AN OVERVIEW OF THE SEC RULES ON DEMUTUALIZATION OF SECURITIES EXCHANGES
Demutualization of securities exchanges has become a global trend with 55 Securities Exchanges in the world currently demutualized. The Stockholm Exchange was the first to undergo this transition in 1993, forging a path followed by many other exchanges including the London Stock Exchange, Hong Kong Exchange and NASDAQ.
Historically, securities exchanges were established as mutual associations to serve the interests of the members and any profit made was distributed amongst its members. Under this model, the broker members own, manage and trade on the mutual securities exchange. A securities exchange, which undergoes demutualization, converts from a mutual association operating on a not-for-profit basis, to a profit-making limited liability company accountable to its shareholders. In effect, demutualization leads to the separation of ownership and management from trading rights. The owners of a demutualized exchange are its shareholders, and users or participants obtain trading rights through contractual arrangements with the securities exchange.
The Securities and Exchange Commission (SEC) recently released the Rules on Demutualization of Securities Exchanges in Nigeria. The Rules were made following propositions by the Nigerian Stock Exchange (NSE) to demutualize by altering its corporate structure from a not-for-profit mutual association of stockbrokers, dealers and other exchange members registered as a company limited guarantee, to a company limited by shares.
In this article, we highlight and analyze the key provisions of the Rules and discuss the potential impact a demutualized structure would have on a securities exchange and the market in general.
PROCEDURE FOR DEMUTUALIZATION OF SECURITIES EXCHANGE
The Rules divide the process of demutualization into two stages: pre-conditions for demutualization and post demutualization requirements. The Rules also impose limits on the number of shares that may be held in a demutualized exchange and certain corporate governance obligations.
Pre-conditions for demutualization
Securities exchanges must obtain SEC’s consent prior to demutualization. To obtain SEC’s consent, which will be in the form of a grant of “No Objection”, the securities exchange must submit a number of documents including; the names and profiles of members of the exchange’s Committee on demutualization, the draft memorandum and articles of association of the demutualized exchange, the proposed allotment of shares to the initial shareholders and the basis of the proposed allotment, and a plan for implementation of the demutualization.
The securities exchange must also submit a valuation report. The process of conversion usually involves a valuation of the exchange, which serves as a basis of the allotment of shares in the demutualized exchange to members.
The Rules also require that the securities exchange submit a plan for the independent and functional separation of the exchange’s regulatory and commercial functions. Securities exchanges are self-regulatory organizations, and if demutualized, there is a risk that the demutualized exchange may in pursuit of profits become lax in its regulatory functions. For example, a demutualized exchange may hesitate to take enforcement actions against users, or suspend trading of highly liquid listed products which are major sources of its transaction fees. Therefore compelling demutualized exchanges to divide their regulatory and commercial functions is an attempt by the SEC to stave off such potential conflicts of interest.
After a ‘No Objection’ has been granted, the mutual securities exchange may commence the process of conversion into a company limited by shares. While the Companies and Allied Matters Act (CAMA) provides for the conversion by re-registration of private companies to public companies and vice versa, it does not provide for conversion from a company limited by guarantee to a company limited by shares.
An alternative to re-registration is to incorporate a company limited by shares and transfer the exchange’s business to the new company. However it is implied under CAMA that the assets of companies limited by guarantee may not be transferred directly or indirectly to its members but must be applied solely towards to the promotion of its objects. Furthermore, on a winding up of a company limited by guarantee, any property remaining after paying the company’s debts and liabilities can only be transferred to another company limited by guarantee with similar objects or applied to any charitable object. Therefore, in the absence of an amendment to CAMA, it is unclear how Nigerian securities exchanges registered as companies limited by guarantee will achieve demutualization and at the same time maintain the membership that it had prior to demutualization.
Once the demutualization process is complete, the securities exchange must apply to SEC for approval to operate as a demutualized securities exchange. The application shall be accompanied by a statement of the authorized and paid up share capital, a certified copy of the return on allotment of shares, certified true copies of the memorandum and articles of association, the particulars of directors, a three year business development plan, and the latest copy of the exchange’s audited accounts or statement of affairs.
The Commission may approve, with or without conditions, or reject the application. It may also direct the securities exchange to take specific actions or make amendments to the documents and information submitted.
The requirement to re-apply for approval to operate as a demutualized exchange seems unnecessarily bureaucratic especially since the demutualized exchange is the successor of a mutual exchange registered with SEC, and SEC would have given its prior consent to the demutualization. A simpler process would be to require the demutualized exchange to file the necessary documents within a specific period after completion of the demutualization or be liable to a penalty.
Capital and Ownership Structure
The Rules impose restrictions on the amount of shares which shareholders can own in a demutualized exchange. No individual may own more than 5% of the share capital of the securities exchange, while the aggregate equity interest of any stakeholder group must not exceed 20%. From the date of demutualization, stakeholder groups whose shareholdings exceed the maximum amount must reduce their cumulative shareholding to 20% within five years.
Strategic Investors - investors with technical expertise in managing securities exchanges or investments beneficial to exchanges may hold up to 30% of the share capital. However, where the securities exchange has compelling reasons to raise funds, SEC may approve the issue of additional shares to them.
The restrictions on ownership are aimed at preventing monopolies in demutualized securities exchanges and ensuring that the control of these entities does not reside in one group or individuals.
The Rules are not prescriptive as to the size of the board of a demutualized securities exchange. However the board is required to be composed in such a way to ensure diversity of experience. Also, at least a third of its members should be Independent Directors. Independent directors are persons who have no significant relationship with the company that may impair or appear to impair the ability of the director to make independent judgements. The exchange is also required to comply with the SEC Code of Corporate Governance for public companies.
POTENTIAL IMPACT OF DEMUTUALIZATION
Generally, demutualization is considered beneficial to securities exchanges. Some of such benefits are increased access to finance, improved corporate governance and management, and stronger protection of stakeholders’ interests.
Increased Access to Finance
Demutualization can lead to an influx of capital into an exchange, as the exchange will be able to tap into both the equity and debt markets to raise finance for its operations. For example, the Nairobi Securities Exchange upon demutualization raised $7.1 million in an oversubscribed initial public offering (IPO). There are also reports stating that the NSE after demutualization may launch an IPO to increase its capital base and provide additional liquidity. This increased access to finance would enhance the ability of Nigerian exchanges to diversify their business, products and services, and meet current global industry standards and technological advancements. For the Nigerian economy as a whole, demutualization may contribute to strengthening the capital market which complements the banking system as an alternative fund raising option and thereby diversify the risk in our financial system.
Improved Governance and Management Structure
Under a mutual structure where the broker-members are the owners and managers of the exchange, decisions are often geared to preserving the interests of the members, which are not necessarily aligned with those of the exchange. However, under a demutualized structure, the separation of shareholders, management, and users, equips the securities exchange to make more strategic decisions, which are not aimed at the protection of vested interests. Demutualized Nigerian securities exchanges would thus be equipped to act more promptly and decisively to meet the competitive changes in the global business environment. More decisions would be made to meet the needs of the market more effectively and ultimately this will aid the maximization of the profits of the exchange.
Protection of Stakeholder Interest
In a demutualized exchange, the needs and interests of the various stakeholders, such as participating companies, listed companies, investors, both retail and institutional, are taken into consideration, since demutualization shifts the interest of the exchange from satisfying broker-members to the satisfaction of market participants at large.
As we have seen demutualization has a number of benefits including enabling a securities exchange to act independently of the interests of individual members and respond more effectively to increasing market demands. Demutualized exchanges are considered to be more efficient and market-oriented.
Despite its increasing popularity, demutualization of securities exchanges is not without its challenges, namely the potential for conflicts of interest issues arising from marrying the securities exchange’s self-regulatory role with its profit-making objectives. The for-profit nature of a demutualized exchange increases the possibility of the exchange abusing its position as both market participant and regulator and pursuing profits to the detriment of effective regulation.
In Nigeria, there are still some issues concerning the demutualization process, one of such is the conundrum on how Nigerian securities exchanges registered as companies limited by guarantee can legally convert or transfer their business to companies limited by shares. Once these have been resolved, the main concern will be the adoption by demutualized exchanges of an efficient corporate structure designed to eliminate risks of conflict. As previously identified, this is central to the success of all demutualized securities exchanges. The onus will remain on SEC, to ensure regulatory and supervisory oversight of demutualized exchanges in order to check issues of conflict of interest and ensure the stability of the exchanges.
 Section 26 of CAMA
 Rule 4 of the Rules
 Rule 6(2) of the Rule
 Rule 5.5 of SEC code on corporate governance