Key Impacts of Participant Insolvency on the CDS of CDC

1. Presented by: Rasool Hooda, Manager Legal & Compliance 11th ACG Cross Training Seminar 2-5 July 2009 Dhaka, Bangladesh A Presentation on “Key impacts of participant insolvency on the Central Depository System of the Central Depository Company of Pakistan Limited ” At the forefront of the Capital Market development

2. Key Background Points • The Central Depository System (CDS), maintained and operated by the Central Depository Company of Pakistan Limited (CDC), is recognised and supported by specific legislation, namely, the Central Depositories Act, 1997 (CD Act) • The CD Act sets out certain basic principles dealing with ownership of securities entered in the CDS [SECTION 4] • Account Holders open Accounts with CDC in the name of the Account Holders [SECTION 4]

3. Key Background Points • Some Account Holders, named as Participants (usually members of stock exchanges), open Sub Accounts with CDC in the name of Sub Account Holders, who are the clients of the Participants • Securities are held in the CDS in electronic form in either Accounts or Sub Accounts • The CD Act provides that the title to securities entered in Accounts vests in the respective Account Holders and that the title to securities entered in Sub Accounts vests in the respective Sub Account Holders [SECTION 4]

4. Key Background Points • In this manner, the relevant Sub Account Holders are protected in case any Account Holder/Participant becomes insolvent as the securities entered in the Sub Accounts of the Sub Account Holders will not be mixed with the securities entered in the Account of the insolvent Participant • The CDC Regulations add to this protection by requiring Participant to segregate their beneficially owned securities from the securities of their Sub Account Holders • Further protection for Sub Account Holders is also provided by a specific provision of the CD Act which forbids Participants from transferring, pledging or withdrawing from the CDS any securities entered in the Sub Accounts of their Sub Account Holders without the consent of the concerned Sub Account Holders [SECTION24]

5. Key Background Points • However, if a Sub Account Holder complains that they did not consent to the transfer from their Sub Account of any securities entered in their Sub Account, the CD Act forbids the record of CDC from being rectified, but the aggrieved person can obtain damages against the defaulting party [SECTION 11] • Furthermore, CDC is expressly exonerated by the CD Act if CDC acts in good faith and without negligence on transfer instructions given to it by Account Holders and Participants [SECTION 8]

6. Legal impact of Participant insolvency • In the above background, there is no immediate legal impact of Participant insolvency on both CDC and the Sub Account Holders of the Participant. In other words, both CDC and the Sub Account Holders of a Participant, as well as the other Elements of the CDS, are remote from the insolvency of a Participant

7. Procedural implications of Participant insolvency • Certain procedures, however, begin to operate in the event of Participant insolvency • Insolvency of a Participant triggers an Event of Non-compliance having certain consequences under the CDC Regulations, which have the force of delegated legislation as they are made under and pursuant to the CD Act • In the event of Participant insolvency, the CDC Regulations empower the CDC to: [REGULATION 15.2.1] • Impose full or partial restrictions on the Participant • Suspend a Participant for a limited time • Terminate the admission of the Participant in the CDS

8. Procedural implications of Participant insolvency • The appropriate action from the above range of actions will be determined by the CDC having regard to the finality of the insolvency proceedings against the Participant • If the Participant is a member of a stock exchange, notice of the action taken against the Participant will also be given to the stock exchange • In case the admission to the CDS of the insolvent Participant is terminated, CDC may make consequential arrangements with the liquidator/administrator of the insolvent Participant for withdrawal from the CDS, or removal from control of the Participant, of the securities entered in the Accounts and Sub Accounts of the Participant

9. Procedural implications of Participant insolvency • While taking withdrawal or removal from control action, CDC must take into account the wishes of the pledgees in whose favour the Participant has pledged any securities and of the Sub Account Holders who have any securities entered in any Sub Accounts controlled by the Participant

10. DOES CDC REQUIRE SPECIAL LEGAL PROTECTION IN CASE OF PARTICIPANT INSOLVENCY? • Yes • In the absence of special legal provision for CDC to deal with Participant insolvency, the general insolvency laws would have applied and the process would have come under control of the courts, which could have caused delay and attendant systemic risk to the functioning of the securities market • If the securities of the insolvent Participant were not held in an insolvency remote manner from the securities of its clients, the clients would have been exposed to the insolvency of their Participant, in the same position as unsecured creditors of the Participant

11. DOES CDC REQUIRE SPECIAL LEGAL PROTECTION IN CASE OF PARTICIPANT INSOLVENCY? • The insolvency procedures stipulated in the CD Act and the CDC Regulations as described above, are enforceable against bankruptcy laws in Pakistan because, being special laws, they override the general laws of bankruptcy • Such special laws also have the advantage of giving expeditious access to their securities to the pledgees and Sub Account Holders of the insolvent Participant, who would otherwise have to wait for the courts and the liquidators to deal with their securities, causing delay and possible systemic risk to the securities market.

12. STIPULATIONS OF PRINCIPLES ON DEALING WITH PARTICIPANT INSOLVENCY • Procedures for dealing with Participant’s insolvency vis-à-vis disposal of their securities controlled by Participants are set out in the CD Act and the CDC Regulations, as described above • The general law of insolvency is set in the Insolvency (Karachi Division) Act, 1909 and the Provincial Insolvency Act, 1920. In case of company insolvency, the Companies Ordinance, 1984 provides that the rules contained in applicable insolvency law will apply to the wind up of such company

13. CDC’S EXPERIENCE IN THE RECENT TURBULENT MARKET CONDITIONS • Relatively few cases of member default were observed in the recent market turbulence • Of these, most were handled efficiently and in a consensual manner by the administrations of the Stock Exchanges • Moreover, Pakistan does not have a culture of institution of insolvency/liquidation proceedings against defaulters • Therefore, it is an open question how Pakistan insolvency laws will deal with Participant insolvency when such cases do come before the courts

14. CDC’S EXPERIENCE IN THE RECENT TURBULENT MARKET CONDITIONS • Our understanding is that the procedures discussed above will be upheld by the courts in the event of Participant insolvency • Other issues to be tested are: • One specific issue which needs to be tested, and on which the CD Act and the CDC Regulations are both silent, is how the courts will deal with allegations of fraudulent preferences • The claw back period for fraudulent preferences in the case of insolvent companies is 6 months before the insolvency strikes, and 3 months in the case of individual bankruptcy

15. CDC’S EXPERIENCE IN THE RECENT TURBULENT MARKET CONDITIONS • Furthermore, whilst the law exempts bona fide transactions from fraudulent preference, the limit to which and the manner in which this exemption will be applied by the courts in relation to securities transactions is to be tested • It is also to be tested to what extent will the CD Act’s bar against rectification of the CDC’s records for unwinding securities transactions recorded by it will be enforced by the courts against fraudulent preference claims ***********

16. Thank you!