Risk-taking in securities market – Safeguards under SEC Act

As the Sri Lankan economy is under financial stress at present and has entered into a programme with the International Monetary Fund (IMF), it is necessary to take stock of the measures that have to be taken to unlock the potential of foreign income flows into the country. 
One of the critical factors that would drive our economic recovery lies in building confidence in the market. Investors looking for opportunities would carry out a risk assessment in making investment decisions and the capital market space is no exception. 
It is critical that risk mitigation strategies are employed by market participants and regulators to build the much-needed confidence in the market to facilitate entry into the market. The key piece of legislation that governs risk mitigation in the securities market is Securities and Exchange Commission of Sri Lanka Act No.19 of 2021 (SEC Act) and the ensuing rules.  

Global standards on risk management
The global standard setting institution for all securities market regulators is the International Organisation for Securities Commissions (IOSCO), which has its headquarters in Madrid, Spain. The Securities and Exchange Commission of Sri Lanka (SEC) is also an ordinary member of the IOSCO. The IOSCO has issued 37 principles and standards for all securities regulators across the globe to follow and work on the regulatory reform agenda. 
The IOSCO identifies risk-taking as an essential and inherent feature in an active securities market and recognises that legitimate risk-taking should not be stifled by regulation. Within this backdrop, the IOSCO has recognised the reduction of systemic risk as a core objective of securities regulation.
It is necessary that risk management processes should be promoted amongst market participants that allow for absorption of some losses accruing from inherent risk and keeps checks on excessive risk-taking. To absorb losses, regulators usually prescribe prudential requirements like minimum net capital and shareholder funds that have to be maintained by market intermediaries such as stockbrokers. The IOSCO identifies investor protection and operating fair, efficient and transparent markets as the other two key objectives of regulation. The three objectives are closely associated with each other and tend to overlap in many respects. Regulators seek to achieve these objectives through setting standards and supervising markets. 
Investor protection is also an essential ingredient in building confidence in the market. For the market to function efficiently, investors must be given fair access to the market and price information. The dissemination of information and prohibition of unfair trading is at the heart of ensuring investor protection.

Investor protection under SEC Act
Part 1 of the SEC Act, which deals with the establishment of the commission, identifies the protection of the interest of both local and foreign investors as one of its prime objectives. 
The SEC Act has enhanced the powers of the commission to intervene in investor protection. The SEC has the power to take measures to carry out market surveillance. It also has powers to regulate the entry and exit of market intermediaries by setting standards and introducing qualification criteria for market participation. The SEC will regulate this entry through the issuance of licences to function as a market intermediary such as stockbrokers, investment managers and corporate finance advisors (CFA). 
The SEC also has the power to take measures to mitigate systemic risk to the financial system as required. The law has given wide powers to the commission to take preventive action on an imminent infringement of the SEC Act. This is where the commission has knowledge that a particular conduct or a transaction may violate the law if carried out and can prevent such action by issuing a directive to the person concerned.  

Disclosure-based regulation

One of the key instruments used throughout the law for investor protection is the efficient dissemination of accurate information. The role of auditors in the law has been elevated to that of a gatekeeper. The auditors have a legal duty to report a material breach of the law to the regulator of market participants identified in the law.  This is a duty cast on auditors in line with the IOSCO principles. 

It is a requirement to release audited financial accounts of listed companies to the market, so that the investors can make informed decisions about their investments. This duty is introduced to enhance the transparency of listed companies and other market participants to protect the investing public. 

Protection of client assets

The SEC Act introduces requirements and standards that have to be put in place for the protection of client assets held by market intermediaries. The commission has also been given wide powers to intervene in safeguarding client assets. In the event of a bankruptcy of a market intermediary, the commission has powers to isolate clients’ assets from the bankruptcy proceedings of the market intermediary. 

The Colombo Stock Exchange (CSE) through its rules imposes limits on the extension of credit that can be given by stockbrokers to their clients. This is to manage the risk exposure associated with credit extensions to protect investors from being overly exposed to market volatility and settlement defaults. 
Regulation of investment recommendations
The law requires stockbrokers to ensure that they have a reasonable basis for the advice they give to their clients. The law prescribes a standard that has to be met. An investment advisor must be aware of the investment objectives, financial needs and particular needs of their clients. This is to ensure that investment advisors take note of the investment capacity and the risk appetite of each of their clients. 
The CSE has made it mandatory that all stockbroker firms enter into a broker-client agreement at the time of onboarding clients, laying out the rights and obligations in trading on the stock exchange. It is a requirement under the CSE rules that the investment advisors explain the risks involved in trading to the clients and sign a risk disclosure along with the agreement.
It is clear that investment advice is brought within the regulated space and the law has attached liability for falling short of the standard set in the law. All investment advisors have to be qualified by the SEC as registered investment advisors to be able to function in an investment advisory capacity. There are provisions in the law to register investment advisors with the SEC and the qualification criteria for registration are given in the law. 
It is important to understand how other countries view the investment advisory function in the capital market space. In Malaysia, investment advice is a licensed function. One cannot engage in the practice without first getting a licence from the Malaysian Securities Commission. The SEC of the USA requires investment advisors to be registered with the SEC. There is a law called the Investment Advisors Act of 1940 that regulates investment advisors and it specifies the information that should be filed with the commission. It also identifies the categories eligible for exemptions. 
This means that only the commission has the power to decide on who would not be required to be authorised by them to give investment advice based on identified criteria. In most countries like in Sri Lanka, the regulator maintains a list of regulated, registered or licensed investment advisors for public information.
Recently, in the media, we saw the SEC warning and taking action against YouTube content creators for making stock recommendations without being registered investment advisors and not having a reasonable basis to do so. The SEC has also warned the public not to rely on unverified information in making investment decisions. 
It is an offence to circulate false or misleading information that can have an impact on price or volume of shares under the SEC Act. A person is likely to be liable under this offence, if that person fails to take reasonable care to check the accuracy of the information or intentionally disseminates false or misleading information. If anyone is charged under this offence, the SEC is likely to check if a person made a reasonable effort to verify the information prior to circulation. 
It is also an offence to fraudulently induce a person to deal in securities. The law identifies intentional or reckless publishing of any statement or forecast relating to listed securities as a market offence. 
The IOSCO principles also recognise access to accurate information as an essential factor in facilitating an efficient market. This, in particular, is pivotal in winning the confidence of foreign investors looking for the standards they have experienced in other global markets in making their investment decisions to enter the domestic market. 
The alignment of domestic regulation and practices with global markets is crucial in building confidence in the domestic market. The dissemination of accurate information to make informed investment decisions operates as a hedge against excessive risk-taking in the stock market. 
Maintaining minimum standards for intermediary services
The law has identified minimum qualifications, such as integrity and capacity standards to work in the capital market space as a market intermediary. All market intermediaries have to be licensed by the SEC. The commission will also look at the past performance of an applicant, the human resource capacity, processes and systems and proper infrastructure in granting a licence to a market intermediary. 
The IOSCO standards specify that minimum entry criteria should be used to authorise market intermediaries to join the market. It is seen as a strategy to reduce the risk caused to investors through negligent and unauthorised behaviour and conduct in the market. In fact, the report of the IOSCO country review of Sri Lanka, published in June 2017, identified activities of investment banks and activities of market intermediaries being unregulated as potentially risky. However, with the enactment of the SEC Act in 2021, this gap has largely been bridged since the IOSCO country review. 
The SEC has powers to monitor, supervise business activities and control entry and exit into the market of market intermediaries. This, in turn, helps to build investor confidence to enter into the capital market sphere. Foreign investors used to well-regulated markets are likely to look for similar protection in alternative investment destinations. 
The World Economic Forum publishes a Global Competitive Index. In the methodology used for assessment, financial market development is identified as a pillar. It places emphasis on the need for a well-regulated securities exchange and states that financial markets need appropriate regulation to protect investors. To be competitive in a global economy, it is important to be placed well in world rankings and assessments as they play a significant role in influencing investor confidence. 
Another critical factor that influences investor confidence is credit ratings assigned to sovereigns and corporates. There are several factors that credit rating agencies look at in making their assessments. In rating a sovereign, governance indicators are considered in the assessment criteria. In that, the rule of law and regulatory quality are taken as factors that will be looked at in grading the governance indictors. Fitch Ratings in its corporate rating criteria identifies management strategy and corporate governance within its key rating drivers. In assessing management strategy, the risk tolerance of corporates and consistency are seen as important elements. 
In the rating assessment, a strong corporate governance structure does not have an impact on the assessment. However, if deficiencies persist in corporate governance structures, this could lead to a negative impact on the assigned rating. Fitch ratings look at the integrity of the accounting and auditing processes. 
Financial transparency is reviewed from the perspective of how easy it is for investors to assess financial conditions and fundamental risks. High-quality and timely financial reporting is looked at as an indicator of robust governance by Fitch Ratings. 
The SEC Act requires all market intermediaries and public listed companies to comply with accounting and auditing standards and to submit their audited and interim financial statements to the regulator. As discussed earlier in this article, the duties imposed on auditors of market intermediaries and public listed companies show the emphasis placed by the regulator to ensure that high-quality financial statements are released to the market. 
The regulatory framework has given the SEC powers to monitor and actively intervene to protect investors subscribing to an initial public offer. A company coming in for a listing has to lodge its prospectus with the SEC. If there are serious inaccuracies in the prospectus, the SEC can immediately issue a stop order and prevent the allotment of shares. The SEC Act has introduced new duties on investment banks in performing a diligence check on their clients making public offers of securities. It is a requirement under the market intermediary rules for CFAs to verify the information submitted by an issuer of a prospectus. Pragmatically, this would require a verification check against original source documents. 
An investment bank is also expected to ensure assumptions relied upon in making financial statements are reasonable and feasible. They must also ensure that the company coming in for a listing is compliant with the governance framework of the Listing Rules of the CSE. This shows that investment banks are entrusted with the responsibility of performing a general diligence check on the requisite standard to inspire confidence in a public fund raise. Once the check is performed, the investment banks, in turn, have to confirm to the SEC that this has been done.
There may be certain teething problems that may be encountered in the practical implementation of these duties. These issues should be cleared with the regulator and a practical approach should be adopted. The important point is that the regulatory framework sets standards that should be followed across the industry. This is what a licensing regime attempts to achieve. This, in turn, would contribute towards building investor confidence in the market in the long run. 
It is likely that a public issue of securities structured by a licensed investment bank is likely to inspire greater confidence in investors as the expectation is that they would have to meet a higher standard in carrying out their functions. 
Benefits of risk mitigation
It is a given that a certain level of inherent risk is prevalent in any capital market activity. What regulation attempts to do is respond to excessive risk-taking by market participants. The long-term sustainability and health of the market depends on the ability of the market to absorb and mitigate systemic risk.
If investors think that their investments are not safe, they are likely to stay away from the market until conditions change. It is only beneficial for each market participant to put in place strategies and processes to manage their risk and inspire confidence in the market. 
Market progression pivots on the level of confidence in the market. In this distressed economic situation, it is necessary that market participants respond to the particular circumstances that we are currently placed in by putting in place safety nets that can absorb and mitigate risk. 
(Suhadini Wickremasinghe, Head of Compliance at NDB Capital Holdings Limited and Attorney-at-Law, convened the Advisory Committee appointed in 2015 by the SEC to draft the SEC Act. She can be reached at [email protected])