Some salient features of proposed Securities Exchange Act: PART II

Responsibilities of auditors – market institutions

Another important provision included is found at section 69 of the proposed bill, which imposes an obligation on an auditor of a market institution to inform the respective board of directors, with a copy to the commission, in instances where (a) any matter which, in his opinion, adversely affects or may adversely affect the financial position of the market institution, to a material extent, (b) any matter which, in his opinion, constitutes or may constitute a breach of any provision of this act, regulations, rules or directives made thereunder or an offence involving fraud or dishonesty affecting the financial stability of the market institution to a material extent or (c) any irregularity that has or may have a material effect on the accounts of the market institution, including any irregularity that adversely affects or may adversely affect, the funds or property of investors in securities.

Issue of securities

Part III of the act pertains to (a) the regulation of the issue of securities, (b) disclosure of financial information by listed public companies, (c) requirements for auditors to disclose financial irregularities, (d) to license market intermediaries and to register their representatives and (e) to protect clients. 

Trade in securities

The chapter on trade in securities categorically stipulates that a corporate entity listed or unlisted will not make a public offer of securities either directly or through a third party by way of a prospectus or similar document, unless approved by the commission and thereby extends the regulation of the SEC to all public offers of securities to raise funds. 

Section 81 provides that where it appears to the commission that a listed public company has contravened or failed to comply with any provision of the act, regulations, rules or directives or has furnished the commission with information that is false, inaccurate or misleading, the commission may issue a directive to the listed public company (a) to cease and desist from any contravention of this act, regulations, rules or directives made thereunder, (b) to do or refrain from doing any matter as specified under this act, regulations, rules or directives made thereunder or (c) to carry out any other matter that the commission considers necessary in the exercise of its powers under this act, regulations, rules or directives made thereunder. It is also a punishable offence for a listed company to submit false information to any market institution.

The commission will also be empowered to issue ‘stop orders’ or ‘interim orders’ where there is imminent violation of the stipulated requirements. 
There is also a requirement that directors and chief executive officers of listed public companies must comply with the fit and proper criteria specified by the commission or by the Rules of the Exchange.

Responsibilities of auditors – listed companies

There is also important new provision imposing duties upon the auditors of listed companies, similar to the provisions identified above in respect of market institutions, to report such instances firstly to the Audit Committee and if no rectification is made within two weeks to the board with further provision to escalate the same to the commission/the relevant exchange where there is non-compliance. The commission is also empowered to require the auditor to submit such additional information, enlarge the scope of the audit, etc.

Market intermediaries

Market intermediaries have been defined to include any person licensed under the act as a credit rating agency, derivatives broker, financial planner, investment analyst, investment manager, managing company, margin provider, market maker, placement agent, stockbroker or any other person who undertakes similar activity and described by rules for the purpose of issuing such licence by the commission and Chapter 2 of Part III seeks to regulate market intermediaries. 

As in the case of market institutions, the proposed act details a comprehensive set of governance requirements to be satisfied before being licensed as a market intermediary and also contains similar continuing governance requirements. 

These governance measures include stringent requirements for directors, chief executive officer, managers or controller of a market intermediary and include grounds for refusal of a licence on the basis that any of the said officers have been convicted of an offence involving fraud or dishonesty or the conviction of which involved a finding that he acted fraudulently or dishonestly; has been subjected to any administrative action taken by the commission; has been convicted or has been compounded of an offence for which he has been charged under the act or under the laws governing securities outside Sri Lanka; has contravened any provision made by or under any law enacted for protecting members of the public against financial loss due to dishonesty, incompetence or malpractice by persons concerned in the provision of financial services or the management of companies; has engaged in any business practices that may be deceitful or oppressive or otherwise improper or reflect discredit on its method of conducting business; has engaged in or has been associated with any other business practices or conducted itself or himself in such a way as to cast doubt on its or his competence and integrity; is an undischarged bankrupt whether within or outside Sri Lanka; the commission has reason to believe that the applicant or any of its officers may not be able to act in the best interest of its clients having regard to their reputation, character, financial integrity and reliability; the commission is not satisfied as to the financial standing of the applicant or the manner in which the applicant’s business is to be conducted; the commission is not satisfied as to the record of past performance or expertise of the applicant, etc.

The new statutory obligations of auditors for market intermediaries are similar as in the case of market institutions, set out above. 

There have been instances in the past where those who possibly should not have been issued licences to operate as market intermediaries, have been issued such licences by satisfying the basic eligibility requirements and it is expected that moving forward, the regime of licensing would be strengthened by these new provisions.

Protection of client assets

The proposed act in Chapter 3 of Part III also includes copious provision on protection of client assets and prevention of commingling of assets by market intermediaries. 

Important provisions are also included to bring liability upon market intermediaries and registered persons to compensate the losses of clients on the basis of unreasonable recommendations and is included as a deterrent to unreasonable/fraudulent/reckless recommendations. In this respect, it is specifically provided as a guideline that a market intermediary or registered person does not have a reasonable basis for making a recommendation to a person unless – (a) he has, for the purposes of ascertaining that the recommendation is appropriate, had regard to the information possessed by him concerning the investment objectives, financial situation and particular needs of the person is accurate and complete and (b) he has exercised due diligence into the subject matter of the recommendation as is reasonable in all the circumstances and made the recommendations accordingly.

Consequently, it is expected that these new provisions will act as a deterrent to market intermediaries and registered persons from being truant in advising their clients.

Trade in unliste        d securities

The proposed new act also makes provision under Part IV for formalized trading in unlisted securities, through registered market operators, the objectives being (a) to provide a platform through a recognized market operator for sale and purchase of unlisted securities in Sri Lanka to local and overseas investors in a transparent manner and (b) to facilitate the disclosure of information relating to unlisted securities to local and overseas investors through a recognized market operator in a transparent manner.

Market misconduct

Part V of the proposed act deals with market misconduct, with the stated objects identified as (a) to prevent false trading, market rigging and market manipulation and (b) to prevent insider trading with a view to establishing a fair, orderly and transparent securities market.

The scope of application of the relevant provisions is wide and covers, in respect of securities, acts or omissions occurring within Sri Lanka in relation to securities of any corporate entity, which is formed or is carrying on business or is listed within or outside Sri Lanka and acts or omissions occurring outside Sri Lanka in relation to securities of any corporate entity, which is formed or is carrying on business within Sri Lanka and in respect of derivatives, acts occurring within Sri Lanka in relation to derivatives, whether traded within or outside Sri Lanka and acts occurring outside Sri Lanka in relation to derivatives traded within Sri Lanka.

Prohibited conduct

Sections 124 to 128 of the proposed act set out the prohibited conduct, the contravention of any one of them would amount to an offence and upon conviction punishable with a fine of not less than Rs.10 million or to imprisonment of either description not exceeding 10 years or to both such fine and imprisonment.

The prohibited conduct includes (a) false trading and market rigging transactions (pumping and dumping), (b) market manipulation (transactions which artificially raise, lower or peg, fix, maintain or stabilize the price or volume of securities, for the purpose of inducing other persons to trade), (c) making statements/disseminating information that is false or misleading, (d) fraudulently inducing persons to deal in securities through making false, misleading or deceptive statements or forecasts, concealment of material facts, etc. and (e) the use of manipulative or deceptive devices to defraud. 

Insider dealing

The new act proposes an even more comprehensive legal regime for insider trading, which is found in Chapter 2 of Part V under market misconduct. 

The relevant information and the prohibited conduct have been defined. 

Section 135 of the proposed new act provides that an insider will not whether as principal or agent in respect of any securities to which defined information relates (a) acquire or dispose of or enter into an agreement for or with a view to the acquisition or disposal of such securities or (b) procure, directly or indirectly, an acquisition or disposal of or the entering into an agreement for or with a view to the acquisition or disposal of such securities. The provision further provides that where trading in the securities to which the defined information relates is permitted on a securities market of an exchange, the insider will not directly or indirectly communicate the information referred to or cause such information to be communicated to another person, if the insider knows or could reasonably be expected to know that the other person would or would tend to (a) acquire, dispose of or enter into an agreement with a view to the acquisition or disposal of any securities to which the defined relates or (b) procure a third person to acquire, dispose of or enter into an agreement with a view to the acquisition or disposal of any securities to which the defined information relates.

The offence of insider dealing is triable before the relevant High Court and brings with it a punishment in the form of a fine of not less than Rs.10 million or to imprisonment of either description for a term not exceeding 10 years or to both such fine and imprisonment. 

There is also provision for parity of information as a defence, for example in the case of listed securities where information came into the possession of the person communicating the information solely as a result of it being made known in a manner likely to make it generally available or if the other party knew or could reasonably be expected to have known the information before the information was communicated.

There is further specific provision enabling/not curtailing the rights of persons who suffer loss as a result of the prohibited conduct, from instituting civil proceedings to recover losses or damages caused.

Civil action by commission against offences

New provisions have been introduced enabling the commission to institute civil proceedings before the Commercial High Court of the relevant province (and presently the Commercial High Court of the Western Province) seeking civil penalties in respect of the contravention of the prohibited acts, where it considers it necessary in the public interest and it has been stipulated that in such proceedings the commission could seek to recover an amount three times the gain made or loss avoided or in an amount of not less than Rs.10 million and not exceeding one Rs.100 million.

There is also provision providing discretion to the commission to enter into an agreement with any person on the basis of any admission of liability to pay an amount not exceeding three times the gross amount of the pecuniary gain made or loss avoided calculated for each offence.  
This is a significant departure from the provisions of the present act, which only permit criminal prosecution of the offences, which could be cumbersome, time-consuming and also require the highest standard of proof. The new provisions which provide discretion to the commission, to institute civil action, as an alternative to a criminal prosecution, provide flexibility to the commission to deal with each offence, on a case-by-case basis, giving consideration to factors such as disgorgement of profits, recovery of penalties, public interest, expediency, etc.

Whistleblower protection

There is now specific provision, which prohibits an employer discharging, terminating, demoting or causing harassment to a person in employment, who provides information to the commission concerning violations or potential violations of the act, regulations, rules or directives made thereunder or any rule of a market institution.

There is also further provision enabling the commission to grant a reward to a whistleblower, who provides information that leads to a successful enforcement action.

These provisions on whistleblowing would no doubt act as an added safeguard in ensuing compliance with the legal provisions.

Enforcement mechanism

The proposed act further provides that in respect of all offences under the act (including contravention of the provisions of the act, submission of untrue, incorrect or misleading information as required by the act, etc.) in respect of which no penalty has been expressly provided for, the offender will be liable on conviction after summary trial by a magistrate to a fine not less than Rs.10 million and not exceeding Rs.100 million or to imprisonment of either description for a period not exceeding 10 years or to both such fine and imprisonment. 

There is also provision to compound offences other than the offences listed under Part V (Prohibited Conduct) for a sum not exceeding one half of the maximum fine imposable for such offence. This provision substantially restricts the scope of compounding as found in the present act, which permits the commission to consider compounding any offence committed under the act.

There are also new provisions empowering the commission to enter into an enforceable settlement agreement with any person with respect to any undertaking between the parties with a view to ensuring compliance with the provisions of the act, regulations, rules or directives issued thereunder except for offences listed in Part V of this act and there is provision for further redress to court in the case of breach of such agreement. 

Administrative penalties and actions

There is further provision for the commission, except in the case of offences listed in Part V (Prohibited Conduct) in respect of contraventions of a provision of the act or regulations made there under or contraventions or failures to comply with any condition or restriction of a licence or registration granted under the act or failure to comply with any provision of the rules of a market institution, any written notice, guideline, directive issued or condition imposed by the commission or any rule issued by the commission, to impose administrative penalties or impose administrative actions including (a) directing the person in breach to comply, observe, enforce or give effect to such provisions, regulations, rules, written notice, condition, directive or guideline; (b) imposing a penalty in proportion to the severity or gravity of the breach on the person in breach but in any event not exceeding Rs.50 million; (c) reprimanding the person in breach; (d) requiring the person in breach to take such steps as the commission may direct to remedy the breach or to mitigate the effect of such breach, including making restitution to any other person aggrieved by such breach; (e) in the case of a promoter or a director of a listed public company, in addition to the actions that maybe taken above, to (i) impose a moratorium on or prohibit any trading of or any dealing in the listed public company’s securities or in any other securities the commission thinks fit, by the promoter or director or any person connected with the promoter or director or (J) issue a public statement to the effect that, in the commission’s opinion, the retention of office by the director is prejudicial to the public interest.

There is further provision that provides that where a person fails to pay a penalty imposed by the commission as set out above, such person will be guilty of an offence under the act and the sum of money due as penalty may, on application being made by the commission to the Magistrate’s Court, be recovered in like manner as a fine imposed by such court, which makes the imposition of administrative penalties an expeditious remedy.

These provisions empower the commission to impose administrative penalties and actions, as well as the provisions referred to above.

Conclusion

In conclusion, the new Securities Exchange Act has brought together international best practice, addressed gaps in the present legal regime and included provisions on the basis of experiences learnt in the past 30 years of operation of the present act and is expected to provide impetus in the growth of a deep and liquid capital market, where there is strong investor trust and confidence.

(Rajeev Amarasuriya is an Attorney-at-Law with a wide practice in the areas of public law and corporate consultancy. He is a Fellow Member of the Chartered Institute of Management Accountants (CIMA - UK) and an alumnus of both the Faculty of Law of the University of Colombo and Harvard Kennedy School of Government, Executive Education. He is a Commissioner of the Securities and Exchange Commission of Sri Lanka. The views expressed herein do not necessarily reflect the views of the SEC)