2008 market crisis: study underscores need for clear definition of 'force majeure'

The imposition of floor on the Karachi Stock Exchange (KSE) through use of force majeure in 2008 sent a chilling signal to the foreign investors, as they felt such extreme actions like applying force majeure powers by bourses to jeopardize their interest at any point of time in the future.
A study on stock exchange crises-2008 by Shamim Ahmed Khan, issued by the Securities and Exchange Commission of Pakistan (SECP), said that it is proposed that force majeure appearing in the RM Regulations should be clearly defined to mean only acts of good or civil disturbance. At the same time both the apex and frontline regulators need to be vested with emergency powers as is the case in other jurisdictions like Malaysia, Singapore and India. These powers are specified and can be used in the case of emergency and natural disaster or in the case of economic and financial crisis or in situations which threaten the integrity or liquidity of the stock market.
The report said that there needs to be a transparent policy with well-defined parameters as is the case with other jurisdictions. It may be mentioned that different jurisdictions have laid down the level at which emergency powers can be exercised. For instance in the case of Malaysia, power to close the stock exchange lies only with the Minister while in the case of Singapore, the apex regulator uses such powers. SECP has informed the Committee that under the Securities Act of 2015, SECP has been vested with emergency powers which could be used in emergent situations. SECP has further said that with the emergency powers now available to SECP, stock exchanges would not be able to exercise indiscriminate powers under force majeure.
It is recommended that SECP should formulate a transparent policy under the emergency powers which should clearly spell out the circumstances in which such powers could be exercised. The quality of stock exchanges plays a pivotal role in the capital market of a country. It has to ensure integrity and transparency of operations, investor protection and market efficiency. This requires the stock exchanges to function as a financial institution, free from any conflict of interest. The crisis of 2008 brought into focus serious conflicts of interest existing in the then composition of the stock exchange boards. As has already been mentioned in the report, during the 2008 crisis, critical decisions were being taken by five broker directors of KSE who were in conflict. Some of the broker directors who advocated imposition of the floor had personal interest in the decision. According to sections 214 and 216 of the Companies Ordinance, 1984, a director has to disclose his interest in any matter which is placed before the board. Section 216 also stipulates that such interested director shall not participate or vote on any matter in which he is interested. The provisions of the Companies Ordinance, 1984 are applicable to the stock exchanges which in 2008 were companies limited by guarantee. In the case of a meeting held on August 27, 2008 it would have been appropriate if the broker directors who were to be affected by the decision should have abstained from voting.
Similarly, in the case of board meetings held earlier, in which decisions were taken which affected the broker directors personally, the directors should have abstained. SECP needs to ensure compliance with the provisions of sections 214 and 216 of the Companies Ordinance, 1984 in the interest of better governance of the boards. In view of conflict of interest of brokers being on the board, a number of exchanges in other jurisdictions do not include any broker on their board and these are functioning successfully. It may be pointed out that Bombay Stock Exchange after demutualization does not have a broker on its board.
During 2008, stock exchanges invoking powers under force majeure took a number of ad hoc decisions. The decisions related to change of circuit breakers, roll-over of DFM positions to CFS MK-II and imposition of the floor. While there are questions as to whether the stock exchanges followed the prescribed conditions required for determining force majeure event, it needs to be decided as to whether it is appropriate to vest the stock exchanges with such discretionary powers. Universally, force majeure refers to events involving natural calamity or civil disorder in a country which is beyond human control. However, the provision of force majeure as mentioned in the RM Regulations is given to misinterpretation and has been used rather indiscriminately. Such powers vested in stock exchanges are fraught with risk.
The report said that there are an excessive number of brokers in Pakistan's market relative to its size. Presently, there are about 345 brokers and all of them can perform all functions - trading, clearing and settlement. The Committee is of the view that with the incidence of misuse of clients' assets by the brokers, it is important that the function of clearing and settlement should be available with only a few brokers who have the financial strength and who fulfill the necessary fit and proper criteria. Preferably, only those brokers should be entrusted with custody of securities of the clients in their sub-accounts who are backed by strong financial institutions. Rest of the brokers would continue to perform trading activities and would not handle clients' cash or securities.
Another important issue relating to broker regime is that the minimum required capital is not risk-based. It is important that as in the case of banks, the capital to be maintained by the brokers should be risk-based and related to the nature of activities being performed in the market segments with which the broker is engaged.
As regards the Net Capital Balance, there have been serious problems in its calculation and a consultant had recommended a capital adequacy template in the year 2006. The template was also used by the Consultative Group on Capital Markets in 2009 for recommending a net adjusted liquid capital formula. However, although the same was again endorsed by the consultant in 2010, the formula is yet to be introduced.
The Committee recommends early steps to revamp the broker regime with respect to classification of brokers, capital adequacy, code of conduct and fit and proper criteria. The stock exchanges exercise regulatory powers as frontline regulators. For this purpose, stock exchanges need to strengthen capacity to be able to perform their regulatory role effectively. As envisaged by the scheme of demutualization, effectiveness of the regulatory functions being performed by the stock exchanges needs to be continuously evaluated, both by the stock exchanges themselves and by the apex regulator, it added.