Unethical practices and disregard for rules at the top percolate throughout. The mistrust of stockbrokers and the capital market today is more a leadership crisis than anything else
Soon middle class Sri Lankan savers will be seeking out better options. For decades investment options were limited to illiquid asset classes like real estate, or capital eroding bank deposits, where returns have lagged inflation.
Faster economic growth and improved fundamentals in the last few years have expanded investment options for middle class households. Investment products like life insurance, pension funds, collective investments like mutual funds and listed company stock are in the reckoning for their savings.
These savers are neither speculators nor sophisticated risk takers. Now that the stock market funk is past and asset prices are rising they are keen to diversify their investment portfolios. As a return they seek more than pitiful bank savings rates but are spooked about handing savings to scandal-tainted stockbrokers who were responsible for ill advising thousands of people who lost some or all their savings.
Investors who blame stockbrokers for the scandal aren’t far off the mark. However it’s not rule bending rogue brokers that caused the scandal but a stockbroker leadership that encouraged unethical and illegal behavior and a regulator that was hamstrung to respond.
Investors are skeptical the capital market is a safe place for their retirement savings. To win back their trust both investment professionals and the capital market regulator have to up their game.
Vanity and terror prevented the stock market regulator, the SEC, from responding to the widespread stock price manipulation crisis during 2010 to 2012. Vanity because it didn’t want exposed its toothless inability to respond and terror because it understood how well connected those who were manipulating stock prices were.
The job of a watchdog is often a thankless one, made worse for the SEC being embarrassingly hamstrung to prosecute wrongdoers. No thief fears the growling of a watchdog she knows is toothless. SEC can only file action against suspect wrongdoers in criminal courts where guilt must be proved beyond a doubt, a somewhat difficult undertaking in securities fraud cases (like insider trading, front running and other types of stock price manipulation) because evidence may appear circumstantial and complex.
Anxieties about its toothlessness have sapped the regulator’s confidence for years. This weakness was understood by the politically connected set that bent the stock market to their will.
Proposed amendments to the SEC act will give the regulator the ability to prosecute wrongdoers in civil and administrative jurisdictions where outcomes are faster and penalties severe. Until these long drawn SEC law updates enhancing the agency’s capability to prosecute are passed, the agency’s toothless snarls won’t frighten seasoned crooks.
Average Sri Lankans see the stock market as an opaque place: the exclusive preserve of the elite and well connected corporate villains. Following organized price manipulation many investors left the market. In 2012 around 117,700 investors traded at least once in the Colombo Stock Exchange. In 2014 it nearly halved to 59,500. Number of active trading accounts isn’t an indication of a stock exchange’s success or
failure, but their halving in a year points to trust and credibility challenges.
SEC act amendments will give the watchdog some dentures to bite as hard as its bark. A regulatory setup capable of protecting investors will win back the confidence of some potential investors. It will also force stockbrokers to behave ethically.
Stockbrokers themselves precipitated the market crisis during 2010 to 2012, by their unethical behaviour, disregard for the rules and failure to put client interest ahead of their own. When unethical behaviour and disregard for rules persists at the top, it percolates throughout the industry.
Stockbrokers now also have to win back the confidence of ordinary investors by demonstrating that the market is not rigged against them. It’s a naive capitalist who will believe a stockbroker is a friend. Brokers move products based on volume and commission, and they will sell to an investor whatever can be sold. After all, stockbrokers allowed their clients to invest in a super ripe market in 2012 where the price to earnings ratio was touching 30 times; a bubble that could pop anytime. By failing to advice clients to run for the door, brokers showed they were either utterly foolish or were exploiting the ignorance and blind trust their clients placed. It was probably a combination of the two, and neither bodes well for those investing their savings in Sri Lankan stocks. Brokers, most of whom took no responsibility for the carnage that followed, are now keen to attract investors to the market.
Investment managers in Sri Lanka are a fragmented bunch. They either serve rich clients, who have an appreciation of risk and asset diversification, or retail investors like pensioners, who have little appreciation of the outsized risks of piling savings in to one risky asset class. In the heady years after the war ended, nobody bothered much about outsized risk taking or diversifying portfolios, because all were making money.
The attractions of the middle class are obvious in a country with an ageing population and a government keen to boost the savings rate. The next decade will be a period of unprecedented savings growth as the Sri Lankan economy rises up the middle-income league table. Attracting most of these as growth capital to companies will propel the private sector and for savers generate the kind of returns necessary for a comfortable retirement. A credible stock market is important not just for savers but also for the private sector.
Stockbrokers’ unethical behaviour and acting against their clients’ best interest eroded their credibility. Many brokers encouraged unsophisticated clients to invest borrowed money in the market, using those very shares as collateral running extraordinary risks. Stockbrokers were also keener about clients allowing the brokerage trade on their behalf. Those allowing the brokerage discretion to their account only found out about trades days after the transaction. None of these actions were illegal but brokerages created the conditions to exploit gullible clients to rig the market and manipulated share prices.
That stockbrokers damaged the market’s credibility as a place for long-term investment in the three years to 2012, is a foregone conclusion. They ratified the stockbroker stereotype of greed and arrogant disregard for people whose interest they pretended to represent. Its leadership ignored the few sane voices and allowed charges to run amok defying client interests, the law and ethical practice. In the short term it paid rich dividends for brokerages. Industry profits topped Rs2.6 billion in 2010 and Rs1.8 billion in 2011.
Gorging clients caught up with stockbrokers in 2012 when they lost Rs299 million collectively and Rs711 million in 2013. The Colombo Stock Brokers Association (CSBA), which represents most brokerages, adopted a code of best practice to help members confused about whose interest they should be serving. The code ‘Principles of best practice for stock broking industry’ objective is to ‘strengthen the ethical behaviour and professional conduct’ of stockbrokers. It highlights the need to comply with the law, put client interest ahead of any other, and encourages whistle blowing.
However voluntary codes are of little use when leadership is lacking. Greedy stockbrokers and a powerful band of thieves, who somehow suspended market regulation, are still at large.
The same greedy crowd still head the stockbroking industry, which found itself short of leadership in the dark days. For all their alleged crimes none were convicted; at least not yet. It’s now difficult to restore the professionalism and business ethics, which deteriorated during the dark days because the crooks are still at large.
Already the ethics code is practiced in the breach according to an industry professional. The code requires brokers moving to a competitor obtain a clearance certificate from their previous employer certifying there are no client complaints pending settlement, no guilt proven in a disciplinary hearing and there are no unsettled debtors in dispute. Following the ethics code in the breach smacks of the same attitude that allowed brokers to swindle their clients in the past.
The stock markets’ diminished position as a place for companies to raise long-term capital is a tragedy for the private sector and economic growth. Ordinary Sri Lankans are also denied fair market to confidently invest their savings. The worst abuses during the bubble years may not be repeated, but that’s little consolation for those in the private sector, capital market and the economy.