Lessons from 'Danka Controversy'

The special programme "Danka controversy," televised by Aaj Markets Special, a talk show programme on Tuesday, 26th June 2006, provided in-depth details regarding the reasons of Stock Exchange Crash of March 2000.
The three participants of the programme revealed their version of the factors that caused the collapse, whereas the other two, who actively participated in the controversial decision-making process, chose to abstain from this programme for unknown reasons.
This is the first time that this type of programme has been televised to unveil the secrets of the collapse due to the "Danka controversy" for which the management and the organisers of this programme must be congratulated for this unprecedented openness.
Though SECP conducted an investigation to unearth the reasons of that collapse, the investigation report was never made public for unknown reasons. As the facts and reasons have now been narrated, explained and made public by the three participants, the public in general and the investors community in particular seem to be perturbed over these revelations made during the programme. These are difficult to swallow and would need a lot of debates and comments on these revelations that have been made public.
It was evident from the discussion that there were accusations levelled by one of the participants who suffered huge losses against some of the members of the KSE management at that time. As the programme was "Ru Bru", and the accusations were made against the person, who was also participating in this programme as ex-Chairman of KSE, therefore, it may be said that the accusations were material enough to be responded in a professional and honest manner.
Iftikhar Shafi, as an investor, accused the management of changing the trading and exposure rules of KSE overnight by acting what should be called maliciously against the investors' interest that caused him huge losses, whereas the then Chairman of the Karachi Stock Exchange defended the management's actions by arguing that the decision was made by the KSE Board that comprised non-elected directors also.
He also defended the changing of rules to protect the risk management and KSE systems and argued that the decision was right as the prices of the shares were rising every day. There seemed to be no effective defence presented to the accusation except that the changes were made purely in line with risk management, without going into detail how it achieved the desired objective.
The ex-Chairman also maintained that the board and particularly himself, were not aware of the positions taken by the said investor.
Here we have an investor, who participated actively in the stock market for a fairly long period of time. His activities in the stock exchange were known to almost all of the brokerage houses, including the investor's community.
Most of the time small and medium-sized investors followed him to carry out their day-to-day trading activities in order to earn quick profits.
It seems very surprising that the KSE board and especially, the elected Chairman were not aware of the reasons behind the increase in prices of those particular scrips that were being traded by this investor, especially when several mutual funds have been providing Badla financing facilities in the market that were directly or indirectly owned by the same Chairman.
Assuming that the Chairman was not aware of those scrips traded by this investor is accepted by the viewers then one would draw the conclusion that it must be a most ineffective and disinterested board that had a very poor knowledge of the working of the stock exchanges.
The board's ineffectiveness and disinterestedness resulted in the collapse of the market from the index level of over 2000 to just below 1300 points, causing huge losses to market participants. It is arguable, if the sudden change of rules was morally and legally justified and was not made with mala fide intention and was in line with the internationally accepted norms of rule of law.
THE RULE OF PROPORTIONALITY: It has been argued in this discussion that the main reason of removing the scrips from list A to B or exclusion of certain securities to qualify for exposure was that their prices rose so high that the risk management desired that those securities should be excluded from the approved list.
Here the clear objective of the sudden changes was that the prices of some of the scrips went too high and, therefore, it was desired that there was a need to limit the risk by excluding these securities from the approved list by replacing with some other securities whose prices were acceptable to the board. Here the objective was to cap the abnormal rise in price as these scripts were accepted by the KSE already but at a lower price. There is a general principle of fairness that a body should not take a decision that may be regarded out of proportion to the objectives sought.
In this case, the decision-making body should have made a decision only to the extent that the high valuation causing additional risk is eliminated and that could have been achieved by capping the prices of those scrips at the previous high which were acceptable to the KSE and not by excluding the entire scrip altogether.
The action taken by the decision-making body seemed to be out of proportion to the objectives sought and therefore, it may be argued that the decision made was based on mala fide intention to cause harm to the investors community that dealt in those securities at that particular time.
Had that case been pursued in a court of law at that time, the decision of KSE would have been declared ultra vires on the basis of mala fide intention and out of proportion and damages could have been awarded for the losses incurred due to this decision.
It is an important principle of rule of law that any change in the existing rules and procedures that desires to be altered must be publicised in advance and all those who may be affected by such a change must be notified well in advance to protect their interests.
As revealed by Iftikhar Shafi in this discussion that he had to run from one bank to another to replace his margin securities as this sudden change had an adverse impact upon the investors' community that held those securities at that particular time, bearing in mind that there may be several small and medium-type investors that may have sold their holdings due to this decision under pressure, duress or fear that has not been made public so far.
It seems surprising that such an important decision that impacted the investment community was taken in such a hurry that the then management of KSE violated all the basic norms of rule of law in this case, thereby causing huge losses to the investing community.
It is being questioned why the KSE management did not foresee the consequences of this change in exposure rules to avert the Stock Exchange crash at that time, which in fact fell by 33% due to these decisions.
There seems to be something seriously wrong within the operation of Stock Exchanges. The allegations made are manipulation through sudden change of trading rules and withdrawal of Badla financing. These are common allegations that had been levelled several times in the past that the big brokerage houses provide Badla financing and suddenly that facility is withdrawn thereby forcing investors to sell their holdings immediately under duress.
This forced selling not only causes loss to the seller but also contributes towards the basic reasons of collapse of the market depending upon the size of selling. Therefore, it has been argued forcefully time and again that these brokerage houses and mutual funds should not be allowed to participate in the provision of Badla financing because it causes conflict of interest and gives birth to manipulative activities.
In consequence, the recent budget proposals taxed income from this source but this taxation was withdrawn again because of representations from a strong lobby of mutual fund managers and the brokerage community.
The crash of March 2000 stock exchange could have been averted, had there been adequate infrastructure in place within SECP and KSE management to foresee the weaknesses within the systems as were revealed in this televised programme. Time and again, it had been suggested that the professional brokerage houses should not be involved in the decision-making process relating to trading rules of the KSE.
The decision-making process should be left with the KSE management and the management should consist of only those not connected with brokerage business, act in a professional manner and the decision-making process should be independent and transparent.
There must be adequate notice to change the rules and regulations relating to trading activities. These changes must be properly discussed and comments sought well before these are implemented so that all stakeholders are aware of the rules of the game and there is a level playing field for all investors alike, irrespective of their size.
Consequently, SECP has taken some positive steps to rectify some of the weaknesses in the system. A non-executive, Chairman who does not belong to the members of the KSE, has been appointed. This is a step to the right direction and that may minimise hasty changes in due course of time. But this should not be considered as the end of the matter.
It must be made sure that the proposals coming from the member directors are scrutinized, analysed and reviewed thoroughly to ensure that its objective is not biased and it does not provide hidden benefit to a section of the class of investors.
Therefore, it is important to ensure that the changes are notified in advance to provide equal opportunity to all stakeholders. The recent decision of KSE Board of Directors to ban the blank short-selling is also being criticised on the same principle that these sort of decisions should be implemented after adequate notice is given to all the stakeholders well in time.
The stock exchanges demutualization programme should be speeded up to ensure an early exclusion of brokerage community from an independent and transparent management of all stock exchanges to ensure confidentiality and level playing field to all stakeholders.
PUBLIC THE INVESTIGATION: It is interesting to observe that there were allegations from at least two participants that the SECP Chairman was requested to interfere and an investigation was conducted into the crash of the stock exchanges but the report was never published and no action was taken against those who were involved in changing the rules.
This attitude shows that SECP was also to be blamed partly for this fiasco. The conduct of the Regulator was not as per the expectation of the investor's community. In cases, where no action is taken after an investigation has been conducted, it amounts to affirmation of the bad practices that have existed in our capital markets for a long time.
We must understand that time has changed and the regulator must enforce international norms and standards that have been practised in most of the advanced countries, if we expect to develop our markets on permanent basis.
The brokerage community must also change its attitude and adopt a positive working relationship between all the stakeholders in exchange and should say good-bye to the practices by killing the goose that lays golden eggs.
DIRECTORS CONFLICT OF INTEREST AND ROLE OF ELECTRONIC MEDIA: It is being observed that all the elected directors of the KSE that are from the members community are frequently being invited at various electronic media forums almost on daily basis to express their views and comments on the performance of the market and their views on the trading and exposure rules of the stock exchanges.
They are being frequently presented to the viewers as "Director" KSE. Their observations, comments and remarks are their personal views and should not reflect the official version of the Board of Directors. So far, the KSE management or SECP has not acted to discourage this practice. These member directors should not be allowed to act as Board's spokesmen in their personal capacity.
This is a serious conflict of interest and must be discouraged. Presently the general public is influenced by their remarks and observations because they are being presented as "director of KSE" by the electronic media. In case, these elected directors wish to express their views on the performance of the market, the media should be directed to identify them as part of the brokerage houses to which they belong and not as "director of KSE", so that the public is not misled by their views and comments.