Chapter 4

1. Chapter 4 The share market and the corporation Websites: www.asic.gov.au www.asx.com.au www.nyse.com

2. Learning objectives • Understand the nature of corporations and reasons for public listing • Consider the origins and purpose of a stock exchange • Discuss the role of primary and secondary markets in equity financing • Explain the derivatives, managed products and interest rate market roles of a stock exchange • Explain the electronic trading and settlement systems for share market transactions (cont.)

3. Learning objectives (cont.) • Explain the importance of information flows for share market efficiency • Identify the main regulators of the share market • Explain the structure and purpose of the private equity market

4. Chapter organisation 4.1 The Nature of a Corporation 4.2 The Stock Exchange 4.3 The Private Equity Market 4.4 Summary

5. 4.1 The nature of a corporation • Share market • A formal exchange facilitating the issue, buying and selling of equity securities • Publicly listed corporation • A company whose shares are quoted and traded on a formal stock exchange • Ordinary share • The principal form of equity issued by a corporation, which bestows a claim to residual cash flows and ownership and voting rights (cont.)

6. 4.1 The nature of a corporation (cont.) • The corporation differs from other business forms • Ownership claims are widespread and easily transferable • Owners (shareholders) do not affect the day-to-day affairs of the company • Shareholders’ liability is limited to: • the issue price of shares of a limited liability company • any partly paid portion of shares of a no-liability company (cont.)

7. 4.1 The nature of a corporation (cont.) • Advantages of the corporate form • Can obtain large amounts of finance at a relatively cheap cost • The liquidity of securities facilitates investor diversification and encourages investment in corporate securities • Separation of ownership and control facilitates: • appointment of specialised management • greater effectiveness in the planning and implementation of strategic decisions (cont.)

8. 4.1 The nature of a corporation (cont.) • Advantages of the corporate form (cont.) • ‘Perpetual succession’—the corporate form is unaffected by changes in management or ownership • The corporate form is suited to large-scale operations (cont.)

9. 4.1 The nature of a corporation (cont.) • Disadvantages of the corporate form • Main disadvantage arises from the separation of ownership and control • Conflict of interest between owners (principals) and managers (agents) known as the agency problem • Management may try to run business for their own benefit, rather than that of shareholders, i.e. maximise shareholder value (share price) (cont.)

10. 4.1 The nature of a corporation (cont.) • Disadvantages of the corporate form (cont.) • Factors moderating conflict of interest between owners and managers • Investors’ ability to sell shares in a corporation, causing the share price to fall • Dismissal from the board at AGM by shareholders • Threat of takeover and loss of employment • Use of performance incentives, such as share options • More rigorous corporate governance (cont.)

11. 4.1 The nature of a corporation (cont.) • Following the GFC, many corporations were forced to raise additional capital through the stock market • This was to ‘sure up’ their balance sheets during the tough economic environment that followed the crisis • The advantage of the corporate form is highlighted by such behaviour • Smaller firms are not able to access capital as easily and would normally be expected to pay a higher rate of return

12. Chapter organisation 4.1 The Nature of a Corporation 4.2 The Stock Exchange 4.3 The Private Equity Market 4.4 Summary

13. 4.2 The stock exchange • Origins of the modern stock exchange traceable to mid-16th century England • Principal functions of a modern and efficient stock exchange in a globalised market are the provision of: • markets for a range of financial securities • securities trading system • clearing and settlement system • regulation and monitoring of market integrity • well-informed market (cont.)

14. 4.2 The stock exchange (cont.) • Specifically, the following roles of a stock exchange are considered: • Primary market role • Secondary market role • Managed Product role • Derivative market role • Interest rate market role • Trading and settlement roles • Information role • Regulatory role

15. Primary market role • A stock exchange facilitates the efficient and orderly sale of new financial securities • New floats/Initial public offerings (IPOs) • Initial listing of a corporation on the stock exchange • Rights issue • Issue of additional shares to existing shareholders on a pro-rata basis • Placements • Issue of new shares to selected institutional investors • Dividend reinvestment plans • Reinvestment of dividends into corporation for additional shares (cont.)

16. Primary market role (cont.) (cont.)

17. Primary market role (cont.)

18. Secondary market role • The stock exchange facilitates trading in existing shares • No new funds are raised by the issuing company • An active, liquid, well-organised secondary market increases the appeal of buying new shares in the primary market • Market liquidity • Ratio of share turnover to market capitalisation • Market turnover • Number of shares on issue x current share price (cont.)

19. Secondary market role (cont.)

20. Managed product role • The stock exchange provides a market for trading managed products • Equity-based managed products are professionally managed funds. • The ‘units’ in these funds are bought and sold on the stock exchange in the same way as shares in corporations. • Managed products are described as: • exchange traded funds (ETFs) • real estate investment trusts (REITs) • infrastructure funds

21. Derivative market role • The stock exchange provides a market for trading equity-related derivative products • A derivative is a financial security that derives its price from an underlying commodity (e.g. gold) or financial instrument (e.g. BHP shares) • Derivative products are described as: • exchange-traded contracts • standardised financial contracts traded on a formal exchange • over-the-counter contracts • non-standardised contracts negotiated between writer and buyer (cont.)

22. Derivative market role (cont.) • The stock exchange provides a market for trading equity-related derivative products (cont.) • Derivatives serve as a: • risk management tool (hedge) • speculative instrument • Derivatives traded on a stock exchange include: • options • warrants • futures contracts • Contracts for difference

23. Interest rate market role • The listing, quotation and trading of typically longer term debt instruments on a stock exchange • Straight corporate bonds • Floating rate notes (FRNs) • Convertible notes • Preference shares (cont.)

24. Interest rate market role (cont.) • This role adds value to a debt issue owing to: • transparency • information about price, yield, maturity, credit rating of debt instruments • ease of entry • electronic trading system facilitates buy and sell orders at minimum cost and time delay at current market prices • liquidity • quotation on a stock exchange provides access to a wider market

25. Trading and settlement roles • The Australian Securities Exchange (ASX) uses ASX Trade and ASX Trade24, which are integrated computer-based trading systems to trade all listed securities and derivatives • Clients’ orders are executed via computer from the broker’s office • Orders are executed in order of time received and the buy/sell price (cont.)

26. Trading and settlement roles (cont.) • The ASX uses CHESS (Clearing House Electronic Sub-register System) • Facilitates the settlement of transactions conducted through ASX Trade • Settlement of transactions within three days (T + 3) • Provides an electronic sub-register that records the ownership of listed securities • A CHESS sponsor is a market participant with access to CHESS, e.g. stockbroker

27. Information role • Investor confidence in the ASX relies on informational efficiency • The current share prices should reflect all information available in the market, determined by: • the speed at which new information flows to the market • the speed at which that information is absorbed and reflected in share prices • The ASX has a critical role in facilitating the flow of information to the market • Corporations Act 2001 (Cwlth) requires information materially affecting the share price of a listed company to be immediately given to the ASX (cont.)

28. Information role (cont.) • Listing rules are stock exchange rules with which a listed entity must comply • Examples of information disclosures required by ASX listing rules • A change in a company’s financial forecasts • Appointment of a liquidator • Declaration of a dividend • Notice of a takeover bid • Disclosure of directors’ interests

29. Regulatory role • The aim of regulation is to ensure market participants have confidence in the integrity of market operations • Two main supervisors in Australia • Australian Securities Exchange (ASX) • Australian Securities and Investments Commission (ASIC) (cont.)

30. Regulatory role (cont.) • ASX • Ensures listed companies meet specified limited levels of performance and standards of information disclosure so investors can make informed decisions • Continuous disclosure • Prescribes appropriate behaviour of broker participants on the exchange • Sanctions include discipline, penalties, loss of licence (cont.)

31. Regulatory role (cont.) • ASX (cont.) • Electronic surveillance systems to monitor trading behaviour of market participants • Detect trades that fall outside certain limits • Cross-references all trades against information on the relevant company, directors and associated parties (cont.)

32. Regulatory role (cont.) • ASIC • Responsible for the supervision of Corporations Law and markets in Australia (Corporations Act 2001 (Cwlth)) • Responsible for market integrity and consumer protection across the financial system, covering investment, insurance and superannuation products • Supervises the ASX, addressing potential conflicts of interest as a publicly listed corporation

33. Chapter organisation 4.1 The Nature of a Corporation 4.2 The Stock Exchange 4.3 The Private Equity Market 4.4 Summary

34. 4.3 The private equity market • Private equity is an alternative funding source for companies unable or not wanting to access equity capital though a public issue • Source of funds • Superannuation funds and life insurance offices • Use of funds • Startups, business expansion, recovery finance for distressed companies, management buyouts • Aim is generally to: • improve profitability sufficiently to realise value though an IPO • break up business to achieve return on investment

35. Chapter organisation 4.1 The Nature of a Corporation 4.2 The Stock Exchange 4.3 The Private Equity Market 4.4 Summary

36. 4.4 Summary • Corporate form of organisation has advantages (fundraising and management) and disadvantages (separation of ownership and control) • The stock exchange has a number of market roles • Primary and secondary • Derivative • Interest rate • Trading and settlement • Information • Regulatory • ASX monitors market participants and ASIC supervises Corporations Law and market integrity