Stock exchange demutualisation simply means converting a membership-based nonprofit exchange into a share-holder-based for-profit exchange. In a membership-based exchange, only members enjoy the privilege of trading right while in a demutualised exchange ownership is separated from trading right for improved and more transparent governance. In other words, a share holder may or may not have trading right while a person without any share may have trading right entitlement. By separating ownership, trading right and management, a demutualised exchange aims at improved governance structure, providing more efficient regulatory framework and reducing conflict of interest. It facilitates collaboration with strategic shareholders who have technical knowledge, skills and exposure to global experience. It can also provide flexibility, improved financing and access to global market. It may lead to greater investors' participation in governance and transparency.
However, converting a nonprofit organisation into a for-profit organisation may have some negative aspects as well. A demutualised exchange will be obliged to operate with profit motive. Earning profit becomes important to shareholders because they will expect dividend from the earnings of the exchange. This may create conflict of interest between drive for earning revenue and maintenance of required standard of quality. For example, this conflict may have an effect on compromising with the quality of listing criteria to accommodate more companies for listing. After all, listing more companies would mean more revenue. If that happens, investors will be the ultimate victim for listing of sub-standard companies. In view of profit motive of the exchanges, such conflict of interest may take place pertaining to regulating trading activities, identification of suspicious activities and taking appropriate action against misconduct. Thus, conflict of interest may take place between regulatory responsibility and business interest. Some people take an extreme view that, in the context of a developing economy, no change of existing conflict of interest takes place just by conversion. With similar board and organisational structure existing, nothing much is achieved. They also feel that, without real good intention of the share holders, demutualisation in itself cannot achieve improved governance.
In the long run, the advantages probably outweigh demerits. Demutualisation is a popular global trend. Starting only in 1993 with Stockholm exchange, demutualisation spread very quickly and most of the major exchanges are now demutualised. India demutualised its exchanges few years back while Pakistan did the same last year by an act of parliament. For quite some time, Bangladesh had been considering demutualisation. However, after the recent stock market crash, the issue came to the forefront. The Government took the initiative and the parliament enacted the law last month. Unlike in other developing countries, Bangladesh stock exchanges cooperated with the law making process and the issue was resolved in an environment of mutual understanding and consultative process.
With the Exchange Demutualisation Act, 2013 in place, the implementation process of demutualisation is now set to begin. Perhaps, some rules need to be framed under the act for necessary clarification and smooth execution. That should not be a problem. After going through the act, it seems that willing cooperation of the exchanges was not entirely an act of generosity of the exchange authorities. The law has taken adequate care of the interest of the exchange members in all the areas including exclusive initial ownership of demutualised exchanges to the existing members, automatic and free trading right entitlements (TRE) to the existing members only in the formative stage and the right to sell TRE within next five years. It seems that in the initial years, existing members remain sole owners and also sole trading right holders just as it was before demutualisation. Furthermore, the members - now turned share holders - will also be entitled to dividends. It seems that the existing members got a good deal in the bargaining process and that may partly explain lack of any serious resistance.
The law has taken care that full demutualisation process takes place over a period of time which is rational for a smooth conversion. It has been provided that existing owners of the exchanges will be hundred per cent initial share holders of the exchanges on the day of demutualisation. Each initial share holder will be given one trading right entitlement certificate (TREC). Trading right certificate holders and persons connected with them will not hold more than 40 per cent of issued shares. Rest of 60 per cent shares will be temporarily held by the initial share holders in blocked accounts. Initial share holders will be entitled to dividends, bonus shares and right shares from blocked shares but sale proceeds will have to be retained in blocked accounts. Maximum 25 per cent of shares held in blocked account will have to be sold to strategic investors. Balance of 35 per cent shares will be sold to institutional investors and general public. Similar provision was made in Pakistani law except that up to 40 per cent blocked account shares could be allotted to strategic investors in place of 25 per cent in Bangladesh. However, in some jurisdictions, some shares were allotted to government and capital market development fund.
A liberal timeframe has been allowed for sale of blocked account shares. Within three years of demutualisation, the Commission will ask the exchanges to enter into agreements with strategic investors within a year and also to send proposals for sale of other blocked shares to institutional investors and general public within the same timeframe. This means that an exchange may get up to four years for sale of blocked account shares depending on when the BSEC (Bangladesh Securities and Exchange Commission) issues the directive. Furthermore, the Commission is competent to extend time further on reasonable ground and there is no time limit for such extension. This kind of liberal and loose timeframe may put at risk the whole process and prolong uncertainties of the conversion.
Basic purpose of demutualisation is separation of trading right from ownership. Under the current arrangement, this is not happening any time soon. On the day of demutualisation, current members are retaining the trading right free of cost. Within five years of demutualisation, an exchange may increase number of TREC by special resolution in the share holders' meeting. After five years, TREC may be issued to an applicant in the prescribed procedure. This seems to mean that, if the existing members so desire, they may continue to remain the only broker house owners for another five years. If this is the intention of the legislation, what benefit such demutualisation may bring remains a question. By contrast, Pakistan law provides that an exchange shall offer for issuance of fifteen TRE certificates each year in a manner prescribed by the commission up to 2019. After 2019, there will be no restriction. This appears to be an improved provision because this will gradually dilute the influence of current members and bring new broker houses in phases paving the way for a smooth conversion.
Another important factor of public interest is listing requirement of the exchanges. Our law has provided that an exchange is entitled to be listed according to prescribed procedure. But decision for listing and its time will be taken by the exchange itself. In my understanding, this means that listing has not been made compulsory and the matter has been left entirely to the discretion of the exchanges. In Pakistan, SEC will have a role on the decision pertaining to listing. Their law provides that exchanges will be listed within such time as the commission prescribes in consultation with board of directors of the exchange. This appears to be mote reasonable as the issue has not been left entirely to the exchanges.
Constitution of the board of directors - and its credibility - during the interim period is probably the most vital issue for successful transformation of the exchanges. It is possible that the current members may remain the only share holders and also owners of broker houses for the next four to five years unless BSEC takes a very active role in early sale of the blocked account shares which may not seem likely. It has been provided that the exchanges will submit a list of proposed directors of the first board to the commission. It is also mandatory that the majority of the directors in the board, including its chairman, will be independent directors. In an ideal situation, this seems to be a sensible proposition. But there is a room for apprehension because these directors, including independent directors, will be elected by the share holders. From our experience of the performance of independent directors in many listed companies and general ethical standard of our social and business culture, it is difficult to be convinced about the credibility of the proposed board. It will indeed be a satisfying experience if the proposed independent directors have the strength and capability to act independently to the best interest of the exchanges and large number of investors who do not have any voice in the board. This will largely depend on the honest intention of the share holders. On the other hand, it is possible that the share holders will nominate persons of their choice who can effectively look after the interest of the share holders.
Again we can revert back to the provision in Pakistan since this is the most recent experience in our neighbourhood. In the first board of their exchange, there will be ten directors. Stock exchange will nominate four of them while another six persons will be nominated by the commission. Chairman will be from one of the persons nominated by the commission. The commission nominees will continue to hold office until they are replaced on a directive of the commission to allow co-option of nominees of the strategic investors, financial institutions or representation of general public. Chairman of the board will not represent TRE certificate holders or their connected persons. It seems to me that the board composition in Pakistan is better for more impartial implementation of the demutualisation process until all the blocked shares are sold out. On the other hand, Bangladesh board may be less impartial during the critical transition period but it may be more independent after all blocked shares are sold out because the majority of the members in the board will be independent directors. It may be relevant here to point out that in Bombay stock exchange, apart from a non-executive chairman and CEO, there are three share holder directors and three public interest directors who are persons of eminence.
With the enactment of law, demutualisation process is about to begin. This is a very challenging task. This article is only a preliminary reaction. Number of rules and regulations will be required as the process continues and unforeseen problems unfold themselves. Let us hope that under the leadership of BSEC, exchange authorities and other stake holders will put their selfish interest aside and do their best for successful and meaningful implementation of demutualisation in the shortest possible time. Only that will set at rest doubts and apprehensions raised in this article. If that does not happen and share holders of the exchanges act to perpetuate their selfish interest, the reform may not mean much
