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by R.M.B Senanayake
The stock market has lost the confidence of investors, particularly the retail investors, because of the allegations of market manipulation, front running and insider trading. What should be done to restore confidence? The allegations about insider trading and front running by broker firm employees were made plausible because of the lack of adequate and timely disclosure by the directors of the listed companies.
Big time investors are alleged to have pushed up prices of selected shares and brokers are accused of selling them to retailers who knew little or nothing about the fundamentals of a company and whether it was worth the high price fetched in the market. Having pushed up the prices, these big timers allegedly sold their shares and the prices tumbled swiftly. Small timers without immediate access to on line trading depended on their brokers. Some of these so-called investment advisors in the broker firms were themselves trading actively on their own account and instead of discharging their fiduciary duty to their clients used their accounts to trade for their own benefit as well.
Disclosure rules – directors trading
To minimize insider trading, Stock Exchanges have in place rules regarding disclosure by listed companies. Listed companies have to publish quarterly earnings figures within two months of the ending of the quarter and the Annual Accounts within five months of the end of the financial year. This seems to be an inordinately long time for the disclosure of the company’s earnings. In contrast, in American stock markets the financial results of the listed companies must be disclosed within 40 days after the end of the quarter for quarterly results and 60 days after the end of the financial year for annual accounts. If they fail to comply, the directors should be held personally responsible.
Presently there is no period when insiders are prohibited from trading in the shares of their company. The rule merely states that they should not buy before the financial results are published. But this rule is too weak. Insiders should be banned from dealing in their shares from the end of a financial period until the results are disclosed. Directors should not be allowed to trade in the shares of their company until the quarterly reports are published.
Directors are also required to disclose their trades to the Exchange which then publishes them in the daily report. But they delay such disclosure. They should be called upon to disclose their trades within 24 hours.
Content of disclosures
The listed companies are also required to make prompt announcements of any price sensitive events or occurrence. But the Directors may sit on such events or occurrence pondering on them without issuing an immediate public statement. This gives the opportunity to interested parties to leak such information to others and the information eventually reaches broker firm employees who could profit from such price sensitive information.
Certain disclosures regarding Corporate Governance have to be made in their Annual Report by listed companies.
Content of the Annual Report- A Code of Corporate Governance
As for the content of the disclosures, the practice in other Stock Exchanges seems to be based on a Corporate Governance Code which the quoted companies are required to follow. We should draw up a Corporate Governance Code for listed companies through discussions with the Association of Directors and it should be made binding on the listed companies by law. The following are some provisions in the UK Code of Corporate Governance which I think are relevant for us to adopt.
The Duties and Responsibilities of the Board of Directors, the Chairman and the Chief Executive should be laid down and published in the Annual Reports. The delegation of power to the managerial cadres should also be spelt out in such Code and published in the Annual Report. The Annual Report of the Company should state whether these provisions were complied with.
There should be a clear division of responsibilities between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision.
The date of appointment of each director, the length of service of each director as a director and, where applicable, the length of service of each director on a board or committee should be disclosed in the Annual Report.
A detailed description of the skills, expertise and experience that each of the directors brings to the board should also be included in the Annual Report. Where a company has directors who have been nominated by the government, a reasoned explanation for such appointments including a description of the skills and expertise these directors bring to the board as provided by the government authority or a statement that no such description has been provided to the company should be stated in the Annual Report.
Disclosure of Off market Trades
Several investors are doubtful about some of the "Crossings" carried out on the trading boards. These are off market trades and do not form part of the auction system. It is best to accept the situation and report them as off market rather than count them as part of the day’s trades which gives a misleading picture to the retail investor about the market when they do not form part of the market’s trading system. These are negotiated sales and the Stock Exchange should in my opinion report them as such. Their names should also be disclosed even if they are foreigners since they are off market. Some investors think they are not all arms length trades but transfers without change in beneficial ownership carried out for tax or other considerations. They then will mislead the investors by creating a false picture of the price of the share in the crossing.
Often they are mere transfers from one company to a connected partner and have been done for extraneous reasons and not because of any genuine investor interest in the share. For example there are many trades in JK Holdings. I remember their shares are also listed as GDRs in Luxembourg Exchange. Could there be arbitrage between the Colombo market and Luxembourg? Several JK Holdings shareholders also borrow against such shares for their other businesses. They would not like to see the price of shares which form their collateral for loans to fall, for it reduces their borrowing capacity. This is another reason to treat such crossings as off market trades which do not reflect their market price
Capital Requirements imposed by the Regulator
The Colombo Stock Exchange and the SEC have not kept pace with the growth in volumes in the stock market. The minimum net capital requirement is still Rs 35 million when the trading turnover exceeds several billions. Of this requirement only Rs 2.5 million has to be provided in cash. The broker firms have resorted to excessive leverage up to several times their capital. In the case of the banks the regulated capital is fixed as a ratio. I think in other countries too there is a maximum Capital/Assets ratio (leverage ratio) to be maintained by stockbroker firms which is about 10-12%. Our regulators did not have any such maximum leverage ratio in place and this made it possible for broker firms to leverage many times their capital. Remember that the total assets could include shares they hold ether on their own account or as shares of defaulting clients where the market value fluctuates. Sometimes they may carry debts which are not recoverable for which there should be provisions or even write-off. So when the broker firms allowed margin credit to their clients they extended such credit lavishly and as the share prices boomed with the extension of such margin credit the leverage of the Broker firms rose dramatically.
Clients misunderstand unrealized capital losses
Our investors fail to realize that unrealized losses are as much losses as realized losses. They prefer to hold on to shares which have fallen in price hoping that their prices would recover losing more and more money when holding them in a falling market. Some broker firms too made the same mistake until the SEC under Mrs. Sugathadasa introduced forced sales. The broker firms then rose in arms and got the authorities to defer the forced selling. But they could not force the authorities to change the computation of the Net Capital which required "hair cuts" ( reduction in the value at which these shares are held to reflect their true market values- a marking to market exercise).
So the excessive leverage is still carried in the books of the broker firms and they may be carrying bad debts as assets. There are no rules regarding provisioning for bad debts where the clients don’t have any collateral and do not pay up. None of the broker firms own their office buildings or have property. Their capital is mainly in the form of financial assets and the figures of their total assets reported in the Central Bank Annual Report show that there is excessive leverage. They have to de-leverage sooner or later although they may lobby government institutions like the EPF or the NSB to buy the shares in their portfolio to keep up their share prices. But the de-leverage process is inevitable and as long as there is the large debt overhang the market cannot have a sustainable recovery even if the listed firms report higher earnings.
http://island.lk/index.php?page_cat=article-details&page=article-details&code_title=71757
The stock market has lost the confidence of investors, particularly the retail investors, because of the allegations of market manipulation, front running and insider trading. What should be done to restore confidence? The allegations about insider trading and front running by broker firm employees were made plausible because of the lack of adequate and timely disclosure by the directors of the listed companies.
Big time investors are alleged to have pushed up prices of selected shares and brokers are accused of selling them to retailers who knew little or nothing about the fundamentals of a company and whether it was worth the high price fetched in the market. Having pushed up the prices, these big timers allegedly sold their shares and the prices tumbled swiftly. Small timers without immediate access to on line trading depended on their brokers. Some of these so-called investment advisors in the broker firms were themselves trading actively on their own account and instead of discharging their fiduciary duty to their clients used their accounts to trade for their own benefit as well.
Disclosure rules – directors trading
To minimize insider trading, Stock Exchanges have in place rules regarding disclosure by listed companies. Listed companies have to publish quarterly earnings figures within two months of the ending of the quarter and the Annual Accounts within five months of the end of the financial year. This seems to be an inordinately long time for the disclosure of the company’s earnings. In contrast, in American stock markets the financial results of the listed companies must be disclosed within 40 days after the end of the quarter for quarterly results and 60 days after the end of the financial year for annual accounts. If they fail to comply, the directors should be held personally responsible.
Presently there is no period when insiders are prohibited from trading in the shares of their company. The rule merely states that they should not buy before the financial results are published. But this rule is too weak. Insiders should be banned from dealing in their shares from the end of a financial period until the results are disclosed. Directors should not be allowed to trade in the shares of their company until the quarterly reports are published.
Directors are also required to disclose their trades to the Exchange which then publishes them in the daily report. But they delay such disclosure. They should be called upon to disclose their trades within 24 hours.
Content of disclosures
The listed companies are also required to make prompt announcements of any price sensitive events or occurrence. But the Directors may sit on such events or occurrence pondering on them without issuing an immediate public statement. This gives the opportunity to interested parties to leak such information to others and the information eventually reaches broker firm employees who could profit from such price sensitive information.
Certain disclosures regarding Corporate Governance have to be made in their Annual Report by listed companies.
Content of the Annual Report- A Code of Corporate Governance
As for the content of the disclosures, the practice in other Stock Exchanges seems to be based on a Corporate Governance Code which the quoted companies are required to follow. We should draw up a Corporate Governance Code for listed companies through discussions with the Association of Directors and it should be made binding on the listed companies by law. The following are some provisions in the UK Code of Corporate Governance which I think are relevant for us to adopt.
The Duties and Responsibilities of the Board of Directors, the Chairman and the Chief Executive should be laid down and published in the Annual Reports. The delegation of power to the managerial cadres should also be spelt out in such Code and published in the Annual Report. The Annual Report of the Company should state whether these provisions were complied with.
There should be a clear division of responsibilities between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision.
The date of appointment of each director, the length of service of each director as a director and, where applicable, the length of service of each director on a board or committee should be disclosed in the Annual Report.
A detailed description of the skills, expertise and experience that each of the directors brings to the board should also be included in the Annual Report. Where a company has directors who have been nominated by the government, a reasoned explanation for such appointments including a description of the skills and expertise these directors bring to the board as provided by the government authority or a statement that no such description has been provided to the company should be stated in the Annual Report.
Disclosure of Off market Trades
Several investors are doubtful about some of the "Crossings" carried out on the trading boards. These are off market trades and do not form part of the auction system. It is best to accept the situation and report them as off market rather than count them as part of the day’s trades which gives a misleading picture to the retail investor about the market when they do not form part of the market’s trading system. These are negotiated sales and the Stock Exchange should in my opinion report them as such. Their names should also be disclosed even if they are foreigners since they are off market. Some investors think they are not all arms length trades but transfers without change in beneficial ownership carried out for tax or other considerations. They then will mislead the investors by creating a false picture of the price of the share in the crossing.
Often they are mere transfers from one company to a connected partner and have been done for extraneous reasons and not because of any genuine investor interest in the share. For example there are many trades in JK Holdings. I remember their shares are also listed as GDRs in Luxembourg Exchange. Could there be arbitrage between the Colombo market and Luxembourg? Several JK Holdings shareholders also borrow against such shares for their other businesses. They would not like to see the price of shares which form their collateral for loans to fall, for it reduces their borrowing capacity. This is another reason to treat such crossings as off market trades which do not reflect their market price
Capital Requirements imposed by the Regulator
The Colombo Stock Exchange and the SEC have not kept pace with the growth in volumes in the stock market. The minimum net capital requirement is still Rs 35 million when the trading turnover exceeds several billions. Of this requirement only Rs 2.5 million has to be provided in cash. The broker firms have resorted to excessive leverage up to several times their capital. In the case of the banks the regulated capital is fixed as a ratio. I think in other countries too there is a maximum Capital/Assets ratio (leverage ratio) to be maintained by stockbroker firms which is about 10-12%. Our regulators did not have any such maximum leverage ratio in place and this made it possible for broker firms to leverage many times their capital. Remember that the total assets could include shares they hold ether on their own account or as shares of defaulting clients where the market value fluctuates. Sometimes they may carry debts which are not recoverable for which there should be provisions or even write-off. So when the broker firms allowed margin credit to their clients they extended such credit lavishly and as the share prices boomed with the extension of such margin credit the leverage of the Broker firms rose dramatically.
Clients misunderstand unrealized capital losses
Our investors fail to realize that unrealized losses are as much losses as realized losses. They prefer to hold on to shares which have fallen in price hoping that their prices would recover losing more and more money when holding them in a falling market. Some broker firms too made the same mistake until the SEC under Mrs. Sugathadasa introduced forced sales. The broker firms then rose in arms and got the authorities to defer the forced selling. But they could not force the authorities to change the computation of the Net Capital which required "hair cuts" ( reduction in the value at which these shares are held to reflect their true market values- a marking to market exercise).
So the excessive leverage is still carried in the books of the broker firms and they may be carrying bad debts as assets. There are no rules regarding provisioning for bad debts where the clients don’t have any collateral and do not pay up. None of the broker firms own their office buildings or have property. Their capital is mainly in the form of financial assets and the figures of their total assets reported in the Central Bank Annual Report show that there is excessive leverage. They have to de-leverage sooner or later although they may lobby government institutions like the EPF or the NSB to buy the shares in their portfolio to keep up their share prices. But the de-leverage process is inevitable and as long as there is the large debt overhang the market cannot have a sustainable recovery even if the listed firms report higher earnings.
http://island.lk/index.php?page_cat=article-details&page=article-details&code_title=71757
