December issue 2006

Instead of solving the issue, the much-awaited forensic report by American investigators to probe the 2005 crash of the Karachi Stock Exchange has only added to the mystery. The report has absolved the big brokers who were allegedly responsible for the fiasco, apparently in connivance with finance ministry officials, and laid the entire responsibility on the flawed trading system.

The US firm, Diligence Intelligence & Risk Management, in its final report, has brushed aside theories of conspiracy or manipulation behind the fiasco and clearly stated that, “We find no patterns of activity or credible evidence to support a theory that, during March 2005, certain influential brokers systematically and manipulatively inflated and then deflated market prices, reaping substantial profits in the process.”

The report, however, pointed out a violation of the rules under Clause 3(b) of the Regulations Governing Futures Contracts and Section 17(a) of the Securities and Exchange Ordinance. Clause 3(b) prohibits a broker from having a net sale position in futures contracts of a particular scrip in excess of Rs50 million without providing evidence that it held the shares sold above the threshold.

The report has identified 88 brokerage houses that took positions over and above Rs50 million in the futures market, but it has not held them responsible. The government has issued show-cause notices to these 88 brokers to fulfill the legal requirements, and to give them an opportunity to present their case.

Independent economists and opposition political parties have criticised the forensic report, terming it an utter waste of national resources and an exercise in futility. According to stock market sources, the government paid the hefty sum of $10,638 per page for the report to the US firm.

“The forensic company’s area of work was very limited and its report has neither fixed responsibility on anyone, nor has it cleared anyone,” says Dr. Shahid Hassan Siddiqui, a senior economist and chairman of the Research Institute of Islamic Banking and Finance. According to Siddiqui, the government will fine the 88 brokerage houses an insignificant amount after issuing show-cause notices for violation of rules and then the matter will stand closed.

The forensic report has tactfully absolved the leading brokers/financial institutions from all responsibility for the market crash, whereas the Task Force, led by Justice (Retd.) Saleem Akhtar, had pointed out alleged “wrongdoings” by 11 brokerage houses. “As a result of our analyses, we did find prima-facie evidence of possible wrongdoing by a significant number of brokers in certain areas,” the forensic report admits, but then it twists its statements by saying, “We are of the view, however, that these potential wrongful acts, individually or collectively, were not elements of an elaborate scheme to manipulate the volatility of the market, as alleged by the Task Force.”

The report, which was officially released by the US firm before the National Assembly’s Standing Committee on Finance on November 21, has disputed various observations of the Task Force report. The Task Force, comprising Dr. Mohammad Zubair Khan, Shahid Hafiz Kardar and Sultan Allana as its members, in its report in August 2005, had pointed out various anomalies and shortcomings in stock trading during March 2005, which ultimately led to the fiasco. It had also held the Securities Exchange Commission of Pakistan (SECP) and Karachi Stock Exchange (KSE) management responsible for the crash, as both institutions failed to control the situation and did not implement laws and regulations.

The Task Force had suggested that the government hold forensic investigations by a reputed firm to ascertain responsibility. US firm Diligence Intelligence and Risk Management was then entrusted the gigantic task of holding forensic investigations in July this year after a bombshell statement by the former chairman, Dr. Tariq Hassan, in which he alleged that high-ranking finance ministry officials, including Prime Minister Shaukat Aziz, had forcibly stopped him from taking action against the “big fish.”

The stock market fiasco, which caused a loss of over Rs780 billion in March 2005 to a large number of small investors, had raised many questions on role of the regulator SECP and the management of KSE. The National Assembly’s Standing Committee on Finance and Revenue, while reviewing the situation, had invited Dr. Tariq Hassan and other finance ministry officials, to give their points of view. The Task Force had also pointed out the involvement of some big brokerage houses in Badla financing, futures and wash trading.

Badla, or carry over transaction (COT), system was to be phased out as per the agreement between the government and the KSE management in 2004. The phasing out of Badla would have led to replacing the margin financing scheme through banks and financial institutions. However, the big brokerage houses, which were also financers of the Badla system, created a panic-like situation by suddenly stopping Badla financing before the system was fully phased out. Prior to the crisis the market was artificially increased to very high levels. The key KSE-100 Index increased by 65 per cent, from 6,218 on December 31, 2004 to 10,303 on March 15, 2005. This market surge created a frenzied panic in the market. However, the sudden stoppage of COT financing hit small investors hard, especially those who had bought large quantities of shares anticipating the appreciation of share values against Badla financing. They could not get the financing to settle their holdings and thus incurred huge losses.

The US company’s forensic report has also agreed to the role of COT in the market crash and the possible wrongdoing of 13 brokers. Justice (Retd) Saleem Akhtar’s Task Force report had pointed fingers at 11 brokers. According to the forensic report, trading data analysis reveals that most of the brokers trading on the KSE participated in the COT market. However, daily new COT transactions on the KSE were heavily concentrated with relatively few brokers. Of the 138 brokers participating in the COT market on behalf of lenders, six brokers accounted for approximately 50 per cent of the total value of COT purchases occurring between January 3, 2005 and March 15, 2005. By order of descending new COT values, the six brokers were: Aqeel Karim Dhedhi Securities (Pvt.) Ltd, Arif Habib Securities Limited, Atlas Capital Markets (Pvt.) Limited, KASB Securities Limited, Orix Investment Bank Pakistan Ltd., and Akberally Cassim & Sons. Aqeel Karim Dhedhi Securities and Arif Habib Securities together represented close to 30 per cent of the total new COT lending market during that period.

The US report has disputed many findings of the Task Force report regarding the role of the major brokerage houses and their Badla financing in the crash. “We do not find sufficient evidence to support the paramount scheme of manipulation in the manner put forth by the Task Force for the period in question. Nor do we find sufficient evidence to support the alleged scheme’s primary element (withdrawal of COT), that was ostensibly responsible for the fall of market prices. We find no patterns of activity or credible evidence to support a theory that, during March 2005, certain influential brokers systematically and manipulatively inflated and then deflated market prices, reaping substantial profits in the process.”

The report admitted that it was unable to provide any conclusive findings in the area of Badla financing because trading information on unregulated Badla was not readily available from the exchanges or the public domain, but only from individual brokers engaging in such activities. Even then, data provided by individual brokers could not be reasonably or easily independently verified or tested for completeness or accuracy with any sufficient degree of certainty. Given this, as well as additional time constraints, reliable and verifiable data related to potential trading levels of in-house Badla were not obtainable.

“We do not find sufficient evidence to support the paramount scheme of manipulation in the manner put forth by the Task Force,” said David Wolfe of Diligence in his briefing to the NA committee.

He said the US team had examined the primary allegations related to the withdrawal of regulated COT financing, in-house Badla, wash trades and violations of Clause 3(b) of the Regulations Governing Futures Contracts (exceeding the Rs 50 million reporting threshold).

“The main question is why the government delayed for more than one year the start of these forensic investigations,” asks Dr. Shahid Siddiqui, the Task Force Chairman. He said the government deliberately did not take any action on the Task Force report to hush up the matter. It was after much hue and cry and pressure from some parliamentarians, as well as allegations by Dr. Tariq Hassan, that the government started forensic investigations.

KSE brokers, on the other hand, are satisfied with the forensic report. They put the entire blame on the SECP for its failure to play its role as watchdog of the shares market. “Dr. Tariq Hassan did nothing to save the market,” alleges Abid Ali Habib, a member of KSE’s Board of Directors. According to Habib, the former SECP Chairman kept mum for eight months after the crash, and it was only when he was kicked out of office that he put the entire blame on others. He said that factually the market had witnessed an unprecedented surge in March and had to correct itself. Unfortunately small investors had indulged in leverage buying and when COT financing was not available, they were stuck. He said the SECP did not understand the market mechanism, and it did not take timely steps to save the market.

As Dr. Siddiqui has rightly pointed out, in the absence of any proper accountability mechanism, there is no chance that the affectees of the 2005 stock market crisis will be compensated. The forensic report has ensured that the matter is now closed.