A Projection into the Future: Demutualization of the Nigerian Stock Exchange (NSE)

A group dominated by brokers developed a platform on which they could trade securities of publicly traded companies. Year after year, that group grew larger, and several brokers formed associations, which later evolved into the Nigerian Stock Exchange. However, with little capital, increasing competition, and almost non-existent corporate governance strategy, investors’ wealth and confidence in stock exchanges declined. Given this situation, the Council and Members of the Nigerian Stock Exchange (NSE) in collaboration with the Nigerian government, enacted several changes to instil confidence in investors. These amendments not only made the NSE demutualization mandatory but also streamlined the corporate governance process.^[1] This was not, however, the first time a government attempted to regulate its stock exchanges.

Historically, governments in both developed and developing countries have attempted and succeeded in regulating their stock exchanges, and the trading that takes place on them^[2]. This paper highlights the transition of a not-for-profit member-owned organization to a shareholder-owned organization, as well as the role of governments in regulating stock exchanges in Nigeria. The primary contribution of this paper is in the field of corporate governance, specifically about the process of stock exchange demutualization. This paper will not only help to improve investors’ perceptions of stock exchanges, but it will also promote the reliability and confidence of stock exchanges.

DEMUTUALIZATION: ITS DEFINITION AND SIGNIFICANCE

Conventionally, stock exchanges operated as a “club of brokers” under a mutual operating system, who enjoy the rights of ownership and decision-making. Stock exchanges^[3] have faced several challenges in recent years, due to technological advancements and improvements, growing competition and globalization. Consequently, many stock exchanges are now rethinking their investment decisions, regulatory reforms and aggressive environment. The challenge for stock exchanges, is to find new opportunities in the present environment, while surviving new threats.^[4]

As a result of this, the 21^st Century saw stock exchanges transforming their corporate governance structures, through demutualization due to the globally competitive environment. Gerald Epstein labelled three words; “neoliberalism, globalization and financialization”, as the phenomenon the world was facing.^[5] Therefore, it is necessary to provide an answer to the question of what demutualization entails.^[6]

Demutualization, in its strictest sense, refers to the change in the legal status of a stock exchange, from a mutual association with one vote per member (and possibly consensus-based decision making), to a company limited by shares with one vote per share (with majority-based decision making). Demutualization makes sense if it causes a shift in the exchange’s goal, from managing the interests of a closed system to managing the interests of an open system.

In simpler terms, stock exchange demutualization is the process of converting a mutually owned association into a company limited by share. In this conversion, decision-making rights are transferred from the members’ association to the number of shares issued (the shareholders). The effect of this is that the ownership structure is transformed, as well as legal and organizational form, and this means less conflict of interest thereby, leading to an improvement on corporate governance of the said stock exchange.

The Benefits

From the experiences of our hero’s past, i.e., those who have successfully championed demutualization, it is obvious that the main allure for the adoption of this process is the need for improved corporate governance structure, reduced transaction costs and an increased attraction of investors’ funds as well. Whilst the reasons are non-exhaustive, the following appear to be more prevalent reasons:

1. Revenue Generation: Increased competition and the possibility of listing in multiple exchanges both within a region and abroad, inevitably leads to a reduction in membership fees, listing fees and transaction fees. This is somewhat foreseeable as the possibility of listing in multiple exchanges, which gives more visibility and exposure to prospective investors, is most likely to be the preferred choice of broker-dealers. In view of this, it is thus inevitable that exchanges will seek to formulate means of generating revenue, which has been described to be mainly by transactions and related services. ^[7]
2. Technological Innovations: The emergence of technology in capital market operations, has garnered competition between exchanges by eliminating barriers and monopolies. Thus, one of the reasons some exchanges embark on demutualization is as a result of technological innovations. ^[8]
3. Operational Structure: This would be inevitable as a new structure is essential to make the exchange a profitable organization. Furthermore, some exchanges have engaged in demutualization for the purpose of mergers.^[9]
4. Competition: Exchanges demutualize in a bid to meet up with ardent competition generated by the possibility of dual listing, alternative forms of trading amongst others. To avoid remaining obsolete, Exchanges embrace these new competitive measures to remain a viable business, and one of the best ways to do this is by converting into a for-profit entity.^[10]

The Demutualization Process of the Nigerian Stock Exchange

The Nigerian Stock Exchange (“NSE”), was a company limited by guarantee up until the demutualization process was concluded. Upon completion, its shares became available for public ownership and is now subject to the rules and regulations governing companies in Nigeria.^[11] This conversion permitted the NSE to carry on business activities to make profits, as is the case with regular corporate entities. It also permitted the NSE to constitute a board of directors to oversee its operations. This gave rise to a new structure – Nigerian Exchange Group Plc (NGX Group) with subsidiaries – Nigerian Exchange Limited (NGX Exchange), NGX Regulation Limited (NGX REGCO), and NGX Real Estate Limited (NGX RELCO).^[12]

Regulatory Concerns with Demutualization

1. Changes due to Ownership

The key regulatory issue arising from the demutualization of NSE, is whether the changes to its ownership and operating structure, will undermine its ability to discharge its role as a frontline regulator competently and effectively. It should be noted, however, that conflict of interest issues are not new to demutualized exchanges. Prior to their demutualization and merger, the Stock Exchange of Singapore and the SIMEX of Singapore already assumed regulatory and business development functions concurrently with potential conflicts on two levels:

1. Members of the exchanges had to set and enforce rules in the public interest that could negatively affect their commercial interests.
2. The exchanges were also expected to conduct effective and impartial supervision of their members. The potential conflicts of interests in these respects, were mitigated by the fact that in a mutually-owned exchange, members share the financial and reputation risks from a failure to properly regulate.

The potential conflict of interests in these respects were mitigated by the fact that in a mutually-owned exchange, members share the financial and reputation risks from a failure to properly regulate.

1. Potential Conflicts

The demutualization and listing of NSE creates a new set of potential conflicts. Profits were never irrelevant to mutual exchanges, but they have now become the primary motivation for shareholders of the listed NSE. Share prices and dividends reflect earnings and prospects more transparently, providing management with a greater incentive to improve operational efficiency and gain a competitive advantage. This is as it should be, and it is a major advantage of demutualizing and listing on the NSE. However, there will be some concern that the greater drive for commercial success will reduce the exchange’s commitment and resources, deployed to effectively fulfil its regulatory and public interest responsibilities at an appropriate standard.

1. The “Public Interest”

The highest point of criticism against the demutualization of stock exchanges has been its ability to still foster public interest. On the other hand, the interest of NSE shareholders and the “public interest” as represented by the users of the exchange can be presented as for the most part, aligned rather than divergent. Common interest in a well-run liquid and large marketplace is not altered by the demutualization of NSE. A fair, transparent and efficiently-regulated market is indispensable to the vibrancy and sustained business success of NSE. Serious investors will not trade on an exchange that does not have internationally acceptable rules of listing, trading and settlement, or does not enforce the rules fairly and effectively. Without the interest and liquidity provided by investors, no exchange will find it easy to attract issuers and to build its business.

1. Credibility

Credibility in regulation is, therefore, a vital commercial asset for NSE. Strong, effective and fair supervision is key to NSE’s brand name. Corporate governance of NSE is not designed to favour short-term revenue objectives at the expense of long-term gains. Shareholders would also have it in their interests to hold the exchange to high standards of market regulation, to achieve sustained returns on their investments.

RECOMMENDATIONS

The regulatory responses to the issues that arise as a result of demutualization, have varied from jurisdiction to jurisdiction, as they are dependent on the legal framework and regulatory philosophy in place^[13]. However, there has been some consistency in dealing with the issues that have arisen, with the general approach tending to keep the self-regulatory function for the time being, while transferring some regulatory functions to the government regulator. The regulatory responses fall into three categories: First, changes to the governance structure to ensure that the public interest is safeguarded and takes precedence over commercial interests; Second, changes to the corporate structure to ensure that the regulatory function specifically continues to be performed and is adequately resourced; and Finally, changes to the regulatory framework to address the conflicts of interest which arise between the exchange upon its listing, and between the exchange and persons dealing with it.^[14]

Changes to the Governance Structure

The governance structure of an exchange, whether mutual or for-profit, has a significant impact on its regulatory and commercial performance, as well as its ability to reconcile the competing interests of its managers, owners, various users and potential users of its services. The structure may have an impact on the delivery of self-regulatory functions.^[15] Failure in this regard may have a negative impact on the market as a whole, as well as exchanges’ ability to deliver on the public policy objectives set for them by governments.

Given the additional pressures that demutualization creates, the statutory regulator and/or government may enact one or more of the following rules: The board of directors may appoint people to represent the public interest. In some cases, such as Hong Kong, the government is empowered by legislation to appoint a majority of directors (in Hong Kong, 8 out of 15). Furthermore, to address the potential conflict that such directors may face, in reconciling the public’s interests with their duties to shareholders, it may be appropriate to provide a statutory remedy.

In Hong Kong, the demutualization legislation imposes an express duty on the exchange to ensure, so far as reasonably practicable, an orderly and fair market in securities or futures contracts traded on or through the exchange. In discharging this obligation, it is required to act in the interests of the public, having particular regard to the interests of the investing public. Where these interests conflict with any other interests that the company is required to serve under any other law, the former must prevail. Since this obligation applies to the exchange, all directors (and not only those appointed by the government) are placed in the same position.^[16]

Changes to the Corporate Structure

Changes may be made to the corporate structure of a group, to ensure that the regulatory function continues to be properly performed (i.e., is carried out independently from, and is not compromised by its commercial operations), and is adequately financed. These actions often involve transferring some or all of the regulatory function to a separate entity, such as:

1. another group company with an independent governance structure and budget (as was done with the NASDR^[17]/NASDAQ^[18] and ASX models^[19]);
2. another self-regulatory organization (or giving the choice to contract out the performance of the functions to another SRO or retaining it in-house but securing its performance in various ways); or
3. the statutory regulator^[20].

In the second case, an assessment must be made of the capacity of the company and its officers, to which the functions are transferred to properly perform them. This may require an assessment of various factors, including: whether the applicant has adequate arrangements in place to operate the market, settle and clear trades, supervise the market, protect retail investors (including compensation funds), and has sufficient resources generally to adequately carry on each of these functions. Even in jurisdictions where the commitment to self-regulation is strong enough, to ensure that there is presently no urge to transfer the regulatory functions to the statutory regulator, it is important to ensure that any restructuring is seen to achieve true independence.^[21]

Unless the public perception is one of genuine independence, then the solution is unlikely to last and pressure will mount for a complete transfer of responsibility to the statutory regulator. Ensuring adequate resourcing of the regulatory function may also involve imposing capital adequacy requirements, or requiring the establishment of reserves, much as for financial intermediaries. There is commonly no requirement for an exchange simply to have sufficient financial resources, to conduct its regulatory functions efficiently. Arguably, such a requirement is desirable. In the NASD case, the SEC was able to direct the expenditure of sufficient resources to particular areas of regulation.

Conflicts of Interest

It is now widely accepted that a self-regulatory exchange should not be responsible for its listing or supervise its compliance with listing rules and trading in its securities^[22]. What should be done when conflicts arise between the exchange and other exchange users is less clear. However, these may entail treating a business competitor harshly, or a business associate leniently than would otherwise be the case, for example, a listed company or broker setting up a new trading or clearing system. In such cases, powers may be needed to step into the shoes of the exchange and discharge the relevant regulatory function.

In Hong Kong, the demutualization legislation provides that whenever the SFC is satisfied that a conflict of interest exists or may arise, or has existed and may be repeated, between the interests of the exchange and the interests of the proper performance of a regulatory function, the SFC may by notice, direct the exchange to take steps specified in the notice (including steps in relation to any of its affairs, business and property). This is to remedy the conflict, or the matters occasioning the conflict.^[23] The exchange may appeal to the Chief Executive in Council but the notice takes effect immediately.^[24] It can be presumed that in such instances of conflict, any third party which feels it is being prejudiced, will make this known to the statutory regulator. However, it can also be assumed that a business associate of the exchange, being given a sweet deal by the exchange, will not be so quick to announce it.

Furthermore, there may be some concern that users of the exchange will be tempted to complain too readily, that conflict of interests may arise, and that the exchange becomes increasingly unable to exercise its normal regulatory and disciplinary functions. While responsibility for stepping into the shoes of the self-regulatory organizations and exercising relevant functions may be assumed by the statutory regulator, it would be possible for the regulator to appoint another person to undertake this function on its behalf.^[25]

Conclusion

Several new regulatory issues arise when a stock exchange demutualizes. Among other things, it is necessary to review the self-regulatory functions which are performed. There are good reasons for exchanges to continue as Self-Regulatory Organizations (SRO), but some changes usually need to be made to the corporate and governance structure of the organization, to ensure that the self-regulatory function continues to be properly performed, and that the public interest is safeguarded.

While self-regulation is firmly accepted as a primary mechanism for the regulation of the securities industry, it needs to be recognized that it also poses risks for the implementation of public policy objectives in the industry: the risk of uneven enforcement, capture of the regulators by the regulated industry and the creation of barriers to entry or competition. These concerns are not necessarily resolved, where a demutualized exchange decides that it is no longer willing to continue to perform all, or some of the SRO functions. If nobody is qualified to assume the functions in its place, the government may have to refuse such a transfer. This would no doubt, call into question the exchange’s commitment to perform the functions to the same standard as before.

The demutualization of an exchange is not incompatible with self-regulation. The ability of the exchange to meet the standards set for it and deliver key regulatory and public interest objectives, depends on a range of factors including the overall regulatory framework, the exchange’s obligations under the law, the formulation, administration and enforcement of its listing and trading rules, its formal and informal arrangements with the statutory regulator, its management structure, the transparency of its decision making processes, its allocation of resources for particular regulatory functions and the experience and quality of its staff.

Arguably, the capacity and the willingness of the statutory regulator to perform its supervisory role, is key to the success of the regulatory framework.

REFERENCE

1. J. W. Carson, ‘Conflicts of Interests in Self-Regulation: Can Demutualized Exchanges Successfully Manage Them?’ (2003) 3183 World Bank Policy Research Working Paper http://ssrn.com/abstract=636602 accessed February 16 2022 ↑
2. Elliott, Jennifer, ‘Demutualization of Securities Exchanges: A Regulatory Perspective. IMF Working Papers (. (2002) 2(10). ↑
3. the capital raised by a company or corporation through the issue and subscription of shares. ↑
4. M. S. Islam and M. Rezaul, ‘Demutualization: Pros and Cons for Dhaka Stock Exchange, [2011] 33(20) http://pakacademicsearch.com/pdf-files/ech/517/24-33%20Vol%203,%20No%2012%20(2011).pdf accessed February 19 2022 ↑
5. G. Epstein, Financialization and the World Economy’, (Edward Elgar Publishing 2005) ↑
6. M. Hammad, A. Awan, and A. Rafiq, “Demutualization in Developing and Developed Country Stock Exchanges” [2015] 3(2) The Lahore Journal of Business http://lahoreschoolofeconomics.edu.pk/businessjournals/V3issue2/03%20Hammad%20et%20al.pdf accessed February 14 2022 ↑
7. O. Akpomudje, “DEMUTUALIZATION OF THE NIGERIAN STOCK EXCHANGE”, [2021] 1(1) Albert Akpomudje Newsletter https://albertakpomudje.com/newsletter_on_stock_bookoldman.pdf accessed February 19 2022 ↑
8. Ibid (n7) ↑
9. Ibid (n8) ↑
10. Ibid (n9) ↑
11. Nigerian Exchange Group Plc Unaudited Financial Statements for the period ended 30 September 2021 https://www.proshareng.com/admin/upload/report/14982-34396_NIGERIAN_EXCHANGE_GROUP_PLC%20_QUARTER_3_%20_FINANCIAL_STA-proshare.pdf accessed February 19 2022 ↑
12. https://ngxgroup.com/about-us/ ↑
13. IOSCO, Methodology for Assessing Implementation of the IOSCO Objectives and Principles of Securities Regulation (October 2003) ↑
14. E. G. Kazarian, “Integration of the Securities Market Infrastructure in the European Union: Policy and Regulatory Issues”, [2006] 2461 https://www.elibrary.imf.org/view/journals/001/2006/241/article-A001-en.xml accessed February 19 2022 ↑
15. A. M. Fleckner, “Stock Exchanges At The Crossroads: Competitive Challenges – Reorganization – Regulatory Concerns” [2005] 10(1) http://www.law.harvard.edu/programs/olin_center/fellows_papers/pdf/Fleckner_6.pdf accessed February 12 2022 ↑
16. Reinventing Self-Regulation, White Paper for the Securities Industry Association’s Ad Hoc Committee on Regulatory Implications of Demutualization, accessed February 14 2022. ↑
17. History of the American and NASDAQ Stock Exchanges. Selected References, compiled by Ellen Terrell. http://www.loc.gov/rr/business/amex/amex.html accessed February 18 2022 ↑
18. The National Association of Securities Dealers Regulators (NASDR) was a self-regulatory organization of the securities industry and a predecessor of the Financial Industry Regulatory Authority (FINRA). It was responsible for the operation and regulation of the NASDAQ stock market and over-the-counter markets. It also administrated exams for investment professionals, such as the Series 7 exam. The NASD was charged with watching over the NASDAQ’s market operations. ↑
19. S. Akhtar, Demutualization of Stock Exchanges Problems, Solutions and Case Studies, (Asian Development Bank, 2002) https://think-asia.org/handle/11540/6137 accessed February 17 2022 ↑
20. S. Ahmed, B. Z. Butt. And K Rehman, ‘Demutualization of stock exchanges in Pakistan: Challenges and benefits. African Journal of Business Management, (2011).5(2) https://academicjournals.org/journal/AJBM/article-abstract/F42428C16528 accessed February 18 2022 ↑
21. International Organization of Securities Commission (IOSCO) Discussion Paper of Demutualization of Stock Exchanges http://www.iosco.org/library/pubdocs/pdf/IOSCOPD112.pdf accessed February 11 2022 ↑
22. Ibid (n13) ↑
23. R. Aggarwal,’ Demutualization and Corporate Governance of Stock Exchanges’, Journal of Applied Corporate Finance’, (2002) 15(1), https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1745-6622.2002.tb00345.x accessed February 18 2022 ↑
24. Ibid (n13) ↑
25. Ibid (n9) ↑