Issues Surrounding Security Regulation in Latin America and the Carribean

By Hugo Nemirowsky, Jesse Wright (02/96, IFM-101, En)



INTRODUCTION

The ongoing process of integration of the capital markets of the Western Hemisphere requires that the legal, regulatory and operational differences that impede higher levels of integration be reduced to a minimum. Previous efforts to eliminate these differences, such as the development of a uniform securities act or the standardization of financial instruments and market practices throughout the region, have met with limited success. Yet, a uniform securities act may not be feasible given each country's legal system and traditions. For the same reason, a single model of regulatory practice is unlikely to emerge. Nevertheless, if efficient capital market intermediation is to be achieved, greater uniformity of legal definitions, interpretations and practice is still a must.

This paper makes several assumptions about the basic organization of capital markets and the legal environment in which they operate. First, the right to private property underpins capital market activity, and disputes concerning ownership and the transfer of private property can be settled through due process of law as defined by rules and procedures that are not arbitrary. Second, fairness, consistency and predictability in the administration of laws and regulations are preconditions for investor confidence. It is a truism that this trust cannot be legislated; rather it rests on the credibility of the legal and regulatory environment. Third, capital markets operate best in a stable macroeconomic environment with low inflation, where the prices of goods, services and financial assets are determined by the market and are free to adjust to changing market conditions.

In addition to a stable legal and economic environment, efficient and competitive capital markets require a number of other conditions. The hemispheric integration of capital markets is dependent on issues such as the national treatment of foreign financial intermediaries and investors. Other policy choices that must be considered are whether to promote universal banking or to create and maintain divisions between commercial banking and investment banking; whether to promote organized exchanges or over-the-counter markets, and so on. Finally, policy makers must decide whether to use tax laws and administrative procedures to promote or discourage various kinds of debt or equity securities and derivative markets.

A basic tenet for securities regulation is the desire to protect the investor. Capital formation and the intermediation of savings will not occur in the absence of a market environment that promotes investor trust and confidence. Accordingly, this paper discusses the basic legal and regulatory concepts and the types of institutions that contribute to a safe and orderly regulatory regime. Its purpose is to contribute to the discussion of how best to integrate Latin American capital markets. The paper is organized along the major themes and functional areas of capital markets regulation. It first deals with the rationale for regulation and its subject matter, including the definitions of a security, public offering, investor protection, disclosure and accounting, auditing and rating agencies. Then it reviews the various capital market institutions and regulatory concerns surrounding them. Following this is a discussion of the role and functions of public and private regulatory agencies. The final section deals with efforts to increase international cooperation among regulatory agencies and the role of multilateral development banks in assisting in the attainment of these goals.

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THE REGULATION OF SECURITIES MARKETS

The Rationale for Regulation

Banking and securities markets are different from ordinary goods and services markets. The failure of a financial institution can cause widespread harm, whereas the failure of a large industrial firm, although it may send tremors through the financial system, likely would not threaten the country's credit and payment systems. Some observers believe that financial risks have become more pronounced and the potential for global "systemic failure" is greater now that the world's banking, securities and commodities markets are becoming increasingly linked.

Financial operations can be very complex; and indeed, securities are sometimes called "intricate merchandise." Securities issuers and financial intermediaries will generally know more about the transaction than investors. This is frequently the case with individual investors although institutional investors are generally well informed. Moreover, financial intermediaries are sometimes in a fiduciary relationship with their client, frequently making investment decisions on their behalf. These "information asymmetries" and trust relationships require a higher level of vigilance on the part of securities industry participants and the regulatory authorities.

Effective and credible regulation of financial markets is often associated with increased investor interest in those markets. Rather than slow the development of capital markets, an optimal level of regulation may bolster investor demand for securities. The United States, Canada, and more recently Chile, have developed self-regulatory and publicly regulated securities market oversight known to be among the toughest in the world. These markets also enjoy a high level of investor demand for securities.

Certain conditions have to be met to develop and preserve an orderly capital market and ensure serious investor interest. These include the establishment of a legal framework specifying the rights and obligations of all market participants (including regulators), the enactment of securities legislation, and the creation of a supervisory authority.

Definition of a Security

The importance of establishing the definition of a security is self-evident, because if a transaction or instrument is not legally defined as such it cannot be subject to the system of securities regulation. Attempts to harmonize securities regulation throughout the Hemisphere, have been hampered by differing concepts of what constitutes a security under civil law as practiced in Spanish-speaking countries and the common law of English-speaking countries. The concept of a security in Spanish-speaking countries is usually associated with the civil law concept of título valor. Título valor not only encompasses fewer financial instruments than the common law concept of a security; it is also restricted to those legal instruments in which a pecuniary or other right is incorporated in the document itself. Moreover, the only evidence of the pecuniary or other right is the existence and possession of the document. Thus, the transfer of ownership of a given financial instrument can be effected via endorsement without specifying the new owner, endorsement specifying the new owner, or a simple physical transfer of the document itself.

Recently, however, newer instruments have been introduced in Latin American securities markets that do not fit this narrow concept of título valor. Although such instruments represent an improvement in the efficiency of capital markets in the region, the fact that ownership of financial assets is inseparable from ownership of a legal document has hindered the development of other characteristics of an efficient capital market, such as bookkeeping entry or dematerialization of securities documents in the nonbank payments systems.

In both developed and emerging capital markets, there is a trend to define a security broadly and leave it to the regulatory authorities and to the courts to interpret the statutory definition of actual transactions and instruments. However, balance needs to be struck between a definition that is broad enough to encompass instruments the government desires to regulate, and precise enough to avoid needless litigation. Latin American countries are also broadening their definition of a security so that traditional títulos valores (drafts, bills, letters of credit, bonds and equities) can include transactions in derivatives and other investment contracts that only involve book entries.

Newer definitions of a security are increasingly based on a description of what constitutes a security, rather than strict and narrow definitions of which instruments can be considered títulos valores. Ideally, any definition of a security should be capable of encompassing a wide range of financial activity involving equity or debt instruments issued by corporations or investment funds, including uncommon arrangements such as investment contracts, participations in profits or interest, and rights or options. The effect of this redefinition is that new security instruments can be introduced without having to resort to amendments to existing legislation. This has also led to more flexible regulatory norms that allow the regulatory agencies to stay abreast of rapidly evolving markets. In any event, securities commissions should be empowered to determine what constitutes a security in cases of doubt.

Public Offering of a Security

Latin American countries generally use compatible statutory definitions of what constitutes a public offering, but differences in interpretation of the statutes have resulted in their inconsistent treatment. The problem lies in differences in the de facto application of the statutes rather than de jure differences, particularly with respect to the scope of the term "public offer." Differences in interpretation are even more pronounced between North American jurisdictions and the emerging markets of the Southern Hemisphere.

In Latin America, most of the legislation on capital markets is based on a definition of public offer of securities that focuses on the holders of these instruments (the investing public) and on the means by which these instruments are conveyed (public mails or media). However, with few exceptions, little thought has been given to defining the concept of "offer" itself. As a result, inaccurate definitions have been used by both market practitioners and by the agencies in charge of regulating capital markets.

Most countries regulate public offerings more strictly than private placements since the primary purpose of securities legislation law is to protect the public. In the United States, for example, the definition of public offering depends primarily on whether the persons to whom the securities are sold are believed to need the protection of the Securities Act. If investors need the protection of the Act, the offering is defined as public and registration with the United States Securities and Exchange Commision (SEC) and a prospectus are required.

The legal and economic definitions of the term "offer" also vary. Legally, an offering is commonly defined as an "offer" of sale as well as the willingness to buy. In economic terms, "offer" denotes the existence of supply or the willingness to sell only. A case can be made for adopting either definition, so long as the public's interest is protected. In other words, the scope and content of the term "offer" should be understood in terms of the practical need to enforce the law as it may apply to, and hence affect, a specific group of individuals. Depending upon the context, the term "offering" can be intrepreted differently, therefore the law should anticipate the different possibilities and make clear their meaning in each instance.

The definition of public offer both in terms of how the offering is structured and how the securities are delivered should comply with several basic criteria that provide a basis for regulation. These criteria include at minimum, a clear, unambiguous definition of the concept of an initial public offering (IPO), as well as other securities activities that take into account the final destination of the securities and the means by which they are transferred. A recent tendency for broadening the concept of "offer" to include the activities of intermediaries in secondary markets, over-the-counter markets, and proxy solicitations or takeover activity should also be taken into account.

Investor Protection

The basic tenet of public securities regulation is investor protection, particularly protection of the unsophisticated investor. Investors lack the quantity and quality of information available to securities issuers or the financial intermediaries who underwrite and trade these securities. A large part of securities laws and regulation is designed to protect against this inherent disadvantage. Yet it must be recognized that there is a need to balance investor protection, with the goal of encouraging capital formation.

The 1986 Financial Services Act of the United Kingdom provides a useful list of elements involved in protecting investors while at the same time encouraging the development of the securities markets. These are listed below:

Self-Regulatory Organizations (SROs) are usually responsible for establishing a dispute settlement procedure that serves as a cost-effective nonjudicial mechanism for resolving client differences with industry participants. It may be desirable, albeit difficult, for the countries of the region to adopt uniform arbitration procedures. Uniform rules for the resolution of controversies, regardless of the country in which the complaint is filed, would reduce costs and boost investor confidence, facilitating the harmonization of the region's markets.

Securities statutes must be careful not to intrude on the SRO adjudication process, and contemplate the requirement that most disputes should initially be settled through the industry's arbitration procedures. This has the great advantage of bringing together informed parties to arbitrate the dispute; normally resulting in timelier, less costly judgements. This option notwithstanding, judicial review by the courts should normally be available.

Investors also look to the legal system for protection in the event of default on financial contracts. They must be able to perfect their liens and take possession of collateral in the event of foreclosure within a commercially meaningful period of time. Foreclosure proceedings are notoriously lengthy in much of Latin America and ways must be found to shorten the process.

Disclosure

Solid and credible capital markets rely on adequate quantity and quality of information and its timely availability. Securities laws in Latin America generally specify the kinds of information (e.g. financial statements, etc.) that must be made available to investors so that they can make an informed judgement about an investment. The laws, however, do not (and probably should not) specify an exact disclosure requirement, but rather require full and accurate disclosure, providing legal remedies in the event of noncompliance.

In emerging markets, full and accurate disclosure is not always the standard. This kind of information is normally more readily available to the professional advisor than to the individual investor. A concerted effort or implementation of programs for disclosure and education for the investing public should be a priority for the securities industry as well as the regulatory authorities. The degree of industry or regulatory involvement in disclosure will depend upon the disclosure philosophy described below.

A concept of investor protection rests on the premise that when provided with complete, timely and material information, the investor is the best judge of the worth of an investment. An informed investor is deemed a better judge of an investment than a securities regulator. Normally, a regulatory agency will not make a judgement as to the attractiveness or riskiness of an investment, but confine itself to determining that all risk information has been provided to the investor. Under this philosophy, risky investments can be offered to the public as long as all the relevant information related to the investment has been disclosed.

A second approach to disclosure is the desire to protect unqualified investors from what is regarded as highly speculative or unsuitable investments. This is based on the notion that some investors may be unsuited to judge the riskiness of an investment and should be protected from unscrupulous operators. This may lead some jurisdictions to require that promoters, in addition to full disclosure, obtain prior approval for certain kinds of public offerings. The concept of an unsuitable investor may also be broadly interpreted to include high net worth investors, with limited investment knowledge, even though they may have access to investment advice.

Accounting, Auditing and Rating Agencies

One of the most effective mechanisms for protecting investors is to ensure that they have access to complete, reliable, and timely information upon which to base their investment decisions. Investors receive this information through a variety of sources, including prospectuses or other sales material, periodic financial statements prepared by companies, and submissions required by regulatory authorities. These should give the investor an accurate picture of the true financial condition of the firm at a point in time and need to be supplemented with regular updates.

Due to the importance of these financial statements, particular attention should be paid to the accounting rules and principles under which they are prepared. Each country, should draw up standardized rules and procedures (known as "generally accepted accounting principles" or GAAP). This standardization should eventually be extended to the entire region. The International Accounting Standards Committee (IASC) has been working since 1973 to define these standards. The IASC, however, does not have legal or other authority to enforce its accounting principles.

Inconsistent financial information is a major obstacle to Hemispheric integration. Compliance with the efforts of regional organizations such as the Council of Securities Regulators of the Americas (COSRA) and the International Organization of Securities Commissions (IOSCO) to develop accounting standards acceptable for multinational securities offerings should be an important national priority. Some regulatory authorities have attempted to minimize differences in cross-border offerings through the Multi-Jurisdictional Disclosure System established by the U.S. and Canada that permits issuers to use their own jurisdiction's disclosure guidelines for certain offerings in the other country. An accounting reconciliation, however, is still required for most offerings.

Audits by outside auditors can supplement or verify the financial information provided by a firm. Audits can also ensure that generally accepted accounting rules have been used, and that transactions have been verified through nonaccounting information. In the United States, the U.S. Auditing Standards Board is the technical body designated by the American Association of Public Accountants to issue auditing guidelines. In addition to accounting and auditing standards for securities issuers, there are also issues regarding the reporting and disclosure standards applied to the securities houses, especially with respect to transactions for their own account. Securities firms, like commercial banks, are highly leveraged financial institutions and should be subject to field examinations by SROs and regulators to ensure compliance with capitalization, liquidity and other measures of financial soundness.

Rating agencies assemble market information and provide an interpretative judgement about the degree of risk inherent in a securities offering. Investors will partly base their investment decisions on these judgements. Rating agencies will likely reflect the characteristics of the countries in which they operate, and hence may face many of the harmonization problems encountered in other areas of the capital market.

The rating agency should be an independent and financially viable institution capable of developing and publishing rating criteria that will win the respect of the investment community. Traditionally, rating agencies have only evaluated fixed income securities, but increasingly they are making judgements on equities, mutual funds and even the overall worth of the firm. Rating agencies will sometimes enjoy official support of the regulatory authority through statutes requiring issuers to seek a mandatory rating of their security.

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MARKET INSTITUTIONS

Securities Issuers

Designing registration and disclosure guidelines for securities issuers is among the most difficult yet important areas of security law and regulation. The reality of the marketplace is that compliance with the guidelines must be cost effective to induce small- and medium-sized firms to publicly issue securities. At the same time, the investing public requires adequate information. The problem is exacerbated if issuers are faced with multiple information demands to access different markets or jurisdictions.

There have also been various attempts to design a region-wide securities registration requirement. The problems are enormous and most efforts have met with only limited success. At root are the differences in corporate size, organization and accounting practices throughout the region. Common disclosure documents and registration requirements for the region must be flexible and able to adapt to a wide range of capital market institutions and activity, while at the same time having rigor and content.

Registration requirements for a large corporate Initial Public Offering ideally should include documents of incorporation, amendments, by-laws and audited financial statements for a representative previous period. The prospectus might additionally include the history and market of the business, and the curricula of directors and corporate officers and their remuneration. Subsequent to the registration and public offering, shareholders and regulators may also be provided periodic updates of financial statements, insider share transactions, minutes of board and shareholder meetings and the disclosure of material facts that may affect shareholder value.

Large corporations are able to meet these information requirements and traditionally have been more active in capital markets. However, there are comparatively few large companies in Latin America and the Caribbean capable of this kind of registration process for an IPO or the listing of their shares on a stock exchange. The great majority of the firms are small- or medium-sized and limited in their ability to meet these kinds of requirements.

Obviously, if the design of registration requirements does not take into account the potential number of firms capable of a public financing, the requirements might well be counterproductive. The cost of preparing this kind of information is not easily absorbed by a small- or medium-sized firm, and represents a crucial barrier to their issuance of public offerings. In addition, previous reporting requirements for many Latin American and Caribbean companies have been minimal because they tend to be family-owned or closely-held operations. Such companies have a small shareholder base, limited credit histories, insufficient or incompatible accounting and information systems, and frequently have never had an external audit.

Most regulatory agencies and financial intermediaries in the region have focused primarily on large firms, and for the most part, have neglected small- and medium-sized companies. However, public placement of shares must not be the exclusive domain of large companies. An efficient low-cost regulatory framework can be developed that complies with prudential requirements and still meets investor protection standards. Public awareness campaigns are needed in most Latin American and Caribbean nations to promote the ideas of equity issuance and ownership.

Tax incentives can be used to motivate companies to publicly place shares and to encourage financial intermediaries to seek the business of small- and medium-sized firms. For example, legislation in Venezuela calls for the development of an intermediate market (intermedio) for medium-sized companies that streamlines reporting requirements for new issues and encourages companies to list their shares on the stock exchange. Japan has recently developed a new market (known as the Frontier Market) which is designed specifically for small companies traditionally excluded from dealing with the major banks and brokerage firms. A significant new development in the United States, is the recent promulgation of Rule 144A, which permits distributions of securities to be made to institutional investors without review of the offering by the SEC. The adoption of corollary provisions in other countries could similarly facilitate cross-border offerings to institutional investors.

Differentiated markets for small- and medium-sized firms, such as those discussed above, are in response to factors normally encountered in emerging markets. In particular, regulatory agencies will need at least some of the following information if they are to successfully promote the issuance of securities by small- and medium-sized firm:

Organized Exchanges and Over-the-Counter Markets

Organized securities exchanges and automated over-the-counter (OTC) markets are an increasing phenomenon in emerging markets. The centralization of trading imparts transparency to the process, and the availability of electronic audit trails represents an opportunity to monitor trading that did not exist until recently. These developments strengthen, the monitoring functions of SROs and regulatory agencies, and enhance investor protection.

Organized securities exchanges have physical locations; they are also normally organized on a not-for-profit basis, and the shareholders hold exchange membership. They trade listed securities following a set of rules and procedures designed to impart maximum competition and transparency to the process. Trading normally must take place on the exchange floor and only admitted brokers (who execute public orders), and dealers (who trade their own accounts), are permitted to trade on the exchange.

Some exchanges use the specialist system where an individual or firm manages the "book" of public orders. In return for the advantage of seeing the order flow, specialists are required to maintain "orderly" markets by using their own funds to temporarily bridge the gap between excess buy or sell orders. The market maker system is frequently used in commodity exchanges where a large number of broker/dealers are assigned to specific securities that trade in a designated "pit." Exchange authorities in emerging markets must sometimes choose a trading system to permit or promote. The choices are wide: single or multiple markets; auction or dealer market; floor based or screen based; and, order driven or quote driven. The system chosen should meet the institutional needs of the country, and provide the greatest stability and competition in terms of tight bid-ask spreads and high liquidity. The question of which of these systems does that best has given rise to lively debate and has yet to be resolved.

Transactions conducted outside an organized exchange are said to be in the OTC market. OTC markets do not have a single location, but reside in a network of commercial and investment bank trading rooms. Transactions are conducted by telephone or computer screen. Broker/dealers handle customer orders either by selling securities from their inventory (for a percentage markup or a bid-ask spread), or act as the customer's agent by purchasing the security from another broker/dealer and charging a commission. Broker/dealers must be prepared to make a continuous two-sided market for the securities in which they are registered to trade. Just as in organized exchanges, they may trade for their own account or they may execute orders for the public. OTC markets are also organized as formal electronic securities exchanges as is the United States National Association of Securities Dealers Automated Quotations, operated by NASD.

Security exchanges and OTC associations are normally SROs, hence the policy issues surrounding them are the same as those for SROs discussed below.

Institutional Investors

Institutional investors sometimes attract special attention in national securities laws. Institutional money managers act as investment companies and investment advisers. Like insurance companies or pension funds, investment companies invest funds for their stockholders. These activities can be comprehensive when they provide investment advise and actively manage accounts.

The regulation of institutional investors, which is normally handled by a separate department within the regulatory authority, tends to be divided along the functional lines of the industry, that is, whether the regulated entity is a securities issuer, purchaser of securities or financial intermediary. Institutional investors can play simultaneous roles in the capital markets when they issue securities, as in a mutual fund, underwrite and distribute issues, and purchase or invest in an offering. This complex web of activity must be kept distinct when the institutional investor is engaged in several of these operations. General guidelines may be useful in establishing internal controls that compartmentalize information within the institution acting in multiple roles.

Investment criteria differ depending upon the published objectives of the institutional investor. They normally describe how the fund will balance rate of return and risk considerations, and should not violate the investment objectives outlined in the prospectus. Moreover, institutional investors will normally act as passive investors and only assume majority equity positions or management control under special conditions described in the prospectus.

Regulators sometimes offer investment criteria guidelines. These are sometimes deliberately general, and unless the intent is to bar specific activities, are couched in terms of the "prudent man rule." The need for flexible regulations is particularly evident in the case of government pension funds. They are sometimes required by law to invest only in government securities which may offer below market rates of return. This does little to promote the growth of domestic equity, debt or real estate markets. In addition, more flexibility is needed to permit access to foreign markets as well as to permit foreign financial institutions access to domestic money management opportunities.

Centralized Payment Systems

As capital markets become more integrated, provisions for more uniform clearance and settlement systems, as well as regional or centralized depository systems will become necessary. This will eventually lead to the clearing of security transactions on an account-entry basis. To increase speed and safety, and reduce the cost of transactions each country should have a single centralized securities depository. Regional depositories should eventually become interconnected or merge.

The task of creating a centralized depository is usually entrusted to securities exchanges when the majority of the transactions are conducted there. However, there are the beginnings of centralized settlement and depository for over-the-counter transactions as well. Centralized securities depositories differ by country, but increasingly the Group of Thirty recommendations are becoming the universal standard and are a potential guide for legislation. The legislation governing centralized depositories might provide for the following:

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REGULATORY AGENCIES

Role and Power

Ideally, the tasks of supervising, regulating and controlling securities markets should be entrusted to an independent agency adequately endowed with qualified staff who have sufficient inspection, monitoring and regulatory powers. This may include the ability to issue opinions and exercise quasi-legislative and quasi-judicial powers, including the ability to impose sanctions. Moreover, regulatory agencies in emerging markets, might seek to promote market activity.

The arguments are not conclusive, but many observers believe that the securities regulatory agency should be an independent body. Unless there are overriding budget reasons, the realities of a rapidly innovating marketplace have created a need for a securities supervisory institution that is able to move quickly and evolve with specialized markets. A specialized agency also indicates the importance attached to this activity, and there is a greater likelihood that resources will not be diverted to unrelated activities. This implies that the body will have a separate legal status and adequate resources under its control.

If a securities agency must report to another governmental ministry or agency, the best organizational structure is that in which the regulatory body enjoys a large measure of autonomy from its parent organization. The technical, dynamic and evolving nature of securities markets requires an autonomous securities commission that can make clear and focused decisions on issues within its jurisdiction, and have the legal authority to enforce compliance subject to judicial review.

In a number of Latin American and Caribbean countries, a specialized agency presents a difficult constitutional problem because at least one of these activities (quasi-legislative powers) challenge the traditional separation of power between legislative, executive and judicial functions. In other cases, these regulatory powers are already reserved to a more established department that may not be related to the securities industry. Current thinking and jurisprudence in this area have tended to argue, albeit not conclusively, that constitutional statutes provide scope for the legislative branch to delegate the task of regulating activities to decentralized dependent government agencies, if the timeliness or nature of the activities in question preclude waiting for a change in the law or a decree from the executive branch. Securities regulators have thus been given quasi-legislative powers.

The functions of a securities commission may differ depending upon the peculiar circumstances of each country, but normally would include those necessary to oversee the registration of securities, public offerings and exchange listings; the supervision and control of markets and intermediaries, including broker/dealers and investment advisors; and oversight of institutional investors and mutual funds. Securities commissions sometimes have authority over company registrations and insurance companies, but this depends upon the historical circumstances of each country.

The securities commissions are granted administrative and enforcement powers to fulfill the above functions. The administrative procedures governing inquiries into the facts of a case should ensure that proceedings are balanced, protect the rights of defendants, and do not give privileged positions to the ruling body or other parties in the proceedings. Rulings normally would be final within the executive branch; appeal to other administrative bodies, other than judicial review, should not be permitted. Other government agencies generally lack the experience and technical knowledge necessary to analyze problems arising in capital markets and therefore should not be included in the review process.

Enforcement of securities regulations requires that the law clearly set forth the sanctions to be applied when regulations have been breached. These include provisions for administrative, civil and criminal sanctions. The severity of sanctions and whether they are categorized as administrative, civil

or criminal will depend upon the philosophy of the regulators and how forcefully they wish to discourage certain kinds of conduct.

Administrative sanctions are imposed by executive authority of the government that "administers the law" and normally involve fines, suspension and revocation of authorizations or licenses to conduct business. Ideally, a securities law would include guidelines that discuss the manner in which sanctions are enforced, including procedural requirements, criteria for imposing fines when regulations establish a range of possible values, the liability of instigators and accomplices, as well as a statute of limitations for bringing charges, and procedures for delaying or dropping a charge.

Administrative sanctions also include formulas used to calculate flexible fines. The fine should be set according to a schedule indicating the percentages to be applied to the total value of the illegal operation. Penalties should fall within a range depending on the seriousness of the infraction. In addition, some form of fine indexation should be adopted in inflationary environments. If indexation is not feasible, suspending or revoking the right to carry out operations in the capital market offers a viable alternative.

Criminal sanctions are applied in those cases where the conduct is believed to be willful or serious, or where there is an intent to cause harm. Definitions of illegal activity differ widely, but normally include securities operations where artificial price setting, unauthorized use of insider information, fraudulent alteration of accounting records or nondisclosure of material facts is involved.

Securities legislation frequently attaches great importance to the establishment of a regulatory authority. Although the laws usually specify that the agency should have adequate, experienced and trained staff, the legislation sometimes does not provide the resources commensurate to this mandate. The desirability of allowing a securities commission to retain monies obtained through the fines it imposes is one solution to the funding problem. However, this is potentially open to abuse and possible conflict of interest when an agency has an incentive to maximize its penalty income, especially with the application of flexible fines.

Market Regulation

The concept of market regulation is that aspect of securities supervision that oversees the operations of the markets and professionals within these markets. This usually includes registration requirements for securities in over-the-counter markets and for those listed on exchanges; registration of broker/dealers; and the setting of capital requirements for securities firms, exchanges, clearing corporations and depositories.

The activities performed by financial intermediaries, whether trading for their own account or acting as agents for the public, entail responsibilities and obligations to serve the public first. There is a potential conflict of interest. Intermediaries in pursuit of profit also have a moral and legal imperative (as fiduciary agents) to serve the public interest before their own. This is a lot to ask from a for-profit individual or firm. It is therefore normally necessary to establish a government agency to regulate or oversee the actions of individuals or firms authorized to perform intermediary operations and act as self-regulatory organizations. In addition to the standards of transparency, fairness and integrity which are expected of individuals who choose this profession, great importance is also attached to the financial strength of the securities broker.

The goal of fostering competition in the securities markets may lead to the practice of permitting all individuals and firms to enter the securities industry provided they meet minimum establishment requirements. The minimum capital requirement, would be set depending on the kind of securities operations entered into. For example, underwriting new issues would require a higher level of capital than the investment advisory business.

The degree of prudential oversight granted to an SRO by a regulator is in part dependent upon the ability of the SRO to monitor and detect dangerous or illegal behavior by its membership. For example, broker/dealers in organized exchanges are operating in a highly transparent and monitored environment. Also, technological advances in electronic monitoring of positions on a real time basis permit the early detection of risky positions, giving the SRO (the exchanges in this case) the ability to close out the trading position quickly. As a result, exchanges, in their capacity as SROs, are given a large amount of responsibility to oversee their markets. This is less true in OTC markets where the prime responsibility for supervision over decentralized markets may fall on the public regulator as opposed to private SROs.

Self-Regulatory Organizations

The first level of regulation in capital markets is generally provided by private sector self-regulatory organizations, supplemented by an additional layer of public oversight. SROs are usually nonprofit institutions such as securities exchanges and professional societies of broker/dealers, securities analysts, etc. These institutions are empowered by legislation or regulatory authority to create rules, and monitor and enforce industry practices among their membership. Sometimes SROs are given explicit statutory authority to conduct a particular activity, such as the National Association of Securities Dealers (NASD) operation of the NASDAQ over-the-counter stock market, or the Securities Protection Insurance Corporation's operation of the insurance fund guarantee for customers of the securities industry.

Regulatory agencies typically can only hold securities industry professionals to a legal standard of conduct, while SROs are able to hold themselves to more rigorous ethical and moral codes that exceed legal requirements. SROs have a difficult task in upholding these codes of conduct and at the same time represent the economic interest of their membership. This potential conflict of interest has occasionally surfaced, forcing the regulatory authorities to intervene in the SRO's monitoring and enforcement functions.

The following are regulatory functions frequently delegated by the national securities act or regulatory authorities to an SRO:

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INTERNATIONAL COORDINATION AND COOPERATION

The Need for Cooperation

The recent bankruptcy and reorganization of Barings Bank of the United Kingdom is a vivid reminder of the need for international cooperation among securities authorities. Trading losses, that ultimately sunk the Barings Bank, were permitted to accumulate in part by the failure of regulators in different countries to share information with each other. An out-of-control trader was able to accumulate large positions in different markets unbeknownst to each country's exchange and regulatory authority. This lack of cooperation by regulatory bodies created a situation where the overall or consolidated risk position of Barings was unknown. The Windsor Accord for information sharing among large country regulators is designed to prevent a future Barings.

The internationalization and integration of securities markets carries with it a concomitant requirement for securities regulators to coordinate and cooperate in their surveillance and enforcement efforts through information sharing. Since cross-border securities fraud is not unheard of in Latin America, the region needs its own Windsor Accord. The absence of a common understanding of fundamental legal and regulatory concepts makes this task difficult but not impossible. Regulatory authorities in the region can and do take into account each country's separate legal and regulatory traditions and can develop harmonized interpretations of statutes.

The integration of the region's capital markets is also forcing regulators to solve jurisdictional issues. For example, what are the respective roles of the securities commissions in cases where a foreign issuer makes a public offering? Who has jurisdiction over the public offering? The commission in the country in which the issuer is domiciled? the commission overseeing the offer? or both commissions? Latin American banking regulators have recently confronted a proliferation of cross-border bank mergers. Securities regulators will increasingly have to deal with cross-border securities activities.

Latin America is also being pulled into the globalization of markets. There is an abundance of Latin American ADRs (American Depository Receipts) and GDRs (Global Depository Receipts) and other offshore issues as a result of U.S. SEC regulations (e.g. Regulation S, Rule 144A and Rule 15A-6). Moreover, futures and options markets in Chicago and elsewhere are listing derivatives contracts based on Latin American equities, currencies, and interest rate products. The level of derivatives trading based on Latin American assets has been substantial, with the volume of equity options and ADR trading in Chicago and New York on occasion exceeding the underlying cash volumes in the host countries. The inter-connections among these markets is not being ignored.

Securities commissions throughout the Hemisphere are entering into Memoranda of Understanding (MOUs). These are formal bilateral arrangements whereby regulatory authorities in each country agree to share information and provide reciprocal assistance in enforcement matters. Recently, the U.S. Securities and Exchange Commission signed MOUs with its counterparts in Argentina, Brazil, Chile, and Peru. The U.S. Commodity Futures Trading Commission has signed an MOU with the Mexican Comisión Nacional de Valores. Multilateral efforts to coordinate securities market regulation include the Project on Uniform Regulations of Public Offerings of Securities, and the adoption by the Council of Securities Regulators of the Americas of various "principles" agreed upon at their annual meetings.

In developing approaches to cooperation, lessons may be learned from two existing models of integration. The first is the European Union which has developed an impressive regional system of securities regulation that, when fully implemented, will allow banks and investment firms chartered by any EU country to operate throughout the Union on the basis of a single license (the so-called "European Passport"), and companies from any EU country to make public offerings and exchange listings throughout the Union on the basis of a single disclosure document. The EU system involves the development of minimum standards of regulation that, by treaty, must be adopted into national law and recognized throughout the Union. This system is based on a high level of political and economic integration not paralleled in the Western Hemisphere, limiting the applicability of the EU's experience.

The Multi-Jurisdictional Disclosure System which currently exist between the United States and Canada may also serve as a good cooperative example. Currently, qualified companies from one country may make public offerings or engage in other specified transactions in the other country on the basis of home state disclosure requirements. The system can be expanded to new areas and additional countries. Finally, the World Trade Organization recently negotiated an interim agreement to liberalize trade in financial services.

The Role of Multilateral Institutions

Multilateral institutions can play a supporting role in helping Latin American and Caribbean countries to develop, harmonize and integrate their capital markets. Multilaterals make resources available through project loans, technical cooperation and grants to finance the strengthening of capital market institutions and oversight. The supervisory activity has included assisting in the drafting or revision of national securities legislation; assisting securities supervisory agencies with financial disclosure, oversight and enforcement; and working with exchanges to improve clearance and settlement systems. Multilaterals have had extensive involvement with capital markets institutions and instruments that include assisting countries to develop or improve money and debt markets, equity markets, commodity exchanges, institutional savings, and risk management activities.


Last updated: 02/26/07