Other Links - Report of The Enquiry Committee on KSE and LSE (Part 2).

Part 2

Lahore Stock Exchange

(Guarantee) Limited (the "LSE")

1. This report has been prepared on the basis of information collected through the following sources:

1.1 The Committee interviewed the following members of the LSE current and past management:

1.2 The following suspended and defaulted members of Lahore Stock Exchange were also heard on their own desire to speak on the Terms of Reference of the Enquiry Committee:

1.3 The Committee visited Lahore Stock Exchange to scrutinize the record and to meet the aforesaid suspended and defaulted members and to conduct interviews of the management of LSE. While conducting investigation, the Committee also looked into the letters forwarded to it by SEC. The Committee held several meetings and discussion over telephone with the current management of LSE.

1.4 The Committee has devoted considerable time to analyze the information collected from various sources. The changes made in exposure rules from time to time, their implementation, the role of the Board of Directors of LSE and its management in respect thereof has also been studied in greater detail.

1.5 The outcome of the investigation has been comprehensively covered in the attached report.

1.6 Before finalizing its report, the Enquiry Committee has also discussed the various issues emanating from the investigation with Mr. Samir Ahmed, Managing Director, Mr. Asim Zafar, then Vice Chairman (Acting Chairman) and Mr. Asif Baig Mirza, then Director of LSE.

1.7 Whereas, the Enquiry Committee has made all-out efforts to examine all the issues in terms of the Terms of Reference, there could be a possibility that some of the non-compliances/lapses might have escaped the attention of the Enquiry Committee. The non-compliances/lapses reported in this report, therefore, may not be considered the only non-compliances/lapses.

1.1 The Committee has examined in detail the Regulations Governing Members’ Exposures, the exposure limits fixed by the LSE and changes made therein from time to time, and their implementation. The investigation of the exposure limits covered period from 1995, when the ‘Regulations Governing Members’ Exposure’ were first introduced. LSE, with the approval of the Federal Government enforced these regulations, placed at Annexure “K” from February 01, 1995. These regulations, authorized the Board of Directors of the Exchange to prescribe:

1.2 Under these regulations, the terms ‘Exposure’ and ‘Loss” have been defined as follows:

‘Exposure’ means the amount of purchases and sales transacted by a member during a clearing period added together after allowing netting off of common scrip purchases and sales.

‘Loss’ means amount payable by the members to clearing house due to difference in purchase and sale prices or difference between transaction price and market prices in case of outstanding transactions of any one or more scrip at any moment of time during a clearing period.

1.3 According to these regulations, the members of the Exchange are required to deposit with clearing house a percentage of their exposure and the amount of loss in cash or in the form of readily realizable securities prescribed by the Board of Directors within 24 hours of the demand. The Board of Directors of LSE in its emergent meeting held on June 16, 1996 has approved to amend LSE’s exposure and loss regulations so as to make the notice period of 24 hours to be changed as “within banking hours” on the same day. Subsequently, these regulations were amended with the approval of Securities and Exchange Commission of Pakistan (the “SEC”), to authorize the Managing Director of the Exchange to specify the time limit for deposit against exposure and loss, not exceeding 24 hours. Computation of the exposure and loss limits is carried out through automated computer system.

1.4 Under the Regulations Governing Members’ Exposure, the Board of Directors is authorized to prescribe these limits. We quote definition of the word “prescribed” from the aforesaid regulations:

1.5 The Board of Directors of LSE prescribed changes in the exposure and loss limits and deposits payable thereon from time to time. On several occasions, however, the Management Committee has exercised this power of the Board of Directors. This issue has been discussed in greater detail later on in this report.

1.6 Initially, LSE has followed KSE exposure regulations. This practice continued for a considerable time. Later on LSE departed from this practice due to its own specific requirements and decided to have its own exposure rules. LSE, being an independent entity, was under no obligation to always follow the rules and regulations prescribed by KSE. Whereas, this was a good move towards independent decision-making by LSE, it has to be seen if LSE has made prudent decisions in respect of various critical issues.

1.7 It is to be noted that rates and scrip acceptable for deposit against exposure and losses were prescribed only on July 09, 1997. Subsequently, however, the changes were brought about in rates and scripts acceptable against exposure and losses depending upon the risk evaluation of the different scripts.

1.8 The maximum number of issued shares of any particular script, which could be held by a member in his account in a particular Clearing was never prescribed by LSE. In its absence, there was a possibility of carry over trade exceeding the net free float of any script.

1.9 LSE introduced future trading from February 01, 2002. The Regulations Governing Futures Contracts of LSE came into force with the approval of SEC. The said Regulations prescribe the exposure and loss limits in respect of future contracts. As Future Trading has commenced only recently and after the constitution of the Enquiry Committee, therefore, this has not been covered in this report.

2.1 Clearing and Settlement Department: Under the present set up, the Clearing and Settlement Department of LSE is responsible for the management of all clearing and settlement functions, including the members’ exposures and loss limits and calling of deposits there against. Under the organizational set up of LSE, a Manager is the head of the Clearing and Settlement Department, who is responsible, among others duties, to monitor the members’ exposures and losses. As there was no provision of a Chief Operating Officer in the organizational set up of LSE, therefore, the Manager, Clearing House was directly reporting to the Managing Director. It was, therefore, the responsibility of the Managing Director to keep vigil on the risk management function of LSE.

2.2 Importance of Management of Exposure and Loss Limits: The management of exposure limits is a very sensitive matter and vital to the smooth functioning of a Stock Exchange, particularly in a volatile market. The responsibility of the management is to keep a constant watch on the overall market situation and take remedial measures to avoid a situation, in which settlement becomes doubtful. The management is to exercise vigilance over the market players and keep on reviewing their position regularly. Under all circumstances, the management has to pre-empt before any ugly situation arises. At any market place, safety of the clearing-house involved in trade settlement is always supreme. Any action by the management to ensure the smooth functioning of the Clearing House is justified, provided they are covered under the rules and taken after considering of all the aspects and is adequately documented, which clearly demonstrate application of mind. The management has to act impartially and with great care. Any abrupt decision of the management, arrived without proper evaluation could adversely affect the market players and investors, which may lead to crisis in the stock markets. It is also essential that market players, even if they are board members should not have any say in the management of exposure limits, as they have their own business interest. There is every possibility that they can take undue advantage, if they have information of the position of other members. Therefore, there should be no involvement of the market players in the management of Clearing House. They should not take part in the proceedings of the Board and other Committee meetings where a business in which they are interested is to be transacted.

2.3 Changes in Exposure Limits by the Board of Directors where the Directors have conflict of interest. In order to ensure that there is no conflict of duty with the personal interest, Articles of Association (Article 88) of the LSE, provides that a member of the Board of Directors of the Exchange shall not be competent to take part in the proceedings and vote on a question in which he is personally interested, the Chairman of the meeting being the final judge whether he is so interested or not.

2.4 Lahore Stock Exchange (Guarantee) Limited, being a company limited by guarantee and incorporated under the Companies Act, 1913 (now the Companies Ordinance, 1984) is required to follow the provisions of the Companies Ordinance, 1984 unless there is any specific exemption from any of the said provisions. Section 214 of the Companies Ordinance, 1984 requires that every director of a company who is in any way, whether directly or indirectly, concerned or interested in any contract or arrangement entered into, or to be entered into by or on behalf of the company shall disclose the nature of his concern or interest at a meeting of the directors. The provisions of Section 216 requires that no director of a company shall, as a director, take part in the discussion of, or vote on, any contract or arrangement entered into, or to be entered into, if he is in any way, whether directly or indirectly, concerned or interested in the contractor arrangement, nor shall his presence count for the purpose of forming a quorum at the time of any such discussion or vote, and if he does vote, his vote shall be void. It is to be noted that the aforesaid provisions are mandatory and their violation attract penalties. In addition the Court may declare a director to be lacking fiduciary behavior if he contravenes the provisions of Section 214 or 216 of the Companies Ordinance, 1984. This issue has also been discussed elsewhere in this report. The directors, therefore, must comply with the aforesaid mandatory provisions while taking decisions in their meetings.

2.5 Requirements for Good Governance at the Clearing and Settlement Department: The essential elements of good management of this department and its responsibilities can be described as under:

2.6 Role of the Managing Director and the Manager Clearing House. According to the Organization Chart of the LSE, the Manager, Clearing and Settlement supervises the functions of this Department, reporting directly to the Managing Director. It is, therefore, responsibility of the Managing Director to set up a system, which ensure regular feed back from this department. Considering the importance of the Clearing and Settlement Department, he must ensure that Clearing and Settlement is functioning smoothly. He should maintain inter-action with the Department to ensure effective risk management. Whereas, the Article 79 of the Articles of Association of LSE provides that the Directors SHALL MANAGE the business of the Exchange, Article 93 laid down the duties and responsibilities of the Managing Director. We quote from the Sub-Article (c) of Article 93 of the Articles of Association of LSE:

2.7 Responsibility of the Board of Directors. Whereas, the duties and responsibilities of the Managing Director have been specifically provided in the Articles of Association of LSE, the directors remain responsible for the overall supervision of LSE objectively for strengthening of the systems, improvement of the efficiencies, and risk management measures from time to time. They have to ensure that the powers are being exercised and functions are performed within the legal framework and the decisions and directives of the Board of Directors and SEC are carried out effectively. They must be aware of the working and functioning of the LSE as a whole.

3.1 LSE amended the exposure and loss limits and deposit payable thereon from time to time. The exposure limits fixed by LSE and changes in respect thereof from time to time are summarized at Annexure “L”. The relevant notices and extracts of the minutes of the meetings of the Board of Directors and its Management Committee have not been attached, however, the same are available and can be produced, if desired

3.2 Amendments by the Managing Committee. Under the Regulations Governing Members’ Exposure, the Board of Directors is authorized to prescribe changes in exposure and loss limits and deposit payable thereon. The Board of Directors can authorize any Committee to recommend changes in the exposure rules and after due consideration and deliberation on the said recommendations, prescribe the exposure and loss limits. The Board cannot give authority to any one to prescribe changes in exposure and loss limits from time to time. Even otherwise, the Board of Directors of LSE has never delegated any authority to the Management Committee to recommend changes in the members’ exposure and loss limits. It has, however, been observed that the Management Committee has been prescribing the exposure and loss limits from May 25, 1998 to June 22, 2000. The minutes of the Board of Directors of LSE do not indicate that the decisions of the Managing Committee were ever presented to the Board for ratification or even for information. On a written query from the Enquiry Committee, LSE has provided us a copy of the excerpt from the minutes of the meeting of the Board of Directors held on June 26, 2000. The said minutes do not record as to what proposal for the exposure rules was proposed/recommended by the Management Committee. The ratification by the Board of Directors was done while discussing “other matters.” No discussion or deliberation or application of mind is reflected in the said minutes. Copy of the said excerpt of the minutes is placed at Annexure “M”. Amendments authorized by the Management Committee are summarized below:

3.3 No convincing reason was given to the Committee for exercise of powers by the Management Committee. Articles of Association of LSE empower the Board of Directors to constitute any committee to undertake any functions and responsibilities entrusted to it. In exercise of the said power, it is a usual practice at LSE to form a Management Committee of the Board of Directors every year in its first meeting after election of Directors. For the year 2000, the Board of Directors in its very first meeting held on January 01, 2000 authorized the Chairman to form the Management Committee on appointment of non-member Directors. Subsequently, the Board of Directors in its meeting held on January 13, 2000 approved the names of the members of Management Committee. The Board of Directors, however, did not delegate any powers to the Management Committee.

3.4 On the specific question of the Enquiry Committee as to when the Management Committee was authorized by the Board of Directors to prescribe changes in the exposure and loss limits and deposit payable thereon, the Managing Director in its letter dated March 16, 2002 informed that “the Management Committee was constituted by the Board of Directors in its meeting held on May 11, 1998, to perform certain functions, mentioned in the minutes of the aforesaid meeting.” The minutes of the aforesaid meeting, therefore, were perused to see if the functions entrusted by the Board of Directors to Management Committee in its meeting held on May 11, 1998 includes any authorization to make changes in the exposure and loss limits and deposits payable thereon. The Enquiry Committee is of the Opinion that the Board of Directors has not delegated any such powers to the Management Committee. As already pointed out, the changes as per regulations are to be prescribed by the Board of Directors. The Enquiry Committee was then told that the Management Committee has made some changes on the recommendations of the Trading Affairs Committee. Implementation of the recommendation of the various Committees formed by the Board was one of the functions entrusted by the Board of Directors to the Management Committee. Again, the Enquiry Committee could not understand as to how the Trading Affairs Committee could undertake changes in the exposure and loss limits and deposit payable thereon. The Committee strongly feels that the LSE Board may not delegate any of its powers, which are to be specifically exercises by it and none others. Moreover, the Board of Directors should properly delegate its authority, wherever it is desired that such power to be exercised by others. The Board of Directors should also make sure that powers are exercised and functions are performed at LSE within the regulatory framework and in accordance with the provisions of the Articles of Association, its decisions and directives of SEC.

3.5 The Enquiry Committee has also observed that whereas the Board of Directors of LSE comprises of 18 Directors, the Management Committee has only 8 members including the Managing Director. The quorum requirements of the Management Committee appear to have never been fixed by the Board of Directors. In its absence, the Management Committee held its meetings on several occasions with the presence of only two to four members, which also included the Managing Director. This shows poor attendance at the Committee meetings and the lack of interest of its members towards the affairs of the Exchange.

3.6 It has also been noted that the Management Committee made decisions regarding changes in exposure and loss limits on some occasions while considering “other business”. Notwithstanding the fact that the Management Committee was not authorized to prescribe changes in exposure rules, the Enquiry Committee is of the opinion that it was quite irregular that important matters like amendment in exposure limits and slab rates for deposits, which are vital for the integrity of the Clearing House were tabled under “other business.”

3.7 The Committee has also observed that neither any justification has been given nor criteria laid down for making changes in the exposure and loss limits. In response to the written query of the Enquiry Committee, the Secretary informed that no working papers were presented to the Management Committee for changes in exposure rules. It is to be noted that in the meeting held on October 07, 1998, the Management Committee increased the exposure and loss limit of members on the request of the Manager Clearing House. The Committee is unable to understand as to why the Management Committee changed the exposure rules on the request of the Manager Clearing House without proper consideration and justification and without referring the same to the Board of directors for approval.

3.8 Amendments by the Board. The Board of Directors under the Regulations Governing Members’ Exposure has the authority to prescribe amendments in the exposure and loss limits and deposit payable thereon by the members of LSE. The changes brought about in the exposure and loss limits are described in this section. These also include the changes made by the Management Committee, which has already been discussed in previous paragraphs.

3.9 July 1995 to March 2000. LSE first introduced the exposure and loss limits and deposit payable thereon on July 25, 1995. Initially when the exposure regulations were enforced, only slab rates were prescribed after allowing free limit. In case of losses, 100% deposit was required after allowing free limit. During this period, the changes, which were brought about were mainly related to adjusting upwards or down-wards (1) free exposure limit, (2) free loss limit, (3) and rates of deposit. Although the necessity and the justification for the decision to make changes has not been recorded in the minutes, it seems that value of membership card and room has been kept in mind while fixing free limits. As the value of the membership card went up in the bullish market, the free limit was increased to allow members to trade more. This was on the presumption that in case members goes default, the sale of his card along with room and other assets would fetch enough money to settle claims against him. Similarly, when the value of the card and room went down in a bearish market, the free limit was reduced. All the shares listed on LSE were qualified for deposit. This system has many weaknesses, as shares listed on LSE include several illiquid shares, which were accepted as deposit. In the case of such shares manipulation of share price was possible.

3.10 April 2000 onwards. The first major improvement in the exposure rules was made effective from April 26, 2000, when it was decided by LSE that in the case of exposure of over Rs. 120 million, no single security would be accepted whose worth exceeds 20% of value demanded. In addition it was also prescribed that only the companies, which have remained active during last 30 days and whose market value shall not be less than 40% of their face value, would be eligible for deposit against exposure and loss. Next major change was made on June 26, 2000 when exemption limit for exposure was removed. It was decided that up to the exposure of RS 10 million, a cash deposit of Rs 500,000 would be required. For exposure exceeding Rs 10 million, slabs from 5% to 35% were fixed. The most important change was introduced on September 26, 2000 when LSE laid down criteria for selection of approved securities on the basis of turnover and earning per share. All companies were accepted for deposit except those on defaulter counter and not on Central Depository System. In the opinion of the Enquiry Committee, the new criteria did address to important issues like volatility in share prices, which hitherto has been a cause of great concern. The new system also laid down a procedure for half yearly periodical review. However, no criteria were laid down for the slab rates and deposit payable, which again was left at the discretion of the Board of Directors.

3.11 Whereas, the Enquiry Committee is of the opinion that the Board of Directors have brought about amendments in the exposure and loss limits and deposit payable thereon in the larger interest of the Clearing House, it is necessary to point out that the necessity of the change, its proper justification and reasons were never recorded in the minutes. The minutes of the Board and Management Committee meetings do not give any reasons, justification, discussion and deliberation on this issue. No working paper was presented for making changes in the exposure rules. The minutes did not record the due diligence and evaluation by the Board while approving changes in exposure rules. In several cases, the changes were made in “emergent meetings”. The Enquiry Committee is of the opinion that there was no need to discuss such important issues in emergent meetings and under other matters and that too without any working paper being presented to the members of the Board. This reflects that the decisions were made in haste and not after proper consideration and deliberation. It has also been observed that adequate notice was not given to the members and major players while introducing changes in exposure rules.

3.12 The minutes of the Board of Directors of LSE demonstrate lack of information, discussion, deliberation and non-application of mind to the serious issue of risk management.

4.1 This is the common knowledge and also dealt in the Report, dated August 2000 of the Enquiry Committee constituted by the SEC on June 17, 2000 to investigate the affairs of Karachi and Lahore Stock Exchanges, that there were lapses in the management of Exposure Limits. The Enquiry Committee has examined this matter in detail and it has been observed that there were several lapses in management of exposure limits. The same are summarized as under:

4.2 The aforesaid issues have been examined detail in Chapter III. Copies of the relevant papers/documents have also been attached, where found necessary.

4.3 There was a clear lapse of responsibility on the part of the management in as much as they failed to discharge their duties and responsibilities prudently and diligently and in the best interest of LSE, its members and investors in general. The Enquiry Committee has observed total failure to review and recheck any procedure, which would have identified the irregularities in the risk management system.

4.4 No plausible reasons were given to the Enquiry Committee for the aforesaid lapses.

4.5 The Enquiry Committee has not found any record, which could provide information that the task of developing software was entrusted to MIS Department of LSE except that copies of notifications for changes in exposure were sent to Manager MIS Department and it was considered sufficient by the LSE management. There is also no evidence that the software was tested prior to implementation of the amendments in exposure rules. This indicates that proper care was not exercised with respect to development of software while making changes in exposure rules.

5.1 The Board of Directors of LSE is responsible for making changes in the Exposure Limits as per regulations. The changes brought in from time to time, is summarized in Annexure “L”. The objective of the changes was that the clearance and settlement should be smooth and in the event of default, the Clearing House could have sufficient deposit in its possession to cover the risk of respective members. Although the decisions for the changes made from time to time have not been agitated from any quarter, the Enquiry Committee considered the decision making process by the Board of Directors while prescribing changes in exposure rules. It is imperative that the directors may reach a decision in respect of exposure and loss limits, which is in line with the purpose of Clearing House protection and investors’ protection. There should be proper evaluation and due diligence before making changes. Moreover, proper notice is given to all concerned before taking any measures relating to risk management. Only then, the decisions could be termed as prudent and reasonable. The Enquiry Committee is of the opinion that the changes were brought about without proper consideration and deliberation on all the issues involved. Moreover, the principle of good governance was not followed by LSE while making changes and their implementation. Following are the observations of the Enquiry Committee in this regard:

5.2 Unauthorized changes in exposure and loss limits by the Management Committee. This issue has earlier been discussed at-length.

5.3 No working paper was presented to the Board of Directors/Management Committee while making changes in exposure rules.

5.4 The minutes produced to the Enquiry Committee in respect of changes made in exposure rules do not indicate any discussion, deliberation and application of mind.

5.5 The changes made in exposure rules were not properly documented with regard to the due process carried out for making such changes.

5.6 In the opinion of Enquiry Committee, adequate notice was not given of the changes in exposure and loss limit to enable the members/major players to adjust their positions, if so required.

5.7 While KSE has made changes in the margin of The Bank of Punjab due to its extreme volatility without any change in its fundamentals and its accumulation by one of its members, the management of LSE has not exercised due care while monitoring members’ exposure. At the same time, the Board of Directors has not taken appropriate measures for the safety of the Clearing House.

5.8 The Management Committee enhanced the exposure limit of Mr. Iftikhar Shafi without recording any justification. This was done at a time when the stock market was in crisis. This issue being policy related was also not put up to the Board for approval. The Enquiry Committee is of the opinion that it was deliberately avoided to get Board’s approval on this issue. This matter has also been discussed at-length later on in this report.

5.9 In some cases, the changes were made in emergent meetings and under “other matters” which reflect that decisions were made in haste without giving adequate notice.

5.10 Enhancement of exposure and loss limits of Mr. Iftikhar Shafi. LSE has a set policy of lower exposure and loss limit for new members of the Exchange for a period of one year. This matter was first discussed in the meeting of the Management Committee of the Board of Directors held on June 22, 1998 and it was resolved that the exposure limits for the new members of the Exchange would be 50% of the normal limit for a period of one year where-after the members would enjoy normal limits As the matter was a policy related issue, therefore, the Management Committee recommended the same to the Board of Directors for approval. The Board of Directors in its meeting held on July 13, 2000 approved the said recommendation of the Management Committee. Consequently the new members were allowed half exposure and loss limits for a period of one year in accordance with the aforesaid policy of the Board of Directors. Mr. Iftikhar Shafi became member of LSE on February 14, 2000 and he was also allowed half exposure and loss limit for a period of one year. However, on May 18, 2000, his exposure and loss limits were doubled i.e., from Rs 20 million to Rs 40 million for exposure limit and from Rs. 500,000 to Rs 1,000,000 for loss limit. Mr. Iftikhar Shafi during his meeting with the Enquiry Committee has contended that he had never requested for increase in his exposure limit. The letter dated May 18, 2000 produced before the Committee by the LSE management did not bear the signature of Mr. Iftikahr Shafi. A copy of the same is placed at Annexure “N”. No plausible reason was given to the Committee on this issue. When LSE was specifically asked to explain the reasons for increase in his exposure and loss limits and the reasons for deviating from the set policy of half exposure and loss limits for new members, the reply of LSE was as under:

5.11 The Enquiry Committee agrees to the reply of LSE to the extent that Mr. Iftikhar Shafi was enjoying the normal exposure limit and it must be in his knowledge, as he did not raise any objection subsequently. The Enquiry Committee, however, is not satisfied with the rest of the reply of LSE because of the following reasons:

1. Non-compliance in implementing Regulations Governing Members’ Exposure. It is the responsibility of Settlement Department to monitor the exposures of members and call deposit against exposure and losses. The existing system and record maintained at the Clearing House do not provide track for examination of the intra-day compliance with the exposure and loss limits regulations. The Enquiry Committee, therefore, has relied on the information and record made available to it by the LSE management.

1.1 No internal audit department exists at LSE to ensure proper compliance with the rules and regulations relating to risk management and to ensure their accuracy.

1.2 The Enquiry Committee has observed that implementation of the exposure regulations were overlooked to provide undue benefits to some of the members of LSE.

1.3 Whereas, there were lapses on the part of the management of LSE in managing exposure limits, the Enquiry Committee is of the opinion that members of the Board of Directors of LSE have also failed to fully discharge their duties towards ensuring compliance with the exposure regulations as well as risk management measures by its management.

2. Lapses. In the previous Chapter, the lapses in management of exposure limits were discussed under “ management of exposure limits.” These lapses, which has come to the notice of the Enquiry Committee, will now be discussed in detail:

2.1 Unsettled Trade (COT) not included in Exposure Calculation. The Enquiry Committee has observed that unsettled trade was not included in exposure calculations resulting in short deposit from the members and exposing Clearing House to a great risk. Exposure Report of Mr. Iftikhar Shafi calculated at 4:48 P.M. on May 26, 2000, the last day of clearing period May 22, 2000 to May 26, 2000 is placed at Annexure “Q” which indicates substantial shortfall in deposit. However, after carrying over his outstanding position, the aforesaid shortfall was converted into excess deposit of Mr. Iftikhar Shafi with the Clearing House. To elaborate this issue, the exposure report of the same clearing period prepared after the carrying over trade is placed at Annexure “R”. To explain it further, the exposure reports of Mr. Iftikhar Shafi for two clearing periods May 08, 2000 to May 12, 2000 and May 15, 2000 to May 19, 2000 are placed at Annexure “S” which shows zero exposure of the said member.

2.2 Exposure Rule to deposit Five (5) securities where exposure exceeds Rs. 120 million not implemented. The exposure rules amended on April 26, 2000 stipulate that if exposure exceeded Rs 120 million, no single security exceeding 20% of the deposit demand would be accepted. This rule was, however, never enforced which is a clear lapse of responsibility on the part of the management. No plausible reasons have been given for the non-application of the said rule. In response to a written query, the Enquiry Committee was told:

2.2.1 The Manager Clearing House informed the Board in its meeting held on June 02, 2000 that there were some difficulties in its implementation. He said that he had written to MIS Manager to develop software for this system, which was in process and manually that was not possible (No such letter was produced to the Enquiry Committee asking MIS Manager to develop software for the calculation of exposure under new rule). When the Board enquired as to why he did not inform the Board of the difficulties in implementation of the formulae, he replied that he had informed the Managing Director who was present in the said meeting and denied having been informed by the Manager Clearing House. The Board did not take it seriously and no action was taken on this major lapse in implementing the new exposure rules. In the opinion of the Enquiry Committee, this issue was not taken seriously at all levels at LSE. The Board of Directors had placed responsibility on the Managing Director who considered the Clearing House Manager responsible for non-compliance. The Manager Clearing House also transferred the liability to the MIS Department for development of software. This alone is sufficient evidence of the negligence of the management in implementing exposure rules. The Board of Directors also did not take any notice of the non-implementation of the said rule till it was discovered.

2.2.2 The Enquiry Committee could not find any justification for non- implementation of this rule. In response to a query of the Enquiry Committee as to why the implementation of this rule remained undetected, Mr. Asim Zafar, the then Vice President, LSE told that it was not in the knowledge of the Board of Directors and the Managing Director was responsible for implementation of the rules and regulations. While agreeing to his stance that it was the Managing Directors who had to implement the rules and regulations, the Enquiry Committee would like to emphasize the obligations of the Board of Directors to ensure that the functions of the Exchange are carried out in accordance with the rules and regulations. The Enquiry Committee strongly feels that the Clearing House should have taken a note of this serious lapse, which if implemented could have saved the Clearing House from the disaster it encountered during May Crisis. The Enquiry Committee is of the opinion that this position must have been in the knowledge of the Managing Director, the Manager, Clearing House and the members of the Board of Directors who ignored it, as it was benefiting the members and enabled them to trade without keeping five securities where their exposure exceeded Rs 120 million. The non-implementation of this rule alone has resulted in over exposing Clearing House and tremendous losses during May Crisis. The names of the members who were beneficiary of this wrong calculation are placed at Annexure “T”. To give an example as to how the Clearing House was exposed to great risk due to non-implementation of this rule, a copy of the exposure report of Mr. Iftikhar Shafi on June 05, 2000 calculated at 5:23 P.M. is placed at Annexure “U”. The report indicates that Adamjee Insurance Company Limited and The Bank of Punjab were accepted as deposit contrary to rules, there percentage being 22% and 72% respectively.

2.3 Exposure Rule that market value of company eligible against exposure shall not be less than 40% of its face value not implemented. The exposure rule amended through notification No. LSE/Exp/1982 dated April 26, 2000 requires that the market value of the company eligible for deposit against exposure and loss should not be less than 40% of its face value. The Enquiry Committee has observed that this rule was not enforced. For instance, the exposure report of Mr. Iftikhar Shafi dated May 09, 2000 shows that 553,000 shares of The Bank of Punjab and 864,000 shares of Bankers Equity Limited were deposited against exposure. The Market value of these shares was Rs. 3.25 and Rs. 3.20 respectively. These shares were accepted as deposit for sufficient period of time contrary to regulations. Please refer copies of exposure reports from May 09, 2000 to May 25, 2000 placed at Annexure “V”. This violation continued till placement of all shares. Similar violation was also noticed for other members.

2.4 Extension of time to deposit exposure contrary to rules. As stated earlier elsewhere in this report, it is not possible to check the intra day compliance of exposure rules owing to the nature of the record maintained at LSE. The Enquiry Committee has, however, noticed that instead of suspension of trading rights of members who failed to provide deposit to the Clearing House against their exposures, relaxation was allowed to them contrary to rules. The Enquiry Committee is of the opinion that strict enforcement of the rules and regulations is necessary particularly in the context of risk management. One such instance is extension of time to Mr. Iftikhar Shafi. On May 03, 2000, Mr. Iftikhar Shafi did not make due payment to the Clearing House by 11:30 A.M. through pay order as resolved by the Board. However, his trading rights were not suspended contrary to rules. The Manager Clearing House made the following note on the suspension letter dated May 03, 2000, which was to be issued to Mr. Iftikhar Shafi “Suspension has been stopped by Managing Director, LSE. Payment has been made at 2:30 P.M. on May 03, 2000.” This indicates that management has favoured the member by relaxation of the rules and regulations. There could be other instances of similar nature. Copy of the said letter is placed at Annexure “W”

2.5 Reduction of Exposure instead of depositing additional shares/cash against Clearing House demand. The Enquiry Committee has observed that in some cases, notices were issues to members by the Clearing House, however, the said members instead of making deposit had reduced their exposure. The Enquiry committee is of the opinion that this practice increases the risk of the Clearing House. Some of the instances are placed at Annexure “X”

2.6 Abnormal increase in the prices of shares deposited as security with the Clearing House. The Enquiry Committee has observed that in some cases, on receipt of demand notice from the Clearing House, the prices of the shares deposited with the Clearing House were increased abnormally apparently to cover shortfall in the exposure. Mr. Iftikhar Shafi was issued a demand notice for Rs. 4.50 million on May 22, 2000 on the basis of exposure calculated at 10:33 A.M. to be paid/deposited within banking hours. At that time he had 7,091,000 shares of The Bank of Punjab as outstanding purchases and 601,000 shares of The Bank of Punjab as exposure deposit with the Clearing House. He failed to comply with the said notice. The exposure was again calculated at 2:35 P.M. soon after the start of the second session. A demand notice of Rs. 7.480 million was again issued to him to deposit the cash/shares in 30 minutes. In response to a query that why his trading rights were not suspended on May 22, 2000., The Enquiry Committee was informed “Loss was covered due to rate fluctuation.” The Enquiry Committee observed an increase of Rs. 8/- in the price of the Bank of Punjab towards the close of the session (Rs. 38 to Rs. 46) wich improved the value of 7.692 million shares of The Bank of Punjab held by Mr. Iftikhar Shafi as outstanding purchases and deposit with the Clearing House. The management, particularly the Clearing House took no notice to safeguard the Clearing House. Subsequently the share price of The Bank of Punjab dropped significantly. Copy of the notice dated May 22, 2000 and relevant exposure summary are attached at Annexure “Y”.

2.7 Incorrect Calculation of Exposure of Mr. Iftikhar Shafi. The Enquiry Committee has noticed that exposure of Mr. Iftikhar Shafi was calculated incorrectly since March 27, 2000 till May 17, 2000. He was allowed half of free limit for exposure and losses on becoming member of LSE. Although, the exposure reports are indicating deduction of half limit i.e., Rs. 20 million from March 27, 2000 to May 17, 2000, however, the exposure demand was somehow calculated after deduction of normal free limit of Rs. 40 million for the above period. The computer software failed to correctly calculate his exposure. The Clearing House also could not identify this lapse during usual monitoring of exposure of members. Some of the exposure summaries are placed at Annexure “Z” which indicates that exposure of Mr. Iftikhar Shafi was wrongly calculated. The Enquiry Committee then have also notices that in the case of Mr. M. Iqbal Khawaja, the exposure was voluntarily reduced to Rs.10 million. His exposure, however, was being correctly calculated after deducting only Rs.10 million and not full exposure of Rs. 40 million, as was the case with Mr. Iftikhar Shafi. The Enquiry Committee is unable to understand as to how the system was calculating incorrect exposure demand in the case of one member while this was not the case for the exposure calculation of other member. A copy of exposure report of Mr. M. Iqbal Kawaja calculated on April 03, 2000 is placed at Annexure “AA”.

2.8 Accumulation of deposit against exposure in volatile scripts. In the case of some of the members, the outstanding positions and the deposit against exposure were accumulated in extreme volatile scripts, however, no notice was taken by the management to ensure the safety of the Clearing House in this respect. The outstanding positions were carried forward and deposits were provided in only those volatile scripts, which should have been noticed by the management of LSE. Please refer Annexure “AB” which indicates the deposit of 15 scripts on March 31, 2000 whereas the position changed over the period and volatile scripts were accumulated as is evident from the exposure report of May 31, 2000.

2.9 Deliveries to members retained without their instructions. In some cases, the shares of the members against deliveries were retained for deposit without any written instructions from the said members. This fact is evident from the exposure position of Mr. Iftikhar Shafi attached with this report. Whereas, this action of the management was for the protection of the Clearing House, the Enquiry Committee is of the opinion that proper instructions for pledge of such shares as deposit against exposure should have been obtained from the members.

3. Trading Rights not suspended on failure to make due payment/deposit against exposure and loss. In this respect, the cases of some of the members have been examined in detail.

3.1 Ms. Sonia Nisar. Ms. Sonia Nisar started trading from May 26, 2000 as per record produced by LSE management to the Enquiry Committee. She has not made any payment/deposit against exposure to the Clearing House. She has purchased 3.0 million shares of The Bank of Punjab and sold 2.0 million shares on May 26, 2000. The balance shares were carried over by her into next clearing starting from May 29, 2000. The loss on account of this transaction calculated at 2:47 P.M. on May 26, 2000 was Rs 5.605 million. After allowing free loss limit of Rs. 500,000, there was a loss of Rs. 5.090 million at 2:47 P.M. She was not issued any demand notice on that date. On May 29, 2000, the market fell further and she suffered further loss on his carried over position of 1,000,000 shares of The Bank of Punjab. The notice was served for deposit, which was not complied by the member. On May 30, 2000 the market was closed. A further notice No. 2435 was issued on that date for deposit of dues by 11:00 A. M. Ms. Sonia Nisar made a payment of Rs. 10 million through cheque No. 696950 dated May 31, 2000. This was not sufficient to cover clearing loss and exposure against outstanding position. Her trading rights were suspended on June 01, 2000. Subsequently she made full payment of the dues to the Clearing House.

3.1.1 In this regard, her exposure summary from June 26, 2000 along with notices issued by the Clearing House and copies of other relevant papers are also attached as Annexure “AC”

3.1.2 No demand notice was issued to Ms. Sonia Nisar on May 26, 2000. She was allowed to carry over her position to next clearing period. When, she again suffered losses on May 29, 2000, notice was issued, however, her trading rights were not suspended contrary to the rules and regulations. The Enquiry Committee is of the opinion that LSE should have suspended her trading rights on May 26, 2000 and she should not be allowed to carry forward his position. Even otherwise, she was in default on May 29, 2000 and he trading rights must have been suspended on that date. It has also been noticed that on the very first day of opening of her terminal for trading, a request was made to increase her exposure. This request is contained in her letter dated May 26, 2000 and recommended by the Manger, Clearing House to increase her exposure from Rs. 20 million to Rs. 40 million. The signature of this letter is different from the signature put by Ms. Sonia Nisar on the letter allowing Mr. Iftikahr Shafi to use her room. Both these letter are placed at Annexure “AD”. The Enquiry Committee is bewildered at the recommendation made by the Manager Clearing House to increase the exposure of a member on the very first day of opening of her trading terminal. This again speaks of the influence of the members over the management of LSE and its policies.

4. Mr. Iftikhar Shafi. Two different summaries of demand against exposure and losses of Mr. Iftikhar Shafi for the period March 20, 2000 to June 06, 2000 have been provided to the Enquiry Committee. There are contradictions in the said summaries. The same are placed at Annexure “AE”. From May 17, 2000, Mr. Iftikhar Shafi did not pay due exposure deposit to the Clearing House. Instead he tried to reduce his exposure and losses through increase in prices of the scripts held in exposure as well as outstanding purchases. This fact is clear from the aforesaid statement, which states “loss covered during banking hours’ on May 16, 2000. “Clearing shares retained “ on May 17, 2000. “position reduced within banking time” on May 19, 2000 and “loss covered due to fluctuations” on May 22, 2000. On May 18, 2000, his exposure was doubled by the Management Committee without approval of the Board of Directors (This issue has already been discussed in detail earlier in this report). Thereafter, during next clearing May 22, 2000 to May 26, 2000, he suffered huge losses. The terminal of Mr. Iftikhar Shafi was not switched off despite the fact that he was in default. The Manager Clearing House issued him notices, however, his trading rights were not suspended. Manager, Clearing House was empowered to suspend the trading rights of a member if his exposure limit is breached. In the meantime, the risk of Clearing House kept on increasing. Mr. Shafqat Ali, Manager Clearing House has contended that, in view of the gravity of the situation, which according to him could have been disastrous for LSE, he made a business decision not to close the terminal of Mr. Iftikhar Shafi which was violation of the regulations. When his attention was brought towards the responsibility of the Managing Director and the Board of Directors to take decisions and that he was never mandated to take business decisions, he said that he kept the Managing Director informed of all such Developments during the May 2000 Crisis. Mr. Jamil Ahmed, the then Managing Director, however, in his interview with the Enquiry Committee has stated that the Manager Clearing House did not inform him of these development and he was directly reporting to the then Vice Chairman. While this statement of the Managing Director is not convincing as he was mainly responsible to take measures for the safety of the Clearing House, the Enquiry Committee is of the opinion that either the Board of Directors had no knowledge of the risk management of LSE or they deliberately avoided to direct the management to take requisite measures at a critical juncture in the history of LSE. Mr. Iftikhar Shafi was suspended on June 05, 2000. Had his trading rights been suspended earlier, the LSE, its members and investors could have avoided the losses. Copies of the letters dated August 08, 2000 written by Mr. Shafqat Ali, Manager Clearing House and letter dated August 05, 2000 written by the then Managing Director to the Mr. Itrat H. Rizvi, Chairman Enquiry Committee are also placed for reference at Annexure “AT”

4.1 In response to the specific query as to why the terminal of Mr. Iftikhar Shafi was not switched of when he failed to deposit the exposure within stipulated time, LSE has informed that he was served notice on May 25, 2000. However, he did not complied with the demand notice. He was again issued notice on May 26, 2000 and he deposited 300,000 shares of The Bank of Punjab at Rs. 39.60. The Enquiry Committee is of the opinion that the rate at closing of the said share was Rs. 33/- and his exposure must had been breached on that date even after the deposit of the said shares. He was, however, allowed to carry over his positions instead of suspension of his trading rights. He was allowed to transfer 3,000,000 shares of The Bank of Punjab to Ms Sonia Nisar who was just given trading rights on that date and re-purchase 2,000,000 shares of The Bank of Punjab leaving the net transfer of 1,000,000 shares of The Bank of Punjab. Ms. Sonia Nisar suffered losses on the said shares, however, her trading rights were also not suspended. Annexure “AF” gives detail of the exposure of Mr. Iftikhar Shafi calculated at the minimum prices of his shares during May 22-25, 2000. Notices were issued during the aforesaid period but his trading rights were not suspended. His trading rights were not suspended on May 26, 2000 and May 29, 2000 despite his failure to comply with the Clearing House demand notice. In the opinion of the Enquiry Committee, his exposure was not properly monitored during the aforesaid period.

5. Mr. Shahid Nauman Rana. Since May 17, 2000, he has been reducing his exposure instead of making payment/ deposit to Clearing House. His exposure breached on May 25, 2000. However, he reduced his exposure. Subsequently he failed to fulfill his obligation of demanded exposure towards Clearing House. On May 30, 2000 instead of making deposit against exposure of Rs. 19.110 million, he made payment of his clearing dues of Rs. 11.541 million. His trading rights were suspended, along with other on May 30, 2000 vide Board Resolution of LSE passed on May 30, 200. However, his terminal was switched off on June 01, 2000. His exposure and loss summaries are placed at Annexure “AG”

6. Mr. Muhammad Iqbal Khawaja. Two summaries for exposure and loss of Mr. Muhammad Iqbal Khawaja have been presented to the Enquiry Committee. Both the statements are contradictory. These are placed at annexure “AH”. Whereas, one indicates that on May 26, 2000 the exposure was within limits, the other indicates due payment against exposure of Rs. 9.773 million. Moreover, one indicates that on May 25, 2000 demand of Rs 387,724/- was raised, which was complied whereas the other summary shows that exposure was not breached. The Exposure report dated May 25, 2000 calculated at 2:43 P.M. tells altogether a different story. According to this, his exposure breached on May 25, 2000. Notice was also served on May 23, 2000 and May 24, 2000 for additional deposit and he is stated to have reduced his exposure. He also exceeded his exposure on May 26, 2000. In the next clearing on May 29, 2000, he suffered further losses. He was suspended on May 30, 2000. However, his terminal was switched off on June 01, 2000. In the opinion of the Enquiry Committee, his trading rights should have been suspended during clearing period May 22-25, 2000.

7. Other Members. Other members were also given relaxation in time to clear their liability and their trading rights were not suspended as per regulations. The Enquiry Committee has not included the details of such members, which can be provided, if so desired by SEC. Their exposure summaries are attached as Annexure “AU”

NON-COMPLIANCE IN IMPLEMENTING “MEMBERS DEFAULT PROCEDURE FOR RECOVERY OF LOSSES REGULATIONS”

1.1 ‘Members’ Default and Procedure for Recovery of Losses Regulations’ were enforced simultaneously with ‘Regulations Governing Members’ Exposure’ and are placed at Annexure “AI”. These regulations laid down the procedure to be followed in the event of default, recovery and distribution of loss of defaulting members and payment of their claims.

1.2 According to these regulations, in case a member fails to pay any amount payable by him, or fails to deliver shares as per rules and regulations of the Exchange, he shall be issued a notice by the Exchange requiring him to deposit the amount and deliver the shares. On failure to comply with the notice by the member within the time allowed, the Board shall suspend him. Once a member is suspended, all his outstanding transactions shall be squared up in the open market and a final notice of loss so determined, shall be served, calling upon him to pay the losses within the time stipulated therein. If he fails to comply with such notice, the Board shall declare him defaulter. Upon such declaration, a statement shall be prepared by the Exchange to ascertain such Defaulter’s scrip wise loss with a statement of transactions made with other members in those scripts. The losses arising out of the squaring up of the transactions by the Exchange in a particular clearing shall be debited to the account of those members with whom such transactions had been originally contracted by the defaulter and such members shall have to pay the losses to the Clearing House of the Exchange. Such payments by the members will, however, be treated as ‘Claims” by them against the defaulter and shall be settled along with other claims out the assets of the defaulter that may be realized/recovered by the Exchange, on proportionate basis.

1.3 According to these regulations, losses shall be recovered first from the deposit of the defaulter with the Exchange, then sale of defaulters’ assets in the control of the Exchange and thereafter, from contribution from the Clearing House Protection Fund (Members Contribution Funs) and any other source as may be determined by the Board of Directors. According to the regulations for Members Contribution Fund, the payment from the Fund shall not exceed Rs 3 million per default. This payment shall be used to satisfy the claims of other members viz - a – viz Exchange related trades executed through LSE in case the liability of the defaulting member is not fully discharged. The said regulations, however, authorize the Board of Directors to utilize the fund for the timely, orderly and efficient settlement of the clearing in the event of non-compliance of the payment obligation of any member. Such payment should be immediately returned to the fund’s accounts through cash or through sale of asset of the defaulter.

1.4 The flow of information from Clearing House in case of exposure default is described at Annexure “AJ”. Default regulations are applicable in case any member fails to pay Clearing House dues/ deposit against exposure and loss.

1.5 The Committee has noted that Default Regulations were not strictly followed by LSE. In case LSE had strictly enforced and followed the exposure and default regulations, the defaulting members would have suspended much earlier. The Enquiry Committee is of the opinion that their timely suspension could have saved the enormous loss to LSE, its members and investors.

1.6 Mr. Iftikhar Shafi has undertaken to pay the losses arising out of his stock exchange transactions through his letter dated June 03, 2000 (placed at Annexure “AK”), which was subsequently formalized as an agreement and executed on June 05, 2000 (Annexure “AL”). Under the agreement Mr. Iftikhar Shafi agreed to pay all losses in his account as well as losses in the account of other defaulting members namely, M/S Mohammad Iqbal Khawaja, Shahid Nauman Rana and Naeem Anwar in that particular clearing. In compliance to the agreement, Mr. Iftikhar Shafi delivered two cheques of Rs. 50 million each to LSE. Due to this agreement, the members aforesaid were not suspended and declared defaulters. .

1.7 The minutes of the Board of Directors meeting of LSE clearly demonstrate the Board of Directors of LSE accommodating suspending members by assuming their liabilities contrary to the rules and regulations of LSE. This was the risk of the counter parties, which was assumed by LSE by using Investors Protection Funds, Members Contribution Fund and by obtaining loans without declaring its members as defaulters. The relevant excerpts from the minutes of the Board of Directors meeting held on June 02, 2000 are reproduced as follows:

1.8 LSE Board of Directors used the funds of the exchange to square up the Clearings. Members Contribution Fund and Investors Protection Fund were used for squaring the position of members without declaring them defaulters. This has resulted in substantial losses to LSE including financial charges on loans in addition to loss of opportunity cost of funds utilized from Members’ Contribution Funds and Investors Protection Funds. The beneficiaries of this action were several members including those who were at that time members of the Board of Directors of LSE and those who were suspended later on. A statement of the scrip-wise losses statement of Mr. Iftikhar Shafi against counter parties is attached as at Annexure “AM”. The Enquiry Committee do not agree to the point of view of the LSE Board of Directors that there was any risk of chain reaction and more defaults in case of strict adherence to the Default Regulations.

2. Article 39 of the Articles of Association of LSE provides that the Board may by a Resolution passed by not less than two third of its number, declare a Member who fails to meet his obligations to the Clearing House, to be a defaulter. The minutes of the meeting of the Board of Directors held on July 21, 2000 at which Mian Muhammad Saeed, suspended member LSE was declared defaulter for non payment of his Clearing House dues, indicates the presence of only eight (8) out of total 18 directors. This appears to be in violations of the provisions of the aforesaid Articles of Association of LSE. Please refer Article 39 and copy of the minutes of meeting of the Board of Directors held on July 21, 2000 placed at Annexure “AN”.

3. In the opinion of the Enquiry Committee, notwithstanding the fact that the Board of Directors had not adhered to the Default Regulations due to the circumstances prevailing at that time and they had made a choice of not following the regulations, now the situation has changed. The Enquiry Committee has learnt that Mr. Iftikhar Shafi has been declared defaulter and his assets had been disposed of by LSE. Now is the time that LSE should invoke the provisions of the Default Regulations to transfer the loss suffered by LSE to the counter parties.

1. Action by LSE for non-compliance in implementing the Regulations Governing Members’ Exposure. No action has been taken so far by LSE for non-compliance of exposure limits by the Clearing House. It is pertinent to reproduce the question put to the management of LSE in this matter and its reply:

“Any action taken by the Exchange for non-compliance in implementing Regulations Governing Members Exposure.”

1.1 The Board of Directors in its meeting held on June 02, 2000 have considered the issue of non-compliance with the exposure rules. The relevant excerpts of the minutes are reproduced hereunder:

1.2 During the course of its meeting with Mr. Asim Zafar, the Then Vice President, LSE, the Enquiry Committee was informed that a Committee was set up for looking into this matter and suggesting appropriate disciplinary action against the personal responsible for the lapses in implementing exposure rules, however, on appointment of Enquiry Committee by SEC to investigate May 2000 Crisis, no further action was taken. The Enquiry Committee is not convinced with the justification given for not taking action against the officers responsible for the lapses. Moreover, no record was produced as to when the Committee was formed and whether it ever met to discuss this issue.

2. Action by LSE for Non Compliance with Members’ Default and Procedure for Recovery of Losses Regulations. So far as the non-compliance with the Members’ Default and Procedure for Recovery of Losses regulations is concerned, no action could be taken because the Board of Directors itself decided not to comply with the said regulations. This apparently was done because of the conflict of interest prevalent in the Board of Directors of LSE. This has already been discussed earlier at-length.

1. Requirements for Good Governance at Clearing and Settlement Staff. The essential elements of good management of Clearance and Settlement Department have already been discussed at Para 2.5 in detail.

1.1 Level of competence of staff. The Committee has conducted the interviews of the senior staff of the Clearing House. Although the staff is working with the Clearing House since long, there have been no supervision and monitoring of the Clearing House and its activities, which has lead the staff to run their affairs independently and taking decisions at times for which they were not mandated. The lapses identified in the report amply demonstrate the gross carelessness of the management of LSE. Thus, they have failed to discharge their responsibilities towards the compliance of Regulations Governing Members’ Exposure and the limits fixed from time to time. The level of the competence exhibited by the Clearance and Settlement senior staff of LSE fell short of the competence needed for the efficient running of the Clearing House, which has the responsibility of managing risk relating to the members obligations towards the Clearing House. The Committee is of the opinion that in addition to the knowledge of the subject, the integrity of the senior officers is of paramount importance. Moreover, the Managing Director may also keep interaction with this department and ensure that the rules and regulations are followed strictly. In the opinion of the Enquiry Committee, the competence of the clearance and settlement staff was not of the level needed for running a Clearing House efficiently and prudently.

1. Mr. Iftikhar Shafi has instructed LSE through his letter dated May 30, 2000 to square up his positions. This is the only letter, which was provided to the Enquiry Committee by Mr. Iftikhar Shafi. A copy of the said letter is placed at Annexure “AO”. According to this letter, he has authorized LSE to dispose of his shares lying with the Clearing House towards losses/exposure and to square up his outstanding positions in his account up to May 29, 2000. Market was closed on May 30, 2000.

1.1 The Enquiry Committee has specifically required from LSE to explain as to why the instructions received from Mr. Iftikhar Shafi to square up his position was not complied with. LSE’s response received on May 19, 2002 is placed at Annexure “AP”

1.2 According to the aforesaid letter, LSE has denied having received the said letter dated of Mr. Iftikhar Shafi. LSE has taken the plea that he was never stopped from reducing his outstanding position. Moreover, squaring can only been done after declaring a member defaulter. Mr. Iftikhar Shafi has not paid Rs. 951,927 demanded by the Clearing House followed by another notice on May 26, 2000 to deposit Rs. 11.667 million. He deposited 300,000 shares of The Bank of Punjab at an average price of Rs. 39.60 per shares amounting to Rs 11.880 million. LSE has also taken the position that outstanding positions of Mr. Iftikhar Shafi could not be squared up under the rules and regulations during accounting period May 29-June 05, 2000. That could only be squared up on the settlement date upon receiving a notice from the member to whom the delivery would be made.

1.3 The Enquiry Committee has examined this issue and its observations are as under:

1.4 The Enquiry Committee is of the opinion that LSE has to follow its rules and regulations and square up the positions of the members whenever there is any failure on the part of the members to make payment/deposit to the Clearing House. LSE should have squared up the position of Mr. Iftikhar Shafi prior to his request. In this regard, LSE has also taken the plea that it was not practically possible to square up huge positions of the defaulting members. The Enquiry Committee is of the view that it was total failure of the risk management of LSE that some of the members were allowed to take huge positions in extremely volatile scripts and no action was taken for the safety of Clearing House.

1.5 LSE management instead of following the regulations have decided to enter into agreement with Mr. Iftikhar Shafi and also allowed time to other members to pay the dues of the Clearing House. The details of placement of deposits of the defaulting members are placed at Annexure “AR”. As the defaulting members did not agitate this issue, therefore, the Enquiry Committee has not gone into its details.

1.1 SEC should ensure that the Board of Directors strictly complies with the requirements of the Companies Ordinance, 1984 pertaining to conflict of interest issue. The Directors of LSE are in a fiduciary duty to safeguard the interest of LSE, its members and the investors and not their personal interest. In the meeting of the Board of Directors held on June 02, 2000 where it was decided not to follow the regulations to save the Badla (COT) supplier, some of the directors who were present in the said meeting, were those who also had provided Badla (COT). They could be regarded as interested directors in terms of the provisions of the Companies Ordinance, 1984. This is very serious issue and SEC may advise LSE to desist from the current practice with immediate effect. Annexure “AS” is placed to give names of the members/others who have supplied Badla (COT). This demonstrates as to how the members with prior knowledge of things could maneuver a situation to their favour and pull out their money from the market.

1.2 SEC may strictly watch the affairs of LSE and take action against the directors who violate the mandatory provisions of the Companies Ordinance, 1984, Articles of Association and directives of SEC.

1.3 The Articles 8.1 strictly prohibit directors from having business dealing with the Exchange. SEC may look into if any of the current activities of the directors could fall under the definition of business dealings.

1.4 In this regard, the Enquiry Committee has also observed that a sizeable number of members of KSE also hold membership of LSE. These members are not active at LSE and visit only to cast their vote at the time of election of Directors of LSE. It is generally believed that they vote collectively for the group of directors of their own choice. Their votes are considered extremely significant for the election of directors. Through the election of their own directors, they are able to maneuver the policies of LSE for their personal gains. This indicates the influence of KSE on the independent decisions making of LSE. SEC may also look into this aspect so that LSE may be freed from the influence of KSE.

2. Management of exposure limits. LSE must strengthen the Clearing and Settlement Department and take necessary steps to induct qualified and experienced staff with high integrity. Software must be tailored to promptly identify the positions of those accounts, which crossed their limits of exposure and losses and identify and block their trading rights automatically. Audit department should also give priority to the compliance of exposure regulations. Status of compliance should also be reported to the Managing Director and the Board of Directors periodically. Before implementing any change in exposure rules, the software must be developed and tested.

3. Power to make changes in exposure and loss limits and deposit payable thereon. This is very sensitive matter to be left solely at the discretion of the Board of Directors, in which the majority of the members are market players and Badla (COT) supplier. It is recommended that the decision of the Board should be made after obtaining comments from all stake-holders and subject to confirmation of SEC. Management Committee should not be allowed to prescribe changes in the exposure rules.

4. Members’ Default and Procedure for Recovery of Losses Regulations. Mr. Iftikhar Shafi has recently been declared defaulter. LSE must now strictly follow its regulations and determine scrip wise loss with a statement of transactions made with other members in those scripts. These losses shall be debited to the account of those members with whom the defaulter originally contracted such transactions and such members must pay the losses to Clearing House of LSE as required by the Default Regulations of LSE.

5. Internal Audit. There is no in house audit department. This has resulted in indiscipline and other irregularities. The Enquiry Committee strongly recommends that SEC may direct LSE to immediately put in place an internal audit system, which could take the system audit of Clearing House periodically.

6. Code of Conduct for Directors. The members of the Board of Directors are subject to usual legal duties and obligations. In addition, in view of high public profile of the Exchange, they are required to follow and be seen as conforming to the ethical standards and norms. SEC may, therefore, prepare and implement a code of conduct for the directors of and make the directors accountable for their misdeeds. Non-compliance with the Regulations Governing Members’ Exposures and Members, Default and Procedure for Recovery of Losses regulations have resulted in losses to the Clearing House/members. It was done to save Badla (COT) supplier, which included many members of the Board of Directors. SEC may take necessary action against those who have refused to follow the rule of law.

7. Clearing House Staff. There is great need to strengthen the professional management at the Clearing House of LSE. There should not be any vagueness in the duties of the Clearing and Settlement Staff. Every officer must know his/her job description. Orientation of the staff is also imperative along with their regular training for enhancing their capacity.

8. Recording of minutes of Board meetings. SEC may take a note of the observation of the Enquiry Committees on the minutes of the Board of Directors, which amply demonstrate lack of information, lack of discussion and deliberations and application of mind. It is recommended that the LSE may recruit a professional and experienced Secretary to the Board.

9. Trust for Members Contribution Funds and Investors Protection Funds. It is recommended that Trust may be established for the administration of the Members Contribution Fund and Investors Protection Fund. This will ensure use of the funds in accordance with the rules and regulations. Investors must also be given adequate representation on the Trust for Investors Protection Funds to ensure that the funds are utilized for the benefits of the investors.

10. Non-compliance of mandatory provisions. Although it may not be relevant to the present enquiry, however, the Enquiry Committee feels its responsibility to point out some issues, which have come to its knowledge during the course of investigation.

10.1 In a Board of eighteen (18) members, it has been noted that in several cases the attendance was less than 50% of the total number of directors. Under the provisions of Section 188 of the Companies Ordinance, 1984, a director shall ipso facto cease to hold office if he absents himself from three consecutive meetings of the directors or from all the meetings of the directors for a continuous period of three months, whichever is longer, without leave of absence from the directors. This provision has also been included under Article 81 of the Articles of Association of LSE. The Enquiry Committee has observed that leave of absence was never given to the directors who could not attend the Board Meetings. SEC may impress upon the Board of Directors to follow the provisions of the Companies Ordinance, 1984 and the Articles of Association of LSE.