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Guide to Markets Regulations

First Edition

Alain A. Ndedi
Marketing Editor Jean Claude Nyoll
Production Yenepad, Pretoria South Africa
Permission Editor Peter Behalal
Copy Editor Alain Ndedi <alainndedi@gmail.com>
Text and Cover designer Yenepad Consulting
4 Vrede Lane, NorthCliff, Johannesburg,
South Africa.

Copyright 2009, by Yenepad, Pretoria – South Africa.

All rights reserved. No part of this book covered by the copyright hereon
may be reproduced or used in any form or by any means, graphic, electronic,
or mechanical, including photocopying, or information storage and retrieval
systems, without the written permission of the publisher.

‘Guide to markets regulations’ – First Edition, April 2009.

Author, Alain A. Ndedi

ISBN 978-0-620-43833-9

Referencing. Ndedi, A, A. 2009. Guide to Markets Regulations. First


Edition. University of Pretoria Printers, Pretoria, SA.

Printed by UP Printers, Tel - 27 12 420 2127 Fax – 27 12 420 2117


TABLE OF CONTENTS

CHAPTERS PAGE

CHAPTER 1: DEFINING THE CAPITAL MARKET 1


CHAPTER 2: GOVERNMENT'S INTEREST AND ROLE IN CAPITAL
MARKET DEVELOPMENT 10
CHAPTER 3: PRINCIPAL GOVERNMENT POLICY ISSUES 27
CHAPTER 4: EQUITY: THE BASIC CAPITAL INVESTMENT 52
CHAPTER 5: DEBT: FOR MORE RISK-AVERSE INVESTORS 67
CHAPTER 6: UNIT TRUST OFFERINGS 82
CHAPTER 7: PUBLIC SECTOR INFRASTRUCTURE FOR AN
EFFICIENT CAPITAL MARKET 94
CHAPTER 8: SECURITIES OFFERINGS: THE REGULATORS’
CONCERNS 110
CHAPTER 9: THE PRIVATE SECTOR: COMPETENCE AND INPUT 124
CHAPTER 10: ISSUER CONCERNS IN CONSIDERING POTENTIAL
PUBLIC OFFERINGS 141
CHAPTER 11: TRANSPARENCY: WHAT DOES IT REALLY MEAN
AND REQUIRE? 152
CHAPTER 12: THE IMPORTANCE OF GOOD CORPORATE
GOVERNANCE 166
CHAPTER 13: THE STOCK EXCHANGE: ITS PURPOSE AND
OPERATION 178
CHAPTER 14: STOCK PRICES AND INDICES 189
CHAPTER 15: MARKET MANIPULATION 198
CHAPTER 16: DEVELOPING PUBLIC CONFIDENCE IN SECURITIES
TRADING 212
GLOSSARY 222
INTRODUCTION

Almost eighty years ago, in 1929, when my mother Cecil Kwedi was just some few
months old, the world experienced its ‘first modern stock market crash’ sparking to the
Great Depression, an economic crisis never seen since then. As from 2008 the world is
engulfed in another global economic crisis of staggering ferocity. Does it mean that we
are living another Great Depression, and will it match the first modern ones in its strong
demand destruction? Some analysts are arguing that the Global Economic Crisis will
ultimately prove far more devastating than the Great Depression. As an analyst, I do
share to a certain degree this assumption. And there a number of reasons supporting my
point of view.
For the past half century, the American consumer has been the driver of the global
economic activity, therefore economic expansion. The capacity of many Americans to
consume has always not been based on intrinsic productivity but rather on debt from
creditors, further lubricated by irrationally loose monetary policies enacted by the U.S.
Federal Reserve. The American consumer has been leveraged to a level that is
unsustainable. The first symptoms were manifested in the sub-prime mortgage meltdown.
The result has been the virtual destruction of the financial world as we knew it, with the
extinction of many of the largest American investment houses and institutions, some of
which have been in existence for more than a century.

A second similarity of our current economic crisis to the Great Depression is the bad debt
that was accumulated in the banking system. This seriously hampered the banks in their
day to day operations and their ability to potential borrowers to extend credit. Thank
Jahveh, not in Africa as the continent banking system is not so flexible like their Western
counterparts. The crisis in the US is already well advanced. It is obvious that banks are
pulling in their horns in terms of making loans and generating credit. That is bound to
have serious negative repercussions on the rest of the world economy if it continues.

The third assumption linked to the first one is the decline in individual consumption.
With commercial banks in their majority being engulfed in huge debts, associated with
western consumers relying on debt to sustain their consumption, it will be difficult to
sustain the world consumption.
In sum, the crisis that we are experiencing originated in the US in bad debts made for
mortgages. As long as house prices fall and people continue to default, the banks will
remains weak.

Whether we want to buy a cell phone, rice or a bag of corn, baked cakes, a loaf of bread,
whether we click our order, telephone the order, use the mail, or go to a retail store, the
transactions, and indeed most economic transactions, are influenced by some form of
market regulation. In "market regulation," the word, "regulation," usually connotes some
extra-market, even administrative, guidance of the market. We'll call this external
regulation to distinguish it from regulation by competition.
What is really regulation? The regulation refers to controlling human or societal
behaviour by rules or restrictions. Regulation can take many forms: legal restrictions
promulgated by a certain governing authority, social regulation like norms, and market
regulation. One can consider regulation as actions of conduct imposing sanctions that
may be sometime fines.

The book, Guide to Markets Regulations, is structured around sixteen chapters and
attempt to bring some insights on ways and means to regulate capital markets and to
equip decision makers, bankers, lawyers, financial analyst, and government authorities in
the way they manage and develop capital markets in their respective countries.
Many points are discussed in the book, and deal with the following points…
 Give the Reserve Banks more oversight authority over institutions to which they
provides credit as a "lender of last resort."
 Strengthen capital, liquidity and financial disclosure regulations for financial
institutions.
 Create a financial oversight panel that could monitor and report to presidents
 Strengthen investigations into trading activity that appears to involve market
manipulation.
I am sure; you will enjoy your reading when going through this piece of work. All my
thanks to my God Jahveh, my mother Cecil Kwedi and all those who far or close have
contributed to make this peace of work a reality.

Yeoville, April 2009


Alain A. NDEDI
Chapter 1 - Defining the Capital Market

Lesson Objectives

• To understand the differences between Capital Market and other financial markets;
• To understand the various forms of investment instruments;
• To understand important policy issues in government regulation; and
• To understand the major institutions that are essential in a Capital Market.

Defining the Capital Market

Introduction
Nearly every country in the world has turned its attention in recent years to Capital Market
Development. The dramatic collapse of the Soviet Union in the early 1990’s, combined with the
extraordinarily strong growth in Capital Markets in developed countries such as England, Japan,
and the United States convinced most government leaders that socialism and government control
or ownership of business enterprises was no longer a viable course. Capitalist principles and free
market economic theory have become favored tools, even in countries with a long history of
socialism and nationalised industries.
We begin our examination of capital markets by defining some terminology, in particular by
defining and noting the differences between capital markets and other financial markets, such as
monetary markets. We will also examine some of the basic steps that must be taken to establish
an effective capital market.

Lesson Core
1. What is meant by the Term “Capital Market?”

Definitions
A capital market is a compound of two basic elements:

1. CAPITAL:
Invested money and property contributed into a business enterprise, investment funds, or capital

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raising government entities (such as special project entities and local government bond issues).

Capital investment is made in one of two forms:

(1) Equity or (2) debt


A capital investment in a business enterprise provides assets for business growth and
development.

2. MARKET:
A forum for the purchase and/or sale of financial interests, including capital investments. The
capital market refers to the buying and selling of capital investments, usually equity or debt
investments to be used by a business in its growth and development. A market can be located at a
physical location, such as a stock exchange, or it can exist without a physical location, such as the
over the- counter market.

When we speak of a Capital Market, we are referring to the joint efforts of investors and
entrepreneurs to foster the growth of business revenues and profits. Investors participate in this
process by putting at risk their money or property for the use of entrepreneurs, who may be
people with whom they have no other business, professional, or personal relationship. Investors
are willing to take such risks because of the possibility that they will receive significant economic
return on their investment if the business in fact prospers. Entrepreneurs participate in the capital
market process by offering various forms of financial instruments that attract investors to their
companies, such as ordinary shares, preferred shares, and various types of debt instruments.

An efficient capital market is one in which the regulatory infrastructure and market conditions
allow a free flow of capital into business enterprises and the ability of investors to translate their
investments into readily available liquid assets.
An equity investment is a permanent investment in the business enterprise. By permanent, we
mean that the investor does not have the right to demand repayment of the investment by the
enterprise. The only two ways that the equity investor receives any economic return are (1)
selling the investment at a profit to someone else and (2) dividends, which are discretionary
distributions made by the company to its shareholders? This is in contrast to a debt investment,
which carries with it the mandatory obligation by the company to pay interest on a regular basis
(often quarterly, and at least annually), as well as a mandatory obligation to repay the principal on

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or before a fixed maturity date.
Although we refer generally to the Capital Market, we must understand that the Capital Market
consists of numerous segments. If we refer to the Capital Market generally, we mean the entire
scope of investing and trading activities through which financial instruments are bought and sold.
Much of that activity occurs on formal stock exchanges, but much of it occurs through over-the-
counter transactions and through private investment agreements.

Some of the principal aspects of capital market activity are:

 Initial Public Offerings (IPOs) by Private Companies


 Privatisation Offerings by State-Owned Enterprises (SOEs)
 Unit Trust and Mutual Fund Offerings
 Venture Capital Raising and Investments
 Options, Warrants, and other Rights Offerings
 Re-Financing of Debt Instruments
 Recapitalizations of Existing Financial Instruments
 Secondary Trading of Equity and Debt Instruments

A common misconception among many people is that a capital market principally is located
within a stock exchange. As we will see, that is not true, and as the list above indicates, there is an
enormous amount of capital market activity that takes place outside the confines of a stock
exchange. A stock exchange is an important component of a capital market, but it is only one
component, and deals with only a limited aspect of the entire capital market.

Market Forces: Supply and Demand


The capital market can be analogised to any other market in the world that operates on a supply
and demand basis. Supply refers to the financial instruments being offered to potential buyers
(called investors). Demand refers to the degree of interest that potential buyers have in purchasing
the financial instruments. As with all other goods, if supply exceeds demand, the prices at which
the financial instruments are sold will go down. If investor demand exceeds supply, prices will
rise.
The problem assessing the quality of an investment opportunity is especially difficult for equity
and debt investments. These are “intangible” investments, that is, the investor receives only a

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piece of paper that evidences the investment, not a product or service. How does the investor
know, or at least have confidence, that the piece of paper will have an increased value six months,
one year, or three years from now? There is no guarantee, which means that equity and debt
investments are “risk-investments,” and they will only be made by persons willing to take that
risk in return for the chance of a positive future economic result.

Market Products: Financial Instruments


Equally importantly in terms of analogies to other markets, financial instruments are in
competition with each other for the buyers’ attention and interest. Not all stocks are equal, just as
not all refrigerators are equal. Buyer interest will depend on differences in quality and pricing.

How do buyers (investors) know the quality of the financial instruments? That is perhaps the
most difficult issue facing the capital market. If buyers are not confident that they know the
quality of what they are purchasing, they will put their funds into alternatives, such as real estate,
gold, jewellery, and bank funds. Much of the entire infrastructure that has been developed for the
capital market has been motivated by the problem of providing adequate and accurate information
to investors. The concept of “transparency,” also referred to as “full disclosure,” is at the heart of
any successful capital market.

Primary and Secondary Markets

Offers and sales of financial instruments take place in two distinct ways:

Primary market: This is the offering of securities by the company to the public.
It could be an initial public offering, called an IPO, or an offering of additional securities by a
company that already has listed securities. In either case, the primary market refers to the first
issuance of securities to the buyers from the company. The company issuing the securities is
called the “issuer.” Sales in the primary market are made directly by the issuer or through
underwriters.

Secondary market: After the issuer has sold securities to the public, anyone interested in
purchasing shares will buy them through the secondary market. The most visible secondary
market is the stock exchange. The over-the-counter market is also a secondary market. Existing

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security holders, such as shareholders, offer their shares for sale through the secondary market.
There is a common misconception that a company sells its shares to the public through the stock
exchange. That is not true. A company sells its shares to the public through underwriters and
other agents. Once those shares are sold, any subsequent trading in those shares takes place on the
exchange.

Financial instruments can be offered or sold in two distinct ways. The public can buy financial
instruments directly from the company in the primary market or from the stock exchange or over
the-counter market in the secondary market.

2. The Beginning of Market Regulation Infrastructure


Some countries, such as Egypt, Kenya, Nigeria, and Singapore have long histories of capital
market development and well established stock exchanges. Many other countries began their
period of modern capital market regulation more recently. The impetus for modernization in most
countries was the fact that governments decided to embark on a program to denationalize
government owned businesses. In most countries the process was referred to as privatization.
In some countries, the process was called equitization. Whatever the term, the goal was the same
---- to reduce state ownership of parastatals and State-Owned Enterprises (“SOEs”) through the
sale of equity interests to the public and major investors.

Privatization could not occur without significant structural changes, especially the formation of
basic infrastructure for a capital market. Before any equity interests could be sold to the public,
basic laws, regulations, and institutions had to be developed to assure investor interests were
protected, that trading markets were established, and that financial intermediaries were properly
licensed.

Basic steps included:

(A) Creation of a supervisory authority with responsibility for oversight of the issuance and
trading of securities.
In most countries, Parliaments provided for the creation of an agency, such as a Capital Market
Authority, to supervise and regulate securities offerings and trading. Prior to such legislation the
supervisory role was assigned to a department within the Ministry of Finance or the Central Bank.
The usual course was for an eventual transference of authority from a Ministry or Central Bank to

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a supervisory agency created by statute.

(B) Creation of a stock exchange to facilitate secondary trading in the securities of the
privatized SOEs. Here too a supervisory authority had to be established to create and operate the
exchange.

(C) Adoption of new laws and regulations for the issuance and trading of securities.
Old statutes, such as Company laws, were inadequate to meet current capital market conditions
and demands. As a result, new statutes needed to be adopted to govern the purchase and sale of
securities, and the securities commissions had to be given authority to issue regulations
supplementing the statute and providing specific rules where necessary.

(D) Adoption of licensing standards and examination procedures for market intermediaries,
including brokers, dealers, and investment advisers.
It was recognized very early that the public had to be assured of the quality and integrity of those
persons who operated the capital market. Thus, licensing and qualification standards were
adopted for brokers, dealers, investment advisers, and their representatives.

(E) Development of public education programs to make the public aware of investment
opportunities and the process for buying and selling securities.
In many countries, most people were (and still are) very uncertain about why a capital market
exists, how it works, and why it might be something for them to consider. The lack of knowledge
includes many well-educated people and professionals, because until very recently there was little
training or academic emphasis on capital market matters. Education programmes became a major
effort in many countries.

5 Basic Steps of Privatization:


1. Create a supervisory authority
2. Create a stock exchange
3. Adopt new laws and regulations for securities
4. Adopt licensing standards and examination procedures
5. Develop public awareness programs

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3. Participants in the Capital Market

The capital market attempts to bring together two basic participants:


• Business enterprises and other entities that are in need of capital investment, and
• Individual and institutional investors who are seeking to invest money and property in return
for an investment interest in the enterprise.

An efficient capital market provides opportunities for companies and investors to be brought
together to match their respective interests.

The principal enterprises seeking capital are:


(1) SOEs undergoing privatization;
(2) SOEs seeking additional capital investment;
(3) Privately-owned companies
(4) Unit Trusts and Investment Trusts
(5) Government agencies and units engaged in specific projects.

The principal investors in a capital market are:


(1) Individuals
(2) Unit Trusts
(3) Pension Plans
(4) Insurance Companies
(5) Foreign Mutual Funds
(6) Investment Firms
(7) Other Joint-Stock Companies or Corporations
(8) Merchant Banks
(9) Commercial Bank Trust Departments
(10) Employee Benefit Plans

One would think that with so many different types of potential buyers and sellers there
would be a lively capital market. That is not the case in many countries.

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4. Principal Forms of Investment
The principal forms of investment in enterprises are:
(1) Ordinary Shares (also called Common Stock)
(2) Preferred Shares
(3) Long-Term Debentures (secured or unsecured)
(4) Short-Term Company Notes

As we will see in later Lessons, financial investments can come in many different shapes and
forms. The four items listed above are the principal forms of investment, but many variations can
be developed within those forms. We will discuss the importance of assuring that capital market
regulations permit enterprises and investors to structure forms of investment in manners that are
considered most appropriate for business and market conditions.

5. Distinguishing the Capital and Monetary Markets


The capital and monetary markets exist side by side. Every day there are financial instruments
bought and sold in each of those markets. Inasmuch as the focus of this Course is on capital
markets, it is important to distinguish the monetary market and to carve it out from our regulatory
concerns.

The capital market differs from the monetary market in several respects:
(1) Short-Term: The monetary market refers to short-term debt obligations with maturities of
one year or less. In a capital market, debt instruments are generally one year or more in length.
(2) Government Bonds: The monetary market sellers include governments raising funds through
bonds and treasury notes for general budgetary purposes.
(3) Large Denominations: Securities bought and sold in the monetary market are in very large
denominations, and therefore they are not available to many individuals.
(4) Institutional Investors: Investors in the monetary market are usually institutions rather than
individuals. The institutional investors include pension funds, insurance companies, banks, and
large business enterprises.
The histories of capital markets differ from country to country. However, all capital markets share
in common basic infrastructure, including statutes, regulations, and fundamental institutions. To
understand the capital market is to understand its purpose, how it differs from the monetary
market, its participants, and the basic infrastructure that exists to put it all together. The purpose
of the infrastructure is to facilitate the trading of financial instruments, which is at the heart and

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soul of the capital market. The capital market exists in order for enterprises to raise funds, for
investors to place their funds into investment opportunities, and for investors to buy and sell their
securities to others. Full disclosure is the sine qua non of every capital market, and many of the
laws and regulations exist for the purpose of assuring that that policy is met.

Conclusion
1. Focus of the Capital Market: The capital market, as distinguished from the monetary market,
focuses on capital raising for business purposes by private and government enterprises.
2. Financial Instruments: The principal products in the capital market are financial instruments
being offered for sale by enterprises and by existing holders of the instruments.
3. Primary and secondary markets: Primary markets refer to the company’s issuance of shares
to the public; secondary markets refer to the trading forums, usually stock exchanges, where
existing shareholders sell their shares to new investors.
4. Privatization as the Catalyst for Capital Market Development: In many countries, the push
for privatization of nationalized companies was the principal motivating factor in creating stock
exchanges and other infrastructure for the capital market.
5. Matching of Enterprises and Investors: The principal purpose of the capital market is to
bring together enterprises that are in need of capital with potential investors who might be willing
to invest capital.
6. Competition within the Market: Within the capital market there is competition among
financial instruments being offered with regard to quality and price. Investors will generally
prefer better quality investments.
7. Transparency as the Principal Ingredient: The most important factor for all potential
investors is the ability to understand the quality of the investment by reason of the issuer’s full
disclosure of all material facts.

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Chapter 2 - Government's Interest and Role in
Capital Market Development

Introduction
Analysis of differing economic models in recent years indicates the importance of Capital
Market Development to the domestic economy. Adam Smith's theory of the "invisible
hand" that shapes economic growth is reflected in the growth of those economies that
rely principally on private investment and business ownership. This is in contrast to the
loss or stagnation of economies that rely principally on government ownership of the
means of production and distribution of goods and services.
An efficient capital market requires continual government understanding and analysis of
market conditions and the demands of both enterprises seeking capital and potential
investors. This is no easy task, for the market is a complex amalgam of legal, accounting,
economic, and social concerns. To understand how the market operates requires
considerable study and expertise. It also requires being alert to the appropriate role of
government; both as to what government can do and what government should refrain
from doing. The major areas that government impacts upon the capital market relate to
(a) the creation of statutes and regulations, (b) the monetary policies of government and
the Central Bank, and (c) the supervisory functions of a securities commission or similar
supervising authority. This Lesson will examine each of these important government
functions.

Chapter Objectives:
Upon completion of this chapter, the participant should be able to understand the
following:
· To understand the importance of permitting companies to
develop through free market economic principles.
· To understand the continuing trend towards privatization.
· To consider the role of government in facilitating free
market economics.

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· To understand the importance of government regulators
understanding the broad scope of subjects applicable to
regulation of the capital market.
· To analyze principal issues involved in drafting securities
statutes.
· To examine the relationship between the Central Bank and
the capital market.
· To consider major issues in creating a securities
supervisory authority.

1. Free Market Economic Principles

(A) Impact upon business enterprises


One does not need to be a trained psychologist to understand the individual motivating
factors that fuel growth in a free market. Individuals who have the freedom to own their
own businesses and enjoy the full benefit of business profits are more highly motivated to
make those businesses succeed than individuals who have no investment stake or interest
in profits. Private owners will take measures that accord with economic efficiency,
because to do otherwise will be against their personal interests. Thus, privately controlled
businesses are more likely to have more efficient work forces, are quicker to close losing
operations, and are quicker to seek new markets.

(B) Government-controlled businesses


Governments have a variety of interests that might interfere with economic efficiency. As
a result, government-controlled businesses tend to be over-staffed, reluctant to close
losing branches or divisions, unconcerned about heavy debt loads, and slow to react to
changing market conditions. Government-selected managers often enjoy job security
regardless of economic results, which is quite contrary to the competitive world of free
enterprise. As a result, many SOEs find themselves with inefficient management, heavily
laden with debt, and unable to shed unsuccessful branches or divisions. Government
borrowing makes up for lack of profits, but as that continues over time the company

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becomes so heavily laden with debt that interest payments alone eat up whatever profits
might be generated.

(C) The trend to free market economies


Governments throughout the world now recognize that domestic economic growth
depends in large measure on moving enterprise capital into private hands. This permits
business to tap into the entrepreneurial skills of its population. As the domestic
population begins to realize that they have a stake in business growth, this will encourage
a shift from savings to investment that is so vital in the capital raising process.

An excellent case in point is the recent success of the stock market in Egypt. Investor
demand for securities traded on the Cairo exchange resulted in index gains of over 80%
for each of 2003 and 2004. These gains have not been the result of good luck, but rather
they come from major shifts in domestic economic policy. As reported in the Wall Street
Journal on February 15, 2005, under "Discovering Egyptian Gains," the appointment of
persons with outstanding economic credentials to important government positions
resulted in "what some call the most far-reaching economic overhaul in Egypt's modern
history." Monetary reforms often cause dislocation and belt-tightening, and suffer
through some periods of popular discontent, but in the long run the measures
substantially improve a country's economic stability and fortunes.

It cannot be doubted, however, that a shift to a market economy causes short-term


economic dislocation in some countries. This has been illustrated where SOEs have
undergone transformation prior to privatization. Employment rolls have been reduced,
unprofitable branches (often in rural areas) have been closed, losing divisions have been
eliminated, and prices for goods and services have increased to more market-driven
levels. In fact, in some countries the increase in electricity and other utility prices for
consumers has been much greater than anticipated, as those utilities have struggled to
balance revenues and expenses. Dislocation and rising prices for basic utilities are not
popular results, especially for politicians, which explain in some degree the slow rate of
privatizations. Unfortunately, too, it must be admitted that some privatizations have

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helped government insiders more than the public, a problem that has caused the public to
be skeptical about government's intentions and privatization programmes.

Yet, privatization is here to stay and the trend towards private enterprise is inexorable,
especially in industries where consumer prices are not likely to be significantly affected.
Governments are under pressure from both the World Bank and internal financial experts
to privatize in order to raise revenue, eliminate costly business operations, boost public
investment opportunities, and increase productivity of goods and services.

(D) Abundant Resources


Many developing countries are rich in natural and human resources. In the past, those
resources have been under-utilized, mismanaged, or subject to economic and political
forces that have not benefited the country's overall economic development. Resources
that exist in many countries include:
(1) Mineral and other natural deposits of productive ores;
(2) Large fertile tracts of land for food production;
(3) Large labor pools of motivated men and women;
(4) Experience in enterprise development, as witnessed by
the enormous informal markets that exist in towns and
cities;
(5) Untapped sources of foreign capital through tourism
and local business development.
The principal goal for government policy-makers and regulators is to
facilitate the development of existing resources. These resources are best
utilized by the private market through well planned and supervised
capital market development. History has shown that centralized
ownership and micro-management by government does not create
efficient production.

2. Government's Role in the Free Market


Government's role in developing a free market economy can be described as one of

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facilitation. Government facilitates capital market development by adopting sound fiscal
policies for itself, by creating institutions that effectively regulate and promote the capital
market, and by enacting laws that appropriately balance business growth and investor
protection. If government does its job well, the free market will develop and take its
natural course. The natural course is that every individual entrepreneur, striving for his or
her own best interests, will help create an economy that is better for all. This is what the
famous economist Adam Smith meant when he referred to the "invisible hand" that leads
to greater efficiencies and utilization of resources and labor. In 1776, Adam Smith wrote
in "An Inquiry Into the Nature and Causes of the Wealth of Nations":
"Every individual necessarily labours to render the annual revenue of the
society as great as he can. He generally neither intends to promote the
public interest, nor knows how much he is promoting it ...He intends only
his own gain, and he is in this, as in many other cases, led by an invisible
hand to promote an end which was no part of his intention. Nor is it
always the worse for society that it was no part of his intention. By
pursuing his own interest he frequently promotes that of the society more
effectually than when he really intends to promote it. I have never known
much good done by those who affected to trade for the public good."

How can government permit the "invisible hand" to operate for the benefit of all? It is
extremely important that all government officials who have any role in capital market
development understand the balancing of standards to be adopted. Balancing must occur
in two different ways:

Did you know …

... that because the free market is not truly 'free' it is just as important to know when not
to make rules, as it is to know when to make rules?

(1) Balancing of business and investor interests


Government regulation can be so rigorous, and so dominated by a desire

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to protect against company abuse, that it becomes far too costly and time-
consuming for companies to comply with the demands. As a result,
companies will avoid reaching out to the public and bringing them in as
investors in their enterprises. There needs to be a balancing of interests.
Companies cannot be permitted to engage in fraudulent securities
offerings, but at the same time the standards must be realistic for local
conditions are and not unduly burdensome.

(2) Balancing of regulation


It is just as important to know when not to adopt rules and regulations as it
to know when market forces will benefit from rules and regulations. This
point cannot be over-emphasized. The free market is not truly "free."
There are many trade practices, customs, understandings, and unwritten
informal rules in the securities industry that govern day-to-day business
operations. These have developed over many years. Sometimes it is better
to let those informalities remain just as they are, for as soon as government
begins to regulate, informal practices suddenly harden into rigid
requirements, and the flexibility that is often needed to meet changing
market conditions can be lost. For example, some trading rules on an
exchange might be much better left to the understandings that have
developed among the traders than be formalized into government
regulation.

3. The Breadth of Government's Role in the Capital Market


The government's role in the capital market development process is
complex. It goes far beyond creating a statute for the regulation of
securities issuances and stock exchanges. In order for the public to have
confidence that the capital market is being run in a fair and transparent
manner, government officials must be involved in a continual process of
understanding:
1 how the market operates,

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2 the principal problem areas faced by private companies,
3 the major concerns of potential investors,
4 the variety of forms of financial instruments in the market,
5 the impact of regional and international developments,
6 the relationship between public and private sector financing,
7 the most effective means of enforcement and sanctions.

Remember …
Governments need to acquire a broad range of knowledge about
capital markets for successful development to occur.

4. Training and Education on the Capital Market


The task of acquiring the broad range of knowledge about the capital
market appears daunting. Much of it is quite technical. How are people in
government ministries and agencies going to acquire this knowledge? This
is probably one of the first and most basic tasks of government in the
capital market development role. Workshops such as this one can fill an
important need in this area. But there is much more that should be done.
Ask yourself whether, in your country:
(1) There are courses in the Faculty of Law that specialize
in capital markets;
(2) There are courses in the Faculty of Business that
specialize in capital markets;
(3) There are post-education training programs in capital
markets for lawyers;
(4) There are post-education training programs in capital
markets for accountants;
(5) There are training programs in capital markets for
judges;
(6) There are training programs in capital markets for
government and agency personnel;

16
(7) Statutes and regulations are readily accessible in
published documents;
(8) Interpretive advice on questions of securities laws is
available through regulatory agencies or other expert
authorities.
Of course all of these programs require time, money, and personnel. But
they are essential infrastructure component to a successful capital market.
Knowledge and the ability to analyze what is important for the domestic
economy have to be in place. When we ask what is needed for an efficient
capital market, too often we start and end by listing formal elements such
as statutes and agencies. But where does the knowledge come from to
know what statutes are best for the domestic market and how agencies can
best develop policies that stimulate market growth? This is an intangible
yet equally vital component to the capital market infrastructure.
The following discussion focuses on structural elements within
government, those institutions that have direct and indirect responsibility
for developing the capital market.

5. Principal Government Institutions Affecting the Capital Market


(A) Ministries and Agencies that Draft Statutes and Regulations

Ministries and agencies that are responsible for drafting and amending the company and
securities statutes must be continually alert to market developments. Here are just a few
major areas that regulators should be aware of in considering appropriate statutes or
regulation:
(1) The Securities Registration Process:

It is very easy to create a registration scheme, full of filing and disclosure


obligations. But, is the scheme too difficult for many companies? Does a
security statute borrowed from a neighboring country or worse yet, from a
developed country such as the U.S. or England, fit the facts that are on the

17
ground? Does it make sense to require several years of audited financial
statements in a country where few companies have any audited
statements? Does it make sense to require the same registration process for
all offerings, regardless of size or the number of investors?

(2) The Secondary Market:


Most countries have created, or are in the process of creating, stock
exchanges for the secondary trading market. That is well and good. But
not all companies that need to raise capital will be large enough to meet
stock exchange listing standards. Therefore, if we want those companies to
be able to sell securities in order to raise capital, there has to be developed
an over-the-counter market or modified listing standards for smaller
companies. In the United States, for example, there are many more
companies trading over-the-counter than on any of the stock exchanges.
The Securities and Exchange Commission has worked closely with
broker-dealers to establish fair trading rules and procedures for the over-
the-counter market.

(3) The Enforcement Process:


It is axiomatic that laws and regulations mean nothing unless there is an
adequate enforcement mechanism. Most securities and company laws
have very complete provisions regarding violations and potential
penalties. But, what is the ability of the Ministry of Justice, Securities
Commission, public prosecutors, or other enforcement arm to investigate
and prosecute possible violations? Is there sufficient funding to support a
trained prosecution staff? Are subpoena powers effective? Are there
temporary measures that can be taken prior to a trial, such as cease-and-
desist orders? Do lawyers and the judiciary understand the securities laws,
or should we require training in this specialized area? All of these are
policy questions and raise the question of resource allocation. Government
policy-makers cannot congratulate themselves on fine-looking statutes and

18
regulations unless they have also assured that means are provided for
effective enforcement.

In the next lesson, we will discuss in detail some of the principal policy issues facing
government policy-maker and regulators. What is clear is that the capital market requires
extreme attention and care in developing, amending, and enforcing laws and regulations.
That, in turn, requires continual analysis of what is happening on the ground, both locally
and beyond. A workshop course such as this is intended to provide at least the start of
that analysis process. You, as a participant, will have the basis for a better understanding
of the capital market that is being developed in your country.
There is one other point to make with regard to the need for government regulators to be
knowledgeable and sensitive to their responsibilities. That point has to do with the human
element. Even in developed countries, the capital market is a mystery to most people.
Many people stay away from investing in a process that seems so unusual and
complicated. It is therefore of critical importance that government regulators recognize,
and educate others, that the capital market is a tool to improve the welfare of all citizens.
Ultimately, the welfare of the local population is what is most important. The capital
market exists to improve the community welfare by expanding economic opportunities.
Government regulators are therefore performing a vital task in developing, supervising,
and enforcing the rules of the capital market. The task is one that government cannot
achieve alone. For the capital market to be successful it requires the coordinated efforts
and support from both the public and private sectors, including an understanding by all of
the capital market's importance in the future hopes for the country and its people.

5. Principal Government Institutions Affecting the Capital Market


(B) Central Bank
The Central Bank plays a key role in regulating interest rates, the public float of currency,
and overall monetary policy. The interest rates that the Central Bank sets for government
treasury notes and other government debt obligations directly influence the capital
market. T-Bills and other government debt compete in the market for investors. If the
Central Bank has not been able to reduce inflationary factors, or if the Bank sets interest

19
rates at high levels, investors will be more likely to put their money into government
securities rather than private company securities. The more funds that go into government
securities, the less there is available for private company development. Moreover, high
interest rates for government debt securities necessarily will drive up the interest rates for
company notes. The result will be that companies may find it very difficult to compete
with government securities, and if they are able to match or exceed the government rates,
the companies might find themselves under severe financial strains to meet the high
interest rate payments.
Sometimes Central Banks have little choice regarding interest rates. If the government
budgetary policy is based on high deficit financing, T-Bills and other government
securities will necessarily have to be sold in large quantities and at high interest rates to
attract sufficient investors. The answer is not to blame the Central Bank, but to go up
another level and question the wisdom of the government's budgetary policy. However,
Central Bank officials are important and respected members of the government's financial
organization. Thus, they should be among the most outspoken in favor of government
monetary policies that stabilize the currency, keep inflation to acceptable levels, and
minimize the amount of debt that the government must raise from the market. What is
most important is to recognize the link between government monetary policy and the
ability of private companies to raise capital. If the direct impact of government financing
upon private company financing is understood at all levels of policy-making,
government's sometimes indifferent attitude towards deficit financing might well be
affected.

5. Principal Government Institutions Affecting the Capital Market


(C) Capital Market Supervising Agency
Government expertise in the workings of the capital market is essential to market
regulation and development. That expertise is best created within an agency that
specializes in the capital market. Most countries have established such an agency,
whether called the Securities Exchange Commission, Securities Commission, Capital
Market Authority, or any other title. It is the government agency that is authorized to
regulate and supervise:

20
o the public offering of securities
o disclosure and transparency standards
o stock exchanges
o brokers and dealers
o enforcement of the securities laws
o over-the-counter markets
o unit and investment trusts
o investment advisers and those are only the major subject areas.

Other responsibilities often include public education, interpretive advice to lawyers and
other inquirers, regulation of offerings by local government units such as towns and
municipalities, developing exemptions from registration for limited forms of offerings,
establishing uniform accounting standards for publicly-held companies, regulating
foreign investment in domestic companies, and advising the Ministry of Finance and
other government officials on the progress of the securities market.

Questions for Reflection:


What are some of the responsibilities of a Securities Exchange Commission or a Capital
Market Authority?
Are the securities laws and regulations your country flexible enough to adjust to changing
market conditions?

In many countries there is a comprehensive statute that establishes the regulatory agency
and at the same time creates the standards to be enforced by that agency. Government
policy-making must be very careful in this area. It is very tempting for legislators to put
everything they can into the securities statutes, including for example:
o exact description of registration statement disclosure items
o exact periodic reporting requirements for public companies
o exact standards for registration exemptions
o exact licensing standards for brokers, dealers, and investment advisers
The problem that such legislation creates is the lack of flexibility to adjust to changing

21
market and commercial conditions. It is entirely appropriate for the legislature to
determine some requirements and to determine specific standards and conditions. For
example, the securities statutes in the U.S. list specific items of disclosure to be included
in registration statements. The problem comes not from the specific provisions but from a
lack of authority to the agency to develop other standards when circumstances warrant. It
is important for an efficient market that the agency charged with market supervision have
sufficiently flexible powers to be able to adjust promptly and effectively to changing
market conditions.

5. Principal Government Institutions Affecting the Capital Market


(C) Capital Market Supervising Agency
The securities statutes in the United States provide excellent examples of administrative
flexibility. The principal statute requiring the registration of securities (the Securities Act
of 1933) contains a schedule of required disclosure elements. In addition, the statute
specifically states:
"Any prospectus shall contain such other information as the Commission
may by rules or regulation require as being necessary or appropriate in the
public interest or for the protection of investors."
In the area of enforcement, the principal statutory provision is Section 10(b) in the 1934
Exchange Act. That provision is a delegation of authority to the Commission to develop:
"...such rules and regulations as the Commission may prescribe as
necessary or appropriate in the public interest or for the protection of
investors"
Regarding a manipulative or deceptive device or contrivance. Rule 10(b)(5), which is the
Securities and Exchange Commission's response to this delegated authority, is the single
most powerful weapon in the enforcement of the securities laws. That Rule has been
amended twice by the Commission to respond to particular problem areas.

Questions for Reflection:


What method does your country use for appointing regulators?
What is the public perception of this method?

22
The securities statute creating the agency will often prescribe the principal agency
commissioners. For example, one appointee by the Ministry of Finance, one appointee by
the Ministry of Justice, etc. Two points should be emphasized in this regard:

(A) Public confidence in objectivity of regulators:

Public perception is absolutely the most important element in creating a viable


capital market. The public must be convinced that the people regulating the
market are objective in their judgments. The more that the agency appointments
appear to be politically motivated, the less the public will have such confidence.
That is why in some countries the terms of office of the appointees exceed that of
the government elections, or why in some countries the law mandates that there
be equal or near-equal representation from various political parties. Another
method that is used in some countries is to assure that a majority of appointees
come from non-governmental bodies, such as bar associations, trade
organizations, and other private sector institutions.

(B) Importance of staff personnel

Most of the work by the agency will be done by staff, not the commissioners.
Staff appointments, which are not covered by legislation, are perhaps even more
important than the identities of the commissioners. Without good staff, the
agency will not perform as hoped. Unfortunately, many legislatures focus on the
upper level commissioners and overlook the importance of staff appointments.
Thus, agencies are not funded adequately in order to recruit, train, and retain
highly skilled lawyers, accountants, and other staff members who are needed to
run the agency on a day-to-day basis. It does not matter how qualified or elite the
commissioners are if there is not an adequate number or quality of agency staff.
We will return to this important point when we discuss enforcement of the
securities laws, because there too the legislature all too often overlooks the

23
importance of providing the necessary funding for enforcement needs.

CONCLUSION
Both history and economic principles have proven that free market
economies produce greater goods, services, and wealth than do
government-controlled economies. Many countries are in the process of
moving away from government control of major businesses and industries,
and this trend will undoubtedly lead to increased economic growth.
However, the free market cannot be entirely "free" from any government
regulation. There are important protections that must be preserved for
investors and to assure fair trade and competition. Government's role is to
balance business and investor concerns to facilitate the growth of the free
market. That is not an easy task, and governments throughout the world
are constantly tinkering and experimenting with various policies to seek
better results. All we can ask of government officials is that they educate
themselves as well as possible and give their best effort to develop
principles, policies, and programs that, in their best judgment, maximize
business and investor opportunities.
Government plays a central role in the capital market by creating the basic
institutions that regulate and supervise the principal market participants.
To do their job effectively, government regulators must be trained to
understand the breadth and demands of the capital market. That is no easy
task, as the capital market consists of a large number of elements, ranging
from various financial instruments to a variety of licensed professionals.
Ministries, Central Bank officials, and securities commissions and their
staffs all play key roles in market development. Understanding the
responsibilities of those government institutions will help regulators
formulate appropriate standards for the market participants.

1. Free Market Policies: Business growth and personal wealth are much more
likely to occur in a free market rather than in a government-controlled economy.

24
2. Government-Run Businesses: Government has many interests other than pure
economics, and therefore government-run businesses often fail to be economically
efficient.
3. The Invisible Hand: Adam Smith's discussion of the effect of allowing each
entrepreneur to follow his or her own course remains a basic principle of the free
market economy.
4. Government's Role: The principal role for government in a free market
economy is to facilitate the interests of both business and investors, not favoring
one over the other and not adopting unnecessary and restrictive rules.
5. Scope of Capital Market Regulation: There is a broad range of subjects that
government officials must study in order to understand how the capital market
operates.
6. Training: There should be adequate training and educational programs for
government personnel, lawyers, accountants, judges, and all others whose
decisions affect the capital market.
7. Agency Authority: Securities statutes should be carefully analyzed by
government regulators to assure that the agencies are given sufficient powers and
authority.
8. OTC Market: Is there an over-the-counter market in your country? If not, is
that an impediment to capital raising by smaller companies?
9. Enforcement of Laws: Enforcement of laws is essential in order to maintain
public confidence in the capital market. Enforcement requires more than statutes,
it requires adequately trained and financed investigators and prosecutors, as well
as knowledgeable judges.
10. Monetary Policies: Monetary policies determined by the Central Bank
directly affect the ability of companies to raise money in the capital market.
11. Government Budgetary Policies: Government's budgetary policies also have
a direct influence on the ability of companies to raise money in the capital market.
12. Agency Ability to Respond to Market Conditions: The agency responsible
for supervising the capital market is responsible for a broad range of related
subjects and must have both the flexibility to be able to respond to changing

25
market conditions and requirements.
13. Government Funding: Government must provide adequate financing to staff
the supervising agency in order to assure that it can perform all of its functions
effectively.

26
Chapter 3 - Principal Government Policy Issues

Introduction
Despite some overall similarities, capital markets vary considerably among countries.
Differences are in part due to local economic conditions and in part due to varying
economic and reform policies adopted by government regulators. Capital markets should
be continually analyzed by policy-makers to assure that regulatory policies are in fact
consistent with local conditions and goals. It is not enough to adopt laws and regulations,
often borrowed from elsewhere, then sit back and wait for the capital market to develop.
Government officials responsible for capital market regulation must:
1 Study and understand local economic factors,
2 Consider the political and social forces that have shaped the economy,
3 Determine appropriate goals for the capital market, and
4 Balance multiple concerns ranging from business development to investor
protection.
This lesson sets forth principal policy questions that should be addressed in the process of
considering capital market regulation.

Chapter Objectives:
Upon completion of this chapter, the learner should be able to understand the following:
1 To consider principal government policy objectives in creating
capital market regulations
2 To determine the principal factual inquiries that should be made in
considering adopting government policies.
3 To analyze the scope and timing of government policy-making.
4 To consider whether discretionary powers should be granted to
supervising agencies.
5 To consider whether alternative registration requirements are
appropriate based on the size and nature of the securities offering.
6 To discuss the scope of the term "securities" in order to determine
the application of the securities laws.

27
7 To consider whether special provisions should be adopted to
regulate an over-the-counter market.
8 To analyze some of the major issues in developing an effective
enforcement programme.
9 To examine principal issues involved in the harmonization of
regional laws.
10 To consider means of educating and interesting the public as to
capital market investment opportunities.

1. The Diversity among Capital Markets


The process of government regulation of the capital market is like baking a cake. The
recipe for success has many ingredients, some obvious, some less obvious. The failure to
add some essential ingredients, or the putting of too much or too little into the baking
pan, might seriously affect the quality of the cake. This cake is not the product of one
cook. Government ministries, banks, agencies, and private sector professionals might all
be in the kitchen. Does each cook know what the other is doing? Without both planning
and coordination, at the end of the day we might wind up with something that we can call
a cake, but it might not be the kind of cake that looked so promising in the recipe book.

There are numerous ingredients to developing an efficient capital market. To further


complicate matters, recipes vary from country to country. No two capital markets are
alike. There are basic similarities, but every market must be studied for its own
peculiarities and localized institutions. We can borrow policies and regulations from
other countries, just as recipes are borrowed among neighbors, but we must make sure
that what we have borrowed will work for our country's specialized conditions. That is
why our recipe starts with questions. In each country a series of questions must be asked
and the answers developed based on local conditions. Those answers will determine each
country's recipe for its capital market.

2. Principal Policy Questions for Government Regulators to Consider


The principal policy questions that government and other quasi-regulatory institutions

28
should consider in capital market development include the following:
(1) What do we want to achieve in our capital market?
(2) What is the current status of the capital market?
(3) Should government regulation precede or adapt to the trading market?
(4) Should the supervising agency be granted discretionary powers?
(5) Should the same registration requirements apply to all securities
offerings?
(6) What are "securities" for purposes of the securities laws?
(7) Should regulations be developed for an over-the-counter market?
(8) What are the most effective means for enforcing the securities laws?
(9) To what extent should laws be harmonized with neighboring
countries?
(10) How can we educate and interest the public to become potential
investors?

(1) What do we want to achieve in our capital market?

(A) Market Goals and Motivations


Many of the capital markets in developing countries are still young enough that it is a fair
question to ask: what are we trying to achieve? Even older markets would benefit from
asking - what are we hoping to achieve by the development and regulation of the capital
market?
It is very tempting to rush into the maze of securities laws, stock exchange rules, and
licensing regulations without asking the basic question, which is "why are we doing
this?" Or, to put it another way, "what are we hoping to achieve?" This basic question
should be the starting point of analysis and should be asked in settings that involve
representatives from both the public and private sectors.

The answers to these questions will differ among countries. Nevertheless, there
are substantial commonalities and we can learn from the experiences in other
countries. We know, for example, that in African countries, the principal capital

29
market goals in recent years have been developed as a result of one or more of the
following factors:
(1) privatization programmes that cannot be undertaken
without a capital market infrastructure;
(2) a desire to create investment opportunities for the local
population;
(3) a desire to stimulate the growth of small and medium-
sized businesses;
(4) a concern that foreign capital is dominating the local
economy and not permitting indigenous economic growth;
(5) a concern that regulation is necessary to curb abuses in
investment schemes.
(B) Priorities, Time-Tables, and Patience
The goals necessarily lead government policy-makers to a sense of direction.
Most developing economies cannot achieve a full-scale efficient capital market at
once. There must be priorities in efforts and inputs. Understanding the priorities
will lead to greater clarity of purpose in the regulatory process.

For more information on the goals of capital markets you can check the
following website: www.developmentgateway.org

If we focus solely on Sub-Saharan countries (although similar themes are heard


across the globe), a common lament that one hears is that capital market
development is going too slowly. We have created the tracks and the engines for
economic growth, but the train has barely left the station, and it is moving far too
slowly. The lament is understandable. After decades of under-development and
misuse of resources, everyone across the continent is anxious to adopt modern
economic tools and create opportunities for jobs, personal income, and public
welfare. Yet, despite all good intentions and the existence of basic infrastructure,
the results have not been produced.

30
Two responses to the lack of hoped-for progress are possible:
1 Resignation, a sense of defeat that the task is beyond our
capabilities. This response is heard from nay-sayers who will say
that the capital market cannot develop in the midst of Africa's
enormous political and social problems. First the problems must be
solved, and only then can we consider creating an efficient capital
market. How do we respond to this argument? Can we respond by
saying that the political and social problems will be resolved by an
improving economy, by optimism among the population that there
is a better future, by developing a capital market that encourages
smaller companies to grow and the unquestioned entrepreneurial
spirit in Africa to thrive? That is not simply a response of
optimism, it is a response grounded in the knowledge that the
enormous physical and personal resources in Africa, including a
highly motivated population and dedicated government officials,
offer a major solution to improving the conditions of life and
fighting the problems that now consume much of our energies.
2 Patience, an understanding that "Rome was not built overnight"
and that capital markets are like slow-growing plants that need
substantial nurturing before they reach maturity. Even the most
developed economies suffer their ups and downs and are
constantly changing their regulations and expectations. The
conditions among countries are so different that it makes no sense
to look at Singapore, Hong Kong, and Frankfurt and wonder why
Kampala, Accra, and Gabarone are not enjoying similar status.
Some African stock exchanges are doing remarkably well in
percentage gains in indices, indeed among the best in the world.
But even those exchanges, such as Botswana, are still very small
(only about 20 listed companies) compared to the country's
potential. And the key word is "potential," for that is what will fuel
future growth. But it will be slow. Developed markets have been at

31
this game for 50, 100, 200 years. Although some exchanges in
Africa date back many years, the fact is that it is only very recently
that African countries began to take hold of their own economies
and developed significant infrastructure for capital market
development. (The principal exception of course is South Africa.)

When one looks back over the past decade, there has been substantial growth in many
African markets, even where stock exchange listings have remained fairly low.
Government regulators must continue to examine set priorities and establish realistic
timetables for achieving those goals. The slow pace will sometimes cause frustration, but
progress will not be impeded if the infrastructure continues to be improved.

(2) What is the current status of the capital market?


Government officials and employees dedicated to creating a better capital market often
do not have fundamental information regarding their country's business climate. The lack
of information is sometimes the result of inadequate sources of information. Sometimes,
however, policy-makers do not sufficiently understand the importance of knowing what
is on the ground and how will local enterprises be affected by the newly-created
regulations. Among basic questions to be asked (and of course answered) are:
1 How many registered companies exist? In what categories?
2 What do we know about the relative sizes of our domestic
enterprises?
3 What industries appear to be in a growth pattern?
4 What are the alternative funding sources, private and institutional?
5 What is the quality of support services from lawyers, accountants,
and investment advisers?
6 Are people investing their savings and, if so, in what kinds of
financial instruments?
7 What are the international factors that affect our local economy
and markets?
8 Is there public confidence in the fairness of the securities market?

32
If not, why not?

Knowing the local conditions is basic to considering appropriate policies and


regulations. For example, if there are very few companies that have audited
financials, what standards should be adopted when and if those companies want to
raise money in public offerings? If most of the businesses are relatively small and
family-owned, should there be developed some alternatives to the expensive,
time-consuming model for registration of securities? If certain private sectors are
showing excellent growth, should regulations be developed to encourage
businesses in those sectors to reach out for public funding? If we want to
encourage risk diversification for private savings, should we consider developing
regulations for unit trusts and investment trusts?

Illustration 1
Country X created its stock exchange 20 years ago during a period of
privatization. There are 24 companies listed on the exchange, all of which
are former SOEs. According to the Registry of Companies, there are
36,000 privately-owned companies in the country. According to the filed
tax returns, 20% of those companies have annual revenues in excess of
$250,000. Yet, not one company has engaged in a public offering of
securities. Why is that? Are the rules too strict, the standards too high?
What efforts have been made to encourage and educate company owners
regarding the capital market?
Asking the right questions is an important task for government officials.
Answering them will often require the input and assistance from a wide range of
public and private sector sources.

(3) Should government regulation precede or adapt to the trading market?


Some countries have adopted full-scale securities laws, licensing requirements,
registration provisions, and so on, before a single company was listed on the local
stock exchange. There are other countries that keep old laws and regulations in

33
place despite evidence that the policies are not achieving the desired goal of
capital market development. In both cases, there is a danger that market forces are
being hindered by rules that are not responsive to local conditions. Market forces
involve such factors as the supply of capital, the supply of investment
opportunities, the competition from foreign capital markets, the impact of
government fiscal policies, and the number and activities of broker-dealers and
investment advisers.

It surprises many people to learn that in the United States, by far the most highly
developed of all capital markets, there was no national legislation or
administrative agency dealing with securities laws until 1933, yet trading began
on the New York Stock Exchange in 1792. There were state securities laws, but
they did not begin until the 1910's. In other words, securities were being offered
to the public and sold on stock exchanges long before formal government
regulation was developed. In some respects that was a problem, because the lack
of regulation led some companies and individuals to take advantage of the system
at the expense of others. But on the whole the process worked fairly well through
self-regulation and protections offered by tort and criminal laws. The point is not
that we should refrain from regulation, but that regulation should:
1 consider trading practices that have developed informally;
2 conform to the efficient practices that have developed; and
3 cover areas where potential problems could arise.

Take note:
If the capital market rules are not responsive to local
conditions; market forces are being hindered.

Certain minimum securities laws and regulations must be adopted before a


capital market has fully developed in order to give guidance to both public
and private sectors. However, the degree of such regulation, and its
content, should be determined by analysis of current market conditions as

34
well as reasonably anticipated conditions in the near future. Regulations
need not be permanent, they can change and adapt to changing market
forces. As the capital market matures, more or different regulations might
be appropriate.

Illustration 2
Country X has a stock exchange that has listing requirements adopted 10
years ago when there were only a few former parastatals listed on the
exchange. The listing requirements relate to the assets of the company,
number of shareholders, amount of public float, and company
capitalization. Unfortunately, very few non-parastatals qualify under those
listing standards. If the policy-makers in Country X want to encourage
greater capital investment in local companies, perhaps the listing
requirements should be modified to reflect actual market conditions. Or,
perhaps policy-makers should consider the development of an over-the-
counter market as an alternative to the restrictive exchange requirements.
In either case, re-consideration of standards adopted in earlier times and
under different circumstances is essential to maintaining appropriate and
timely policies.

(4) Should the Supervising Agency be granted discretionary powers?


Legislation, no matter how well drafted, is
1 inflexible,
2 fails to adapt well to changing conditions,
3 is slow and difficult to amend, and
4 leaves difficult interpretive questions unanswered.
Parliament should not attempt to "micro-manage" a capital market through
legislation that attempts to cover all possible contingencies and leaves little room
for a flexible response to changing market conditions. The supervising agency
responsible for administration of securities and other relevant laws, the Capital
Market Authority or whatever it may be called, should be granted both rule-

35
making and discretionary powers. This is especially important in these days of
volatile market forces and rapidly changing financial instruments.
There is, however, a basic concern to granting discretionary authority to an
agency. That is the concern of favoritism, or to use a less kind term, corruption.
The concern can be alleviated to some degree by assuring that agency personnel
meet standards of integrity and ethical conduct. Requiring public disclosure of all
agency actions can also alleviate it.
What areas would be appropriate for agency discretion? Two examples could be:
(1) Disclosure standards for various types of registered
offerings; and
(2) Exemptions from registration for certain limited
offerings.
The first area, disclosure, relates to whether the same registration requirements
should apply to all offerings. In order to encourage public offerings by small and
medium-sized companies, it might be appropriate to develop different registration
standards based on the size of the offering. Although this is a decision that could
be debated and made by Parliament, it is a decision that much more readily could
be made by the agency endowed with supervisory authority in the securities field,
especially as the differences in registration requirements might need to be
considered for several different types of registered offerings.

The second area, exemptions, relates to whether there should be some


exemptions from registration for offerings limited in size, or limited in the type
or number of purchasers. If an important policy is to facilitate the growth of local
enterprises, consideration should be given to creating limited offering exemptions
that permit smaller companies to raise capital without the time, expense, and
rigors of registered offerings. Again, the supervisory agency may be the most
appropriate body to consider and determine rules in this area. An example of
discretionary authority is found in Section 3(b) of the Securities Act of 1933 in
the U.S., which permits the Securities and Exchange Commission to create
registration exemptions up to $5 million

36
"…if it finds that the enforcement of this Act with respect
to such securities is not necessary in the public interest and
for the protection of investors by reason of the small
amount involved or the limited character of the public
offering."
Several years ago the U.S. Congress granted even broader discretionary authority
to the Securities and Exchange Commission. Congress added Section 28 to the
1933 Securities Act, which states that:
"The Commission, by rule or regulation, may conditionally
or unconditionally exempt any person, security, or
transaction…from any provision of this Act…to the extent
that such exemption is necessary or appropriate in the
public interest, and is consistent with the protection of
investors."

The SEC has used its discretionary powers to create registration exemptions and
to modify registration requirements for smaller companies. Similar discretionary
powers have been granted to securities administrators in the various states, and
they too have used those powers to improve the capital-raising opportunities for
smaller businesses.

5. Should the same registration requirements apply to all securities offerings?


Registration for purposes of a public offering of securities is a time-consuming,
expensive process. If one of the basic policies of capital market development is to
facilitate the opportunities for small and medium businesses to raise capital, it
might be appropriate to consider limited forms of registration and even
exemptions from registration for certain types of offerings. If a company only
wants to raise $50,000 by selling ordinary shares to 20 or 30 persons, should the
regulations insist upon the same registration statement and process that is required
for a $5 million offering that will be sold to 1,000 persons?

37
Government policy-makers must always consider two goals, which appear
conflicting but need not be:
(i) Investor protection and
(ii) Enterprise development.
Laws and regulations could be created that are so heavily weighted in favor of
investor protection that few if any companies would want to raise capital under
those conditions. Balancing is important, for it makes no sense to create a
monument of laws aimed at protecting investors if the result is to make it too
costly or difficult for companies to raise capital.

Is it possible to develop alternative disclosure standards for registered offerings


based on the size of the offering or the nature of the company? In the United
States, for example, a public offering that is limited to $5 million can be made
under a different disclosure and registration format than a public offering in
excess of that amount. Exemptions from registration have been created both by
statute and administrative rule for a variety of offerings based upon size (for
example up to $1 million) or the nature of the purchasers (for example, a limited
number of experienced investors).
Regulations in most African countries do not make distinctions among offerings
based on size, nature of the purchasers, or other factors. The "one size fits all"
approach to regulation might have the unfortunate consequence of discouraging
some capital formation activities. Thus it is important for policy-makers to
consider whether and to what extent the full-scale registration process should be
modified for limited types of securities offerings.
If a full registration process is to be reduced in some circumstances, it may be
done either by:

1. Registration Exemption
The offering would not involve the filing or government review of any
registration documents. The offering would involve only the company and the
investors. Disclosure laws would continue to apply, but there would be no fixed

38
requirement as to the form of disclosure or the specific items to be included. The
form and content of disclosure would be left to the decision of the company itself.
In some countries, even if there is an exemption, the company is required to file a
form with the securities agency informing the agency of the offering and its
results.

2. Registration Modification
The company is required to file a registration statement with securities agency,
but the form and content of that filing is less than a full registration. For example,
the amount of financial statements might be reduced from three years to one year,
or requirements as to the employment of sponsoring brokers or subscription
agents might be modified.

Question for Reflection:


Does your country use the "one size fits all" approach to capital market
regulation? If so, what elements could be changed to allow more
flexibility?
Here are some examples of registration exemptions or modified forms of
registration that might be considered:

1. Amount Being Offered:


If the amount of securities being offered for sale is relatively small, it would be
too costly for most companies to comply with all the registration requirements.
Perhaps a minimum figure could be used, for example, $100,000, below which
the offering would only have to comply with modified requirements.

2. Number of Purchasers:
Most public offerings have hundreds, perhaps thousands, of purchasers. Suppose
a company plans to raise capital from a much smaller number, for example 30
purchasers. An exemption or reduced form of registration could be considered for
this more limited offering.

39
3. Type of Purchasers
Most public offerings involve sales to a wide variety of purchasers, including
individuals who are not experts or experienced in stock market investments. But,
suppose that a company wants to raise capital from a group of people who are
experienced and knowledgeable in the securities market. Would it be necessary
for the company to go through a full registration process for these types of
purchasers?
It is extremely important to emphasize that registration exemption, or modified
forms of registration, would not reduce the basic disclosure requirements. All
offerings must meet basic disclosure standards, and every offeree must be given
the full facts about the company and the securities being offered. What is being
discussed here is a reduced requirement for the registration process, not a
reduction in the fundamental disclosure requirements.

6. What are "securities" for purposes of the securities laws?


Most laws and regulations define securities in a fairly narrow manner. Ordinary and
preferred shares are covered, as well as company debentures. But beyond those obvious
forms of securities, statutes are sometimes quite unclear. This could be a serious
oversight, as the securities laws should apply to a broad variety of situations in which
people are being asked to part with their money upon the promise of an economic return.

Here are examples of possible securities offerings that are "investments" and therefore
should be considered for inclusion in the definition of "securities:"
1 Limited partnership interests
2 Promissory notes issued by a person or sole proprietorship
3 Promissory notes issued by a general partnership
4 Profit-sharing schemes that do not involve the ownership of shares
5 Membership interests in foreign limited liability companies
6 Pyramid schemes
7 Investment contracts

40
Let's consider some Illustrations:
Illustration 1: Limited Partnership Interests
A limited partnership consists of two types of partners: general partners who run
the operation and limited partners who invest money. Limited partners have some
rights under law and by contract, such as the right to elect and remove the general
partners. However, the limited partners usually are far removed from day-to-day
operations. Limited partnership interests are therefore very much like corporate
shares. General partners who offer to sell limited partnership interests should be
treated as offering "securities" just like shares, and the securities statute should be
written broadly enough to include such partnership interests.

Illustration 2: Pyramid Schemes


Pyramid schemes are very popular "get rich quick" schemes. They can be very
dangerous. Basically, they work like a "chain letter." Whatever the scheme, it
usually involves people receiving money because they are able to bring new
people into the scheme. There is usually some kind of business that technically is
involved, such as the sale of cosmetics, but the business is only a sham disguise
for what is really important, which is getting money for bringing in new people
who pay to become part of the scheme. If A pays $25 to get into the scheme, and
then receives $10 for every new person he/she brings in, A will make a profit by
bringing in B, C, and D, who each pay $25. The scheme usually also pays A for
new people that B, C, and D bring in, e.g. $5 per person. IF B, C, and D each
bring in 3 new people, A will receive $45 (9 times $5). And the process goes on,
with potentially vast riches that one can receive. These schemes are nothing more
than "Ponzi Schemes," that is, investments that pay money to old investors only
from the money received from new investors, with no real business in between.
Eventually the strings run out, and the entire scheme collapses, leaving many
people with nothing to show for their investment. Because these are technically
investments, they should be covered by the securities laws.

41
Questions for Reflection:
What are some of the other forms of investment that should be considered
in a broad definition of 'securities'?

Why should pyramid schemes be covered under securities laws?


Illustration 3: Investment Contracts
An investment contract has been very well defined in United States law to be (a)
an investment by a purchaser of money or property (b) in a common enterprise (c)
induced by the expectation of receiving a profit (d) based essentially on the efforts
of the promoter. In other words, the purchaser is a "passive" investor who gives
money to a promoter who has promised an economic return based on what the
promoter says he/she can do with that money. For example, a promoter might sell
to purchasers small pieces of silver for $100 each, and the promoter will claim
that he will arrange for the purchasers to sell the silver at $150 each.
Unfortunately, what usually happens is that the promoter has no ability to fulfill
the promise, and by the time the purchasers find that out the promoter has long
disappeared. To make matters even worse, the silver that was purchased was
probably worth only $10, not $100. This is clearly a fraud, and perhaps there are
other laws that could apply. But the securities laws should also apply because they
usually contain much stronger and more effective criminal sanctions to be
applied.

It is important to draft the securities statutes broadly because there are innumerable
varieties of investment schemes. Experience has shown that promoters of investment
schemes will strive to develop investment programmes that technically skirt but do not
fall within the application of the securities laws. Investor protection is a principal goal in
any capital market, and that necessarily must include a broad application of the securities
statutes. As the Supreme Court of the United States has stated, the definition of securities
should be:
"...capable of adaptation to meet the countless and variable schemes
devised by those who seek the use of money of others on the promise of

42
profits."

7. Should regulations be developed for an over-the-counter market?


The emphasis in most developing countries has been on the creation and regulation of
stock exchanges. In fact, in Zimbabwe and some other countries there are specific rules
prohibiting brokers from executing trades in any securities except on a stock exchange.
These rules effectively preclude development of an over-the-counter market. In some
countries that do not have such a specific prohibition, the OTC market has not developed
because of a lack of regulations regarding trade practices and disclosure obligations.

What is an over-the-counter market? An OTC is a secondary trading market that is not


on an exchange. The OTC is usually operated by broker-dealers among themselves. The
broker-dealers are "market makers" because they put out quotations as to the price at
which they will buy or sell specific OTC securities. Individual buyers or sellers will then
make their transactions through the broker-dealers who are "market makers" in the
specific stocks.

Illustration 4
Tech-Ton, Inc. is an OTC security. Prosperus, Inc., a broker-dealer, has put out a
quotation on Tech-Ton shares with a "bid" price of $6 per share and an "asked"
price of $6.50 per share. That means that Prosperus is willing to buy Tech-Ton
shares at $6 from anyone willing to sell, and is willing to sell Tech-Ton shares at
$6.50 to anyone willing to buy. Prosperus will make a profit of $0.50 per share for
all shares bought and sold, and that is their profit for making a market in Tech-
Ton stock. Suppose that A wants to buy 100 shares of Tech-Ton stock. A will
contact his/her stockbroker, who will contact Prosperus, and Prosperus will sell
100 shares to A at $6.50. In order for Prosperus to be an effective "market maker"
in Tech-Ton stock, Prosperus must own enough shares itself so that it can fill any
buy orders that come in. That is why Prosperus is a "dealer," because it is in the
business of buying stock for itself.

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What is an OTC market?
An Over-The-Counter market is a secondary trading market this is not an
exchange usually operated by broker-dealers among themselves.

Should there be specific regulations for the OTC market? The answer depends in part
upon whether there are sufficient companies whose securities might be traded in the OTC
market, as well as whether there is sufficient interest among broker-dealers to undertake
the organizational requirements of creating and operating such a market. However,
government policy-makers should consider the fact that not every company desiring to
sell securities to the public will qualify for listing on the stock exchange. Moreover, there
might be some companies that prefer not to list on the exchange. If the goals of creating
opportunities for capital raising by enterprises and broadening investment opportunities
for investors are to be achieved, consideration should be given to the development of an
OTC market.

8. What are the most effective means for enforcing the securities laws?
Did you know ...
... that a Capital Markets Authority with subpoena power has the authority to require
individuals to testify?

Prompt and effective enforcement of the securities laws is essential to sustain public
confidence in the integrity of the market. How is that enforcement to be achieved? Does
the supervising agency, e.g. the Capital Markets Authority, have adequate staff and
financial resources to investigate allegations of securities law violations? Does the
agency have subpoena power to aid in the discovery of evidence? Does it have authority
to seek emergency orders to stop offerings or trading activities? If there are criminal
penalties for securities fraud, do prosecutors have sufficient resources to investigate and
prosecute fraudulent activities?
Administrative and criminal sanctions are important, but overworked government
agencies are not always able to follow through on allegations of fraud or other
misconduct. An enforcement gap would be created unless private actions were permitted

44
by aggrieved investors. There is no fury like an investor, or group of investors, who have
been defrauded of their investments. Permitting such private actions might require a
combination of both substantive and procedural laws. If such private actions are
permitted, can they be brought as class actions, in which multiple investors with similar
claims join together in a single lawsuit? Class action litigation is the single greatest fear
of most public companies in developed countries, as the damages could be enormous.
Consider the following Illustration:

Illustration 5
Company XYZ issues a press release stating that it has signed a major contract to
supply goods to a large South African company. The share price for XYZ shares
rises from $5 to $12. Unfortunately, the press release fails to state that the contract
is subject to the approval of the South Africa Ministry of Commerce. Three weeks
later the Ministry denies the contract. The Company then issues a press release
stating that the contract has been rejected, and the share price falls back to $5.
During that 3-week period, investors purchased on the stock exchange a total of
60,000 shares of XYZ stock at $12 per share. Those purchasers have suffered a
loss of $7 per share. A class action lawsuit could be brought seeking total
damages of $420,000. XYZ Company not only does not have the contract, it
might be liable for $420,000 in damages to investors misled by the original press
release. That is strong incentive to make sure that press releases are fully accurate.
Companies might not worry about administrative or criminal sanctions, but they can be
certain that the failure to make full disclosure will result in private litigation. Private
litigants become effective enforcers of the securities laws. To assure that this
enforcement mechanism has force, laws regarding private actions and class actions
should be analyzed and appropriate modifications made if necessary.

9. To what extent should laws be harmonized with neighboring countries?


Question for Reflection:
True or False: Similar laws are a sufficient enough reason to allow harmonization to
occur.

45
Harmonization has a nice ring to it. It reminds us of harmony, and who doesn't favor
harmony? Yet, harmonization of laws regarding capital markets is not necessarily the
best policy. Sometimes it will be an appropriate policy, especially where two or more
countries are attempting to create a regional stock exchange and public offerings on a
regional basis. Sometimes, however, harmonization ignores important economic or
market conditions that differ among countries. For example, the stock exchange in Lagos,
Nigeria, is much larger than the stock exchange in Accra, Ghana. Ghana might want to
join the Nigerian exchange on a regional basis. Should Ghana attempt to harmonize its
listings standards with those of Nigeria? The answer might be yes if there is a desire to
unify the two markets. The answer might be no if Ghana desires to encourage smaller
companies to list their shares and such companies would not meet the Nigerian standards.

Harmonization for no other reason than similarity of laws is not an appropriate policy.
Harmonization makes sense only if it benefits all of the countries whose laws and
regulations are being conformed. The cost-benefit analysis is what government policy-
makers must undertake before deciding yes or no on proposed harmonization.

10. How can we educate and interest the public to the advantages and risks of
investing?
The capital market cannot thrive without active participation by the local population.
Institutional traders, such as pension plans, bank trust funds, and insurance companies,
have neither the commitment nor the capacity to fund the capital needs of an entire
market. The movement of investments from private savings accounts to publicly-traded
companies is a vital element in capital market growth.
Per capita income varies among countries, and in some countries it is below $300 per
year. One may wonder how it is possible to have an active capital market in a country
that has a low per capita income. There are several responses that can be made to this
concern:
1 Per capita income figures are based on reported statistics and do not necessarily
reflect actual income figures.

46
2 Per capita income figures are averages. Because many people in rural areas have
extremely low incomes, the national per capita figure does not reflect the income
levels of middle and upper middle classes.
3 Low cost-of-living rates for many people in rural areas means that even those
with low incomes can save some money.
4 If we can begin to attract more investments from individuals who currently can
afford them, in time economic growth will raise the per capita levels for all.

The problem of educating and attracting potential investors is a global phenomenon.


Even in highly developed markets in Europe, for example, less than 20% of the
population participates through investments in the market. Therefore, we should not set
our sights too high.
Why do so many people avoid investing in public securities? There might be many
reasons, but three of the principal ones are:
(1) Fear of Loss: Money stored under the bed, or better yet, in a bank,
will not be lost. Money invested in securities is subject to the risk of loss.
Many people are not willing to chance the potentiality of gain if it means
the risk of loss.

(2) Concern for Immediate Needs: Again, money under the bed or in a
bank can be immediately obtained to meet financial needs. Money
invested in securities might not be readily obtainable if the market is not
active.

(3) Fear of the Unknown: Most people have little or no knowledge how
the market works or how investments are made. All they know is that their
money disappears into the hands of brokers and companies. The fear of
the unknown contributes to the lack of public participation.

There are solid, positive answers to all of the fears and concerns held by the public. Of
course there is risk, but historical data confirms that investment in securities generally

47
leads to growth, not loss, in income. It would be unwise to minimize the risk of loss, as
that is always possible, and no investor should be encouraged to invest more than he or
she can afford to lose. However, it would be equally unwise to fail to provide evidence
that income growth is the more likely result over time. Investors should be educated in
the importance of long-term holdings. Yes, it is possible to make quick profits in the
market, but investment should be viewed as a long-term commitment. Moreover, it is a
commitment that should only be made with funds that are not expected to be needed in
the near future.

Question for Reflection:


What are some of the methods your government uses to educate and interest the public in
securities investment?

Who should be responsible for educating and attracting the public? Brokers and
investment advisers have much to gain by increased participation, but unfortunately in
many countries they do not have sufficient resources to undertake large-scale education
campaigns. The government is the only institution in most countries that has the capacity
to educate the public and provide information on a broad basis to attract potential
investors. Consideration should be given to creating a public education programme
within the securities commission that is adequately staffed and funded. The programme
should include:
1 information meetings throughout the country,
2 brochures describing investment procedures and opportunities,
3 articles in newspapers and the media regarding capital market developments,
4 a "hot line" for telephone and computer inquiries from the public,
5 Educational materials for distribution to schools and universities,
6 Presentations to trade organizations and professional groups, plus such other
measures as are considered appropriate given the circumstances in the country.
Much of this can be done on a relatively small budget, and the rewards could well
go far beyond the rather minimal costs.

48
CONCLUSION
Imagine a country that has no capital market and little or no infrastructure to adapt
to modern economic conditions. One day you are called into the President's office
and told that you are in charge of developing a capital market "just like
Johannesburg." You are given a title, a committee from the Ministry of Finance, a
budget (of course too small), and a round-trip ticket to visit the New York Stock
Exchange. What is the first thing you should do? The best answer is to cancel the
trip to New York and instead plan to visit government officials, securities
commissions, and exchanges in Nairobi, Lagos, Accra, Gaborone, Harare,
Kampala, or other closer locations. Beyond that, your task is enormous.

This Lesson raises a number of fundamental issues for your initial agenda. For a
long period of time you will be asking questions and gathering information. That
is a process that will never end even after infrastructure and a capital market are
formed. One of your major tasks will be to convince yourself and others that the
process requires patience, that there will be many bumps along the road to
success, and that progress will be made despite political and social problems that
also require enormous government attention and resources. The road is a long
one. As the Chinese proverb tells us, a journey of a thousand miles begins with
the first step. Many countries are well beyond their first steps, but there are still
miles to go and much to examine in order to improve the prospects for our capital
markets.

In this Lesson we have examined the following main points:


1. Variable Registration Requirements. If there is only one principal
process for registering securities for a public offering, that process might
make it very difficult for many small and medium-sized companies to
raise capital. Consideration should be given to registration exemptions and
modified registration requirements for smaller companies.
2. Diversity Among Markets: Because of the diversity that exists among
capital markets in different countries, it is important to be cautious in

49
borrowing laws from other countries and assuming that those laws will be
effective.
3. Analysis of Policy Issues: Government regulators cannot draft statutes
and determine policy without first analyzing the particular facts on the
ground in their own country and the goals that the capital market is
intended to achieve.
4. Timing and Scope of Regulation: It is not necessarily desirable that a
capital market be highly regulated from the start. There may be strong
reasons to permit the market to develop in response to local and global
conditions without imposing strict regulatory constraints.
5. The Importance of Agency Authority: Legislation is difficult to pass
and to later amend. Yet, conditions in the capital market often change.
Therefore, it is very important that the securities commission have
authority to issue regulations that reflect changing conditions without first
seeking Parliamentary approval.
6. Agency Discretion: Among the most important subjects to consider for
possible agency discretionary authorities are disclosure obligations and
exemptions from registration. Both of these could be very important in
assisting smaller companies to raise capital under the securities laws.
7. Definition of Securities. The term "securities" should be broadly
defined in order to cover a broad variety of investment schemes.
Otherwise, it would be possible for unscrupulous promoters to sell
investments to the public and avoid the securities laws.
8. Regulations for An Over-the-Counter Market. Many developing
countries have focused on the development of stock exchanges and have
ignored the possibility of an over-the-counter market. Yet, an OTC market
might be very important for smaller companies that cannot qualify for
exchange listing. Consideration should be given to what's "on the ground"
and whether an OTC market makes sense in each country.
9. Effective Enforcement Mechanisms. Effective enforcement of the
securities laws requires both government and private actions. Government

50
enforcement needs an adequate investigative and prosecutorial staff and
powers, and civil actions require effective means for private litigants to
bring lawsuits for recovery of damages.
4. Harmonization of Laws. Harmonization might be a good policy, but
there can be counter-arguments. Government policy-makers should
consider whether foreign laws and regulations adapt well to local
conditions. A cost-benefit analysis should be made before deciding that
laws within a region should be harmonized.
10. Public Education. Public participation in the market is essential.
There are several key factors that cause the public to avoid investing in
securities. Government agencies should undertake a variety of means to
educate the public to securities investing, including procedures,
advantages, and risks.

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Chapter 4 - Equity: The Basic Capital Investment
Lesson Objectives
• To examine basic reasons why debt offerings are not commonly made by private
companies
• To examine the role and operation of debt rating agencies.
• To consider the effect of overall monetary rates on the debt market for private
companies.
• To consider factors as to whether debt offerings should be subject to the securities laws.
• To consider the potential effects that debt offerings have on a company’s capital
structure.
• To understand the transferability of corporate debt.
• To examine the principal reasons and disclosure issues regarding a company’s decision
to issue debt to the public.
• To review the principal rights of debt holders as against the company.

Introduction
Debt financing is much more prevalent in the monetary market than in the capital market.
The monetary market refers generally to debt instruments that mature in one year or less.
Worldwide, there is a tremendous market in short term corporate notes, in fact much
larger than equity markets.
In most developing countries, there is relatively little public financing by private
companies through long-term debt offerings. Government bonds and debentures issued
by major lending institutions (such as the East African Development Bank) are generally
purchased by banks and other institutional buyers. Business enterprises, even ones that
are listed on stock exchanges, generally have not sought capital through the issuance to
the public of debt instruments. Nearly all of the debt owed by such companies comes
from loans from banks and other lending institutions.
In more developed financial markets there are many companies that issue corporate notes
to the public, and those notes can be bought and sold in secondary markets just like
shares of stock. Generally the notes are issued by fairly large companies, as they are able
to get fairly good ratings on the notes.

52
The lack of public debt offerings is not due to any legal impediments. The legal structure
is in place in most countries to accommodate debt financing. Debt financing should be
regarded as a viable financing option. Equity financing is not always the best alternative
for every company. Company advisers should be aware of the possibilities of public
offerings of debt instruments, and government regulators should understand the nature
and variety of debt offerings. Corporate debt markets will inevitably develop in many
countries. Companies that have good financial strength will receive favorable ratings, and
they will find that debt offerings will sometimes be preferable to other financing
opportunities.

Chapter Core
1. Public Debt Offerings
There are no legal or financial impediments in most countries that prevent companies
from raising capital through public offerings of debt. There are several reasons why this
is rarely done:

1. Lack of Rating Agencies


Rating agencies play a central role in developed markets. Debt investors have much
different concerns than equity investors. Debt investors are much more risk averse, are
motivated in large measure by the promised interest rate, and are utilizing funds that they
expect to be returned within a specified period (unlike equity for which there is no
expectation of repayment). The ability of the company to meet its current and long term
debt obligations is critical to the investment decision. Debt investors are usually not
willing to “gamble” on companies to the same degree as equity investors.
How do potential debt investors determine whether a company’s current and future
prospects will enable it to meet its proposed debt obligations? That is where rating
agencies play a major role. These agencies carefully analyze the company and prepare a
report that states the agency’s opinion regarding the quality of the debt offering. Debt
investors use those reports to make their investment decisions.
Rating agencies utilize a broad range of resources to measure the quality of a company
and its debt offering. Among the factors considered are:

53
• The company’s financial history
• Experience and quality of company management
• Current and anticipated competition locally and globally
• Amount of debt that has priority over the offered debt
• Total debt obligations
• anticipated cash flow of the company
• Any regulatory factors that could affect the company
• Promised interest rate compared to market rates for comparable companies
• Length of time before debt becomes fully payable

Essentially, rating agencies are attempting to evaluate the degree of risk associated with
the debt offering. If the offering has very low risk to potential investors, it will be given a
high rating. If the rating agency believes that there is a medium risk that the interest and
principal will not be fully repaid, the rating will be mid-range. A high risk offering will
receive the lowest grades.

Did you know…


that rating agencies are attempting to evaluate the degree of risk associated with the debt
offering?

Grading is on a scale, either numerical or by letters, and often there are combinations of
letters and numbers. For example, in the United States a rating that is above a C is
regarded as “investment grade,” which means that the debt offering does not carry a high
risk of default and is therefore suitable for smaller investors. But there can be many
variations, such as AAA, or AA+, or BBB-. Investors need to know the grading scales
used by particular agencies so that they can judge the respective merits of debt offerings.
The debt rating generally affects the terms of the debt being offered.
A company that is rated as low risk can offer debt with a lower interest rate than a
company rated a higher risk, because investors will demand a higher interest rate in
return for their taking a higher risk. For example, rating agencies in the United States
recently downgraded the ratings for both General Motors and Ford Motor Company. The

54
ratings are so low that any new debt offerings by either company will require them to pay
higher interest rates than companies that have higher ratings, which of course only further
exacerbates an already insecure financial situation.

Companies that are given ratings with medium or high risks must also consider adding
some “sweeteners” to their debt offerings, such as convertibility options. Sometimes a
rating can be so low that no investors will be interested, regardless of the terms being
offered. Therefore, rating agencies can have a very large impact on the debt offering
market. Companies that rate the quality of debt offerings are just beginning to emerge in
Africa and elsewhere. Their most important role in the early stages will be the rating of
government and large institutional debt offerings. This trend will have a healthy effect,
for it will force governments and other large institutions to institute efficient debt
management practices and to undertake modern accounting methodologies.

Some of the major global rating agencies include:


Within the near future we will begin to see more independent, third party ratings of
government and other institutional debt issues. We might see some interesting reactions
from government officials if and when proposed government debt issuances are low-
rated. Until now, most governments and other large institutions have been able to sell
their debt without making a great deal of disclosure regarding the debt issuance or the
comparison of its terms to debt issued elsewhere. Ratings agencies will change that, for
they will insist on full disclosure and will make very sharp comparisons among differing
government issues. Eventually, as the public comes to understand the role of ratings
agencies and gains confidence in their reports, we may begin to see private companies
make public debt issuances that are rated. This is basically a matter of developing
investor interest and educating investors to understand the differences between debt and
equity issuances.

2. Lack of Public Offerings Generally


The lack of debt offerings is part of the larger problem of a lack of public offerings
generally. Companies do not engage in public debt offerings if they do not already have a

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public equity market for their shares. Without a substantial equity base, companies cannot
afford to make debt offerings. The debt equity ratios would be far too high to attract debt
investors. Therefore, if we are going to see public issuances of debt by operating
companies, the potential candidates for such offerings are those companies already listed
on exchanges. In many countries, that number is not very high.

3. Instability in Monetary Rates


Investors of long-term debt offerings do not want to take a substantial risk that their debt
instruments will decrease in value in the future. The risk grows in economies that have
unstable interest rates and up-and-down inflationary cycles.
Suppose a company offers to sell 3-year debentures that pay 15% annual interest. That
interest rate might be favourable today, but will it be favourable next year? If the
economy experiences inflationary growth, a 15% annual return might not high enough to
keep pace with the market. The value of the debenture will decrease if the interest rate
falls below market. Investors who might want to sell their debt investments prior to
maturity will get less than their original purchase price. On the other hand, if they hold
the debt until maturity, their annual return might be less than what they could be getting
with competing debt instruments. As is evident, the stability of the monetary market is a
major factor in facilitating debt offerings by operating companies.

Illustration:
Company LTD sells a four year corporate bond for $100, paying 15% annual interest. If
the inflation rate in the country is, for example, 8-10% annually, the bond will have a
negative rate of return in the second year and every year thereafter. If the bond owner
tries to sell the bond before maturity, the bond will not be able to be sold except at a very
low price, for example $50. At that price, a 15% return is actually a 30% return ($15
interest payment on a bond that cost $50), which allows the bondholder to stay above the
inflationary rate during the period prior to maturity. The loser is the original bondholder.
The longer the original bondholder owns the bond, the greater the economic loss. Thus,
anyone analyzing whether to buy a bond in the first place must consider its long-term
value in light of inflationary factors.

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4. Government Competition
In many developing countries, the government is the largest issuer of debt through T-
Bills and government bonds. In some countries the debt issuances are necessary to
finance the budget. In other countries the debt issuances are primarily for monetary
control purposes. In either case, government issuances are often at high interest rates
because of political and economic factors (in some countries the interest rate exceeds
30%). Even in countries where the interest is at much lower levels, it might be very
difficult for operating companies to be able to issue debt that matches or exceeds the
government rates. Debt issued by operating companies usually must exceed government
rates by at least several percentage points, as government debt is generally regarded as a
safer form of investment. The overall result is that operating companies may have
difficulty competing with government in the debt market.

2. Government Concerns Regarding Public Debt Issuances


Debt offerings that are part of the capital market, as opposed to the monetary market,
raise regulatory issues not unlike those applicable to equity offerings. However, because
debt offerings are considerably different in kind from equity offerings, government
regulators need to be alert to concerns that are particular to debt financing.

1. Is the Offering Subject to Registration Requirements?


Companies borrow money all the time, and in doing so issue notes to lenders. Are the
notes securities and do the registration requirements of securities laws apply? Most
Company and Securities statutes do not give a clear answer to which debt offerings are
subject to registration. Statutes tend to define “security” so broadly that every loan of any
kind would be covered by the securities statute, a result that cannot be intended. For
example, “security” is defined in the Zimbabwe statute to include:
“Any debt security, that is to say----
(1) any instrument creating or acknowledging indebtedness which is issued or proposed
to be issued by a company, including any debenture stock, loan stock, bond or note....”
Uganda similarly defines a security to include:
“Debentures, stock, shares, bonds or notes issued or proposed to be issued by a body

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corporate.”
The definitions in the United States are no more specific. The only major difference is
that in the United States there is a specific registration exemption for short-term (9
months or less) notes of prime commercial quality. Given the broad definitions, questions
naturally arise whether the securities laws apply to every debt offering in which a “note”
is issued. The answer is surely no, for it would make no sense to apply the securities laws
to notes issued in connection with secured lending financing with banks and other
institutions, or to loans obtained from a small group of existing shareholders. This issue is
very much related to the question of whether some transactions should be exempt from
registration under a kind of “limited offering” or “private offering” exemption, a topic
that is discussed in other Lessons. The question of definition, i.e. when is a note issued in
connection with a loan a “security” for purposes of the Securities laws, has two elements:

(1) Registration
Which debt offerings should be subjected to the registration provisions required for
ordinary share offerings? If the debt offering is being made to large institutional lenders
who are fully capable of demanding information and protecting their own interests, is it
necessary to impose upon companies the costs of registration?
(2) Antifraud
Even if some debt offerings should be exempt from registration, should they also be
exempt from the antifraud provisions of the securities laws? Some short-term notes are
exempt from registration in the United States, but they are not exempt from the antifraud
provisions. The policy question for government regulators to ask is whether debt
purchasers should have causes of action against the company if misleading statements
were made to them to induce the note purchases, even if the offering was exempt from
registration? There is probably more case law and commentary in the United States on
these questions than in any other country. The principal case is Reves v. Ernst & Young,
decided by the Supreme Court in 1990. The case involved unsecured demand notes
issued by an agricultural cooperative. Notes were offered through advertisements to co-
op members and to the public. Approximately 1,600 people purchased notes totaling $10
million. Unfortunately, the co-op became insolvent.

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The note holders sued the co-op’s auditors under the securities laws, claiming that the
notes had been sold based upon misleading financial statements. The defendant auditors
responded that the notes were not securities and therefore the securities laws did not
apply. The argument that the notes were not securities was based on the facts that (1) the
notes were demand notes and therefore unlike a security, which is a long-term
investment, and (2) the payment of a fixed interest rate was unlike the sharing of profits
that occurs with ordinary securities. The U.S. Supreme Court held that the notes were
securities. It announced a four-part test for determining when debt obligations were
securities:

(1) Motivations of seller and buyer: A note is a security if the seller plans to use the
money for general business purposes or to finance investments and the buyers are
motivated principally by the profit to be made from holding the notes.
(2) Plan of distribution: The more people the seller attempts to sell the notes to, the
more likely it is a security.
(3) Reasonable expectations of parties: If the purchasers believe that the transactions
are protected by the securities laws, their reasonable belief will be upheld.
(4) Risk-reducing factors: If the securities laws are not necessary because other laws
exist that protect the purchasers, the notes might not be securities.
Securities laws do not and should not apply to all
notes issued, so government’s must decided which
ones are exempt from registration and which ones
are exempt from antifraud provisions

The Court did not say that all four factors must be present. It appears from subsequent
cases that the two most important factors are the first two, the motivations of the
respective parties and the attempted sales efforts. Because of the wide variety of debt
instruments that exist, it is impractical to attempt to create a legislative definition of a
security that would clearly create a dividing line between notes that are, and notes that are
not, securities. However, statutes and regulations should be examined to determine that

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they are not too narrowly drafted, and securities commissions should consider issuing
interpretive guidelines that reflects their own judgments in this area.

2. What is the Effect of the New Debt Upon the Company’s Capitalization?
Debt issuances are sometimes made because major shareholders do not want to dilute
their equity positions. If a company needs an additional $200,000, the sale of more equity
would reduce the percentage ownership of existing shareholders. The sale of debt would
not affect the equity ownership and might therefore be the preferred course.
On the other hand, the sale of notes imposes financial burdens that the sale of equity does
not. Debt obligations, unlike equity, place large demands upon a company’s working
capital, requiring periodic interest payments and, eventually, repayment of principal. If
companies have too much debt, large amounts of company income will be used for no
purpose other than to pay interest to lenders. That leaves shareholders with little if any
income remaining for share dividends. Company management are being paid salaries and
enjoying other benefits of control, but minority shareholders are being left out in the cold.
Elsewhere in these Lessons we discuss whether government agencies should exercise
“merit review” of securities offerings. Even if agencies do not have such powers, they
should nevertheless insist that the disclosure documents set forth the risks to the company
that could occur because of the high ratio of debt to equity.
An additional concern is raised if the debt is convertible. Debt is sometimes sold on the
basis that the debt holder has the option to convert the debt into equity, based upon a
formula that is set forth in the offering documents.

Companies might prefer to sell convertible debt for two reasons:

What are some of the advantages and disadvantages to offering convertible debt?
(1) Convertibility is an advantage for lenders and therefore the company might get a
lower interest rate on the indebtedness; and
(2) If the debt is converted, that will eliminate the mandatory interest payments,
repayment of principal obligation, and improve the company’s balance sheet debt-equity
ratio. Although there are advantages to issuing convertible debt, conversions could

60
substantially dilute the equity interests of existing shareholders. Therefore, if a debt
issuance is convertible, it would be appropriate to require that the disclosure documents
state the amount of dilution that could occur upon conversion. In such circumstances, it
would also be appropriate to determine whether shareholders have approved the debt
issuance or at least have been advised of its potential consequences.

Illustration:
Company PUB is selling 10,000 ordinary shares to the public. The offering appears to
give the shareholders 30% of the voting power and equity in the Company. However, the
company also has outstanding $100,000 in corporate notes that are convertible into
ordinary shares. If the notes are fully converted, the shareholders who purchase the
10,000 shares being offered will have only a 15% voting power and equity interest. They
will have been diluted by 50%, a potential that must be fully disclosed in the offering of
the ordinary shares.

3. Will the Notes Be Transferable by Debt Holders?


Notes issued in the capital market could vary from one to several years in length. During
that time prior to maturity the value of the notes will fluctuate, depending upon the
financial strength of the company and how the interest rate compares to alternative
investments. Note holders may want to sell the notes prior to maturity, either because of a
personal need for income or because the value of the notes have changed. Will there be a
secondary market for such sales? Notes are often not listed on an exchange. Unless an
active over-the-counter market develops, it might be very difficult for note holders to sell
their notes to third parties. This makes the investment illiquid until the maturity date,
which could be several years away. The fact of potential illiquidity and the risk that note
purchasers take as a result of this fact should be major disclosure items in offering
documents.

Questions for Reflection:


How can the risk of illiquidity for some notes be eliminated?
How do sinking fund obligations protect investors?

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How is a company that offers to pay annual instalments protecting investors?

4. Will there be a sinking fund or instalment payment program?


If the notes will not be repayable for at least several years, are there any protections to
note holders regarding the company’s use of its income in the meantime? In other words,
are there any requirements on the company to set aside portions of its income each year
in order to have the full amount available at the maturity date? Some notes have sinking
fund obligations that require the company to pay an escrow agent an annual amount until
the notes are eventually paid. Alternatively, some notes require the company to redeem
the notes in annual instalments, so that each year a portion of the debt is reduced. Both of
these measures are designed to protect note holders, as they require the company to plan
for proportionate annual amounts rather than wait until the year of maturity to see what it
has available.

5. How Will the Company Use the Proceeds from the Offering?
It is quite common for companies to obtain new debt financing in order to replace old
debt financing. There are at least three common instances for replacement financing:

(A) Maturity of Prior Debt


A substantial bank loan has become due, and the company’s assets are entirely being
used for operations and equipment. Where will the company get the money to pay the
bank? One answer, and a frequent result, is to re-finance the loan with the bank. This is
fine as long as the bank is willing to continue to be a lender, and as long as the interest
payments are not beyond the company’s capabilities. Sometimes, however, companies
might prefer to pay off a bank loan with money raised from the issuance of debentures.
Perhaps the bank has required a high amount of collateral or other security that has
become burdensome, or perhaps the bank interest rates have become too high, or perhaps
the bank has imposed conditions on business operations that the company wants to
eliminate. Whatever the cause, the result might be a public issuance of debt securities.

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(B) Decrease in Market Rates of Interest
An outstanding loan might have been taken when interest rates were much higher than
now. A $50,000 loan at 22% interest requires annual interest payments of $3,500 more
than a $50,000 loan at 15% interest. Loans usually are pre-payable, that is, the borrowers
have the right to pay the principal in full prior to the maturity date. There may be a small
penalty or premium to be paid for prepayment, but not necessarily. If there is a good
economic reason to replace one debt with another, a company might choose to float a
public debt issue at a lower interest rate and pay off the existing bank loan.

(C) Repayment of Shareholder Loans


Major shareholders, such as founders and managers, often make loans to their companies.
There are often good legal and economic reasons for making capital contributions in the
form of loans rather than additional stock. The loans could be and often are substantial. It
is not uncommon to see companies making public offerings of debentures in order to
obtain funds to pay off insider loans. After all, the insiders control the company, and why
not get paid for their loans from money raised from others?
There is nothing illegal about any of the three instances noted above. In each of them, the
company is raising fresh capital to pay off old debt. In other words, the investors’ monies
are not giving the company new working capital. The problem is that many potential
investors in the new debt offering might be thinking that the new money will be used to
help the business grow. That is not so. Therefore, from the perspective of a government
regulator, the principal concern must be disclosure. In this case, the disclosure must
concentrate on the fact that the company is not going to be obtaining substantial new
capital for business expansion or other operating purposes. Investors might be much more
cautious about buying debentures if they realize that the money is going to a prior lender,
not to the company. In fact, if the proceeds of the debt offering will be mostly used to pay
off loans from shareholders and managers, many state securities administrators in the
United States might not permit such an offering under their “merit review” powers.

6. What Are the Rights of Debt Holders Against the Issuing Company?
Offering documents should fully discuss all of the rights and procedures regarding debt

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holders. These disclosures could be even more necessary than disclosures regarding
shareholder rights, because Company laws usually provide substantial provisions for
shareholders and most of them are well known to potential investors. However, there are
few if any statutes (other than insolvency laws) that provide specific rights for debt
holders. Rights and procedures applicable to debt holders are usually set forth in the debt
instruments themselves, or in a basic instrument that applies to all debentures, such as a
trust indenture entered into between the company and the trustee on behalf of the
debenture holders. Rights and provisions that should be disclosed include:

• Rights, if any, to annual or periodic reports and financial statements;


• Transferability rights
• Rights to inspect records or make inquiries;
• Rights in the event of a default in payment;
• Other factors that might constitute a default;
• Conversion rights, if any;
• Procedure to obtain replacement debentures if lost or stolen;
• Sinking fund obligations by the company, if any;
• Redemption provisions;
• Procedure for giving notices for transfer, change of address, and death;
• Name, address, and telephone number for officer responsible for receiving notices and
providing information.

Government regulators should assure that the disclosure obligations for debt offerings
include these and other material items of information that are particular to debt offerings.
When debt offerings began to become popular in the United States, legislation was
passed that set forth required provisions in a trust indenture for any debt offering over $1
million. That was The Trust Indenture Act of 1939, and its provisions are still in effect. It
would be a useful exercise for government administrators to review that statute to
determine whether any of its provisions should be incorporated in disclosure rules or
other regulatory provisions specifically designed for debt offerings.

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The six concerns with public debt issuances that government regulators must be aware of:

1. Is the offering subject to registration requirements?


2. What is the effect of the new debt upon the company's capitalization?
3. Will the notes be transferable by debt holders?
4. Will there be a sinking fund or instalment payment program?
5. How will the company use the proceeds from the offering?
6. What are the rights of debt holders against the issuing company?

Although there are currently very few public debt offerings by private companies or
SOEs, the legal structure is in place to allow such offerings and in time we will begin to
see more and more debt offerings as companies realize their advantages over equity
offerings in particular circumstances. Government regulators have had very little
experience considering the important public policy issues that could arise in a debt
offering. Some debt offerings might not fall within the securities laws. But if a company
offers debt generally to the public, the securities laws will certainly apply. There are
disclosure concerns that are different than equity offerings, concerns regarding the degree
of risk, and concerns regarding the right of debt holders. Government officials need to
understand these issues in order to effectively consider and adopt regulations regarding
debt offerings.

Conclusion
Among the principal points discussed in this Lesson were:
1. Rating Agencies: One of the impediments to engaging in public debt offerings has
been the lack of rating agencies. Rating agencies are beginning to develop across Africa.
Initially they will focus on government-issued debt, but they will also have the capacity
to issue ratings on debt issued by companies and SOEs.
2. Rating Standards: Rating agencies consider a broad variety of factors in assessing the
risk of the debt investment. They then give a grade to the offering based upon analysis of
those factors. The grade allows potential investors to better understand whether the debt
offering is low risk, high risk, or something in between.

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3. Impact of Monetary Rates on Debt Market: The government’s budgetary policies
and the monetary policies carried out by the Central Bank substantially affect the debt
market. If there is high inflation, or substantial instability in the value of the currency,
investors will generally avoid fixedrate debt instruments.
4. Government Competition: If the government is paying a very high interest rate on T-
Bills and other government debt, this will dry up the market for private debt and also
force companies to have to pay high interest rates on debt, which could be a serious
financial problem.
5. Application of Securities Laws: It would not be appropriate to apply the securities
laws or registration requirements to all debt offerings, even though all debt is a form of
investment. Government regulators should develop regulations and interpretive
guidelines that help define what types of debt offerings should be regulated.
6. Disclosure Issues: Debt offerings raise disclosure issues that might be very different
from equity offerings. Among the major disclosure concerns that government regulators
should assure are part of disclosure documents are the impact upon the company’s capital
structure, the ability of debt holders to transfer or sell the debt prior to maturity, whether
the offering proceeds will be used for new capital or simply to retire old debt, and the
rights of debt holders against the company.

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Chapter 5 - Debt: For More Risk-Averse Investors

Introduction
Debt financing is much more prevalent in the monetary market than in the capital market.
The monetary market refers generally to debt instruments that mature in one year or less.
Worldwide, there is a tremendous market in short term corporate notes, in fact much
larger than equity markets.
In most developing countries, there is relatively little public financing by private
companies through long-term debt offerings. Government bonds and debentures issued
by major lending institutions (such as the East African Development Bank) are generally
purchased by banks and other institutional buyers. Business enterprises, even ones that
are listed on stock exchanges, generally have not sought capital through the issuance to
the public of debt instruments. Nearly all of the debt owed by such companies comes
from loans from banks and other lending institutions.
In more developed financial markets there are many companies that issue corporate notes
to the public, and those notes can be bought and sold in secondary markets just like
shares of stock. Generally the notes are issued by fairly large companies, as they are able
to get fairly good ratings on the notes.
The lack of public debt offerings is not due to any legal impediments. The legal structure
is in place in most countries to accommodate debt financing. Debt financing should be
regarded as a viable financing option. Equity financing is not always the best alternative
for every company. Company advisers should be aware of the possibilities of public
offerings of debt instruments, and government regulators should understand the nature
and variety of debt offerings. Corporate debt markets will inevitably develop in many
countries. Companies that have good financial strength will receive favorable ratings, and
they will find that debt offerings will sometimes be preferable to other financing
opportunities.

Lesson Objectives
• To examine basic reasons why debt offerings are not commonly made by private
companies

67
• To examine the role and operation of debt rating agencies.
• To consider the effect of overall monetary rates on the debt market for private
companies.
• To consider factors as to whether debt offerings should be subject to the securities laws.
• To consider the potential effects that debt offerings have on a company’s capital
structure.
• To understand the transferability of corporate debt.
• To examine the principal reasons and disclosure issues regarding a company’s decision
to issue debt to the public.
• To review the principal rights of debt holders as against the company.

Lesson Core
1. Public Debt Offerings
There are no legal or financial impediments in most countries that prevent companies
from raising capital through public offerings of debt. There are several reasons why this
is rarely done:

1. Lack of Rating Agencies


Rating agencies play a central role in developed markets. Debt investors have much
different concerns than equity investors. Debt investors are much more risk averse, are
motivated in large measure by the promised interest rate, and are utilizing funds that they
expect to be returned within a specified period (unlike equity for which there is no
expectation of repayment). The ability of the company to meet its current and long term
debt obligations is critical to the investment decision. Debt investors are usually not
willing to “gamble” on companies to the same degree as equity investors.
How do potential debt investors determine whether a company’s current and future
prospects will enable it to meet its proposed debt obligations? That is where rating
agencies play a major role. These agencies carefully analyze the company and prepare a
report that states the agency’s opinion regarding the quality of the debt offering. Debt
investors use those reports to make their investment decisions.

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Rating agencies utilize a broad range of resources to measure the quality of a company
and its debt offering. Among the factors considered are:
• The company’s financial history
• Experience and quality of company management
• Current and anticipated competition locally and globally
• Amount of debt that has priority over the offered debt
• Total debt obligations
• anticipated cash flow of the company
• Any regulatory factors that could affect the company
• Promised interest rate compared to market rates for comparable companies
• Length of time before debt becomes fully payable

Essentially, rating agencies are attempting to evaluate the degree of risk associated with
the debt offering. If the offering has very low risk to potential investors, it will be given a
high rating. If the rating agency believes that there is a medium risk that the interest and
principal will not be fully repaid, the rating will be mid-range. A high risk offering will
receive the lowest grades.

Did you know…

that rating agencies are attempting to evaluate the degree of risk associated with the debt
offering?

Grading is on a scale, either numerical or by letters, and often there are combinations of
letters and numbers. For example, in the United States a rating that is above a C is
regarded as “investment grade,” which means that the debt offering does not carry a high
risk of default and is therefore suitable for smaller investors. But there can be many
variations, such as AAA, or AA+, or BBB-. Investors need to know the grading scales
used by particular agencies so that they can judge the respective merits of debt offerings.
The debt rating generally affects the terms of the debt being offered. A company that is
rated as low risk can offer debt with a lower interest rate than a company rated a higher
risk, because investors will demand a higher interest rate in return for their taking a

69
higher risk. For example, rating agencies in the United States recently downgraded the
ratings for both General Motors and Ford Motor Company. The ratings are so low that
any new debt offerings by either company will require them to pay higher interest rates
than companies that have higher ratings, which of course only further exacerbates an
already insecure financial situation.
Companies that are given ratings with medium or high risks must also consider adding
some “sweeteners” to their debt offerings, such as convertibility options. Sometimes a
rating can be so low that no investors will be interested, regardless of the terms being
offered. Therefore, rating agencies can have a very large impact on the debt offering
market.
Companies that rate the quality of debt offerings are just beginning to emerge in Africa
and elsewhere. Their most important role in the early stages will be the rating of
government and large institutional debt offerings. This trend will have a healthy effect,
for it will force governments and other large institutions to institute efficient debt
management practices and to undertake modern accounting methodologies.

Some of the major global rating agencies include:

Fitch: http://www.fitchratings.com
Moody’s: http://www.moodys.com
Standard and Poor’s: http://www2.standardandpoors.com

Within the near future we will begin to see more independent, third party ratings of
government and other institutional debt issues. We might see some interesting reactions
from government officials if and when proposed government debt issuances are low-
rated. Until now, most governments and other large institutions have been able to sell
their debt without making a great deal of disclosure regarding the debt issuance or the
comparison of its terms to debt issued elsewhere.
Ratings agencies will change that, for they will insist on full disclosure and will make
very sharp comparisons among differing government issues. Eventually, as the public
comes to understand the role of ratings agencies and gains confidence in their reports, we

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may begin to see private companies make public debt issuances that are rated. This is
basically a matter of developing investor interest and educating investors to understand
the differences between debt and equity issuances.

2. Lack of Public Offerings Generally


The lack of debt offerings is part of the larger problem of a lack of public offerings
generally. Companies do not engage in public debt offerings if they do not already have a
public equity market for their shares. Without a substantial equity base, companies cannot
afford to make debt offerings. The debt equity ratios would be far too high to attract debt
investors. Therefore, if we are going to see public issuances of debt by operating
companies, the potential candidates for such offerings are those companies already listed
on exchanges. In many countries, that number is not very high.

3. Instability in Monetary Rates


Investors of long-term debt offerings do not want to take a substantial risk that their debt
instruments will decrease in value in the future. The risk grows in economies that have
unstable interest rates and up-and-down inflationary cycles. Suppose a company offers to
sell 3-year debentures that pay 15% annual interest.
That interest rate might be favorable today, but will it be favorable next year? If the
economy experiences inflationary growth, a 15% annual return might not high enough to
keep pace with the market. The value of the debenture will decrease if the interest rate
falls below market. Investors who might want to sell their debt investments prior to
maturity will get less than their original purchase price. On the other hand, if they hold
the debt until maturity, their annual return might be less than what they could be getting
with competing debt instruments. As is evident, the stability of the monetary market is a
major factor in facilitating debt offerings by operating companies.

Illustration:
Company LTD sells a four year corporate bond for $100, paying 15% annual interest. If
the inflation rate in the country is, for example, 8-10% annually, the bond will have a
negative rate of return in the second year and every year thereafter. If the bond owner

71
tries to sell the bond before maturity, the bond will not be able to be sold except at a very
low price, for example $50. At that price, a 15% return is actually a 30% return ($15
interest payment on a bond that cost $50), which allows the bondholder to stay above the
inflationary rate during the period prior to maturity. The loser is the original bondholder.
The longer the original bondholder owns the bond, the greater the economic loss. Thus,
anyone analyzing whether to buy a bond in the first place must consider its long-term
value in light of inflationary factors.

4. Government Competition
In many developing countries, the government is the largest issuer of debt through T-
Bills and government bonds. In some countries the debt issuances are necessary to
finance the budget. In other countries the debt issuances are primarily for monetary
control purposes. In either case, government issuances are often at high interest rates
because of political and economic factors (in some countries the interest rate exceeds
30%). Even in countries where the interest is at much lower levels, it might be very
difficult for operating companies to be able to issue debt that matches or exceeds the
government rates. Debt issued by operating companies usually must exceed government
rates by at least several percentage points, as government debt is generally regarded as a
safer form of investment. The overall result is that operating companies may have
difficulty competing with government in the debt market.

2. Government Concerns Regarding Public Debt Issuances


Debt offerings that are part of the capital market, as opposed to the monetary market,
raise regulatory issues not unlike those applicable to equity offerings. However, because
debt offerings are considerably different in kind from equity offerings, government
regulators need to be alert to concerns that are particular to debt financing.

1. Is the Offering Subject to Registration Requirements?


Companies borrow money all the time, and in doing so issue notes to lenders. Are the
notes securities and do the registration requirements of securities laws apply? Most
Company and Securities statutes do not give a clear answer to which debt offerings are

72
subject to registration. Statutes tend to define “security” so broadly that every loan of any
kind would be covered by the securities statute, a result that cannot be intended. For
example, “security” is defined in the Zimbabwe statute to include:
“Any debt security, that is to say----
(1) any instrument creating or acknowledging indebtedness which is issued or proposed
to be issued by a company, including any debenture stock, loan stock, bond or note....”
Uganda similarly defines a security to include:
“Debentures, stock, shares, bonds or notes issued or proposed to be issued by a body
corporate.”
The definitions in the United States are no more specific. The only major difference is
that in the United States there is a specific registration exemption for short-term (9
months or less) notes of prime commercial quality. Given the broad definitions, questions
naturally arise whether the securities laws apply to every debt offering in which a “note”
is issued. The answer is surely no, for it would make no sense to apply the securities laws
to notes issued in connection with secured lending financing with banks and other
institutions, or to loans obtained from a small group of existing shareholders. This issue is
very much related to the question of whether some transactions should be exempt from
registration under a kind of “limited offering” or “private offering” exemption, a topic
that is discussed in other Lessons.
The question of definition, i.e. when is a note issued in connection with a loan a
“security” for purposes of the Securities laws, has two elements:

(1) Registration
Which debt offerings should be subjected to the registration provisions required for
ordinary share offerings? If the debt offering is being made to large institutional lenders
who are fully capable of demanding information and protecting their own interests, is it
necessary to impose upon companies the costs of registration?

(2) Antifraud
Even if some debt offerings should be exempt from registration, should they also be
exempt from the antifraud provisions of the securities laws? Some short-term notes are

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exempt from registration in the United States, but they are not exempt from the antifraud
provisions.
The policy question for government regulators to ask is whether debt purchasers should
have causes of action against the company if misleading statements were made to them to
induce the note purchases, even if the offering was exempt from registration? There is
probably more case law and commentary in the United States on these questions than
in any other country. The principal case is Reves v. Ernst & Young, decided by the
Supreme Court in 1990. The case involved unsecured demand notes issued by an
agricultural cooperative. Notes were offered through advertisements to co-op members
and to the public. Approximately 1,600 people purchased notes totaling $10 million.
Unfortunately, the co-op became insolvent.
The note holders sued the co-op’s auditors under the securities laws, claiming that the
notes had been sold based upon misleading financial statements. The defendant auditors
responded that the notes were not securities and therefore the securities laws did not
apply. The argument that the notes were not securities was based on the facts that (1) the
notes were demand notes and therefore unlike a security, which is a long-term
investment, and (2) the payment of a fixed interest rate was unlike the sharing of profits
that occurs with ordinary securities. The U.S. Supreme Court held that the notes were
securities. It announced a four-part test for determining when debt obligations were
securities:
(1) Motivations of seller and buyer: A note is a security if the seller plans to use the
money for general business purposes or to finance investments and the buyers are
motivated principally by the profit to be made from holding the notes.
(2) Plan of distribution: The more people the seller attempts to sell the notes to, the
more likely it is a security.
(3) Reasonable expectations of parties: If the purchasers believe that the transactions
are protected by the securities laws, their reasonable belief will be upheld.
(4) Risk-reducing factors: If the securities laws are not necessary because other laws
exist that protect the purchasers, the notes might not be securities.

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Securities laws do not and should not apply to all notes issued, so government’s must
decided which ones are exempt from registration and which ones are exempt from
antifraud provisions.
The Court did not say that all four factors must be present. It appears from subsequent
cases that the two most important factors are the first two, the motivations of the
respective parties and the attempted sales efforts. Because of the wide variety of debt
instruments that exist, it is impractical to attempt to create a legislative definition of a
security that would clearly create a dividing line between notes that are, and notes that are
not, securities. However, statutes and regulations should be examined to determine that
they are not too narrowly drafted, and securities commissions should consider issuing
interpretive guidelines that reflects their own judgments in this area.

2. What is the Effect of the New Debt Upon the Company’s Capitalization?
Debt issuances are sometimes made because major shareholders do not want to dilute
their equity positions. If a company needs an additional $200,000, the sale of more equity
would reduce the percentage ownership of existing shareholders. The sale of debt would
not affect the equity ownership and might therefore be the preferred course.
On the other hand, the sale of notes imposes financial burdens that the sale of equity does
not. Debt obligations, unlike equity, place large demands upon a company’s working
capital, requiring periodic interest payments and, eventually, repayment of principal. If
companies have too much debt, large amounts of company income will be used for no
purpose other than to pay interest to lenders. That leaves shareholders with little if any
income remaining for share dividends. Company management are being paid salaries and
enjoying other benefits of control, but minority shareholders are being left out in the cold.
Elsewhere in these Lessons we discuss whether government agencies should exercise
“merit review” of securities offerings. Even if agencies do not have such powers, they
should nevertheless insist that the disclosure documents set forth the risks to the company
that could occur because of the high ratio of debt to equity.
An additional concern is raised if the debt is convertible. Debt is sometimes sold on the
basis that the debt holder has the option to convert the debt into equity, based upon a

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formula that is set forth in the offering documents. Companies might prefer to sell
convertible debt for two reasons:

What are some of the advantages and disadvantages to offering convertible debt?
(1) Convertibility is an advantage for lenders and therefore the company might get a
lower interest rate on the indebtedness; and
(2) If the debt is converted, that will eliminate the mandatory interest payments,
repayment of principal obligation, and improve the company’s balance sheet debt-equity
ratio.
Although there are advantages to issuing convertible debt, conversions could
substantially dilute the equity interests of existing shareholders. Therefore, if a debt
issuance is convertible, it would be appropriate to require that the disclosure documents
state the amount of dilution that could occur upon conversion. In such circumstances, it
would also be appropriate to determine whether shareholders have approved the debt
issuance or at least have been advised of its potential consequences.

Illustration:
Company PUB is selling 10,000 ordinary shares to the public. The offering appears to
give the shareholders 30% of the voting power and equity in the Company. However, the
company also has outstanding $100,000 in corporate notes that are convertible into
ordinary shares. If the notes are fully converted, the shareholders who purchase the
10,000 shares being offered will have only a 15% voting power and equity interest. They
will have been diluted by 50%, a potential that must be fully disclosed in the offering of
the ordinary shares.

3. Will the Notes Be Transferable by Debt Holders?


Notes issued in the capital market could vary from one to several years in length. During
that time prior to maturity the value of the notes will fluctuate, depending upon the
financial strength of the company and how the interest rate compares to alternative
investments. Note holders may want to sell the notes prior to maturity, either because of a
personal need for income or because the value of the notes have changed. Will there be a

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secondary market for such sales? Notes are often not listed on an exchange. Unless an
active over-the-counter market develops, it might be very difficult for note holders to sell
their notes to third parties. This makes the investment illiquid until the maturity date,
which could be several years away. The fact of potential illiquidity and the risk that note
purchasers take as a result of this fact should be major disclosure items in offering
documents.

Questions for Reflection:


How can the risk of illiquidity for some notes be eliminated?
How do sinking fund obligations protect investors?
How is a company that offers to pay annual installments protecting investors?

4. Will there be a sinking fund or installment payment program?


If the notes will not be repayable for at least several years, are there any protections to
note holders regarding the company’s use of its income in the meantime? In other words,
are there any requirements on the company to set aside portions of its income each year
in order to have the full amount available at the maturity date? Some notes have sinking
fund obligations that require the company to pay an escrow agent an annual amount until
the notes are eventually paid. Alternatively, some notes require the company to redeem
the notes in annual installments, so that each year a portion of the debt is reduced. Both
of these measures are designed to protect note holders, as they require the company to
plan for proportionate annual amounts rather than wait until the year of maturity to see
what it has available.

5. How Will the Company Use the Proceeds from the Offering?
It is quite common for companies to obtain new debt financing in order to replace old
debt financing. There are at least three common instances for replacement financing:

(A) Maturity of Prior Debt


A substantial bank loan has become due, and the company’s assets are entirely being
used for operations and equipment. Where will the company get the money to pay the

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bank? One answer, and a frequent result, is to re-finance the loan with the bank. This is
fine as long as the bank is willing to continue to be a lender, and as long as the interest
payments are not beyond the company’s capabilities. Sometimes, however, companies
might prefer to pay off a bank loan with money raised from the issuance of debentures.
Perhaps the bank has required a high amount of collateral or other security that has
become burdensome, or perhaps the bank interest rates have become too high, or perhaps
the bank has imposed conditions on business operations that the company wants to
eliminate. Whatever the cause, the result might be a public issuance of debt securities.

(B) Decrease in Market Rates of Interest


An outstanding loan might have been taken when interest rates were much higher than
now. A $50,000 loan at 22% interest requires annual interest payments of $3,500 more
than a $50,000 loan at 15% interest. Loans usually are pre-payable, that is, the borrowers
have the right to pay the principal in full prior to the maturity date. There may be a small
penalty or premium to be paid for prepayment, but not necessarily. If there is a good
economic reason to replace one debt with another, a company might choose to float a
public debt issue at a lower interest rate and pay off the existing bank loan.

(C) Repayment of Shareholder Loans


Major shareholders, such as founders and managers, often make loans to their companies.
There are often good legal and economic reasons for making capital contributions in the
form of loans rather than additional stock. The loans could be and often are substantial. It
is not uncommon to see companies making public offerings of debentures in order to
obtain funds to pay off insider loans. After all, the insiders control the company, and why
not get paid for their loans from money raised from others?
There is nothing illegal about any of the three instances noted above. In each of them, the
company is raising fresh capital to pay off old debt. In other words, the investors’ monies
are not giving the company new working capital. The problem is that many potential
investors in the new debt offering might be thinking that the new money will be used to
help the business grow. That is not so. Therefore, from the perspective of a government
regulator, the principal concern must be disclosure. In this case, the disclosure must

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concentrate on the fact that the company is not going to be obtaining substantial new
capital for business expansion or other operating purposes. Investors might be much more
cautious about buying debentures if they realize that the money is going to a prior lender,
not to the company. In fact, if the proceeds of the debt offering will be mostly used to pay
off loans from shareholders and managers, many state securities administrators in the
United States might not permit such an offering under their “merit review” powers.

6. What Are the Rights of Debt Holders Against the Issuing Company?
The offering documents should fully discuss all of the rights and procedures regarding
debt holders. These disclosures could be even more necessary than disclosures regarding
shareholder rights, because Company laws usually provide substantial provisions for
shareholders and most of them are well known to potential investors. However, there are
few if any statutes (other than insolvency laws) that provide specific rights for debt
holders. Rights and procedures applicable to debt holders are usually set forth in the debt
instruments themselves, or in a basic instrument that applies to all debentures, such as a
trust indenture entered into between the company and the trustee on behalf of the
debenture holders. Rights and provisions that should be disclosed include:

• Rights, if any, to annual or periodic reports and financial statements;


• Transferability rights
• Rights to inspect records or make inquiries;
• Rights in the event of a default in payment;
• Other factors that might constitute a default;
• Conversion rights, if any;
• Procedure to obtain replacement debentures if lost or stolen;
• Sinking fund obligations by the company, if any;
• Redemption provisions;
• Procedure for giving notices for transfer, change of address, and death;
• Name, address, and telephone number for officer responsible for receiving notices and
providing information.

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Government regulators should assure that the disclosure obligations for debt offerings
include these and other material items of information that are particular to debt offerings.
When debt offerings began to become popular in the United States, legislation was
passed that set forth required provisions in a trust indenture for any debt offering over $1
million. That was The Trust Indenture Act of 1939, and its provisions are still in effect. It
would be a useful exercise for government administrators to review that statute to
determine whether any of its provisions should be incorporated in disclosure rules or
other regulatory provisions specifically designed for debt offerings.
1. Is the offering subject to registration requirements?
2. What is the effect of the new debt upon the company's capitalization?
3. Will the notes be transferable by debt holders?
4. Will there be a sinking fund or installment payment program?
5. How will the company use the proceeds from the offering?
6. What are the rights of debt holders against the issuing company?

The six concerns with public debt issuances that government regulators must be aware of:

Although there are currently very few public debt offerings by private companies or
SOEs, the legal structure is in place to allow such offerings and in time we will begin to
see more and more debt offerings as companies realize their advantages over equity
offerings in particular circumstances. Government regulators have had very little
experience considering the important public policy issues that could arise in a debt
offering. Some debt offerings might not fall within the securities laws. But if a company
offers debt generally to the public, the securities laws will certainly apply. There are
disclosure concerns that are different than equity offerings, concerns regarding the degree
of risk, and concerns regarding the right of debt holders. Government officials need to
understand these issues in order to effectively consider and adopt regulations regarding
debt offerings.

Conclusion
Among the principal points discussed in this Lesson were:

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1. Rating Agencies: One of the impediments to engaging in public debt offerings has
been the lack of rating agencies. Rating agencies are beginning to develop across Africa.
Initially they will focus on government-issued debt, but they will also have the capacity
to issue ratings on debt issued by companies and SOEs.
2. Rating Standards: Rating agencies consider a broad variety of factors in assessing the
risk of the debt investment. They then give a grade to the offering based upon analysis of
those factors. The grade allows potential investors to better understand whether the debt
offering is low risk, high risk, or something in between.
3. Impact of Monetary Rates on Debt Market: The government’s budgetary policies
and the monetary policies carried out by the Central Bank substantially affect the debt
market. If there is high inflation, or substantial instability in the value of the currency,
investors will generally avoid fixed rate debt instruments.
4. Government Competition: If the government is paying a very high interest rate on T-
Bills and other government debt, this will dry up the market for private debt and also
force companies to have to pay high interest rates on debt, which could be a serious
financial problem.
5. Application of Securities Laws: It would not be appropriate to apply the securities
laws or registration requirements to all debt offerings, even though all debt is a form of
investment. Government regulators should develop regulations and interpretive
guidelines that help define what types of debt offerings should be regulated.
6. Disclosure Issues: Debt offerings raise disclosure issues that might be very different
from equity offerings. Among the major disclosure concerns that government regulators
should assure are part of disclosure documents are the impact upon the company’s capital
structure, the ability of debt holders to transfer or sell the debt prior to maturity, whether
the offering proceeds will be used for new capital or simply to retire old debt, and the
rights of debt holders against the company.

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Chapter 6 - Unit Trust Offerings

Chapter Objectives
• To understand the distinction between shares offered by an operating company and
units offered by a unit trust.
• To analyze the distinctions between closed end and open end unit trusts.
• To consider advantages and disadvantages to investors in investing in unit trusts.
• To examine important disclosure issues regarding unit trust offerings.
• To examine the meaning and differences between load and no-load unit trusts.
• To consider various elements of regulation appropriate for unit trusts.

Introduction
Unit Trusts are unique forms of offerings. Investors who purchaser units in an investment
trust do not actually invest in any single operating company. Instead, investors invest in
the investment trust itself, whose assets are composed of a broad variety of investments
in operating companies, real estate, or other income-producing activities. Investors in unit
trusts therefore have no direct relationship with the operating companies whose stock is
held by the trust. Nor do investors in investment trusts have any control over the
decisions by unit trust managers to buy or sell additional investments. The value of an
investor’s holding is based upon the net asset value of the trust, a figure determined by
the total combined value of the trust holdings. The total is divided by the number of units
outstanding to obtain a per unit value, and that is the value at which unit trust shares are
bought and sold. Unit trusts can vary widely in their investment policies. Some unit trusts
are specialized in that they state in advance that they only invest in certain types of
industries, others might be very broad in their investment policies and investors have no
idea what future investments might be made. Because of the unique nature of unit trusts,
and investor relationships, many countries have adopted specialized legislation regarding
unit trust management and operation. This Lesson will focus on the kinds of information
and issues that government regulators should consider in developing legislation and
regulation for unit trusts.

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Chapter Core
1. Unit Trust Characteristics
The principal characteristics of a unit trust are:
Trust: The term "trust" comes from the fiduciary nature of the fund managers. They are
trustees of the unit holders, as they are responsible for investing and managing the unit
holders' funds.
Investment Company: A Unit Trust is essentially an investment company. It sells its
own shares, or trust units, to the public and uses the proceeds to invest in shares, financial
instruments, real estate, and other investment opportunities.
Economic Return Dependent on Investment Success: A Unit Trust does not engage
in any business operation other than investing. Thus, the economic return for its
shareholders, or unit holders, is directly related to the quality and success of the
investments made by the Unit Trust managers.
Investments Owned Solely by Trust: Trust investments in various companies are
owned entirely by the trust, just like corporations hold title to corporate assets. Investors
in a Unit Trust do not have any direct or beneficial interest in the trust investments. A
Unit Trust share owned by a shareholder is simply an intangible interest that is
transferable and carries limited voting authority.
Unit Price Based on Net Asset Value: Trust units are priced in accordance with the net
asset value of the Trust, which changes every day. The net asset value is essentially the
total value of the investments and other assets held by the trust, divided by the number of
units outstanding.
Trust Managers Elected by Unit Trust Holders: Purchasers in a Unit Trust elect
directors but have no authority regarding the trust's investment decisions.
Dividends: Unit Trusts pay dividends to their shareholders. As with operating
companies, dividends are discretionary and determined by the board of directors.

In a Closed End trust, profits are often used to increase existing investments or pursue
new investment opportunities, as Closed End trusts do not issue new shares to raise
additional capital. As a result, dividends in Closed End trusts might tend to be lower than
for Open End trusts, but that difference might be offset by higher appreciation in shares.

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Generalizations must be taken with great caution, as Unit Trusts differ enormously in
results and share values.

Questions for Reflection:


- How are Unit Trusts like corporations?
- How are Trust units priced?
- How are shareholder dividends within a unit trust determined?

2. Attraction of Unit Trusts to Investors


To an investor, a Unit Trust offers two basic advantages:
(i) Expertise:
Investment decisions are made by trust managers who claim to have knowledge and
experience in finding good investment opportunities. Individual investors who prefer to
rely on the supposed expertise of others, rather than make their own investment choices,
find unit trusts to be attractive.
It is fairly easy for persons to claim to be experts in investing who in fact have little
experience and are unsuited to making investment decisions with other people’s money.
As the old saying goes, “a little knowledge is a dangerous thing.” Some people who have
a little knowledge think that they can “figure out” the market in advance. No one has
such an ability, yet that doesn’t stop some people from claiming that they have special
abilities. That is a problem that government administrators cannot ignore. Disclosure and
licensing provisions for unit trust managers and fund advisers should specifically include
personal qualifications, experience, and historical data.

(ii) Diversification:
Investors in Unit Trusts "own" (in a very loose and non-legal sense) portions of many
different companies and other entities in which the Unit Trust is invested. Some of those
companies may succeed more than others. Hopefully more will succeed than fail. By not
having "all their eggs in one basket," investors are able to reduce their risk of loss
through diversification. An individual who does not have a lot of money to invest might
choose to put everything into one company.

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If that investment does not do well, there is no backstop for the losses that follow.
In a Unit Trust, the failure of one or more investments might not ruin or perhaps even
diminish the investor's total value. If a trust’s investments are well spread among a
diverse group of companies, chances are good that losses in some areas will be offset by
gains in others. Of course, investors hope that gains will occur everywhere, which is
precisely what happened during the mid-1990's when stock markets everywhere were
rising like high tides. Unfortunately, when the balloon burst in the late 1990's, and
markets fell, so did Unit Trust investments, as there were too few stocks that continued to
go up while the rest of the market was sliding down. One hopes for neither boom nor
bust, as both tend to be driven by forces that can get out of control. In more constant
markets, diversification can be a solid investment strategy. Here too, however, the
supposed advantage must be viewed with caution. Diversification might be more of a
curse than a virtue if the fund’s idea of diversity is limited to a single industry, which is
what happened to some funds that invested heavily in dot.com companies. Or, investment
managers might think that their diversity consists of investments in numerous high risk
companies. Government regulators should also be alert to this issue. Investment policies,
goals, and history should be a function of full disclosure to potential unit trust investors
Unit Trusts are not everyone’s cup of tea.
Many investors prefer to make their own decisions. They might seek the advice of
stockbrokers or investment advisers, but in the end they prefer to be "the masters of their
own fate." They might be willing to take investment risks that prudent and conservative
managers would not. They might want to invest large portions of their funds in particular
companies or industries. They might enjoy the “thrill” of making investment decisions
and following the daily progress of their making. Investors who are risk averse can
choose to diversify their own investments, although the more investments the greater the
broker fees. Moreover, Unit Trusts charge administrative costs and fees borne by the
shareholders, as discussed below, and these do not exist for investors who make their
own way in the market. The bottom line is that Unit Trusts must be seen simply as an
alternative investment opportunity that is likely to have special appeal to some but not all
investors.
- In an Open End Unit Trust, all shares sold back to it by the shareholders are redeemed.

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- Open End Trusts often sell additional shares and use the proceeds to fund redemptions
and invest in new opportunities.
- Open End Trusts are not legally permitted in countries where a Companies Act prohibits
a company from reducing its share of capital.

3. Reliance on Management’s Investment Skills


The most important element in the success of a Unit Trust is the investment capability of
its board of directors or whoever is delegated investment authority. Investors in a Unit
Trust are totally relying on the Trust managers' investment skills, as the Trust itself has
no other product or means of revenue. It is therefore very important to investors that they
be aware of who the managers will be and what the Trust's investment objectives will be.
Trusts may vary with regard to the objectives. Some trusts concentrate on conservative
investments the will give steady returns, such as real estate, bonds, and well established
companies. Other Trusts are more adventuresome and invest in start-up companies and
other more risky ventures.

4. Types of Unit Trusts: Open-End and Closed-End Trusts


Unit Trusts tend to start out in most developing countries as broad-based rather than
devoted to a particular market segment. That is appropriate in markets that do not have a
large number of diverse investment opportunities or a broad spectrum of investor
interests. As markets grow, specialized Unit Trusts often develop. One of the largest
mutual fund companies in the United States (where unit trusts are called mutual funds)
has over 100 different types of funds to appeal to various investors. Most of the different
funds are based upon investment strategies, such as (i) large company growth, (ii) mid-
cap growth, (iii) high yield bonds, (iv) tax-free municipal bonds, (v) foreign stocks, (vi)
convertible securities, (vii) high yield dividends, (viii) emerging companies, (ix)
government bonds, (x) money market securities, (xi) real estate, (xii) health-related
securities, and (xiii) precious metals securities, to name a few.
The two principal forms of Unit Trusts are "Open End" and "Closed End." The
distinction is based upon the resale and marketability of the units or shares (the term
"shares" will be used for convenience in our discussion).

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(1) Open End Unit Trusts
In an Open End Unit Trust, all resales of unit trust interests (shares) held by shareholders
are made back to the Unit Trust, which is required to repurchase any and all shares that
are offered. Repurchases are sometimes referred to as "redemptions." The Unit Trust is
said to "redeem" shares that are sold back to it by the shareholders.
Share value in a Unit Trust is determined by “net asset value.” That is the price at which
shares are sold by the trust, and it is also the price at which shares are redeemed. Net
asset value reflects the current value of the collective investments that have been made by
the Unit Trust. Determining the net asset value of a fund is a complex task, especially
where investments are diverse and not wholly in liquid assets with readily ascertainable
value. Net asset valuations change frequently. Changes in net asset value are caused not
only by changes in the day-to-day valuation of the trust investments, but changes can also
be caused by redemptions which cause the fund to sell investments or issue new shares.
An Open End fund often sells additional shares (thus the name "open end"), using the
proceeds from such sales to fund redemptions and to invest in new opportunities. Each
sale of additional shares is subject to registration and public offering requirements.

Open End Unit Trusts are not legally permitted in some countries. The fundamental
problem in those countries is the prohibition found in The Companies Act against a
company reducing its share capital, which is what would happen whenever there is a
repurchase of shares by the trust. In the absence of special legislation, Open End trusts
cannot exist in the face of such prohibitions. Many countries have resolved that problem
by adopting special legislation for Unit Trusts that specifically allow redemptions and
thus override the Companies laws.

Points to Remember:
“The bottom line is that Unit Trusts must be seen simply as an alternative investment
opportunity that is likely to have special appeal to some but not all investors”

(2) Closed End Unit Trusts

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The principal feature of a Closed End Unit Trust is that shareholders resell their shares in
the secondary market similar to any other securities. The sale price is determined entirely
by investor demand, as with any other stock. Although Closed End trusts also calculate
their net asset value, the sales price for their shares is not necessarily equivalent to that
valuation. The shares could sell higher or lower than current net asset value, depending
upon the market's assessment of the trust’s future.
Closed End Unit Trusts issue a fixed number of shares and, unlike Open End trusts, do
not issue new shares there after (hence the term "closed end"). Therefore, one
disadvantage for a Closed End trust is that it cannot raise new capital to invest in new
opportunities. It must sell existing investments in order to pursue others, or the managers
can choose to start an entirely new fund and seek new investors. Closed End trusts can be
formed under The Companies Act and managed by a board of directors elected by the
shareholders. Unlike Open End trusts, Closed End trusts are compatible with the
provisions of most Companies acts. However, because of the specialized nature of Unit
Trusts in general, most countries have adopted specific legislation that applies to and
governs both Open End and Closed End trusts.

(3) Advantages and Disadvantages of Open and Closed End Trusts


Open End trusts are quite common in many countries. In the United States, Open End
trusts are much more numerous than Closed End trusts. There are advantages and
disadvantages to the various forms of trusts.
Points to Remember: - A Closed End Unit Trust issues a fixed number of shares and
shareholders resell their shares in a secondary market.

- A Closed End Unit Trust must sell existing investments in order to pursue others.
- Closed End Unit Trusts can be formed under the Companies Act in a country.

Advantages of Open End trusts:


(i) Resale of Shares: Shareholders have a ready market for the resale of their shares. The
trust is required by its own charter to redeem all shares offered to it. The redemption
price is usually net asset value, which is based on actual value of the fund and not on

88
market perception by other investors.
(ii) Raising Additional Capital: The trust has the ability to pursue new investment
opportunities by selling new shares rather than having to liquidate existing investments.
Disadvantages of Open End trusts:
(i) Need for Liquidity: The obligation to redeem shares means that the trust must keep a
portion of its assets liquid in order to pay for redemptions. If redemptions exceed
anticipated amounts, the trust will need to liquidate fixed investments, which could cause
a loss in a forced sale situation.
(ii) Risk of Loss: There is a considerable risk of substantial loss in a weak market
situation. If a large amount of redemption orders come in, the trust will need to liquidate
some of its investments to pay for the shares. The forced sale of those investments will
cause those investments to decrease in market value (because of the selling pressure),
further reducing the value of any remaining holdings in those investments owned by the
trust. A spiraling downward effect could start. The net asset value of the trust will
decline, causing more shareholders to redeem in order to "get out" before the fund price
drops further, and the additional redemptions will lead to further investment liquidations,
further declines in net asset value, and so forth in a circular, ever-lowering pattern.
(iii) Influence of Redemption Rights on Investment Policies: The fact that the trust
must redeem all shares offered to it could affect the investment decisions of its managers.
Sometimes the influence could be conservative, causing managers to avoid newer
companies with higher risks as they would not want any failures to cause a drop in net
asset value. Sometimes the influence could be the other way, causing managers to make
high risk investments in the hopes of “hitting the jackpot” and thereby shoring up a
falling net asset value. In either case, investment decisions might not be motivated by an
investment strategy consistent with the trust's long term goals. The advantages and
disadvantages of Closed End Unit Trusts are to some degree the mirror image of Open
End trusts.

Advantages of a closed end trust:


(i) Not subject to Redemption problems. A Closed End Unit Trust is not subject to the
buffeting, downward spiral in net asset value that could occur for Open End trusts.

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Closed end shares are traded in the market. The trust itself is not involved in the resales
of its own shares and such resales do not affect the trust's net asset value
(ii) More investment flexibility. Because the trust does not have to be concerned with
redemptions, it can keep a large portion of its investments in assets that are not quickly
transferable into cash. This permits investments in real estate and other investments that
offer the opportunity for long term growth.

Disadvantages of a closed end trust:


(i) Potential lack of resale market. The lack of a ready market for the resale of shares
by unit holders. Indeed, unless there is a significant number of shares and shareholders,
there might not be any viable resale market. Closed End shares might therefore sell at a
discount below their net asset value because of their lack of liquidity.
(ii) Fixed investment funds. The "closed end" nature of the trust also restricts trust
managers from pursuing new investment opportunities unless they liquidate existing
investments. Liquidation of any investment, especially a sizeable one, could well cause a
drop in value by reason of the selling pressure.
Despite the differences between Open and Closed End funds, both are similar in their
most important factor ---- their success or failure is dependent upon the investment skills
of their management. Management must be able to make intelligent decision both as to
when an investment should be made and when that investment should be terminated. At
the end of the day, an investor's return will be based upon the wisdom of the trust's
management.

5. Load and No-Load Unit Trusts


Unit Trusts make money by charging fees to investors.
There are basically two different ways in which this is done:
(1) Load Funds
A load fund charges a front-end fee as a condition to taking the investor’s money. The fee
could be several percentage points, e.g. 4%, which means that the investor immediately
begins with only 96% of his or her investment. Of course, load funds will tell potential
investors that their track record of success means that the initial fees will soon be

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overcome. However, as a matter of disclosure, investors must be cautioned that they
immediately begin “in the hole” and might have to remain with the fund for a long period
of time before they are able to obtain an overall satisfactory return on the full amount that
they invested. Load funds tend to be ones that have excellent reputations based upon past
results are thus are able to receive up-front payment.

(2) No Load Funds


No load funds are often more popular with investors because they do not charge up front
fees. Instead, such funds charge annual management fees, usually based upon
a small percentage of the fund’s entire assets. Although the fees might look small, e.g.
less than 1%, they are a constant tax on the fund and thus affect investors’ return no less
than load funds. It is very important that the trust’s disclosure documents fully reveal the
percentages and amounts paid in fees to fund managers. Both load and no load funds take
money from investors, directly or indirectly. The load funds start out with bigger chunks,
but the no load funds could catch up in time with their periodic management charges.
Neither type of fund has an inherent advantage for investors. What should be much more
important to investors is the quality of the fund’s management and their investment
strategies.

6. Investor Concerns Particular to Unit Trust Offerings


Unit Trusts do not involve the sale of any products or services. They therefore present
special investment concerns that are either unique to Unit Trusts or are shared with, but
greater than, those for operating companies. These concerns include:
(1) Management Skills
By far the single most important disclosure factor for potential investors is the investment
skills of the trust managers. Who will be making investment decisions? On whose
advice? What is their prior investment history? What special skills, if any, do they
possess? In other words, why should the investor trust his or her money with those
individuals rather than make his or her own decisions?
(2) Investment Strategy
Every Unit Trust should have publicly-announced investment goals and strategies.

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What kinds of risks are they willing to take? Are they looking for solid, risk-free
investments that pay dividends, or higher risk investments that offer the hope of future
growth? If a mixture, which policy is the prevalent one? Of course, trust managers cannot
be expected to tie their hands in advance by a too-specific investment strategy, but what
should be disclosed is the general approach to risk and return that will motivate most of
the trust's investments.

(3) Fees and Costs


Trust managers are compensated through fees paid to them by the trust. In addition, the
trust might hire advisers and others to help make investment decisions and to manage
trust funds. The basis of all fees and existing contractual arrangements should be fully
disclosed.

(4) Conflicts of Interest


Experience in other countries has shown that trust fund managers are not above conflict
of interest situations. One area of concern is the hiring of fund advisers and
administrative personnel. Is there any relationship between those employees and board
members? A second area of concern is whether investments could be made in businesses
or property in which board members have personal interests. Are there any internal rules
or policies that prohibit such investments? Are there any limitations on conflict of interest
transactions? These are important disclosure concerns for potential investors.

(5) Valuation
Unit Trust shares are valued based upon the fluctuating value of the trust investments.
When shareholders plan to sell their shares, or others plan to buy shares, they need to be
confident that the trust has bet accurately reporting its collective valuation. What are the
standards that will be used in determining valuation? Who will be making the valuation?
How often? If appraisers are to be used to appraise not liquid assets, who will they be and
what appraisal method will be used? The trust might not be in a position to fully answer
all of these and other questions regarding valuation, but it should be able to give a fairly
complete description of what it plans to do in this important area.

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7. The Need for Regulation
For all the reasons noted above, investments in Unit Trusts are much different and pose
some risks that are much higher than investments in operating companies. Unit Trusts are
a welcome addition to the capital market and play an important role in generating
investor capital, but they are a form of investment that must be carefully regulated.
Among the major regulatory concerns are the following:
(i) Prospectus Disclosures: Special disclosure concerns for Unit Trust investors, as
noted above, suggest that the prospectus rules should include an entire set of specialized
disclosure requirements directed at Unit Trust offerings.
(ii) Licensing: Unit Trust managers, and perhaps even board members, should be subject
to licensing procedures to assure their good character and knowledge of the securities
industry. Licensing will also permit securities commissions to be able to act quickly and
effectively in the event of any abusive practices.
(iii) Property Protection: Unit Trusts might have very large amounts of cash and
property in their possession. Regulations should be developed to safeguard those assets,
in particular the deposit of assets in banks or other depositaries and the assignment of
responsibilities with the trusts for the safeguarding of trust assets.
(iv) Code of Conduct: Substantial rules exist for broker-dealers regarding how they treat
their customers and their interests. Similar rules should be considered for trust managers,
especially in areas such as conflict of interest, property management, diversification
standards, valuations, and advertising.
This is a partial list of important areas for regulatory consideration. The Unit Trust
market is still relatively young throughout Africa and other developing areas, and there is
time to develop standards that comport with existing conditions and goals. Unit Trusts
offer an excellent investment vehicle for many investors. Carefully thought out regulatory
provisions could help to assure those investors are provided adequate investment
safeguards.

The regulation of unit trusts poses problems that do not exist with regard to ordinary
operating companies. There are disclosure concerns for investors, fiduciary concerns
regarding the quality and activities of management, property protection concerns

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regarding the trust nature of the investment vehicle, and other factors discussed in this
chapter.
Unit trusts can be very important investment devices in capital markets. They can raise
money from investors who might otherwise be reluctant to invest because of their lack of
experience or knowledge about the market. They are also important because they provide
alternative investment opportunities within a stock exchange. As an exchange grows, so
will the number and variety of unit trusts. In some developed countries unit trusts own a
very high percentage (for example 30-40%) of all funds invested in stocks. Although unit
trusts are a very healthy and appropriate part of a capital market, they present substantial
regulatory concerns. Expertise should be developed in the securities commission
regarding the structure and operation of unit trusts, and government officials should draw
on that expertise in considering appropriate regulatory measures.

Conclusion
Among the principal points discussed in this Lesson were:
1. Nature of Investment: A unit trust is an investment company, not an operating
company, and therefore the unit holders have a much different type of investment than
they do with shares of an operating company.
2. Advantages to Investors: The principal reasons why investors buy shares in unit
trusts are (a) the supposed expertise of trust management to invest funds wisely and (b)
the ability to diversify risk among a broad range of investments.
3. Variety: Unit trusts can come in all sizes and shapes. Some trusts specialize in certain
types of investments, and it is very important from a disclosure standpoint that investors
be aware of the investment policies and goals of trust management.
4. Open-End Trusts: Open-end trusts provide a market to unit holders for the resale of
their shares. Open-end trusts also can sell additional units to raise capital.
5. Closed-End Trusts: The units of closed-end trusts are traded in the secondary market
just like shares of stock, and the trusts are under no obligation to buy back the units.
Closed-end trusts sell a fixed number of units and once that maximum number is reached
no more units are sold.
6. Load Funds: Load funds charge an up-front commission to investors. It is very

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important that full disclosure be made to investors of their costs of buying units in a load
fund.
7. No-Load Funds: No-load funds do not charge up-front commissions. They get their
compensation through annual management fees. The fees are a small percentage of the
fund’s assets but could add up to quite a large total over time. Disclosure to investors of
the size and effect of such fees is very important.
8. Disclosure Issues: Unit trust offerings present unique disclosure issues. Disclosure
provisions should be developed with specific reference to unit trusts, including such
matters as investment policies and goals, management experience in investing decisions,
fees and costs imposed upon the trust and investors, potential conflict of interest
concerns, and methods of valuation of unit trust interests.
9. Regulation Generally: In addition to disclosure issues, many other concerns exist
because of the amount of assets held in trust for investors and the potential for misleading
the public as to investment policies and results. Government regulators should assure that
specific rules are developed for unit trusts to the extent that they are needed.

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Chapter 7 - Public Sector Infrastructure for an
Efficient Capital Market

Chapter Objectives
• To gain an understanding of the basic regulatory infrastructure in an efficient capital
market.
• To examine the necessity for regulation that adapts to and covers different types of
public offerings of securities.
• To examine some of the major disclosure issues that should be required by regulation.
• To understand the role and importance of the secondary trading market.
• To examine the importance of timely disclosure of material information to the
secondary trading market.
• To examine the various methods by which publicly-held companies can disseminate
information to the exchanges and public.
• To discuss standards for determining when information should be disclosed.
• To understand the necessity for adequate training and staffing of the securities agency.
• To understand the important role of the judicial process in the capital market system.

Introduction
When the topic turns to national capacities, the term “infrastructure” inevitably becomes
central. What does “infrastructure” mean in the context of capital markets? That is not an
easy question. The answer could vary depending on the size, activity, and goals of the
capital market. For example, if the main purpose for the development of a stock exchange
is to create a secondary market to support the government’s privatization programme, it
might not be important to consider infrastructure appropriate to promote capital raising
by small or privately-held companies. We will assume that there are two fundamental
goals for capital market development in every country:

(1) Maximizing business financing opportunities and


(2) Providing investment opportunities for the local population.

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Given these goals, the essential public sector elements for an effective capital market
include the clarity and adequacy of regulatory standards and the existence of an effective
supervision and enforcement process.

Chapter Core
1. Capital Market Goals
In this Lesson we are going to make two fundamental assumptions:
1. Maximum financing opportunities for businesses: Every country wants to maximize
the capital raising opportunities for its domestically-situated businesses; and 2. Diverse
investment opportunities for the local population: Capital market growth depends upon
providing to the local population and other investors a broad variety of investment
opportunities.
Based on the two fundamental assumptions, we will posit a government regulatory policy
that seeks to develop a capital market appealing to both institutional and individual
investors and to many companies that desire to raise capital.

2. Essential Public Sector Elements


There are at least six essential public sector elements necessary for an efficient capital
market:
1. A clear and complete regulatory process applicable to capital raising;
2. Regulatory standards and directions to assure full disclosure in public offering
documents;
3. An accessible and efficient secondary market for the trading of securities;
4. Regulatory standards compelling timely disclosure of material information to the
secondary market;
5. An adequately staffed and trained agency to supervise and enforce regulations
applicable to the capital market.
6. A judicial system that permits timely and effective enforcement of the securities laws.
Each of these public sector elements must be present. A failure to develop capacity in any
one of these areas will seriously undermine the ability to create an efficient capital
market.

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Question for Reflection:
-Which of the six public sector elements necessary for an efficient capital market exist in
your country?

(1) A clear and complete regulatory process applicable to capital raising:


Securities offerings can come in all sizes and shapes. Among the major forms are:
(i) A privatization offering in which only the government is selling its shares, with no
new capital going into the company.
(ii) A privatization offering that includes the sale of shares by the company to raise fresh
capital for its own use.
(iii) A public offering to a broad number of investors by a private company that will be
publicly-owned as a result of the offering.
(iv) A public offering of additional shares by a company that already is listed on an
exchange.
(v) An offering to a relatively low number of investors by a private company that is not
seeking to become publicly-owned.
Each of these offerings raises distinct regulatory concerns. Yet, the securities laws often
do not distinguish among offerings and require every offering to go through the same
process. That raises questions of interpretation. A privatisation that involves only the sale
of government shares is technically not a primary offering. Should it be subject to the
same requirements as primary offerings? Are there special concerns regarding
privatization that calls for different types of disclosures and different rules as to sales to
investors? Securities offerings by private companies also vary considerably. Should a
company raising $25,000 from 50 investors in its own community be subject to the same
requirements as a company raising $2,500,000 from 1,000 investors throughout the
country?
These questions must be answered and regulatory standards adopted that relate to the
distinct forms of offerings. Each distinct type of offering raises questions of timing,
filing, the roles of the Registrar of Companies and the securities commission, the role of
the stock exchange, the manner in which disclosure must be made, the manner in which

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disclosure can choose to be made, disclosures by underwriters and brokers, and allocation
of subscriptions.
Too often the securities laws are based on a “one-size fits all” philosophy. The result is
too little regulation for some types of offerings, and too much for others. Sometimes rules
simply don’t apply, which leaves companies and their attorneys wondering whether they
qualify to do an offering. The sine qua non of capital market regulation is a set of laws
and regulations directed at the types of offerings and procedures that are regarded as most
likely and appropriate within the country.

Remember...
that because there are many different kinds of securities, securities laws should not be
based on the ‘one size fits all’ philosophy

(2) Regulatory standards and directions to assure full disclosure in public offering
documents
Every country with securities markets has developed disclosure standards applicable to
public offerings. However, those standards are not all the same, and some are taken from
sources that have become outdated. For example, in some countries disclosure standards
are contained in schedules to Company Laws, yet those Company Laws are often quite
old and have not been amended, or have not been amended regarding the schedules.
Moreover, to the extent that updated disclosure requirements have been instituted, in
some instances they have been adopted only for companies that will be listing on the
stock exchange.
A second major problem is that the requirements might be written with inadequate
guidance or instructions. The result may be that some disclosures are not made because
the companies or their advisers were not aware that the requirements called for them.
Two examples illustrate the importance of clear and full instructions:

Example A: Competitive Factors


In some industries an extremely important piece of information would be the nature of
the primary competitors, including their numbers, strength, and market share. If the

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requirement to discuss the business conditions of the company does not clearly include a
requirement regarding competitive factors, this important information might be omitted,
to the detriment of potential investors.

Example B: Environmental Regulation


If a business, for example a mining company, operates in a manner that could involve
environmental regulatory matters, disclosure standards should mandate the description of
those matters and their impact upon the company’s operations. Unless there is a clear
instruction to include such a matter, it could be overlooked or omitted, especially if at the
time of the public offering there is no pending environmental concern. Perhaps the most
expansive set of disclosure instructions has been developed by the U.S. Securities and
Exchange Commission. Although the scope and detail of those instructions might not be
applicable in other countries, the instructions provide an excellent checklist for
comparison purposes (http://www.sec.gov). A brief example of the breadth of those
instructions relates to the disclosure item regarding “General Development of the
Business.” The general instruction calls for a description of the general development of
the business over the past five years, or such shorter time as the business has existed.

The following is a list of some of the specific items to be disclosed in accordance with
the SEC’s instructions for answering this item:
• Any material reorganizations, mergers, or consolidations
• Acquisition or disposition of any material amount of assets
• Material changes in mode of conducting business
• Breakdown of revenues, profits, and assets by segment lines
• Principal products or services, broken down by segments
• Status of a new product or segment that requires material use of assets
• Importance and duration of patents, trademarks, licenses, and concessions
• Material information regarding working capital requirements
• Amount of dependence upon major customers
• Names and relationship to customers accounting for at least 10% of sales
• Competitive conditions, including company’s own competitive position

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• Amounts spent on research and development
• Material effects relating to compliance with environmental laws
• Revenues from foreign sources
• Risks relating to foreign operations

A second problem associated with some disclosure standards is that they vary depending
upon whether the company plans to list on a stock exchange. Companies planning to list
on an exchange must provide some information not otherwise required. For example, in
Uganda the company must describe “Risk Factors” if it plans to list its shares on an
exchange. Although it is commendable that this important disclosure be made, there is no
sufficient reason why the disclosure is not just as important for companies that might not
be listing their shares on an exchange. Of course, if there is no over-the-counter market,
and all companies therefore list their shares, the requirement would be universally
applied. However, we may anticipate that as more companies seek to raise capital
through public means some of them will choose not to become listed and an over the-
counter market will develop. Therefore, disclosure distinctions between listed and non-
listed companies should not be continued.
Regulators should periodically review the disclosure requirements in their respective
countries. In doing so, they should ask themselves the following questions:
(1) Do the requirements give adequate notice as to the scope of what is required?
(2) Are there clear instructions that set forth the nature of the required disclosures?
(3) Are there any material areas of disclosure not adequately covered?

An effective method to conduct the periodic review is through comparison with the
disclosure standards and instructions developed in other countries. However, local
conditions and concerns may mandate differences in disclosure standards, and those who
are in the regulatory process should always be alert to domestic policies that create a
particular set of disclosure concerns not necessarily shared with other countries.

Questions for Reflection:


What are some of the things companies in your country are legally required to disclose?

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Can you think of any items, in addition to those listed above, that should be included in
disclosure laws?

(3) An accessible and efficient secondary market for the trading of securities
An organized, active secondary market must exist for an efficient capital market. Unless
a secondary market existed, there would be no willing buyers of securities in the primary
market. That is why most countries have focused upon the creation of a stock exchange
early in their securities market development. In most cases the exchanges have been
carefully and well created. They are generally not-for-profit entities controlled by
member organizations who are licensed broker-dealers. Internal trading rules are
developed to assure a fair and open market trading system. All that is well and good.
The role of government is not over when an exchange has been licensed and organized.
Although the exchange may begin to operate in an efficient manner, government officials
must continue to review exchange policies to assure that they meet public policy goals.
The review should include the following:

1. Listing Standards
In many instances, listing standards for an exchange are so high that few if any private
companies could hope to become exchange-listed. The standards might have been
developed with privatisation in mind, and with the desire to assure that only the strongest
and most attractive privatised entities were on the exchange.
However, the result is that privately-owned companies are frozen out of any possible
listing. They do not have the asset size or sufficient public ownership of shares to qualify.
This therefore becomes a negative factor in trying to encourage privately held companies
to raise capital through public offerings.

2. Public Access to Market Information


Communication facilities in many countries make it difficult for people outside of the
main city in which an exchange is located to have current information. This is one of the
reasons why some countries, such as Nigeria, have considered developing regional
exchanges. If an exchange is attempting to be attractive to all members of the public,

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steps should be taken to assure that there is real-time access to trading information in
numerous locations throughout the country. It is not necessary to create expensive local
offices, for in this day of computer technology it might be sufficient to place computers
in post offices or other government facilities that will carry real-time quotations and that
will permit individuals to communicate orders should they so desire. Otherwise,
exchange trading will be limited to a fraction of the public and will not develop as
broadly as desired.

Points to Remember:
- Smaller companies should be allowed to trade their shares in an over-the-counter
market that exists independent of a stock exchange.
- The development of an over-the-counter market will in turn help foster the development
of a stock market.
- Regulators must remain in continual contact with stock exchange personnel.

3. Alternative Trading Facilities


Some countries specifically prohibit stockbrokers from trading in any securities not listed
on the stock exchange. This policy might be beneficial for the development of the stock
exchange, but it has serious adverse effects upon smaller companies who would like to
raise capital but are not eligible under listing standards. Those companies should have
their shares traded in an over-the-counter market that exists independent of the exchange.
But if such a market is prohibited, or if regulators fail to develop guidelines and standards
for such a market, the result is that smaller companies are impeded from offering shares
to the public. In many developed countries there are large over-the-counter markets. Such
a development should be encouraged, not feared, and brokers should be freed from the
prohibition against trading only on the exchange. If brokers are able to quote and trade
stocks in an over-the-counter market, they will be more motivated to encourage smaller
companies to raise capital through public offerings, thus increasing the flow of securities
that are publicly traded. The benefit of developing an over-the-counter market will also in
time extend to the stock exchanges, as companies initially too small to qualify for listing
may grow and reach the eligibility standards.

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4. Continual Supervision of Exchange Policies
Regulators in every country should maintain continual contact with stock exchange
personnel. Often there is a tendency to let the exchange run itself, and once it has been
created the regulators job is done. That would be a mistaken notion. An exchange needs
constant review, and a regulator interested in responding to current concerns needs
continual discussion with exchange personnel. Problems of listings, company eligibilities,
public access, and improved trading facilities are problems that go beyond the exchange
itself. They affect the ability of companies to raise capital, for companies will not act
unless they are confident that an efficient secondary market exists. Thus, the problems
are shared ones, and they should be addressed through mutual discussion and
cooperation.

(4) Regulatory standards compelling timely disclosure of material information to the


secondary market.
Timely disclosure of material information is the sine qua non of the secondary market.
Without adequate provisions to compel such disclosure, investors would be trading in the
dark. The result would be nothing more than organized gambling, as no one would have
sufficient information to be meaningful trading judgments. Even worse, some insiders
might have information that should be disclosed to the public, and those insiders could be
buying or selling shares to innocent investors on the other side who are being cheated out
of potential profit opportunities. Casinos are fine places for those willing to take total
risks, but stock exchanges attract a different breed, and investor interest would soon
disappear if there was a lack of trust in the trading process. It takes only one time to get
burned, only one instance of buying shares and then discovering adverse information that
the company should have previously disclosed, to convince an investor that there are
better ways to spend money. Stock exchanges in developing countries are too fragile
already to be able to withstand loss of investor confidence or interest.

Effective disclosure standards require several different elements:


1. Periodic Public Reports:

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All companies listed on an exchange or traded in an over-the-counter market should be
required to file with the securities commission periodic reports on financial and business
matters. At a minimum, there should be quarterly financial reports reflecting for each of
the first through third quarters, filed within a reasonable time frame after the close of the
quarter (for example, 30 days). Although unaudited, these reports would provide
significant information to the market regarding the company’s progress. As with all
reports, they should be in comparative format as to prior fiscal periods. In addition, an
annual report, including audited financials, and a discussion of company developments
during the year, should be filed as soon as practical after the close of the fiscal year.
Although neither the quarterly nor annual reports provide immediate information to the
market, they are very important safeguards as mandatory disclosure documents. In some
countries, monthly reports of major developments are also required. Copies of at least the
quarterly and annual reports should also be sent to all shareholders.

2. Immediate Disclosure to the Market


Most stock exchanges require as part of the listing obligations that companies inform
them as soon as possible of any material business developments. Some of those potential
developments are listed, for example dividend declarations, but it is important that the
requirement be written in a broad manner to encompass any potential material
development, for example the death of a principal officer, the loss of a major customer,
the signing of a major contract, etc. In countries that have over-the-counter markets,
disclosure should also be made to each of the principal market-makers in the company’s
securities.

Did you know…


That the declaration of dividends, the death of a principle officer, the loss of a major
customer and the signing of a major contract should all be immediately disclosed to the
market?

3. Immediate Disclosure to the Public


Disclosure to a stock exchange is generally not sufficient to assure that the trading public

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is aware of material developments. Public knowledge can be assured only by
dissemination of information in the broadest effective means. This usually means the
delivery of press releases to the leading financial newspaper and to other newspapers that
have broad national distribution. There will necessarily be a timing gap between the
delivery of the press release and its publication, and during that time neither the company
nor any of its insiders should engage in the buying or selling of company securities or the
tipping of the information to others. A problem could develop if a newspaper fails to
publish the information. In order to attempt to assure that the market is not operating on
an imbalance of information, the company should contact the exchange and any principal
broker-dealer firms to assure that the information has been distributed at those levels.

Materiality, Timing, and Soft Information:


The triggering event for disclosure is materiality. That is not a concept that is necessarily
clear. People can differ as to whether some information is material. For example, suppose
that a major new contract has been orally agreed to by both sides and the lawyers are
busy preparing the final versions of the written contract. It might take several days to
complete the written contract. Should disclosure of the non-binding oral agreement be
made now or should disclosure wait for the formal signing of the contract? A company
should ordinarily not be faulted for being cautious and holding off disclosure until it is
sure that the contract is signed. However, what if the contract is extremely valuable and
the company knows that some people who know about it might start buying shares before
the public announcement? What if the company learns that there are rumours in the
market regarding the transaction? In other words, when should a company announce
information that is not “finalized” but is on the path to completion? Future-oriented
information is sometimes referred to as “soft information” because it is speculative, as
opposed to “hard information” that is already established. Hard information that is
material must be disclosed immediately. But what about soft information that is
speculative? When is it material? The test used by courts in the United States is a
balancing one. On the one side is the likelihood that the transaction or event will occur,
and the other element is the significance to the company. Thus, an extremely important
transaction might need to be reported at an earlier time in the negotiating process than a

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less important one, although clearly the company will need to disclose that the transaction
has not been concluded and could be changed or terminated.

Business considerations demand that companies should not be required to disclose every
piece of material information as soon as it occurs. There are often confidentiality issues
and good business reasons why it is better to wait a bit before there is public disclosure.
For example, preliminary financial data might show that the quarterly results are worse
than anyone anticipated. That information does not have to be immediately disclosed
before the company has had an opportunity to develop more complete figures. Of course,
during this period there can be no trading or tipping by company insiders. How long can
a company sit on material information before it must be disclosed? There is no clear rule.
Generally, disclosure must be made as soon as there is no longer any legitimate business
reason to withhold the information.
Although specific rules can be developed to require reports to commissions and
exchanges, there will be numerous occasions when companies are uncertain whether
information should be disclosed at that time. The securities commission will provide a
major benefit to companies by being available with advice and guidance in a confidential
manner.

Rule of Thumb:
Generally disclosure must be made as soon as there is no longer any legitimate business
reason to withhold the information.

(5) An adequately staffed and trained agency to supervise and enforce regulations
We can learn a bit from history. Before the Securities and Exchange Commission was
created in 1934 in the United States, securities laws were mainly developed and enforced
at the state level. Unfortunately, very little resources were spent on staffing the state
administrative agencies. The result: widespread fraud, insider trading, and investor losses.
A central securities commission is the primary starting point for the supervision and
enforcement of the laws regulating the capital market. In developing countries, the
securities commission performs numerous major functions, including the review and

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reform of statutes, creation of regulations, supervision of stock exchange procedures, and
the review of public offering documents, licensing of brokers and dealers, and private
sector education and training. On top of all of these important functions, there must be
adequate staff and time to devote to the investigation of possible securities law violations
and the bringing of enforcement actions. If a commission is thinly staffed, it will not have
the resources to devote to enforcement. Unfortunately, history has shown that a lack of
adequate enforcement opens the door to illegal practices by promoters and insiders.
Eventually wrongdoers might get caught, but in the meantime many innocent investors
have been duped, and public confidence in the capital markets suffers.
It is not simply a matter of hiring staff. The staff members must be well trained in legal
and business matters. They must be able to review financial statements and complex
transactions. They must be able to assert challenges against companies that are
represented by highly paid lawyers and accountants. Working for the securities
commission is a valued public service profession, but salaries must be sufficiently high to
attract and retain high quality staff members. Staff positions with the securities
commission cannot be viewed as low level government jobs given only to young people
starting their careers. An inexperienced staff will be no match against the experienced
and sophisticated law firms and accountants representing public companies.

How big should the staff be? That will vary depending on the nature of a country’s
capital market. There is considerable work to be done even in countries with a very small
market. The larger the commission staff, the better each staff member will be able to
perform his or her tasks. Even in countries with less than 20 publicly traded companies, a
commission staff should not consist of less than 5-8 members. Assuming that the
government is committed to promoting the capital market, staff members will be kept
busy even where there are relatively few listed companies. As markets grow, so must the
staff. Staff itself must receive technical training. Many of the problems that might arise in
capital markets are not taught in universities or experienced in normal business
transactions. Staff must be thoroughly trained in matters such as:
• reading financial statements
• understanding various types of financial instruments

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- Review and reform statutes,
- Create regulations,
- Supervise stock exchange procedures,
- Review public offering documents,
- License brokers and dealers, and
- Educate and train the private sector.

Some functions of securities commissions in developing countries include:


• reviewing policies and procedures of broker-dealers
• analyzing claims and results by investment funds
• recognizing potential conflict of interest situations
• advising companies regarding disclosure concerns.

Training requires the government’s financial commitment. Indeed, when all is said and
done, it is possible to measure a government’s true commitment to a high quality capital
market system by its willingness to devote resources for the staffing, payment, and
training of securities commission staff.

(6) A judicial system that permits timely and effective enforcement of the securities
laws.
Enforcement powers granted to the securities commission and private rights granted to
investors require ready access to a judicial system that can effectively apply sanctions as
necessary. This statement is easy to make, and easy to agree with, and in every country
there is a judicial system in place for the enforcement process. However, there are some
fundamental problems that exist in various countries that impair effective enforcement.
Government policy makers cannot be content with the fact that a judicial system exists.
There must be continual analysis of the system’s role and effectiveness. As has long been
noted, rights without effective remedies translate into the loss of the rights themselves.
Public confidence in the fairness of the markets includes as a fundamental element the
belief that violators will be promptly and efficiently prosecuted and that civil remedies
will be available to compensate for investor losses.

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Among the principal areas of concern that should be examined on a country-by
country basis are:
1. Judicial Expertise
Do the judges understand the laws and regulations regarding the capital market and their
purpose and importance? Most judges will not have been trained in capital market
matters, and many of them will not have business or legal experience in financial matters.
Judges who do not fully understand the philosophy and purpose of securities laws and
regulations might not understand the problem areas being addressed by securities
commissions and private plaintiffs. For example, suppose that a company offering
document discusses a particular problem area in a manner that has so many technical
terms that many readers cannot understand it. Or the disclosure is buried in an
inconspicuous place in the document. Unless a court understands the philosophy of full
disclosure and that an offering document is not like a contract but must be read with the
unsophisticated investor in mind, it might excuse the problem on grounds that the
disclosure was made even if not understood. Other examples could be given in the
financial area, where judges might not fully comprehend the nature of the financial
instrument, e.g. a closed end investment fund interest, and therefore might not appreciate
the importance of certain disclosure requirements. As in any case, the securities
commission or private counsel must do its best to educate the court, but it must be noted
that at the same time the company or insider’s counsel is doing its best to assure the court
that there really is no violation or that the dispute is highly technical and unimportant.

2. Accessibility
It might be easy to file an action, but how long will it take before the case will actually be
heard? Delays could be very long, especially in countries that have inadequate facilities
for civil cases. As the old saying goes, justice delayed is justice denied. That maxim is
especially true in this area, for the longer the delay, the more opportunity for the
company, promoters, or insiders to disappear or simply dissipate whatever assets they
might have had.

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3. Civil Actions
Many countries continue to have rather old procedures for civil actions. Those procedures
might make it very difficult for investors to ban together as a class, or to obtain
meaningful pre-trial discovery, or to seek temporary orders that freeze assets or provide
injunctive relief. The most effective remedy against company or insider wrongdoing is
the class action remedy, in which all affected investors join in a single suit and seek a
recovery that is shared according to their proportionate losses. However, in many
countries it is difficult or nearly impossible to bring a class action. Without such a
process, individual lawsuits will be few and far between. Most investors will not have the
financial ability to sustain a lawsuit on their own. If an investor has lost $300 as a result
of company wrongdoing, it makes no sense for that investor to bring a lawsuit, as the
expenses will exceed the recovery. If 100 investors have lost $300 each, and the total
lawsuit is brought for $30,000, the amount of the potential recovery permits an effective
lawsuit to be brought.
This chapter has set forth basic public sector elements for a viable capital market. The
elements basically involve registration of securities offerings, disclosure guidelines for
public offerings, access to a secondary trading market, disclosure requirements for
secondary market transactions, an effective supervising securities agency, and effective
means for judicial enforcement of the laws. These are minimum, basic essentials.
Government regulation will include many more elements, such as licensing of broker-
dealers and investment advisers, rules as to market manipulation and insider trading, and
provisions for creating self-regulatory organizations. Indeed, government review of the
capital market and consideration of potential new rules is a never-ending process.
We have reviewed the starting points, the items that must be first and most carefully
considered. This lesson has only related to the public sector. There are innumerable
private sector institutions and issues that affect the capital market and that government
official should keep in mind. Capital market regulation is a kind of “partnership” between
the public and private sectors. That is why it is so important for government officials to
maintain a continuing dialogue with the private sector to learn of the “real world”
problems, issues, concerns and desires for those who work daily in the capital market.

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Chapter Review
2. Statutes, rules, regulations, and administrative releases of the securities and Exchange
Commission (United States): http://www.sec.gov
3. Rules and regulations instituted by California for the regulation of securities trading:
http://www.corp.ca.gov/srd/security.htm
4. Nigerian Investment Promotion Commission policy statements and objectives:
http://www.nipc-nigeria.org
5. Policies and standards adopted by the North American Securities Administrators’
Association:
http://www.nasaa.org
5. European Union structure and laws: http://www.eurunion.org

Conclusion
Among the principal matters discussed in this Lesson were:
1. Capital Market Goals: Government policy-making and regulation of the capital
market must start by examining the particular goals that are intended to be achieved by
capital market development. Those goals will directly influence the scope and nature of
regulations.
2. Essential Regulatory Infrastructure: An efficient capital market requires certain
basic public sector infrastructure. Government regulators should assure that these items
are present and effective.
3. Necessity for Clear Rules on Capital Raising: There can be many diverse types and
reasons for capital raising. Regulations must be sufficiently broad to give adequate
guidance and supervision to all the various forms.
4. Disclosure Standards and Guidance: Disclosure requirements must be broad enough
to encompass the wide varieties of potential material information and also contain
guidelines so that companies can understand exactly what is being asked.
5. Differentiation in Disclosure Requirements: Disclosure distinctions between
companies that plan to list on an exchange and those who do not plan to list should not be
continued, as all material information is relevant to potential investors regardless of
whether the company will be listed on an exchange.

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6. Accessible Secondary Market: A viable secondary market must exist so that
shareholders can trade their shares when desired and companies can make offerings
assured that a secondary market will exist for the shares. This includes review of listing
standards for exchanges, communication facilities for the public to know what is
occurring, and alternative trading opportunities such as the OTC market.
7. Disclosure in the Secondary Market: Requirements must be established to assure
that material information is not only disclosed on a timely basis but is broadly distributed
to markets and potential investors.
8. Materiality Standards: Inasmuch as liability can result from failure to announce
material information, it is important that the definition of “materiality” be considered by
the securities commission.
9. Securities commission staffing: It is not enough that there be a securities commission,
for it must have adequate staff, the staff must be well trained, and the staff must have
sufficient financial resources to carry out its obligations.
10. Effective Enforcement Programmes: Securities laws will lose their value, and the
public will lose confidence in the market, if violations are not promptly and effectively
sanctioned. A major obligation of government is to put enforcement mechanisms in
place.
11. Judicial Expertise: Judges who are not knowledgeable about capital markets will
have difficulty applying securities laws. Training programmes for judges and prosecutors
should be undertaken on a continual basis.
12. Civil Actions: Government regulators should assure that civil procedure rules permit
effective enforcement against securities violations, especially with regard to prompt trials
and class action lawsuits.

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Chapter 8 - Securities Offerings: The
Regulators’ Concerns

Lesson Objectives
• To examine the principal issues that regulators must examine in developing standards
for registered public offerings.
• To analyze disclosure requirements in terms of breadth and purpose.
• To understand the concerns that regulators have regarding the economic viability of
proposed public offerings.
• To consider issues affecting the fairness of public offerings to potential investors.

Introduction
A public offering can be a glorious occasion. The day the offering begins is full of
tension and excitement. Will investors buy the securities? Will the offering be fully
subscribed? Will disclosure issues arise that haven’t been fully thought about or treated in
the documents?
Despite the excitement attached to the opening of a public offering, the offering itself is
only the final act in a drama that began many months earlier. The drama was initiated by
the early, uncertain discussions regarding whether the company, SOE, or other entity
should consider a public offering of securities. If the decision was “yes,” normal life
ceased and there began a whirlwind of management meetings, telephone and electronic
communications with professional advisers, preparation of numerous draft documents,
and an unceasing barrage of laws, regulations and listing requirements for digestion,
analysis, and response. In this Lesson, we will be examining the registration process from
the company and management’s perspective, discussing some of the principal economic
and legal issues that must be confronted.

Lesson Core
1. Summary of Major Concerns Regarding Proposed Offerings
The registration drama includes both companies and government regulators. Government

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regulators set the stage by the adoption of laws and regulations governing registration of
offerings. They also remain active throughout the registration process, especially in the
review of disclosure documents. Let’s consider the following hypothetical:

Illustration 1
Killington Hotels, Ltd. Owns three hotels, two of which are in your country, and one is in
a neighbouring country. The company has just filed a registration statement with the
securities commission for the sale of $2 million of ordinary shares. The registration
statement is very short. It briefly describes each of the hotels, names the company
directors, and states that the company plans to use the new money “to build new facilities
for our existing properties.” The company lost money last year because of unrest in the
neighbouring country that totally destroyed the hotel industry. The company’s
underwriter is a well known and highly experienced broker dealer. What are the major
concerns that regulators must address in reacting to this registration? At a minimum, the
concerns are:
1. Full Disclosure (Transparency)
2. Viability of the Offering
3. Fairness to Investors
There are, of course, many other concerns that regulators must consider with regard to
IPOs, such as subscription and allocation processes, review processes by registrars and
commissions, form and content of share certificates, and standards for face-to-face and
Internet marketing. This Lesson, however, will focus only on the central issues as noted.

2. Full Disclosure (Transparency)


(A) Basic Disclosure Regulations
Full disclosure of all material information, also known as “transparency,” is the absolute,
number one essential requirement for all securities offerings. Nothing destroys public
confidence or a willingness to participate in the capital market faster than a concern that
potential investors have not been given full information. Before the registration has been
distributed to the public, government’s role is to assure that it is written in as complete
and understandable a manner as possible. A major task for government regulators is to

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assure that disclosure standards are both (a) complete and (b) understandable.
What does it mean that disclosure standards are complete?

It means at least the following:


(i) A clearly delineated list of disclosure items;
(ii) A set of instructions for answering each of the disclosure items;
(iii) Specialized disclosure standards for particular forms of business.
Let’s discuss each of these items.

(i) Clearly delineated list of disclosure items:


Disclosure requirements in some countries are set forth in several different places,
starting with schedules to Companies Acts, and often including securities commission
regulations and stock exchange rules. Some Company Act schedules are very outdated
and fail to give comprehensive guidance to issuers with regard to required disclosure
details. Unfortunately, too, those schedules have been adopted by parliaments and
therefore are not easily amended. In some countries, securities commission regulations
have updated and supplemented the statutory listing. That is a step in the right direction,
although in some instances the more modern disclosure requirements are applicable only
to issuers that plan to list on an exchange. In some countries the stock exchanges also
impose special disclosure requirements for companies that plan to list shares on the
exchange. Is there a justification for a bifurcated disclosure system that distinguishes
listed from unlisted securities? That is very doubtful. Except for specific information as
to listing applications, information that could be material to investors in a listed company
is probably just as material to investors in companies that do not plan to be listed. Rather
than having disclosure requirements spread across various schedules and differing sets of
instructions, it would be well to consider placing all instructions in a single set of
instructions and requiring the application of those obligations to all public offerings.

(ii) Instructions for answering disclosure requirements:


Even in countries that have modern versions of disclosure requirements, there is often a
lack of detailed instructions to give guidance for issuers in providing such disclosure.

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Instructions are vital, because broad categories of disclosure do not often give issuers or
their advisers’ sufficient guidance with regard to specific areas. For example, should a
description of the company’s business be broken down by major segments, with revenue
and assets noted for each segment? Should the impact on the business of government
regulations, e.g. environmental rules, be discussed? What is meant by conflict of interest
transactions and what degree of disclosure is required for such transactions? There are a
myriad of issues that can arise in attempting to follow disclosure requirements, and the
more instruction given the better.

(iii) Specialized disclosure standards:


Guidance is especially important in specialized circumstances, such as industries with
depleting resources (mining, oil and gas, minerals, etc.) or that involve significant foreign
marketing and currency conversions (tourism, international trade, etc.). Companies
preparing registration statements should not have to guess what the disclosure
requirements mean with regard to their unusual business activity. If there is doubt as to
the required scope of disclosure, important information might be inadvertently omitted.
Moreover, a lack of clear instructions will increase the administrative burden on the
commission, and perhaps also the exchange, in reviewing and commenting upon draft
disclosure documents.

(B) Risk Factors


There are two major areas of disclosure that are somewhat subjective and open-ended:
(i) Risk factors and
(ii) Management’s analysis of financial results.

These are items of extreme importance to potential investors and every country’s
disclosure standards should insist upon these disclosure items.
Risk factors are those matters that, in the company’s judgment, make the investment one
that is particularly speculative or risky. By human nature, and a natural desire to be
optimistic, managements of most companies will not want to admit that there are any
speculative or risky aspects of the investment. An important role of underwriters and

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lawyers is to convince management that disclosure of risk factors is (i) necessary, (ii)
appropriate, and (iii) will not destroy the offering if the company’s strengths are also
made known. It is also a crucial role for the securities commission in reviewing the draft
registration statement to raise questions regarding potential problem areas that perhaps
have not been disclosed in the risk factors discussion. Even if the securities commission
does nothing more than demand fuller disclosure, that is an extremely important role for
public protection purposes. Some countries might go further and permit their
commissions to refuse to allow offerings to go forward if analysis of the risk factors
convinces the commission that the offering is not viable or fair to potential investors,
subjects that are discussed below.
How does the “risk factors” instruction read in your country? Is it broadly or narrowly
drafted? A broadly drafted instruction would read something like the instruction in the
United States:
“Where appropriate, provide under the caption “Risk factors” a discussion of the most
significant factors that make the offering speculative or risky.”
A short list of examples is given in these instructions, expressly noting that the list is not
exclusive. By contrast, a narrowly drafted instruction is found in the
Uganda regulations:
“In relation to the business of the issuer, information shall be presented on any new
venture risks, construction risks, licensing risks, potential increased competition,
regulation, dependence on key personality, taxation, level of indebtedness, dilution,
unexpectedness of dividend.”
Uganda appropriately requires “risk factors” disclosure, but why is the description drafted
as an exclusive list of items? The list of items covers much, but does it cover all potential
areas of risk? Ask yourself whether any of the specified items in the regulation include
the following risk factor disclosed in a recent U.S. prospectus by a company whose
revenues are dependent on Internet operations:
“We derive a substantial portion of our revenues (89%) from the sale of advertisements
on our web site...Our ability to generate revenues will depend, in part, on...advertisers’
acceptance of the Internet as an attractive and sustainable medium...and willingness to
pay for advertising...at current rates.”

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Disclosure of potential or existing Risk Factors should be a fundamental requirement for
all registered offerings, and perhaps the listing should be required to be set forth in the
early pages of the prospectus. Moreover, regulators should review the instructions for
Risk Factors disclosure to assure that there are no gaps and that companies are required to
state matters that they know about even if not within a specific enumeration of items.

Questions for Reflection:


What do you think some common risk factors that the companies that operate in your
country should be required to disclose?
How, if applicable, are the disclosure standards in your country written?
Do you think that they are too broad or two narrow?

(C) Management’s Analysis of Financial Results


Financial statements are usually incomprehensible to untrained investors and often are
not easily understood by their professional advisers. Bottom lines might be understood,
but bottom lines are the result of what came above, and many judgments go into
determining individual items on income statements and balance sheets. An important
disclosure section for potential investors and their advisers is Management’s Analysis of
Financial Results (or whatever similar title might exist in your country). This discussion
should not be brief or too formal. It should state in very direct, simple language:
• The major financial results of the company,
• Management’s analysis of why the company has achieved those results,
• Any trends that are apparent to management, and
• Any problem areas that might impact upon future financial results.

The instructions for management’s analysis should be clear and complete. The section
should not be simply a restatement of the audited financials. That would tell too little.
Potential investors should be given the benefit of the same thinking about the company’s
results that management has: Why is the company doing well? Why isn’t it doing better?
Why one product competing well in the market but another product is is not? What
problems areas exist? Similar to Risk Factors, management’s analysis section should give

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clear guidance but be open-ended in its instructions so as to generate as broad a
discussion as possible.

3. Viability of the Offering


Disclosure alone is not sufficient to satisfy government’s concerns. Government must
also be concerned that the offering is viable, that is, that it provides to potential investors
a reasonable investment opportunity. Markets in most developing countries cannot afford
to have offerings that never should have been sold to the public. It only takes one or two
such offerings to poison the well for all future efforts by legitimate companies to raise
capital. Careful review of the disclosure documents should alert the securities
commission and other review authorities to potential problems areas regarding the
offering. In every instance, however, the review authorities should ask the following
questions:
(i) How was the offering price determined?
(ii) Will there be sufficient shares sold to sustain a secondary market?
(iii) Is the offering’s minimum amount a realistic figure?

Let’s examine each of these items.


(i) How was the offering price determined?
Setting the offering price for the securities can be a difficult task, involving analysis of
both current and anticipated economic results. If the price being offered is too high, the
price will not be sustained in the secondary market and the resulting drop will dampen
enthusiasm for later offerings by other companies. If the price is too low, the company
will not have received the full benefit of the offering, thus losing out on the ability to
raise much needed capital, as well as creating more dilution of management’s ownership
interest than was necessary. This will cause management of other companies to think
twice about the public offering of their securities. Government reviewers can rely to a
considerable extent on the expertise of the broker-dealers, underwriters, and merchant
banks that put their names behind the offering. They too are concerned that the offering
be a viable one, that investors are fairly treated, and that their firms’ reputations remain
strong. Nevertheless, review authorities should not give free rein or too much deference

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to others. Securities professionals make mistakes, sometimes glaring ones as evidenced
by the dot.com debacles in the United States. Moreover, securities firms are compensated
from the proceeds of the offering and thus their judgment may be unduly influenced by
their own economic desires.
The valuation and pricing of securities can be a difficult task, as it involves many
variables and subjective judgments. Among the factors to be considered are:
(A) Book value per share, determined by dividing net assets by the number of shares to
be outstanding after the offering;
(B) Earnings per share, determined by dividing the net profits by the number of shares
to be outstanding after the offering;
(C) Comparable market prices, determined by reviewing the share prices of similar
companies in similar lines of business;
(D) Discounted cash flow, determined by establishing the anticipated cash flow of the
company over a future period of years, discounted to current value;
(E) Share yield, determined by determining the amount of dividend or interest to be paid
as a percentage of the offering price;
(F) Subjective analysis of market conditions, including factors such as company
potential, strength of management, and potential investor interest.

Supervisory authorities should be alert to the alternative valuation techniques. Review


authorities should not demand a particular offering price, but they should be advised by
the issuer how the price was determined and make an independent evaluation of the
process and result. If the review authorities have any concern that the price does not
reflect the fair value of the securities being offered, they should refrain from approving
the offering until fuller explanation is received or until the issuer determines that a
different pricing formula should be utilized.

The dot.com debacle


During the mid-to-late 1990s when individuals and business began using the Internet to
sell products, aspiring Internet entrepreneurs thought they could bypass the long haul to
success and achieve instant wealth just by starting up a website. But lack of planning and

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poor financial controls meant that these companies quickly faded into oblivion. The
dot.com debacle occurred in the spring of 2000 when the Nasdaq’s value fell by 62%.
The Nasdaq fell from a high of 4260 to a low of 1620 in just twelve short months.

(ii) Will there be sufficient shares sold to sustain a secondary market?


A public offering might be entirely successful for the issuer but not for the investors. If
the number of shares being sold is not sufficient to create an active secondary market,
investors will hold shares with limited transferability and liquidity. The result will be a
diminished enthusiasm by investors with respect to future offerings.

In most instances the underwriter has a strong interest in seeing that an active secondary
market develops, because the underwriter stands a good chance of earning substantial
commissions (along with others) from the secondary trading process. However, it must be
emphasized again that underwriters and other professionals are not infallible, and indeed
may sometimes be so close to the forest that they cannot see the trees. In other words,
review authorities might be in a much more objective position to assess the chances for
an active secondary market.

Among the factors to be considered are:


• What percentage of the shares remains locked up in management?
• What percentage of the shares is being sold to institutions?
• What percentage of the shares is being sold to employee trusts?
• What percentage of the shares is being sold to foreign investors?

In other words, after plotting the above percentages, what is left for the public and will
there be enough public shareholders and enough shares in their hands to sustain an active
secondary market? Public offerings commonly are divided among several tranches. That
is fine, but from the review authorities’ perspective the question must be asked whether
the tranches will result in sufficient shares in the public’s hands to anticipate an active
secondary market. If the answer is negative, the offering might need to be revised. A
related issue is whether the company plans to have its shares traded on an exchange or in

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the over-the-counter market. Purchasers of the securities in the public offering should not
be left without a viable secondary market. If an exchange listing is planned, the listing
requirements will go a long way in assuring an adequate public float for an active market.
However, if listing is not planned, has the company taken any steps to assure that an
over-the-counter market will develop? Have broker-dealers committed themselves to
becoming market makers in the shares? These issues should be discussed fully with the
issuer and its representatives prior to approval of any offering.

(iii) Is the offering’s minimum amount a realistic figure?


The offering document should disclose the minimum amount required to be sold in order
for the offering to go forward. This is a basic disclosure requirement. It is closely tied
into the disclosure of the intended use of the proceeds. How was the minimum amount
determined? Experience indicates that a great deal of thought is given to the maximum
amount to be offered, because of its impact upon percentages of shares sold and dilution
of management interests.

But far less attention is often given to the minimum amount that must be sold in order for
the offering to go forward. Suppose that an issuer needs to raise $1 million for much
needed plant expansion and working capital. If the offering only raises $250,000, should
it go forward? Some issuers and their advisers will be inclined to say yes, the offering
should proceed even at that lower amount, for it will still give the issuer some much
needed capital and also provide compensation for the underwriters. The money might be
needed by the issuer, but is it the best result for investors? Some aspects of the intended
use of proceeds will not be satisfied. How important were those items that will not be
funded? Is the minimum amount only a temporary relief for the issuer, who will then,
faces further financial problems and have to start all over with another pubic offering or
some high debt financing?
Review authorities can place substantial reliance upon the expertise of the issuer’s
advisers and representatives. But, the cautions given above apply equally here. Indeed,
perhaps with even greater force, as the setting of the minimum amount to be received is
often not given a great deal of emphasis in the analysis of the registration process.

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Review authorities should carefully examine this disclosure and raise appropriate
questions if there is any basis for concern regarding whether the minimum figure is too
low. This also ties into the question of the secondary market, for the fewer shares sold the
less likely an active secondary market will develop.

4. Fairness to Investors
Government must be concerned that public offerings treat investors fairly. This notion
seems paternalistic, that is, why should government be concerned about fairness instead
of just letting the investor decide if he or she wants to buy the securities. This is an
ongoing debate, as some people believe that investors should just be given full disclosure
and left to decide on their own, while others believe that government has an obligation to
protect its citizens against offerings that, even though there is full disclosure, has little
chance of success. Unfortunately, the history in the securities markets has shown that
investors often do not have the experience or ability to judge in advance whether an
offering is fair. Decisions to purchase shares are often made on advice of advisers, who
themselves may not be fully objective.

Questions for Reflection:


How would you go about determining if a minimum amount for an offer was realistic?
What questions would you ask?
Does the securities commission in your country review the minimum amounts offered?

Among the elements that determine fairness is the price at which the securities are being
offered. The pricing and valuation of shares is discussed above in connection with the
viability of the offering. It is also a matter relating to the offering’s fairness. In
considering whether the offering price is fair, review authorities should ask:
(1) How does the offering price compare to the price at which the securities were
sold to insiders?
If there is a big differential between the price at which insiders bought their shares and
the price being offered to the public, can that differential be justified by management?
(2) Will the public’s percentage of ownership interest fairly reflect their financial

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contribution to the company?
If the public shareholders are putting in 50% or more of the new assets of the company,
will they hold a majority of the voting power? If not, is their voting percentage a fair
reflection of their contributions?
(3) Are there employee stock option or stock bonus plans that will materially impact
upon the percentage interests of the public shareholders?
It is well and good to reward employees with stock options or bonuses, but what will be
the long-term, cumulative effect upon the public shareholders of those additional shares?
Are the additional shares so numerous that public shareholders will have their holdings
substantially diluted by shares issued to employees?
Review authorities should also look at the share holdings of insiders. It is very likely that
insiders will want to take advantage of the secondary market that develops after the
public offering in order to cash out on some of their holdings. What is the relative size of
the holdings of the insiders compared to public shareholders? A potential problem could
be created if insider sales on the secondary market are large.

Illustration 2
Granite Company recently completed a public offering in which it sold 100,000 shares to
the public at $5 per share. In addition to the publicly owned shares, company directors
and officers own 300,000 shares that were either given to them or purchased by them at
very low prices during the past several years. There are no company restrictions on
directors or officers who wish to sell their shares. Thus, it is foreseeable that some
insiders will want to take advantage of the newly created secondary market and cash in
some of their shares. This would create a serious “overhang” on the market, which could
keep the price of the stock depressed for years. Each time the price rose slightly, insiders
would sell some of their shares, and the demand on the sell side would have the
inevitable result of causing a share price reduction. The problem foreseeable in the above
illustration can be anticipated in many companies where insiders hold large amount of
stock relative to what is being offered to the public. Unless there are restrictions placed
on insider transactions, either by company restrictions or by regulation, public investors
would find that they will likely have a somewhat depressed secondary market for their

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shares.

This chapter has discussed the principal government concerns that arise in most public
offerings of securities. Although a number of issues are described, it should not be
supposed that others might not exist. Each offering has its peculiar features. Government
regulators and review authorities must analyze each offering on its particular merits,
raising questions particular to the company and its plans. What is most important to
emphasize is that government cannot delegate to the company, underwriters, securities
professionals, or others, its fundamental obligation to protect the public interest. The
development of appropriate rules and regulations is the starting point, but thereafter there
must also be a continual vigilance that the public interest is in fact being served.

Conclusion
Among the principal matters discussed in this Lesson were:
1. Comprehensive Disclosure Standards: Disclosure requirements for public offerings
should be complete and, if possible, set forth in a single document.
2. Disclosure Guidance: Well-drafted instructions should be provided to guide issuers
and their advisers in drafting disclosure documents.
3. Specialized Disclosures: Specialized disclosure requirements should be developed for
companies and industries that have particular concerns.
4. Risk Factors: Offering documents should set forth basic risk factors regarding the
offering, and instructions should be drafted to assure that the disclosures are as broad as
appropriate.
5. Management’s Analysis of Financial Results: The prospectus should include a
clearly-written, non-technical analysis by management of the company’s financial results
and anticipated trends and problem areas.
6. Viability of the Offering: Government regulators should be concerned as to whether
the offering is economically viable, as this is an important protection for potential
investors who may not know how to evaluate the offering’s risks.
7. Fairness to Investors: In addition to whether the offering is economically viable,
there are also concerns regarding the fairness to investors, such as how the offering price

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was determined, potential future dilution through additional share issuances, and the
relative size of insider holdings.

Chapter Review
1. Statutes, rules, regulations, and administrative releases of the securities and
Exchange Commission (United States):http://www.sec.gov
2. Rules and regulations instituted by California for the regulation of securities
trading:http://www.corp.ca.gov/srd/security.htm
3. Nigerian Investment Promotion Commission policy statements and objectives:
http://www.nipc-nigeria.org
4. Policies and standards adopted by the North American Securities Administrators’
Association: http://www.nasaa.org

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Chapter 9 - The Private Sector: Competence and Input

Chapter Objectives
• To gain an appreciation for the importance of government officials to develop an
ongoing communication with those engaged in marketplace transactions.
• To understand the importance in developing expertise among the private sector
individuals who deal most closely with issuers and investors.
• To understand the functions of the various licensed securities professionals.
• To consider the principal conditions for granting licenses to securities professionals.
• To understand the role of stock exchange rules on securities professionals.
• To understand the principal forms of self-regulatory organizations (SROs).
• To review the various forms of disciplinary actions that may be taken against licensees.
• To understand the principal private causes of action that may be brought against
licensees.

Introduction
The essential elements of a capital market infrastructure require a great many actors, both
on the stage and behind the scenes. Many of those individuals are in government and
quasi-government positions, and they are responsible for developing the statutes,
regulations and guidelines for the market to operate. The rest of the essential actors are
“on the ground,” the entrepreneurs, investors, advisers, and others involved in raising
capital and trading securities. The public and private sector participants are a kind of
partnership when it comes to capital market development and operation. The former
create the framework for organization and operation, the latter carry out those policies
and engage in the transactions that are central to capital-raising activities. Because of this
close nexus, it is essential that public sector officials:
(1) Communicate with private sector individuals,
(2) Understand their problems and concerns, and
(3) Effectively respond to changes in the marketplace as appropriate.
Broker-dealers and investment advisers are perhaps the most regulated people in the
world, at least in the securities world. In most countries there are three different sets of

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rules that apply to them:

• Licensing statutes
• Securities commission regulations
• Stock exchange rules
In some countries a fourth set of rules exists:
• Internal organizational rules which brokers impose upon themselves.

All countries with established securities markets have adopted, or are in the process of
adopting, laws and regulations regarding brokers, dealers, broker representatives, and
investment advisers. Most of these laws and regulations are very similar and provide very
clear guidance for licensing and enforcement purposes. The discussion in this Lesson will
focus on some problem areas that are extremely important to investors and that affect the
trust and confidence investors have in securities professionals and the capital market
generally. Those areas involve problems of churning, suitability, and misrepresentation.

Lesson Core
1. The Importance of Private Sector Competence
In many developing countries the emphasis in recent years has been on the public sector
infrastructure. Thus, a great deal of attention has been given, and rightly so, to finding the
right personnel for such institutions as:
• Central Bank supervisory departments
• Securities commissions and staff
• Stock exchange boards and office
• Ministry of Finance and Ministry of Justice
• Foreign Investment offices.
The staffing and training of these departments and offices can be seen as Stage One in the
development of capital market expertise. Stage Two is the development of expertise in
the private sector. If Stage Two is not adequately addressed, the efforts of those in Stage
One will have little impact. Unfortunately, that has been seen in some countries where
there is very little private sector activity because of a lack of private sector expertise in

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capital market matters. Who are the private sector actors essential to the capital market?
The list includes:
• Lawyers
• Accountants
• Stockbrokers
• Investment advisers
• Company management
• Market analysts
• Media personnel
With regard to advising companies about issuing securities, the most important persons
on this list are lawyers and accountants. They are the ones who generally have the closest
relationship with company management. Management expects these professionals to
know the securities laws and the advantages and disadvantages of going public. But do
they? In many countries there are is very little academic or post academic training to
prepare lawyers or accountants for the rigid demands imposed by capital market laws and
regulations. The result could be inadequate or even misleading advice. If company
management consults brokers or investment advisers, perhaps they will obtain better
practical information, but those professionals are generally not fully aware of all of the
legal and accounting requirements applicable to offerings and ongoing market activity.
Some investors consult with lawyers and accountants, but most of them rely exclusively
on advice from stockbrokers, investment advisers, and what they read in the media. Is
that advice accurate? Have those securities experts followed proper procedures in making
their analyses and avoiding conflict of interest situations?

Recent scandals in the United States have involved market analysts who have issued
reports recommending that certain stocks be purchased but they failed to disclose that
their reports were motivated by the desire of their own investment companies to obtain
business from the companies whose shares are being discussed.
In general, it is probably safe to conclude that in many countries the degree of expertise
among stockbrokers and investment advisers is higher than what exists among lawyers
and accountants. That is partly because the former are required to pass exams testing their

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knowledge of the market, the latter are not. It is also the full-time job of the former, while
most lawyers and accountants get involved in securities matters only occasionally.
Hence, education and on-going training programs for lawyers and accountants are
essential, but so too ongoing programs for everyone involved as securities professionals.
Two scenarios illustrate the importance of expertise in the private sector:

Illustration 1:
Beverage Masters is a successful, family-owned business that creates and sells non-
alcoholic drinks. Recently, Coca Cola and Pepsi Cola began to aggressively market their
products. In order to compete, Beverage Masters needs substantial additional capital for
advertising, marketing staff, and working capital. The family owners fear that raising
equity will cause them to lose control of the business. Bank loans can be obtained, but at
very high interest rates. The company’s lawyers and accountants are not knowledgeable
about the variety of financing measures that might be taken to assure continued family
control, such as preferred shares, different classes of shares, debt issuances, and
redeemable interests.
Furthermore, the overall lack of knowledge has caused the whole capital raising project
to slow down. The result is that the company failed to raise sufficient funds in a timely
manner, lost significant market share, and began a downward cycle in its business. These
results might have been entirely different had the company management or its
professional advisers been more knowledgeable about financing possibilities in the
capital market.

Questions for Reflection:

Are lawyers, accountants, investment advisors, and other private sector actors
adequately trained in your country?
What kind of training is available for these actors? Is it ongoing training?
Is there any kind of mandatory training for actors in the private sector market in your
country?

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Illustration 2:
Olympic Fund is a closed-end investment fund. It recently began to advertise heavily,
claiming that investors were receiving “fantastic” returns on their investments. That was
actually true. Many local people bought shares in the Fund. Unfortunately, the Fund’s net
asset value soon dropped sharply. The local investors might have avoided making an
unwise investment if their lawyers, accountants, investment advisers, or stockbrokers had
demanded disclosure documents that would have shown that a major reason for the
Fund’s success was due to only 2 of the stocks it owned, and that most of the other
investments were very poor. Moreover, local investors were not sufficiently advised that
in a closed-end fund they cannot get out unless they can find buyers for their shares. The
Olympic Fund was not listed on any exchange and therefore it was extremely difficult for
any of the investors to sell their Fund units to others. Many investors were hurt
financially, which caused many other potential investors to decide not to invest in the
securities market.
The problems shown in the above Illustrations can occur even in the most developed
capital markets where securities professionals have substantial experience. But they are
more likely to occur where experience is limited, for experience leads to competence.
(There is a wonderful maxim that says: “Good judgment comes from experience, and
experience comes from bad judgment.” Let’s hope there are not too many bad
experiences with private sector professionals, and continuing training programs will
hopefully limit that possibility.)

2. The Importance of Private Sector Input into the Regulatory Process


Private sector competence is a major factor in the operation of a capital market. In
addition, however, and a matter that is too often overlooked, is the importance of two-
way communication between the public and private sectors.
A personal story might illustrate the point here. At a capital market workshop in a
developing country several years ago, the participants were entirely from government
ministries and other offices. Their country’s stock exchange was several years old and
there was a small but active trading market. The government participants were
enthusiastic to learn more and to determine the kinds of policies that would be best for

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their country’s continued development. Curiously, however, none of the participants had
ever sat down with any of the broker-dealers, fund managers, or company officers of
listed companies to discuss the actual effect of their regulations and the problem areas
that were being faced on the ground. No private sector personnel had been invited to
participate in the workshop. Through good chance, one of the workshop speakers was the
managing director of a listed company. He described in detail the legal and regulatory
problems faced by his company in trying to comply with all the laws and regulations
imposed on public companies. The reaction in the room was electric.

For the first time government regulators responsible for making the statutes and
regulations were meeting with someone who had to live by those rules. Some of those
rules were necessary for the protection of the market and investors, but others might have
gone too far in imposing costs and burdens on companies. Those costs and burdens also
prevent other companies from considering a public offering.
The participants learned a major lesson that day, which is the importance for government
officials to have a continual communication with private sector personnel. Unfortunately,
there is an ever-present degree of distrust between the public and private sectors. Many
private sector individuals believe that government officials responsible for drafting and
enforcing regulations do not really know or understand market realities. Many
government officials believe that private sector individuals are only interested in making
money and will violate regulations every chance they get. The perceptions are, like most
generalizations, overly stated and unfair. Nevertheless, the perceptions may affect and
inhibit communication. Continual communication and monitoring of the private sector is
necessary for many reasons, among them:
• To understand new forms of financial instruments
• To be aware of company concerns regarding regulatory compliance
• To determine whether trading procedures can be improved
• To consider new ideas to help smaller companies raise capital
• To understand problems in the timely dissemination of information.
These and many other market matters are within the daily experience of brokers, dealers,
exchange personnel, securities professionals, and others. Policy-makers and other

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government officials will be materially assisted in understanding the “on the ground”
reality of the capital market by establishing and promoting communication channels with
private sector personnel. Some of the measures that can be considered are (i) joint
government business committees, (ii) joint workshops with public and private sector
personnel, (iii) periodic “retreats” for open-ended discussion between private and public
sector personnel, and (iv) periodic open meetings sponsored by the securities
commission.

In the United States, the SEC has an annual meeting called the “Small Business Forum,”
in which it invites managements of small companies, lawyers, and others to comment
upon existing laws and to discuss capital-raising problems. The more the opportunity for
cross-communication, the better each of the public and private sectors will appreciate the
problems of regulation and compliance. In addition, to the extent that the cooperative
effort includes the drafting of proposed statutes and regulations, the better those statutes
and regulations will be in adjusting to the realities of the market. In some countries, local
bar associations have committees that actively review and comment upon proposed new
statutes and regulations, and propose amendments to existing standards.

Point to Remember:

It is extremely important for government officials to have continual communication with


private sector personnel.

3. Licensed Securities Professionals


Before going any further, some definitions are necessary.
(1) Broker
A broker is a person or entity who buys or sells securities as an agent on behalf of others.
A broker might be a firm, rather than an individual, that is licensed as a broker and that
employs broker representatives to deal directly with customers.
(2) Dealer
A dealer is a person or entity who buys or sells securities as principal as a regular part of

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its business operation. The difference between a broker and a dealer is that a broker acts
as agent, buying and selling securities on behalf of customers, and a dealer is a principal
that buys and sells securities on its own behalf. A dealer might be a firm, rather than an
individual, that is licensed as a dealer and that employs broker representatives to deal
directly with customers.
(3) Broker Representative, Stockbroker
A broker representative, also commonly known as a stockbroker, is an individual
employed by a broker who deals directly with clients of the broker, taking orders and
assuring that they are executed. These are the persons who have the most direct contact
with customers, and their qualifications in terms of knowledge and character are probably
more important than any other licensees.
(4) Investment Adviser
An investment adviser, as that term is used technically, is an individual who has a regular
business of giving investment advice to others and who receives compensation for such
advice. The person is not associated with a broker or dealer and therefore cannot execute
orders for clients. Because these persons advertise themselves as market experts, and the
public relies upon them, they should also have very strong qualifications in terms of
knowledge and character. Broker representatives are of course investment advisers, but
they are licensed separately from investment advisers because they execute orders on
behalf of customers.
Some countries also have a licensed sub-class of investment representatives, who are
employees of investment advisers. In addition, there are usually distinct licenses granted
to unit trusts and to unit trust managers. Unit trust managers and sales personnel are
usually regulated by statutes specifically written for unit trusts. The qualifications for
licensing unit trust personnel should be no less strict than licensing for ordinary brokers
and representatives.
Most firms that are licensed as brokers are also licensed as dealers, because firms
sometime find it necessary or convenient to trade in securities for their own account. This
is certainly true if over-the-counter markets exist, for the OTC is basically run by firms
who buy and sell securities as principals. Even if no OTC market exists, firms usually
want to be able to buy or sell securities in their own name in order to maintain an even

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flow of trades and an orderly trading market. Therefore, firms usually are both brokers
and dealers, hence the common name “broker-dealer.”

4. Licensing: Statutes and Regulations


Unlicensed individuals or entities cannot make trades on an exchange, cannot engage in
the business of effecting trades in the over-the-counter market, cannot engage in the
business of giving investment advice, and cannot act as agents for companies selling their
shares. All of these activities require licensing by the securities commission. Some
countries require separate licensing for brokers and dealers, while some have a single
licensing scheme for firms that want to be both. All countries require each broker
representative to be licensed, as well as each investment adviser and investment
representative. Licensing often is regulated through both statutory provisions in an
overall securities statute and in regulations issued by securities commissions. The statute
usually sets forth certain minimum conditions, such as honesty and integrity, and leaves
to the commission the authority to develop financial and other standards. The authority
granted to commissions is usually very broad and thus commissions have wide discretion
in establishing conditions and requirements. The usual conditions to obtaining a license
are:
(1) Financial
Brokers, dealers, and investment advisers are each required to have specific minimum
capitalizations. The minimum capitalization varies among countries, ranging from
approximately $15,000 in some countries to much larger amounts. As a general rule, the
larger the capital market, the higher the minimum required. The minimum capitalization
requirement is regarded as an important protection for investors if there are any claims
against the firms based on improper handling of orders or accounts.
(2) Good Character
Applications by firms and representatives include a full history of the applicant’s
business and professional experience. The securities commissions are usually granted
express authority to deny an application if the commission believes that the applicant
does not possess the requisite qualities of honesty and integrity necessary for a licensee.

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(3) Knowledge of the Market
Many people think that they know something about stock markets, but licensing
authorities must be able to determine who is truly qualified. Written examinations to test
the knowledge of applicants on capital market matters is the only effective measure. In
some countries, there are several different forms of examinations, depending on the types
of investments for which services will be provided. For example, the basic examination
would allow the individual to provide advice and services on equity securities, a different
examination would cover debt securities, another would cover municipal financing, and
so forth. If an individual wants to provide a full range of advice and services, all
examinations must be taken and passed.

5. Stock Exchange Rules


Stock exchanges operate through broker firms, and each trading session is dominated by
the activities of the trading and broker representatives from those firms. It is therefore
extremely important to the exchange that the brokers and their representatives follow
standards of fair practice. In addition to requirements imposed by regulations, exchanges
will also have their own set of requirements. The exchange requirements supplement the
regulations and deal with specific matters such as the trading procedures, conduct on the
floor of the exchange, trading in securities off the exchange, settlement and clearance
procedures, and other matters that affect the honesty, fairness, and integrity of the
exchange trading activities.
Examples of exchange rules that might not be covered by securities commission
regulations, or that supplements such regulations with further detail, include:
• Due diligence to know essential facts of client;
• Timely notification to client of each executed order;
• Limitations on exposures to single clients;
• Limitations on exposures to single securities;
• Full disclosure of conflict of interest situations.
Stock exchange rules must be reviewed and approved in advance by the securities
commission. The commission is therefore able to compare its regulations with the
proposed rules to determine reasonableness and compatibility.

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6. Self-Regulatory Organization (SRO) Rules
As markets grow, and broker-dealer firms increase in number and size, it is often in the
best interests of the broker-dealers to create their own self-regulatory organization. There
are two major catalysts for such organizations:
(1) OTC Trading
If over-the-counter trading is permitted, rules must be adopted to govern the process and
to assure the honesty and integrity of the OTC market. The securities commission is able
to adopt rules, but the broker dealers themselves are in the best position to know the OTC
market and to develop rules that will govern their respective activities. This is the process
in the United States, where rules adopted by the National Association of Securities
Dealers supplement rules adopted by the Securities and Exchange Commission for the
operation of the over-the-counter market.
(2) Discipline
The securities market is extraordinarily competitive. Brokers and their representatives
spend enormous time and energy trying to attract and retain customers. If a firm or
individual bends the rules to try to get an advantage, or acts in such a way that gives a
bad name to the entire industry, it is very important that disciplinary action be taken
swiftly and effectively. Brokers do not want to rely on exchanges or commissions to
police all incompetent or unacceptable conduct. The brokers themselves sometimes can
know the facts and act more effectively. Therefore, by forming a broker-dealer SRO, and
establishing self-imposed rules of conduct and enforcement mechanisms, the SROs can
be a major factor in assuring public confidence in the trading markets. In countries where
this has been done, disciplinary action is usually subject to review and approval by the
commission. This is an appropriate safeguard against arbitrary or other inappropriate joint
action. At present there are very few broker-dealer SROs in Africa or other developing
areas. The broker-dealers still tend to be small in number and have not been a major
influence in market regulation. However, the structure exists for SROs to develop and to
become a major factor in market regulation and enforcement. We can expect to see a
growth in broker-dealer SROs in coming years. Government regulators should prepare
for the development of SROs by taking action in advance to develop rules and regulations

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governing the formation and licensing of SROs and the supervisory powers of the
securities agency.

7. Disciplinary Actions Against Licensees


As is evident from the above discussion, licensees are subject to regulatory enforcement
proceedings from several sources:
(1) By the securities commission for violation of the statute or its regulations;
(2) By an exchange for violation of exchange rules;
(3) By a broker-dealer SRO for violation of self-imposed rules. Sanctions for violation of
rules and regulations range from:
(1) Censure, meaning a written reprimand;
(2) Temporary suspension from trading, such as one day or one week;
(3) Long-term suspension from trading, such as one month or longer;
(4) Permanent suspension and loss of license;
(5) Monetary fines.
The importance of prompt and effective disciplinary action cannot be over-stressed.
Nothing will cause the public to lose faith faster in the capital markets than the perception
that they are being victimized by securities professionals and that the government is not
doing enough to prevent that.

At a minimum, every securities commission should have a “hot line” telephone number
for calls from individuals who are aggrieved by actions taken by licensees. In many
countries, the securities commissions have staff members whose sole functions are to
monitor brokers and investment advisers and to investigate complaints against them. At a
minimum, every securities commission should have a “hot line” telephone number for
calls from individuals who are aggrieved by actions taken by licensees. Often those
complaints will not have merit, but all should be examined and the commission must be
diligent in assuring that legitimate complaints are processed appropriately.

NASDAD: The National Association of Securities Dealers was formed more than sixty
years ago in the United States. NASD registers member firms, writes rules to govern their

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behavior, examines them for compliance and disciplines those that fail to comply. They
also educate industry professionals and investors, and support member firms in their self-
compliance activities. NASD has a staff of 2,000 and an annual budget of some $400
million.

8. Private Actions Against Licensees by Investors


Rules imposed upon licensees do not necessarily mean that private investors can sue to
recover damages if those rules are violated. The regulatory structure is often written in a
manner that limits enforcement actions to government, exchange, or other administrative
actions. It is therefore necessary to assure that specific statutory provisions are in place to
provide investors with private causes of action against brokers or others who failed to act
properly.
There are three major areas where investors have been able to succeed in private actions
against brokers or other licensees for damages caused to them:

(1) Churning
Churning refers to the practice by some stock brokers to engage in multiple transactions
on behalf of their clients, thereby creating large broker commissions. Churning usually
cannot occur when investors are knowledgeable about the market and understand their
own investments. However, there are many people who know very little about the market
and entrust their stock broker with their funds. They will therefore follow the broker’s
advice because they do not know any better. If the broker takes advantage of the situation
by creating numerous trades for the primary purpose of enriching the broker through
commissions, investors should be able to sue for recovery of all damages suffered. The
damages would be not only commissions paid but the loss of principal that might have
occurred as a result of the multiple trades. Brokers will sometimes defend their conduct
by showing that their customers approved each of the transactions, but such evidence
should not be given great weight where it is clear that the customers were relying entirely
on the assumed expertise and honesty of their stock broker.

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(2) Suitability
Every stock broker is required to know the financial condition and goals of his/her
clients. That is because investment strategies vary among individuals. For some investors
it makes sense to place some money into high risk investments. For others, that would not
be a suitable strategy. Stock brokers must know their customers. Indeed, “know thy
customer” is a major maxim in the securities industry. If brokers recommend securities
that are totally unsuitable for their customers, the customers should be able to recover for
losses incurred. This does not mean that brokers are “insurers” against investor losses, for
usually brokers act in good faith and their recommendations can be justified. But where
there is no justification for recommending some securities, investors should have a
private cause of action to recover damages for their misplaced trust. In the United States,
the highest number of actions against brokers is for violation of suitability standards.

(3) Misrepresentation
Brokers and other licensees are required to have a reasonable basis for their
recommendations. Thus, in addition to “know thy customer” is the rule to “know thy
stock.” It is surprising how often brokers and others make recommendations based on
little or no hard facts. Everyone is always looking for the “hot tip,” for that one piece of
information that is certain to turn us into millionaires. As a result, rumours and false
information abounds in the market. Brokers and other licensees cannot let themselves be
misled, as they have a duty to their clients to investigate the facts of any company’s
securities that they recommend. We must be careful here, for it would not be appropriate
to hold brokers liable for (a) decisions made entirely by their customers, based on the
customers’ own information and desires nor (b) broker recommendations that are based
on a mistaken but not unreasonable basis. Liability should be imposed only when brokers
make misrepresentations that they knew or should have known were wrong or without
any factual basis. Some illustrations might be useful:

Illustration A:
ABC Mining Co. has reported large losses the past two years. A broker doing research
into the industry has learned from suppliers and creditors of ABC that ABC is doing

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much more business than in the past. Even though the broker has no personal knowledge
of the facts, it would not be unreasonable for the broker to recommend ABC stock to
customers.

Illustration B:
A broker knows that Sunrise Hotels, Co. is having serious financial difficulties. The
broker calls a favoured customer and advises him to sell his Sunrise shares. A few
minutes later a customer calls the broker and asks for a recommendation to buy some
shares. The broker advises the customer to purchase Sunrise shares, thereby assuring that
the favoured seller will have a purchaser.

Illustration C:
A potential investor calls her stockbroker and tells him that she has $300 to invest and is
interested in computer company stocks. The broker finds in his desk a brochure written
last year by a software company that states that the company expects to make record
profits for the year. The broker recommends that stock to the customer without any
further investigation. Had more research been done, the broker would have easily
discovered that the "record profits" turned out to be a loss, and that the company's
principal officers resigned two months ago. The company files for bankruptcy three
months after the customer buys the stock.
Licensing and other standards imposed upon brokers and other licensees might result in
disciplinary action in situations where a broker acts improperly. However, there should
also be available to investors a private cause of action for recovery of damages.
Otherwise, investors would have suffered injury without any remedy. Care must be taken,
however, not to impose liability for wrong judgments alone, for that would be unfair to
brokers. Everyone makes mistakes, and brokers are entitled to their mistakes. We should
separate the honest and reasonable mistakes from the deliberate misrepresentations or
statements that are made without any factual basis or reasonable belief.

Capital market development requires a working partnership between the public and
private sector. Each must understand and appreciate the concerns of the other.

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Government officials can attend workshops and listen to experts about the capital market,
and all that is good, but it is also essential that they meet with and listen to the private
sector professionals who are most affected by statutes, regulations, and proposed
standards of conduct. It is also essential that private sector professionals have adequate
training to be able to provide effective advice to companies and investors. This is a public
policy concern, as there will be a considerable loss of public confidence in the markets if
the so-called professionals upon whom companies and investors rely do not know as
much as they should. It is therefore appropriate for government to review the education
and ongoing training efforts in their country and to consider whether and to what extent
public funds should be used to support the development of private sector competence.

Conclusion
Principal issues raised in this Lesson include:
1. Private Sector Competence: Many developing countries have focused substantially
on developing infrastructure and expertise within government, but it is also essential to a
viable capital market that securities professionals in the private sector have sufficient
training and knowledge to advise companies and investors.
2. Training of Lawyers and Accountants: Lawyers and accountants are the most
important of the securities professionals in advising companies on laws and regulations
affecting capital raising activities. Their education and training should include substantial
doses of capital market doctrine.
3. Training of Stockbrokers and Other Advisers: Investors deal most closely with
stockbrokers and investment advisers. Public confidence in the markets demands that
these professionals have adequate and continual training in market requirements and
standards of conduct.
4. Public-Private Sector Communications: It is essential that both public and private
sector individuals understand and appreciate the concerns of the other, and thus ongoing
efforts should be made to assure a steady process of communication and feedback.
5. Private Sector Input Into Statutes and Regulations: Steps should be taken to assure
that private sector professionals have effective input into new regulatory proposals and
amendments of existing laws.

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6. Variety of Licensed Entities and Individuals: Distinct licensing provisions must be
developed for each of several different types of licensees, including brokers, dealers,
broker-representatives, investment advisers, and unit trust managers.
7. Licensing Conditions: The principal conditions for obtaining licenses are financial,
character, and knowledge of the market. Written examinations are the principal means for
determining market knowledge.
8. Stock Exchange Rules: Brokers and other securities professionals who operate within
the confines of a stock exchange are also subject to special rules developed by the
Exchange. The rules are subject to review and approval by the securities commissions.
9. SRO Rules: In some countries there are self-regulatory organizations in addition to a
stock exchange, the principal one being an organization of broker-dealers. SROs also
create important rules regarding trading and customer relations.
10. Actions Against Licensees: Government regulators should assure that effective
measures and resources are in place, including both administrative and civil, for agencies,
investors, customers, and others to bring appropriate actions against licensees. Among the
principal concerns of customers that could lead to disputes are churning, suitability, and
misrepresentations.
11. Alternative Dispute Resolution: Arbitration and mediation could be effective
measures for resolving disputes with or among licensees and appropriate regulations
should be developed to permit or require such measures.
External links
1. Rules and procedures of the National Association of Securities Dealers (United States):
http://www.nasdr.com
2. Example of private organization services to assist limited offerings in the United
States:
http://www.venturea.com
http://www.nevwestsecurities.com

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Chapter 10 - Issuer Concerns in Considering
Potential Public Offerings

Chapter Objectives
• To consider the financial, control, and other concerns relevant to companies considering
raising capital through public offerings of securities.
• To review some basic financial considerations affecting a company’s decision to raise
additional capital.
• To appreciate some of the principal concerns regarding whether capital should be raised
by a debt offering or an equity offering.
• To understand the concept of “leveraging.
• To consider some of the major disclosure concerns from the company’s perspective.
• To consider certain marketing questions, such as tranches and stock listing.
• To review the principal forms of underwriting.

Introduction
The regulatory and public policy issues regarding the registration of securities for a
public offering look very different from the government’s perspective than from the
company’s perspective. In a prior lesson we discussed government’s concerns regarding
the registration of securities. In this Lesson we will discuss some of the company’s
concerns. Unless each of the various sides understands the problems faced by the other,
there will be little opportunity for development of standards that adequately reflect both
policy concerns and the concerns of the business world. The company’s concerns are
principally about financial issues and control, which have very little to do with
government regulations. However, companies that are considering public offerings must
be well advised about the government regulations because those regulations will affect
the planning, costs, and timing of potential public offerings.

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Chapter Core
1. Company Analysis of Whether Additional Capital is Needed
A company’s concerns about a public offering begin long before the registration process
begins. They begin with the recognition that the company must have additional capital
input, either to maintain its current business or to grow. Even if a business is profitable it
might need additional capital. Profits are easily eaten up through higher costs of labour,
supplies, transportation, taxes, rent and other financial demands. The fact that a business
is profitable does not mean that it does not need more capital investment. Indeed, even
the word “profit” can be misleading, as “profit” for accounting purposes does not
necessarily mean cash on hand in the real world. Consider the following Illustration:

Illustration 1
Rockwell Mining Co. engages in the exploration and mining of minerals. Its financial
statement for the year ended December 31 showed $3,500,000 in revenues, and
$2,100,000 in expenses. Net profit before taxes was therefore $1,400,000. However, a
closer look at the company’s situation reveals that:
a. Revenues included accounts receivable of $1,000,000. However, because of financial
difficulties being faced by some major customers, there is a good chance that at least one-
third of the accounts receivables will not be paid.
b. The company’s mining equipment is getting old. Last year the company spent
$250,000 in repair costs. It is likely that the company will have to invest $1.5 million in
new equipment.
c. Land leases in some important areas are running out. They will have to be renewed at
higher rates, probably costing an additional $200,000 annually.
d. The company’s pension plan for its employees is under-funded by $250,000.
Employees are threatening to walk out unless the company fully funds the plan.
When one considers the above factors, a reported profit of $1,400,000 no longer looks as
good. Indeed, the company appears to be facing immediate costs of nearly $2 million,
and its true profits might be nearer to $1 million depending on how many customers pay
their bills in full. The result could be a true cash shortage of nearly $1 million, despite
reported net profits of $1.4 million.

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Timing is also an important consideration with regards to the need for capital.
Businesses have several financial goals to meet: immediate, intermediate, and long-
term.
i) Immediate goals are within the next several weeks and could include such matters as
payroll, rents, taxes, or payment to trade creditors.
ii) Intermediate goals are over the next several months and could involve such matters
as production costs; additional hiring of employees, professional fees, and anticipated
marketing costs.
iii) Long-term goals include the repayment of bank loans, the funding of research for
product development, and the acquisition of land and machinery for business growth.
Business management must make continual judgments regarding all of these demands,
comparing them to anticipated revenues. Some businesses may be seasonal, for example
tourism, and therefore a current cash surplus means very little if there will be months
with very little income. All of these concerns require careful financial planning. When
the judgment is made as to overall financial needs, it is usually much better to raise
capital in a single, comprehensive effort than to continually go back to the bank or
investors with repeated requests.

2. Determining the Amount of Capital to be Raised


Experience has shown that business managements overflow with confidence and
therefore tend to overestimate revenues and underestimate expenses. The junkyard of
failed businesses is filled with companies that had great ideas and products but
inadequate capital to succeed. If a company thinks it needs $50,000, it probably needs
$200,000. If a company thinks that it will cost $1 million to research and market a
product, it will probably cost $2 million before any revenues begin to come in. It is
wonderful that entrepreneurs have confidence in their products, services, and marketing
abilities, for without confidence there would be no new business development. But the
downside risk that is seen too often is that the entrepreneur’s confidence clouds the
judgment as to how much capital is needed to start and develop the business.

When a company adds up its capital requirements and decides to engage in a public

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offering, there are two questions that the company must resolve:
i) What is the total amount that we would like to raise in this offering?
ii) What is the minimum amount that we need to raise in order to make this an effective
offering?
Disclosure regulations generally require companies to state the minimum amount that
must be raised in order for the offering to go forward.

Predictions that are too rosy are more than a problem just for the business management.
They also create problems for investors and lenders, for both groups are dependent upon
the success of the company and its ability to match costs and revenues. One of the most
unhappy consequences of a public offering is when the company realizes that it did not
raise enough money and now needs to make another offering, The second offering will
almost always have the effect of reducing the share price because of the larger-than-
anticipated number of shares outstanding.

Illustration 2
Rosehill Coffee Co. had a public offering last year in which it sold 400,000 shares at $2
per share, raising $800,000. Rosehill underestimated the amount of capital it needed. Its
earnings per share are $0.10 ($40,000 profit divided by 400,000 shares), and the market
price has dropped to $1.50, a multiple of 15 times earnings. If Rosehill issues an
additional 100,000 shares, its earnings per share will drop to $0.08 ($40,000 divided by
500,000), and the market price will drop to $1.20 (15 times earnings per share).
Eventually the funds raised by the second offering will begin to produce profits, but until
that happens the earnings per share will continue to be depressed because of the larger
number of shares outstanding.

3. The Dilution Impact of Offering on Existing Shareholders


The question of how much capital is needed is often closely tied to management’s
concern regarding the new securities issuance’s impact on existing ownership interests.
The more that is raised as equity capital, the higher the percentage interest in the
company that must be allotted to outside investors. This concern could lead to an

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underestimation of what is needed, as management generally is determined to maintain as
high an equity percentage as possible.
Dilution will undoubtedly occur whenever ordinary shares are sold. However, that fact
should not deter management from engaging in a public offering, as the advantages of
such an offering might far outweigh the dilution concern. In the following Lesson we will
be discussing the advantages of a public offering from the company’s perspective.

4. Should the Offering be Debt or Equity?


The issuer has the option of selling equity, debt, or a combination of both. Sometimes
there will be little choice. If the company already has a high amount of bank debt, or debt
that is secured by liens on property, it will probably be unable to sell even more debt to
the public. If the amount of outstanding debt is not high, debt financing may be much
more feasible. Selling debt to the public is not often regarded as a major method to
finance a company, but in fact it can be a very appropriate method in some
circumstances.

What are the advantages to the issuer to sell debt?


(A) Debt-holders will not cause dilution in company ownership.
(B) Debt offering presents the possibility of leveraging, or gearing.
(C) Debt can be eliminated through future earnings or financing.
How can a company sell debt and “leverage” its economic return?
Leveraging, sometimes called gearing, refers to the possibility of a company making a
profit based on money provided by others. It works very well when the company’s rate of
return on the borrowed funds exceeds the interest rate owed to the lender.

Illustration 3
Company A wants to purchase a new production machine that will substantially improve
its manufacturing efficiency. The machine cost is $100,000. The Company is able to
borrow that amount from a bank at 20% annual interest. Suppose that the Company
anticipates that it will be able to make a return of 30% from the new machine. If the
Company’s projections are correct, annual interest of $20,000 will be exceeded by the

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$30,000 in additional income for the Company. The result is that the Company will have
increased its income by $10,000 without any outlay of capital.
The Illustration seems to have a very happy ending, but doesn’t the Company have to pay
back the borrowed money at some time? Of course that is true, but three factors must be
noted:
(1) Repayment from earnings: if the Company’s income has increased as anticipated, the
earnings will generate funds for repayment.
(2) Ability to raise more capital: if there are increased profits, the Company will have an
easier time in the future raising additional capital to pay off its debt.
(3) Refinancing: refinancing the debt with the bank or other lender is a very common
option, especially when the Company has shown its ability to make periodic interest
payments.

Equity will usually be the choice for most companies, rather than debt. The principal
advantages of equity are:
(a) Equity is a permanent investment without any repayment obligation.
(b) Equity does not require any interest payments or other return on investment.
(c) Equity allows a public securities market to be established that could have long-term
benefits to the company.

5. Disclosure Concerns for Companies


A registered offering opens the company’s front doors, back doors, closet doors, kitchen
doors, and every drawer in the house to public inspection. For many companies that
might not pose any problem. For others, there might be concerns regarding such matters
as who is on the company payroll, how much compensation is being paid to the highest
directors, possible conflict of interest transactions, potential legal problems, the identities
of major customers and markets, and much more. For some companies, going public is
not worth the problems that exposure will create. Unfortunately, this is not a subject that
is open to compromise with government policy. Full disclosure has to be the norm for all
offerings, large and small. Perhaps there might be modifications regarding the amount of
financial statements that are needed, and there might be instances where confidential

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information such as trade secrets should not be disclosed. Indeed, there should be a
government policy regarding requests by companies for confidentiality of certain
information. But non-disclosure is the exception and the exception must stay very
narrow. Disclosure concerns will vary from company to company. Some companies will
have problems with environmental regulations that must be disclosed, others might have
employee difficulties. Generalization is difficult, but the principal areas that have
traditionally caused the most problems for companies in considering “baring their souls”
in a public offering are:
1. Management compensation and other fringe benefits;
2. Conflict of interest transactions, for example leases of property from current
shareholders;
3. Potential tax problems based on prior reported income;
4. Employment relations and major employment contracts;
5. Dependence, if any, on major suppliers or customers;
6. Market competition;
7. Lack of experience, if any, in developing or marketing particular products or services;
8. Potential problems in repayment of loans or other obligations;
9. Threatened or pending litigation.
This list looks very much like the information that is generally described under “Risk
Factors” in a prospectus. Without a doubt, the “Risk Factors” section is the most difficult
one for the company to write, as it is a kind of confessional of potential problems that
most entrepreneurs would much prefer not to reveal to the world.

Questions for Reflection:


What are some common disclosure concerns of companies in your country?
Do you think that exemptions for disclosure requirements should be granted?
If so, in what areas? If not, why not?

6. Will there be Separate Tranches in the Offering?


Dividing an offering into specific tranches for particular types of purchasers is a
European and African custom. It is usually not found in the United States. In the U.S., the

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offering is usually made to everyone and anyone on a first come, first serve basis.
In Africa, the usual process is to reserve portions of the offering for specific groups, such
as employees, foreign investors, institutional investors, and small investors. This is not
mandatory, but it is the common process. In some countries this is an important process
as it assures that some portion of the shares are reserved for the public and will not be
purchased entirely by large institutions and by foreign investors. An important factor for
companies to realize is that dividing the offering among tranches might affect the
liquidity of the stock in the secondary market. For example, setting aside a major
percentage, e.g. 20% for an employee trust, effectively eliminates those shares from the
secondary market. Similarly, institutions might not trade shares as frequently as smaller
investors, and therefore the percentage held by institutions might also adversely affect
liquidity.

7. Should the Company List the Shares on an Exchange?


In countries that permit over-the-counter markets, companies have the choice of listing
their shares on the exchange or having them traded through the OTC system. A common
misconception is that companies sell shares on the exchange. That is not true. Companies
sell shares directly to buyers either directly or through underwriters. The company can
choose to list those shares on the exchange, assuming it meets listing qualifications. The
shares that are listed are owned by shareholders, not the company, and it is the
shareholders who offer them for sale on the exchange. The same is true in the OTC
market.

Did you know …


… that dividing a public offering among tranches may affect the liquidity of the stock in
the secondary market?

In recent years there have been several companies that have chosen to de-list from an
exchange, that is, voluntarily have their shares removed from exchange trading. This
could be a serious blow to shareholders if there is not an effective OTC market and could
raise questions of fiduciary duty to the shareholders. If there is an OTC market, delisting

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might not hurt the shareholders and could save the company substantial money in listing
fees, trading fees, and the sending out of periodic reports required by exchanges. On the
other hand, government regulators should assure that investors who trade in the OTC
market are protected by disclosure rules that are substantially similar to exchange
requirements.

8. Will the Offering be Underwritten?


Broker-dealer firms and merchant banks make substantial fees from underwriting new
issuances of securities. Often there is competition among such firms to become the lead
underwriter in an offering. Companies must be very careful in selecting the underwriter.
It could be a serious mistake to select an underwriter who promises that it will be able to
sell the shares at a higher price than anyone else. Each potential underwriter makes a
prediction to the company regarding the price at which the shares can be sold and how
well the market for the shares will develop. Companies must be on their guard to
determine whether the predictions regarding the proposed offering price are realistic or
whether they are simply efforts by potential firms to get the underwriting contract. If
shares are priced too high in an offering, the offering could be a failure for the company.
The company should also consider the secondary market. Usually the lead underwriter
continues to have a major role in developing the secondary trading market, whether on an
exchange or OTC market. It is in the company’s best interest to have a strong secondary
market, and therefore selecting an underwriter with capabilities in that regard should also
be considered.

There are three basic forms of underwriting:


$ Firm Commitment Underwriting
$ Stand-by Underwriting
$ Best Efforts Underwriting

In a firm commitment underwriting, the underwriter purchases all of the shares itself
from the company and then resells them to the public. The underwriter takes a large risk
in a firm commitment underwriting and usually this type of underwriting occurs only

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when the company is so strong that the underwriter is very confident in being able to sell
all or nearly all of the shares being offered.
Underwriting commissions are the highest for a firm commitment underwriting, which
means that the company gets slightly less total funds, but the company also has no risk of
marketability. Most companies will not have a firm commitment underwriting.
The standby commitment is quite common. The underwriter agrees that it will purchase
any shares not bought by the public within a certain time frame. Again the marketing risk
is substantially on the underwriter, but the underwriter might protect itself by limiting the
percentage or number of shares that it will purchase.
The least risky underwriting is the best efforts underwriting, in which the underwriter
simply promises to do its best in trying to sell the shares. The entire risk of marketing the
shares falls on the company. The commissions are the lowest for this form of
underwriting, but of course the company’s risk is the highest.

9. Miscellaneous Concerns
There are many more technical factors that a company has to consider in making a public
offering. The list could go on, but we have touched upon many of the major concerns.
Among other concerns are:
• Restructuring management to make the company more appealing;
• Selecting a public relations firm to assist in printing and publishing reports;
• Selecting a registrar to maintain an accurate list of shareholders;
• Appointing an accounting firm to do the required audits;
• Cleaning up “problem areas” prior to any public offering of securities;
• Selecting banks and escrow agents for subscriptions and allocations;
• Determining whether to attempt to sell shares in other countries;
• Determining the process for the transfer of stock certificates;
• Instructing insiders on rules against abuse of confidential information.
The amount of work, time, energy, and cost that goes into a company’s public offering is
enormous. That is one reason why companies avoid public offerings if there is any viable
alternative. It is important that government regulators understand that the rules and
regulations have enormous costs associated with them. On the other hand, the effort may

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well be worth the prize, for there can be considerable advantages to being a public
company.

Conclusion
The principal issues discussed in this chapter were:
1. Financial Planning: A company must engage in careful financial planning to
determine short-term, medium, and long-term financial requirements.
2. Risk of Under-Estimation: A common risk among companies is that managements
often under-estimate the amount of capital needed over a given time frame.
3. Minimum Amount to be Raised: In determining the minimum amount that will allow
a public offering to go forward, both government regulators and company management
must be very careful examining the assumptions that are used to formulate the figure.
4. Dilution: An important factor that could lead to a lower-than-needed offering is
management’s concern regarding the dilution of their control.
5. Choice of Debt or Equity: Management should consider the potential advantages of
each of debt and equity prior to deciding the nature of the offering.
6. Leveraging: A major advantage of a debt offering is the ability to leverage the debt
and thereby permit existing shareholders to make a higher economic return than if the
offering had been solely equity.
7. Disclosure Concerns: Disclosure concerns vary among companies but some of the
common ones are matters that should be carefully described in the Risk factors section of
the prospectus.
8. Tranches: Companies should not only consider whether the offering will have
separate tranches, e.g. for employees, but also the impact of those tranches upon the
eventual secondary market.
9. Stock Listing: In countries that allow over-the-counter trading, companies should
review the respective exchange and OTC standards to determine what would be best for
their shareholders.
10. Underwriting: Companies should select underwriters who not only can manage the
primary offering but who also can offer important support in creating a secondary market
for the shares.

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Chapter 11 - Transparency: What Does It Really Mean
and Require?

Chapter Objectives
• To explore the meaning of transparency in the context of a company’s public offering of
securities.
• To compare and contrast the transparency concept when applied to a public company’s
disclosure requirements.
• To examine the appropriate manner and standards to achieve transparency goals.
• To examine major problem areas for companies required to meet transparency
standards.
• To consider some of the principle ways that companies get into trouble with regard to
transparency requirements.

Introduction
No term is used more often than “transparency” when describing regulatory objectives.
But what does that term really mean? Without doubt, transparency is the indispensable
element of an efficient securities market, but do we really have a good understanding of
the concept’s requirements and limitations? Although transparency is clearly accepted as
a common good, when applied to government actions, transparency does not extend to
matters for which public disclosure is contrary to national interests. In the securities field,
transparency similarly does not mean full disclosure of every fact relating to a company.
Such a standard would result in a barrage of useless information, and investors would
have a difficult time separating the important from the unimportant. To be an effective
doctrine, transparency must be defined by notions of materiality, and there must also be
an acknowledgment of company interests regarding the timing of disclosure and
confidentiality of some matters.
This chapter will explore the parameters of the transparency concept and focus on some
of the main problem areas facing government regulators and companies in attempting to
determine when the transparency doctrine demands full and immediate disclosure.

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Chapter Core
1. Transparency: The Concepts of Full Disclosure and Materiality
Before examining transparency standards, we must begin by asking what the goal of the
transparency requirement is. From the perspective of government regulators,
transparency is required so that the reviewing and supervising agencies can determine
whether government-established investor protection goals are met. For potential
investors, transparency is required so that they can determine the potential risks and
rewards of the investment.
Generally, government and investor interests in transparency overlap, and transparency
standards serve both interests. However, there might be differences in emphasis. For
example, whether a company will be able to pay any dividends in the next few years is
not a matter of special importance to government reviewers, but it is a matter of vital
concern to potential investors. Thus, transparency standards developed by government
regulators must take into account investor concerns and assure that dividend policy is
prominently discussed and displayed This is just one of numerous examples where
government’s interest in transparency matches in theory but not necessarily in importance
to investor interests. Government regulators must continually put themselves into the
proverbial shoes of potential investors in order to develop transparency standards that are
meaningful both in scope and emphasis.
What are the standards for transparency in the Capital Market? One might think that
transparency is equated with full disclosure. That response only raises the question, full
disclosure of what? Disclosure of every fact that can possibly be relevant to the
company? It takes only a brief analysis to realize that it is not in the government’s
interest, nor the interest of investors, to require the disclosure of every fact relevant to a
company. Full disclosure, standing alone, is both an impossible and unworkable standard.
There must be some limitation that makes the disclosure meaningful. That limitation is
generally found in the concept of materiality. Full disclosure of material facts and events
is a standard that gets one closer to the goal of transparency.
We have now shifted the problem of definition from transparency, to full disclosure, to
materiality. When is a fact or event material? We could easily reply that a fact is material
when it is important, but have we done anything more than shift to yet another ambiguous

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concept, namely “importance.” Two examples will illustrate the difficulty of knowing
whether something is material:

Illustration 1:
The CEO of Company ABC is 47 years old. He has been CEO for eight years, during
which time the company has substantially prospered. However, during that time he has
developed a drinking problem and there are days when he is unable to come to the office
due to that problem. Is this drinking problem a material fact that must be disclosed to
potential investors? On the one hand, the CEO has been doing a good job, and there is no
way of determining whether or to what extent his drinking problem has affected the
company’s results and prospects. To be sure, if you asked potential investors whether
they would like to know about the drinking problem, they would assuredly answer yes.
But is it a material fact that must be disclosed, as opposed to a fact that some people
would like to know? If one is inclined to say that this is a material fact, let’s change the
facts from a drinking problem to a marital problem. Is the latter also material because on
some days the CEO’s mind is focused on something other than Company ABC? One
would hardly think so.

Illustration 2:
Company XYZ sells 15% of its product to the government. Recently, negotiations began
with government officials that could result in a major increase in the amount sold to the
government. The negotiations are still in their early stage but it is clear that the
government is very interested in increasing its purchases if it can get the right terms. Is
the fact of the negotiations material? Is Company XYZ obligated
to disclose the negotiations and the possible major increase in business? Once again,
many potential investors would surely like to know about the negotiations, but are they
material under transparency standards? Disclosure at this point might not only jeopardize
the negotiations, but it could cause undue excitement among potential investors who will
lose money if the stock price rises and later falls if the negotiations fail to result in new
contracts. If one is inclined to say that the fact of the negotiations is material, let’s change
the facts and say that the negotiations have not even started, and all there is so far is a

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telephone call to arrange the first meeting. Is this also material because of what it might
lead to in the future? One would hardly think so.
Full disclosure, or transparency, must be defined in terms of what is necessary for
(i) Investor protection and
(ii) For the government to do its job properly in assuring that companies provide
necessary information to the Capital Market.
However, it must be recognized that no matter how transparency is defined, there will
necessarily be some ambiguity. This is because it is impossible to predict every possible
disclosure item or event. That is not to say that there cannot be specific disclosure
standards. On the contrary, one of the most important tasks of government is to write and
continually review and update specific disclosure standards.
Disclosure standards were traditionally found in Schedules to Company Laws in various
countries. Those standards suffered from two defects:
(i) They were usually insufficient in detail and
(ii) They became outdated in an ever-changing commercial world.

In recent years, many countries have adopted a two prong approach to mandatory
disclosure matters. The first set of requirements is set forth by statute, often in a more-
recently enacted statute that focuses specifically on the securities market. The second
prong is the delegation to the supervisory agency for the securities market of the power to
adopt more specific and detailed disclosure obligations consistent with the statutory
standards. In the United States, for example, the primary securities statute sets forth in
very general terms 32 items of disclosure in connection with the public offering of
securities. But the statute does not stop there. If it did, disclosure standards would soon
become outdated and unreasonably rigid. The statute therefore authorizes the Securities
and Exchange Commission to require:
“...such other information as the Commission may by rules or regulations require as being
necessary or appropriate in the public interest or for the protection of investors.” Section
10(c), 1933 Securities Act.
The SEC’s Regulation S-K is a specific listing of disclosure requirements, and it is
dozens of pages long. For those who would like to get a flavour of the scope of the

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disclosure requirements, you may access the SEC Regulation on the Internet at
www.sec.gov.us. It is well and good to develop a comprehensive set of disclosure
requirements so that both the reviewing agencies and the companies are able to
understand what is expected, but it is also necessary to realize that no set of detailed
standards will answer every disclosure question. Consider Illustrations 1 and 2 set forth
above. No amount of regulatory detail will be able to answer the disclosure issues raised
in those examples. No matter how detailed a disclosure standard, there will inevitably be
numerous circumstances that are on the fringe and raise questions of application. That is
the reason why, in addition to specific disclosure standards, there must be an underlying
concept of materiality that can be used to determine when particular facts or events must
be disclosed.

2. Defining Materiality
In the securities world, two types of material information exist side by side. One is called
“hard information,” the other “soft information.”
Each carries its own materiality standard.
(A) Hard Information
Hard information is historical. It is based upon facts or events that have occurred,
whether 1 minute ago or 10 years ago doesn’t matter. Something is a hard piece of
information if it is unchangeable. The fact that the company made a profit of $100,000
last year is a hard fact. Nothing that happens in the future will change that fact. The fact
that the company yesterday signed a supply contract with the government is a hard fact.
The contract might turn out to be less valuable than currently anticipated, or it might even
be eventually cancelled, but the fact of the contract is immutable. What is an appropriate
materiality standard for hard information? In the United States, hard information is
material when it “would have assumed actual significance in the deliberations of a
reasonable shareholder.” This definition comes from the Supreme Court case TSC
Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976).

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Three things must be noted about this definition:

(1) The test is objective. It is based on a reasonable person’s belief. Thus, one would not
look at a particular investor and say that he or she has the sophistication, knowledge or
experience to know better, or to know certain facts that are not disclosed. The issue is
addressed from the perspective of an ordinary, reasonable person.
(2) The term “would” is a narrower concept than “might” or “could.” There are
many facts that a reasonable investor might consider important, but that is a broader
scope than facts that a reasonable investor would actually consider significant. The
difference is subtle but important. A potential investor who thinks “I might like to know
X” is probably not as committed to the importance of that information as the investor
who thinks “I would want to know X.” The “would” standard narrows the scope of
information that is material. This means as well that companies will not inundate
potential investors with tons of information that “might” be relevant but are not material.
The “would” standard limits information to the truly significant.
(3) The term “deliberations” means that the investor puts the information into the
mixing bowl of material facts, it does not mean that the investor’s decision is
necessarily determined by that information. The information does not have to be at a
level that makes or breaks the investment decision. Investors would want to know the
information, but their decisions are based on many pieces of information and not any one
factor alone. Thus, even though a negative piece of information might not have affected
the ultimate investment decision, it would be material nevertheless and therefore a
required disclosure item.
Hard information, if it is material, must be disclosed. If a company is offering to sell
securities, it must be disclosed in the disclosure documents. If a company has securities
trading in the secondary market, the information must be disclosed at the earliest
appropriate time (we will see below that the timing of disclosure is also an important
question).

(B) Soft Information


Soft information is speculative, it is future-oriented, it is based on anticipated events or

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possible outcomes. In Illustration 2 above, whether the company will in fact enter into a
major new contract with the government is speculative. It is speculative right up to the
moment when the contract is signed, because before that time there is no assurance that
the contract will come into being. It is speculative even if everyone believes that a
contract will be signed, it is speculative even if there has been a “handshake”
understanding between the parties, it is speculative even if it has been approved at all
lower levels and awaits only a Minister’s signature.

In trading markets, the most common soft information is a company’s prospects. Stock
analysts make their living from predicting how companies will do in the future. Indeed,
that is the basis on which most securities are bought and sold. Purchasers believe that the
company has a bright future, sellers have lower expectations. Many companies foster
such beliefs by commenting upon their own future prospects, either in speeches given by
officers or in press releases that predict particular revenue or profit results. It is common
to read, for example, that a company predicts that “our profits for the coming year will be
much higher than our profits last year.” Is soft information material? Of course, because
it is often information that reasonable investors would consider important. But, if it is
speculative, when must a company disclose soft information? That is the issue in
Illustration 2 above. The possibility of the major government contract may be material,
but at what point in the negotiations does the possibility become sufficiently real that it is
now material and therefore subject to disclosure? Here too, the United States Supreme
Court has tackled the issue and attempted to provide definitive guidelines. The facts of
the leading case, Basic Inc. v. Levinson, 485 U.S. 224 (1988), are interesting. Basic
Incorporated, a publicly-traded company, was engaged in merger negotiations with
another major company. There were rumours floating that Basic might be engaged in
merger negotiations. However, the Company consistently denied that it knew any reason
for the stock price increase.
The Company issued several press releases during the period of negotiations denying that
it was engaged in merger negotiations. When the merger agreement was eventually
announced, the stock price rose significantly. Persons who had previously sold Basic
stock were angry, and they argued that they had been misled by the Company into

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believing that nothing important was happening, which is why they sold their stock. If the
Company had disclosed the merger negotiations, they argued, they would not have sold
their shares and they would have reaped the benefit of the eventual price rise. The legal
issue was whether and when the Company was obligated to disclose the merger
negotiations, and whether the Company could deny such negotiations until a contract was
actually signed. Basic argued that they did not want to mislead the public, and therefore it
was appropriate to deny the existence of negotiations until an agreement was actually
signed.

The Supreme Court recognized that the issue involved speculative, soft information, that
is, what was the likelihood that the company would enter into a merger agreement? With
regard to this speculative information, the Court set forth three basic principles:
(1) There is no absolute requirement to disclose soft information. A company has the
right to remain silent about future possibilities until such time as the information becomes
“hard,” that is, the potentiality becomes a reality. Thus, in the case at issue, the company
could have simply stayed quiet, refusing to make any comment, or the company could
have replied by stating “no comment” in response to inquiries.
(2) If a company chooses to make a statement about an existing situation, it must
make an accurate disclosure. It cannot, for example, deny that merger negotiations are
occurring if in fact that is not true. Nor can it predict that future profits will increase
unless the company has a reasonable basis to make that conclusion. Once the company
chooses to respond to speak or to respond to rumours, its public statements must be
accurate.
(3) A company will be liable to investors if its public statement fails to disclose
material information. With regard to disclosure of pending merger negotiations, the
Court adopted a balancing test involving (i) the likelihood of a merger agreement and (ii)
the magnitude of the potential merger on the company’s financial statements and
operations. If the potential merger will have a highly major impact on the company, such
as merging the company out of existence, the fact of negotiations might be material even
though they are at an early stage. If the potential merger is of lesser, yet still material,
significance, materiality might not arise until negotiations have reached a more concrete

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stage. It must be emphasized, however, that the balancing test comes into play only if the
company chooses to make a public statement. Otherwise, the company can remain silent,
or issue a “no comment” press release. Thus, in the United States, so-called soft
information is not required to be disclosed. A company must disclose material facts and
events that are occurring or have occurred, but the company is not required to speculate
as to the future results of those facts or events. If the company chooses to make any
comment (other than “no comment”), and the information is material, it must make a full
disclosure of the information. These standards have been developed through a long and
careful judicial process, and it is likely that they will be persuasive in other jurisdictions
where there are no firm lines drawn with regard to hard and soft information and their
respective disclosure standards.

3. Problem Areas and Pitfalls


Despite every effort to be as direct and clear as possible with regard to disclosure
standards, problems of application and interpretation inevitably arise. It is important that
government regulators have sufficient discretion to be able to differentiate among various
circumstances and to react with an understanding of both company and investor interests.
On the other hand, the problem areas can be dangerous pitfalls for companies, because if
companies mistakenly conclude that because of special circumstances they can delay or
modify its disclosure obligations, such decisions could lead to severe government and
judicial penalties and loss of reputation.

In brief, some of the common problem areas and pitfalls are:


(1) Timing: Must a material piece of information be disclosed as soon as it is discovered
by the company? In many countries, there are stock exchanges or other regulatory
policies that demand immediate public disclosure whenever a particular event occurs,
such as a Board decision to declare a dividend, or the scheduling of a special meeting of
shareholders. However, outside of those specific instances, when must material
information be disclosed? Generally, disclosure should be as prompt as possible. Any
delay increases the risk of liability for the company, for people will be trading in the
company securities without full knowledge of material information. Nevertheless, there

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will be circumstances where the legitimate business interests of the company militate
against immediate disclosure and those interests should be recognized.

Illustration 3: Foster, Ltd. manufactures products X and Y. It has just received a formal
letter from lawyers for GreatGoods, Inc. stating that Foster is violating a patent owned by
GreatGoods with regard to product X and demanding that Foster cease and desist from
further manufacture and sale of that product. If true, the result will be devastating to
Foster. Foster’s officers and lawyers believe that there is absolutely no truth to the charge
and they are certain that GreatGoods and its lawyers will agree after investigation that the
charge is false. Should Foster issue a public statement at this time that it has received a
charge of patent violation? Even if such a statement includes Foster’s own belief that the
charge is without merit, it is likely that any public statement at this time will have a
material adverse impact on Foster’s stock, and might also have negative impacts on
Foster’s business relationships with creditors and others. In other words, Foster might
have a legitimate business interest in delaying disclosure of the alleged patent violation
until such time as it is clear that it is unable to convince GreatGoods that such allegation
is without merit. When actual litigation becomes imminent, public disclosure cannot then
be avoided.

(2) Confidentiality: Many businesses have trade secrets or other confidential information
that give the businesses a competitive advantage. The formula for making Coca Cola is a
trade secret that has been so well guarded over the years that even within the Coca Cola
Company it has been impossible for any one person to discover the formula. It would be
rather ludicrous to demand in the interests of transparency that Coca Cola reveal its secret
formula. On a less global scale, many companies have agreements with customers or
creditors that contain confidential information. When a company offers its securities for
sale, must it disclose material confidential information?

Illustration 4: Nautilus, Ltd. is engaged in a public offering of its ordinary shares.


Nautilus has a long-term contract with its most important customer that results in 45% of
the company revenues. The contract has certain provisions that are very favourable for

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Nautilus. If those terms were made public, Nautilus’ competitors would be able to react
and destroy Nautilus’ competitive advantage. Must Nautilus disclose the favourable
terms in its prospectus? Alternatively, if Nautilus must provide a copy of the agreement
to the Capital Markets Authority or other supervisory agency (as is often required), can
Nautilus request that the agreement been kept confidential?
Confidentiality is an extremely important issue for many companies. Yet, the
confidentiality concept often conflicts with the transparency concept. Sometimes a
company’s desire for confidentiality will not withstand scrutiny under investor protection
principles. In those instances, the company will have to choose between keeping its
information confidential and raising capital from the public. Sometimes, however, the
confidentiality issue is appropriately paramount. In those circumstances, the regulatory
agency should strive to assure that as much material information is disclosed without
harming the company’s legitimate interests.

(3) Deceptive Disclosure: Has material information been disclosed in a manner that is
clear to the ordinary investor? If not, disclosure is inadequate. Sometimes a failure to
make a clear disclosure is the innocent result of the “lawyer’s problem,” that is, too much
technical verbiage. Lawyers are capable of writing about the simplest situation in such a
way that no one of ordinary intelligence can possibly comprehend. Sometimes a failure to
make a clear disclosure comes from deliberate “burying” of the facts, such as in a place
where one would not expect to see the discussion, or in long footnotes, or somewhere in
the depths of the financial statements. In the United States, there are cases in which
investors have recovered damages from companies even though the company’s
documents contained full disclosure but in ways that investors could not understand or
recognize. This concern regarding clear disclosure has led to some important reforms in
recent years, including:

(A) Plain English: All public documents for securities offerings and periodic reports must
be written in plain English, that is, in terms that the ordinary investor can understand.
Technical, legalistic language must be avoided or clearly explained. Sentences must be
short, to the point, and must not deal with multiple issues. The SEC reviews offering

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documents and requires revisions to language whenever, in its judgment, the Plain
English guidelines have not been followed.
(B) Risk Factors: Many companies undertaking IPOs have real or potential problem areas
that could affect share value in the future. These could include such matters as the
strength of competitors, the uncertainty of consumer acceptance of the company’s
products or services, the inexperience of management, the lack of any prospect for
dividends, the reliance of one or two major customers, the reliance on one or two key
management personnel, etc.

If a company wants to minimize the impact of disclosing such factors, it will spread them
out over a 30-40 page prospectus. However, it has now become fairly standard in many
countries to require that all such Risk Factors be prominently set forth near the front of
the prospectus and in a single section. Failure to discuss a particular risk factor, or any
attempt to hide it elsewhere in the document, will be a disclosure violation that could
destroy the public offering.
(C) Summaries: Reading and understanding a prospectus can be a daunting task, and for
many well nigh impossible. Despite every effort to simplify the disclosure process, a
prospectus is usually 30-40 pages or more in length, not including another 15-20 pages of
financial statements and footnotes to the financials. It takes a substantial commitment of
time, energy, and brainpower to wend one’s way through a prospectus in order to
understand the major elements of the company and the offering. In an effort to assist
investors, many countries now require that a prospectus include, at the beginning, a brief
summary of the major aspects of the company and the offering. Supervisory agencies that
review draft offering documents should be especially alert to assure that the summaries
are complete and sufficiently clear to give ordinary investors a comprehensive
understanding of the company and the offering.

(4) Jumping the Gun: Insider Trading: Whoever said that the best laid plans of mice
and men often go astray might have been talking about the securities industry. Despite
every effort by a company to maintain confidentiality until information is ready to be
publicly disclosed, there will sometimes be insiders who cannot hold themselves back

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from taking advantage of their inside information. If the information involves some
favourable development, the insiders will buy shares on the market and tell their friends
to do the same. If the information is adverse, for example anticipated losses in profits, the
insiders will sell their shares and tell their friends to do the same. Insider trading and
tipping destroys the integrity of the securities market, for it results in a lack of public
confidence that everyone is playing on a level field. Companies cannot be permitted to
tolerate insider trading, and all public companies should adopt policies that forbid
employees to utilize confidential information for their own or others’ benefit. If a
company learns that insider trading has occurred, it is likely that the company must then
make public disclosure of the confidential information, even though the disclosure would
otherwise be premature or inappropriate. It is commonplace to hear general demands for
transparency and compliance with transparency principles. However, when it comes to
applying transparency principles to actual disclosure concerns, the transparency concept
becomes considerably more hazy. What exactly must be disclosed, and when, are often
difficult questions. Transparency is not a goal unto itself. It is required for purposes of
investor protection. Yet, investor protection is not achieved by requiring a company to
publicly divulge every bit of information that one might want to know about it. Such a
standard would make transparency an impossible burden for companies and regulators,
and impose upon investors the onerous task of trying to separate important from
unimportant mounds of information.

Limitations are needed in order to assure that investors are provided information that is
material and understandable. Regulators must recognize that specific disclosure standards
are necessary, but at the same time such standards must have an underlying materiality
basis to resolve application questions. Regulators must also be sensitive to problems
faced by companies that are trying, often in good faith, to comply with disclosure
requirements while at the same time protecting their legitimate business interests.
Discerning appropriate transparency standards and developing sensitive guidelines are
among the most important goals that government regulators face in creating guidelines
for the capital market.

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In this chapter, among the principle matters discussed were:
1. Transparency has its limits. Although transparency is the dominant goal of securities
laws, the transparency concept contains ambiguities that must be further defined and
limited.
2. Regulator and investor disclosure interests overlap in content but not necessarily
emphasis. Regulators should examine and develop disclosure standards that reflect the
interests of potential investors.
3. Materiality is the governing principle of full disclosure. Transparency means full
disclosure of material facts and events, not every piece of relevant information about the
company.
4. There may be legitimate business interests to delay or not reveal some company
information. Regulators must be alert to legitimate business concerns regarding the
timing of disclosure and matters of business confidentiality.
5. Hard information. Material, hard information must generally be disclosed
immediately.
6. Soft Information. Soft information is not required to be disclosed, but a company that
chooses to make a public statement cannot be deceptive about the existence of soft
information.
7. Statutory disclosure guidelines should be both specific and general. The most
appropriate disclosure standards are those that combine specific disclosure items and
authority to the supervisory agency to adopt additional or modified standards as
necessary.
8. Disclosure must be apparent to and understandable by the ordinary investor.
Disclosure must be open and plain to all and not hidden in complex language or buried in
footnotes.
9. Companies must be alert on insider trading during periods of non-disclosure. A
company cannot remain silent about confidential information if its insiders are trading on
the information.

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Chapter 12 - The Importance of Good
Corporate Governance
Chapter Objectives
• To discuss why good corporate governance is a necessary element of an efficient capital
market.
• To discuss the characteristics of good corporate governance.
• To analyze the role of government in establishing good corporate governance standards.

Introduction
The role of corporate governance in a capital market is increasingly important. In part,
the increased prominence is due to some of the major scandals and corporate debacles in
the United States, Italy, and elsewhere. In the U.S., the scandals that rocked the corporate
world in 2001-2002 led to an enormous loss of public confidence in the capital market. It
has taken several years for confidence to be regained, and many skeptics remain
convinced that corporate management can never be trusted. Without such confidence and
trust, capital investments will not be made, or will be limited to only the safest
circumstances, depriving start-up and other companies of much-needed capital. This
chapter will examine the importance of good corporate governance to a capital market,
the fundamental elements of good corporate governance, and government’s role in
creating the foundation for good corporate governance standards.

Chapter Core
A. Is good corporate governance really important? Questions a skeptic might ask:
1. Does good corporate governance help a company sell products?
No, good corporate governance does not help a company sell products. In fact, good
corporate governance does not necessarily improve a company’s bottom line. Good
corporate governance might even cost more than bad or mediocre corporate governance,
because good corporate governance often involves higher costs for reports, independent
personnel, and professional services. If this is so, it is fair to ask whether we over-
estimate the importance of good corporate governance when examining the elements that

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comprise a viable and efficient capital market. One might be tempted to put this element
far down the list of essentials. After all, good corporate governance will not save a
product that has no market appeal. Good corporate governance will not prevent
competitors from grabbing ever-larger market shares. Even the best managed
corporations will sometimes fail and fold. If a company does not have a good product, or
good research, or adequate capital, or runs into some kind of bad luck or disaster, good
corporate governance will not save it.
So, is good corporate governance really an important element for the capital market? The
answer is a resounding, unequivocal, yes. Good corporate governance might not assure
the success of a company, but bad corporate governance will often destroy or severely
limit a company. Moreover, good corporate governance engenders public confidence that
management is devoting itself as best it can to the best interests of the company. Public
confidence translates into a willingness to invest capital. For many investors, certainly for
unit trusts and other institutional investors, good corporate governance is one of the
primary factors leading to an investment decision.
2. Don’t companies prosper even without any corporate governance standards?
Lots of us can point to companies that are thriving despite what seems to be a total lack
of internal corporate governance standards. These companies are usually dominated by a
single family or a small group of controlling shareholders and are run informally and for
the personal benefit of the controlling family.
The companies have found a highly successful place for themselves in the market, and
are very profitable, but internally they resemble autocratic fiefdoms, with the company
owners lavishing upon themselves most of the benefits of their successful business.
Frankly, their conduct should not disturb us. As long as these companies are law abiding,
how they manage their affairs and spend their profits is their business not ours.
Good corporate governance is much more of a concern for public, than private
companies, although to be sure the principles of good corporate governance should be the
goal of all business enterprises. Good corporate governance becomes truly important
when a company enters the capital market. When a company seeks outside investors, and
when a company has outside shareholders and note holders, it is then that problems of
mismanagement, self-dealing, profligacy, and lack of accountability become serious

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concerns.
3. Aren’t investors more interested in a company’s profit than its governance?
Of course, a company’s net profit at the end of the day is of paramount importance to
inventors. Investors will assuredly be willing to forgive slight indiscretions in corporate
governance in return for hefty dividends. However, while good corporate governance
principles can tolerate slight indiscretions and failures, and perfection is a goal not
necessarily a norm, there is no doubt that good corporate governance is as important to
the company in the long run as its ability to produce net profits. Why is good corporate
governance so important? The answer is found in the motivation that leads one to
participate in the capital market. That motivation is in large measure derived from a
confidence that the management of the company, the stewards of investor funds, will use
those funds efficiently and in the best interests of the company. Who would be willing to
invest capital in a company whose management was suspect as to how those funds would
be used? How many developing companies would be able to raise much-needed capital if
potential investors recognized that the company suffered from lack of internal controls
and accountability standards?
When we think about why investors put their money into certain stocks or debentures, a
primary reason is because such investors believe that the company managers will operate
in a transparent, responsible, and accountable manner. In short, the existence of good
corporate governance is a principal factor in investment decisions. Perhaps many smaller
investors are not aware of or think much about this factor, but assuredly good corporate
governance is of foremost concern to institutional and larger investors whose investments
are so critical to the capital market.

4. Can a lack of good corporate governance hurt a company?


Suppose a prospective investor is faced with a choice between two companies. Company
A has a record of good profits but its management thumbs their collective noses at good
corporate governance principles. Company B does not have such good profits but it has
good prospects and a respected, responsible management team. Which is the better long-
term investment? The answer is of course impossible to know in foresight, and many
variables will impact upon both companies in the future, but there are several reasons

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why a well-managed company is likely to be the better long-term investment. Those
reasons include:
(A) Capital Raising Opportunities
As discussed above, major capital investors look to well governed companies. The more
trust that is accorded to management’s objectivity and devotion to the best interests of the
corporation, the more attractive the company is likely to be to potential investors.
(B) Investors Concern Regarding Self-Dealing Transactions
Investors tend to be wary of companies that engage in self-dealing transactions, such as
purchasing supplies from related entities, leasing property from company officers, or
putting inexperienced family members into high-paying positions. There is an ever-
lingering concern that the transactions, not being arms-length, are too favourable to
insiders and permit insiders to draw excessive capital out of the company through indirect
means.
(C) Lack of Objectivity on the Board of Directors Could Affect Decision-Making
A well-governed company generally has several independent board members who are not
relatives, friends, or employees of the managing officers. These directors are expected to
bring objective considerations into the board room when difficult issues arise. Potential
investors look for companies that have such boards, and indeed the movement in recent
years has been in the direction of boards that have a majority of independent directors.
(D) Well-Managed Companies Generally Have Excellent Professional Guidance
Public companies are in frequent need of professional advice, from lawyers, accountants,
investment bankers and others, in order to assure that they meet regulatory requirements,
disclosure standards, and financial goals. Professional advisers operate most effectively
when they are confident that their recommendations will be met with considered,
objective analysis. This is often best achieved by assuring a prominent role for
independent directors. In the United States, for example, audit committees are required to
consist of at least a majority of independent directors, including at least one director with
financial experience.

B. Characteristics of Good Corporate Governance


There is no single formula to define good corporate governance. Although governance

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styles vary among companies, we may safely assert that well-managed companies
possess the following characteristics:

1. Objective Decision-Making
Objectivity in the corporate context means that the directors and officers at all times
consider the best interests of the corporation as paramount in making any company
decisions. Investor demands for objectivity have caused many companies to move
towards having a majority of board members be non-employees who have no major
financial interest in the company. Self-dealing transactions are looked upon with concern,
for the decision-making is inevitably skewed by concern for the personal interests of the
interested director or officer. In those instances when the company considers engaging in
a transaction that involves an actual or potential conflict of interest with one or more
directors or officers, procedures should be in place through Company law and internal
controls to assure full disclosure of the facts, an approval process that involves only
disinterested directors or shareholders, and a judicial review process should shareholders
question the fairness of the transaction to the company.

2. Accountability
Good corporate governance includes transparency with regard to board decisions and
periodic full disclosure to shareholders of corporate results and plans. Shareholders
should have the right to examine board minutes and demand inspection of corporate
records where there are legitimate concerns that actions have not been taken in the best
interests of the corporation. Shareholder inspection rights are a subject that should be
included within the Company law, although such rights must be limited to circumstances
where shareholders indeed have a proper purpose for examination. Accountability also
includes internal reporting controls so that corporate managers, and ultimately board
members, can efficiently review results of operations and assess the quality of existing
management. An additional element of accountability is the annual shareholder meeting,
where directors and principal officers are expected to come face to face with shareholders
and directly answer their questions and concerns.

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3. Enforceability
Without an effective enforcement procedure, good corporate governance standards alone
are insufficient. As much as we would like to think that market forces and reputational
concerns would keep corporate managers from acting wrongfully, history has proven
time and again that corporate managers are not immune from temptation. Unless an
effective enforcement process is in place, there may be little to stop temptation from
succeeding. Effective enforcement procedures include civil actions by the corporation
itself against wrongful acts by corporate managers, derivative actions by shareholders
against such wrongdoers in the event the corporation fails or refuses to act, administrative
actions by supervising agencies with authority to order disgorgement of ill-gotten gains
and disbarment from corporate office, and criminal actions by government authorities
directed against particularly egregious conduct.

C. Government’s Role in Promoting Good Corporate Governance


1. Statutory Provisions
What can and should government do to promote good corporate governance? The
emphasis here is upon clear and effective provisions in the Company law, plus the
development of enforcement mechanisms to punish those who continue to treat the
corporation as their private fiefdom.
Among the provisions that are necessary in a Company law are:
1. Annual meetings of shareholders.
2. Annual reports to shareholders.
3. Shareholder powers:
---- to elect and remove directors
---- to call special shareholder meetings
---- to inspect corporate records
---- to vote on major structural changes
---- to vote on amendments to the Articles of Incorporation
4. Disclosure and voting process for conflict of interest transactions.
The Company law or Securities laws might contain additional requirements for publicly-
traded corporations, including:

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5. Audit committees composed of a majority of independent directors.
6. Compensation committees composed entirely of disinterested directors.
7 Special shareholder voting rights if certain dilution percentages apply to proposed
transactions (the New York Stock Exchange requires a shareholder vote any time a
proposed transaction would involve the issuance of more than 19% additional shares).

2. Fiduciary Duties: Care and Loyalty


Directors and officers owe the duties of care and loyalty to the corporation. These are the
two fundamental categories of fiduciary duties. The duty of care refers to the obligation
to learn the facts, ask the proper questions, consider appropriate alternatives, and in
general to be diligent in the decision-making process. The duty of loyalty refers to the
obligation to devote oneself fully to the interests of the corporation, avoiding personal
interests, and maintaining the confidentiality of corporate information.
Fiduciary duties come from the law of trusts, from the notion that directors and officers
are trustees of the corporate assets and must treat with those assets solely as trustees for
the benefit of the company and shareholders. Historically, fiduciary duties were first
recognized by courts and applied against mangers who failed in their obligations. Some
jurisdictions continue to leave the definition of fiduciary duties entirely to courts and
have no statutory provision. Many jurisdictions, however, have placed at least one or both
of these obligations in their Company laws or similar statutes.

Duty of Care
In the United States, it is common for the statutory corporate laws of the various states to
set forth and define the duty of care. Florida has a typical provision, which states:
“A director shall discharge his or her duties as a director, including his or her duties as a
member of a committee:
(a) In good faith;
(b) With the care an ordinarily prudent person in a like position would exercise under
similar circumstances; and
(c) In a manner he or she reasonably believes to be in the best interests of the
corporation.”

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Duty of Loyalty
The duty of loyalty is generally not set forth in a specific statutory provision, although
there is no strong reason why there cannot be a general provision setting forth some of
the more fundamental elements of the duty. Those elements include:
(a) Maintaining the confidentiality of company information;
(b) Assuring that company information is used only for company purposes;
(c) Refraining from conflict of interest transactions unless fair to the company and
appropriately disclosed and approved by disinterested directors;
(d) Assuring that business opportunities relevant to the company are pursued on behalf of
the company rather than oneself;
(e) Refraining from any competitive enterprise.

The duty of loyalty is open-ended, for it encompasses a wide variety of activity that could
place the interests of the director or officer, or one of their associates, in front of the
interests of the corporation. The limitless variety of circumstances that could raise a
loyalty question is a principal reason why the doctrine is not often defined by statute.

3. Shareholder Derivative Actions


Suppose a director or officer violates a fiduciary duty, causing economic injury to the
corporation. What is the appropriate enforcement response? The obvious answer is that
the corporation can sue the individual to recover its losses. That is of course true. But
when we say that “the corporation can sue” what we really mean is that the board of
directors can decide on behalf of the corporation to bring a lawsuit. How often will that
happen when the miscreant is a member of the board?
Let’s consider the following Illustration, which is similar to the facts of an actual recent
case in the United States:

Illustration:
Company ABC has five board members, as follows: (1) John Jones, the founder and
major stockholder of the Company; (2) John Jones’ wife; (3) Harold Smith, an attorney

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who does work for both the Company and John Jones; (4) Paul Morris, a banker whose
bank has large accounts of both the Company and John Jones; and (5) Justyna Sparrow,
the President of a major supplier of raw materials to the Company.
When John Jones announced his retirement several months ago, the Board awarded him a
bonus of $5 million, payable immediately, and a lifetime consulting contract of $2
million per year, although it was known to everyone that Jones and his wife intended to
move to Spain and have nothing further to do with the business. The board vote was 3-0,
with Jones and his wife not voting. A shareholder of Company ABC has demanded that
the bonus and lifetime contract be rescinded, arguing that they are a waste of corporate
assets. He asserts that the directors violated their duties of care and loyalty. As we can
see, the shareholder is probably correct in his assertions.
Now, consider whether Company ABC will sue to rescind the bonus and contract. Who
will vote for the lawsuit? Certainly not Jones or his wife. Certainly not the attorney who
represents Jones. Does the banker want to lose the lucrative bank accounts? And all three
who voted for the contract would be admitting wrongdoing.
Will any of them really vote to sue themselves? The answer is a resounding no. In these
circumstances, who can bring the lawsuit? The answer developed in many jurisdictions is
to give a shareholder the right to bring a lawsuit on behalf of the corporation when the
corporation itself fails or refuses to act. This is what is called a “derivative action.” It is a
lawsuit brought by a shareholder on behalf of the corporation to recover damages owed to
the corporation, or to seek an injunction, when the corporation itself fails or refuses to
bring such a lawsuit.
The most common application for the derivative action is where there has been self-
dealing by board members. Even so-called “independent” directors are often reluctant to
authorize litigation, because often they are the ones, who approved the self-dealing
transaction, or sometimes their “independence” is simply on the surface and their
dominant loyalties are to the controlling shareholders or directors who appointed them to
their positions. Whatever the reason, if there is a legitimate basis for recovery by the
corporation, and the board refuses to make the claim, it is entirely appropriate for a
shareholder to step into the shoes of the corporation and make the claim on its behalf. If
no such opportunity existed, wrongdoing by corporate management would often go

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unpunished, which could have a downward spiralling effect on management’s conduct.
There are a number of technical elements regarding the initiation and process for a
derivative action. For those interested in the details, a good starting place is Subchapter D
of the Model Business Corporation Act developed by the American Bar Association,
which can be accesses on the Internet through www.abanet.org. We could devote a great
deal more time to discussion of the derivative action, but for our current purposes it
suffices to emphasize that this important litigation safeguard should be included within
the Company law or otherwise provided for in civil procedure statutes.

4. Judicial Competence
Without a judiciary that is accessible and responsive, statutory and fiduciary standards
will not be adequately enforced. Lack of enforcement, unfortunately, is an open door to
avoidance of legal requirements for those tempted by personal gain. One of the major
themes throughout this course is the importance of developing effective enforcement
mechanisms. This is as much the government’s role as the development of statutory and
regulatory provisions. Government’s role with regard to the judiciary includes:
---- Establishment of courts accessible to civil lawsuits;
---- establishing litigation procedures that lead to prompt, effective relief;
---- Training of prosecutors in the details of company and securities laws;
---- Appointment of competent persons to be judges; and
---- Educational and ongoing training courses for judges in technical business subjects.
As is evident, government regulators have a major role to play in the development and
enforcement of good corporate governance standards. To do their job well, government
regulators must learn about business practices, the customs of the commercial world, and
the internal processes of corporate governance. Some of this knowledge can be obtained
through courses and workshop. In addition, it is recommended that there be regular,
ongoing meetings and conferences between public and private sector personnel, so that a
meaningful dialogue can lead to practical, realistic statutory and regulatory provisions.

Good corporate governance is not an abstract goal; it is an essential element in


developing a viable capital market. Investors place their funds into the hands of

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management. Unless investors have full trust and faith in the objective and careful
decisions of management, investors will stay away. Money under the bed will probably
be considered safer than money in the hands of persons who do not adhere to good
governance standards. Thus, the creation through statutes and regulations of good
corporate governance standards is essential, but beyond that it is also essential to assure
that such standards can be effectively enforced. Government’s role is thus twofold, for it
encompasses both the creation and the enforcement of good corporate governance
standards. Inasmuch as the business world is ever-changing and increasingly complex,
government officials must assure that they are continually educated with regard to current
business practices and concerns.

Conclusion
In this Lesson, we have discussed the following principal points:
1. Good corporate governance induces investment. Investors must be confident in the
integrity of management, and adherence to corporate governance standards is a measure
of management’s responsibility.
2. Corporate governance standards are more important for public than private
companies. Private companies hurt only themselves if they engage in inefficient
management. Public companies hurt investors, and hurt their chances of obtaining needed
capital.
3. Lack of good corporate governance can harm a company. Failure to abide by
appropriate governance standards can hinder the ability to raise capital, result in
inefficient self-dealing transactions, lead to inappropriate decision-making processes for
board decisions, and make it difficult for professionals to give effective advice and
assistance.
4. Good corporate governance methods vary among companies but are based upon
several fundamental principles. Those principles are objective decision-making,
accountability, and enforceability.
5. Government plays a prominent role in developing good corporate governance
standards and procedures. Government’s role includes developing statutory and
regulatory standards for corporate conduct, and assuring that appropriate enforcement

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mechanisms are in place.
6. Shareholder derivative actions are an important element in the good corporate
governance enforcement arsenal. Derivative actions must be permitted by statute in
order to assure that shareholders can seek effective relief on behalf of the corporation for
director or officer breaches of fiduciary duty.
7. Good corporate governance standards must be backed up by effective judicial
enforcement. Government must therefore assure that there is adequate access to courts
by private litigants and that judges are competent and trained to understand corporate and
securities law matters.

Lesson Review
1. American Bar Association www.abanet.org

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Chapter 13 - The Stock Exchange:
Its Purpose and Operation

Chapter Objectives
• To understand the role of a stock exchange as a secondary market.
• To understand the nature of an exchange as a self-regulatory organization.
• To review the listing of securities on an exchange, including principal requirements for
listing, disclosure of proposed listings, waiver of listing requirements, and de-listings of
securities.
• To consider the reasons and effect of second tier listings on exchanges.
• To consider the potentialities of regional stock exchanges.

Introduction
Stock exchanges are popping up all over the world. From Vietnam to Tanzania, new
exchanges have been created and more are on the way. The major reason for the
development of stock exchanges in recent years has been government privatization
programmes. In order to sell stock in SOEs to the public, there must exist a secondary
market for the public to later trade the shares among themselves. That is the role of an
exchange, as a secondary market. Although exchanges are referred to as “self-regulatory
organizations (SROs)” because they are privately owned and operated, in fact all
exchanges are licensed under government standards and all exchange rules must pass
government approval. The result of this administrative structure is a kind of partnership
between government and exchanges with regard to determining functions and operations.
It is therefore very important for government officials to understand the purpose of role
of exchanges in order to work effectively with exchange directors.

Chapter Core
1. The Exchange as a Secondary Market
A stock exchange is a secondary market. That is, the securities that are bought and sold
on an exchange are bought and sold by shareholders, not by the issuing company. There

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is a very common misconception that a company sells its shares on the stock exchange.
That is not true. A company sells its shares in a primary offering directly to shareholders
through the use of underwriters and other intermediaries. The sale by the company is a
direct transaction between the company and the shareholder and is not done on an
exchange. This is true even for companies that already have shares listed on the exchange
and then decide to sell more shares. Even companies with shares already listed on an
exchange do not sell new, additional shares on the exchange. Those shares are also sold
in direct transactions off the exchange.
Because an exchange is a secondary market, it is not absolutely necessary to have an
exchange in order for companies to sell their shares. Companies can sell shares in the
primary market and let the investors figure out on their own how they will later trade and
sell those shares. Obviously this is not a happy prospect for investors, and that is why
exchanges are formed early in the capital market development process. If there is no
exchange, investors will be reluctant to buy shares in privatisations or other offerings,
because the investors will not have a ready and available forum in which to sell their
shares at a later time.
However, an over-the-counter market can operate as a forum for trading shares in the
secondary market. The OTC market can exist with or without an exchange. There are
only very few countries that have OTC markets without exchanges. Some countries, such
as Zimbabwe and Nigeria, have exchanges and no OTC market. In most developed
countries, exchanges and OTC markets both operate concurrently. In fact, in the United
States, more companies’ trade in the OTC market than on all the exchanges combined.

2. Exchange Ownership
Who owns a stock exchange and who makes its rules? Most statutes require that
exchanges be non-profit entities, as it is considered most appropriate from a public policy
standpoint that an exchange serve the public investors and keep costs of trading as low as
possible. In most countries, the model followed is that an exchange is formed as a not-
for-profit company by licensed broker-dealers. The licensed broker-dealers are the
members and owners of the exchange and form its governing board. Once formed, the
exchange then applies for licensing pursuant to statutory and regulatory provisions. The

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licensing process is generally under the control of the securities commission, or in some
countries the Central Bank. Specific rules govern the licensing conditions, including
minimum capitalization, adoption of rules of trading, and internal regulatory provisions.
Although an exchange is usually a not for-profit corporation that does not mean that it
has no revenues. All not for-profit organizations are permitted under law to charge for
their services and to pay salaries to employees. The exchange therefore charges a small
fee for every transaction. The fee is generally a small amount, no more than is necessary
to provide for exchange expenses and expansion plans.

Did you know…


… that a company does not ever sell its shares on the stock exchange? Instead, a
company sells its shares directly to shareholders through a primary offering with the help
of intermediaries.

3. The Exchange as a Self-Regulatory Organisation


Although a stock exchange begins its existence through a government-issued license, it is
treated as a self-regulatory organization (“SRO”). That means that the exchange selects
its own Board of Governors and officers and determines its own rules of membership and
trading subject to review and approval by the securities commission. Exchanges have the
authority to discipline, suspend, or expel members, or floor traders for violation of
exchange rules.
It is not totally accurate to refer to exchanges as “self regulatory organizations,” although
that is the common reference. It is more accurate to think in terms of a partnership
between an exchange and the securities commission. That is because all exchange rules
must be reviewed and approved by securities commissions, and the commissions have the
ultimate authority to impose additional rules and requirements upon exchanges. The term
“SRO” is used because exchanges can propose their own rules, and once the rules are in
place, the exchanges apply them without further approval from the commission.
However, if an exchange decides to impose disciplinary actions against members or floor
traders, any sanctions must be reviewed and approved by the securities commissions.

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Points to Remember about Exchanges:
- Licensed dealers form most stock exchanges as not-for-profit companies.
- Once formed, an exchange must apply to the securities commission for a license.
- Even though exchanges are not-for-profit, most charge a small fee for each transaction
in exchange for their services and to pay salaries.

As a matter of government policy, it is important to allow securities commissions to


develop licensing and other exchange standards. Statutes are not flexible and are more
difficult to change, and in today’s global economy it is necessary that stock exchanges
are able to adjust rapidly to changing capital market conditions. For example, listing
conditions should be prescribed by the exchange (subject to securities commission
approval), not by statute. The same is true for all trading procedures. The more flexibility
is built into the regulatory system, the better the exchange will be able to respond to
changing market conditions.

4. Listing of Securities on the Exchange


A company must make an application to the stock exchange in order to have its shares
listed. The application is generally referred to as a “listing application” and must contain
certain information that will indicate whether the company meets the listing eligibility
standards. The standards vary among exchanges.
Following is a list of the principal elements in a listing application.

(1) Minimum Value of Securities to be listed:


The equity or debt securities to be listed must meet a minimum standard. For equity
securities the value is the number of listed shares multiplied by the market price. The
Lagos Stock Exchange, for example, requires a minimum 1million shares with a value of
$500,000. For debt the value is the amount that the company receives for the issuance of
the debt.

(2) Accounting Records:


There must be audited financial statements covering a minimum number of years. The

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usual time frame for most exchanges is 5 years. This requirement is usually at least as
high, and often greater, than the financial statement requirements for a registered
offering.

(3) Public Ownership of Securities:


The percentage of listed shares owned by the public must meet a certain minimum, for
example 30%. This is sometimes referred to as the “public float.” Shares owned by the
public do not include shares owned by directors, officers, company employee trusts, or
other kinds of ownership as defined in the stock exchange rules. The purpose of this
requirement is to assure that there is enough public ownership of shares to have an active
trading market.

(4) Minimum Number of Shareholders:


The shares must be owned by a minimum number of shareholders, for example 1,000.
The purpose of this requirement is to assure that the company will have an active trading
market.

Did you know…


… that exchanges are SROs that means they have the authority to discipline, suspend, or
expel members, or floor traders for violation of exchange rules?

There are additional listing, non-quantitative requirements that part of the listing
application for most exchanges, such as the avoidance of conflict of interest between the
company and any director or substantial shareholder, a limit on any outstanding warrants
or options that could dilute the value of the stock, and corporate governance requirements
that could affect a broad range of internal company procedures.
Viewed as a whole, listing requirements can be very substantial. The basic policy of most
stock exchanges is that they only want to list high quality, broadly traded companies. As
discussed below, a number of exchanges have created second tiers for smaller companies
and have modified the listing requirements for such companies. Each exchange should
continually be reviewing its listing requirements from two, seemingly opposed but

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actually consistent, perspectives:
(1) Are the standards high enough to assure that only good quality companies are
listed?
(2) Are the standards too high and discourage good quality companies from listing
on the exchange?

5. Company Disclosure of Proposed Exchange Listing


A company making an IPO (initial public offering) decides in advance whether it plans to
list the shares on an exchange. It is extremely important to potential investors that they
know in advance the kind of secondary market that will exist for the later trading of
shares. The company must disclose in its offering documents whether it will apply to list
the shares on the exchange. If the company does not intend to list its shares on an
exchange, it must disclose that fact and also disclose whether there is likely to develop
any secondary trading in the over-the-counter market.
A company making an IPO does not know in advance whether its application to list on an
exchange will be accepted by the exchange. That is because the exchange’s listing
requirement, discussed below, include minimum capitalization requirements that can only
be achieved by the company after the public offering is completed.
Therefore, the offering document can only state that the company has applied for
exchange listing, it cannot state that the shares will definitely be listed (unless the
company already meets exchange qualifications, which would not happen in IPOs).
If the offering is fully subscribed, the exchange application will likely be granted
immediately and the shares will be listed immediately on the exchange. However, if the
offering is under-subscribed, the application might be denied. In many countries, the
company is required to offer to shareholders to return their investments if the company
had announced its intention to list on an exchange but the listing application has been
denied.

6. Waivers of Listing Requirements


Most exchanges permit waivers of particular listing requirements by the Exchange Board
of Governors. This is appropriate, for the Exchange is in the best position to determine

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whether the failure to meet a particular requirement is in fact material to the quality of the
listing. For example, a company that is making an IPO might anticipate that it will have
at least 1,000 shareholders, but in fact the offering results in 950 shareholders. The
Exchange Board could well determine that the difference is not material. Exchange
Boards must be careful about granting waivers, as each waiver acts as a kind of precedent
for future companies and the cumulative effect of waivers could erode the validity of the
listing standards.

7. Second Tier Listings


Many African stock exchanges have created a Second Tier on which companies that do
not qualify under standard listing requirements can nevertheless list their shares if they
meet reduced Second Tier requirements. Second Tier requirements are generally lower
for each of the major elements listed in Items C (1)-(4) above.
The purpose of having a Second Tier is perhaps laudable, for it gives smaller companies
the opportunity to have their shares listed on the exchange. Once listed, those shares can
be traded under the same procedures as all other listed securities. Second Tier companies
are subject to similar disclosure requirements that apply to First Tier companies,
including the requirement to make full and timely disclosure of any material events.
Unfortunately, on many exchanges the Second Tier has not developed as hoped. In part
that is because there is insufficient trading volume even on the First Tier, and investors
who are drawn into the market are more likely to be interested in First Tier companies.
The result is that, with a few exceptions, there is very little stock exchange activity for
Second Tier companies. A lack of activity means a lack of liquidity, which in turn can
result in an under-valuation of the company’s stock.
The problem is not only an overall lack of sufficient trading in the Exchange. There is
also a perception among many investors that Second Tier companies are not as high
quality as First Tier. This is often a misconception, because the difference between First
and Second Tiers is based on size, not quality. Nevertheless the perception persists. As a
result, some companies might prefer not to list on an exchange rather than be regarded as
inferior or lesser quality. Exchanges should address the perception of inequality created
the multi-tier listings. It might be worthwhile to reconsider whether a Second Tier is

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necessary. For example, if listing standards were reduced for all companies, it would not
be necessary to have more than one tier. Public investors would continue to be protected
by disclosure requirements imposed on all listed companies, by corporate governance
standards applicable to all companies, and by exchange trading procedures that apply to
all trades of every listed company.

Questions for Reflection:


- Why don’t companies making an IPO know in advance whether or not they will be listed
on a stock exchange?
- What is one of the dangers of waiving listing requirements?
- Can you name several reasons why second tier exchanges have not been successful?

8. De-Listing of Securities
Company securities can be taken off the exchange in two circumstances:

(1) Exchange action:


Securities may be de-listed if any of the listing requirements are no longer satisfied. Thus,
for example, if the stock price goes so low that the securities as a whole fail to meet the
minimum capitalization value, the Exchange Board would consider the possibility of de-
listing. The Exchange Board should be given broad discretion in determining whether to
delist a company’s securities. The decision to de-list will have a very major negative
impact on all shareholders and of course on the company as well. The Board should
consider the history of the company and whether it has made good faith efforts to
improve the company’s operations and income. If there has been any fraud or wrong-
doing by company management, de-listing might be an appropriate sanction. Even then,
however, the Board should also take into account the effect of de-listing upon innocent
shareholders.

(2) Voluntary de-listing:


A company might choose to take its securities off the market. Why? One reason might be
the cost of compliance with Exchange rules. For example, suppose that an exchange

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requires that a listed company send its shareholders quarterly and annual financial
reports. That requirement created added accounting, mailing, and clerical costs. The more
the shareholders, the higher the costs. For companies trying to reduce overhead
expenditures, exchange listing might be a candidate for reconsideration. That is
especially true for companies whose stocks are very lightly traded. If there is little
trading, and costs are high, it might be considered in the best interests of the company
and its shareholders to de-list and to develop trading through an over-the-counter market
or by some other means, such as an internet web site. In recent years there have been
several voluntary de-listings in exchanges all across Africa. This is not a good long-term
trend. The most effective response by exchanges is to increase the benefits of exchange
listing through such means as public education, increased company listings, and perhaps,
if possible, lowers costs.

9. Development of Regional Exchanges and Cross-Listings


An ongoing, important debate whenever there are multiple exchanges within close
geographic proximity is whether exchanges should combine their operations into a single,
regional exchange. That has already been done in West Africa with the West Africa
regional Bourse in Cote D’Ivoire, and serious discussions are taking place regarding a
union of the exchanges in Kenya, Tanzania, and Uganda. Regionalization could be a
benefit in circumstances where local exchanges are too small to provide adequate
economic support for the exchange and licensed professionals. However, regionalization
is not the only answer to small markets. Cross-listing of securities can be easily
accomplished and is being done on a broad number of exchanges throughout Africa.
Cross-listing maintains the independence of the local exchange and at the same time
provides increased trading opportunities on the local exchanges.

Regionalization must be very carefully approached. Efforts to combine exchanges in


developed countries, such as the Frankfurt and London Exchanges, have fallen apart
because of fundamental differences in policy and procedure. Each country must be
assured that it will continue to be able to control its own licensed professionals, engage in
enforcement actions, and take necessary steps to protect local investors from any

190
improper exchange activities. Public policy concerns are also dominant. For example, if
an exchange is located in another country, local citizen might be less likely to entrust
their funds to such foreign entities. Or, locally operated companies might be unwilling to
submit themselves to regulatory controls in foreign countries.
These concerns might exist even if a small, auxiliary trading center is maintained in each
country. In short, regionalization can be a two-edged sword, having both advantages and
disadvantages.

The creation, structure, and operation of a stock exchange involve a partnership between
the public and private sectors. Government is responsible for developing licensing
requirements and the basic conditions for the organization of the exchange. The private
sector, especially the licensed broker dealers, is responsible for the operation of the
exchange, including the development and enforcement of rules for the integrity and
fairness of the trading of securities.
Although the exchange is referred to as a self-regulatory organization (SRO), in fact the
securities commission must be in a position to review and approve exchange rules and
any enforcement actions that the exchange decides to take. Therefore, government
officials need to understand the mechanics of exchange operation while at the same time
they should give appropriate weight to the expertise and judgment of the operating
professionals.

Conclusion
The principal points in this Lesson included:
1. Secondary Market: the stock exchange is a secondary market. It is the place where
shareholders buy and sell shares. It is not the place where companies sell their shares.
2. Ownership: A stock exchange is a government-licensed entity that is usually owned
by its members, who are licensed broker-dealers.
3. Self-Regulation: An exchange is a self-regulatory organization (SRO). However, the
development and enforcement of exchange rules is a partnership between the exchange
and the securities commission.
4. Exchange Listing: For a company to have its securities listed on an exchange, its

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application must show certain qualifications regarding the securities and the company.
5. Disclosure of Proposed Listing: It is extremely important for prospective
shareholders in an IPO to know whether the company plans to list the shares on an
exchange following the offering.
6. Waivers: The Exchange generally has, or should have, authority to waive or modify
listing requirements in instances where that would be appropriate.
7. Second Tier: Many exchanges have created second tier listings for companies that do
not qualify for main listing. This type of listing has both advantages and disadvantages to
be considered.
8. De-Listing: A company’s securities can be taken off the exchange by action by the
exchange governing board or by voluntary action by the company.
9. Regionalisation: The movement towards regionalization is healthy but should be
pursued with care to assure that appropriate controls remain in place for investor
protection.

1. General Information on Stock Exchanges throughout the world: Mbendi:


http://mbendi.co.za
2. African Stock Exchange Association (ASEA): http://www.asea.wananchi.com
3. New York Stock Exchange listing application and rules: http://www.nyse.com
4. Description of the Singapore Stock Exchange:http://www.ses.com.sg
5. Rules and procedures of the National Association of Securities Dealers (United States):
http://www.nasdr.com
6. Capital Market Development: The Road Ahead: Changing Trends in Stock Exchange
and Capital Market Development: Lessons for Africa (by Chief Dennis O. Odife)
UNITAR/DFM Document Series #13:
http://www.unitar.org/dfm/Resource_Center/Document_Series/Document13
/Odife/1Intro.htm

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Chapter 14 - Stock Prices and Indices

Chapter Objectives
• To understand the processes that cause stock prices to rise and fall.
• To understand what is meant by discounting for future events.
• To consider several ways that share price movement affects companies.
• To examine the development of stock indices and stock index funds.

Introduction
In the prior chapter we discussed the formation and operation of a stock exchange. In this
chapter we will examine how prices are set for securities that are bought and sold on the
exchange, the effect of price changes on shareholders and companies, and stock indices.
An exchange is like an auction market where the price of an item is determined by the
buyers. Although it is the shareholders who benefit or suffer loss when the share price
goes up or down, there are also indirect effects on the company. That is why it is
important for a company that the price of its shares remains high. Unfortunately, the
desire to keep the share price high leads some companies to issue misleading information
or withhold information. Market manipulation is an important concern and is discussed in
the next chapter.

Chapter Core
1. The Processes that Control Stock Price Movements
(A) Buyer Demand
What makes the price of a stock rise or fall? The answer is simple, although the reasons
might be very complex and difficult to determine. The simple answer is demand. Demand
comes from two sources, existing shareholders seeking to sell and potential investors
seeking to buy. If the demand on the sell side is greater than the demand on the buy side,
the stock price will fall. It will fall until the price gets to a point that it attracts more
buyers, and at that point a brief period of equilibrium will occur when the price stabilizes.
Conversely, if buyers’ demands are greater than sellers’ desires to sell, the price will rise.
It will finally settle at a point when more sellers come into the market to take advantage

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of the higher price.

(B) Matching Orders


Who sets the price that rises or falls? No one actually sets the price. Every sell order is
recorded on an exchange, and so is every buy order, both sets of orders coming in from
brokers on behalf of their customers. If the buy and sell orders are at or very near the
same price, the transaction will be executed. If there is a disparity between buy and sell
orders, brokers might adjust their customers’ orders (with customer approval) either up or
down in order to execute a transaction. Suppose, for example, that a stock opens the day
at $10 per share. An order comes in to buy 1000 shares at $10. There is a sell order for
200 shares at market. 200 shares from the buy order will be purchased at $10. But there
are no other sell orders, and the buyer wants to purchase another 800 shares. The bid
might be raised, for example, to $10.10. If that doesn’t result in any sell orders, it might
be raised higher. If a sell order for 2,000 shares comes in at market when the bid is
$10.25 per share, the bid for 800 shares will be matched with 800 shares of the sell order
at the latest bid price of $10.25. The company’s shares will then be quoted at $10.25 and
will stay at that price until a transaction is made at a different price.

(C) Discounting for the Future


It is much easier to explain how stock prices move than what causes investors to want to
buy or sell particular shares. Of course investors are motivated by company news,
especially financial results. However, it must be emphasized that stock prices nearly
always reflect future anticipated results. This is known as “discounting” for the future.
Thus, a company that might not have strong sales might have a high stock price because
there is broad investor confidence in the future. Thus, the stock price might be at $20 per
share when the company has no earnings. Later, when the company announces good
sales, the stock price might not rise from $20, because the future results had already been
discounted i.e. reflected, in the stock price. Indeed, one often sees that the announcement
of good results is followed by an immediate decrease in the stock price, as investors had
thought the results would have been even better and are now selling the stock which they
believe is priced too high. Persons who are not cognizant of the discounting factor in

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stock prices will not understand why prices sometimes fall on good results and rise on
poor results.

As a result of the discounting of future result, stock prices almost always reflect
speculation as to the future results of the company. The crystal ball has not been invented
yet that will give accurate predications of the future, although some supposed stock
market “experts” will claim that they have just such a crystal ball.
The future is obviously unknown, and a stock price can be affected by numerous variable
factors, both domestic and global. Every day buyers and sellers are making guesses as to
the future. If their guesses are correct, they will congratulate themselves for being so
intelligent. If their guesses are wrong, they will still regard themselves as intelligent,
blame others for the poor quality of information received, and try again. And that is what
keeps the market going.

(D) Exchange Controls


Stock exchanges do not want to see wild gyrations in the prices of the stocks. That is very
de-stabilizing and reduces investor confidence in an orderly market. Big changes in stock
prices could occur, however, when there are major new events that affect the company.
Large price changes could also occur when there is a large imbalance between potential
buyers and potential sellers even in the absence of any new developments.
In order to protect against sudden, major shifts in share prices, many exchanges impose a
limit on the amount that the price of a share can move up or down in a single day. The
exchange also can control sudden price changes by stopping the trading in the shares of a
company if the exchange expects or has just received news of major developments in the
company and the exchange management believes that traders should have time to learn
and evaluate the consequences of such developments.

Questions for Reflection:


- How is the price of a stock determined?
- What are matching orders?
- Why don’t stock markets want to see major shifts in share prices?

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2. Who Wins and Loses when Share Prices Change?
(A) Shareholders
Because an exchange is only a secondary market, any rise or fall in the price of a
company’s stock only affects shareholders, not the company. The company receives
money for its stock only one time, that is, when the stock is sold by the company to a
shareholder. After that, any change in the stock price affects only the shareholders. Thus,
if a company sells its stock for $10 per share, and one month later the shares on the
exchange are trading at $12 per share, the rise in value goes entirely to the shareholders.
To put it another way, a company’s capitalization is not affected in any way by a rise or
fall in the price of shares on the exchange.
Shareholders are not actually affected by price changes as long as they continue to own
the shares. A drop in value from $12 to $10 per share is a “paper loss” and it is possible
that the shares will later rise in value and there will be no loss at all. That is one reason
why many shareholders continue to hold onto shares even when their value goes down,
because they feel better taking a “paper loss” than a real loss.
Market advisers generally disagree with this approach. Their usual advice is that shares
should be sold as soon as it is apparent to the investor that the shares are not performing
as well as expected. Shareholders can protect against substantial losses in value by
hedging their shares through the purchase of options. If the share price falls, the loss in
value can be made up by the gains in “puts” that were used as hedges against such losses.
The use of options to hedge against market losses is fairly common for very large
purchasers of shares, not for most individuals, and must be done only after careful
planning and advice from securities professionals.

(B) The Company


Although the company’s financial statements are not affected by the rise or fall of the
company’s stock price, the stock price has an indirect effect upon the company in at least
four ways:
(1) Sale of Additional Shares by the Company:
If the stock price rises, that will make it easier for the company to sell additional shares to
raise more capital. Suppose that a company would like to raise $200,000. If its share price

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is $10, it will need to sell 20,000 shares.
If the share price rises to $15, it will only need to sell 13,333 shares. The fewer shares it
must sell the less dilution of voting power for pre-existing shareholders.

(2) Mergers and Acquisitions


Companies can use their own shares as consideration to merge with or acquire other
companies.

Illustration 1
Suppose ACQ Company desires to purchase TGT Company. TGT is valued at $500,000.
Rather than use cash, ACQ can use its shares as consideration. If ACQ shares are selling
at $10 per share, ACQ can offer to buy TGT for 50,000 ACQ shares. If the price of ACQ
shares instead is $20, ACQ need only use 25,000 shares, which will reduce the dilution
impact on pre-existing ACQ shareholders. Thus, a rising share price makes it easier for
companies to use their shares for acquisitions, and also makes those shares more
attractive as consideration.

(3) Stock Options


If the company issues stock options to its employees, a rise in the price of the shares will
make these options more valuable. This will not only give economic benefit to the
employees but also will improve employee morale and future employment prospects.
And all of this will be at no cash cost to the company.

Illustration 2
The shares of Monroe Technology are selling for $3 on the exchange. The company gives
its employees options to buy Monroe shares from Monroe at $3 any time over the next 1
year. Monroe shares increase to $5 on the exchange. Every option held by an employee is
worth $2.
If an employee has options to buy 500 shares, he/she can exercise the options, pay $1500
for the shares bought from Monroe (500 shares at $3), and sell the shares on the exchange
for $2500 (500 shares at $5). In order for this to occur, the company must also list the

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shares on the exchange that are sold in the exercise of options.

(4) ESOPS and Employee Retirement Plans


Companies sometimes create Employee Stock Ownership Plans and employee retirement
programmes that are substantially funded by company stock. The stock price thus
becomes a very major concern for employees. When stock prices rise, companies will be
in a good position to reward their employees through such plans. On the other hand, as
we saw with the Enron debacle in the United States, falling stock prices could mean the
ruin of anticipated retirement income for hundreds or more employees.

Points to Remember:
- A change in the price of a stock only affects shareholders because the company only
receives money for its stock when they sell it to a shareholder.
- As long as shareholders don’t sell their shares they have only suffered a ‘paper loss’ if
the value of the shares decreases.
- Options can be used to hedge the price of shares against potential losses

3. Stock Indices
Many exchanges, even smaller ones, now publish a Stock Index on a daily or other
periodic basis. A Stock Index can either cover a specific group of stocks, such as the Dow
Jones Industrial Average that is based on 30 selected stocks, or it can cover all the stocks
listed on the exchange, such as the Ghana All-Share Index.
Every index has an initial starting point, for example 100. Thereafter, the index number
will rise or fall depending on the market performance of the stocks included in the index.
The calculation of the index can be a very complex task, for it must take into account the
relative market sizes and number of shares traded among all of the stocks. Thus, an
increase in the price of the shares of a company with a small trading volume might not
offset a decrease in the price of the shares of a large company with a high trading volume.
Despite the complexities of calculation, many investors and other market watchers are
influenced by the daily rise or fall in market indices. As a general rule, a rising index
means that stock prices generally have gone up and of course vice versa. It must be

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emphasized, however, that an index does not reflect the results of any individual stock,
and that some stocks might go up while the index falls, and some might go down while
the index rises. The index is an overall scorecard and not an indicator of any individual
company’s performance.

4. Stock Index Funds


In recent years we have witnessed the rise of stock index funds. Stock index funds are
attractive to investors, who believe that over time the stock market as a whole will rise,
and therefore the stock index will rise, but who do not want to risk selecting which stocks
are more likely to go up more than others. The value of the stock index fund is based
entirely on the stock index.

Illustration 3
The Stock Index for the exchange, which is measured by using all of the companies on
the exchange, is at 875. Last year the Index was 1,035. An investor believes that the
“worst times” are over and that people will begin putting money back into the stock
market. Thus, prices will start rising.
However, the investor does not know which stocks are likely to go up, or which will do
better than others. The investor therefore buys units in the Stock Index Fund at 875. If
he/she has guessed correctly and the Index goes up to, for example, 940, that is an
increase of 65 points for the investor, or approximately 7.5%. The investor can then sell
the Index units and make a 7.5% profit on his/her investment.
Buying an interest in a stock index fund is very similar to buying an interest in a unit
trust. In both cases the investors do not have direct ownership of company shares. The
principal difference is that a unit trust tends to be much more selective in its investments
while a stock index fund is based either on all shares on the exchange or on a pre-
determined group, such as Standard & Poor’s 500 Share Index.

When one cuts through all the rules and regulations regarding exchanges, the two most
important ingredients that determine the success of an exchange are (i) listed companies
and (ii) investor interest. Exchange governors spend a great deal of their time trying to

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improve both of these factors. They cannot do it alone, as exchanges are licensed and
ultimately controlled by government, usually through the securities commission.
Government officials therefore need to know the basic purposes, functions, and policies
of stock exchanges. Otherwise, they will not be able to work effectively with exchange
officials to create favourable rules that will help the exchange attract new listings and
greater numbers of investors.

Conclusion
Among the principal points discussed in this Lesson were:
1. Price Movements: The principal cause of share price movements is the balance
between the demand to buy from potential buyers and the willingness of existing
shareholders to sell.
2. Discounting: Share prices usually reflect what investors believe will occur in the
future. Therefore, when the expectations are met, the share price is not likely to move
because the price has already been discounted to reflect that fact.
3. Shareholder Gains and Losses: Shareholders are continually having “paper” gains
and losses, and none of that has economic consequences until the shares are actually sold.
4. Hedging: Shareholders can protect themselves against market losses through hedging,
which involves purchasing options whose value move opposite to the market. Hedging is
usually done only by large, sophisticated investors.
5. Consequences to the Company: Movements in share prices do not affect the
company’s financial statements, but they could have indirect consequences on the ways
that the company uses its shares for business purposes.
6. Stock Indices: Stock Indices are general indicators of the market as a whole but do not
reflect the rise or fall in value of any particular stock.
7. Stock Index Funds: Stock Index Funds are used by investors who want to diversify
their risk, as with unit trusts, and who believe that the market as a whole will rise over
time.
Lesson Review
1. General Information on Stock Exchanges throughout the world: Mbendi:
http://mbendi.co.za

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2. African Stock Exchange Association (ASEA): http://www.asea.wananchi.com
3. New York Stock Exchange listing application and rules: http://www.nyse.com
4. Description of the Singapore Stock Exchange: http://www.ses.com.sg
5. Rules and procedures of the National Association of Securities Dealers (United States):
http://www.nasdr.com

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Chapter 15 - Market Manipulation

Chapter Objectives
• To review the relationship between information and market pricing.
• To understand methods by which companies and insiders can manipulate market prices
to their advantage.
• To consider major policy questions that face government regulators attempting to
regulate market manipulation.
• To set forth various illustrations of conduct that raise questions as to what the applicable
regulatory standards should be.
• To distinguish the manipulative measures that might be taken by the company,
company insiders, and outsiders.

Introduction
Market manipulation probably began the day that the first stock market opened, and it has
continued to this day. It occurs in good times and bad times, when the company has
positive news and when it has negative news, when insiders are already rich and when
they want to become richer, when people think the market is going up, and when people
think the market is going down. In every country in the world the temptation exists to
make money through deceptive and unfair measures.
Why do people engage in such manipulation? Sometimes the reason is obvious, such as a
need for more money. But how can we explain insider trading abuses by people who
already are wealthy? How is it possible to explain the case in the United States during the
manipulation hey-days of the 1980's when the manager of a large investment company,
whose salary was a monumental, unbelievable $515 million per year, engaged in market
manipulation so he could make some extra money. To him, and perhaps to many others,
the market is a kind of “game,” and the winner of the game is the one who ends up with
the most at the end. Unfortunately, it is always the little investors who get hurt by market
manipulation. When they do, they lose confidence in the market, and that begins a
downward cycle that affects the economy and the ability of businesses to obtain needed
capital. That is why regulations against market manipulation are so important. They are

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not simply moral pronouncements of what is right and what is wrong. They are necessary
standards to protect investors and future capital market development.

Chapter Core
1. Information and the Efficient Capital Markets Hypothesis
The price of a share of stock is almost entirely dependent on the quality of information
known about the company. In highly developed and active markets, the Efficient Capital
Markets Hypothesis (ECMH) is an accepted concept by many market analysts. ECMH is
based on the fundamental premise that the stock market is efficient. In other words, the
market responds quickly and accurately to information, and any material new information
is immediately absorbed and reflected in changed stock prices. Therefore, as soon as a
company or other source reports a material new fact, the stock price for that company
will rise or fall based upon that new information. In an active market, there is practically
no time difference between dissemination of the information and the change in stock
price.
Therefore, stock traders have very little opportunity to take advantage of material new
information before the stock price changes, because the change in price will be
practically immediate. The dissemination of material market information through stock
exchanges and other communication facilities is still not at the highest level in many
developing countries. There are fewer numbers of traders, fewer broker-dealer firms, and
more limited communication facilities. As a result, announcements of material new
developments might not be disseminated as broadly as possible and might not result in
the immediate change in price that occurs in an active market. Improving technology has
allowed exchanges to react fairly well to new information, and therefore stock prices
generally do reflect current information.
However, in order to prevent the misuse of information, stock exchange and securities
commission rules should provide for some minimum period of time before which a
company or insiders can begin to trade on the basis of publicly-released information.

Illustration 1
Harrow Networks, Inc. is publicly-traded on the exchange, trading at $22 per share. At

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11:00 a.m., the company announces that it will increase its dividend from $1 to $2 per
share. The minute that announcement is made, several Harrow officers purchase shares
on the exchange at $22. The stock price rises within ½ hour to $26.

Points to Remember:
1. The Efficient Capital Markets Hypothesis states that that the market will respond
quickly and accurately to information. This means stock prices instantaneously react to
new information.
2. In developing countries, due to limited resources, stock exchanges are not as efficient.
3. In order for news pertaining to stock markets to be publicly announced, it must be fully
disseminated.
4. Thus, Securities commissions will likely want to make rules regarding how soon after
an announcement trading can begin.

In this Illustration, the officers will argue that they waited until the news was publicly
announced before buying shares. However, the fact that the news was announced does
not mean that it was disseminated fully within the market. The officers clearly took
advantage of their position. Regulations should be adopted to require some period of time
before the company and insiders can trade on new information. Such regulation is
especially important for announcements that are made while the market is closed, in order
to avoid off-market transactions where it is even more likely that non-insiders will not be
aware of the information.

2. How to Get Rich in the Stock Market


If we accept the theory that stock prices are the result of current information, then we can
understand that stock prices are always dependent on future information, which of course
nobody knows. Some might think that they can predict the future, but that can be a
dangerous assumption when money is bet on that ability. If stock prices move as a result
of information, and we do not know the future, how is it possible for anyone to make “a
killing” in the market? To put it differently, how can anyone be certain that they can
make money in the stock market? There is only one answer. Unfortunately, that answer is

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---- cheat. In other words, violate the law, engage in criminal conduct. That is the only
certain method of making money in the market, because no one knows the future and
therefore no one knows whether stock prices will rise or fall in the next minute, hour, or
day.

Cheating can occur several ways:

(1) Put out false information. The company, or insiders in the company who want to
make money on the company stock, can affect the stock price by putting out rumours or
false information. If a company’s stock is selling at $5 per share, and the company wants
that price to increase, it can issue press releases or other reports that state, falsely, that
company revenues and income are rapidly rising. The same can be done by a company
insider who wants to sell some shares. When the price rises, the insider sells.

(2) Withhold material information. If there is important new information that is certain
to affect the company’s stock price, insiders who know that information can buy or sell
shares in advance and therefore “get a jump” on the market. Therefore, the insiders will
cause the company to withhold the information until after they have acted. This works for
both good news and bad news.

(A) Good News


The company has just signed a very large contract that will substantially increase
revenues and profits. The news should be disclosed to the market immediately. Instead,
insiders delay the disclosure for a day, and in the meantime the insiders buy as many
shares as they can at the current market price. When the announcement is made the
following day, the price will go up, and the insiders will have a nice profit on their shares.
(B) Bad News
The company has just received a financial report that shows an unexpected loss for the
quarter. The news should be disclosed to the market immediately. Instead, insiders delay
the disclosure for a day, and in the meantime the insiders sell as many shares as they can
at the current market price. When the announcement is made and the stock price falls, the

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insiders will not be hurt like the ordinary investors. In fact, they can then purchase shares
at the lower price and keep the difference as profit.

(3) Selective disclosure. Instead of withholding material information, insiders disclose


that information to a few outsiders, known as “tippees.” The tippees then buy or sell
shares, depending on the nature of the information, and they make the profit when the
information eventually becomes public and the stock price changes.
(4) False Trading Appearances. A more difficult cheating method is to give the market
the appearance that there is a great deal of interest and activity in a particular stock. This
takes a coordinated effort among a number of people.
They undertake to put in numerous buy and sell orders, keeping their own costs low, but
at the same time giving others the false impression that something “big” is happening
with that company. This activity is sometimes accompanied by putting out false rumours,
something that is especially easy to do these days through the Internet. Many people (and
even brokers) will be fooled into thinking that the increased market activity shows that
something important is about to be revealed, and they will buy the shares in the
anticipation of good news. The buying pressure will cause the price to rise, and at that
point the group that had been manipulating the purchases and sales will sell their shares
at a high price. When it turns out that there is no new information, the price will fall back
to its original level.

3. Government Policy Questions Regarding Liability Provisions


All of these methods of cheating in the market are well known and are addressed by
statutes and regulations. The Company and Securities statutes in most countries very
specifically outlaw market manipulation. Most of the provisions are very broad and
include company, insider, and tippee liabilities. However, there are some important
policy questions that are sometimes not clear in the statutes and regulations. Here are
some of the main questions to ask:

(1) What should the standard of culpability for violations?


What does it take to be guilty of a violation? Is it enough that the company or insider

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makes a false statement, or must the false statement be made with a “wilful intent” to
deceive others? What if the statement was made as a result of negligence? That is, the
company or insider believed the statement to be true but it was not. Many statutes use a
“wilful intent” standard, which means that the violator must intentionally plan to deceive
others. However, even that standard raises questions. What if the company or insider
makes a false statement without checking the true facts? In other words, the statement is
made recklessly, without any attempt to find out how true it is. Investors who rely on that
statement might suffer large losses when the truth becomes known. Should they be able
to recover against the company or insiders who should not have made the false
statement? In the United States, where “wilful intent” to deceive is the general standard,
courts will consider “reckless disregard of the facts” to also be a violation of the “wilful
intent” standard.

(2) When is information “material” and therefore required to be disclosed?


Some information is more important than others. If a company is charged with violating
the statute because it did not disclose certain information, how are we to know that the
information is material and therefore should have been disclosed?
What is the standard for materiality? This question is extremely important, for companies
and insiders need guidance to know when they must disclose information and when
information can be withheld. Two examples can illustrate this problem area:

Illustration 2
ABC Company has been trying to get its product into the United States market. It has just
signed a contract with a U.S. distributing agency in which the agency promises to use its
best efforts to market the product in the U.S. Is this material information that must be
immediately disclosed? The company might not think so because it does not know if the
U.S. distributor will be successful.
The company might think that if it makes an announcement the public will react too
positively. On the other hand, some people might believe that the information is material,
because it is a major first step in entering the U.S. market. They would argue that the
contract should be disclosed, even with the caveat that there is no guarantee that the U.S.

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efforts will be successful. Who is right under the law?

Illustration 3
XYZ Company is in negotiations with a major foreign company that wants to buy XYZ.
The purchase price would be very high and XYZ shareholders would make a big profit.
However, there are many issues unresolved and it is not at all certain that the proposed
purchase will occur. Should XYZ disclose the fact of the negotiations now? Should XYZ
wait until there is a “handshake” agreement? Should it wait until there is a formal
contract? In other words, when is the information material?
Both of these Illustrations raise the question of how to define materiality. Most statutes
and regulations do not define materiality. There are many cases on this point in the
United States. The definition of materiality developed by the U.S.
Supreme Court is that “a reasonable investor would consider it important in deciding
whether to invest.” Two elements of this definition are worth noting. One is that the test
is based on an objective standard. It is not, “what did this investor do,” rather it is what
would a “reasonable” investor believe? The second point is that the test does not mean
that the information would have made an investor act one way or another. It is, instead,
that the information would be important, but not necessarily decisive.
Illustration 3 presents another problem, because there might be very good business
reasons for XYZ not to disclose the negotiations. We must be alert to the fact that
sometimes companies must be able to withhold even material information if there are
strong business reasons to do so. This is an especially sensitive problem when companies
are engaged in merger negotiations. That information might be very material, but it could
be very harmful to the companies if the information was disclosed too soon. Therefore, it
is also necessary to develop standards that permit companies to withhold material
information where there are legitimate business reasons to remain silent. In the United
States, companies are permitted to answer “no comment” if asked about possible merger
negotiations. However, once it is clear that a merger agreement will be made, at that point
the company must disclose the information.

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(3) Who are proper plaintiffs?
Many people might suffer losses from untrue or withheld information, but do they all
have claims against the company or insiders? Here are several examples to consider:

Illustration 4
ABC Company issue 1,000 shares to the public at $10 per share. The registration
statement that is given to purchasers states that the company has recently entered into a
major contract with a supplier in England. In fact, no such contract existed. It was being
negotiated, but it was not signed and the negotiations ended without a contract. When that
information became known, the stock price dropped to $6. Certainly the persons who
purchased shares in the public offering and still own those shares have a cause of action
against the company for damages, probably for the difference of $4 per share. But what if
a purchaser sold his shares at $9 before the true information was known? Does he have a
cause of action? And what about the person who bought those shares on the exchange
before the true information was known at $9? Does he have a cause of action?

Questions for Reflection:


Are there materiality standards in your country? If so what is the test for materiality?
How does the materiality test in your country differ from the one the Supreme Court of
the United States uses?

Illustration 5
An officer of ABC Company starts a false rumour that ABC might be acquired by a
major foreign business. In three weeks, the stock price of ABC shares rises from $8 to
$15 per share. The insider then sells all of his shares. One week later the rumour is denied
and the stock price falls back to $8. Everyone who bought at a price above $8 suffers a
loss, but does each person have a cause of action against the insider? Suppose the insider
made $2,000 profit from spreading the false rumour. Suppose also that 300 investors
have now lost an average of $6 per share and that they had bought a total of 4,000 shares.
Does the insider owe $24,000 to those investors ($6 times 4,0000 shares), even though he
only had a $2,000 profit?

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Illustration 6
The stock of XYZ, Ltd. is selling at $3 per share. XYZ believes that the share price is too
low. XYZ issues a press release stating that it has just discovered a major new drug to
prevent malaria. The statement is totally false. The stock price jumps to $10 immediately.
Two days later, Josef purchases 1,000 shares at $10. Josef did not know of the press
release or hear the false information. He bought XYZ shares because he thought XYZ
was a very good company. One week later the truth becomes known, and the share price
falls back to $3. Josef has a $7,000 loss. Does he have a cause of action against the XYZ,
or is he precluded from suing because he did not know or rely on the false information?

Illustration 7
Star Mining Co. shares are trading on the stock exchange at $15 per share. Three months
ago the company discovered that its principal mine was in danger of collapsing and
needed to be closed for repairs. The repairs would take 6 months and the cost and delay
would seriously affect revenues and profits. The company did not reveal this information
to the public. In fact, it falsely stated that the mine would be closed for only one week
and that there would be no effect on company income. A few days ago the information
became known to the public because some employees revealed the mine closing to
others. The company was forced to admit the truth, and the stock price fell to $5. There is
not much doubt that persons who bought shares at $15 between the time that the
information should have been disclosed and the time when it was disclosed have a cause
of action against the company. But what about Star Mining shareholders who have held
their shares from the beginning. They have also suffered a loss. They will argue that they
would have sold their shares if they knew the truth and that they were misled by the
company. Do they have a cause of action even though they didn’t buy or sell any shares
during the period of non-disclosure?
There is no simple answer to any of the above Illustrations. Statutes and regulations must
be examined to determine who proper plaintiffs are. For example, does everyone who
suffers a loss as a result of false information have a cause of action, or is it only those
persons who actually relied on the false information? Do persons have a cause of action
based on what they “would have done had they known the truth,” or must persons

210
actually buy or sell shares in order to be proper plaintiffs. When a company issues a false
registration statement, can all persons who rely on that false information bring a cause of
action, or only the persons who bought shares in the registered offering?

Points to Remember:
1. There is no easy or simple way to determine when an investor has a cause of action.
2. Not all investors who hold the same shares can be treated equally.
3. Statues and regulations must be examined in order to determine who the proper
plaintiffs are.

4. Who are proper defendants?


A. The Company
The company is usually responsible for false statements that it issues, even if the false
statements are made by an officer without authority or approval from the company.
Company liability is based on agency and estoppels theories, and the only way for a
company to avoid liability is to immediately issue a public correction.
B. Company Management
Company management poses more difficult questions of liability. Some directors and
officers know more than others, and some are in a better position to avoid false
information. Here are some Illustrations of the kinds of problems that can arise in
considering who is a proper defendant:

Illustration 8
ABC Company fails to disclose that a major patent has been lost as a result of litigation
in Germany. Four of the six company directors know about the results of the litigation,
two do not. The two directors knew that there was litigation in Germany, but they have
not been told the result, nor have they asked any questions. The share price is $20 and
stays that way for two weeks, when the news of the litigation in Germany becomes
known. The price then falls to $12. Certainly the company is liable for failure to disclose
material information. Are the directors? What about the two directors who did not know
the litigation result?

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Illustration 9
XYZ Company is about to print its annual report to shareholders. A draft of the report is
given to each of the directors to review. The report states that XYZ has higher profits
because of major new customers in China. In fact, the Chinese business is very small, and
the main reason for the higher profits is that XYZ has reduced its number of workers.
Director Okamba has read the draft and he does not know that the statement about China
is false. He believes it to be true because the report was written by the President, who
Okamba believes is an honest person. When the report is issued to shareholders and
others, the stock price rises from $6 to $10, mainly because of the statement in the report
about China. Later, when the truth becomes known that the China business is small, the
stock price drops back to $6. Is XYZ Company liable for the losses to investors who
purchased shares between $6 and $10? How about the directors who read and approved
the draft, especially Mr. Okamba?
These Illustrations pose questions of responsibility and accountability. What do we
expect and require of the company and management? Is there a difference in liability
between knowing something and “should have known” something? Is there a difference
in culpability standards between directors and officers who are insiders and run the
business, and directors who are outsiders and are not engaged in daily business matters?
The problems here pose serious risks. If we impose liability too lightly, it will be
impossible for companies to find persons willing to serve as directors. If we impose
liability only for the most egregious conduct, are we sufficiently protecting the investing
public?

Definition:
Estoppel: Is a legal term describing the preclusion of a party from alleging in a legal
action anything that is contrary to previous actions or admissions of that party.

C. Outsiders
There is another set of problems regarding defendants, and that involves persons who are
not directors or officers but who discover or learn confidential information. What is their
obligation and liability, if any?

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Illustration 10
Peter works in a law firm. He hears one of the partners discussing the fact that the lawyer
is preparing a very important and profitable contract for a firm client, Overseas Trading,
Ltd. Peter immediately buys 200 shares of Overseas Trading stock at $4 per share on the
exchange. Three weeks later the contract is signed and announced, and the stock price
rises to $8. Peter sells his shares and makes a $800 profit. Has Peter violated any laws? Is
he liable to anyone?

Illustration 11
Same facts as in Illustration 10. Peter tells a friend that Overseas Trading is about to get a
huge new contract. The friend also buys shares and also makes a big profit. Has Peter
violated any laws? Has the friend? Is the friend liable to anyone?

Illustration 12
Same facts, again. Peter’s friend tells another friend that “I think you should buy
Overseas Trading. I heard it from a good source.” Peter’s friend buys many shares and he
too makes a big profit. Has Peter violated any law? Has Peter’s friend violated any law?

Illustration 13
Anne Massubi is President of Midland Trading Co. One day she arrives home and tells
her husband that she has to fly to Johannesburg, because a company there is interested in
making a tender offer for Midland. The husband immediately purchases 1,000 shares at
$7 per share. The husband also telephones his daughter and tells her “it is a good time to
buy Midland stock.” The daughter buys 500 shares at $7.
Two weeks later Midland announces that a tender offer will be made by a South African
company for Midland shares at $15 per share. The husband makes a $8,000 profit, and
the daughter makes a $4,000 profit. Neither of them are directors or officers of Midland.
Has either of them violated any laws? Do existing statutes or regulations give answers to
these problems? Some statutes impose liability upon anyone who has material
confidential information and uses it for his/her advantage. Even a statute as simple as that
can cause problems. What if a stock analyst figures out on his/her own, using only

213
publicly available information, that a company is about to announce a major new
development. Is the stock analyst someone who has confidential material information and
he/she cannot use even her own knowledge? And what about people who are advised to
buy or sell certain stocks but are not told the reason why, such as Peter’s friend in
Illustration 12 and the daughter in Illustration 13. Do they have confidential information
and should they be barred from buying or selling shares?

Questions for Reflection:


1. Do the statues and regulations in your country take into account the varying situations
presented in the above illustrations?
2. When do you think it is appropriate to hold outsiders liable?
3. Do you believe that statutes should impose liability on anyone who has material
confidential information and uses it to his/her advantage?

As is evident from the above Illustrations, there are many issues involved in determining
potential liability for disclosure or non-disclosure of material information. We have
discussed in other chapters the importance of having private causes of action available to
investors and courts that are knowledgeable about securities law matters. Many the issues
discussed in this Lesson will eventually find their way into litigation, if litigation is a
reasonably feasible possibility. Judicial interpretation of statutes therefore will become a
major source of understanding regarding potential liabilities and the meaning of market
manipulation. That is yet an additional reason for government officials to take measures
to develop educational programmes for prosecutors and judges so that a comprehensive
understanding of the policies behind the statutes is understood by those who will make
important interpretive decisions.

Conclusion
Among the principal issues discussed in this chapter were:

1. The Misuse of Information: The market moves on information. Market manipulation

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is therefore almost always based on the misuse of information, whether positive or
negative.
2. Manipulative Methods: There are many different ways that information can be
misused. Government regulators should be aware of these various methods and provide
clear standards prohibiting such activities.
3. Culpability: Regulations should make the standard of culpability clear, whether it is
negligence or wilful to intent to deceive or some other standard.
4. Materiality: A definition of materiality would be useful in developing antifraud
regulations.
5. Plaintiffs: Government regulations and litigation procedures should be developed to
clarify who has standing to bring civil causes of action against those who violate
securities laws.
6. Tippers and Tippees: Regulations should be developed to make it clear that trading or
tipping inside information is a violation for both the tipper and tippee.

Lesson Review
1. Statutes, rules, regulations, and administrative releases of the Securities and Exchange
Commission (United States): http://www.sec.gov
2. Rules and regulations instituted by California for the regulation of securities trading:
http://www.corp.ca.gov/srd/security.htm
3. Nigerian Investment Promotion Commission policy statements and objectives:
http://www.nipc-nigeria.org
4. Policies and standards adopted by the North American Securities Administrators’
Association:
http://www.nasaa.org
5. Examples of securities law cases in the United states:
http://www.seclaw.com/seccases.htm.

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Chapter 16 - Developing Public Confidence
in Securities Trading

Chapter Objectives
• To consider the importance of public confidence as a necessary ingredient in a
successful capital market.
• To understand that statutes and regulations do not themselves establish public
confidence in the markets, but that a concerted effort must be made to assure that the
entire system operates in an open, honest, and fair manner.
• To consider some of the principal factors that affect public confidence in the markets.

Introduction
It is appropriate that our final chapter emphasizes public confidence in the capital market,
and in particular in the buying and selling of securities. In many countries, the lack of
public confidence is the single greatest problem to creating an active public market. Too
few people “trust the system” enough to put their money into it. Many people continue to
believe that it is safer to put their money under their bed, or in a bank account, than to
give it to a stockbroker to invest in a company. Unfortunately, this belief sometimes has
some historical roots in corrupt practices such as misleading privatization offerings and
insider trading that have not been effectively prevented or sanctioned. The general
distrust of anything that is “government” can reach, for some people, government-
licensed stock exchanges and government-selected securities commissions. There is
probably no greater challenge to government officials than to overcome public distrust.
This chapter will raise several issues that should be addressed by government officials
who want to create a positive atmosphere for an active public market.

Chapter Core
1. The Importance of Public Confidence
A securities market can be something like a fancy banquet hall, with long tables filled
with platters of culinary offerings, and well-dressed attendants lining the walls waiting to

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serve upon beck and call. Unfortunately, there may be no one at the table, or only a very
few diners. The infrastructure is complete and impressive. What keeps the intended
patrons away is a general mistrust in the quality of the food. Much the same can be said
of securities markets in many countries. Government ministries have spent much time,
money and energy preparing the infrastructure for securities trading, but the general
population often has not responded with the enthusiasm that is hoped. In discussing this
issue with representatives from many sub-Saharan countries, the single most important
theme that is heard is the lack of public confidence in the fairness of the markets. Years
of corruption in government and financial sectors have taken their toll. When government
agencies now urge people to invest their savings in companies listed on the stock
exchange, can those agencies be trusted?
Can the companies be trusted? Can the exchange be trusted? Despite every effort to
develop a securities commission staffed with knowledgeable and dedicated staff, it is
nevertheless a government agency and therefore falls into the aura of potential mistrust.
Even stock exchanges are mistrusted, for they have been created through government
action and are managed by government licensees.

In addition to the general fear of corruption, privatization programmes in some instances


have caused suspicion as to whether the parastatals being offered are truly worthy
investments or are simply being pushed off onto unsuspecting investors.
That is especially true when some of government’s better assets mysteriously wind up in
the hands of favoured politicians or their allies. The mistrust often extends to the
companies themselves. If the government has retained a significant interest in the former
parastatal, or has some form of controlling voting power, there is genuine fear that the
company’s operations and management structure will be affected by political concerns,
which often lead to inefficiency and lower profits. Furthermore, how can potential
investors be certain that the disclosure laws are being followed and enforced? If there are
not adequate enforcement procedures in place, including administrative, civil, and
criminal sanctions, how can the public be confident that companies are providing
accurate and timely information?

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Recent corporate scandals in the United States provide an excellent illustration of the
effect of a loss of public confidence. When the Enron debacle began to unfold in late
2001, the U.S. stock markets were already being adversely affected by a general
economic downturn. As a result of Enron, World.com, Xerox, and other financial
accounting scandals, there developed an enormous mistrust in the financial reporting by
companies. That mistrust continues to exist, despite efforts by Congress and others to
initiate better disclosure measures. Unfortunately, public confidence is quickly lost and
slowly regained. Fortunately, in the U.S. at least, a long history of favourable and
efficient markets will speed the public’s recovery of confidence. Most developing
nations, however, do not have that background or history on which to draw support for
public confidence.

2. Principal Factors that Affect Public Confidence in the Markets


Public confidence is an intangible, yet essential element in the infrastructure necessary
for a viable capital market. What are the factors that affect public confidence? There are
several that appear to be the most important:

1. Market Integrity:
No one is willing to buy or trade securities without confidence that they are being treated
fairly. Fair treatment means that all investors and potential investors in the market are
dealing with the same information, and that the information is accurate. Thus the
importance of two fundamental requirements.
(1) Timely disclosure of material information by companies; and
(2) Prohibition against use of confidential information by insiders.

2. Broker and Investment Adviser Neutrality:


Customers have an implicit faith in their brokers and advisers, a faith based upon the
licensing process and the appearance of good faith and objectivity. If such advisers do not
treat their customers with absolute fairness, the market will be seriously hurt. Thus the
importance here of:
(1) Strong licensing standards; and

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(2) Swift and effective disciplinary sanctions.

3. Transferability and liquidity:


The ability to attract investors into a market is linked directly to the potential investors’
perceived risks of liquidity. It is risky enough to buy a stock not knowing how the
company will fare in the future. It is even more risky to buy a stock not being sure that it
will be readily transferable when the time comes to sell. In many markets, the amount of
public investor activity is so low that at any given time there are too few buyers and
sellers in the market to assure immediate liquidity. Thus the importance of:

Did you know …


… that the United States Congress passed the Sarbanes –Oakley Act, which reformed the
statues and laws governing financial accounting rules, to try and restore public
confidence in the aftermath of several accounting scandals?

(1) An adequate number of securities trading in the market to generate significant


continuing public interest; and
(2) The requirement that all publicly-traded securities have both a minimum number of
shareholders and public float (shares not held by insiders).

4. Effective Enforcement Process


Investors know that occasionally there will be companies or persons who try to make
money in the market through illegal means. That is an inevitable but unfortunate part of
the securities market. Temptation often proves too great a force for some people.
Investors will not lose faith in the market because of a few bad apples, but they will
quickly lose faith if there is a lack of effective enforcement.

Effective enforcement means:


(1) Criminal prosecution, whenever appropriate;
(2) Administrative sanctions by the securities commission, and
(3) The availability of private remedies for investors who have suffered losses as a result

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of the misconduct.

Each of these enforcement mechanisms requires government input. There must be


adequate funds provided for the investigation and prosecution of criminal conduct, there
must be a sufficient budget for the securities commission to afford its own investigators
and lawyers, and there must be civil procedure statutes that allow effective private causes
of actions. If the public sees that these are in place and that wrongdoers are promptly
apprehended and punished, there will be a sense that enforcement will have a deterrent
effect and thereby create a fairer marketplace. If the public perceives otherwise, there will
be no interest to take part in the trading market, as all will perceive that such trading will
be equivalent to playing poker with persons who “deal from the bottom of the deck.”
There are other factors that also impact upon public confidence, including for example
the quality of the companies being offered, and the quality of corporate governance
procedures. For further discussion on confidence-building measures, please review the
article “Confidence Building in Sub-Saharan Markets” that you may access through this
Website.

Principal Factors that Affect Public Confidence:


1. Market integrity
2. Broker and investment advisor neutrality
3. Transferability and liquidity
4. Effective enforcement process

CONCLUSION
The role of government in establishing, supervising, and facilitating the growth of the
capital market is complex. It involves much more than simply establishing rules and
creating supervising authorities. The content of those rules must be developed based upon
both “what is the on the ground” and the goals to be achieved. Rules cannot be static,
because the market is changing all the time.
Flexibility must be written into the rules, and discretion must be accorded to agencies to
act without going back to Parliament. Government regulators will not know what the

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market looks like or how it is changing without continual study. This workshop is one
major way that the market is studied. As we have discussed, discussions with market
professionals and participants is also of critical importance. Finally, no market will
succeed without public confidence. All of the factors that affect public confidence must
be kept at the top of policymakers’ lists, and each factor must be continually examined to
assure that its requirements are being achieved. These are challenging tasks. The
responsibility placed upon government regulators is high, but the opportunities are great.
An efficient, viable capital market will result in significant economic gains, which will in
turn have major benefits to the welfare of the entire population. Government regulators
therefore stand at the head of a process that offers enormous promise and opportunity,
and their response to these challenges will very much determine the growth and
prosperity of their country.

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GLOSSARY

Capital Investment: A capital investment is a transfer of money or property to a


company by an investor who receives in return a financial instrument evidencing the
investment.
Financial Instruments: A financial instrument evidences an investment in a company or
other economic entity made by the purchaser of the instrument for the purpose of earning
an economic return through market appreciation, dividends, interest, or a combination of
these elements.
Transparency (Disclosure): This term, one of the most widely used in securities
regulation, refers to the goal of full disclosure of all material information relevant to the
buying and selling of securities. Transparency requirements are imposed on companies,
insiders. Brokers, investment advisers, and all others who are significantly associated
with securities trading in the primary and secondary markets.
Primary Market: The primary market is the offer by an issuer of its own securities. If
the issuer is making its first public offering, that is referred to as an initial public offering,
or IPO. In a primary market, the issuer sells its securities directly to purchasers, usually
using the services of an underwriter.
Initial Public Offering (IPO): This is the first time that a company offers securities for
sale to the public. It is usually a registered offering. As a result of the IPO, the company
becomes a publicly owned and traded company.
Issuer: This is the term used for the company or other entity that is offering its own
securities for sale.
Secondary Market: The secondary market is the buying and selling of securities among
shareholders. An issuer sells shares only in the primary market. Thereafter, all trading in
the shares is in the secondary market by existing and potential shareholders. A stock
exchange is a secondary market.
Institutional Investors: Institutional investors are companies that regularly make
substantial amounts of purchases of financial instruments, such as pension funds,
investment banking firms, banks, and insurance companies.

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Monetary Markets: This term generally refers to the offer and sale of debt instruments
that have a maturity of less than one year. The market includes short-term company notes
as well as government bonds.
SOEs: State Owned Enterprises, or SOEs, are business organizations that are wholly or
substantially owned by the government. Some SOEs are the result of government
nationalization programs and some are the result of a decision by government to
undertake a particular business activity, such as the production and distribution of
electricity, telecommunication facilities, or other large-scale enterprises.
The Invisible Hand: This term refers to the famous statement by Adam Smith, one of
the most prominent and influential economists of all time, that the efforts of individual
entrepreneurs to act in their own economic interest leads through "an invisible hand" to
the promotion of the public good.
Securities Registration: This term refers to the process of filing with, and review by, the
Capital Market Authority (or similar agency) the documents that issuer intends to use in
making a public offering of securities.
Over-the-Counter Market: This is a secondary market for trading securities that are not
listed on an exchange. The OTC market is operated by broker-dealers who provide stock
quotations and match buy and sell orders.
Treasury Notes: These are government issued debt obligations that are sold in large
denominations, often known as T-Bills. The notes are usually sold in blocks ranging from
30-days to 1-year or longer. Interest rates for the notes vary according to their length.
Supervising Agency: This term refers to the principal government agency that has
responsibility for interpreting the statutes, issuing regulations, and supervising the offer
and sale of securities in the primary and secondary markets. See "Capital Markets
Authority."
Capital Markets Authority: This is the title used in some countries to refer to the
principal government agency that supervises the capital market, including review of
registrations, licensing and supervision of exchanges and brokers, and the issuance of
regulations. Other titles include Securities Commission, Securities Exchange
Commission, and Division of Securities Regulation.

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Prospectus: A prospectus is the document that is given to prospective purchasers by the
issuer or the underwriter in a registered public offering.
Risk Diversification: This term refers to an effort by investors to minimize their
economic risk by investing in a wide range of securities so that potential losses in some
investments might be offset by gains in others. If an investor does not own a diverse
portfolio of investments, the investor risks losing a substantial portion of the total
investment based on the results of the principal securities owned.
Exemptions from Registration: These refer to provisions in the statutes or regulations
that permit companies to offer their securities for sale without going through the full
registration process. See "Securities Registration."
Transparency (Disclosure): This term, one of the most widely used in securities
regulation, refers to the goal of full disclosure of all material information relevant to the
buying and selling of securities. Transparency requirements are imposed on companies,
insiders. Brokers, investment advisers, and all others who are significantly associated
with securities trading in the primary and secondary markets.
Pyramid or Ponzi Schemes: These are "chain letter" type promotions that promise large
financial rewards based upon the ability of early investors to attract additional investors.
It is common in these schemes that money invested by newer purchasers are used in part
to provide income to earlier investors. Investments in pyramid schemes could be
investment contracts and therefore subject to regulation by securities laws.
Investment Contracts: This is a type of a security that is characterized by an investment
in a common enterprise induced by the expectation of an economic return based on the
efforts of the promoters or others. The term usually refers to investments other than
stocks or debentures that cover a broad range of supposed profit-sharing arrangements.
Administrative Sanctions: This refers to orders that the supervising agency is
authorized to impose upon companies or persons who violate securities laws and
regulations. Sanctions vary among countries but can include cease and desist orders, stop
orders, monetary penalties, restitution, and rescission.
Harmonization: Harmonization refers to the attempt to create uniform statutes and
regulations among two or more countries, especially neighboring countries within a
regional area.

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Discretionary Powers: This term refers to the delegation to the supervising agency of
the power to make rules and regulations in a manner that is considered in the public
interest and is consistent with statutory provisions. It is an open-ended authority insofar
as the agency has the ability to determine the appropriate standards to adopt.
Rating Agencies: Rating agencies are private companies that analyze debt obligations
and prepare reports stating their opinion as to the risk and viability of the debt
obligations. In general, debt obligations that are rated low must provide a higher interest
rate in order to attract potential investors.
Debt: Debt refers to a loan to a company that creates an obligation to repay on a
particular date, referred to as the maturity date, as well as an obligation to pay a fixed
amount of interest on a periodic basis. If the obligation is one in which the debt holder
can demand repayment at any time, the debt is referred to as a “demand note.”
Sweeteners: This term refers to extra elements added to equity or debt offerings to make
them more attractive to potential investors. Examples include convertibility, participation
in additional dividends, extra voting rights, options, and warrants.
Fitch: http://www.fitchratings.com
Moody’s: http://www.moodys.com
Standard and Poor’s:http://www2.standardandpoors.com
Debt-Equity Ratio: The amount of debt loaned to a company equity relative to the
amount of equity invested in that company creates a ratio that financial analysts use to
measure a company’s financial health. If there is a high amount of debt compared to
equity, analysts might fear that the company does not have sufficient invested resources
to carry the debt financing burdens. Ratios vary among companies, and some companies
are much more able to succeed with high ratios than others, depending on other financial
factors.
Monetary Rates: This term refers to the interest rates in the monetary market, such as
government T-bills, with regard to financial instruments that have a maturity of one year
or less.
Long-Term Debt Offerings: This refers to company offerings of debt obligations that
have maturity dates in excess of one year.

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Debt Financing: This refers to a company’s effort to raise necessary capital principally
through the issuance of debt obligations, such as debentures or bonds.
Company Capitalization: This refers to the total amount of equity investment in a
company. It might also include long-term debt that is regarded by the company and debt
holders as an investment in the company.
Sinking Fund: This refers to the obligation of a company to pay a fixed amount of
money into an escrow account each year during the life of a debt obligation to assure that
the full amount of principal is present when the debt reaches maturity.
Closed End Unit Trust: A unit trust that issues a fixed number of shares and in which
unit shareholders sell their shares in the secondary market, rather than selling them back
to the trust as in an Open End Unit Trust. See “Open End Unit Trust.”
Investment Company: Technically, an investment company is a company that makes
investments in securities on behalf of other people who have provided capital for such
purpose. A unit trust is an investment company.
Net Asset Value: This term refers to the current value of the collective investments held
by a unit trust. The value changes on a daily basis and determines the price at which unit
trust interests are bought and sold by investors.
Open End Unit Trust: A unit trust that is not restricted in the number of shares that may
be offered to the public and that is required to purchase all unit interests that current
holders desire to sell.
Unit Trust: A unit trust is a fund of money invested by unit trust interest holders that is
managed on behalf of the interest holders by trustees who invest the funds in securities
and other financial instruments as the trustees determine. The collective success or failure
of the trustees’ investments is measured by the unit trust’s net asset value.
Redemption Rights: In the context of unit trusts, redemption rights are the rights of
interest holders in open end unit trusts to have their unit trust interests re-purchased, i.e.
redeemed, by the trust.
Load Funds: Load funds are unit trusts that charge a front-end fee when the investor
purchases units. This is in contrast to a No-Load Fund. See “No-Load Fund.”
No-Load Funds: No-Load funds are unit trusts that do not charge front-end fees to
investors but instead charge periodic management fees, generally a percentage based on

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the total fund assets. A load fund charges an upfront fee and a no load fund charges
annual management fees.
Unit Trust Share: This is a unit of interest in a unit trust purchased by an investor. The
price paid for the share is usually measured by the net asset value of the trust at the time
of purchase.
Material Information: This is the basic standard for determining whether there has been
sufficient disclosure in the offering of a security for sale. Material information is
information that a reasonable investor would consider important in making an investment
decision. Materiality is not limited only to information that would be decisive in making
the decision. Instead, it is all information that is sufficiently important that it an investor
should know it in making the ultimate decision.
Periodic Public Reports: Publicly-traded companies are usually required by law or by
stock exchange rules to submit periodic reports to the securities commission and/or the
exchange that sets forth material business developments and financial statements for that
period of time. Periodic reports in many countries are required to be made monthly,
quarterly, and annually.
Soft Information: This refers to information regarding a company that is speculative and
future oriented, such as projections of future profits or potential business developments. It
is contrasted with “hard information,” which refers to past or current facts that are readily
verifiable.
Risk Factors: In a disclosure document offering securities for sale, “risk factors” sets
forth the company’s list of actual or potential problem areas that may cause the securities
to have a higher than ordinary risk of loss.
Listing Standards: In order for a company to have its shares listed for trading on a stock
exchange, the company must qualify with the exchange. The set of standards to
determine qualification are called listing standards.
Is there an active secondary market in your country? If so, why? If not, why not?
What steps could be taken to encourage the development of an active secondary market
in your country?
Management's Discussion and Analysis of Financial Results: In some countries, full
disclosure includes a requirement that the disclosure document contain an analysis by

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company management that discusses the reasons why, in management's opinion, the
company has achieved certain financial results and what factors have affected and will
continue to affect company operations.
Transparency (Disclosure): This term, one of the most widely used in securities
regulation, refers to the goal of full disclosure of all material information relevant to the
buying and selling of securities. Transparency requirements are imposed on companies,
insiders. Brokers, investment advisers, and all others who are significantly associated
with securities trading in the primary and secondary markets.
Book Value Per Share: Book value is the result obtained by subtracting liabilities from
assets as shown on a company's balance sheet. When that figure is divided by the number
of shares outstanding, the result is book value per share. Assuming that the financial
statement figures are approximately equal to the assets and liabilities that would exist in
the event the company is liquidated, book value per share roughly means the amount per
share that a shareholder would receive in the event the company liquidates.
Comparable Market Prices: This phrase refers to the stock market prices for shares of
companies that are engaged in similar businesses. When a company is considering an
IPO, one of the factors in determining the price of the shares to be offered is the
comparable prices of similar publicly-traded companies. Analysis is not based on share
price itself but rather on the average multiple of the share price over earnings per share.
Discounted Cash Flow: This is a method used to evaluate an investment opportunity, or
a company offering securities, by examining projected future profits over a period of time
and converting the projections into current value.
Earnings Per Share: The net profits of a company, divided by the number of shares
outstanding, results in an earnings per share figure. This is a useful method for comparing
results among similar companies. Generally speaking, companies with higher earnings
per share will be more attractive to investors.
Share Yield: This refers to the annual dividend income that a shareholder receives as a
percentage of the current market price of the shares. For ordinary shares, share yield is
based on the most recent dividend declarations. For preferred shares, the yield is based on
the fixed preferred dividend rate.
Public Float: The number of outstanding shares that are owned by shareholders who are

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not company insiders is referred to as the public float. The number is considered
important because it is presumed that those shares are more likely to be traded than
shares owned by insiders.
Overhang: This refers either to (a) shares that might be issued in the future based on
current options or other rights, or (b) shares that have been issued but are not yet freely
able to be re-sold because of legal or other limitations. If there is a large overhang on
publicly-traded securities, shareholders are at risk that the current share price will become
diluted if and when the shares that make up the overhang come into the market.
Capital Requirements: This phrase refers to the amount of funds needed by a company
to meet its reasonably anticipated costs until it can begin to generate sufficient revenues
to become self-sustaining.
Dilution: This refers to the reduction in monetary value or voting power of existing
shares as a result of a company's additional issuance of new shares.
Leveraging (sometimes also called Gearing): This generally refers to using borrowed
funds to create revenues that, after payment of interest on the loans, results in a net profit
to the company. Leveraging can also apply to a company that sells preferred shares with a
fixed rate of dividends. Leveraging works well when a company's economic return on
borrowed funds exceeds the interest rate on the borrowed funds.
Tranches: With regard to a public offering of securities, this term refers to separate
groups of shares that are reserved for purchase by specifically identified types of
purchasers, such as employees, foreign investors, or institutions.
Underwriter: An underwriter acts on behalf of an issuer in selling securities being
offered to the public.
Transparency: Transparency refers to the obligation to make full and readily
understandable disclosure of all material facts and events.
Materiality: Hard information is material when a reasonable investor would consider it
important in making an investment decision. Soft information is material based upon a
balancing test between the significance of the potential event to the company and the
probability of that event occurring.
Hard Information: Hard information is a fact or event that has occurred. It is immutable
and unchanging.

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Soft Information: Soft information relates to a fact or event that may occur in the future.
It is uncertain, even if there is a high degree of probability that it will occur.
Plain English: This refers to the government-imposed requirement in the United States
that disclosure of material information be made in a manner that is clear and
understandable to ordinary investors.
Broker: A broker is a licensed person or entity engaged in the business of buying and
selling securities on behalf of others. This is in contrast to a dealer, who is in the business
of buying and selling securities for itself and not as an agent for another. See “Dealer.”
Dealer: A dealer is a licensed person or entity that is in the business of buying and selling
securities for its own account, generally for the purpose of making an over-the-counter
market in one or more securities.
Broker Representative: This is a licensed individual who is employed by a broker firm
who deals directly with customers in advising and filling buy and sell orders. The term
“stockbroker” is often used to refer to broker representatives.
Investment Adviser: An investment adviser is a licensed person who is in the business
of providing advice to customers on the buying and selling of securities. Investment
advisers, unlike broker representatives, do not have the ability to execute orders.
Broker-Dealer: This is the term used for an entity that is licensed both as a broker and a
dealer, which is the usual situation for most firms in the business of trading securities in
the secondary market.
Churning: This refers to an unreasonable amount of trading in a customer’s account
caused by a broker representative for the purpose of generating broker commissions.
Suitability: This refers to whether a particular securities transaction is appropriate for an
individual in light of that individual’s financial and other circumstances. In some
countries, brokers are required to assure that they do not lead customers into transactions
that are not suitable, unless the customer clearly understands and agrees to the
transaction.
Self-Dealing Transaction: A self-dealing transaction, also known as a conflict of interest
transaction, occurs whenever a corporation enters into a contract or other business
arrangement with a director, officer, or someone with whom a director or officer has
close personal or financial ties.

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Fiduciary Duties: A fiduciary duty is an obligation owed by all corporate directors and
officers to the corporation by reason of the position of trust and confidence enjoyed by
the director or officer.
The two fundamental fiduciary duties are the duty of care and the duty of loyalty. These
obligations that exist regardless of any statutory provision, although the duties may be set
forth in statutes if desired.
Derivative Action: A derivative action is a lawsuit brought on behalf of a corporation by
a shareholder after it is clear that the board of directors of the corporation has failed or
refused to pursue the claim. Derivative actions are often brought against directors or
officers for breach of fiduciary duties.
OTC Market: The over-the-counter (OTC) market is a secondary trading market that is
entirely run by broker-dealers, who provide quotations and assist in making a market in
traded shares. Companies whose shares are traded in the OTC market are either unable to
qualify for listing on a stock exchange or choose not to list their shares on an exchange.
Listing Application: This is a stock exchange form that companies must complete in
order for the exchange to determine if the company's shares are eligible to be traded on
the exchange.
Public Float: The number of outstanding shares that are owned by shareholders who are
not company insiders is referred to as the public float. The number is considered
important because it is presumed that those shares are more likely to be traded than
shares owned by insiders.
Second Tier Listing: In some stock exchanges, listed companies are divided between
First Tier and Second Tier companies. First tier companies meet the highest listing
qualification standards. Second tier companies meet modified standards for listing.
Stock Exchange: A stock exchange is a licensed, self-regulatory organization, usually
formed as a non-profit corporation that establishes and operates the trading processes that
take place through its services. Most stock exchanges have a physical location, called a
trading floor, but it is possible to have a stock exchange operated entirely through
electronic means.
Cross Listing: If shares are listed on more than one stock exchange, either within the
same country or on exchanges in different countries, so that trades in those securities can

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be made on any of such exchanges, those shares are said to be cross-listed.
De-Listing: When a company's shares are removed from the list of shares qualified to
trade on an exchange, the shares have been de-listed.
Discounting for the Future: This phrase refers to the practice of valuing shares based
upon future expectations in addition to current results. If shares have been so valued, the
fact that future expectations are met should not have a material affect on the share price,
as those expectations had already been taken into account in valuing the shares.
Matching Orders: This is the process on an exchange or OTC market in which buy
orders of potential share purchasers are compared to sell orders from existing
shareholders. If the corresponding orders are an exact match, the exchange or broker-
dealer in the OTC market will execute the trade between the parties. If the corresponding
orders are not an exact match, but are quite close, the orders might nevertheless be
matched at a middle price or on some other basis in accordance with exchange and OTC
rules.
Hedging: An investor who owns an interest in a financial instrument can reduce the risk
of loss by purchasing a corresponding financial instrument that offsets some or all of the
losses in the primary instrument. The corresponding instrument is generally in the form
of some kind of option or other investment that involves a lower investment of funds and
can be surrendered without too big of a loss if the hedging instrument proves
unnecessary. A simple example of a hedging strategy would be to own shares, for
example at $10 per share, and at the same time purchase options to sell an equal number
of those shares at a fixed minimum price, for example $9 per share, thus assuring against
a sudden decline and loss in value.
ESOPs: An Employee Stock Ownership Plan (ESOP) can be organized in several
different ways, but essentially it is a company-wide program in which Plan Trustees
purchase or obtains shares of the employees' company and allocates those shares to the
accounts of individual employees based on salary, longevity, or other factors set forth in
the ESOP Plan. Ownership of the allocated shares is transferred to the employee at
retirement or some other specified date or eventnal
Stock Indices: Many stock exchanges, and OTC markets, have an index that reflects the
overall price movement of stocks during a given day or other period of time. In smaller

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exchanges, the index is made up of all company stocks that trade on the exchange. In
larger exchanges, the index is comprised of a representative group of companies. The fact
that there is a rise or fall in the index only gives a general result and does not necessarily
reflect the price movement of a particular stock.
Stock Index Funds: This is a form of investment in which purchasers buy interests in a
unit trust or similar fund that invests solely in companies that constitute a specific market
index. For example, a Dow Jones Industrial Index Fund would purchase shares of all
companies that comprise the Dow Jones Industrial index.
Culpability Standard: This term refers to the legal standard for holding an entity or
person liable for violation of securities laws. The standard can vary among statutes from
simple negligence to gross negligence to wilful intent to strict liability and the standard
might differ within a statute depending upon the nature of the transaction.
Efficient Capital Market Hypothesis: If a secondary market for the trading of securities
is efficient, the price of a company's publicly-traded shares will always and immediately
reflect publicly disseminated information relative to that company.
False Trading Appearances: This phrase refers to efforts by either a company or
individuals to manipulate the price of shares of a publicly-traded stock by making it
appear that there is a high demand to purchase the shares of that company. When the
price of the shares rises as a result of the manufactured demand, other investors may be
enticed to buy the stock, falsely believing that there is a high value, which further causes
a price increase. The initial manipulators then sell their shares and reap the profits.
Selective Disclosure: This term refers to a publicly-traded company disclosing material
information to a limited number of favoured people rather than, or in advance of,
disclosing the information to the public as a whole.
Tippees: Persons who receive material confidential information from company insiders
and who act on that information by trading in the company stock are tippees.
Debt-Equity Ratio: The amount of debt loaned to a company equity relative to the
amount of equity invested in that company creates a ratio that financial analysts use to
measure a company’s financial health. If there is a high amount of debt compared to
equity, analysts might fear that the company does not have sufficient invested resources
to carry the debt financing burdens. Ratios vary among companies, and some companies

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are much more able to succeed with high ratios than others, depending on other financial
factors.
Monetary Rates: This term refers to the interest rates in the monetary market, such as
government T-bills, with regard to financial instruments that have a maturity of one year
or less.
Long-Term Debt Offerings: This refers to company offerings of debt obligations that
have maturity dates in excess of one year.
Sinking Fund: This refers to the obligation of a company to pay a fixed amount of
money into an escrow account each year during the life of a debt obligation to assure that
the full amount of principal is present when the debt reaches maturity.
Rating Agencies: Rating agencies are private companies that analyze debt obligations
and prepare reports stating their opinion as to the risk and viability of the debt
obligations. In general, debt obligations that are rated low must provide a higher interest
rate in order to attract potential investors.
Debt: Debt refers to a loan to a company that creates an obligation to repay on a
particular date, referred to as the maturity date, as well as an obligation to pay a fixed
amount of interest on a periodic basis. If the obligation is one in which the debt holder
can demand repayment at any time, the debt is referred to as a “demand note.”
Sweeteners: This term refers to extra elements added to equity or debt offerings to make
them more attractive to potential investors. Examples include convertibility, participation
in additional dividends, extra voting rights, options, and warrants.
Company Capitalization: This refers to the total amount of equity investment in a
company. It might also include long-term debt that is regarded by the company and debt
holders as an investment in the company.
Debt Financing: This refers to a company’s effort to raise necessary capital principally
through the issuance of debt obligations, such as debentures or bonds.

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About the author

Alain A. NDEDI is Cameroonian political economist based in South Africa. He is an


accountant by training, futurist and financial analyst. He publishes widely in the fields of
entrepreneurship education, NEPAD and impact evaluation. He is owner of a production
company, Unyembe Media.

This is an informative document for bankers, lawyers, and students. As


an academic, I find the book very instructive and strongly recommend it
to navigate in the world of finance.
Edwin Ijeoma, University of Pretoria.

The content is rich and simple to grasp, especially for non financial
professionals…
Sébastien Hervieu, Journalist, Le Monde

If there is any book in Finance dealing with issues of the current


economic meltdown, guide markets regulation is one…
Raymond Akamby, SABC International

This book is a great achievement and denotes the vision of the author
regarding the well being of humankind in dealing with economic
challenges
Disebo Khoaly McCarthy, Yenepad Consulting

ISBN 978 – 0 – 620 – 43833 - 9

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