Regulation of Nominee Accounts in Emerging Markets Final Report EMERGING MARKETS COMMITTEE OF THE INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS FR11/11 OCTOBER 2011 Copies of publications are available from: The International Organization of Securities Commissions website www.iosco.org © International Organization of Securities Commissions 2011. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ii Contents Chapter Page Executive Summary 5 1 Purpose, Scope and Methodology 6 1.1 Purpose of the Report 6 1.2 Assessment Methodology 7 1.3 Surveyed Jurisdictions 7 1.4 Background 8 2 Structure and Framework for Securities Holding System 10 2.1 Securities Holding System 10 2.2 Components in Securities Holding System 13 2.3 Investor Protection 14 2.4 Structure and Operational Framework for Nominee Account 16 3 Regulatory Measures and Market Practices to Address Nominee Account- 19 Related Problems 3.1 Shareholder Communication 19 3.2 Maintenance of Securities 22 3.3 Operation of Nominee Accounts 24 3.4 Protection of Beneficial Owners in Case of Insolvency 29 3.5 Other Issues Encountered in EMC Jurisdictions 31 4 Recommendations for Better Regulation of the Nominee Account System 32 to Protect Investor’s Interests 5 Conclusion 35 Appendix A Draft Survey Questionnaire on Regulation of Nominee 38 Accounts in Emerging Markets Appendix B Summary of Responses to the EMCWG3 Survey 48 Questionnaire on Regulation on Nominee Accounts in Emerging Markets iii iv Executive Summary As the growth of capital markets has resulted in a sharp rise in trading volumes, the ―direct holding system‖, where investors take physical possession of securities and the delivery of physical certificates completes a securities transaction, makes issuer‘s communication with a large number of shareholders very costly and time-consuming and also prevented investors to undertake securities trading in a timely and efficient manner. In an effort to address this issue, market intermediaries began to hold their client‘s securities in their name (nominee accounts) and maintained records in their books to track securities ownership. Under this indirect holding system, also referred to as street name registration, an investor neither receives physical certificates nor appears as the securities owner on the issuer‘s register. The immobilization and dematerialization of securities prompted by the creation of stock exchanges and central securities depositories also contributed to the adoption of the indirect holding system in many jurisdictions. The indirect holding system, now the prevailing form of securities holding in many world jurisdictions, has significantly enhanced the efficiency of securities transactions and laid the foundation for substantial growth of capital markets over the past decades. However, the indirect holding system also has several issues that could have adverse implications for investors‘ interests including the shareholder rights. In recognition of this, some jurisdictions have been shifting to a new ownership system (modified holding system) under which the investor‘s ownership is registered directly on the issuer‘s register without a need to hold physical certificates personally. Technological advancements, especially in the IT industry, have contributed to the development of this system, as they enable issuers or market intermediaries to keep track of constant changes in securities ownership with considerably less cost and resources. Among the three types of securities holding systems described above, the indirect holding system is most widely used, even in emerging markets with relatively less sophisticated capital markets and, in some jurisdictions, the adoption of this system is still in progress. This will remain so, for some time to come, as the shift to the modified holding system often requires considerable resources, market sophistication, and a certain level of technological development. In this regard, following the pre-approval by Emerging Markets Committee (EMC) Plenary meeting in Istanbul on 14 October 2010, a mandate on Regulation on Nominee Accounts in Emerging Markets was approved in written procedure as the Emerging Markets Committee Working Group on the Regulation of Market Intermediaries (EMCWG3) new mandate on 22 November 2010 to explore common issues associated with the use of nominee accounts under the indirect holding system and develop useful guidance for regulators. The objectives of the mandate are: (1) to assist the members of the Emerging Markets Committee in obtaining a better understanding of different practices and regulations concerning the nominee account system operating in the member jurisdictions; and (2) to identify useful regulatory elements that could be adopted by members, if any, that may improve their frameworks in this area.; and (3) to develop recommendations for better regulation on nominee accounts in order to more effectively protect investor interests and thus to keep their confidence in their financial markets. 5 Chapter 1 Purpose, Scope and Methodology of the Report 1.1 Purpose of the Report This report intends to identify effective regulatory mechanisms and tools for the nominee account system, develop recommendations to better regulate nominee accounts and help regulators address relevant investor protection issues pursuant to the IOSCO Objectives and Principles of Securities Regulation,1 Principle 312 that requires market intermediaries to establish an internal function that delivers compliance with standards for internal organization and operational conduct. While the operation of nominee accounts function in a different manner across jurisdictions, it can be broadly defined as a type of account in which the investor holds his/her securities in the name of a different entity, i.e., the market intermediary or the Central Securities Depository (CSD) who acts as the nominee account operator and whose name appears on the register of the issuer. When investors buy or sell securities through the intermediary, in many markets, the securities traded are not directly registered in the names of the investors but instead recorded in the single name of the intermediary who brokers the transactions using a nominee account. This practice has become an indispensable element to the functioning of modern securities markets, as the use of nominee accounts facilitates the efficiency of securities trading by reducing administration time and costs. However, greater efficiency is accompanied by risk. First of all, in the case of stocks in a nominee account, as they are held in the name of the intermediary rather than the actual beneficial owners and the name of the beneficial owners does not appear on the share register, the intermediary‘s failure to pass on payouts and communications to the beneficial owners would deprive them of their shareholder rights. In addition, the misuse of the nominee account by the intermediary that is allowed to take direct custody of investors‘ securities in some jurisdictions may be a source of concern from an investor protection point of view. The use of nominee accounts by market intermediaries may also give rise to regulatory and supervisory issues related to securities ownership, such as the identification of beneficial owners of securities, as well as those pertaining to the operation of an omnibus account. Particularly, in case of a nominee account operator‘s default or bankruptcy, it is often quite difficult to identify ultimate beneficiaries if proper records and documentation to identify the ownership are not adequately maintained. Despite the efficiency achieved by the use of the nominee accounts, they may also increase the investor‘s risk of not being able to recover their assets if the intermediary faces financial difficulties, particularly in a pooled nominee or omnibus account. 1 The Objectives and Principles of Securities Regulation consist of 38 Principles of securities regulation (including the eight new principles added in June 2010) which are based upon three overarching Objectives of securities regulation: protecting investors; ensuring that markets are fair, efficient and transparent; and reducing systemic risk, Objectives and Principles of Securities Regulation, IOSCO Report, June 2010 available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD323.pdf. 2 Principle 31 of the Objectives and Principles of Securities Regulation for market intermediaries states the following: ―Market Intermediaries should be required to establish an internal function that delivers compliance with standards for internal organization and operational risk, with the aim of protecting the interests of clients and their assets and ensuring proper management of risk, through which management of the intermediary accepts primary responsibility for these matters.‖ 6 In an effort to address these concerns and formulate recommendations that member regulators in the EMC may take guidance from, this report intends to look into the nominee account systems and other securities holding systems in EMC jurisdictions and identify common regulatory issues related to the nominee account and the measures or approaches taken to address them. Based on those findings, the report aims to outline recommendations that regulators in the EMC member jurisdictions may take guidance from. This report is mainly divided into three parts. First, the structure and framework for securities holding system, as well as investor protection issues and the overview of the