office can conduct investigations of possible violations that may be criminal or civil in nature. If the violation is civil in nature, the SEC may bring an action in court requesting injunctive relief and/or sanctions.[37]

The SEC’s broad umbrella of powers includes the power to register, regulate, and oversee brokerage firms, transfer agents and clearing agencies such as the Depository Trust Corporation.  The SEC also supervises and controls self-regulatory organizations, such as the New York Stock Exchange and the Financial Industry Regulatory Authority.[38]

Unless exempted by law, before a corporation can offer a security for sale to the public, it must register the security with the SEC,[39] which requires extensive application paperwork. This application and supporting documents provide the SEC with information regarding the company’s properties and business. Also, to determine the financial status of the company, copies of financial statements prepared by third party independent accountants must be included in the registration application. Some exceptions to the SEC registration requirements include sales of securities through employee benefit plans and private offerings.[40] After completing the SEC registration and other filing and disclosure requirements, a company may offer to sell securities on a public securities exchange during what is referred to as an Initial Public Offering.[41] Some of the important securities laws that are enforced by the SEC include: Securities Exchange Act of 1933[42], Securities Exchange Act of 1934[43], the Sarbanes-Oxley Act of 2002[44] and the Dodd-Frank Wall Street Reform Act[45]. 

State Regulation of Securities

States can also regulate the securities industry’s activities within their state. Currently, all 50 states have adopted securities laws,[46] referred to as “Blue sky” laws. Enforcement of state level securities laws are usually carried out by designated state agencies, though their duties and responsibilities may vary from state to state. Moreover, all states have laws requiring the registration of securities and brokerage firms.

State laws charge enforcement agencies with tasks such as processing filings and administering and enforcing applicable state laws related to the regulation of broker-dealers. Due to the overlap in state and federal laws, state regulators are also responsible for coordinating their compliance and enforcement efforts with federal regulators.

Self-Regulatory Organizations

Within the securities market, self-regulatory organizations offer securities to the public and are responsible for adopting their own rules and regulations.[47] These rules are aimed at protecting public interests and preventing fraud in the securities exchange market.

Currently, there are several registered national securities exchanges that are self-regulatory organizations, including the New York Stock Exchange and the Nasdaq.[48]

Additional oversight of SROs is conducted by the Financial Industry Regulatory Authority. FINRA is a private, not-for-profit organization that Congress authorized to  oversee the self-regulatory organizations in the securities market.[49]  FINRA oversees them and provides professional training and testing and licensing services to the organizations.[50]  In overseeing SROs, FINRA serves the public by protecting investors from becoming the victims of fraud and maintaining the public’s trust in the securities market.[51]

In our next module, we will focus on the rights that come with being a stockholder, including coting, dividends, dissolution, share transfers, inspection and the right to enforce these rights through litigation.

[1] See B. Ravikumar, “How Has Stock Ownership Trended in the Past Few Decades?,” Federal Reserve Bank of St. Louis, (April 9, 2018), https://www.stlouisfed.org/on-the-economy/2018/april/stock-ownership-trended-past-few-decades.

[2] 18A Am. Jur. 2d. Corporations § 350 (2015).

[3] Id.

[4] Id.

[5] “Holding Your Securities Get the Facts,” U.S. Securities & Exchange Commission, (Mar. 4, 2003), https://www.sec.gov/reportspubs/investor-publications/investorpubsholdsechtm.html.

[6] Id.

[10] See “Holding Your Securities Get the Facts,” U.S. Securities & Exchange Commission, (Mar. 4, 2003), https://www.sec.gov/reportspubs/investor-publications/investorpubsholdsechtm.html.

[11] “When Paper Paralyzed Wall Street: Remembering the 1960s Paperwork Crisis,” FINRA, (Aug. 19, 2015), https://www.finra.org/investors/when-paper-paralyzed-wall-street-remembering-1960s-paperwork-crisis.

[13] See 17 C.F.R. 240.17f-1; “Lost and Stolen Securities Program,” U.S. Securities and Exchange Commission, https://www.sec.gov/files/377fin.pdf 

[14] See “Holding Your Securities Get the Facts,” U.S. Securities & Exchange Commission, (Mar. 4, 2003), https://www.sec.gov/reportspubs/investor-publications/investorpubsholdsechtm.html.

[15] Bradley Gibson, “My Dog Ate the (Security) Certificates,” American Bar Association, Business Law Today, Vol. 18, Number 1 (Sept./Oct. 2008), https://apps.americanbar.org/buslaw/blt/2008-09-10/gibson.shtml.

[16] See “Holding Your Securities Get the Facts,” U.S. Securities & Exchange Commission, (Mar. 4, 2003), https://www.sec.gov/reportspubs/investor-publications/investorpubsholdsechtm.html.

[17] Luis A. Aguilar, “Strengthening Oversight of Broker-Dealers to Prevent Another Madoff,” Harvard Law School Forum on Corporate Governance and Financial Regulation, (Aug. 1, 2013), https://corpgov.law.harvard.edu/2013/08/01/strengthening-oversight-of-broker-dealers-to-prevent-another-madoff/.

[18] See “Holding Your Securities Get the Facts,” U.S. Securities & Exchange Commission, (Mar. 4, 2003), https://www.sec.gov/reportspubs/investor-publications/investorpubsholdsechtm.html.

[19] “Transfer Agents,” U.S. Securities and Exchange Commission, https://www.sec.gov/fast-answers/answerstransferagenthtm.html 

[20] See “Holding Your Securities Get the Facts,” supra note 5.

[21] Id.

[23] See “Holding Your Securities Get the Facts,” supra note 5.

[24] Id.

[25] Id.

[26] Id.

[27] Id.

[28] 18A Am. Jur. 2d. Corporations § 354.

[29] “What is the Difference between Voting and Nonvoting Shares?”, Upcounsel, https://www.upcounsel.com/difference-between-voting-and-nonvoting-shares

[30] 18A Am. Jur. 2d. Corporations § 355.

[31] 18A Am. Jur. 2d. Corporations § 355.

[32] 18A Am. Jur. 2d. Corporations § 355-56.

[33] 18A Am. Jur. 2d. Corporations § 357.

[36] Id.

[37] Harold S. Bloomenthal & Samuel Wolff, Securities Law Handbook 3 (Vol. 1 2018 ed.); see also “What We Do,” U.S. Securities and Exchange Commission, https://www.sec.gov/Article/whatwedo.html#laws 

[38] See “What We Do,” U.S. Securities and Exchange Commission, https://www.sec.gov/Article/whatwedo.html#laws 

[39] See 15 U.S.C. § 77a, et. seq.; 15 U.S.C. § 78l.

[40] See “Information About Some Companies Not Available From the SEC,” U.S. Securities Exchange Commission, https://www.sec.gov/answers/noinfo.htm 

[41] See “Investor Bulletin, Investing in an IPO,” U.S. Securities and Exchange Commission, Office of Investor Education & Advocacy, https://www.sec.gov/investor/alerts/ipo-investorbulletin.pdf  

[42] See Securities Exchange Act of 1933 (15 U.S.C. § 77a., et. seq.).

[43] See Securities Exchange Act of 1934 (15 U.S.C. § 78a., et. seq.).

[44] See Sarbanes-Oxley Act of 2002 (15 U.S.C. § 7201, et. seq.).

[45] See Dodd-Frank Wall Street Reform Act (12 U.S.C. § 5301, et. seq.).

[46] “Blue Sky Laws,” U.S. Securities and Exchange Commission, https://www.sec.gov/fast-answers/answers-blueskyhtm.html 

[47] Bloomenthal, supra note 37, at 6.

[49] See “About FINRA,” FINRA, https://www.finra.org/about 

[50] See id; Bloomenthal, supra note 33 at 6.

[51] Robert W. Cook, “Protecting Investors from Bad Actors,” FINRA, (June 12, 2017), https://www.finra.org/newsroom/speeches/061217-protecting-investors-bad-actors