LSC 2310 CAPITAL MARKETS LAW

CHAPTER ONE

INTRODUCTION

Capital is necessary for the running of business. There are many ways to raise capital, including
applying for and obtaining loans from lenders such as banks. A small-scale trader may obtain a
small loan from a friend for purposes of starting general merchandise shop in the neighborhood.

Another prominent way of obtaining capital for a business is through the capital markets created
by law where businesses entities seeking for capital and investors seeking for investments to put
their money in meet. Such markets have come to be known as capital markets.

DEFINITION OF TERMS

TERM SOURCE DEFINITION

1 Capital Black’s Law A securities market in which stocks and bonds with long-
Market Dictionary term maturities are traded
Xxxx
Alternative term for capital market in the Black’s law
dictionary is “financial market”
Economic Capital market is a market where buyers and sellers engage
Times in trade of financial securities like bonds, stocks, etc. The
buying/selling is undertaken by participants such as
individuals and institutions. Capital markets help channel
surplus funds from savers to institutions which then invest
them into productive use. Generally, this market trades
mostly in long-term securities.

1|Page
 < What is Capital Market? Definition of Capital Market,
Capital Market Meaning - The Economic Times
(indiatimes.com) > last accessed on 5/06/2022
Privatization A capital market can be either a primary market or a
and Capital secondary market. In primary market, new stock or bond
Market issues are sold to investors, often via a mechanism known as
Development: underwriting. The main entities seeking to raise long-term
Strategies to funds on the primary capital markets are governments
Promote (which may be municipal, local or national) and business
Economic enterprises (companies). Governments issue only bonds,
Growth, whereas companies often issue both equity and bonds. The
Michael main entities purchasing the bonds or stock include pension
McLindon funds, hedge funds, sovereign wealth funds, and less
(1996) commonly wealthy individuals and investment banks
18/10/18 trading on their own behalf. In the secondary market,
existing securities are sold and bought among investors or
traders, usually on an exchange, over-the-counter, or
elsewhere. The existence of secondary markets increases the
willingness of investors in primary markets, as they know
they are likely to be able to swiftly cash out their
investments if the need arises
O'Sullivan, “A capital market is a financial market in which long-term
Arthur; debt (over a year) or equity-backed securities are bought and
Sheffrin, sold
Steven M.
(2003).
Economics:
Principles in
Action. Upper
Saddle River,
NJ: Pearson

2|Page
 Prentice Hall.
p. 283. ISBN
0-13-063085-
3. 18/10/18
2 Capital Capital means any long-term financial instrument whether in the
Market Markets Act, form of debt or equity developed or traded on a securities
Intstrume 2000 exchange or directly between two or more parties for the
nt (Section 2) purpose of raising funds for investment;
3 Commodi Capital means a market or facility licensed by the Authority or a
ty Market Markets Act, facility, whether electronic or otherwise at which, offers or
2000 invitations to sell, purchase or exchange commodity
(Section 2) contracts are regularly made on a centralized basis, being
offers or invitations that are intended or may reasonably be
expected to result directly or indirectly in the acceptance or
making, respectively of offers to sell, purchase or exchange
of commodity contracts but does not include— (a) the office
or facilities of a commodity dealer or broker; (b) the office
or facilities of a clearing house;

4 Derivative Black’s Law A financial instrument whose value depends on or is derived

Dictionary from the performance of a secondary source such as an
underlying bond, currency, or commodity
Capital
Markets Act
5 Derivative Black’s Law A market for the exchnge of derivative instruments – Also
Market Dictionary termed paper market
Capital means a place at which, or a facility, whether electronic or
Markets Act, otherwise, by means of which offers or invitations to sell,
2000 purchase or exchange-traded derivative contracts are
(Section 2) regularly made on a centralised basis, being offers or
invitations that are intended or may reasonably be expected

3|Page
 to result, directly or indirectly, in the acceptance or making,
respectively, of offers to sell, purchase or exchange-traded
derivative contracts, whether through that place, facility or
otherwise, but does not include— (a) the office or facilities
of a derivatives broker; or (b) the facilities of a
clearinghouse;

HISTORY OF THE CAPITAL MARKETS

1. In Europe

In the early 12th century, a practice of brokerage started to develop in France where traders referred
to as Courretiers de change managed Agricultural debts on behalf of banks. These were the first
brokers known in the history of capital markets. Prior to the French Courretiers, there were
merchants who lent capital to businesses. It is thought that this could have led to the practice of
trading of debts.

Early 14th Century

There were no equivalents of the present-day capital markets. The available mechanism was to
obtain loans from lenders, and since there were no proper mechanisms for obtain loans, the banks
were hesitant to lend money as the risks of loss were very high. The lenders that took leap of faith
and filled the gap left by the banks.

With the time, the lenders started trading in government securities. The pioneers in this business
were the merchants of Venice. This motivated other players; banks in the nearby towns such as
Genoa and Florence started engaging in government securities trading.

Money lenders traded debts among themselves and as this practice evolved, they began to sell debt
issues to individuals, marking the first sale of securities to individuals.

4|Page
Stock Exchange Markets

It is believed that the first stock exchange market was created in Antwerp in Belgium. Van der
Beurze, an influential man in Belgium, revolutionized stock exchange in Europe when he began
hosting in house, transactions similar to those of a stock exchange. The market in his house was
mainly concerned with the trading in government securities and debts. There were no current
structures of securities such as shares.

Thus, trading of debts and government securities was brought under one roof. Traders did not have
to travel for long distances in search of buyers or sellers. This helped them to save time and costs.

There was increased interaction between traders which led to increased confidence and trust
amongst themselves. The confidence such trading under one roof spread to the neighboring cities.
They joined other traders in the securities market at Van der Beurze’s house.

Similar markets started coming up in other cities, having been motivated by the market in Antwerp.
The practice spread from city to city until it reached Amsterdam, the capital city of Netherlands.

The Concept of Companies

Companies were important drivers of the development of securities exchange markets. Initially
however, it was an expensive affair to create a company in England. They were created either
through a Royal Charter or a special Act of Parliament. Thus, charter could be possibly obtained
through many associations coming together. The associations that weren't incorporated continued
operating as though they were already incorporated.

Initially, the incorporated companies didn’t have structures that separated the management from
ownership. When this happened later, fortunes of companies improved as the managers would
smoothly run the companies without interference from the owners.

5|Page
Europe’s Contact with India

This revolutionized the ownership of companies as ownership through shares was introduced.
Ships going to India constituted lucrative business because of discovery of valuable minerals and
raw materials for industries.

However, the voyages to and from India were plagued with many risks, including bad weather and
piracy. Some ships could not return at all.

This led to companies inviting interested persons to buy stakes from the companies as a way of
mitigating risks, in return for dividends to the investors (shareholders). To spread the risk of loss,
diversification was introduced which meant that the investors put their money in a variety of ships
so that if any failed to returned, they still benefitted from the ones that returned.

East India Company

In the 17th century, the British, Dutch and French gave charters to the companies called East India.

1600 AD - East India Company was formed. It was a British company called “Governor and
Company of Merchants of London Trading with East Indies.” it was the first company to adopt
the concept of limited liability.

1602 AD – Dutch East India Company formed. It was the first company to have a fixed capital
stock. Continuous trade in company stock emerged in Amsterdam exchange.

Emerging Risks and the Bubbles Act

With the emergence of companies as the vehicle for trade came also the problem of loss of
securities. There were no proper laws in place to regulate companies. Fraudsters, fashioning
themselves as promoters, would come up with a company, obtain capital through Security
Exchange markets then abscond with the investors’ money. This drove away the confidence of
investors from the promoters.

6|Page
The delinking of management of companies from ownership was a double-edged sword. The fact
that the owners did not have direct control over the running of companies meant that they were in
the dark and this afforded opportunity for mismanagement.

The English parliament, out of sympathy for the public who had lost their investments to fraudulent
promotes, enacted a legislation called the Bubbles Act in 1720 which prohibited the business of
promoting companies.

Bubbles Act Repealed

It was apparent that the enactment of the Bubble Act was an overreaction. This Act was not just
meant to stop fraudulent promoters. It stopped the formation of companies altogether. This
negatively affected the commerce was booming at the time. There was a huge volume of commerce
which as a matter of fact required the formation of more companies.

It was even made worse that the statute lasted for over a century. By the time it was repealed in
the year 1825 AD, other countries had overtaken Britain as the pioneer in modern stock market.

In 1844, England enacted the Joint Stock Companies Act which, among other things, required the
registration and incorporation of partnerships.

Limited Liability

Even with the enacted of the 1844 Act, the liability of the company owners was unliited. This
meant that their personal assets would be resorted to address the liability of their companies.

In 1855, the principle of limited liability was introduced through the Limited liability Act.

In 1856 AD, various company laws were consolidated into one statute; Joint Stock Companies
Act.

7|Page
London Stock Exchange

This came into existence in 1801 AD. However, it was frustrated by the Bubbles Act which was
not repealed until 1825 AD. Issuance of shares is a central part of incorporation of companies.
This means that by banning of the incorporation of companies, issuance of shares did not take
place.

New York Stock Exchange

It was created in 1817 and began to trade on the very day. However, Philadelphia Stock Exchange
came first in existence in the USA. Due to its strategic location at the center of commerce and
trade in the New York, the New York Stock Exchange overtook Philadelphia Stock Exchange and
became the best and powerful Stock Exchange in the USA.

The London Stock Exchange was the most powerful in Europe, while the New York Stock
Exchange cement its place as the most powerful exchange in the world.

EVOLUTION OF CAPITAL MARKETS IN KENYA

Trading in stocks started in Kenya at the turn of the 20th century, but it was not in the year 1953
when the Nairobi Stock Exchange received its first international recognition when it was
recognized by the London Stock Exchange.

1954

The Nairobi Stock Exchange was registered under the Societies Act as a voluntary association of
Stock brokers. This was aimed at empowering the NSE to take the role of nurturing securities
market.

Transactions were done through telephone calls and negotiations.

By the year 1968, the public sector securities listed were 66. Of these securities, Kenya owned
45%, Tanzania 23% while Uganda owned 11%.

8|Page
1977

The Nairobi Stock Exchange was the only stock exchange in East Africa. It thus listed companies
from Uganda and Tanzania. With the collapse of the East African Community in 1977, the
companies from Uganda and Tanzania were delisted from the Nairobi Stock Exchange, and
subsequently nationalized by the governments of the respective countries.

1990 – Capital Markets Authority

In January, 1990, the Capital Markets Authority was created vide the Capital Markets Act, Cap
495A. The creation was necessitated by the need for a body that would be responsible to promote
and facilitate a robust and efficient market in Kenya.

1991

The Nairobi Strock exchange was registered as a private company limited by shares. The trading
shifted from negotiation over a cup of tea to a floor-based outcry system at the IPS Building along
Kimathi Street in Nairobi.

1993 – Increased Paid up Capital

The Capital Markets Authority increased the Initial paid up capital for investment Advisors to 1
million Kenya Shillings, while the paid-up capital for stock brokers was increased to 5 million
Kenya shillings from Ksh 100,000/-.

1994 – Amendment of the Capital Markets Act

The amendment brought in important provisions. It was mandatory that all the securities exchange
be approved by the Capital Markets Authority.

Many people, motivated by the proper organization of the Nairobi Stock Exchange, joined it as
stock brokers.

Due to the increased number of participants, there was need to move to a bigger space. Therefore,
in July, 1994, the Nairobi Stock Exchange was moved to the Nation Centre. A computerized
delivery and settlement replaced the previous outcry system.

9|Page
1995 – Investor Compensation Fund

This was established to compensate investors who suffer loss as a result of the breach of rules by
the licensed brokers.

1997 – Formation of Association of Kenya Stock Brokers

Was established for the purpose of educating members. Another purpose for its creation was to
promote good ethics amongst the stake holders in the stock market.

1998 – Creation of Disclosure Guidelines

This was done to ensure transparency. Listed companies were required to adhere to the set
standards. This was most important especially during the initial public offers.

1999

A number of phenomenal activities happened:

Firstly, at the beginning of the year, the Capital Markets Authority provided for the creation of
committees to enable best corporate governance practices.

March 1999 – Central Depository and Settlement Corporation Limited established under the then
Companies Act, Cap 486.

November 1999 – Kenya, Uganda, Tanzania, Rwanda and Burundi signed the East African
Community Treaty in Arusha. This signal hope for the creation of a regional stock market.

2001

Notable events that happened this year include:

Division of the Nairobi Stock Exchange Market

The stock market was divided into the following:

Fixed Income Securities (FISM)

Alternative Market Segment (AIMS)

10 | P a g e
Main Investment Market Segment (MIMS)

The East African Community Secretariat organized for a meeting of the new Capital Markets
Development Committee in Dar es Salaam, Tanzania.

2004

The Kenya’s, Uganda’s and Tanzania’s securities exchanges created East Africa Security
Exchange Association.

Depository system was centralized the same year and trading in stocks automated.

2006 – NSE Live Trading

Nairobi Stock Exchange began live trading on its automated trading system

2007 - Wide Area Network

NSE established its Wide Area Network (WAN) platform. Stakeholders needed not to be
physically present on the floor. They are able to trade from their offices through terminals linked
to the trading engine of the Nairobi Stock Exchange.

2011 – Name Change

Nairobi Stock Exchange Limited changed its name to Nairobi Securities Exchange Limited

11 | P a g e
 CHAPTER TWO

CLASSIFICATION OF CAPITAL MARKETS

Introduction

It has been said that the capital markets provide a means of acquiring capital, managing risks and
making money.1 the following paragraph captures well the whole purpose of the capital markets:

“Notwithstanding the frailties of the capital markets, access to capital remains a vital
part of global economic growth. Capital market participation allows companies to use
financial instruments as a means of accessing capital, managing risk and making money.
The capital markets provide marketplace where persons with financial capacity can meet
persons who have needs for long-term or short-term capital. The capital markets also
provide a means for shifting risk from one party who is less willing or able to retain a
financial risk to another party who is more willing or able to take on that risk.”

That said, there are two ways in which businesses access capital. These are through issuance of
equity and through issuance of debt.

Issuance of Equity

This is a scheme where a corporation sells a stake in the company in exchange for money from the
investors. The stake is sold in form of a financial instrument, which is basically a contractual
agreement between the buyer of equity and the corporation.

The financial instrument entitles the buyer to ownership of the company as well as periodic
dividends. It is noteworthy that the value of the instrument is subject to external factors that may
result into the decline or appreciation of the value thereof.

1 Rechtschaffen N.A., Capital Markets, Derivatives and The Law, 2014, Oxford (page 46, paragraph 3)

12 | P a g e
Issuance of Debt

Issuance of a financial instrument that is a debt means borrowing money from an investor. The
issuer could be a private entity, such as a company issuing a debenture, or a public entity such as
the government, local authority or a government agency. The financial instrument may take the
form of bonds or bills.

The issuer is under obligation to repay the principal amount in full at the date of maturity of the
debt. He is also under obligation to pay to the investor periodic interest on the principal sum as
agreed.

Derivatives

This is the third category of financial instruments. These instruments derive their value from
another asset index or investment. They are contractual agreements that obligate parties to
exchange assets or cash flows.2

Derivative transaction – it is a bilateral contract or payments exchange agreement whose value

derives from the value of underlying asset or underlying reference rate or index.

Derivatives include: forwards, futures, options and swaps.

CATEGORIES OF CAPITAL MARKETS

There are two categories of capital markets, namely;

Primary markets

Secondary markets

2this definition was given in the US case, Procter & Gamble Co. V. Bankers Trust Co., 925 F. Supp. 1270,1275 (S.D.
Ohio 1996

13 | P a g e
1. Primary markets

This is where the initial offer of a new financial instrument is made. For example, in the year 2008,
Safaricom PLC Limited made its initial public offer (IPO) of its shares.

The parties in a primary market are the issuer and the purchaser.

The IPOs may further be disaggregated into various categories, including;

Restricted offer

Rights issue

Electronic initial public offer

Restricted offer

As the name suggests, this is an IPO which is issued to a few individuals or entities to avoid the
enormous costs involved in opening the initial public over to the entire public. The expenses come
in form of hiring layers, stock brokers and financial experts in order to make the IPO successful.

Instead of incurring huge expenses by going the route of offer to the general public, an issuer may
approach a small constituency of investors such as banks, insurance companies, wealthy
individuals and financial institutions to buy instruments initially offered in exchange for funds.
The offer is thus restricted and promote economy and swiftness.3

Rights Issue

In this case, the first priority in the IPO is given to the shareholders of the company. The rationale
is that the shareholders would be interested in furthering their interest in the company. If they fail
to purchase the issue, the public is given opportunity to purchase the shares.

3see Article by Shem Oganga

Oganga, s., Evolution of the Capital Market, Quest Journals,Vol. e 7 ~ Issue 7 (2019)pp.:55-72

14 | P a g e
 Electronic IPO

This is basically harnessing technology to roll out IPO online according to the guidelines of the
regulators.

2. Secondary markets

A secondary market involves the transfer of an instrument that has already been issued and is being
held by a buyer, to a subsequent investor. The transfer of the instrument may be done as many
times as possible.

Secondary markets are important because they create liquidity in the market. However, the
instruments traded in the secondary market are subject to changes in value. A purchaser may end
up with an instrument that has a diminished value or vice versa.

15 | P a g e
 CHAPTER THREE

FINANCIAL INSTRUMENTS

Financial instrument is generally defined as a contract involving financial obligation. Under

section of the Capital Markets Act, a financial instrument:

“includes securities, mortgage contracts, property contracts, pension contracts, i

nsurance contracts, leasehold contracts, certificates of interest and any variations or
derivatives thereof;”

A financial instrument, just like any other contract, has an offeror (the corporation) and the offeree
(the investor).

A financial instrument creates rights on the one part, in this case for the benefit of the investor,
and obligations on the second, in this case to be fulfilled by the corporation issuing the instrument.

There is value offered and obtained in any contract. Equally, under a financial instrument, an
investor gets consideration in form of interest or dividend for the money given to the corporation
for investment. The invested money is the value that the corporation gets from the financial
instrument.

Differentiating Debt from Equity

As stated above, a financial instrument either takes the form of a debt or equity. There are various
criteria for distinguishing a debt from equity. Various criterion can be seen to have emerged from
the American capital markets system. These include:

The judicial distinction/criteria

The Financial Accounting Standard Board (FSAB) distinction/criteria

16 | P a g e
 1. Judicial Criteria

The courts in the US have previously stated that the distinction as to whether an instrument is a
debt or equity depends on the intention of investor. In Slappey Drive Indus. Park v. United States,
561 F.2d 572, 581 (5th Cir. 1977), it was held that generally, shareholders place their money at the
risk of the business while lenders seek more realistic return. The Court, as quoted verbatim, held
thus:

“contributors of capital undertake the risk because of the potential return, in the form of profits
and enhanced value, on their underlying investment. Lenders, on the other hand, undertake a
degree of risk because of the expectancy of timely repayment with interest”

In short, the investors who go for debts are averse to risk. They want certainty on the return to their
investment, meaning, they want their principal amount intact at the end of the contract, plus
interest, though not much. The lower the risk, the lower the interest/profit on investment.

On the other hand, equity purchasers are after higher returns on their investments, and this means
that they are willing to take high risks.

Objective Economic Reality Test

This was applied in Fin Hay Realty v. United States, 398, F.2d 694 (3d Cir. 1968). The issue in
this case was whether additional funds paid by the shareholders to a corporation was additional
capital, hence equity, or whether they were loans for which the company was supposed to pay back
interest, apart from the principal sum. Two shareholders had created Fin Hay in exchange for stock
allocation and made additional contributions in exchange for unsecured promissory notes payable
on demand with interest of 6%. Years later, the original shareholders died. The US Internal
Revenue Service (IRS) disallowed the continued deduction of interest from the so-called by the
company. The court, in adopting the objective economic reality test, held as follows:

The additional contributions were capital contributions because:

i. they did not dilute the shareholders’ equity interests and

ii. they were not called up during the lifetime of the shareholders

17 | P a g e
the court further stated that the shareholders could structure their contributions in a way that would
receive a favourable tax treatment rather than structuring it as a debt. The court stated that the
following factors distinguish a debt from equity:

i. the intent of the parties

ii. the identity between the creditors and shareholders
iii. the extent of participation in management by the holder of the instrument
iv. the ability of the corporation to obtain funds from outside sources
v. the ‘thinness’ of the capital structure in relation to debt
vi. the risk involved
vii. the formal indicia of the arrangement
viii. the relative position of the obliges as to other creditors regarding the payment of interest
and principal.
ix. The voting power of the holder of the instrument
x. The provision of a fixed rate of interest
xi. A contingency on the obligation to pay
xii. The source of interest payments
xiii. The presence or absence of a fixed maturity date
xiv. A provision for redemption by the corporation
xv. A provision for redemption at the option of the holder
xvi. The timing of the advance with reference to the organization of the corporation.

Focus on Contract interpretation

Courts interpret contract between the holder and the issuer to determine whether a financial
instrument is a debt or an equity. In Slappey Drive Indus. Park v. United States (supra), the issue
was whether the transfer of property by several shareholders to their company in exchange for
promissory note was a debt or equity. The court found that the contributions by the shareholders
amounted to equity because;

- The shareholders failed to insist on timely repayment

- The shareholders only asked for payment when the company has plenty of cash

18 | P a g e
 - The proceeds went towards the purchase of capital assets
- The proportionality of the shareholders’ equity interest equaled the shareholders’ debt
interest

The court listed the factors to be considered in distinguishing debts from equity:

i. The names given to the certificates evidencing the indebtness

ii. The presence or absence of a fixed maturity date
iii. The source of payments
iv. The right to enforce payment of principal and interest
v. Participation in management flowing as a result
vi. The status of the contribution in relation to regular corporate creditors
vii. The intent of parties
viii. ‘thin’ or adequate capitalization
ix. Identity of interests between creditor and stockholder
x. Source of interest payment
xi. The ability of corporation to obtain loans from outside lending institutions
xii. The extent to which the advance was used to acquire capital assets
xiii. The failure of the debtor to repay on the due date or to seek a postponement

FASB Approaches

FASB adopted three approaches in differentiating debts from equity. These include:

- The Basic Ownership approach

- Ownership Settlement approach
- Reassessed Expected Outcome

The Basic Ownership approach

This is where a basic ownership instrument is considered equity. A basic ownership instrument is
that which a) is the most subordinated instrument in an entity, and b) entitles the holder to a share
of the entity’s net assets after all high priority claims have been satisfied.

19 | P a g e
The rest of the instruments, such as convertible debts and options, are to be classified either as
assets or liabilities. Claims against an entity are liabilities if they decrease the net assets of that
entity. They are assets if they increase the net assets of the entity.

Ownership-Settlement Approach

This classifies instruments according to return and settlement requirements. Under this approach,
the following instruments are considered equity:

- Basic ownership instrument

- Other perpetual instruments, such as preferred shares
- Indirect ownership instruments settled by issuing related basic ownership instruments

Reassessed Expected Outcome (REO)

It classifies an instrument depending on the direction of movement of fair value of the financial
instrument compared to the direction of movement of the fair value of the basic ownership
instrument.

It is noteworthy that depending on whether an instrument is equity or debt affects it in the following
three ways:

- whether a purchaser is guaranteed return on his investment

- whether the instrument is subordinate to other instruments in case of bankruptcy

- whether the instrument receives favourable tax treatment.

20 | P a g e
 CHAPTER FOUR

USE OF FINANCIAL INSTRUMENTS

The core objective of a financial instrument is to provide capital for business to an entity. However,
financial instruments may be used for any of the two purposes:

i. Hedging risks

ii. Enhancing Yield/Making profit

Hedging risks

This function is fulfilled when an instrument is purchased with the sole aim of protecting its price
in future. The buyer or seller thereof gets an assurance that even if the price of the instrument falls
in future, his interest will not be affected.

Derivatives are the products that play hedging function. They derive their values from underlying
assets. They include forwards, futures, options, swaps.

For example, a cereal company may enter into a contract to purchase a certain quantity of wheat
at a certain price within a period of six months from a farmer. In this case, the underlying asset is
the wheat, while the contract is the derivative. The factory has hedged itself against the risk of
future increment in wheat price. On the other hand, the farmer has hedged himself against the
possibility of suffering loss in case the wheat prices drop.

Enhancing Yields/Speculation

Speculation – the practice of buying or selling stocks, commodities, land, or other types of assets
hoping to take advantage of an expected rise or fall in price.

21 | P a g e
Derivatives, and other financial instruments, may also be used as profit making tools. For example,
in share market, a purchaser may buy shares of a certain company in the hope that the shares will
appreciate in value in future at which point he will sell them, thus making profit.

Same applies to derivatives. Still on the example of a wheat forward contract discussed under the
hedging risk function, a third party may purchase the forward hoping to take advantage of the rise
in wheat prices. Therefore, compared to the wheat farmer and the cereal factory which created a
forwarded contract to protect against the risk of change of price, the third party buys the forward
on speculation that he will benefit from it when the price of wheat increases.

22 | P a g e
 CHAPTER FIVE

SECURITIES

Introduction

As stated earlier, the capital markets create an arena where the investors obtain capital for their
businesses, while the lenders are able to find a variety of businesses in which they can put their
money. The lenders, upon investment, are put in possession of financial assets known as Securities.

Types of Securities

Under Section 2 of the Capital Markets Act, Securities are defined as:

““securities” means—

(a) shares in the share capital of a company ("shares");

(b) any instrument creating or acknowledging indebtedness which is issued or proposed

to be issued ("debt securities");

(c) loan stock, bonds and other instruments creating or acknowledging indebtedness by or
on behalf of the Government, Central Bank, or public authority ("Government and public
entities");

(d) rights, options, or interests, whether described as units or otherwise, in, or in respect of
such shares, debt securities and Government and public securities;

(e) any right, whether conferred by warrant or otherwise, to subscribe for shares or debt
securities ("warrants");

(f) any option to acquire or dispose of any other security;

(g) futures in respect of securities or other assets or property;

(h) securities and collective investment scheme products structured in conformity with
Islamic principles for investments;

23 | P a g e
 (i) units in a collective investment scheme, including shares in an investment company, or
other similar entities whether established in Kenya or not;

(j) interests, rights or property, whether in the form of an instrument or otherwise,

commonly known as securities;

(k) the rights under any depositary receipt in respect of shares, debt securities and warrants
("depositary receipts");

(l) asset backed securities; and

(m) any other instrument prescribed by the Authority to be securities for the purposes of
this Act, but does not include—

(i) securities of a private company, other than asset backed securities;

(ii) bills of exchange;

(iii) promissory notes, other than asset backed securities;

(iv) certificates of deposit issued by a bank; and

(v) any other instrument prescribed by the Authority not to be securities for the
purposes of this Act;”

Shares

A share is an indivisible unit of capital which expresses ownership relationship between the holder
of the share and the entity. The denominated value of the share is its face value. All the
denominated values of the issued shares, put together, translates to the capital of the entity.

A Share is the interest of a shareholder in a company measured by a sum of money.

Debenture

Is a type of security backed by the general creditworthiness and reputation of the issuer. They are
not backed by physical assets or collateral. Issued mostly by governments and corporations to
secure capital.

24 | P a g e
Bill

Is a document evidencing one person’s indebtedness to another.

Bond

It is a debt security under which the issuer owes the holder a debt. The issuer is obliged to pay the
holder interest thereon. Principal amount is returned to the holder on the date of maturity.

Futures

Is a binding contract made on the floor of a futures exchange to buy or sell a commodity or a
financial instrument on a stated future date and at a specified price. They are standardized contracts
in terms of quantity, quality, delivery location and delivery time. Usually, there is no actual
delivery of the specified item; what happens is that the futures are settled through counter-
contracts.

Futures are very useful because by securing the future price of a commodity or security, they
prevent the risk of wild fluctuations.

Options

Are contracts in which the seller gives the buyer the option, but not an obligation, to buy or sell a
specified number of shares within a set period of time.

Mortgage-backed Securities

These are investments that are secured by mortgages. They are asset-backed securities. This allows
investors to benefit from mortgage business without having to buy or sell an actual home loan.

Mutual Fund

Is a professionally managed investment scheme that brings together a group of people and invests
their money in stocks or other securities. Usually, it is operated by an asset management company.

25 | P a g e
DEBT SECURITIES

A businesses entity needs capital to be able to operate. One of the ways of obtaining capital is to
borrow from the public. To this end, various forms of debt securities have been created. Debt
securities are also known as bonds. They are attractive to the investor because they are low-risk
financial instruments. However, they attract lower interests.

Bankruptcy – in case of bankruptcy, holders of debt securities have claims that rank higher than
shareholders.

Business ownership – holders of debt securities have no ownership rights over the issuer of a debt
security. Therefore, they don’t have a say in the management of the business.

Equity – Debt securities do not dilute the equity or ownership rights in a business.

Some Definitions

Per Value

This is the principal amount of the debt obligation that the issuer repays the buyer upon maturity.

Coupon Rate

This refers to the rate of interest that will be paid on the principal amount.

Classification of Bonds

Short-term Bonds

These are bonds that have a life of between 30 days to 5 years.

Mid-term Bonds

Have a lifetime of between 5 to 12 years.

Long-term Bonds

Have a lifetime of between 12 to 30 years.

Debt securities include:

26 | P a g e
- bonds

- indenture

- mortgage-backed securities

- Repurchase Agreements (Repos)

BONDS

These are debt instruments which are issued by governments or government entities that guarantee
payment of interest on the principal amount and the return of the principal amount at the maturity
date. It can also be issued by a non-government corporation. There are various categories of the
issuers of bonds. These include:

Government Bonds

This may be issued by the national government agencies.

Municipal Bonds

These are issued by municipal authorities to raise revenue for public expenditure. In the case of
Kenya, entities that fall under this category for purposes of raising revenue are the county
governments.

Article 212 of the Constitution of Kenya requires that borrowing by a county government must be
guaranteed by the national government. Therefore, a county government bond must be guaranteed
by the national government.

Corporate Bonds

These are issued by corporations for raising of capital.

27 | P a g e
INDENTURES

It is a contract entered into by a corporation issuing a bond or debenture and a trustee for the
holders of the said bond or debenture, describing the rights of the issuer and the holders.

An indenture clearly states the responsibilities of a trustee. A trustee in this instrument usually
passive during the existence of the trust, and is only called into action where there is default on the
part of the issuer.

Once there is default on the part of the issuer, the trustee is required to collect all money owed to
the bondholders. He is under effective duty to protect the interest of the holders; he may not escape
liability if he fails to discharge this duty.

An indenture should carry the following terms:

- maturity date of the bonds

- the interest rate

- redemption, subordination and convertibility features

- registration, transfer and exchangeability of ownership provisions

- covenants of the trust

- default definitions, provisions and remedies

- procedures for amending the indenture

Repurchase Agreement (Repo)

It is a financial instrument that provides a mechanism for short-term borrowing. It provides for
sale and repurchase of a financial instrument. They are often used by governments.

Repos have the status of secured loan because the security acts as collateral in the event of default.
They are, however, different from loans because the title passes from the seller to the buyer.
28 | P a g e
Reverse Repos – these are the opposite of repos, that is, they are bought with the right of reselling
them to the seller.

Mortgage-Backed Securities (MBS)

These are financial instruments that use pools of mortgages as collateral for issuance of securities.

They are created by buying mortgage loans from the banks or mortgage companies, repackaging
the accompanying credit risk, then selling that risk to the investors in form of securities.

The mortgage-backed risks can be broken down further into four categories:

- mortgage-backed bonds

- pass-through securities

- collateralized mortgage obligations and real estate mortgage investment conduits

- stripped mortgage-backed securities

Mortgage-backed bonds

The obligations of the issuer are credit enhanced through the pledging of specific mortgages as
collaterals.

They don’t involve the sale or conveyance of ownership of the mortgages acting as collateral.

Pass-through Securities

The mortgages are placed in a trust and certificates of ownership sold by the issuer to the investors.
The issuers act as conduit by collecting monthly cash flows from homeowners and distributing the
same proportionally to the holders of the certificates.

Pass-through certificates represent the sale of assets from the issuer to the investor.

29 | P a g e
The owner of this security receives a pro rata share in underlying mortgages.

Collateralized Mortgage Obligations (CMOs) and Real Estate Mortgage Investment

Conduits (REMICs)

These represent ownership interest in the cash flows arising from the underlying pools of
mortgages or mortgage securities.

A single-purpose entity is created. It holds the mortgage collaterals and funnel payment of cash
flows from homeowners to the investors.

CMOs and REMICs differ from Pass-Through Securities in as far as ownership of underlying
mortgages is concerned: the former entitles the holder to ownership of cash flows only, while the
latter entitles the holder to pro rata ownership of the underlying mortgages.

Stripped Mortgage-Backed Securities

Under this category, an investor owns either the principal amount or interest cash flow from a pool
of mortgages or pass-through securities.

30 | P a g e
 CHAPTER SIX

DERIVATIVES

They provide means of shifting risk from one party to another counterparty that is more willing or
able to bear the risk.

The party assuming risks may do so with the aim of either making profit from purchasing the
derivative or to manage its own risks.

Derivative Transaction- is a bilateral contract or payments exchange agreement whose value

derives from the value of an underlying asset or underlying reference rate of index.

Functions that derivatives serve include:

- hedging against market risks

- management of assets and liabilities

- lowering of funding costs

- speculation for profits.

Derivatives are used to manage risks by enabling user to isolate, trade and transfer one or more
distinct risks.

Counterparty Risks and Credit Ranking of Derivatives during Insolvency

In a derivative contract, risk is transferred from one party to another. It is therefore important that
a counterparty to whom the risk is transferred has a strong credit-worthiness. The collapse of such
counterparty may cause system problems to the capital markets, apart from the fact that the
counterparty who transferred the risk from himself may suffer huge losses.

Huge losses may be suffered by a holder of derivative when a counterparty becomes insolvent
because the holders of derivatives are considered unsecured creditors, hence will be subject to the
regulations of insolvency that apply in ranking of creditors for purposes of distribution of the estate

31 | P a g e
of an insolvent entity. Since creditors hardly obtain their entire claim from an insolvent debtor, a
derivative holder will suffer losses because he will not be able to obtain the entire value of the
contract.

To avoid imminent losses to counterparties, governments have had to bail out entities in financial
distress.

Categories of Derivatives

There are two categories of derivatives, namely:

i. Over-the-Counter Derivatives

ii. Standardized Agreements.

Over-the-Counter Derivatives

Over-the-Counter derivatives are privately negotiated and traded agreements. They are contracts
that are directly negotiated between the counterparties. These contracts allow parties to negotiate
specific terms of the contracts, hence come up with contracts tailored to its specific needs.

This kind of contracts, however, tend to be subject to counterparty risks.

Usually, counterparties are not required to maintain certain margin of deposits to guard against
risks.

Standardized Agreements

These are traded through an organized exchange. Standardized agreements virtually eliminate
credit risks.

In standardized agreements, the buyer is one counterparty on one side, while the exchange (such
as the Nairobi Security Exchange) is the second counterparty.

The exchange imposes its own margin requirements on open contract. This requires the
participants to maintain a certain balance with the exchange over the life of a derivative.

32 | P a g e
The exchange takes steps to minimize its own counterparty risks by regulating other market
participants to ensure their financial integrity.

The table below shows the difference between the standardized agreements (Exchange-Traded and
the Over-the-Counter Agreements (OTC).

STANDARDIZED (EXCHANGE- OVER-THE-COUNTER

TRADED
Centralized market place Bilaterally negotiated
Standardized terms Flexible terms
Daily mark-to-market Collateral agreements
Constant maturity Mature over time

Shifting Risk in Derivatives

A derivative, as a tool of managing risks, is used to confer the right over an underlying asset whose
owner does not have an immediate need or ability to transfer the said asset. The contract thus locks
the future price of the commodity, therefore guarding against the risk of change of price in future.

Leverage

This is defined as making investment with a small upfront monetary commitment using borrowed
fund.

OTC derivatives may not require any payments towards the underlying asset until the derivative
matures.

Exchange-traded derivative may only require minimal payment (good faith margin deposit) at the
time a position is opened.

Leveraging basically serves to obtain future control over an asset that has not already been
purchased.

The market price of a derivative does not only consist of the spot price of the underlying asset, but
also carry costs that would be incurred in holding down the underlying asset until future

33 | P a g e
transaction. The carry costs could include items such as storage costs if the item is a physical
commodity. Carry costs decrease as the derivative moves closer to maturity.

A derivative constitutes a loan transaction because the ownership of the underlying asset is
effectively transferred to the buyer without payment of the price of the underlying asset
immediately. The non-payment from the date of contract formation to the date of the maturity
constitutes an extended loan.

Carry Costs – they tend towards zero as the derivative moves closer to maturity.

Market price – they tend towards spot price of the commodity as the derivative moves towards
maturity.

Market Risk

Market risk is defined as the potential for change in market prices. Derivatives are forward looking,
hence they are used to keep in check the market risk. The market risk is determined by four factors,
namely;

- interest rates

- exchange rates

- equity prices

- commodity prices

Types of Derivatives

There are four types of derivatives, including; futures, forwards, options and swaps.

1. Forwards

Is a contract between two counterparties for exchange of a specified amount of a product for a
specified price to be paid at a specified date or dates in future.

The terms of the Forwards are not standardized. This makes it different from the Futures whose
terms are standardized.

34 | P a g e
Forwards are not traded in an exchange market. This marks another difference between a Forward
and Future; the latter is traded at the exchange.

They are privately negotiated bilateral contracts; hence they fall under the OTC agreement class.

The disadvantage is that since they are not traded in exchange markets, the seller goes through the
trouble of finding a buyer by himself.

A Forward is meant to facilitate the sale and delivery of a physical commodity. It is meant to
ensure that the physical commodity is available for physical delivery on the date of maturity.

In In Re Borden Chemicals and Plastics Operating LP v Bridgeline Gas Marketing, LLC, the
position that Forwards contemplate actual delivery of the underlying physical commodity was
emphasized. In this matter, the plaintiff had made payments for natural gas prior to filing for
bankruptcy under the US law. Gas delivery was made a month later. The trustee sought the return
of the payments during the statutory period. Bridgeline argued that payments made by Borden
were protected by the US Bankruptcy Code because they were settlement payments pursuant to a
forward contract. The court acknowledged that the distinguishing feature of a forward contract is
that a party is expected to make actual delivery. The court held that since the agreement between
Borden and Bridgeline contemplated actual delivery, the agreement constituted a Forward
Agreement; hence it was protected from any of the Borden’s bankruptcy claims.

Futures

These contracts are the same as forwards. The main difference is that Futures are exchange-traded,
while Forwards are private bilateral agreements.

The chief purpose of a Future is not to transfer the ownership, but the risk of the underlying
commodity.

Even though futures include the terms of future delivery of the commodity, the delivery is usually
not common as a future contract usually contains the terms of settlement in lieu of delivery either
through cash settlement of offsetting transactions.

How Futures Reduce Counterparty Risks

This is achieved by the following elements of a Future:

35 | P a g e
i. They require a performance bond. A performance bond is created by making a “good
faith” margin deposit as collateral for the transaction.

ii. Futures are marked-to-market on a daily basis with an exchange of cash flow between
firms.

iii. Futures exchange recognize only exchange members as counterparties to individual

transactions.

Futures as Hedging Instruments

Futures possess more qualities as hedging instruments compared to forwards which are suitable as
profit-making instruments.

Large pool of assets – many assets and commodities are suitable for Futures contracts. Agricultural
commodities were the main underlying assets in Future contracts. Other non-agricultural
commodities were thereafter included, such as metals and other instruments such as foreign
currency.

Standardized terms of Contract – since futures terms of contract are standardized, the liquidity in
them increases because many participants may trade in the same financial instrument.

Exchange Acts as Clearing house – it acts as buyer to all the sellers and seller to all the buyers.

Only a Margin of the total value required – participants are not required to put up the entire value
of the contract, but just a fraction of it.

Differences Between Futures and Forwards

FUTURES FORWARDS
1 Traded in Exchange Bilateral private contracts
2 Standardized terms of contracts Terms of contract tailored to suit
counterparties

36 | P a g e
 3 Delivery may be extinguished through Actual delivery is intended
cash settlement or offsetting
transactions
4 Mostly serves the function of transfer of Mostly serves the function attaining
risk merchandize goals
5 Requires “good faith” marginal deposit Marginal deposit not a precondition
as collateral

Foreign Exchange Forwards and Futures

Counterparties may enter into a Forward or Future agreement for the buying and selling of an
underlying foreign currency at a certain rate at a specified future date. This transaction involves
the exchange of a notional capital between the counterparties. The specified future exchange rate
normally differs from the spot exchange rate (current exchange rate).

If the future agreed exchange rate in the Forward or Future is greater than the spot exchange rate,
the currency is said to be trading at premium.

If the agreed exchange rate is lower than the spot exchange rate, the currency is said to be trading
at a discount.

A future or forward contract for foreign exchange often requires a margin for collateral purposes.
This is usually a fraction of the notional amount of capital being traded.

Options

These are derivatives which give the right, but not the obligation, to buy the underlying asset,
instrument or index on or before the option’s exercise date at a specified price referred to as the
strike price.

A call option – gives the right, but not the obligation, to the call option purchaser to buy a specific
quantity of underlying asset from the call option seller on or before the exercise date at the strike
price.
37 | P a g e
A put option – gives the right, but not the obligation, to the put option purchaser, to sell a specific
quantity of underlying asset from the put option seller on or before the option’s exercise date at
the strike price.

The price paid by the buy of an option is called premium.

Options allow counterparties to speculate or hedge on an asset’s price movement using very little
capital (a high degree of leverage)

Swaps

A swap is an over-the-counter derivative contract in which two parties agree to exchange cash
flows on a notional amount over a period of time in the future.

Characteristics of Swaps

i. They are privately negotiated, just like the OTCs. Therefore, they are similarly placed as
OTCs in terms of risk exposure.

ii. They have extreme flexibility allowing them to be crafted to meet the specific needs of
the counterparties.

iii. Swaps have a beginning valuation date, intermediate swap interest exchange dates, and a
final termination date.

Parties often enter into numerous swap transactions in the course of business relations. As a result,
parties have developed a practice of reducing these transactions into one master agreement.

The International Swaps and Derivatives Association (ISDA) which is a financial trade association
consisting of institutions that deal in OTCs, came up with a standardized contract for swaps called
the “ISDA Master Agreement”.

ISDA Master Agreement

Allows parties entering into a swap relation to document all their derivative transactions under one
document.

38 | P a g e
ISDA Master Agreement reduces costs. For instance, the Master Agreement provides for netting
payments due to each party under a single transaction. This basically means that the parties should
compute what each party owes to the other and then find the net difference, which is then paid to
the party entitled thereto.

Example of the relationship in which ISDA Master Agreement may be applicable is the money
transfer between banks.

Individual transactions under ISDA Master Agreement are memorialized in supplements called
“Confirmations”.

In case of default by a party, Master Agreement allows for setting of an early termination date by
the aggrieved party which is effective across all the outstanding transactions. Once an early
termination date is designated, all the outstanding transactions are netted and a single value that is
owed to a party from all the outstanding transactions is arrived at.

This protects the non-defaulting party against the claims from bankruptcy trustee/liquidator in case
of insolvency. The non-defaulting party is unhooked from the risk of losing the amount owed to it
by the defaulting party, which, in the absence of ISDA Master Agreement, could just be treated as
an unsecured creditor.

39 | P a g e
40 | P a g e