regulation for corporate governance in pakistan capital markets

REGULATION FOR

CORPORATE GOVERNANCE IN PAKISTAN

CAPITAL MARKETS

eme CONTEMPORARY ECONOMICS

ADB Project TA 3696-PAK "Regulation for Corp. Gov."

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INTRODUCTIONCORPORATE GOVERNANCE:

FAIRNESS TRANSPARENCY/DISCLOSURE ACCOUNTABILITY

Checks and Balances Audits

1. Internal2. External

RESPONSIBILITY/DIRECTION


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BUT WHAT IF: FRAUD/DECEIT/LIES OPAQUENESS/LACK OF DISCLOSURE

• UNTIMELY• INCOMPLETE

CONFLICTS OF INTEREST SUBSTANDARD ACCOUNTING PRACTICES SINGULAR CONTROL LACK OF SHAREHOLDER RESPONSIBILITY NO REGULATION OR ENFORCEMENT


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Disclosure

RECOMMENDATION to

Companies,

Stock Exchanges,

and SECP:

Disclosure should be disclosed…on web sites


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Corporate Disclosure Policy—Basic Shareholder Rights

Immediate disclosure of material information Response to unusual market activityClarification of rumorsDealings by directorsNote on “Interlocking Directorates”


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Immediate disclosure of material information--Code

• Buying or selling of company’s shares, by Director, CEO, or executive (xxvi)– To Company Secretary within 4 days of transaction

– “Closed period”/Insider trading

• Results, business decisions, or news that may materially effect market price – To Exchange, review need for trading halts

– Before news to media; during non-trading hours

RECOMMENDATION: during non-trading hours; to Exchanges BEFORE dissemination.


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WINNERS LOSERS

GOOD PRACTICES BAD PRACTICES

Shareholders Stakeholders Management Directors Company Exchanges SECP Government/Economy

Shareholders Stakeholders Management Directors Company Exchanges SECP Government/Economy


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Immediate disclosure of material information—ACT-UP Elements

• Accurate

• Complete

• Timely

• UP-to-date


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Other (Immediate) Disclosures

• Related Party Transactions– Personal/Company Loans– Personal/Company Purchases/sales

• Remuneration Package of Directors, Executives, and CEO (in Annual Report)– Including Stock options (off balance sheet)– Severance pay, bonuses, service contracts

• Compliance with Code of Corp. Gov.– Need to explain non-compliance– Web site postings


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Disclosure and Other Recommendations

• Board approves related party transactions

• Form Remuneration Committee…NEDs

• Company must explain ANY non-compliance with Code

• Company, SE, and SECP to post on web sites the compliance statement and explanations for non-compliance


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Disclosure Policy--Response to unusual market activity and

clarification of rumors

• Material or not material?

• Immediate Response

• Refute or confirm or clarify

• Research if necessary

• Registered person as source?


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Continuous Disclosure Requirements

Sufficient notice for shareholders meetings Pre-emptive rights Quarterly and annual accounts reporting Compliance with accounting standards Fixing of book closure datesWhistleblowers…tips from public and professionals


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Continuous Disclosure (cont.)

• For Equitable Treatment of Shareholders• To Protect Share(Stake/Policy)holders’

Rights• At Annual Meetings

– Notices– Voting

• In Annual Report– Accounting practices


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Shareholders’ (Customers’) Complaints

• Written complaint to company– Response?

• At annual meeting…heard? Satisfied?• Complaint to Stock Exchange

– Satisfactory response?– Arbitration?

• Complaint to SECP– Satisfactory response?

• Court system remedy


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Initiation of Customer Complaint Investigations

• Company (Broker) compliance officer• Written complaint with documentation• Response from Company; accepted or rejected by

customer?• If not accepted by customer, or resolved, Stock

Exchange should be contacted (same time as SECP?)

• RECOMMENDATION: SECP Brochure on web site re: Customer Complaints and Resolutions


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Exchange Investigations: Sources of Customer Complaints

• Determine Source:– Trading Practices– Sales Practices– Operational– Written

• Research history of Brokerage Firm– Note repeat complaints


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Customer Complaints…Review Documents in Firm’s Files

• Customer files, new account information

• Account statements

• Commission reports

• Broker or trader files

• Advertising files

• Correspondence files

• Complaint files


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Exchange Investigation Report

• Gather evidence

• Copies rather than originals

• Document in report, facts and findings

• Resolve…write to customer, or

• Refer to SECP, or

• Refer to Justice or Courts System


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Continuous Disclosure (cont.) Need to Explain

• Financials– Discrepancies or significant deviations in accounting

practices or results

– Lack of dividend declaration or payment

– Significant tax liabilities

• Shareholdings and Transactions• Operations: Past and Future

– Significant risks, lawsuits

– Going concern


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Defects in Annual Reports (Meetings)

• Shareholders’ meetings only once a year• Information presented reaches investors too

late• Management may only be required to

provide info on agenda points• Only shareholders, not potential investors

or others, admitted to shareholder meetingsTherefore need for continuous disclosure


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Responsibility For Financial Reporting and Compliance

• CEO and CFO must sign financial statements– Personal liability?

• Company Secretary to furnish compliance certificate to registrar, along with list of shareholders– List of shareholders, public info? – Web site?


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Regulatory Practices for Continuous Disclosures

• SE/SECP monitoring of annual meetings• Whistleblowers?• Review of annual reports

– Capable?

• Reliance on auditors– Trained– Understanding of Capital Markets/Corp. Gov.?

• Investigations of discrepancies or significant notes in annual reports


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CIS Disclosure Issues

• Is a CIS required to exercise voting rights?

• Who should make decisions about voting and other rights attached to CIS?

• Should a CIS provide information to its investors about how its rights as a shareholder will be exercised?– Questions above from IOSCO


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CIS Guidelines and Practices

• Act in best interests of CIS investors

• Publish voting records

• Disclose conflicts of interest

• Vote according to investment objectives of CIS– Financial considerations– Social objectives


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CIS Regulatory Techniques

• Require regular disclosure of individual company holdings of CIS

• Prospectus disclosure of top holdings• Limit CIS investing to a certain % in a company• Prohibit CIS investing for control of a company• Limits amount of CIS-group investing, again

relating to control


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Insurance Company Risk Disclosure Issues

• Disclosures of exposure to financial risk and how it is managed

• Market or trading risk, comparing risk to return• Funding liquidity risk, including funding provided

by largest creditors• Credit risk, nature of exposures, e.g., replacement

values…disclosure on non performing loans• Reserve adequacy and loss development


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Role and Need of Independent External Auditors(Code)

• Rating by ICAP

• Compliant with Code of Ethics

• Directors recommend appointment

• No other services

• Rotate auditors (or partner?) every 5 years

• No prior affiliation or relation (2 years)

• Partner to attend AGM


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Enforcement Actions on Non-Compliant Disclosures

• Stock Exchanges or other intermediaries to take enforcement action

• SECP to take enforcement action

• What actions?– Imposition of sanctions or penalties

• publication of non-compliant companies and sanctions administered?


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Best Practices:Exchange Sanctions for Non-Compliance of Listing Rules

• Warning, non-public• Public statement of facts• Temporary halt of trading (issuer’s request)• Temporary suspension of trading, with explanation

to market• Delisting, or cancellation of listing• Fines against companies and/or directors• Criminal sanctions…by SECP or Criminal Code• Or...‘Black list’/Defaulters’ Counter?


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Continuous Disclosure Elements:ACT-UP

• Accurate

• Complete

• Timely

• UP-to-date


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Corporate Governance Practice

Regulatory Framework• Statutory laws and regulations• Code of corporate governance• Standards of best practices, e.g. a due diligence

guide or “Statement of Ethics and Business Practices” (viii.a)


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Regulatory Framework (cont.)

Top…Down• From Government Laws• To SECP Regulations• To Institutions’ Rules• To Intermediaries’ Policies and Procedures• To Boards’…Management’s…Employees’ Codes

and Practices• To Individual actions…ethics

ETHICS

WHAT IS ETHICS?


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Corporate Governance Structure

Role of chairman, chief executive officer, non

executive directors and audit committeesRoles, duties, and responsibilities of directorsRelated party transactionsInsider tradingPrompt and adequate disclosuresFair treatment of minority shareholders


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Role of Chairman

• Elected by Directors– Executive?

• CEO?

– Non-executive?

• Presides over meetings of the Board

• Ensures minutes of meetings recorded


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Role of CEO

• Chairman? Director?

• Appointed and remunerated by Board of Directors

• Appoints CFO, Company Secretary, and head of Internal Audit

• Runs the day to day business of Company

• Disclose good and bad developments


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Role of NEDs

• Transparency– Representation of minority shareholders?

• Impartial checks and balances– No threat of job security

• Majority on Audit and other committees…for NBFIs– Board investment committee– Remuneration committee


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Role of Audit Committee

• NEDs mostly• Quarterly meetings• Recommend to Board external auditors• Determine measures to safeguard assets• Review announcements prior to publication• Oversight of quarterly, annual finc’l statements• Considers major findings of internal investigations

and management’s responses• Monitors internal control system


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External Auditors

• KEYS:– Independent– Board (Audit Committee) Oversight– Understanding

• External auditors work for the shareholders, not for management

– Other conflicting services, e.g., consulting?


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Roles, Duties, and Responsibilities of Directors

• “Direct” company in meeting its goals

• Independent? NED? Broker-related?

• Annual Statement of Ethics and Practices

• Appoints and monitors management

• Disclosure of information to shareholders

• Review control issues of Audit Committee

• Appoints external auditors


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Significant Issues for Board Decisions and Review

• Annual and long term business plans

• Budgeting

• Internal reports, including cases of fraud

• Internal and external audits and financials

• Joint venture or distributor agreements

• Material regulatory review notices

• Significant liability claims or judgments


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Keys to Board Effectiveness:

• Communications

• Information

• Expertise

• Experience

• Independence

• Effective senior managementRecommendation: Board Manual


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Supervisory Board

• Split Board

• Board for operations of company

• Another board for shareholders rights and protections

• Specialized boards

• Interrelated

• ACT-Up Information


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Related Party Transactions

• Transactions with/for company subsidiaries, directors, executives

• May be legitimate or – At ‘higher than market’ rates or prices, or– At ‘lower than market’ rates or prices

• Disclosure• Approvals needed? By Board?

Shareholders?


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Related Party Indicators

• Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates prevailing at the time of the transaction.

• Selling real estate at a price that differs significantly from its appraised value.

• Exchanging property for similar property in a non-monetary transaction.

• Making loans with no scheduled terms for when or how the funds will be repaid.

• Purchase of assets at greater than fair market value• Loans at less than market interest rates


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Determining the Existence of Related Parties (Auditing

Procedures)• Evaluate the company's procedures for

identifying and properly accounting for related party transactions.

• Request from appropriate management personnel the names of all related parties and inquire whether there were any transactions with these parties during the period.


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Identifying Transactions With Related Parties

1. (SECP or SE to) Provide audit personnel performing segments of the audit or auditing and reporting separately on the accounts of related components of the reporting entity with the names of known related parties so that they may become aware of transactions with such parties during their audits.


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Identifying (continued)

2. Review the minutes of meetings of the board of directors and executive or operating committees for information about material transactions authorized or discussed at their meetings.

3. Review conflict-of-interests statements obtained by the company from its management.


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Identifying (continued)

4. Review the extent and nature of business transacted with major customers, suppliers, borrowers, and lenders for indications of previously undisclosed relationships.

5. Review accounting records for large, unusual, or nonrecurring transactions or balances, paying particular attention to transactions recognized at or near the end of the reporting period.


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Examining Identified Related Party Transactions

1. Obtain an understanding of the business purpose of the transaction.

2. Examine invoices, executed copies of agreements, contracts, and other pertinent documents, such as receiving reports and shipping documents.

3. Determine whether the transaction has been approved by the board of directors or other appropriate officials.


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Examining (continued)

4. Confirm transaction amount and terms, including guarantees and other significant data, with the other party or parties to the transaction.

5. Inspect evidence in possession of the other party or parties to the transaction.


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Potential Related Party Indicators

1. Agreements under which one party pays expenses on behalf of another party

2. Circular arrangements between related parties

3. Engaging in business deals (such as leases) at more or less than market value

4. Identification of an unidentified related party

5. Inadequate disclosures

6. Payments for services at inflated prices


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Indicators (continued)

7. Sale of securities

8. Sales without substance

9. Unusual, material transactions, particularly close to quarter or year-end


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Sample Related Party Questionnaire

1. Have you or any related party of yours had any interest, direct or indirect, in any sales, purchases, transfers, leasing arrangements or guarantees or other transactions since [Beginning of period of audit] to which the company [Or specify and pension, retirement, savings or similar plan provided by the client] was, or is to be, a party?


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Questionnaire (continued)

2. Do you or any related party of yours have any interest, direct or indirect, in any pending or incomplete sales, purchases, transfers, leasing arrangements, guarantees or other transactions to which the company is, or is to be, a party?


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Questionnaire (continued)

3. Have you or any related party of yours been indebted to the company at any time since [Beginning of period of audit]? Please exclude amounts due for purchases on usual trade terms and for ordinary travel and expense advances.

The answers to the foregoing questions are correct to the best of my knowledge and belief

DATE SIGNATURE


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Insider Trading

• Material information

• Non-public

• Insider use or passed on

• Significant gains

• Trading in securities or derivatives prior to public news or announcements


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Insider TradingDetection Techniques

• Surveillance of unusual trading activity, either by price movement or share volume– By Exchange– By SECP

• Review “insider” activity prior to public news

• Again, unusual (‘outside-of-pattern’) activity


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Company Policy and Procedures to Deter Insider Trading

• General Company Policy, pre- and post- trading– Report intent to trade

– Report trade

– Arrangement with Depository

• Determination by Company if info:– Material

– Non-public

• Prohibit or report trades


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How Companies Can Restrict Access to Material, Non-Public (i.e.,

Confidential) Information• Files containing information should be sealed,

and have restricted access • Telephone conversations or meetings discussing

confidential information should be conducted in private whenever possible

• Confidential information should be communicated to others on a need-to-know basis only, e.g., if information is needed to perform duties.


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Companies Restricted Access (continued)

• Visitors should not be permitted to wander through the Company’s offices and should be escorted to and from the reception area.

• Secretaries and receptionists should generally avoid responding to inquiries from outsiders.

• In appropriate cases, code names should be used in confidential documents being prepared or used within the office.


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Fair Treatment of Minority Shareholders

• Ownership structure

• Transparency of ownership

• Concentration and influence of ownership

• Shareholder Meetings

• Ownership rights

• Equitable treatment of shareholders of same class


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Self Dealing Issues

• Trading ahead or “frontrunning”

• Cherry picking; Preferential allocations

• Best price or execution

• Wash trades

• Marking the close

• Churning

• Misappropriation of funds/securities


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Investigation Techniques

• Review documents– Internal– External

• Interview– Harmed parties or whistleblowers– Suspected violators– Supervisors

• Report facts and findings


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Initiation of Investigations

• Trading irregularities discovered through surveillance

• A customer complaint filed against a member• A member complaint against another member• Financial or other reports or calculations that are

inaccurate, or even not filed on time• Discovery of alleged trader or sales practice

violations• Prior problems or violations with follow-up

inspections


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Investigation and Enforcement

• Enforcement Objectives– Protect shareholders/policy holders– Promote investor confidence– Encourage broad and active participation in

the market by all investors– Punish wrongdoers/level playing field– Remedy ‘harm’ to investors– Deter (prevent) illegal conduct


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Basic Elements of Enforcement Program

• Investigate possible violations of the securities laws vigorously but fairly

• Recommend and implement enforcement proceedings where warranted

• Remedy harm to investors• Punish wrongdoers and impose sanctions that

correspond to misconduct• Refer matters to other authorities (i.e., justice

minister) for follow-up action as appropriate.


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Reasons that Investigations Should be Private and Non-public

• Preserve integrity of the investigation• Protects the reputation of innocent market

participants and others• Ensures that securities, funds, or documents are not

removed beyond the jurisdiction of the regulator• Preserves the “element of surprise”• Press inquiries…all to be referred to supervisors or

the delegated press relations person…to develop a standard response to press inquiries regarding on-going investigations


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Investigations: Criteria and policy considerations

• Allocation of resources…own staff? Outside auditors or inspectors?

• Nature of conduct…with intent to harm? Unintentional?

• Size of harm or losses to investors and markets

• Supervisor and management involvement and ongoing oversight


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Develop Theory of the Case

• Possible motives for conduct

• Benefits and relationships to promoter, trader, or others (e.g., family members or business associates, relationship of trader to company, broker or others…note, this theory may change during investigations)


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Develop Investigative Plan

• Define scope and objectives of investigation• Identify issuers, promoters, traders, and time

period• Investigation should seek to develop facts and

evidence to support each element of an alleged violation

• Many cases are largely based on circumstantial evidence

• Identify necessary documents and witnesses


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Issuer and Company Documents

• Periodic reports, offering circulars, prospectuses, and other disclosure

• Press releases and promotional materials• Documents related to Board of Directors and

other meetings, including meeting minutes, agendas, lists of attendees

• Notes or summaries of meetings and telephone conversations


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Decision to Initiate Proceedings or to Close the Investigation

• Criteria and policy considerations• Allocation of resources• Impact on investors and the market• Other• Preparation of recommendation• Supervisor and management oversight• Criminal and other accompanying

proceedings• Possible settlement


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Publicity Considerations

• Issue press release after public proceedings initiated

• Announce enforcement proceedings on (SE/SECP) website


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Basis for Appropriate Sanctions

• Statutory authority• Policy considerations• Seriousness of misconduct• Nature of misconduct• Repetitive or continuous• Single instance• Amount of monetary damage• Likelihood of future misconduct• Previous violations


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Caution

• Over regulation may cause great expense in time, money, and personnel

• Public companies consider ‘privatizing’ • Private companies to seek private financing• Stress general ethics and conduct• Costs to accomplish

– Rotation of auditors…rather than rotation of partner


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Recent International Laws and Reports

• Sarbanes-Oxley Act of 2002 (US)

• Higgs Report, January 2003 (UK)

• Council of Institutional Investors 2002 (US Pension Funds)

• IOSCO Technical Committee Report, October 2002


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Sarbanes-Oxley Act

• Prohibits most company loans to directors and executives

• CEO and CFO now criminally liable for financial misstatements

• Real time reporting (within 2 days)• Whistleblower protections• Public Company Accounting Oversight

Board


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Higgs Report

• Chairman and CEO separate individuals

• At least 50% of Board, NEDs

• Board evaluated by Board Review Committee

• At least one member of Audit Committee to have recent and relevant experience

• Disallowing ex-CEOs as Chairmen


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Council of Institutional Investors

• All directors should be elected annually via confidential ballots counted by independent tabulators

• Audit, nominating, and compensation committees…independent directors

• A corporation should disclose information necessary for shareholders to determine whether each director qualifies as independent


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IOSCO Technical Committee

Statement of principles to guide securities regulators requiring:

• Transparency and disclosure by listed entities,

• Independence of external auditors, and

• Need for public oversight of the audit function


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And Finally...

• Disseminate information

• Educate

• Instill ethical behavior

• Partner and transformation


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CASE STUDY

How Leeson Broke Barings…Issues:– Employee actions and profits (?)– Management and supervision activities– Accounting and audits practices– Board disclosures and (non-) actions– Regulatory (non-) actions– Ultimate shareholder questions


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Leesen/Barings: Role Play

Split into Individual Smaller Groups comprised of:

– Board of Directors– Shareholders– CEO/Management– Regulator (i.e., Exchange or Commission)– Audit Committee/auditors


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Leesen/Barings: General Questions

1. Choose 1 person, group, or body as the main cause of Barings going down

2. Why was the position not detected or investigated?

3. Describe some types of Risk associated with this situation


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Leesen/Barings: General Questions (continued)

4. Describe some mistakes or fatal errors in judgment made by:

– Management and Supervision of Barings

– Internal Audit

– CEO

– Operations (i.e., Back Office)

– Board of Directors

– Shareholders

– Stakeholders (i.e., creditors, debtors, employees)


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Leesen/Barings:Individual Group Questions

1. What went wrong, and why?2. What corporate governance principles or practices

were NOT applied by (or for) your group?3. What corporate governance principles and practices

should have been applied?4. What the regulators could have/should have done?5. Complete the sentence describing the ‘Lessons

Learned by Leeson Broking Barings’:6. “This could have been prevented if ………………”


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Leeson/Barings Case Study

• Leesen Keys:– Resultant losses; bad decisions– Did not arbitrage; huge positions– Hid losses– Dual roles as trader/bookkeeper


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Leesen/Barings Case Study

• Management and supervision– Checks and balances; reviews– Customer positions– Trader positions – Questions– Reports and reporting


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• Accounting and Audit Practices– Actions of internal auditors– Findings of external auditors– Audit or Risk Committee practices


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• Board disclosures and actions– Questions on losses– Questions on profits– Disclosure to shareholders


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• Regulatory actions– Position limits– Inquiries– Report reviews– Hedging– Capital considerations


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• Shareholder actions and questions– Risks– Disclosure– Strategies– Remuneration


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Leesen/Barings Case Study: 13 (Shareholder) Questions

1. What is the company’s philosophy towards financial risks?

2. Do (supervisory) board members understand the financial instruments the company uses or owns (particularly derivatives)?

3. Who formulates the firm’s guidelines and policies on the use of financial instruments?

4. Has the board approved these policies?5. How can the board foster a risk management

culture within the firm?


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13 Questions (continued)

6. How does the board ensure the integrity of the risk management system?

7. Is there a separation of duties between those who generate financial risks and those who manage and control these risks?

8. What type of financial instruments may the firm use?

9. How are these financial instruments valued?10. Is there a (position/value) limit in place?


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13 Questions (continued)

11. What are the major risks resulting from financial instruments?

12. Are senior managers and the board of directors kept abreast of the financial exposures facing the company at any one time?

13. As a shareholder, how much information on the financial risks of the company can I reasonably expect?


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ISSUES:1. Segregation of front and back-office2. Senior management involvement3. Adequate capital4. Poor control procedures

Credit risk Market risk No limits


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ISSUES (continued)

5. Lack of supervision…disclosure…corp. gov.

Conclusions:• Management assumed positions hedged, rather

than checking or supervising• No attention to profitable account• Management/board entered new businesses

without ensuring adequate support and control


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CASE STUDY

• Sprint and Coca Cola– Shareholder rights– Disclosure– Dual roles of auditors– Shareholder actions– Results


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CASE STUDY

• Insider Trading, Martha and ImCloneSale before public news

Stock decline

Friend of CEO

Stop/loss order?