Benefits of institutional investors entering the Sri Lankan capital market

It was reported in the news today that the Colombo stock index ended at 6,292.94 on 7 April, its highest close since 14 December 2016. The index has climbed 5.32% in the last nine sessions through Friday. The key reason being  Foreign, institutional, and high-net worth investors are buying shares. Institutional investors specially foreign funds buying at the expense of retailers has many benefits and hope these investors will drive the governance agenda in the local companies, too.

Hope our local Boards will be challenged by the impact of changing pressures and dynamics that boards in the developed world face. These Institutional investors should continue their push for more uniform standards of corporate governance in Sri Lanka.

They should hopefully keep the local listed companies in check, in relation to:

* Company plans for sustained long term value creation,
* Avoiding short-term priorities that compromise long-term interests,
* Strengthening the process for Directors and CEO remuneration, so that it may not be an irresponsible action,
* Having appropriate key performance indicators to measure board and CEO performance,
* Improving focus on board composition and diversity,
* Setting up effective sub committees of the board,
* Paying attention to significant changes being introduced by new accounting standards,
* Ensuring related party transactions are on arms length basis.

If the institutional investors get adequate representation on the boards of local listed companies, some benefits will accrue not only to the company and its shareholders but also confidence in the capital market will grow. We would like to see these institutional investors pressuring boards to demonstrate that they are actively involved in guiding a company’s strategy for long-term value creation. They should also replace non performing board members with skilled members, rather than leave the existing old boys club to continue their marriage vow of ‘until death do us part’.

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Board Diversity and Shareholder Value

One of the important governance issues facing shareholders, regulators and interest groups seems to be the gender composition of board of directors. But yet, a key driver for good corporate governance should be a positive relationship between board diversity and shareholder value creation. Should this be legislative or voluntary is another point of contention.

In India, the 2013 Companies Act introduced a mandatory minimum of at least one female director for most listed companies which has increased India’s gender diversity at the board level to one of the highest rates in Asia, with 14% of all directorships held by women. Gender diversity remains a challenge for Japanese boards, with only 3% of directorships held by women. Many countries in Europe continue to encourage gender diversity at the board level, as national laws regulating the number of female directors proliferate on the back of an EU directive. On average, 21.2 % of board members of the largest publicly listed companies in the EU were women, in 2015, and only 19.2% of corporate directors in the Fortune 500 were women.

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Board diversity took shape as the right thing to do and to create equal opportunity for women who make up half the population, at the highest level. However, there is research to indicate that diversity actually enhances shareholder value. Therefore, board diversity must be considered in the context of shareholder value as opposed to making a token appointment to look good. There is however a possibility that a portion of the women appointed may come from the controlling families of the company.

One such study which examines the relationship between board diversity and firm value for Fortune 1000 firms was published in 2003 titled- “Corporate Governance, Board Diversity, and Firm Value” by David A. Carter∗ Betty J. Simkins W. Gary Simpson, Oklahoma State University, D.A.Carter et al./The Financial Review 38 (2003) 33–53. This research was important because it presented the first empirical evidence examining whether board diversity is associated with improved financial value. After controlling for size, industry, and other corporate governance measures, they found a significant positive relationship between the fraction of women or minorities on the board and firm value.

For Sri Lanka to improve diversity ratio on boards, it’s not going to be voluntary. The only option for effecting change is to take a top-down approach that will force organizations to change from the top to create a work environment that will allow female executives to thrive and add value. The number of qualified professional women has been growing in Sri Lanka. They can add value, but corporate Sri Lanka needs a strong push, so that it can take the first steps toward a legislated change.

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“You needed me” love song for your Auditor.

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Independent auditors have been under fire from regulators and the public for over 15 years due to several global scandals and collapse of corporates. This is a very important profession to protect the interests of the shareholders and one that supports the growth of the capital markets, unhindered. So, had to find a love song for my 2017 Valentine’s Day message that could motivate auditors and reflect the way they would like to be appreciated when they try to help directors to do the right thing but don’t get appreciate for their efforts.

The song “You needed me” by Anne Murray is this year’s winner! The lyrics below would be a lovely message to hear from a member of the client board of directors who has benefited from an auditor performing his duty in compliance with the rules.

“I cried a tear, you wiped it dry ….(for some wrong doing)
I was confused, you cleared my mind….(did some wrong recording)
I sold my soul, you bought it back for me…(on fraudulent reporting)
And held me up and gave me dignity…(by rectifying the errors)
Somehow I needed you (changed from you needed me)

You gave me strength to stand alone again….(because of the audit)
To face the world out on my own again
You put me high upon a pedestal
So high that I could almost see eternity…”

If directors truthfully admit the assistance provided by auditors who ensure compliance with regulations and standards by companies, they should say that it gave them dignity and they were put on a pedestal rather than in the dog house by regulators. Though many don’t want to acknowledge this fact, when financial statements have been audited by an external auditor they are considered more reliable by investors, lenders, regulators and the public than those that have not. An audit also provides some assurance that your financial statements are free of material error and that you have not committed fraud or misreported facts while compiling the statements. With properly audited financial statements you can face the world confidently on your own, as you have nothing to hide.

When you hear Anne Murray sing this song, think of your auditor, next time!

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Become civilized with GSP (Generalised Scheme of Preferences)

In its report of 9 December 2010, the Committee on Economic, Social and Cultural Rights (CESCR) had observed serious failures to implement the International Covenants on Economic, Social and Cultural Rights, which resulted in the withdrawal of benefits arising from additional tariff preferences for SriLanka to trade with the EU.

There are three main variants (arrangements) of the GSP Scheme:
* the standard/general GSP arrangement, which offers generous tariff reductions to developing countries. Practically, this means partial or entire removal of tariffs on two thirds of all product categories.
* the “GSP+” enhanced preferences mean full removal of tariffs on essentially the same product categories as those covered by the general arrangement. These are granted to countries which ratify and implement core international conventions relating to human and labour rights, environment and good governance;
* ” Everything but Arms (EBA) arrangement for least developed countries (LDCs), which grants duty-free quota-free access to all products, except for arms and ammunitions.

Applying for GSP+ and implementing these covenants has a twofold impact on SriLanka. First is that GSP+ supports developing countries to assume the special burdens and responsibilities resulting from the ratification of 27 core international conventions on human and labour rights, environmental protection and good governance, as well as from their effective implementation and therefore drives better governance and protection for our people. The other impact is for businesses where the special tariff preferences will increase trade with the EU and bring economic prosperity to our people. Only shortsighted people would like to think that there’s no benefit accruing to a developing country like ours with an awful track record on human and labour rights, environment protection and good governance.
Because of the monitoring process for compliance with the core conventions more indirect benefits will accrue to our people, due to-
* Sri Lanka having to strengthen the national institutions for tackling human rights, labour rights, environmental protection and good governance;
* Further action required to effectively implement the international conventions covered by the GSP+ arrangement;
* Building capacity and technical expertise to improve reporting to international monitoring bodies, including various UN agencies, such as the ILO.

Some benefits that are listed in the Report on assessment of the application for GSP+ by Sri Lanka prepared by the EC staff, are already having some impact on governance, for example:

* The 19th Constitutional amendment which reinstated the Constitutional Council as a guarantee of the independent appointments to key institutions, such as the Human Rights Commission, the Attorney-General, the Inspector General of the Police etc.
* Initiating a Constitutional reform process which should offer the opportunity to address structural deficiencies that contributed to human rights violations.
* The government has started a legislative process to replace the Prevention of Terrorism Act and is making good progress in releasing persons detained under it.
* The President and the Commanders of the armed forces have issued instructions to security personel to ensure that the fundamental rights of persons arrested or detained are respected and that such persons are treated humanely, as well as that strict actions will be taken against human rights violations.
* Several legislative processes are underway to improve the rights of women and children, for example, with regard to discrimination, domestic violence, the minimum age of marriage, marital rape, sexual exploitation and hazardous work.
* In September 2015 Sri Lanka decided to co-sponsor the UN Human Rights Council Resolution 30/1 on “Promoting reconciliation, accountability and human rights in Sri Lanka” and is taking steps to implement it.

The monitoring process under the GSP+ will definitely ensure that our government and its agencies pay due respect to good Governance, Rule of Law and Human Rights, to improve the lives of all Sri Lankans. Therefore, GSP+ will result in SriLanka losing its title as a ‘banana republic’ and joining the civilized world!

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Governance framework for ‘Insuretech’ to succeed in Sri Lanka

IMG_1658.JPGThe word “Fintech” has got on the vocabulary of every manager in financial services sector, even though most of them are just copying some software patches to improve efficiencies in the back office – that should have been there in the first place. Where as fintech in developed markets has crept in to the front end of acquiring and servicing customers expediently using technology.

Developments in this space will be very slow if the regulators don’t keep pace with industry developments. Inability to assess potential risks of innovative technology will only slow economic growth. The insurance regulator has to keep pace with global developments and support the Industry to innovate and grow in the local market.

An insuretech like Lemonade, the first so-called peer-to-peer insurance company, started by technology entrepreneurs, targeting smartphone users by offering ease-of-service transitions and cheap prices on homeowners and renters coverage, may get held up due to delays in regulatory approval in Sri Lanka, but not in the USA.

In the US, healthcare business post Obamacare paved the way to healthcare related Insuretech companies like Oscar, Collective Health and League.

✅Oscar is reinventing how to manage care, process medical claims, control healthcare costs, and provide transparency. With all the complexity hidden behind an easy experience for members, its making the healthcare system simple, smart and friendly.

✅Collective Health is a software and services company working to create a better healthcare experience. They assist companies in the U.S. to take better care of their people with a complete health benefits solution. They are bringing together the best medical, pharmacy, dental and vision networks.
✅League enables employers to provide their employees with health spending accounts, wellness accounts and group insurance plans, all delivered through a mobile-first platform. Users of the League App find health professionals, book appointments or speak to their team of advisors to get health tips. The League digital wallet allows users to pay for services from their phones.

Similarly, there are Insuretech providing online services (ZhongAn an Internet insurance company, in Shanghai), policy comparisons (Policybazaar in India) and aggregators who are all breaking in to insurance sector using technology. Rather than reject innovation due to the absence of regulations or for the lack of understanding the potential risks, the regulators should use professionals to help them understand the risks and encourage innovation. For example, Monetary Authority of Singapore (MAS) has outlined a framework for driving the country’s fintech industry, by supporting Fintechs with a conducive regulatory environment and ecosystem.

MAS will use a regulatory sandbox that would enable financial institutions to test products under less stringent laws which provides an environment where experiments could fail “safely and cheaply” without widespread adverse consequences, to the market. Applicants would be reviewed and approved to proceed with the sandbox by MAS. The regulatory sandbox guidelines outlined how startups or financial institutions could go about testing fintech products and services that were likely to be regulated by MAS.

Under this ecosystem MAS is planning to use the blockchain technology to pilot a system that could be used to issue and transfer funds between the participating banks. The pilot system would allow the participating banks to deposit cash as collateral with the MAS in exchange for MAS-issued digital currency, which could be redeemed later for cash. The banks then would be able to pay each other directly using the digital currency, instead of sending payment instructions through MAS.

Innovation can be managed with a similar governance framework alongside a conducive regulatory environment to encourage other competitors who are ready to invest in Insuretech to benefit the consumers and help the insurance sector expand. Existing insurers who are not willing to innovate will have to improve their processes to stay in contention with the Insuretech companies.

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Disclosures in Financial Statements for better Governance

When there is a contentious issue that requires disclosure, most people throw out the excuse that shareholders rarely read this information or they won’t understand the issue and therefore should not confuse them! In practice this may be true, for small investors. However, companies are obliged to make disclosures to provide information that would not otherwise be obtainable and on which informed decisions can be made. When management understands that they will have to publish something which was not appropriate they would be very careful. Thus disclosure requirements will guide the decisions of management if they know in advance that they will have to reveal the information later.

The need for better disclosures is important to deter management and directors unilaterally misusing or mismanaging companies. Disclosures other than in financial statements like for SEC or regulatory purposes also are very important.

For example, to prevent excessive remuneration being drawn by directors and executives, Switzerland opted for public disclosure of compensation. In addition to disclosure, Switzerland also mandated shareholder vote. Its the so-called “say on pay” mechanism of the ordinance in 2014. The logic is that companies will adjust their behavior to ensure the proposals are not rejected by the shareholders. Mostly, this has resulted in better governance of public companies.

Another way of deterring inappropriate conduct is when company insiders know in advance that a decision will be subject to shareholder approval, this changes the nature and content of the decision itself. For example, entry to a new market or entering into a major transaction, etc. Due to disclosure requirements, management would be forced to justify and evaluate pros and cons, under a conflict of interest situation.

Disclosures on related party transactions would highlight if some shareholders are taking more than their share as directors’ remuneration without declaring adequate dividends, as the basis of distributing profits.

Another area that highlights proper governance mechanism is the communication of judgments and estimates made in preparing the financial statements. The 2008 financial crisis brought to light the inadequate nature of disclosure of risks associated with the business and also the inadequacy of minimum disclosure regime encouraged by accountants and auditors. Needless to say, it’s not easy to provide investors with a complete understanding of the underlying economic effects of transactions and account balances through disclosures in financial statements. The Investor relations unit should handle information needs of institutional investors, in addition to the required disclosures.

Lack of transparency in financial reporting, affects investor trust, especially when it occurs in financial institutions. When this happens the overall stock market will decline and underperform . Consequences of inadequate disclosure therefore can affect the broader economy as investors will stay away from the capital market.

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Increased Tax collection for better Governance.

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The only practical means of raising revenue to finance government spending is taxation. If people continue to require the government to provide goods and services then the government requires money to fund these needs. Tax collection in Sri Lanka has steadily declined over the years. Tax as a percentage of GDP has halved over 25 years. Whereas, tax level in major industrialized countries has reached more than 3 times the level in Sri Lanka.

The Ministry of Finance has recently commenced a publicity campaign to encourage people to pay taxes for a better future.

The ideal tax system should raise essential revenue without excessive government borrowing, and should do so without discouraging economic activity. Therefore, the policymakers in Sri Lanka will have to get their policy priorities right and have the political will to implement the necessary reforms. Tax administration must be strengthened to accompany the much needed policy changes.

How does the government achieve this fine balance of raising revenue for its activities and encourage economic activity without creating dissent among the populace?

  1. Establish a rational, modern, and efficient automated tax systems to increase tax collection and reduce malpractices.
  2. Prevent profit transfer by foreign investors with tight transfer pricing rules with better administration & monitoring.
  3. Strengthen legal provisions to deter tax abuse and provide adequate technical training to build a good team of tax auditors. In addition to preventing evasion by auditing it will signal a more robust enforcement to the would be evaders.
  4. Simplify tax administration. In the Ease of doing business ranking, the combination of number of tax payments per year (47) and the time spent for tax compliance (167 hours) has kept Sri Lanka’s rank down at 158.
  5. Formalize the informal economic sector also known as shadow economy. This could bring in more people in to the tax net and increase collection. For example a lawyer who is paid in cash, the doctor who does not declare cash receipts from patients and large enterprises in import/export trade that choose to avoid taxes using ‘two’ books. Improving both tax policy and tax administration is important to tackle informality.
  6. Use better computer systems and advanced analytics to identify suspicious behavior of registered and unregistered businesses. Individual tax payer’s behavior or lifestyle spending can also be analyzed automatically by integrating data on spending patterns, import or purchase of assets, etc.
  7. Use experts without conflicting client interests or senior tax commissioners to identify and tighten tax loopholes used by companies on an ongoing basis. This way companies may escape one year of non payment due to a specific loophole in law, as opposed to the tax authority taking legal action over many years, later.
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