Financial Market Regulation
Index crash of 1996: A case of regulatory failure
Barrister Tureen Afroz
Bangladesh securities market experienced the worst turmoil in 1996. In my previous article published in the DS, I have stated that until mid 1996 Bangladesh securities market failed to attract investors, both local and international. However, between July and mid-November 1996, both Dhaka and Chittagong Stock Exchanges experienced an unprecedented bullish run. During this period, market capitalization went up by 265% and the average daily turnover increased by over 1000%. There were about 192 securities listed with both the stock exchanges at that time. According to the official record, price index at Dhaka Stock Exchange increased by 281% and at Chittagong Stock Exchange increased by 258%. Then the bubble burst: share prices of both the stock exchanges dropped by 25% from their peak in mid-November. It was reported that outside in the 'kerb (informal) market' the prices went down further.
The regulatory move to control the situation was very slow. The regulatory authority took time to realize the possible impact of index crash on the entire economy. The Bangladesh Securities and Exchange Commission (SEC) declared that the market would be viewed as 'normal' till the index remained above the 1500 points. The government carried on a massive media campaign striking out any possibility of crash and further promised recovery measures only if the index dropped below 1500. The Finance Minister even made public statement to the effect that 'It's not at all a crashing situation. The market has become over heated and now it is stabilizing through correction.'
It was only in late December 1996 that the SEC constituted an Enquiry Committee to investigate into the irregularities of stock market activities during July 1996 to November 1996. In March 1997, the Enquiry Committee prepared a lengthy report identifying a number of companies being in breach of specific provisions of securities market regulation and commented that such companies were guilty of fraudulent acts in relation to securities trading. The Enquiry Committee also identified some of the country's biggest brokers who were apparently involved in market manipulation. Based upon the Enquiry Committee Report, the SEC obtained warrants of arrest against 32 people in 7 brokerage firms and 8 listed companies. The SEC also filed 15 share-scam cases in the High Court Division of the Supreme Court of Bangladesh.
A case of regulatory failure
I argue that the 1996 index crash was caused by the failure of a number of regulatory institutions. However, it is unfortunate that the Enquiry Committee Report failed to address the regulatory aspects in a comprehensive way. The said Report served two purposes: (a) it identified some of the market manipulators involved in many fraudulent activities during the period in question; and (b) it brought into light the irregularities involved in the day-to-day operation of the stock exchanges. The Report, however, completely ignored the role that should have been played by the SEC as a regulatory body to handle the crisis.
Regulatory failure by the stock exchanges
During June-November, 1996 the two stock exchanges were aware of many irregularities and mal-practices that took place at the exchanges. However, the exchanges remained indifferent towards regulating (and/or banning) such activities. According to the records, the exchanges, even though were experiencing sharp increase of prices in most of their listed shares, they did not take any action to investigate or control the situation.
Further the trading procedure at both the stock exchanges was susceptible to fraudulent misuse by vested quarter. The Delivery Versus Payment System (DVP) of trading method at the stock exchanges allowed the buyers/seller of the share to settle the transactions directly between them and without involving the stock exchanges. This system was misused by many brokers/dealers to show artificial trading so that the investors would be induced to buy and demand more shares. Also, the usual practice of T+4 settlement procedure was not followed at the Dhaka Stock Exchange. Forward deals, though forbidden under law, took place in the exchanges at very high prices.
Also, the management system of the Dhaka Stock Exchange was not appropriate; there was no clear demarcation between management and operation and as such, conflict of interest was bound to grow. In addition, such concentration of control in the same group of people actually discouraged to take strict actions against members of the stock exchanges engaged in unethical practices. It was also observed that the stock exchanges did not have internal auditing system for their day-to-day operation.
Regulatory failure by the SEC
It is true that in 1996, securities market of Bangladesh had only a few years of experience in active trading. Therefore, the SEC, as the central regulator of the securities market, should have been more careful in performing its duty as a market watchdog. However, over the period June November 1996 the SEC was rather in conscious disregard of market movements. For example, there emerged an unauthorised and unregulated kerb market right outside the Dhaka Stock Exchange and securities were traded at exceptional high prices in the kerb market affecting the overall price movement. However, the SEC failed to take necessary steps to control such activities and thereby the SEC failed miserably to watch and guard the interest of the market.
The SEC also failed to carry on necessary inspection to monitor the activities of market intermediaries. Irregularities at the stock exchanges or by the brokers/dealers could have been guarded in proper time had the SEC become a bit more vigilant in protecting the interest of the market. Also, the SEC needed to be more alert to the cases of insider trading and market manipulation, which ultimately results in loosing of market confidence.
Finally, it is the duty of the securities market regulators to be alert and prepared for any crash situation. However, in 1996, the regulatory response to merely identify a crash was far behind the time. A more regulatory effort to carry on market surveillance could enable the SEC to make a timely response to the crash.
Further it is essential for regulators to make it apparent to the market that they have a power to control the market, as and when necessary. Enforcement mechanism, exercised by the regulators, encourages the market to move towards proper direction. By adhering to strict enforcement mechanisms against market culprits, the regulators can always discourage such happening in future. However, it is argued that during June-November 1996, the SEC unfortunately failed to enforce securities market regulations against the market malpractices.
It became apparent that from June-November 1996, the stock exchanges were not self-regulating themselves well and market intermediaries were in breach of a number of legal provisions; there was wide range of insider trading taking place to manipulate the market price of the shares. There were even serious allegations regarding the registered chartered accountants certifying false financial statements along with the valuation of assets and property. Many of these activities could amount to fraud and would clearly violate specific provisions of the already existing securities market laws of the country.
However, the SEC, even though entrusted with wide regulatory power, failed to take strict action against such market misbehaviour/malpractices. For example, the SEC failed to prosecute under Order 17 and/or to impose penalty under Order 24 of the Securities and Exchange Ordinance 1969 against 'insider trading' committed by director or sponsor of the issuers. Similarly, the SEC even though observed that during 1996 a number of companies management were making public disclosure of false information, it failed to take any timely action against those companies. Also, the market manipulation activities of the brokers/dealers clearly fell under the fraudulent activities as stated in Ordinance 17 of the Securities and Exchange Ordinance of 1969 and therefore, would attract the penalty provision under Ordinance 24. Nevertheless, the SEC failed to take any reasonable regulatory measure to control such activities.
It is stated that a regulator should be a thoughtful observer to the market and not a reluctant bystander. From the ongoing discussion it is clear that both the SEC and the stock exchanges were inactive to apply any enforcement mechanism against fraudulent activities and malpractices in 1996. It is stated that such failure of the SEC and the stock exchanges to actively enforce their regulatory power has made the market vulnerable to manipulation and finally to crash. Alternatively, it is strongly argued that in 1996 neither the SEC, nor the stock exchanges had the required 'regulatory capacity' to regulate the securities market and as such, the unregulated market had valid reasons to crash.
The author is an Assistant Professor of Law at BRAC University School of Law.