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Pakistan Capital Market Proposal The Corporate Debt Market

September 1999

Table of Contents
1 INTRODUCTION 2 CORPORATE DEBT MARKET MARKET INFRASTRUCTURE 2.1 REGULATORY FRAMEWORK 2.1.1 STRUCTURE 2.2 TFC ISSUES 2.2.1 LISTED TFCS 2.2.2 UNLISTED TFCS 2.3 ISSUING TFCS 2.3.1 ROLE OF CREDIT RATING AGENCIES 2.3.2 ROLE OF ADVISORS & ARRANGERS 2.3.3 ROLE OF THE TRUSTEE 2.3.4 UNDERWRITERS 2.3.5 LEGAL ADVISORS 2.3.6 ROLE OF SELF-REGULATORY ORGANIZATIONS 2.3.7 THE ROLE OF THE CENTRAL DEPOSITORY COMPANY (CDC) 2.3.8 MARKET PARTICIPANTS 2.3.9 MARKET MAKERS 2.3.10 ROLE OF BANKERS TO THE ISSUE 2.3.11 COST OF THE ISSUE 2.3.12 TAXATION POLICIES 2.3.13 LISTING REQUIREMENTS 2.3.14 SHELF REGISTRATION 3 SECONDARY MARKET ISSUES 3.1 3.2 3.2.1 MARKET MAKING THE OTC MARKET PROCESS FLOW OF THE OTC MARKET 3 4 4 5 6 6 7 7 7 8 9 10 10 11 11 12 15 16 16 18 18 20 22 22 22 23 25 25 25 25 26 27

4 INSTRUMENT ATTRIBUTE ISSUES 4.1 4.2 4.3 4.4 4.5 CALLABLE TFCS PUTABLE TFCS CONVERTIBLE TFCS ASSET-BACKED SECURITIES HYBRID SECURITIES

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GLOSSARY
COI CDC DCR-VIS EOBI GOP GOPb ICI ICP IFC Interbank IPO ISE KESC KSE LSE NBFI NIT NSS PACRA Pak Kuwait Pak-Libya PEVL PICIC PILCORP Pre-IPO PVCL SAPICO SBP SECP SLR SPLC SSGC TFC UTP Certificate of Investment Central Depository Company of Pakistan Limited DCR-VIS Credit Rating Company Employees Old Age Benefit Institution Government of Pakistan Government of Punjab ICI Pakistan Limited Investment Corporation of Pakistan International Finance Corporation First International Investment Bank Limited Initial public offer Islamabad Stock Exchange Karachi Electric Supply Corporation Karachi Stock Exchange Lahore Stock Exchange Non Banking Financial Institution National Investment Trust National Savings Schemes Pakistan Credit Rating Agency Pakistan Kuwait Investment Company (Pvt.) Ltd. Pak Libya Holding Company (Pvt.) Limited Pakistan Emerging Venture Limited Pakistan Industrial Credit & Investment Corporation Limited Pakistan Industrial Leasing Corporation Limited Private placement Pakistan Venture Company Limited Saudi Pak Agricultural & Investment Corporation (Pvt.) Ltd. State Bank of Pakistan Securities & Exchange Commission of Pakistan Statutory liquidity requirement Saudi Pak Leasing Company Limited Sui Southern Gas Company Limited Term Finance Certificate Unit Trust of Pakistan

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Introduction

The corporate debt market emerged in Pakistan with the first Term Finance Certificate (TFC) issue of Sapphire Textile Mills Limited in 1995. This was an unlisted issue of Rs. 100 million with a tenor of 5 years. Since then the market has grown to include 8 listed TFC issues to date, and 7 or more unlisted issues. Traditionally a major source of project funding had been Development Finance Institutions (DFIs) set up specifically for this purpose by the Government of Pakistan. In the last few years, these institutions have suffered due to mismanagement and over-due loans and are currently in the process of being restructured or privatized. TFCs thus could fill this void which existed in the long-term corporate debt market. There were, however, regulatory issues in the TFC markets that hindered progress and are still being resolved piece meal by the Stock Exchanges and the Securities and Exchange Commission (SECP). The corporate debt market is still at an early stage of development, but its prospects appear promising given the ready market for TFCs and their relatively attractive yields, and a large and growing pool of investible funds. Furthermore, the government is keen on developing the corporate debt market and additionally has been receiving pressure from multilateral agencies such as the IMF and the ADB to expedite the process. The government took the much needed initiative in this direction by exempting all entities and individuals from withholding tax on profit derived from all listed and rated fixed income instruments in the Finance Bill 1999. In addition, the rates on government schemes such as the National Savings Schemes (NSS), which were competing with the corporate debt instruments, were brought done significantly.

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2 Corporate Debt Market Market Infrastructure


2.1 Regulatory Framework There are two main regulatory bodies that govern the financial sector: the State Bank of Pakistan (SBP) and the Securities and Exchange Commission of Pakistan (SECP). The SBP is the regulator of the financial market, with executive and advisory powers. Through an amendment in 1994, under the State Bank of Pakistan (Amendment) Act of 1994, the GOP extended full autonomy to the SBP for the formulation and implementation of monetary policy. The SECP has been entrusted with promoting the development of the capital markets in Pakistan, under the Securities and Exchange Act of 1997. The SECP acts as the regulatory body for all aspects of corporate activity, including the stock exchanges, company registrations, and securities issuance by companies. Similar to the SBP, the SECP reports to the Ministry of Finance. Consequently, through its two regulators, (SBP and SECP), the Ministry of Finance plays an important part in capital market development. The SBP and the SECP regulate all fixed income securities. Additionally, debt instruments/TFCs that are listed on the stock exchanges also have to comply with the listing requirements of the respective stock exchanges. The SBP regulates the issuance of all government securities including Treasury Bills (T-Bills) and Federal Investment Bonds (FIBs). The SECP is the regulatory body responsible for administering all laws governing both the corporate sector and the securities market. The diagram below is meant to provide an insight into the current regulatory framework of fixed income securities.
Regulators and Instrum ents

Ministry of Finance

SBP

SECP

Directorate of NSS

T-Bills

Equity Securities

Debt Securities Various NSS Schemes

T hrough Companies Ordi nanc e 1984

FIBs

Listed TFCs

Unlisted TFCs

Other gov t. securities with the exception of NSS

The statutes administered by the SECP include the following: 4

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The Securities and Exchange Ordinance of 1969 The Companies Ordinance of 1984 The Securities and Exchange Act of 1997

The Securities & Exchange Ordinance of 1969 was enacted for the purpose of regulating the securities market and the operations of the stock exchanges. The provisions of the Ordinance were expected to ensure the orderly development of the market while providing investor protection. Over the years, the Ordinance has been under continual review, and appropriate changes have been made in light of the changing policy framework of the Government. The Securities and Exchange Act of 1997 provides the basic legal framework of the Commission and powers conferred on the SECP. The Companies Ordinance of 1984 provides the basic legal framework for the corporate sector. It also provides the enabling framework for the issuance of corporate debt securities. It is important to define the concept of a corporate debt security in the context of the Companies Ordinance of 1984. Debt securities are referred to as Term Finance Certificates (TFCs). TFCs are issued as redeemable capital under Section 120 of the Companies Ordinance, 1984. The return promised by the issuer to the investor is built into the repurchase price at the time of maturity. The difference in the original purchase price and the repurchase price is not described as a fixed return or interest, but referred to as expected profit so as to give an Islamic character to the instrument. The SECP requires that all public TFC issues must fulfill the following conditions: Listing on either of the 3 stock exchanges Mandatory requirement of Credit Rating Appointment of Trustees Security for the TFC holders must be specified in the Security Trust Deed 2.1.1 Structure TFCs are issued as registered physical certificates, with each certificate representing a single cash flow. Thus a 5-year TFC with a semi-annual coupon payment will be represented by a set of 10 certificates, accompanied by a certificate of holding. The individual certificates are not detachable from the certificate of holding and traded separately. The issuer maintains or arranges to be maintained a register for ownership of the certificates of holding and delivers to the holder payment for each individual TFC on its maturity date. TFCs are initially issued at the aggregate face value denomination, usually a minimum of Rs. 5,000. The denomination for institutional investors that purchase TFCs in bulk is usually Rs. 100,000. The individual certificates comprising together with the certificate of holding have to be structured such that each certificate comprises a component of principal and interest/profit. This is in keeping with the Islamic nature of the instrument where profit can only be paid against redemption of principal. This is in contrast to a straight bond, which comprises of a series of interest payments and redemption of principal at maturity. In Pakistan, the element of interest is considered un-Islamic, as a result, to eliminate the interest perception, the issuer promises investors an expected rate of profit. Thus, while both the issuer and the potential investor share the perception that the return on a TFC is in the nature of a fixed return, interpreted in purely legal terms, it is by no means certain that it is indeed a fixed obligation on the part of the issuer. This creates a potential 5

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doubt about the character of the TFC as a fixed income instrument. 2.2 TFC Issues An issuer has two options when issuing TFCs; either issue an unlisted paper or a listed paper. The advantages of issuing an unlisted paper are savings in terms of costs and ease in transaction processing. The advantages of issuing a listed paper are ease in placing the instrument as the range of investors is broader (individuals, corporates and pension/provident funds are not eligible to invest in unlisted papers unless specific permissions are sought1) and enhancing the market recognition of the issuer. [The Costs to the Issuer have been elaborated on in the preceding section]. 2.2.1 Listed TFCs There currently exists a structure of issuing listed TFCs as private placements and public offers. The participants of the private placement subscribe to the TFCs on the issue date, however they place their commitments prior to the date of the public offer. Most listed issues are structured to have about 60-80% of the issues size as a private placement and the remaining as a public offer (initial public offer or IPO). The structure of the issue primarily depends on the issue size, ease in placement, and the understanding between the issuer and arrangers. To get an issue listed on the stock exchange, a certain portion of the issue must be offered to the public, however, the Stock Exchanges do not specify a minimum amount that must be offered in the IPO. In case of Commercial Papers, which are debt instruments with a tenor2 of less than one year, there is no compulsory requirement of public offering in case the instrument is issued for a maximum period of 365 days or its size is upto Rs. 100 million3. If the issue size exceeds Rs. 100 million, then a certain amount of the issue has to be offered to the public. Coupon pricing is negotiated between the Advisors and Arrangers of the issue and the issuer. Factors used in determining the coupon price are the current interest rate environment, instrument rating, pricing of similar TFCs in the market and the issuers reputation. TFCs appear to be very promising instruments for corporate debt development in Pakistan. With traditional medium to long term sources of funding drying up for various macro and microeconomic reasons, and the tight credit limitations imposed by the State Bank through its Prudential Regulations, the potential for companies to tap into TFCs as a source of funding has increased. After a modest start in 1995, today there are 7 listed TFC issues (excluding Nishat Tek, which has matured) in the market with 3 more in the pipeline expected to be issued within this year. The table below exhibits these issues and their respective structures.

Issuer Issue Date Issue Size (millions) Tenor (years)


1

Packages 2/95 232 5

SSGC 10/95 500 5

Nishat 1/96 250 3

ICI 10/96 1,000 5

Gatron 6/98 250 5

Interbank 12/98 326 5

SPLC 1/99 250 4

Dewan 5/99 873 5

NDLC 12/99 450 5

PILCORP 12/99 287.5 5

According to Section 120 of the Companies Ordinance of 1984, which states that a company can only issue redeemable capital (in the form of TFCs) to scheduled banks or financial institutions or any other person that has received specific permission from the Federal Government by notification in the official gazette. 2 Tenor is defined as the time from issue date until final maturity 3 As per the current Karachi Stock Exchange Rules for listing of short term and long term debt instruments

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Issuer Coupon (%) Rating Pre-IPO IPO Packages 18.50 A+ 110 122 SSGC 18.25 A+ 400 100 Nishat 18.00 A+ 175 75 ICI 18.70 AA 750 250 Gatron 18.00 A+ 200 50 Interbank 17.50 A 326 SPLC 18.25 AA200 50 Dewan 19.00 A+ 500 373 NDLC 17.00 A+ 330 120* PILCORP 18.00 A175 75

* Expected Issue Date ** Excludes the Green Shoe Option

2.2.2 Unlisted TFCs There are several unlisted debt issues in the market, however due limited solicitation, restricted circulation of information and absence of trading of unlisted issues, the exact number of unlisted TFCs in the market cannot be accurately determined. The table below shows the structure of the widely distributed unlisted issues in the market to date.
Issuer Sapphire Textile Mills Al Karam Textile Mills Premier Tobacco Ind. Ltd. Lakson Tobacco Co. Ltd. Askari Leasing Saudi Pak Ind. & Agr. Inv. Co. KESC Size (millions) 100 50 75 75 250 300 11,500 Coupon (%) 19.00 16.00 16.50 16.50 17.10 17.00 17.50 Issue Date Mar. 95 Mar. 96 Mar. 96 Mar. 96 Nov. 97 Jan. 98 Feb. 99 Tenor (years) 5 0.5 0.75 0.75 3 3 5 Rating N.A N.A N.A N.A A+ AANA

Unlisted TFCs can only be issued to financial institutions. Provident/pension funds, mutual funds and retail investors cannot invest directly in the initial issue of unlisted TFCs. However, these investors may subsequently invest in unlisted TFCs by purchasing them through financial institutions. Karachi Electric Supply Corporation (KESC): KESC is the largest TFC issue in Pakistan to date, with a total issue size of Rs. 11.5 billion, about 72% of the total market size of TFCs. Also known as the KESC Power Bonds, KESC is not considered to be a part of the corporate debt market, as the issue is backed by a sovereign guarantee from the Government of Pakistan. The instrument was not rated and the entire issue was privately placed with commercial banks and NBFIs. The Power Bonds received special approval from the SBP, giving it the status of approved security for the purpose of the Statutory Reserve Requirement (SLR). The issue was placed with the understanding that the investors were taking a risk on the Government of Pakistan and not KESC, the company itself. 2.3 Issuing TFCs The issuance of debt requires contributions of several entities/firms. Each of these contributors plays a vital role in the successful issuance of TFCs. The preceding sections go on to describe the participation of the contributors.

2.3.1 Role of Credit Rating Agencies Credit rating agencies play an immense role in the development of the corporate debt market especially since the SECP and the stock exchanges require all listed TFCs to be rated. 7

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There are two rating companies in Pakistan, DCR-Vital Information Systems (DCR-VIS) and Pakistan Credit Rating Agency (PACRA). PACRA instrument ratings have been used for all the TFC issues in the market, with the exception of the Dewan Salman Issue. PACRA was established prior to the first public issue of TFC (Packages). This agency was incorporated in 1994 and commenced operations later that year. It is a joint venture amongst Fitch IBCA Inc., International Finance Corporation (IFC) and the Lahore Stock Exchange. The other credit rating company is DCR-VIS Credit Rating Company (DCR-VIS). The Company was incorporated in 1997 as a joint venture between Duff & Phelps Credit Rating Company of USA and Vital Information Services (Pvt.) Ltd., a research house in Pakistan, and the Karachi and Islamabad Stock Exchanges. The two rating agencies are registered with the SECP under the Credit Rating Companies Rules of 1995, which were issued under section 33 of the Securities & Exchange Ordinance of 1969. These rules prohibit the operation of any company as a credit rating organization unless it has been registered with the SECP. Once permitted, the registration remains in force for one year and is subject to renewal on a year to year basis. This procedure facilitates the SECPs role in monitoring the performance of such companies, although the yardstick of performance has not been spelt out in the Rules. However, the SECP has played a critical role in spreading awareness of the need and utility of credit ratings. It has decreed that all public issues of TFCs obtain credit ratings. 2.3.2 Role of Advisors & Arrangers The Advisors and Arrangers, also known as Structuring and Placement Agents play a key role in advising and assisting the issuer in structuring and successfully placing the TFCs. Usually the Advisor & Arranger are the same firm or a Consortium of firms jointly providing the services outlined below. Structuring the instrument Assisting the Company in determining the adequate value of the security for the instrument Assisting the Company in securing an instrument rating Carrying out a due-diligence exercise to ensure accuracy and credibility of information provided by the issuer. Preparing an Information Memorandum in collaboration with the issuer Assisting and appointing the legal advisor to the issue and the trustee Soliciting interest from investors and placing the issue Appointing the bankers to the issue Appointing a computer balloting agent and advertising and printing agent Arranging underwriting for the public offer Drafting the prospectus Preparing the listing application Seeking and subsequently obtaining approvals from the Stock Exchange and the SECP Overseeing the public subscription and ensuring timely disbursement to the issuer Responsible for the formal listing of the instrument

The table below shows the advisors of the TFCs in the market to date.
Issuer Advisors & Arrangers

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Issuer Sapphire Textile Mills Limited Packages Limited Al Karam Textile Mills Limited4 Premier Tobacco Industries Ltd. Lakson Tobacco Co. Ltd. Sui Southern Gas Co. Limited ICI Pakistan Ltd. Nishat Tek Ltd. Saudi Pak. Agr. Inv. Co. (Pvt.) Ltd. Askari Leasing Limited Gatron Industries Limited First International Investment Bank Ltd. Saudi Pak Leasing Co. Ltd. Karachi Electric Supply Corporation Dewan Salman Fibre Limited Pak Libya Holding Co. (Pvt.) Ltd. Pakistan Industrial Leasing Corp. Ltd.

Advisors & Arrangers Citicorp Investment Bank Limited Bank of America & First International Investment Bank Ltd. (Interbank) Interbank and Jahangir Siddiqui & Co. Ltd. American Express Bank American Express Bank Citicorp Investment Bank Limited Citicorp Investment Bank Limited Bank of America Orix Investment Bank Limited American Express Bank Bank of America and Khadim Ali Shah Bokhari & Co. Ltd. First International Investment Bank Ltd. Jahangir Siddiqui & Co. Ltd. and Muslim Commercial Bank Ltd. UBS Securities (Pakistan) Limited Bank of America AMZ Securities (Pvt.) Ltd. and Habib Bank Limited Jahangir Siddiqui & Co. Ltd.

2.3.3 Role of the Trustee A trustee is a financial institution that is designated by an issuer of TFCs, to act as the custodian of the security and to protect the interests of the TFC holders. Trustees are appointed to assure that TFC holders have representation to enforce the contractual obligations of the issuer. The Trustee has the right to exercise all powers and discretion conferred upon it by the Trustee Act 1882, and the Security Trust Deed. For providing its services, the trustee charges a fee from the issuer. The industry practice has been 0.10% of the issue size, however the trustee fee paid out in the recent issues of Saudi Pak Leasing and Dewan Salman had been about 0.05% of the issue size. The trustee fee is negotiable between the issuer and the trustee institution, or between the advisors on behalf of the issuer. The table below lists the trustee to the TFC issues in the market.
Issuer Sapphire Textile Mills Limited Packages Limited Al Karam Textile Mills Limited Sui Southern Gas Company Limited ICI Pakistan Limited Nishat Tek Limited Premier Tobacco Industries Ltd. Lakson Tobacco Co. Ltd. Saudi Pak Agr. Investment Co. (Pvt.) Ltd. Askari Leasing Limited Gatron Industries Limited First International Investment Bank Limited Saudi Pak Leasing Co. Ltd.
4

Trustee/ Security Agent Citicorp Investment Bank Limited Crescent Investment Bank Limited First International Investment Bank Limited Crescent Investment Bank Limited Crescent Investment Bank Limited First International Investment Bank Limited American Express Bank American Express Bank ORIX Investment Bank Limited American Express Bank Crescent Investment Bank Limited Al Faysal Investment Bank Limited Pakistan Kuwait Investment Company (Pvt.) Ltd.

This was the first issue of commercial paper (CP) in Pakistan. The concept of CP in Pakistan is a TFC with a tenor of less than 1 year. Also called a Short Term Finance Certificate (STFC).

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Issuer Karachi Electirc Supply Corporation Dewan Salman Fibre Limited Pak Libya Holding Co. (Pvt.) Ltd.

Trustee/ Security Agent Crescent Investment Bank Limited ORIX Investment Bank Limited ORIX Investment Bank Limited

2.3.4 Underwriters Although not a requirement, underwriters of TFC issues have mostly been financial institutions or corporate listed brokerage houses that agree to purchase the TFCs in the IPO in case of under subscription. Prior to December 1997, the public issues of TFCs had to be fully underwritten. However, this condition is not compulsory anymore and is left to the discretion of the issuer. Nevertheless, issues that have come to the market after December 1997 have been fully underwritten with the exception of the Interbank TFC. The rationale being that the general public subscribing to the public portion will have more faith in the issue being successfully closed. The industry practice for underwriting commission has been 0.50% of the amount underwritten. The table below lists the underwriters for the listed TFCs.
Issuer Packages Limited Sui Southern Gas Co. Ltd. ICI Pakistan Ltd. Underwriters International General Insurance Co. of Pak. Ltd. Muslim Commercial Bank Limited Citicorp Investment Bank Limited Faysal Bank Limited Muslim Commercial Bank Limited National Bank of Pakistan Citicorp Investment Bank Limited Faysal Bank Limited Fidelity Investment Bank Limited Khadim Ali Shah Bokhari & Co. Ltd. First International Investment Bank Ltd. Atlas Investment Bank Limited Platinum Commercial Bank Limited ORIX Investment Bank Pakistan Limited No underwriting, issue size was determined by the amount subscribed. BMA Capital Management Limited First Credit & Discount Corporation (Pvt.) Ltd. Fidelity Investment Bank Limited Pakistan Kuwait Investment Co. (Pvt.) Ltd. Al-Meezan Mutual Fund Ltd. ORIX Investment Bank Limited SAPICO Jahangir Siddiqui & Co. Ltd. Khadim Ali Shah Bokhari & Co. Ltd.

Nishat Tek Limited

Gatron Industries Limited First International Investment Bank Ltd. Saudi Pak Leasing Co. Ltd.

Dewan Salman Fibre Limited

2.3.5 Legal Advisors Legal Advisors to the issue are appointed by the issuer and are responsible for drafting the various legal documents required to be executed. This section describes the various agreements executed in a TFC issue. The TFC Investor Agreement 10

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This agreement is executed between the investors who participate in the private placement of a TFC issue and the issuer. The investors participating in the private placement take an undertaking that they will subscribe to the TFC issue for a specified amount, on or before the public issue. This agreement regulates the terms and conditions of the TFCs and determines the number of TFCs to be issued to the investor/investors. This agreement is valid until the issue date, after which the terms and conditions are regulated by the Security Trust Deed. The TFC Underwriting Agreement This agreement is executed between the underwriters and the issuer. The agreement compels the underwriters to subscribe to the TFCs in case of under subscription (or no subscription at all), in accordance with their underwriting commitments. The Security Trust Deed This deed is executed between the Trustee and the issuer and specifies the functions and obligations of the Trustee. The Trustee has the right to exercise all powers and discretion conferred upon it by the Trustee Act 1882, and the Security Trust Deed. The Security Document The Security Document defines the terms and conditions of the charge/hypothecation of assets as security for the TFC. The Security is created in the favour of the Trustee.

The table below lists the legal advisors to the listed TFCs in the market.
Issuer Packages SSGC ICI Nishat Tek Gatron Interbank Saudi Pak Leasing Dewan Salman Legal Advisor Liaquat Merchant & Company Rizvi Isa Kabraji & Barrister Farrukh Panni Rizvi Isa Kabraji Liaquat Merchant & Company Liaquat Merchant & Company Hassan & Hassan Advocates Mohsin Tayebali & Co. Liaquat Merchant & Company

2.3.6 Role of Self-Regulatory Organizations The major self-regulatory organizations (SROs) in Pakistan that are involved in the issuance of a TFC are the three stock exchanges. The requirement to list all public TFCs on either of the stock exchanges places an important responsibility on stock exchanges in developing the secondary debt market. Listing is allowed only after compliance is confirmed with the conditions stipulated in the listing rules of the respective stock exchanges. (Refer to the section on the listing requirements). 2.3.7 The Role of the Central Depository Company (CDC) The Central Depositary Company of Pakistan (CDC) was incorporated in 1993 in order to manage and operate the Central Depositary System (CDS). An IBM led consortium along with the management of the CDC has implemented the CDS. The consortium comprised of international depository experts, management and 11

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financial consultants, information technology experts, legal advisor and international software companies. The core services of CDS are efficient delivery, settlement and transfer of securities transactions through computerized book- entry system. The CDC started operations after the implementation of the Central Depository Act, 1997. Some of the shareholders of the CDC include the Karachi Stock Exchange (KSE), International Finance Corporation (IFC), Lahore Stock Exchange (LSE), Islamabad Stock Exchange (ISE), Muslim Commercial Bank and Citibank. The stock exchanges require all listed instruments deemed eligible by the CDC to be registered with the CDC. Although, the stock exchanges have not issued written documentation stating the requirement of registering TFCs with the CDC, however, recently, the Karachi Stock Exchange has made this registration mandatory. As a result, all TFC issues coming to market will have to be registered on the CDC. The previous issue of Dewan Salman was the first issue to be registered with the CDC. In this issue, investors had a choice of receiving their TFCs in scripless form (in the CDS) or in the shape of physical scrips. 2.3.8 Market Participants The market participants consist of banks, non-banking financial institutions (NBFIs), development financial institutions (DFIs), incorporated brokerage houses, corporates and individuals. There are 46 commercial banks, 10 DFIs, 16 investment banks and 2 security dealers that are permitted by the State Bank of Pakistan to act as dealers in treasury securities. 2.3.8.1 Commercial Banks Commercial banks have the largest pool of investible funds with total time deposits standing at over Rs. 661.77 billion5 as of September 6, 1999. It is evident that the bulk of these funds are deployed in normal commercial banking operations. Most commercial banks also maintain their investment portfolios (in addition to the SLR requirement). These investment portfolios represent a substantial amount and, theoretically, could be a major source of investment in corporate TFCs. Presently, however, there is some ambiguity on the classification of any such investment. The current view of the SBP is that investing in TFCs is similar to normal lending operations, therefore, the investment is treated as normal advances. The contention of commercial banks, on the other hand, is that investment in TFCs should be treated like any other security, particularly if the TFC is listed on the stock exchanges. Despite the obvious logic of this contention, it seems that commercial banks are not likely to emerge as major participants in the primary market for TFCs, even though they have played an active role in taking up large portions of the publicly quoted issues. 2.3.8.2 Non Banking Financial Institutions (NBFIs) A principal source of TFC investment by the entire NBFI sector could be the investment of 15% of their deposits (part of SLR) in TFCs. Under current SBP regulations, NBFIs are allowed to invest in TFCs as part of the SLR. Investment banks and leasing companies are categorized as NBFIs in Pakistan and have the potential to play a major role in participating in corporate debt issues. Investment banks: There are currently 16 investment banks operating in Pakistan. The total deposits, in the form of Certificates of Investment (COIs) mobilized by the investment banks is estimated to be 30.72 billion 6. Some of these investment banks have actively participated in the private placements of listed TFCs, and have
5 6

Dawn: Economic and Business Review; Money Market review or the week ending September 6, 1999 Derived from the Annual Reports of 1998 of 14 Investment Banks

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acted in the capacity of advisors, arrangers and trustees to the issue of TFCs. Unlike commercial banks, investment banks treat their investments in TFCs as part of their investment portfolio. Hence, investment banks are likely to continue their active participation in future TFC issues. Leasing companies: Leasing companies are another important component of the NBFI sector. Leasing companies may also issue COIs, provided that they comply with the SECPs requirement of being in operations for 2 years and having earned an after tax profit of at least 15%7. However, out of the 33 leasing companies currently in operation, only 18 have been successful in raising these deposits in the form of COIs. The total amount raised as at June 30, 1998 was over 7.61 billion8. Due to the fact that leasing companies can earn over 24% from their core leasing activities, there is little incentive for them to participate in lower yielding TFCs, although one leasing company has been active in investing and trading in TFCs. Development Financial Institutions: There are 10 DFIs in Pakistan that cumulatively have large investment portfolios. A few of them such as Pakistan Industrial Credit & Investment Corporation Limited (PICIC), the three joint venture companies, Pakistan Kuwait Investment Company (Pvt.) Ltd. (Pak Kuwait), Pak-Libya Holding Co. (Pvt.) Ltd. (Pak-Libya) and Saudi Pak Industrial and Agricultural Investment Co. (Pvt.) (SAPICO) have previously participated in TFCs. The table below gives a break-up of the investment portfolio size of some of these DFIs.
Development Finance Institution Bankers Equity Ltd. Industrial Development Bank of Pakistan Pakistan Industrial Credit & Inv. Corp. Ltd. Pakistan Kuwait Investment Co. (Pvt.) Ltd. Pak-Libya Holding Co. (Pvt.) Ltd. Saudi Pak Agr. & Inv. Corporation (Pvt.) Ltd. National Development Finance Corp. Total
Source: Annual Reports as at the date given above

Investment Portfolio (Rs. Million) 1,066.63 2,291.99 1,798.59 4,540.70 2,544.23 1,045.96 7,802.59 13,288.11

As at (Date) 30-Jun-98 30-Jun-97 30-Jun-98 31-Dec-98 31-Dec-98 31-Dec-98 31-Dec-95

7 8

Pakistan Leasing Year Book 1998, published by the Leasing Association of Pakistan Derived from the Annual Reports of 1998 of 33 Leasing Companies

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2.3.8.3 Other Institutions Mutual Funds: There are presently 2 open-ended funds and 40 close-ended mutual funds in Pakistan. Among the 2 open-ended mutual funds, National Investment Trust (NIT) is a government institution and the other, the Unit Trust of Pakistan (UTP) is in the private sector. NIT is the largest open-ended fund, with an investment portfolio size of 27.6 billion9 as at June 30, 1997. However, NIT has a policy of not investing in any kind of fixed income instruments and only invests in equity securities. UTP on the other hand, has started participating in TFC issues that have come to market in the last year. UTPs total investment portfolio size as at December 31, 1998 was Rs. 322.90 million10. As at December 31, 1998, UTP had not made any investments in TFCs, however they participated in the last issue that came to market in May 1999 to the extent of Rs. 25 million11. As more issues come to the market, the investment in TFCs is bound to increase. Out of the 40 close-ended funds, 26 have been floated by the Investment Corporation of Pakistan (ICP), which likewise is a government controlled organization. As of August 6, 1999, the market capitalization of closeended mutual funds was around Rs. 2.9 billion12 against their combined paid-up capital of Rs. 4.7 billion. There is prohibition on any mutual fund against investing more than 10% of the investment portfolio in unlisted security and 20% in rated fixed income securities 13. In addition, a mutual fund cannot invest more than 10%14 of its total investment portfolio size in a single security. Some mutual funds have already invested a part of their portfolio (though modest) in corporate TFCs, however the prospects for greater participation by mutual funds in the corporate bond market appear bright, especially since more issues are coming to the market. The State Life Insurance Corporation (SLIC) is the largest insurance company in Pakistan and is another organization, which maintains a substantial investment portfolio. This organization was created in 1972 as a consequence of the nationalization of life insurance companies. The total portfolio of SLIC was valued at over Rs. 36.68 billion15 as of December 31, 1997, with an average annual return during 1997 of 16%. Investment in TFCs was Rs. 120.8 million, which is a meager 0.33% of the portfolio size. As more issues come to the market, the potential for SLICs participation in the corporate debt market should increase, given the attractive rates offered by these instruments. Insurance Sector: This sector represents a large pool of investible funds estimated to be over Rs. 5.99 billion16. This estimate also includes Pakistan Insurance Corporation (PIC), whose major shareholder is the Government of Pakistan (51%). PIC has an investment portfolio of Rs. 1.08 billion as at December 31, 1997 and can potentially be a source of investment in TFCs. However, PIC has not invested in any TFCs to date. Out of the 38 insurance companies, only 10 companies have invested in TFCs, representing an estimated sector participation of a meager 1.52%17. Given the fact that Pakistans emerging debt market is growing and investor awareness has increased, insurance companies are likely to increase their participation. The Employees Old Age Benefit Institution (EOBI), which is another government organization, also maintains a large investment portfolio. The value of the investment portfolio as at June 30, 1997 was over Rs.
NITs Annual Report for 1997. The Annual Report for 1998 is not available as yet. UTPs Half Yearly Report as at December 31, 1998 11 Information obtained from UTP 12 Quotation sheet of the Karachi Stock Exchange on August 6, 1999 13 S.R.O 28 (1)/99, Amendment to the Investment Advisory Rules, 1971 14 Investment Advisory Rules, 1971 15 SLICs audited financial statements for 1997. Annual Report for 1998 is not available as yet 16 Derived from the 1998 Annual Reports of 37 of the 38 listed insurance companies. 17 Derived from 1998 Annual Reports of listed insurance companies.
9 10

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19.17 billion18, with an investment of Rs. 8.35 billion in FIBs, Rs. 7.18 billion in Defense Saving Certificates and Rs. 1 billion in WAPDA Bonds. EOBI has participated in TFC issues previously (Packages and ICI) and given the attractive returns and the fact that more issues are expected to come to the market, participation is likely to increase. 2.3.8.4 Individuals The participation of individuals in TFCs had been insignificant primarily because of the to lack of active secondary market trading and inadequate knowledge about TFCs. In addition, TFCs had to compete with the National Saving Schemes (NSS) that offered more attractive rates of returns. As at June 30, 1997, the total investment in NSS was Rs. 464.67 billion19. This massive pool of funds could have easily been invested in TFCs had the market been bigger and the rates offered more competitive. Multilateral agencies such as the World Bank, the IMF and the Asian Development Bank (ADB) have been putting pressure on the government to reduce the rates offered on these schemes in an attempt to provide incentive for the development of the debt market. As a result, on May 14, 199920, the government slashed the rates on these schemes by 2%. It is believed that this reduction will increase the participation of individuals and this has already been witnessed in the Dewan Salman TFC issue. Market Makers The fact that the SECP requires all public issues of TFCs to be listed on the stock exchanges is by itself no guarantee of liquidity. Given the fact that the corporate debt market is still rudimentary, the role of market makers is instrumental in ensuring investors that there will be sufficient liquidity for public TFCs. Most of the TFCs issued so far have several institutions mentioned in the prospectus as designated market makers. This arrangement does not preclude other members of the stock exchanges from dealing in TFCs. The only difference between an ordinary broker and a designated market maker is that the latter is obliged to quote a firm buy/sell price on TFC whereas there is no such obligation on the part of the former. The efficiency of the Market Maker is the spread between the quotes and the tradable amounts. This implies that the marketmaking role can be performed effectively only if sufficient funds are available to hold TFCs until they are offloaded in the market. However, neither the SECP nor the stock exchanges regulate or evaluate the performance of the in designating market makers,. the SECP does not try to evaluate their financial standing or subsequent performance. [The role of Market Makers is further elaborated in the section on Secondary Market Issues]. The table below lists down the designated market makers in all the listed TFCs to date.
2.3.9 Issuer Packages Limited Sui Southern Gas Company Ltd. Market Makers First International Investment Bank Limited Citicorp Investment Bank (Pakistan) Limited Muslim Commercial Bank Limited Arif Habib Securities Ltd. BMA Capital Management Fidelity Investment Bank Limited Jahangir Siddiqui & Co. Ltd. Khadim Ali Shah Bukhari & Co. Ltd. M. Rashid Jamal

Annual Report 97 of EOBI, Annual Report 98 is not available as yet. Economic Survey 1998-99 20 The Business Recorder
18 19

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Issuer ICI Pakistan Limited Nishat Tek Limited Gatron (Industries) Limited First International Investment Bank Limited Saudi Pak Leasing Dewan Salman

Market Makers Shoaib Capital (Private) Ltd. No specific market maker designated. First International Investment Bank Limited Khadim Ali Shah Bukhari & Co. Ltd. No specific market maker designated. First International Investment Bank Limited Jahangir Siddiqui & Co. Ltd. First Credit & Discount Corp. (Pvt.) Ltd. No specific market maker designated.

2.3.10 Role of Bankers to the Issue The stock exchanges and the SECP require that Bankers to the Issue be appointed for all public issue of TFCs. The role of the Bankers to the issue is to act as a collectorate on behalf of the issuer for the subscription money from the public issue of TFCs. The Issuer at its discretion appoints the Bankers. However, based on the experience of previous issuers, the stock exchanges and the SECP insist that Habib Bank Limited, Allied Bank of Pakistan Limited, United Bank Limited, Muslim Commercial Bank Limited and First Women bank Limited be appointed by the issuer as Bankers to the Issue. As a result, most of the issues that have come to market include these banks. The current industry practice for commission to the Bankers to the Issue is 0.50% of the public issue size. 2.3.11 Cost of the Issue In issuing corporate debt in the form of listed Term Finance Certificates (TFCs), a company has to incur costs in addition to the coupon payments. The following components, excluding the coupon comprise the cost of the issue. The following costs are applicable to both listed and unlisted TFCs: Advisory or Structuring Fee Placement or Arrangement fee Stamp Duty (0.15% of Issue Size) Instrument Rating Fee and Entity Rating fee in case the issuer does not have an entity rating. (Unlisted issues may not be rated). This fee is payable to the credit rating agency. Trustee Fee Instrument Surveillance Fee payable to the credit rating agency Miscellaneous Expenses: printing, legal fees, advertising, etc.

The additional costs below pertain to listed TFCs. Underwriting Fee if deemed necessary by the issuer Commission to Bankers to the Issue (industry practice: 0.50% of the IPO) Brokerage (mandatory commission of 1% of the IPO) Initial Listing Fees (1/20th of 1% of Issue Size) Annual Listing Fees determined by issue size is as follows: Issue Size 16 Annual Listing Fee

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Issue Size Up to Rs. 50 million Rs. 50 million - Rs. 200 million Above Rs. 200 million

Annual Listing Fee Rs. 25,000 Rs. 50,000 Rs. 100,000

KSE Service Charge (Rs. 25,000) SECP Processing Charge (Rs. 25,000) Computer balloting fee CDC Security Deposit21 is determined by the issue size and is refundable after the maturity of the instrument. The structure of the security deposit is as follows: Issue Size Up to Rs. 50 million Rs. 50 million - Rs. 125 million Rs. 125 million - Rs. 250 million Rs. 250 million Rs. 500 million Rs. 500 million Rs. 1 billion Above Rs. 1 billion Security Deposit Rs. 100,000 Rs. 200,000 Rs. 300,000 Rs. 400,000 Rs. 600,000 Rs. 800,000

CDC Annual Fee is determined as follows: Issue Size Up to Rs. 50 million Rs. 50 million - Rs. 200 million Above Rs. 200 million Annual Fee Rs. 25,000 Rs. 50,000 Rs. 100,000

2.3.11.1 Recommendations The costs that can be controlled by the stock exchange include brokerage, listing fees and service charge. A reduction in some of these costs will provide impetus towards development of the debt market. With reference to discussions with the KSE officials, some of the costs that the KSE is willing to reduce and implement, in order to support of the development of the debt market are: For listed companies, KSE is willing to reduce its annual fee by 50%, and have it capped at Rs. 50,000. The KSE service charge of Rs. 25,000 can be waived for listed companies. A substantial portion of the cost to the issuer is the mandatory brokerage commission. The KSE is willing to reduce this to 0.50% flat or equivalent to the private placement commission, whichever is higher. The KSE officials have suggested that Commission of Bankers to the Issue should be negotiable and regulatory authorities such as the SECP should intervene and regulate this. We feel that this commission should be capped at 0.25% of the IPO. This commission is one of the largest components of cost paid by the issuer to the banks for just collecting the subscription money. In addition, no interest is paid out on the subscription money, and hence the banks earn the commission plus the interest on subscriptions from the
21

Fee structure obtained from CDC

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subscription date to the time that the money is released. The Interbank TFC that was issued in December 1998 paid out 0.25% commission to Bankers to the Issue. This clearly suggests that banks are willing to provide their services at this commission rate. Hence, 0.25% should be set as a benchmark for future issues. This will result in reducing the cost of the issue and will encourage more issuers to use TFCs as a preferable way of raising finances through Pakistans capital markets. 2.3.12 Taxation Policies Stamp Duty: A major impediment towards the issuance and subsequent trading in TFCs had been the enormous stamp duty (which is regulated by the provincial governments). However, after June 1994, the stamp duty applicable to the initial issue of TFCs and subsequent transactions were slashed to 0.15% and 0.10% respectively and as a result, a number of TFC issues came to market. Deduction of Zakat: The rate of Zakat (Islamic tax on wealth) is also the same for both debt and equity securities. It is deductible at the rate of 2.5% of principal redeemed for all TFC holders that are Muslim citizens of Pakistan, except where a statutory declaration of exemption is filed, and in case of certain non-corporate entities such as Trusts, Funds, etc. The impact on TFCs is different from that on equity. In the case of the former, the principal repayment at maturity is also subject to Zakat levy. Consequently, TFCs have to be structured in a complicated manner with the objective of minimizing liabilities on account of Zakat. Income Tax/Withholding Tax: The treatment of expected profit used to be exactly the same as dividends and as a result were subject to income tax/withholding tax. Prior to July 1, 1999, all persons with the exception of companies were exempt from withholding tax. Companies were subject to 10% tax on expected profits. In the Finance Act of 1999 that was implemented on July 1, 1999, this exemption has been extended to companies as well, effectively exempting all persons/entities from withholding tax.22 Wealth Tax: TFCs are liable to wealth tax in the hands of non-corporate TFC holders, except in cases where the TFC is liable to Zakat deduction or has been acquired through remittances from abroad. Capital Gains Tax: Both TFCs and equity securities are exempt from capital gains tax. This exemption is valid until June 30, 2001.23 2.3.13 Listing Requirements The Karachi Stock Exchange revamped listing regulations in December 1997, prior to which the KSE had TFC specific listing regulations, however, these were modeled after equity listing rules for unlisted companies. Thus prior offerings (Packages, SSGC, Nishat and ICI) faced considerable problems to fulfill these exhaustive criteria, which listed 37 documents including copies of all material contracts, LCs, and details of plant and equipment etc., the process took anywhere from 3-6 months. This exposed Issuers and Pre-IPO investors to substantial interest rate risks considering the volatile interest rate environment in Pakistan.
Clause 10B of Part IV of the Second Schedule to the Income Tax Ordinance, 1979, the withholding tax provisions of sub-section (7D) of Section 50 23 Clause 116 of Part 1 of the Second Schedule of the Income Tax Ordinance, 1979
22

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The current listing requirements distinguish between less than 1 year instruments and those for a longer maturity, as well as, between TFC Issues by a listed and an unlisted company. The rules are part of an annexure to this document. The following two sections have identified components of the listing regulations that can be further improved or resolved in order to make the process more fluid, relevant and efficient. 2.3.13.1 Documentation for Listing of Debt Instruments The Stock Exchange requires a copy of the feasibility report that should be certified by a financial institution. This requirement should be more explicit, stating that a feasibility report is required if a new project is being set-up or other major expansion activity and is being financed through a TFC issue. Companies that are issuing TFCs to expand their existing businesses need not submit a feasibility report. In addition, we feel that the scope of certifying a feasibility report should not be restricted to financial institutions only, but should include corporate listed brokerage houses that possess the capability to make such assessments. Copies of individual consent of each Director, CEO, Company Secretary, legal advisor, etc. are required for Publication of their names in the Prospectus. This requirement is purely a legal issue and is the responsibility of the Arranger. This should not be a requirement for the stock exchange for listing purposes. The fact that the directors and CEO sign on the final prospectus obviously means that they have consented to do so. This requirement has been a cause of substantial delays in the past. The Stock Exchange requires a Credit Rating Report that should not be more than 3 months old prior to the date of the listing application. Previously, the private placement of many issues took a substantial time and as a result, prior to the listing application, the credit rating report was older than three months. Consequently, the Credit Rating Report had to be issued again by the rating agency, resulting in additional costs and time to the issuer. With 8 listed TFC issues in the market, we are of the opinion that investors are now more educated and will be able to make investment decisions in a short time period. So although many issuers prefer to get this period extended, we feel that this requirement should not be amended in order to enhance the efficiency of issuers and advisors and encourage the issues of proficient companies. The Stock Exchange currently requires all material contracts for listed debt issues of unlisted companies. These documents should specify those material contracts relating to the use of the TFC funds and/or the project being financed through the TFC should be submitted to the Stock Exchange. A Profile of the Printer is also required as part of the documentation. The inclusion of this information does not add value to the assessment of the listing application, and hence should be waived. Furthermore, if mandatory registration on the CDC is imposed, this service will not be required.

2.3.13.2 Redemption and Other Key Issues The documentation of TFCs, which consist of the Information Memorandum and the Prospectus, should not present any ambiguities to investors, particularly individuals. The issues of ICI and SSGC were confusing to investors. For example in ICI, the TFC was quoted to yield a return of 18.70% annually or 9.35% every 19

Pakistan Capital Market Proposal The Corporate Debt Market


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semi-annual period. Many individuals assumed this to mean that the semi-annual profit to be booked would be 9.35%, whereas this was not the case. The table below is an extract from the ICI prospectus showing the redemption schedule. Month 6 12 18 24 30 36 42 48 54 60 Total IRR (%) Semi-annual coupon (%) 9.35 9.35 9.35 9.35 9.35 9.35 9.35 9.35 9.35 9.35 Principal 427.53 390.97 357.54 326.97 832.01 715.30 612.45 521.97 442.49 372.78 5000.00 Profit 39.97 76.53 109.96 140.53 468.82 507.62 532.55 545.11 546.68 538.47 3,506.24 Redemption 467.50 467.50 467.50 467.50 1,300.83 1,222.92 1,145.00 1,067.08 989.17 911.25 8,506.25 18.70

In order to develop the debt market, it is imperative to ensure that TFC structures are simple and the documentation is easily understood and adhered to. Example of an issue where the documentation was not complied with was the recent issue of Dewan Salman. The Information Memorandum as well as the prospectus stated that the Green Shoe option was to be 37.5% of the IPO, which was Rs. 200 million. At the time of the IPO, Dewan received Rs. 363 million in subscription money and according to the Green Shoe option, it had a right to retain up to Rs. 75 million out of the over subscribed amount. However, Dewan went and obtained approval from the Securities and Exchange Commission of Pakistan to retain the entire amount. As a result, many institutional investors were faced with potential liquidity/over exposure problems. The reason being that the market had believed the issue to be oversubscribed and accordingly many institutions applied for subscription amounts larger than their desired investment in the TFC, in order to successfully achieve the targeted investment. The prospectus should contain the final terms and conditions for the TFC issue. In the interest of developing the debt market, no clauses should be amended or removed after the issue. The reason being investors will lose faith in the credibility of the prospectus if they perceive that the regulatory authorities will permit changes after the issue date. These changes may impact initial investment decisions that were made based on the documentation provided in the prospectus. 2.3.14 Shelf Registration Issuers who desire to issue a debt instrument in tranches can employ the facility of shelf registration. This facility was granted by the stock exchanges in December 1997 and has so far been utilized by one issuer; namely First International Investment Bank Limited. The Stock Exchanges may give approval for Shelf Registration once all rules are complied with, for a maximum period of three years. During this time, the 20

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issuer is required to submit the Credit Rating Report every six months until the time of the public issue. The offering document/Information Memorandum is also required to be updated to reflect current scenarios.

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3 Secondary Market Issues


The foundation necessary for developing an active secondary market is evident in Pakistan and this can be gauged from the fact that there exist corporate entities interested in issuing TFCs and an investment community interested in buying them. Moreover, there are potentially large pools of funds (both institutional and individual) available for investment in TFCs. While all the participants in the primary market are actively involved in matching the needs of borrowers with those of the lenders, the critical success factor is the efficiency of the secondary market for TFCs, which continues to be an area of concern, both for participants and policy makers. 3.1 Market Making As mentioned before, the listing of TFCs on the stock exchanges does not guarantee liquidity. The effective role played by market makers would enhance liquidity in the market. The SECP and the Stock Exchanges have to actively regulate the performance of designated market makers when granting approvals for listing of TFCs. A transparent criteria has to be established which may contain a minimum balance sheet size/leveraging strength and expertise in TFC trading. Additionally, the SECP and the stock exchanges may monitor that these conditions are being effectively met by the lead managers and underwriters, which will form basis for their qualification as lead managers, underwriters and market makers. This critical success factor may be gauged by opinions of market participants as well as trades being reported to the stock exchanges. 3.2 The OTC Market The Karachi Stock Exchange (KSE) allows all members of the stock exchange to participate in trading of TFCs. In general, only those members that operate active money market operations (10) 24 engage in TFC trading. This is primarily due to their client base profile of Fixed Income investors who generally also engage in regular money market activities. Hence, other members whose client base is only targeted toward equity investors have been dormant in TFC trading. The table below gives a break-up of the annual trading volumes of the listed TFCs.
Issuer Packages Limited Sui Southern Gas Company Ltd. ICI Pakistan Limited Nishat Tek Limited Gatron (Industries) Limited First International Investment Bank Limited Saudi Pak Leasing Co. Ltd. Dewan Salman
Source: Market estimates of Jahangir Siddiqui & Co. Ltd.

Guesstimate Annual Turnover 50 million 90 million 150 million N.A 100 million Unavailable 110 million 240 million

% of Issue Size 24 18 15 N.A 40 Unavailable 44 28

The reason for exact trading volume histories not being available is that even though listed TFCs (similar to
These comprise of JSCL, KASB, UBS, Finex, WI Carr, First Capital Securities, AMZ Securities, BMA Capital Management, Invescap Securities and Crescent Capital.
24

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shares of listed companies) are required to be transacted through a member of the exchange 25, market participants do not always follow this practice. Additionally, money market brokers who are not members of the exchange transact in TFCs without the relevant information being disclosed to the stock exchanges. As can be ascertained from the table shown above, an obvious reason for low trading is the large institutional holding in TFCs as compared to individual investors. In addition, the limited number of issues and small issue sizes hinder the depth of the market. Most institutions tend to treat TFCs as a long-term investment; as a result the floating stock in the market is limited. The table below shows the proportion of institutional holding in TFCs listed on the KSE.
Issuer Packages Limited Sui Southern Gas Company Ltd. ICI Pakistan Limited Nishat Tek Limited Gatron (Industries) Limited Saudi Pak Leasing Dewan Salman
Source: Information obtained from the above companies

Institutional Holding (%) 93 88 80 N.A 80 90 89

It is reasonable to conclude that the following conditions have to be created for an active secondary market. Increase in the number of issues to the market Large issue sizes Increase in the portion of TFCs offered in the IPO Transparent trade reporting at the exchanges Active market makers

3.2.1 Process Flow of the OTC Market As pointed out earlier, the current market participants are those that regularly participate in the money market and as such trade TFCs through their brokers. Since the money market is an OTC market in Pakistan, the TFC market too, has also stemmed from this present system. Investors contact brokers who in turn provide quotes for specific TFCs based on market demand and supply, which is largely dependent on current interest rate environment.

25

As per Section 8 of the Securities & Exchange Ordinance, 1969

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DATA FLOW CHART OF TFC OUTRIGHT PURCHASE/SALE

Buy er

Broker

Seller

Buy er/Seller
Communication line

Broker Matches Bid/Of f er

Counter Of f er/Bid

No Y es

A copy of "buy er contract" is sent to broker (carbon copy )

Buy er signs the "buy er contract" (Original)

Buy er Contract (2 copies) Seller Contract (2 copies)

Seller signs the "seller contract" (Original)

A copy of "seller contract" is sent to broker

Cross/SBP cheque will be prepared

Copy to Broker's contract f ile

CDC/scrip will be sent

Trade is reported to the quoations department of the KSE

Either CDC of f set entries or phy sical settlement Monthly bill to clients

24

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4 Instrument Attribute Issues


In order to develop the debt market, it is imperative to introduce elements that will provide flexibility in investment decisions to market participants. The Pakistan market is still at a nascent stage, nevertheless the following attributes should be introduced to enhance the education of market participants and inform them on alternative financing techniques. 4.1 Callable TFCs A callable TFC is a TFC in which the certificate holders have sold the issuer an option (more specifically, a call option) that allows the issuer to repurchase the contractual cash flows of the TFC from the time the TFC is first callable until the maturity date. Because fixed income securities lock into a particular rate of return over a longer period of time, the issuer is exposed to the risk that it will be locked into expensive financing as interest rates decline. In most parts of the world, issuers commonly seek to reserve the right to redeem these instruments prior to their maturity date (a call), in order to protect against a downward movement in market interest rates. The exercise of a call right allows the issuer to redeem more expensive TFCs and issue new TFCs bearing a lower rate of profit. Where calls are permitted, there is usually a requirement that a premium (specifically, a call premium) over par be paid. This price is determined prior to the issue date. Whether or not TFCs are sold pursuant to a public offering or a private placement, the terms of the instrument and all rights of the instrument holders are found in an indenture or purchase agreement. This document is negotiated in a private deal between the issuer and the placement agent and in a public deal between the issuer and the underwriters. In a public offering, a trustee, or in a private offer, an agent bank, who represents the TFC holders in their relationship with the issuer, qualifies the indenture. 4.2 Putable TFCs The same rational applies to putable TFCs. In the case of a putable TFC, the TFC holder has the right to sell the TFC to the issuer at a designated price and time. A putable TFC can be seen as representing two separate transactions. First, the investor buys a nonputable TFC. Second, the investor buys an option from the issuer that allows the investor to sell the TFC to the issuer. This option is called a put option. In the Pakistan context, only a few select companies, which have very stable credit ratings, may be prospective issuers of a TFC with a put option as essentially considerations other than interest rate movements will effect investor decisions. 4.3 Convertible TFCs Convertible TFCs give the investor the option to convert an interest-bearing debt instrument into an equity security. Convertible TFCs are similar to normal TFCs in that they have a set coupon and maturity date, however the rate of return to investors is generally lower that would be paid in a normal TFC of similar rating, security and tenor. The investors compensation for accepting the lower interest rate in the equity kicker, the right of the TFC holder to acquire the issuers common stock at a specified conversion price. In 25

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the US, corporations that have invested in common stock of other publicly traded companies may issue bonds exchangeable into such stock, rather than convertible into the issuers common stock. The legal documentation is substantially the same, but the shares for which the securities are exchangeable must be placed in escrow with a depository bank in an arrangement that isolates them from the claims by the issuers creditors. The conversion price is fixed at a premium of generally 15 to 20% (in the US) above the market price of the common stock at the time of issue. The conversion price usually remains constant over the term of the instrument, except as adjusted pursuant to anti-dilution provisions to take account of events such as stock splits, stock dividends, or rights permitting the holder to purchase common stock at a price below the prevailing market price. As a result, the market price of a convertible TFC will fluctuate, both in response to the market for fixed income securities and in response to the market price of the underlying common stock. A Convertible TFC structure has the potential to become a viable option in the Pakistan market. The reason such offerings have not taken place in Pakistan is due to the poor performance in the equity markets since 1995, which is also the time when awareness of the corporate debt market increased and large issues such as the ICI and SSGC issues came to market. Hence, convertible structures in which the coupon can be priced cheaper than straight debt instruments will only become feasible once investors perception of the equity market improves. 4.4 Asset-Backed Securities The issuance of asset-backed securities (ABS) is a specialized financing technique through which the issuer pools and repackages the cash income stream derived from an asset or group of assets into a dedicated debt service to support an issuance of securities. The securities are structured to resemble bonds or fixed income instruments; investors are paid interest periodically and their principal investment is eventually paid off. However, interest and principal payments made to the purchasers of these securities are satisfied out of the cash flow from the pooled assets. ABS do not represent obligations of, or interests in, an actual business enterprise, and purchasers of ABS do not view themselves as making a direct investment in the future performance of a business, as TFC holders and stockholders do. To establish an ABS structure, the assets to be financed must generate a predictable cash flow for a period of time that the securities will be outstanding, must be separable from the transfer companys other assets and must have a discernible market value. A simple ABS structure involves a number of steps. First, the company, which owns the assets to be securitized (originator), transfers the assets to a newly created entity (the securities issuer or "special purpose vehicle (SPV)). Then, the SPV issues securities, which are collateralized by the repackaged assets in either a registered public offering or a private placement. The assets provide a cash flow stream designed to ensure adequate coverage of principal and interest on the securities, usually well in excess of 1:1. (The securities must be over-collateralized). In addition, the credit quality of the securities may be further enhanced by a bank letter of credit, third party insurance, a cash reserve or spread account or subordination of any residual interest retained by the originator. Finally, the SPV transfers the proceeds of the sale of the securities to the originator, thus providing cash for the assets transferred. The SECP is currently working on the issuing and implementing of the rules for Asset Backed 26

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Securitization. The rules are expected to be implemented within this year and are proposed to be made under section 506 of the Companies Ordinance, 1984, and section 43 of the Securities and Exchange Commission of Pakistan Act, 199726. The first ABS issue is in the pipeline and is expected to take place as soon as the ABS rules are implemented. The issuer is the Provincial Government of Punjab (GOPb) and the assets to be securitized are bridge toll receivables. The estimated issue size is Rs. 600 million and the tenor is 5 years. The structure of the ABS has not yet been determined. However, once the rules are implemented and the GOPb issue is successfully placed, more issues can be expected to take place, originating from other provincial governments, municipal entities, leasing companies, credit card companies and house financiers. 4.5 Hybrid Securities Hybrid securities are debt securities that are similar to bonds insofar as they have a maturity date and pay a specified minimum rate of return. However, the principal at maturity, interest rate, or both of such securities are indexed to the price of a specific commodity, foreign exchange rate or securities index. Hybrids generally pay a lower guaranteed rate of return than conventional fixed-rate debt securities of comparable quality and maturity, but offer the investor the possibility of higher returns (as well as greater losses), depending upon movements in the price of the underlying commodity, exchange rate for the currency, or value of the stock index. The market in Pakistan is rudimentary and investors will probably find the structure of these securities too complex to comprehend. Additionally, in Pakistan there is lack of well-recognized indices the most credible being the KSE-100 index, which is heavily dependent on a few large capitalized stocks and hence attracts criticism. There are no futures or commodity indexes to speak of.

26

Draft for Asset Backed Securitization Rules, 1999

27

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