Capital market regulations and the regulator: Changes to the securities laws

Colombo Stock Exchange CSE Bourse investors 

The capital markets of Sri Lanka operated without too many glitches from way back as 1896; during which time, the survival of the market was underpinned by good ethical regulations and practices, with no recorded history of any incidents or issues questioning the integrity of the market. 

The birth of securities laws in Sri Lanka could be dated back to 1987. Since then, the Act has been amended three times; with the introduction of unit trusts in 1991 and in 2003 and 2009 respectively to upgrade the takeovers and mergers code to reflect unaddressed legalities and to enhance visibility and disclosures.

Over the years, the Sri Lankan capital market has grown exponentially and has been subject to constant refinement. Therefore, I believe it is imperative that we advocate change to the 35-year-old principal Act that we have before us which may not address the modern sentiments, issues and concerns. 

A Securities and Exchange Bill was presented in 2018, approved by the Cabinet but unfortunately did not see the light of day due to the change of regime. What I will attempt is to deliberate on some aspects of the 2018 Bill, other pressing concerns, and lacunas in the current system, in the hope that it will prompt the regulators to take some note in preparation of the new Bill. 

The 2018 Bill that was before Parliament included some positives which are seen in developed markets that were topical and much-needed reform to our system. Some of those features were inter alia; 

i. Expansion of powers, rights, duties, and remedies; 

ii. Stricter regulation and oversight; 

iii. Duties of auditors under the regulations; 

iv. Whistleblower protection; 

v. Civil remedies for insider dealings; 

vi. Capture more market participants. 

One of the vital characteristics of any legislation is its objective clauses. In the recent Bill that was presented to Parliament, certain changes were proposed to the new Act. The four object clauses of the said Bill are; 

a. To establish the Securities and Exchange Commission of Sri Lanka for the creation and maintenance of a fair and efficient and transparent securities market; 

b. To protect the interest of investor both local and foreign; 

c. To ensure the maintenance of high professional standards in the provision of services under this Act; 

d. To mitigate systematic risk in the financial system. 

It is noted that even the old Act consists of four objects. However, clause (d) of the proposed Bill provides to ‘mitigate systemic risk’ in the financial system. This clause stands out to be unusual and its suitability for a disclosure-based regulatory system is debated. This clause would take the regulation inching towards a merit-based regulatory regime. This particular aspect would have to be deliberated further and an informed decision must be made on the matter after wide consultation with appropriate stakeholders. 

The Commission 

Securities commissions in developed countries the USA, UK, Malaysia, Singapore, Hong Kong, Australia, etc., are known to have executive commissions; however, this is not considered a suitable approach for developing countries. Accordingly, developing countries have non-executive commissions. 

In most developed countries like the USA, commission members are permanent and are executives. They are duty-bound to make decisions on behalf of the office they hold (regulator). In countries like ours that are developing, full-time commissioners are not an option due to the scarcity of professionals and commissions are non-executive. Hence the commission members are vested with the responsibility of limiting their scope to activities revolving around policy-making than an executive body. 

However, we find a deviation from this, where the commission has assumed the responsibility and is tasked with executive decisions on behalf of the secretariat. Further, as such appointments carry a political undertone, the appointees assume a sense of responsibility to carry out acts that are ultra vires to their policy-making role provided in the Act. It is clearly articulated in the proposed Bill that the chief executive officer of the secretariat is the Director-General, and the Director-General alone is vested with the authority to make executive decisions. 

In an ideal situation, the commission is to be tasked with macro-level policy-making for the securities market rather than micro executive decisions. As such, the Commission will not need to spend an inordinate amount of time conducting day-to-day operations involving listings, staff matters and the likes, paving way to remove deep rooted operational inefficiencies. 

The independence of the office of the Director-General is preserved under the current Act and should be, as the appointment and the removal are decided by the Minister himself and not the Commission. Therefore, the staff would function under his executive authority. 

The recent proposed Bill made a deviation from this norm and included provisions allowing the commission to appoint the Director-General rather than the Minister, thus, compromising the independence of the office of the Director-General. Further, the commission is also empowered to remove from office the Director-General by a 2/3rd majority on grounds that are stated therein. This creates the possibility of dissent in a well-functioning commission. 

The Cadbury Commission Report on Corporate Governance spelled out two decades ago, clearly articulates that for the functioning of a corporate the separation of ownership and management is a vital component, for the success and development of an entity. A parallel can be drawn to this rule in the context of market institutions and to hold true to this day.

As for the legal representation of the commission, the Constitution provides for any State institution to be represented by the office of the Attorney General’s Department in any legal matter. The recent Bill includes a provision that empowers the non-executive Chairman to appoint an Attorney-at-Law from the Commission or any other Attorney-at-Law to represent the commission. This section seemingly adds to the unusual provisions contained in the new Bill. 

It is not a farfetched conclusion to draw, that if the provisions of the new Bill are brought into law, it would create a circumstance that cripples the growth of the office of the Director-General as it tends to encourage a radical decision-making environment and deviates from the true point of such regulation i.e. policy-making. 

Demutualisation and parallel regulations 

The new regulations will have to be brought up by the policymakers for the regulation of markets and market institutions in line with other developed jurisdictions. The regulation of a de-mutualised exchange would take utmost priority for such a market to function efficiently and successfully. Currently, the regulation permits only licensing of a single (one) exchange for Sri Lanka, and the policy should be to move away from a single institution to a competitive framework of more exchanges. Accordingly, it is paramount that the Act to demutualise the Colombo Stock Exchange will need to be parallel to these regulations

Regulations will also have to be brought to strengthen clearing and settlement, i.e., clearinghouse and central depository system which will take away the risk that is currently prevalent in the market. Sri Lanka also has to be mindful that it should internationalise securities markets and permit cross-border transactions in the wake of moving towards an international financial hub in the region. 

The SEC should also permit the securities of a licensed stock exchange to be listed on its exchange for greater governance and transparency. 

Duties of auditors

In a more contemporary securities regime, the duties of auditors should come under scrutiny and regulation with their scope being expanded to make listed and market institutions more transparent. An auditor should be given the right in the event of any contravention of any rules or regulations which may adversely affect the financial position of the listed public company to a material extent, the auditor shall immediately report such matter or non-compliance to the audit committee in writing to, and if no remedial measure is taken within two weeks, refer the matter to the Board of Directors in writing to rectify the breach, or deter the commission of a breach that has not yet happened. 

If no action is taken the auditor must notify the Commission and the Exchange and appropriate disclosures made to shareholders. Such empowered auditors would create an environment where investors are more comfortable in trading in such a market and maintain transparency in all market functions. 

Market misconduct

All market misconduct will need to be brought under the main Act and not in regulations that currently exist in the current Act. Under market misconduct, the following will need attention;

a. False trading, market rigging, and market manipulation 

b. Insider trading.

c. Stock market manipulations; 

d. False or misleading statements; 

e. Fraudulently inducing persons to deal securities; 

f. User manipulative and deceptive devices. 

Insider dealing provisions will need to be expanded to capture a wide variety of instances that an insider may attempt to create an environment that is not a level playing field. 

The need for compounding of offenses

The major offenses including insider dealing will not fall under the ambit of compounding the offense by paying a fine and without the admissions of guilt as in the last Bill. In Securities offenses and financial fraud, it is important to note that sanctions need to be implemented that would be practical and enforceable and the offenders should be dealt with actions that will hurt them most, professionally, and that is imposing fines and penalties that will create a dent in their reputation. 

There is another train of thought that compounding should and must be permitted as a more practical approach to offending. With our current legal system and the laws’ delays to reach a finality of a criminal case from a Magistrates Court to a superior Court will take a good number of years. Testimony to that is a case filed by the SEC in1996 is still awaiting an order from the Supreme Court. Hence compounding all offenses as done currently is a way forward and make public the offenders which will create reputational damage to the parties involved. 

In an evolved system, the punishments should not reflect the common reaction of i.e. jail time and other like limitations of liberty, rather offenses such as the above should be met with more a progressive approach such as suspension, penalties, financial loss, and other reputational damage, etc. As white-collar crimes cannot be treated the same as a quintessential criminal offense. 

Changes to the Takeovers and Mergers Code 

The Takeovers and Mergers Code of 1995 was only amended in 2003 to facilitate instances where an offeror was incapable of fulfilling his obligations under the code. The Takeovers and Mergers Code has functioned so far without causing many issues and not disturbing the momentum of the market and can stay as it is with a few clarifications and adjustments to its implementation. Our market is not ready to accept a complicated takeover and mergers law that are prevalent in developed markets. 

Some of the observations on the Takeovers and Mergers Code;

• Section 26(8) speaks of a comparable offer to the other class of shareholders. The offer is made necessary for the takeover and the control of the company and the additional responsibility of making an offer for non-voting shares and other categories of shares will be an unnecessary burden and depicts the purpose that is enshrined in the Code. This class of other shareholders should be aware of their rights and responsibilities. 
• The Code provides that any offer has to be “declared unconditional as to acceptance” and states that 50% or more shares would be the test for acceptance (section 19). The clarity of this statement is yet in discovery mode and is something that would need to be addressed. This particular section speaks of a person acquiring over 30% shares and is mandated to make an offer under the Code and;

a. Acquires over 50% or more of mandatory shares of the offer will be required to accept the shares offered; 

b. In the event, he is unable to acquire more than 50% of shares, what would be the outcome? 

i. Is the offeror entitled to acquire the shares that were offered; 

ii. If he does, will the purpose of the Takeovers and Mergers Code be made redundant? It could lead to more than one party having over 30% more shares, and a tussle for control will and can be eminent. In a situation such as this, isn’t it prudent to ask the offeror to divest shares below 30% as the offer has failed? As such, point a. and b. above should be deliberated further and a justifiable and equitable answer should be found. 

It is my humble opinion that it is time for the Act to be empowered to heightened regulatory scrutiny and that it should not contribute to undermining the investor confidence and the operations of the SEC, rather it should be a factor that fosters robust development of the capital market.

Needless to say, policy-based oversight which directs the functioning of an efficient, orderly and well-regulated market, with improved transparency, integrity, governance, assuaging negative public sentiment is imperative to create an ecosystem where capital market players can transform the way they operate, making optimal decisions within a sound legal framework. The SEC, CSE together with other stakeholders should attempt to move Sri Lanka with rigour towards achieving a status of being a share owning democracy.

(The writer is an Attorney-at-Law, Solicitor of the United Kingdom and Wales, a former Director-General of the Securities and Exchange Commission of Sri Lanka, and a Senior Advisor of the Ministry of Finance. He is now a legal consultant practicing in Financial Markets.)