Regulations against Fraud in Stock Exchanges: A Comparison of UK and the USA - Research Paper Example

 Title of the project AGAINST FRAUD IN STOCK EXCHANGES, A COMPARITIVE STUDY BETWEEN UK AND USA S.NO HEADING PAGE NO 1 Summary 3 1.1 Problem Statement 4 1.2 Aims and Objectives 5 1.3 Rationale / Justification 5 1.4 Research Methods 6 1.5 Ethical Considerations 6 1.6 Time Scale and Plan 7 1.7 Resources / Cost 7 2 Literature Review 8 2.1 Insider Trading 9 2.2 Audit Committee 10 2.3 Corporate Governance 10 2.4 Corporate Governance in UK 11 2.5 Effective Corporate Governance Structure 11 2.6 How Can We Improve? 12 3 List of References 14 1. Summary Fraud in the Stock Exchanges includes listing made by a company by producing false documents, and many false disclosures are made especially to create interest in the shares of the company through press releases in specialised media. By announcing false price sensitive information, the vested interest will create a surge in the prices of its shares in the stock market and will sell their holdings at fabulous prices and will book unprecedented profits over it. Series of price sensitive information will be made in press and media and advertisements will be wantonly placed by these vested people in anticipation selling their holdings later at a good profit. One another methodology is to boost the stock price and to generate demand for the issuance of new shares. Fraud against the stock exchange include to secure national stock exchange listing status or to cater for minimum exchange listing demands to avert from being delisted. (Rezaee 2002: 59). The fraud against stock exchanges also includes hijacking the prices of the stock of a company by reporting false earnings, to hike income earned, window dressing of accounts, falsification of accounts and booking future earnings to current earnings to meet the stock exchange's expectation. These types of actions have ended in corporate frauds where investors have lost their hard earned money in trillions. In the late 1980’s and in the beginning of 1990s, a chain of financial frauds rocked the UK which shattered the confidence of the public on commerce and industry. Well known businesses like Bank of Credit and Commerce International, the Mirror Group, Polly Peck and Barrings were tumbled. Now, corporate fraud has become more sophisticated than compared to a decade ago. In USA, the fall of giant corporations over night like Enron, WorldCom, Arthur Anderson and large number of corporate frauds being reported in the United States at the dawn of 21st century aggravated the need for stringent law to maneuver the corporate scandals and the result was the introduction of Sarbanes-Oxley Act (SOX). In this research essay, I am going to analyse the frauds committed against stock exchanges of UK and USA and its impact and how governments have responded to prevent frauds and ways and means to curb these frauds in the near future. 1.1 Problem Statement The Serious Fraud Office of UK reported that the fraud estimates against stock exchanges per annum run at £ 5 billion in the late 1990s. Home Office of UK estimated that fraud was running at £ 10 billion at the start of 2000. The survey conducted by KPMG International reported that value of fraud cases in UK Crown Courts had crossed many billions Sterling. In an empirical study carried over by Alexander Dyck et al in 2007, it has been proven that only about 7% of the frauds are unearthed by the SEC (Stock Exchange Commission of USA) and about 15% are uncovered by the auditors. The whistle blowers are the industry regulators (17%), the media (14%) and the employees (19%). It is surprising that SEC investigation was able to discover only just 7% of corporate frauds where as non-regulators like media, employees and non-financial market regulators uncovered more corporate frauds than regulating bodies. This suggests that serious and vigorous action and legislations to be introduced by the governments to prevent frauds against the stock exchange all over the world. Under this, both UK and US stock exchanges have tightened their listing rules and has advised their listed companies to introduce strong corporate governance, to inform the stock exchange and the investors about price sensitive information by proper disclosures, to file quarterly and annual financial performance statements, to avoid insider trading, etc. mainly to prevent the fraud against the stock exchanges all over the world. Despite of these efforts and measures, the fraud against stock exchanges is on the increase and this research study will focus its main attention on these issues and will suggest various measures to plug the loopholes of the legal mechanism to safeguard the interest of the gullible investors. 1.2 Aims and Objective The following will be the main aims and objectives of this research study. Whether the existing listing requirements are adequate enough to prevent any fraud against stock exchanges in UK and USA? This research essay will discuss in detail about initiatives that the UK and US governments in implementing to reach this objective and its progress. This research study will also be suggesting the appropriate regulatory mechanisms necessary in the future to achieve this target. This research topic will also discuss in detail about what measures should be introduced to plug the loophole in the existing laws and regulations to prevent fraud against the stock exchange in UK and USA. 1.3 Rationale / Justification To protect investors, stock exchanges both in UK and US have introduced many measures to prevent fraud. Organised stock exchanges both in UK and US including London Stock Exchange, AMEX, NYSE and the NASDAQ insist that listed companies should introduce strong corporate governance, should introduce audit committees with independent and professional directors.( Rezaee 2002 : 161). To prevent fraud against stock exchanges, listing rules should require certain minimum mandatory disclosure requirement. So as to promote transparency, fairness, responsibility and accountability, board of directors should disseminate the necessary information if they deem that such information is significant and has to be divulged suitably to the general public. Thus, disclosures should be intended at offering both the public and the shareholders with proper information and data on an even and timely basis. Thus, timely disclosure of quality and accurate information to investors will always give first-rate ranking to the so called translucent companies. 1.4 Research Methods Qualitative research This research project will be conducted mainly by qualitative research methods and accompany by analysing secondary data, like companies and stock exchange’s annual reports, press releases, published books, journal articles on the subject, stock exchange and governments official website…etc. The reasons for choosing qualitative research method instead of quantitative research method are due to three perspectives: 1) the nature of the research project; 2) the scale of the project; and 3) the cost of carrying out the project. Also, as the project is not a funded project, it will be too costly to carry out a survey such as printing, mailing, delivering and collecting the questionnaires, etc. Finally, it is too time-consuming to collect enough quantum of qualified questionnaires and to analyse the large amounts of data from received questionnaires. 1.5 Ethical Considerations Ethical issues are also significant for gathering information and data from the organisations and from the employee or staff of the organisation. I will obtain information mainly from online from stock –exchange’s websites and it is assured that I will keep the confidentiality of the data and information that I collect from these sources. I do not believe there is any opportunity to create ill feeling to anybody during the process of this research. If any question or clarification is sought by these stock exchanges or companies, then concise narration of rationale and arrival of conclusions would be furnished to the them wherever asked for. This necessitates development during the process of literature review, ethical issues may happen while considering about yardsticks of professional demeanor, particularly for researchers and in their comments about ethical issues and their possible solutions. (Punch, 2005). Ethical issues associated with assessing secondary data are not a critical subject which has been mostly deliberated, even in books, which are associated to research issues and ethical processes. In secondary research, if at all ethical issues do present, they are liable to correlate to the assessment of small sub-sets of the data and I will focus attention on the privacy of respondents. (Dale et al 1982:199). Whenever secondary data is used, it is better to recognize the source by in-text referencing. This I have done in this essay and also in this section. It is better not to use the secondary data in the research, if the secondary data are likely to create credible damage. I have made special attention that such data has not made inroads in this research. Further, there should always be openness and honesty in presenting these data, since secondary data have already been published, 1.6 Time Scale & Plan 10 March - 17 March 2010 18 March - 25 March 2010 Introduction Literature Review. 26 March 2010 – 5th April 2010 Plan the methods and research strategy. 6 April 2010 – 14 April 2009 Data collection. 15 April 2010 – 22 April 2010 Data analysis. 23 April 2009 – 30 April 2010 Writing dissertation. 1 May 2010 – 15 May 2010 Final review and Submission. 1.7 Resources / Costs Since, I am using only secondary data for this research purpose, the cost will be very minimal and will be borne by me. II. LITERATURE REVIEW UK was a pioneer European nation to enact laws against insider trading through enactment of “The Company Securities (Insider Dealing) Act of 1985 thereby declaring insider trading as a criminal offense. This act imposes criminal punishments for those corporate insiders to benefit from the crucial happening in a company. In USA, the regulation of insider trading rests mainly on “section 16 (b) and section 10(b) of the Securities Exchange Act of 1934.” A restriction is imposed by section 16 (b) on the “short swing insider –trading profits.” US is having insider trading law, which imposes both the civil and criminal punishment for the offenses committed as the proof of establishing purely circumstantial evidence, which is less onerous in a civil context. Rule 10b-5 introduced by Securities Exchange Commission of USA (SEC) is a more widespread anti-fraud prevention legislation which is used as a major tool to prevent insider trading in the USA. (Salinger 2005: 429). The toll of corporate failure is finally borne by creditors, employees, shareholders and financial institutions of the failed company. In UK, through Cadbury, Greenbury and Turnbull reports which were published in the late 1990s, paved the way for the OECD in illustrating how the director’s duty of care in respect of board management and the executive compensation should be administered. The UK’s revised Combined Code now recognises the necessity for a risk management structure and leaves no room for imprudent risk taking. Now, in UK, director’s duty has been enshrined in the statute itself. (O’Brien 2007:160). The US” Sarbanes-Oxley Act of 2002 “(SOX) has demanded a drastic enhancement of US corporate governance practices. SOX made it statutory for adoption by US listed companies of a proper system of internal control and needed directors to initiate supervising and reporting operational risk. (Calder 2008:4) Sarbanes-Oxley Act (SOX) or SOX was introduced in July 2002 thereby introducing a major assortment of changes. SOX toothed SEC with more powers and authorized to impose the civil penalties on erring corporations to compensate gullible investors who were victims of such scandals. To avoid auditor collaboration with fraudulent management, SOX stipulates that no consulting work should be carried over by audit firms. Further, SOX through section 404introduced more internal controls which are analogues to COSO’s internal control framework. One another special feature of SOX is that it safeguards the interest of whistleblowers especially employees. Section 301 of SOX now requires audit committees of publicly traded companies to frame structures for “secret unknown revelation by employees as regards to suspicious accounting practices or questionable audit matters. “ Whistle blowing employees now being offered protection under SOX from being fired from the company. The Sarbanes –Oxley Act offers additional investigative techniques to assist to control corporate fraud in America. As per the SOX, corporate officers are now made responsible for filing their corporation’s income tax returns, financial disclosure statements and to certify as to their conduct pertaining to the exploitation of corporate records. SOX now impose stricter imprisonment up to twenty-year imprisonment for the alteration, manipulation, destruction or distortion of financial records so to obstruct federal tax investigations and causing bankruptcies.(Anand 2006:21 ) 2.1 Insider Trading Insider trading said to be occurred when someone has information that is unavailable to the public yet. Thus the information gathered through the insider trading sources is deployed to gain from trading in a Company’s publicly traded stock. United States is the first country to legislate a law on insider trading as early as 1934. Other countries were unenthusiastic to regulate the insider trading until 1980. In UK, there were no criminal proceedings against inside trading until 1980. In U.S.A, the insider trading was protected by the ‘Securities and Exchange Commission (SEC)’ which was launched under the ‘Securities Exchange Act (1934).” Any insider trading practice is being considered as unfair practice to the interest of investors. (Anand 2006:128). 2.2 Audit Committee NASD and NYSE have established guidelines on audit committee to strengthen the effectiveness, qualifications and independence of audit committees of public traded companies. The new NASD regulations on audit committee stipulate that public companies listed on both on the NASDAQ and the American Stock Exchange (AMEX) should have audit committee compulsorily. The combined code in UK stipulates that there should be audit committee with enough independent directors. 2.3 Corporate Governance U.K has a unitary board of directors system where both non-executive and executive directors offer their advice on every board meeting. European nations have a dual board system which consists of a management board and supervisory board. The supervisory board will have employee directors. Corporate governance plays a dominant role in UK and institutional investors are very particular about its implementation. For example, Dutch/Shell group has exaggerated its tested reserves of oil and gas and later engaged in strategies to restore its standing and restored public faith on it. Standard Life is the UK’s oldest institutional investors. It is upbeat in corporate governance issues and stresses that its investee companies should adhere to corporate governance without failure. 2.4 Corporate Governance in UK In 1992, the Cadbury Report was published and UK has become a pioneer in Corporate Governance and the Cadbury Code became an exemplar for the self-control of listed company boards in other nations. Cadbury Code vehemently recommended for the following: Non-executive directors assumed an expanded role. Executive remunerations received a tighter control. Financial reporting has to give full and transparent disclosure. Institutional investors took active part in the management of the company. Auditors and Accountants are regulated independently. The above recommendations were combined together in a new Combined Code which was implemented in July 2003 and was meant to make the board more independent and more efficient in controlling the top management team of the companies. (Mallin, 2007: 17) 2.5 Effective Corporate Governance Structure The new combined code stresses the following for the implementation of an effective corporate governance structure: Though, these governances are compulsory for a listed company in UK, there is no bar on the other types of companies to follow the same. It is suggested that those companies functioning on an international level should follow these guidelines to have an effective corporate governance structure: There should be chairman and CEO to lead the company. It should be seen that no individual has unlimited authority in managing the affairs of the company. Board should comprise both executive and non-executive independent directors. It should be seen that no small group of individuals or individuals can dictate the board’s decision taking authority. All directors of the board should be re-elected once in three years. The annual report of the company should contain a report on company’s remuneration policy and short notes on the each director’s remuneration. The company should have adequate internal control to protect both the company assets and shareholder’s investment. Board should take efforts to consult institutional investors before initiating any major policy changes and on director’s and key employee’s pay packages, mainly through the extra-ordinary or annual general meetings. Remuneration committee should consider and analyse industry standards while fixing remuneration to top executives. Further, there should not be any discount while executive share options are allotted. (Mallin, 2007: 23) How can we improve? It is to be noted that the insider trading act has regulated the stock market by augmenting the liquidity and has reduced adverse choice and thus has resulted in cost of equity. One of the chief advantages of insider trading is the dissemination of information to the investors which results in augmented adherence by the traders and investor. Though the Insider trading act is in effect, it has not brought any considerable change to enhance liquidity, lessen information irregularity and to augment trading volume in the stock market as envisaged. Both UK and US government should rethink and reform its corporation act to implement severe criminal proceedings against insider trading imposters to deter them to resort to white collar crimes in the guise of insider trading. The frauds and scams in stock markets could be easily perpetrated if there are laxity, callousness and lethargy by the authorities and the greed of those vested interests in the top political hierarchy. However, now timely intervention by the governments in fixing the loopholes and by tightening the regulations and rules for the efficient playing of stock exchanges is highly laudable. The role of government monitoring agencies like SEC, FSA in finding and deterring fraudsters in the stock market has really helped in the reduction of frauds against stock exchanges. Moreover, the dawn of internet technology has really assisted to a great magnitude for the supervision, control and recording the share deals very accurately on the daily basis. Thus, despite Bearish or Bullish movements arising in the stock markets due to fluctuations in share prices, the investors have to be more careful and alert over their investment decisions and should focus on the safety of the investment by doing extensive research on the subject. List of References Anand, Sanjay. (2006). Sarbanes-Oxley Guide For Finance and Information Technology Professionals. London: John Wiley & Sons. Calder, Alan. (2008). Corporate Governance: A Practical Guide to the Legal Framework. London: Kogan Page. Dale B M, Boone, Louis E & David KL. (1982). Foundations of Marketing. Canada: Holt, Rinehart and Winston. Mallin, Chris A. (2007). Corporate Governance. Oxford: Oxford University Press. O’Brien, Justin. (2007). Private Equity, Corporate Governance and the Dynamics of Capital Market. London: Imperial College Press. Punch, Keith. (2005). Introduction to Social Research: Quantitative and Qualitative Approaches. London: Sage Publications. Rezaee, Zabihollah. (2002). Financial Statement Fraud Prevention and Direction. London: John Wiley & Sons. Salinger, Lawrence M. (2005) Encyclopaedia of White-Collar and Corporate Crime. London, Sage Publications. Read More