Recent equity public offers show that a large number of individual investors continue to choose paper certificates despite having the option to get digital securities.
For instance, in public offers of Kot Addu Power Company, Attock Petroleum Limited, and Pakistan Petroleum Limited, paper certificates as percentage of total shares issued are estimated at 65, 49 and 48 respectively.
In view of the problems that arise due to issuing paper certificates in public offers, some options for facilitating investors in subscribing to digital securities may be considered.
Investors who opt for paper certificates run the risk of their damage, loss, theft, and forgery. Worse, due to automation of trading and settlement, investors cannot sell paper certificates in the regular market without first converting them into digital records. This process of conversion, known as dematerialization, could take a few weeks and investors may lose some good opportunities to sell their shares.
Dematerialization also involves out of pocket expenses and hassle as investors have to visit the office of broker or CDC, which may not be located in their city of residence. The service charges of CDC for dematerialization, at one paisa per share, are nominal but brokers may charge more for this service.
As in the case of investors, paper certificates also create unnecessary cost and hassle for the company or the majority shareholder making the public offer. These days number of successful applicants opting for paper certificates could run in tens of thousands and applications are routed from bank branches spread all over the country.
Printing so many certificates and then delivering them involves expense and managerial time. Where investors hold on to their paper certificates, ongoing distribution of bonus and right shares, again in the form of paper certificates, adds to the costs of the issuing companies. The same is true for some other corporate actions such as share splits and mergers.
Paper certificates also increase cost and hassle for banks which accept the applications for subscription. These banks have to sort, store, and distribute these certificates. Some account holders do not collect their shares from their banks for months. Bank branches usually have limited space for keeping sensitive documents and these certificates become an administrative burden.
Issuing paper certificates is also inconsistent with international best practices and with the objective of establishing CDC. Internationally, capital markets are aiming at elimination of paper certificates to maximize efficiency in trading, clearing, and settlement.
Substantial progress has been made in some developed markets, such as those in France and Denmark, in achieving a paperless environment. Some use explicit or implicit disincentives for issuing paper certificates in public offers and re-materialization of digital securities.
Some have gone further. For instance, in Japan, by law, no listed company would issue paper certificates by 2009. Here, according to the website of CDC, digital securities account for about 60 per cent of total securities in terms of market value, excluding the holdings of the government. This statistic, though encouraging, shows that there is room for improvement.
Growth in proportion of dematerialized securities requires that further issue of paper certificates must be minimized, if not eliminated. To do that, we first need to understand why investors continue to choose paper certificates. There are three major reasons. (a) Investors do not have ready access to a broker or CDC office. Most brokerage houses are located in and around the buildings of stock exchanges in Karachi, Lahore, and Islamabad. At present, there are only three branch offices of CDC which are also located in the premises of stock exchanges. (b) Investors are not aware that they can receive and keep their securities in digital form. At the moment, the number of investor accounts, maintained directly with the CDC, is only about 32,000 while the number of sub-accounts, maintained with brokers, is estimated at 150,000.
(c) Investors having no prior shareholdings do not see any merit in opening a depository account until their application for subscription has been successful. Earlier, group-accounts maintained by brokers were used by investors to subscribe to securities in digital form without any initial documentation or fees. However, group account facility has been discontinued – and rightly so – as it had become an instrument for market abuse.
In view of the problems caused by paper certificates and the reasons investors continue to choose them, CDC should consider the following three options to facilitate subscription of securities in digital form.
First, a special purpose omnibus account should be created by the CDC for each public offer. All investors not having a depository account could choose to receive securities in digital form by selecting this account in the subscription form. The subscription form in each public offer should explain the advantages of using omnibus account.
Securities allotted to successful applicants should be delivered to this special account. Investors would then be able to move their securities to an investor-account or a sub-account by sending a written instruction to CDC and paying the required fee for this service.
The strength of this option is that it would be highly effective in reducing paper securities in a short time because all investors would be able to avail omnibus account without any upfront cost or hassle.
Its weakness is that it could strain the resources of CDC because serving these accounts on an on-going basis would require dealing with a large number of geographically dispersed individuals. It may be preferable that CDC let a large bank set up and maintain these omnibus accounts because it would have the manpower and branch network to serve these accounts.
Second, successful applicants who applied for paper certificates should be given a second chance to receive their shares in digital form. Once the application of an investor has been successful, it makes clear economic sense to open a sub-account or an investor account. CDC has reduced the annual fee of investor accounts to Rs500 and investors ought to take advantage of this highly secure mode of custody.
These investors should not be issued paper certificates if they inform the concerned share registrar within the stipulated time that they would prefer to receive their securities in digital form.
The strength of this option is that it could be implemented within a short time and the cost of contacting investors could be kept within reasonable limits. Its weakness is that it may not be very effective because only those investors who are based in Karachi, Lahore, and Islamabad are likely to pursue this option.
Third, CDC should broaden its own branch network or let a bank provide investor account services. Recently, it has been reported in the press that CDC is going to open branches in four more cities, where branches of some brokerage houses are operating. The strength of this option is its effectiveness because it would be most convenient for investors to have a branch in their own city. Its weakness is that it would consume a lot of capital and time before new branches could substantially reduce paper certificates.
Perhaps letting a large local bank run the investor account services would be a preferable option. This option is already being pursued by CDC in Karachi. If the bank can expand investor account services to its other branches, it would be a faster and low cost way of reaching the investors.
Once investors have been adequately facilitated in receiving their shares in digital form, it would be appropriate to stop issuing paper certificates altogether through regulatory intervention.
Elimination of paper certificates in public offers would be an important step forward in enhancing the operational efficiency of the stock market to the advantage of investors and all other market participants.