SECP decision: The recent decision made by the Securities and Exchange Commission of Pakistan (SECP) in the matter of show cause notice issued to Pakistan-Kuwait Investment Company (Pvt) Limited (PKIC) circulated to all stock exchanges regarding the insider trading has been widely appreciated by the investor's community. The company has been held responsible for insider trading through its senior most executive member of the management team that happens to be the Managing Director of the company.
This bold decision should be regarded as a milestone for the success of those who have been for a long advocating that there must be strong and immediate actions on the insider trading and those involved must be punished according to law.
The chairman of SECP, Dr Tariq Hassan, along with his team must be congratulated for this exemplary and swift action that should restore investors confidence in the capital markets of Pakistan.
Are the penalties adequate? It is being argued that the penalties imposed in shape of fines amounting to Rs 535,510 being two times the amount of gain accrued to PKIC in this case are not adequate and may not help to achieve the desired goals of eliminating or minimising the insider trading.
This is a two time gain accrued to this company but what about the gains made by others who followed their footstep in the same brokerage house that dealt with their trading transactions?
Barring from being a director: SECP should have barred the individual from being director of any company in future in addition to the above fine that has been imposed. A condition should have been imposed that the individual himself who has violated the law should pay this fine and the company should have been instructed not to reimburse this fine to this individual.
The management of Fauji Fertiliser Company Limited should file a separate legal action against this director as he has indulged himself in unethical insider trading and has violated the fiduciary responsibility of being a director of Fauji Fertiliser Company Limited.
It may be argued that if Fauji Fertiliser Company Limited does not exercise its legal action against an individual who happens to be its director and that has involved himself in unethical and insider trading and violated the fiduciary duty of being director, the management of this company may itself be exposed to a legal action from any shareholder of the company for being negligent to protect the rights of it's shareholders.
Volatility becoming a normal practice: It must not be taken lightly that whenever multinational companies hold board meetings to review the performance of their company and to decide the appropriation and distribution of their earnings, the shares of these companies become exceptionally volatile due to the reason that it has become practice that the financial results are invariably leaked and that becomes the basis of insider trading.
Whether the directors themselves, their associates or the brokerage houses that have the contact with these directors, conduct this inside trading is an issue that remains to be resolved.
There is no doubt in our minds that insider trading cannot be stopped altogether but at least it could be minimised by making it mare difficult.
Let us look at some of the reasons contributing towards insider trading in Pakistani capital markets.
ELECTION OF DIRECTORS: SECP has introduced Code of corporate governance to be implemented through the listing rules of the three stock exchanges of Pakistan. Under Article 6.8 of the code, listed companies are required to encourage effective representation of non-executive directors, including those representing minority interests on the Board so that the Board includes core competencies considered relevant in the context of each listed company. Let us critically evaluate the Article 6.8 to see if it meets today's complex business requirements. It is being reproduced hereunder for easy reference for the general investors.
THE CODE STATES THAT IT IS DESIRABLE THAT:
-- Election of minority shareholders by proxy solicitation is facilitated.
-- The board includes at least one independent director representing institutional equity interest. Independent director is one who is not connected on the basis of family relationship with the listed company or its promoters or directors or does not have pecuniary relationship with the company or its associated companies, directors, executives or related parties.
-- There shall not be more than 75% executive directors on the board though the SECP can relax this condition
APPOINTMENT OF NON-EXECUTIVE DIRECTORS: It is argued here that historically the structure of the listed companies have been based upon non-executive directors that are known to families of those directors having majority shareholding.
There is very little exception of multinational companies that are organised on professional grounds and were managed by executive directors and majority of directors are executive directors with very few exceptions of directors that are non-executive. So the Code of Corporate Governance did not introduce any new provision or requirement to the structure of the board.
This requirement was just a matter of formality that reconfirmed the existing practice being practised in the corporate sector. In fact the emphasis should have been on the appointment of non-executive directors that are in real terms "independent"
PROXY SOLICITATION: The facilitation of the election of minority shareholders by proxy solicitation is also an old practice and should not be regarded that some new development has taken place in the structure of boards. As explained above, families owning majority shares giving proxies in favour of non-executive directors that happened to be having soft corners for the family management's used this method.
However, it may be argued that facilitation to seek proxies have created more damage than good to our capital markets as persons elected as directors on proxies acted as insiders for insider trading purposes.
Their appointments are meant to facilitate insider trading for those institutions that provide proxies to these individuals. It is argued that these individuals act as their agents for this unethical purpose and cannot be considered independent to act freely without any pressures from those that have supported them through proxies.
AVAILABILITY OF CORE COMPETENCIES: The aims and objectives of the Code of Corporate Governance that it would facilitate availability of core competencies are a misconception. To achieve this result, there must have been a defined process of election of non-executive directors that should contribute effectively towards the management of the companies.
According to investor's perceptions, Pakistan is the only country where the investment institutions provide proxies to individuals having no prior record or back ground of any corporate experience and in some cases it has been observed that most of these individuals are unsuccessful and unemployed individuals that are meant to be used for insider trading.
Under these circumstances how these individuals may provide core competencies to effectively discuss and propose strategic options facing these listed companies.
If we look at the list of directors of Hub Power Company limited, at least two directors have been elected by obtaining proxies from the institutional investors arranged by the large brokerage houses and these two individuals only own 500 shares each in their own name.
It is being argued, how these non-executive directors with only 500 shares each have been able to secure directorships in such a large company. If they are appointed as directors because of the proxies, what was the purpose behind their appointment and who has been using them for insider trading.
Are they really interested to become directors of a listed company with this small shareholding of 500 shares and being paid a nominal fee to attend board meetings?
If I have a choice to become a non-executive directors on these terms provided I have no other ulterior motive behind my appointment, I would refuse immediately for a non-executive position due to the enormous legal responsibilities attached to these positions and the amount of time and effort desired to meet the demand of this responsibility.
This shows that accepting non-executive position through proxies where there is only 500 shares held with the individual has some other motives that needs to be fulfilled and this is achieved through insider information that is passed on to these institutions that provide and arrange proxies for them.
A first class stable stock that provides a regular rate of return to their shareholders is being priced at historically low valuation when it is providing the highest yield of more than 12% at the current market valuation.
This is only because this stock has been exposed to insider trading so heavily that today the investors would listen that only one generator is in operation and within a week all four starts working.
Rumours in this stock is so common that serious investors have started neglecting this share altogether and daily volume has gone down drastically in this scrip. This scrip has become a joke for the investors. It is suggested that SECP should review the rules that encourages use of proxies to individuals for Board memberships.
There must be suitable criteria that must be fulfilled before this option is exercised by the institutional investors.
If we compare our rules with the rest of the developed economies, it is interesting to observe that Higgs Review suggested appointment of nomination committees that should screen the candidates for non-executive directorships to ensure that good experienced candidates are taken to ensure their effective contribution in the management of the company.
In fact the recent trend is to employ head-hunters to select candidates for non-executive directors that are in real terms "independent" and still these economies are facing shortages of candidates to accept the liabilities associated with these positions.
INDEPENDENCE OF DIRECTORS: The word "independent" has the literal meaning of being self-governing, self-sufficient, free, autonomous and sovereign. It may be argued that if one has any type of interest, he may not be able fulfill the above definition of the word "independent".
If we analyse the definition and interpretation of the above clause that has been incorporated into the listing rules of the stock exchanges, we should be able to argue that a non-executive director that fulfills the above three conditions and represents an institution can be declared as an independent director. If this conclusion is correct then, the basic definition of an "independent director" as described above seems outdated as any institution that appoints a person on the Board of a company as director has a special interest to protect the investment the institution has made in the share capital of the company.
Therefore, it is safe to conclude that anyone having an interest in the company's business cannot be called as an "independent director".
Independence has been defined in the "Review of the role and effectiveness of non-executive director proposed by Sir Derek Higgs in January 2003 that has been implemented in the United Kingdom through the listing requirements of London Stock Exchange from November 2003 and that reads as follows:
1. "A non-executive director is considered independent when the board determines that the director is independent in character and judgement and there are no relationships or circumstances which could affect, or appear to affect, the director's judgement. Such relationships or circumstances would include where the director:
2. Is a former employee of the company or group until five years after employment has ended;
3. Has, or has had within the last three years, a material business relationship with the company either directly, or as partner, shareholder, director or senior employee of a body that has such a relationship with the company;
4. Has received or receives additional remuneration from the company apart from a directors fees, participates in the company's share option or a performance-related pay scheme, or is a member of the company's scheme;
5. Has close family ties with any of the company's advisors, directors or senior employees; holds cross-directorships or has significant links with other directors through involvement in other companies or bodies;
6. Represents a significant shareholder; or
7. Has served on the board for more than ten years.
The board should identify in its annual report the non-executive directors it determines to be independent.
The board should state its reasons if a director is considered to be independent notwithstanding the existence of relationships or circumstances which may appear relevant to its determination."
The above definition clearly excludes all those directors from being designated as "independent" directors if they represent significant shareholders. This definition should be contrasted with the Pakistani Code of Corporate governance where it clearly states that anyone representing institutions would be regarded as "Independent" director.
This basic difference is causing great problems and it is suggested that SECP must come up with a compatible version of new definition of "independent" that should be regarded truly effective.
In fact, the UK code of corporate governance suggests that at least half the board should be composed of non-executive independent directors compared with the Pakistani code that requires only non-executive directors. This is a major difference between the two codes and does determine the effectiveness of directors.
ROLE OF AUDIT COMMITTEES: Code's Article 7.56 provides that the code requires every listed company to establish an Audit Committee, comprising at least three members including the chairman, from among its directors.
The majority of its members should be non-executive directors of the company while the chairman of the Committee should also preferably be a non-executive director.
Recently when the Audit Committee of the Pakistan Telecommunication Company Limited met to review the first quarter accounts of the company, the price of PTCL share tumbled the same day and continued its dive till the results were announced by the board regarding its earning per share. Is it not an insider trading?
The ex-chairman of Karachi Stock Exchange and head of a large brokerage house were interviewed by Geo electronic media during its programmes of "Tezi- Mandi" on this issue and they were very much open and accused the management for insider trading.
The topic of insider trading has become so disturbing to the investors that the electronic media and press have started criticising it almost on daily basis. What message we give to investors whether they are local or foreign to convince them to invest in our capital markets that are in the grip of insider trading.
It seems interesting thing is that these are the largest brokerage houses that are involved in this practice through intermediaries. We are sure that SECP must have taken a notice of these allegations.
Audit Committees failure to keep the information confidential: It is interesting to observe here that most of the audit committees are composed of non-executive directors that are elected on the basis of proxies or they represent investment institutions that have substantial and material interest in the financial results of the company.
Normally the audit committee reviews the financial results of the company prior to being presented to the board of directors meeting.
This is the time when most of the insider trading takes places and earning per share is disclosed that places a material impact upon the price of any securities. It is material information that is disclosed to interested parties and that information becomes the basis of insider trading.
SUSPENSION OF TRADING: To protect this disclosure and to safeguard the interest of those investors having no excess to this material information, it is suggested that soon before the audit committee meets to review the financial results till the Board of directors meeting takes place, the trading in the company's share should be suspended.
This is generally accepted principle in developed countries where before any important announcement takes place, the stock exchange is notified earlier and the trading in that security is suspended till the announcement takes place. This action not only minimises the insider trading but also becomes transparent for all the parties.
INSTITUTIONAL DIRECTORS REPRESENTATION: The Pakistan Kuwait Investment Company case is a classic example where an institutional director acting on behalf of his institution did insider trading.
How long it has been happening remains a mystery but it provides us with a lesson that investment institutions have converted themselves into traders and not investors.
Therefore, SECP should reshape their rules and regulations in the light of the above case and should ensure that institutional investors officials, directors and senior managers should not be represented on Board of directors of any company in which these institutions have invested.
They should not be represented on Audit committees that review the financial performance before the information is placed before the Board of directors.
We are aware of the legal problems associated with this proposal. Till the law is amended or other viable option is developed, it might be prudent to use Code of Corporate Governance by adding a clause that should ensure that the directors have signed a confidentiality agreement that should legally bar them to disclose any sensitive information to anyone that may take advantage compared with those that have no access to it.
This agreement should include disclosure regarding financial results. This confidentiality agreement should also be binding upon company's auditors, bankers, senior management and other stakeholders alike.
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