SEC Act – Practical implications for the market

This article attempts to draw out the practical implications of the law on the capital markets industry rather than delve into an analysis of the legal provisions.

The article looks at the conceptual framework outlining the law and connects it to the legal provisions to understand the practical implications of the law.

Context of the law
The law is introduced in the context of the aftermath of the global financial crisis in the period 2007 -2008, where a number of financial regulators revised their capital market laws. Malaysia, Singapore, Hong Kong and Australia made significant changes to their capital market regulatory framework. 

Pakistan enacted a new capital markets law in 2015. Similarly, in Sri Lanka, the Securities and Exchange Commission of Sri Lanka Act No.19 of 2021 (SEC Act),which had been in the pipeline of the Securities and Exchange Commission of Sri Lanka (SEC) for some time, was enacted in September 2021. 

It is timely that the outdated 1987 Act was repealed and a new Act was put in place in line with the global and regional trends.  Certain sections of the SEC Act are modelled on the provisions that can be found in Malaysia and Singapore. The design and scheme of the law shows the influence of regional laws.

The design of the law
The law itself consists of seven parts which has already been widely discussed in the media. Conceptually, it covers governance of the SEC, capital market infrastructure institutions, capital market actors, market misconduct, finances and the enforcement toolkit.

Departing from the general practice, the objectives and purposes are included for each Part to guide that particular part. This sets out the context and intention for the whole Actand helps the reader to understand the context to the substance of the law better. The law covers a broad range of topics in comparison with the repealed Act.The conceptual framework is set at a macro level, leaving room for explanations and clarification to be includedin the rules. 

It is important that rules are issued to ensure that the Commission does not use discretion arbitrarily when implementing the law. The SEC Act draws out the regulatory boundaries in carrying out capital market activities. This need for rule making will be discussed with examples throughout thearticle.

To understand the design of the law, firstly, this article will look at how the SEC has altered its area of authority. The new law has made in-roads into the expansion of its regulatory ambit beyond the scope covered under the repealed Act. 

Still the main focus is on listed securities. The new inclusion is that the law has extended the regulatory reach to the unlisted securities market as well. All public offers made by listed companies and Initial Public Offerings need the approval of the SEC. 

Certain public offers made by unlisted companies can also be regulated. The Commission has the power to define what constitutes a public offer in terms of volume, class and nature of securities, type of investors and nature of the issuer. This can be done by issuing rules. In the absence of rules, the jurisdiction on public offers will firmly remain with listed securities and securities to be listed. 

In managing the expanded regulatory reach, the SEC can delegate certain powers to any authorized person under the SEC Act similar to powers seen in the repealed Act. In most instances the delegated authority is the Colombo Stock Exchange (CSE) as seen in practice. 

The CSE needs to have rules that govern trading, stockbrokers and listing to name a few. These rules are contractual by nature and contractually binds the relevant stakeholders engaged in the related activities. 
The Commission’s power to enforce CSE rules is strengthened by including it in the statutory scheme of the law, which was not seen previously. Licensed exchanges, depositories and clearing houses are identified in the law as Market Institutions.  

The SEC can issue a directive to comply with the rules of a Market Institution. If a person fails to observe the directive, the Commission can apply to Court to enforce these rules. Similar provisions can be found in the Singapore Futures Act 2001. 

The SEC can also take action for a rule violation by imposing administrative sanctions. These provisions have enlarged the legal framework of the SEC by threading Market Institution’s rulesinto the statutory scheme of the SEC Act. 

In the exercise of the regulatory powers, the law has recognized a graded scale of regulation ranging from stringent to lenient applied to different market participants.The SEC Act regulates alternative trading platforms called Recognized Market Operators (RMO). A Market operator has to register with the SEC and the regulatory scheme is to be spelt out in the rules. 

The type of investors, issuers, unlisted securities and trading participants are to be determined through rules. The objective of including electronic platforms in the law is to facilitate the transparent buying and selling of unlisted securities. 

The role of the law is to provide an enabling environment for the recognition, framework and workings of this facility based on transparent criteria.In contrast, the law adopts a far more stringent regulatory regime for the Market Institutions by the control of entry and exit into the market by issuing licenses, on site supervision and monitoring of audited financial accounts.

A similar example is the difference in the scale of the regulatory reach between the Market Intermediaries and Supplementary Service Providers. 

Market Intermediaries are Stockbrokers, Investment Managers, Corporate Finance Advisors and Managing Companies among others. The Market Intermediaries are licensed and supervised by the SEC. Supplementary Service Providersare auditors, custodians and trustees who will provide professional services to Market Intermediaries and Market Institutions. 

The Commission can seek information, clarification and explanation from them on their professional services offered to Market Intermediaries and Market Institutions. A Managing Company which is licensed by the SEC as a Market Intermediary, managing a unit trust scheme,has to appoint a trustee classified as a Supplementary Service Provider to hold the client funds invested in the unit trust scheme.

The Managing Company would need the professional services of a commercial bank to act as a trustee to implement their scheme. This exemplifies the nexus and the difference between the Market Intermediary and the Supplementary Service Provider at the same time. 

The law has set the boundaries for the purpose of regulation of Supplementary Service Providers. The SEC can issue rules and guidelines on duties and obligations within the statutory boundaries identified in the law.   

Changing regulatory landscape for Market Intermediaries
Companies connecting issuers and investors to capital market transactions are called Market Intermediaries. Unlike in the previous legal regime, entry and exit of all intermediaries are regulated through a uniform licensing scheme. 

The law lays down the grounds for refusal of a license, which was not seen under the repealed Act. This is applicable to both a new applicant and an existing Market Intermediary applying for a renewal of a license. The grounds for refusal of a license is  indicative of the assessment criteria the SEC would look at in evaluating a new or renewal application for a Market Intermediary. As an example, the SEC would look at the past performance or the expertise of an applicant.  

A license can also be refused where the SEC thinks that it would be against investor interest to grant or renew a license. In instances like this, there may be room for a regulator to act in an arbitrary manner. 

It would be healthy for both the regulator and the market if there is further guidance on the criteria given in the law within the specified boundaries. The Malaysian Securities Commission has put out an exhaustive licensing handbook detailing transparent criteria with practical illustrations.

SEC was already in the practice of controlling exit and entry of intermediaries in the market. The law has recognized new categories of intermediary services in the market that will be regulated.  Market Intermediariesregulated under the previous law were the Stockbrokers, Investment Managers, Credit Rating Agencies, Stock dealers and Margin Providers.The new Market Intermediaries are Derivative Broker, Derivative Dealer, Market Makers, Corporate Finance Advisor (CFA) and Managing Companies. 

All Market Intermediaries will be regulated under a uniform licensing scheme in contrast to the repealed Act.The law has only given a skeletal framework for the regulation of Market Intermediaries. It primarily identifies the categories of Market Intermediaries and governs their entry and exit to market. 

The specificities of the regulatory regime governing Market Intermediaries have to be in the rules. The business conduct, prudential requirements, record keeping , annual audits of books, trading of derivative contracts and stock borrowing and lending are some areas mentioned in the law where rules can be made by the SEC. 

Some of the areas mentioned here are borrowed from the repealed Act. The difference is that certain additional duties have been introduced in the law relating to Market Intermediaries which requires further guidance considering the practical implications. 

A Market Intermediary making a recommendation of a security is required to disclose any interest it has or any connected person may have in buying or selling the same security. 

In the event that a research arm of a Market Intermediary publishes a research report recommending a particular share, this provision will be activated. How does a Market Intermediary deal with this scenario? The first question is does this include only trading carried out by a company which is a Market Intermediary,its Board of Directors or only the person making a recommendation? 

The term ‘connected person’ is not defined but the law limits it to any person acting jointly or acting together under an arrangement. Secondly, disclosure is required to be made in relation to any interest in securities. 

Pragmatically, this could even include an insignificant purchase of 100 shares. This section needs clarity and limits to be drawn out to capture its intention. The SEC can issue rules relating to disclosures by Market Intermediaries about security transactions under the rule making powers of the SEC. 

In looking at the broadened categories of Market Intermediaries the immediate impact would be felt among the Investment Banks which will now have to obtain a license as a CFA from the SEC to continue their operations. 
There are statutory liabilities placed on CFAs.  There is a duty on a person giving information to the Commission to ensure that the information provided is not false or misleading. 

CFAs acting as managers for an Initial Public Offer (IPO) signs a statutory declaration in the prospectus confirming full and fair disclosure of all material factors and also states that they are satisfied with the profit forecasts. This declaration in the prospectuscan make a CFA liable in the instance of an omission of material information or an overstated profit forecast. 

An extension of the regulation of Market Intermediaries is captured in the requirement to register investment advisors attached to these companies. This would primarily impact investment advisors attached to stockbroker firms. 

Currently, they have to complete a certificate course and satisfy certain other requirements imposed by SEC to be qualified as Registered Investment Advisors (RIAs). However, the new law has introduced a statutory scheme that may requires them to obtain a registration from the SEC. 

The professional qualifications and experience is only one branch of the assessment criteria in granting or renewing their registration. Similar to the assessment criteria introduced for a Market Intermediary in granting or renewing a license, a Registered Investment Advisor would also be assessed for his/her continued engagement in his/her professional capacity. 

The SEC has powers to issue directives to registered persons. Through the statutory scheme the SEC has assumed direct control over the professional conduct of RIAs. The new registration scheme has also introduced new duties to RIAs.  

The law has introduced a standard for making recommendations of securities to clients. There should be a reasonable basis for making recommendations. The assessment criteria forhaving a reasonable basis includes an analysis of the clients’ investment objectives, financial position and particular needs. 

This would primarily impact RIAs attached to Stockbroker firms. In the face of client complaints, RIAs would have to demonstrate that the standards set in the law were satisfied. Both the Market Intermediary and the RIA can be held accountable by the SEC for non-compliance with the standard. 

Another significant tool introduced to supervise Market Intermediaries is the gate-keeping role given to Auditors in carrying out their external audits. If auditors notice a breach of the SEC laws, Market Institution rules or any other matter which adversely affects the financial position of a company to a material extent,that has to be immediately escalated to the Board of the Market Intermediary and the SEC. 

These duties are not new to the global capital market sphere. Similar provisions can be seen in Singapore, Malaysia, Thailand, Hongkong and Australia. In fact the International Organization for Securities Commission (IOSCO), of which SEC is also an ordinary member, has identified audit oversight in their principles and objectives that serve as a benchmark for financial markets. 

IOSCO states that effective oversight of those performing audit services is critical to the reliability and integrity of the financial reporting process and helps to reduce the risks of financial reporting and auditing failures in the public securities market. The ultimate purpose of such oversight is to protect investorinterests and further the public interest in the preparation of informative, true, fair and independent audit reports.

Mandatory reporting duties are also introduced for auditors of Public Listed Companies (PLCs) and Market Institutions. The escalation process of reporting a non-compliance is the same for Market Institutions and Market Intermediaries while for PLCs it differs. It is a stepped up escalation process that has to be followed by PLCs. 
First, the auditor has to report their findings to the audit committee and if no remedial action is taken within two weeks, to report to the Board and still if no remedial action is taken within another two weeks the matter has to be escalated to the SEC. 

The distinction in the escalation process can be viewed from a systemic risk perspective. Market Institutions and Market Intermediaries being critically ingrained in the capital market system, a failure of such an institution is likely to pose systemic risk to the market. 

However, an audit finding of non-compliance with the law by a Market Intermediary should be allowed to be discussed with the management and obtain management comments prior to escalation. 

This would be necessary to place the audit finding in context and understand the significance of the finding from a business perspective and also from a systemic risk perspective.

Enforcement toolkit
The SEC enforcement programme is equipped with multiple tools that can be used to remedy a breach of the law or to punish market offenders. The law has introduced parallel legal remedies for violations of the law. 
The new law has recognized civil sanctions and administrative sanctions which are widely available in other jurisdictions like Hong Kong, Australia, the United States, the United Kingdom, Singapore and Malaysiato securities regulators. 

This would be in stark contrast to the remedies under the repealed law where the Commission was only able to avail themselves of criminal sanctions or the compounding of an offence. 

The application of  parallel legal remedies can be better understood in examining Part V of the law dealing  with market misconduct involving offences like market manipulation, insider trading and securities fraud. A person found to have committed market misconduct can be indicted in the High Court and be sentenced to a jail term of not more than 10 years or be imposed a minimum fine of Rs.10 million or both such jail term and fine. 

The Commission may instead decide to file civil action taking into consideration the nature and manner of the contravention and the extent of the loss caused to aggrieved investors. The Court can order a person found to have contravened the law to pay up to three time the profits made or the loss avoided or pay a penalty between 10 and 100 million rupees. 

The SEC also has another option available where it can enter into an agreement with a person to pay three times the profits made or the loss avoided by the commission of the offence without the intervention of Court. Although administrative sanctions are available for breaches of the other parts of the law, it is not available for Part V market misconduct. 

In deciding the appropriate remedy and the course of action, it may be useful for the market to understand the transparent criteria used by the SEC in making these determinations. The SEC Act has set out the basic broad criteria that will be considered in filing civil action. 

However, it may be useful to elaborate on the parameters. The US SEC has published an enforcement manual giving exhaustive details on the investigation process and recommendations on enforcement action to the Commission. 

Another feature that is built into the law is the ability of the SEC to take pre-emptive action to prevent an imminent infringement of the law. The SEC can issue directives to a person to prevent imminent harm. This is similar to quiatimet action seen in the common law practice where a Court can issue an injunction to prevent wrongful action which is threatened or imminent. 

Further, the SEC can issue freezing orders prohibiting a person from disposing of assets or entering into a transaction on a reasonable suspicion of a contravention. However, the order must be confirmed by a Court while such order is in force. The maximum period the SEC can enforce such order is seven market days which can be extended by Court. 

Futuristic developments in the law
The law has provided a framework for the growth and development of the market and capital market infrastructure. One such example is the legal framework which is set in place for the operation of a clearing house acting as a central counterparty mechanism (CCP). 

The CCP can contain the counterparty risk that can arise from the inability of a market participant to settle a securities transaction executed on the exchange. A CCP mechanism is needed for trading of derivatives on the exchange. 

Another example is thecreation of an enabling environment for the regulation of a demutualized exchange. Once the CSE is converted from a mutual exchange to a demutualized exchange through a special Act of parliament, the SEC Act will take over the continuous regulation of the exchange. The law has also provided the framework for the listing of the CSE on its own exchange. 

Conclusion
The rules currently being formulated by the SEC and the CSE under the law will further elaborate the intention of the law. The market should study the rules carefully to fully appreciate the impact of the law on the capital market industry.  

(Suhadini Wickremasinghe, Attorney-at-Law, is the Head of Compliance – NDB Capital Holdings Limited. She convened the Advisory Committee appointed in 2015 by the SEC to draft the SEC Act. She can be contacted via [email protected])