SEC crisis and corporate dirty linen
By Professor Willie Mendis, Senior Professor of Town and Country Planning, University of Moratuwa
With the advent of the liberalised economic culture in 1977, the role of town planners in Sri Lanka diversified from being exclusive regulators to that of `promoters' of development. The Urban Development Authority Law No: 41 of 1978 pioneered this trend by empowering the Urban Development Authority (UDA) "to promote integrated planning and implementation of economic, social, and physical development of areas designated for urban development".

The powers and functions of the UDA allow it to enter into "joint ventures" for the purpose of carrying out an approved development project. It was complemented by the Board of Investment offering attractive fiscal and other incentives to high-value investments in such projects. Accordingly, it became imperative for town planners engaged in the promotion of development to be woven into the web of intricacies of the "capital market". Hence the `building blocks' needed by them to promote urban investment were conceived in a model which was formulated in the late 1970s which included the necessity to develop the Colombo Stock Exchange as one of the `blocks'. Access to inexpensive capital was possible through the stock market to attract equity participation in high - value urban development projects. On the other hand, the vulnerability of investors was also a concern. Hence the need for a proper regulatory environment for protecting investors in the capital markets.

Eventually, stock market operations became familiar to the town planning community in Sri Lanka. Furthermore, the significance of the daily performance of share prices and of the All Share Price Index (ASPI) became useful monitors for the planners to gauge the demand and supply for investment in built-up space in urban areas. By this time the UDA had begun several joint ventures in listed companies. In addition, it had also entered the debt market with the issue of secured debentures for select projects.

The settled environment in the operation of the share market in Sri Lanka therefore lulled investors, including the town planning community, into a false sense of security and they returned to business as usual. The bubble however burst with the shocking collapse of several corporate giants in the USA. The revelations of what occurred at Enron, World Com, etc., became traumatic when the downfall of these leaders of Corporate America was associated with its accountants and auditors.
The accountants and auditors involved in the scandal comprised famous names like Arthur Anderson, KPMG, and frontline brokerage houses such as Goldman Sachs, Morgan Stanley, and Saloman Smith Barney. Most recently the US SEC has decided to investigate the role of the credit-rating firms for possible anti-competitive practices in a field dominated by three big players, Moody's Investors Service, Standard & Poor, and Fitch Ratings.

Their grading of a company's creditworthiness influenced investor confidence in such companies listed in the stock exchange. Consequently, the US SEC is also looking into possible conflicts of interest stemming from the fact that rating agencies are paid by listed companies whose debt securities they evaluate. The investigation arose from the Enron failure. The three big players had maintained high ratings for Enron even as its stock price plummeted in late 2001.

Against such a backdrop what triggered my interest was the action taken in the US to restore investor confidence in its traumatised share market. The action that created the biggest impression was the enactment of the bi-partisan supported Investor Protection Law, also known as the Sarbanes - Oxley Statute of 2002, named after its sponsors. When I returned to Sri Lanka, I was amazed to find that our own SEC was embroiled in a miniature version of the WorldCom-type saga. The recent determination by the Attorney - General to frame charges of insider - trading against the SEC Chairman and another leading figure of Corporate Sri Lanka resurrected fears of a loss of investor confidence in our share market. In such a context, I was able to conceive the parallels of the incidents in the USA and in Sri Lanka as shown in the accompanying chart.

The striking similarities in the processes of the SEC crises between the two nations suggest that the emergent situation in Corporate Sri Lanka needs to be steadied before it snowballs to a point where investors lose confidence in the market. This is critical if the country is to move ahead to a share owning democracy where investors find that fixed deposits or Treasury Bills are not as attractive investments as dividends and capital gains earned from a transparent share market. It is particularly relevant, if as recently reported private sector pension funds are to be set up where prospective applicants will have the discretion of investing in a fund of their choice which will give them the maximum yield. The issue of investor confidence becomes pivotal in avoiding what happened to the retirement funds of Enron employees in the USA.

In the above context, it is pertinent to quote from a recently published newspaper article : "Our local corporate scene has still to see anything like the exposure of the scandals in the USA. It is not that all's well with our corporate sector. Far from it. It's just that the network of friends among the CEOs, directors and auditors are very powerful. They all come from a small class of men who have gone to the same schools and hobnob at the same clubs. The poor investors and depositors in banks are left high and dry when the crunch comes as seen in the unfolding Pramuka Bank drama.”

The situation has been compounded by the reported details of the alleged conflicts of interest of some SEC Commissioners in relation to the current crisis, as reported in The Sunday Times FT.

In these circumstances, the challenge is not to fear the worst but to face it. Consequently, it will be alright to air corporate dirty linen in public, even if it means losing face, if the business community wants to clean up its standards and practices. Professionalism alone cannot be expected to bring about this change. Moral values are essential whether it is capitalism, socialism, or any other `ism'. Society needs to ensure and safeguard the same by the protective net of an Investor Protection Law to deter those who are so greedy that they have no qualms about robbing other people's money.

The recently reported allegation by the former Chairman of the Ceylon Chamber of Commerce that our business community was corrupt, unethical, and not transparent, adds fuel to the fire. It therefore becomes incumbent on the government to bolster confidence, as recently stated by the Minister of Finance. Sri Lankans would like to see all-party agreement on this issue, as was manifest when the SEC Amendment Act was unanimously passed by Parliament on 28 January 2003.

As the nation progresses towards increased private sector-led economic transformation in a very liberal business environment, it is important citizen participation through share trading can be done in a fair and orderly manner.

The opinion expressed by the Minister of Finance in Parliament when it was debating the SEC Amendment Bill, that "this transformation has highlighted the need for further amendments to the SEC Act to facilitate market development in a properly regulated environment", is a step in the right direction. It is however uncertain whether the Amendment Act alone will suffice to promote investor confidence, as the Minister has also conceded that excessive regulation is unproductive.

The shock waves of the present SEC crisis has already inspired a group of concerned citizens to initiate the formation of an Association styled as CITIRIGHTS under the Companies Act, with several allied objects, including the following:

  1. To protect shareholders in public and private companies.
  2. To undertake litigation in the interest of the shareholder.
  3. To provide legal aid to shareholders.
  4. To encourage, support, create an awareness and stimulate the dissemination of knowledge relevant to stock market activities.
  5. To encourage the study, research and investigation of stock market activities, and to promote by lawful means the creation and growth of a vibrant share owning society.
  6. To make representations at forums, meetings and to relevant authorities with regard to matters concerning any problems faced by stock market investors and make investors aware of their rights and duties as shareholders of companies.
    This type of initiative by the investor community will hopefully deter greed and exploitation in the share market.

It will also convey to the accounting industry and its professional institutes that oversight bodies are growing in the formal and informal sectors to inspire confidence in investors that their investments are safer than before.

Yet, we need to acknowledge that in the real world of business, bad apples do surface from time to time in any profession. The time may therefore be opportune for all political parties represented in Parliament to unite in the passage of an Investor Protection Law with powers to require the SEC to establish an Accounting Oversight Panel which would obligate public companies to make available the right disclosures and also to monitor same in enabling investors to take informed decisions. The punitive punishments for violations will however represent only one side of the coin. It is most likely that investors will not have much faith in long drawn processes of litigation.

In all probability neither will the offenders be much concerned as can be seen from the following quote in a recently published article on what a US prisoner named Alfred Porro, a corporate lawyer, recalled of his painful downfall: "for those who manage to hold on to their money, prison can just be a place to mark time. A guy who has ripped off millions of dollars isn't worried about going to jail.

They have millions of dollars put aside. They are on vacation." Hence, it is pertinent to note that a recent publication on `Codes of Conduct for CFOs and others' states that the Investor Protection Law in the USA requires relevant companies to disclose whether or not they have adopted a code of ethics for their principal accounting officer, and if not, why not. The rationale for the latter being that 'rebalancing the various elements of corporate governance is only part of the solution, and that attitudes and behaviour have to change as well, not just at the top of an organisation, but throughout'. The central aim of the latter being to change the corporate culture and values for the better.

Fortunately, the Institute of Chartered Accountants of Sri Lanka, the premier national professional accountancy body in the country, has itself launched a competition for the award of the Best Corporate Governance disclosures for companies listed in the Colombo Stock Exchange with the aim of helping to build investor confidence at a time when post-Enron concerns still continue to linger.

Meanwhile, the lessons of the current breakdown in public confidence needs to go beyond the accounting and auditing profession to others, including town planners. The latter in particular could be equally vulnerable as its members promote development which eventually becomes linked to the axis of Investment - CSE - SEC. Hence all professions in this axis need to contribute collectively to good governance, whether in the public or private sector. Each of its professional institutes must therefore scrutinise its own governance.

The public trust in them was placed in their respective Acts of Incorporation. In the bigger picture, the private sector which has been termed as the `engine of growth', needs a paradigm shift in building investor confidence. Public sector reforms as envisaged in Regaining Sri Lanka must necessarily accompany it with equal seriousness.

At stake is the social, economic, and political stability of the country. It may have been the reason which prompted a leading US Senator, Trent Lott, to state as follows, at the time Harvey Pitt resigned under pressure as Chairman of the US SEC:

"The SEC Chairman must be someone that has the confidence of the American people, the markets and both sides philosophically and politically". In these circumstances, when there is now an opportunity arising from our current SEC crisis, where all stakeholders seem united in building investor confidence, it is appropriate to introduce an Investor Protection Law. This is as important for the economy as the peace process is for political stability.
Parallels in SEC crises in the US and Sri Lanka

  • Harvey Pitt, SEC Chairman, resigned under pressure in November 2002 on ethical grounds after allegations that he was 'soft' on the accounting industry.
  • Michael Mack, SEC Chairman, resigned under pressure in January 2003 due to alleged charges of insider trading.
  • US media alleges that the SEC was sweeping its problems under the carpet.
  • Sri Lanka media alleges that the SEC was sweeping its problems under the carpet.
  • Arthur Anderson, auditors of Enron, faulted for not reporting the true health of Enron Corp. Also, accounting firm KPMG sued by SEC for alleged securities fraud. *Sri Lanka Accounting and Auditing Standards Monitoring Board launches investigation into whether KPMG Ford Rhodes Thornton, auditors of Pramuka Bank, had carried out the audit according to Sri Lanka Accounting Standards.
  • Alleged pressure from the accounting industry on Harvey Pitt, SEC Chairman, wherein he was unable to tell the SEC that his nominee to the Accounting Oversight Panel had chaired an audit committee of a company embroiled in an accounting scandal. *Alleged conflict of interest of the President, Institute of Chartered Accountants of Sri Lanka, being a Commissioner of the SEC, due to his reported reaction to a recent SLAASMB announcement that some audit firms had not complied with accounting standards, by stating that the auditors should be exonerated from any negligence as compliance depended on materiality.
  • According to the SEC Corporate Finance Division, the review by the SEC of the financial statements of a substantial majority of the Fortune 500 companies, have raised questions. Furthermore, in the second quarter 2002, 48 of them practised reporting rules that departed from nationally recognized standards.
    The SEC has reviewed 100 annual reports and accounts of listed companies, and found that 50 companies had not complied with the relevant rules and regulations.

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