Equities · Reading 40
Equity Jurisdictions, Classes, and the Voting Process
CFA Level I · Equities · Reading 40 · about 27 min
What you'll learn
- LOS 40.a Describe how economic and voting rights differ across jurisdictions (direct investing, depository receipts, dual listing) and across share classes (dual-class structures).
- LOS 40.b Describe the voting process and the roles of management, the board, custodians, proxy advisors, asset managers and asset owners.
Module 40.1
Rights of Equity Shareholders
This reading explains how shareholder rights vary with the jurisdiction and the class of shares: direct and indirect foreign investing, depository receipts, dual listing and dual-class structures. It then describes how shareholder voting works and what management, the board, shareholders, custodians, asset managers and proxy advisors each do in it.
LOS 40.a — Rights across jurisdictions and share classes
The economic and voting rights of shareholders (Reading 39) can differ when a company has more than one class of shares, or when the investor holds shares of a foreign company.
Investing in foreign shares: direct versus indirect
Investors often show home asset bias: they overweight assets from their own country. Buying foreign shares counters this bias, and there are two routes.
Direct investing means buying a foreign company's securities in that company's own (foreign) market. Obstacles include:
- extra cost of opening and running securities accounts abroad;
- unfamiliar market procedures (e.g., clearing and settlement);
- different tax rules, trading hours and reporting requirements, with disclosures possibly in a foreign language;
- foreign exchange risk and extra transaction costs, because the investment and its return are in a foreign currency;
- possible restrictions or taxes on moving capital back home;
- a foreign stock exchange that may be illiquid.
Indirect investing means owning an instrument that represents the foreign shares instead of buying the shares on their home exchange. Such vehicles reduce some of the obstacles to direct investing. A common one is the depository receipt (DR).
Depository receipts
Key concept
A depository receipt represents ownership of shares in a foreign company and trades in another country's market, in that market's currency. A domestic depository bank holds the deposited foreign shares, issues receipts each representing a set number of those shares, and acts as custodian, handling dividends, stock splits and other corporate events.
- The investor does not have to exchange currency to buy a DR, but the DR's value is still affected by exchange rate changes, as well as by the firm's fundamentals and economic events. So a DR holder's return can differ from that of a home-market holder of the same shares.
- To rule out arbitrage, the DR price should equal the foreign share price converted at the current exchange rate (times the number of shares per DR), although this can break down.
Example. One DR represents 3 shares of a eurozone company whose shares trade at €40, and the exchange rate is $1.10 per €. The DR should trade near . If the euro weakens to $1.05 while the share price is unchanged, the DR falls to . The dollar-based holder loses $6 per DR, a loss that a euro-based holder does not suffer.
| Type | Where issued / traded | Currency | Notes |
|---|---|---|---|
| American depository receipt (ADR) | United States | US dollars | |
| European depository receipt (EDR) | Europe | Typically euros | |
| Global depository receipt (GDR) | Outside the United States and outside the issuer's home country | Usually US dollars | Not listed on US exchanges but can be sold to US institutional investors. Usually listed where investors know the firm |
Exam convention: GDRs are not subject to the capital flow restrictions that governments impose, so they give the firm and investors greater opportunities for foreign investment. Current practice: because GDRs are sold outside the issuer's home country, they avoid the home government's limits on direct foreign purchases, but DR programs still have to follow the foreign-investment and DR rules that apply to them.
Key concept
| Sponsored DR | Unsponsored DR | |
|---|---|---|
| Foreign company involved in the issue? | Yes | No; a bank issues it on its own |
| Voting rights | Passed to the DR investor | Retained by the depository bank |
| Disclosure requirements | Usually greater | Usually lower |
Dual listing
Some large multinationals make their shares easier for nondomestic investors to own through dual listing: the shares are listed on a home-market exchange and also on at least one exchange abroad. The investor owns the actual shares rather than a receipt.
Dual-class share structures
A company may have more than one class of common stock (e.g., Class A and Class B shares). In a dual-class share structure, some classes carry more voting rights than others (e.g., 10 votes per share versus 1). This lets a group such as the founders keep effective control while owning less than a majority of the shares. Classes may also differ in economic rights, such as dividends or priority in a liquidation. Economic rights are sometimes in the same proportion as votes; in other cases one class has more economic rights and another has more votes. The rights attached to each class appear in the company's regulatory filings (in the United States, those made with the SEC).
Differences in dividends, votes or liquidation priority between two holders of the same company's common shares are therefore often explained by different share classes. Cumulative/noncumulative and participating/nonparticipating are features of preferred shares; they do not distinguish classes of common stock. Preferred shares usually carry no vote, and under an unsponsored DR the depository bank keeps the vote, so of these three instruments a common share is the one that normally gives its holder a vote.
Common exam traps
- GDRs: issued outside the US and outside the home country, but usually denominated in US dollars.
- Sponsored and unsponsored are easily swapped. The investor gets the votes only when the foreign company takes part in the issue (sponsored).
- DR holders still bear currency risk even though they never exchange currency themselves.
- Dual listing (same shares on several exchanges) is not the same as a dual-class share structure (share classes with unequal votes).
- Buying a foreign company's shares on its home exchange is direct investing; buying DRs is indirect investing.
LOS 40.b — The voting process and who takes part in it
Voting rights are how owners exercise authority over a company. Participants and their roles:
Key concept
| Participant | Role in the voting process |
|---|---|
| Management and board | Put forward routine matters for a vote (e.g., selection of the auditor, board candidates); decide which matters go to shareholders; solicit shareholder proposals; prepare the proxy statement, often with voting recommendations |
| Shareholders (asset owners) | Vote in person at the annual meeting or by proxy (proxy cutoff is usually slightly earlier); may submit shareholder proposals; may delegate their votes to asset managers |
| Custodian (broker or bank) | Holds shares on behalf of the beneficial owner; distributes proxy statements; determines the shareholder of record eligible to vote |
| Asset managers | Vote proxies delegated to them; CFA Institute members and candidates must vote proxies on relevant issues in an informed, responsible way and in the beneficial owners' interests (Standard III(A) Loyalty, Prudence, and Care) |
| Proxy advisors | Specialist firms that recommend to institutional investors (e.g., mutual funds holding many companies across markets) how to vote proxies, based on current information and good corporate governance principles |
Exam convention: a custodian holds the shares in the name of the beneficial owner. Current practice: shares held through a broker are often registered in the name of a nominee ("street name"); the custodian's own records show the investor as beneficial owner, and the economic and voting rights stay with the investor.
Shareholder proposals
A shareholder proposal recommends (or requires) that the company or its board take a specific action. Proposals are typically nonbinding, but strong support signals issues shareholders expect management to address. A company need not put every shareholder proposal to a vote, although regulations may require management to explain why it rejected one.
Proxy statement and record date
The proxy statement sets out the agenda, including every proposal that shareholders will vote on, frequently with a recommendation from management or the board. It also states the voting requirements and deadlines. Only the shareholder of record on the record date may vote; the record date is often 30 days or more before the meeting. A holder who sells between the record date and the meeting keeps the right to vote those shares, and someone who buys after the record date cannot vote them at that meeting.
Common exam traps
- Custodians distribute proxy materials and determine the holder of record; they do not decide how shares are voted or draft proposals. Voting power stays with the beneficial owner.
- Strong support does not usually make a shareholder proposal binding, and the company may leave some proposals off the ballot (regulations may require it to give reasons).
- Buying shares shortly before the meeting does not confer a vote: eligibility is fixed on the record date.
- Proxy advisors recommend; asset managers (when delegated) vote; custodians administer.
Exam shortcuts
- When two holders of the same company's common shares get different votes, dividends or liquidation priority, the likely explanation is different share classes; cumulative, noncumulative, participating and nonparticipating are preferred-share features and can be eliminated.
Bottom line
- Direct investing means buying a foreign company's securities in its home market, with obstacles such as account costs, unfamiliar procedures, different tax and reporting rules, foreign exchange risk and a possibly illiquid exchange; indirect vehicles such as depository receipts reduce some of these obstacles.
- A depository receipt represents a set number of a foreign company's shares held by a depository bank and trades in another market in that market's currency, yet its value still changes with the exchange rate, so the holder bears currency risk without exchanging currency.
- To rule out arbitrage, a DR should be priced at the foreign share price converted at the current exchange rate, times the number of shares per DR, although this relationship can break down.
- A GDR is issued neither in the United States nor in the issuer's home country; it is usually denominated in US dollars and, although not listed on US exchanges, can be sold to US institutional investors.
- In a sponsored DR the foreign company takes part in the issue and the voting rights pass to the investor; in an unsponsored DR a bank issues it alone and the depository bank keeps the votes.
- Dual listing puts the same shares on a home exchange and at least one foreign exchange, whereas a dual-class structure gives some classes of common stock more votes (and possibly different economic rights), which can let a group such as the founders keep effective control with less than a majority of the shares.
- Shareholder proposals are typically nonbinding, and a company need not put every one to a vote, although regulations may require management to give reasons for rejecting one.
- Only the shareholder of record on the record date, often 30 days or more before the meeting, may vote, so a holder who sells between the record date and the meeting can still vote and a buyer after the record date cannot vote those shares at that meeting.
Quick check
A Chilean pension fund opens a brokerage account in Tokyo and buys the shares of a Japanese manufacturer on that company's home stock exchange. This is an example of:
Show answer and explanation
Correct answer: B
Direct investing in foreign companies means buying the foreign firm's securities in its own (foreign) market. The pension fund does this when it buys on the Tokyo exchange.
Why the other options are wrong
- A. Indirect investing means holding an instrument that represents the company's shares, such as a depository receipt, instead of buying the shares on their home exchange.
- C. Dual listing is something a company arranges: its shares trade on one or more foreign exchanges in addition to its home exchange. The pension fund is simply buying the shares on the company's home exchange, which is direct investing.
Key takeaway Buying foreign shares on their home exchange is direct investing; buying DRs is indirect investing; dual listing is a company's decision to list its shares abroad.
Practice Questions
The founders of Veridian Apps own 15% of its shares but control a majority of the votes, because each of their shares carries ten votes while every other share carries one. This arrangement is an example of a:
Show answer and explanation
Correct answer: C
In a dual-class share structure, some classes of common stock carry more votes than others. This can give a group such as the founders effective control while they own less than a majority of the shares.
Why the other options are wrong
- A. Cumulative preference shares concern dividends in arrears and typically carry no voting rights.
- B. Participating preference shares concern extra dividends and typically carry no voting rights.
Key takeaway Unequal votes across classes of common stock indicate a dual-class share structure, often used to keep founder control.
Kavanagh Dairy set the record date for voting at its annual meeting 35 days before the meeting. Ingrid Solheim, who owned 800 Kavanagh shares on the record date, sells them to Paulo Mendes 5 days before the meeting. Who is entitled to vote those 800 shares at the meeting?
Show answer and explanation
Correct answer: B
Eligibility to vote is fixed on the record date: the custodian identifies the shareholder of record as of that date. A shareholder who sells after the record date but before the meeting remains eligible to vote the shares, so Solheim votes them.
Why the other options are wrong
- A. Mendes bought after the record date, so he is not the shareholder of record for this meeting and cannot vote these shares at it.
- C. A sale after the record date does not cancel the votes; the seller who held the shares on the record date keeps the right to vote them.
Key takeaway Voting eligibility follows the record date (often 30 or more days before the meeting). Ownership on the meeting day does not matter.
This reading has 15 questions in the full bank. Practice all of them.
Key Takeaways
- Buying foreign shares on their home exchange is direct investing; buying DRs is indirect investing; dual listing is a company's decision to list its shares abroad.
- Unequal votes across classes of common stock indicate a dual-class share structure, often used to keep founder control.
- Voting eligibility follows the record date (often 30 or more days before the meeting). Ownership on the meeting day does not matter.