3. Specialized Companies Division

• 3.1 Overview
• 3.2 Leasing
• 3.3 Modaraba
• 3.4 Mutual Funds
• 3.5 Venture Capital Companies and Venture Capital Funds
• 3.6 Special Purpose Vehicles for Asset Backed Securitization
• 3.7 Credit Rating Companies
• 3.8 Oversight of Accountancy Profession

The Specialized Companies Division (SCD) is responsible for regulation and monitoring of leasing companies, modarabas, mutual funds and other specialized companies. A list of all specialized companies licensed by the Commission is presented in Appendix C. In addition, the Division maintains oversight overthe accountancy profession and has been actively involved in new initiatives for improving transparency and disclosure in financial reporting of companies. The SCD has played a pivotal role in introduction of the Code of Corporate Governance (the Code), which is the first-ever institutional effort of its kind in Pakistan.

Substantial progress was made during the year in the regulation and monitoring of specialized companies. Besides an internal restructuring of the Division that required recruitment of professionals and streamlining of operating procedures, a two-pronged approach was adopted for enhancing effectiveness of regulatory actions. A thorough review of relevant rules and regulations was undertaken and amendments proposed after due consultation with industry representatives. These amendments are aimed at making the rules more responsive to the needs of the industry and plugging the loopholes identified in the process of applying these laws. At the same time, monitoring and surveillance mechanisms were enhanced to enable the Commission to take proactive measures and impose appropriate punitive or remedial measures to deter further violations. The SCD conducted a number of investigations and special audits during the course of the year and took appropriate follow up action.

On January 11,2002, the SBP and the Commission jointly announced the transfer ofsupervisory functions of certain Non-bank Financial Institutions (NBFIs) from the SBP to the Commission effective July 1,2002. These NBFIs include investment banks, discount houses and housing finance companies. Subsequent to the transfer, all financial institutions -with the exception of commercial banks and Development Finance Institutions (DFIs) - will be regulated by the SCD. The transfer, however, was delayed pending enactment of necessary amendments in relevant laws by the Government.

Following the transfer of regulatory supervision of these institutions, the Commission intends to implement the concept of the Non-bank Finance Company (NBFC).A NBFC, as a company duly licensed by the Commission, would be able to carry out any one or more of the following forms of business, subject to compliance with the prescribed criteria:

(i) investment finance services;

(ii) leasing;

(iii) housing finance services;

(iv) venture capital investment;

(v) discounting services;

(vi) investment advisory services (as management company of dosed-end mutual

funds); and (vii) asset management services (as management company of open-end mutual

funds).

The main objective behind the introduction of NBFC is to consolidate the activities of the non-bank financial sector under one umbrella. Consolidation is expected to lead to reduction in operating expenses as well as strengthening of the capital base of these companies, thereby providing a fillip for future development of this sector.

In order to provide a comprehensive framework for the regulation and monitoring of NBFCs, the Non-Bank Finance Companies (Establishment and Regulation) Rules, 2002 were drafted for issuance under appropriate provisions of the Companies Ordinance, 1984. The draft Rules were notified in the official gazette in May 2002 to solicit public opinion. After considering the comments and suggestions of the concerned quarters, the Rules were finalized and forwarded to the Ministry of Finance for approval prior to promulgation.

The SCD has also been instrumental in developing a policy framework to encourage mergers and consolidation in the financial sector. The SCD worked closely with the SBP and the Central Board of Revenue (CBR) to recommend certain tax incentives for mergers/ amalgamations of banks and NBFIs. In recognition of the growing economic need for mergers and business reorganizations, the proposed tax incentives were introduced through the Finance Ordinance, 2002. These incentives include carry forward and set-off of losses of merged institutions, tax admissibility of expenses on merger, continued availability of unabsorbed depreciation and admissibility of different tax rates to banking and non-banking operations of a merged institution. It is envisaged that these fiscal incentives would facilitate consolidation of the financial sector, which will lead to enhancement of capital base and economies of scale of financial institutions, thereby improving competitiveness and cost effectiveness within the sector.

A brief review of the activities of the SCD during the financial year 2002 is given below.

The Leasing Wing of the SCD regulates and monitors activities of leasing companies in accordance with the provisions of the Companies Ordinance, 1984 and the Leasing Companies (Establishment and Regulation) Rules, 2000.

As financial intermediaries providing medium and long term financing, leasing companies have made a significant contribution towards development of the financial sector in the country. Leasing companies have also played an important role in the development of small and medium scale enterprises in Pakistan and remain a significant player in the vehicle financing business. Previously, establishment of various small leasing companies and entry of other financial institutions into the leasing business had resulted in a fragmented sector with limited opportunities for growth. Moreover, leasing of plant and machinery was adversely affected due to increase in the number of sick units in textile and cement sectors. The capital base of a number of leasing companies was, therefore, eroded due to the large amount of provision that was needed against such non-performing assets.

During the year under review, the number of leasing companies decreased from 32 to 30 as a result of consolidation through mergers and amalgamations. Of these 30 companies, one is in liquidation. Consolidation in the sector is expected to continue as a few more mergers are in the pipeline while some are at an advanced stage of negotiations. These include not only intra-sector mergers but also cross-sector mergers involving modarabas and investment banks. It is anticipated that the

encouraging trend of mergers and consolidation in the sector would result in improving resource mobilization potential and operational efficiency of leasing companies due to strengthening of capital base and economies of scale, respectively.

During the year, investment in leases increased by 9 percent to Rs. 37.5 billion, a significant portion of which was invested in vehicle financing. An important factor that contributed towards this growth was the availability of tax concessions in the Finance Ordinance, 2001 through which First Year Allowance for depreciation of leased assets at the rate of 30 percent was accorded to leasing companies and ceiling on cost of vehicles for depredation allowance was increased to Rs. 750,000 from Rs. 600,000. In the Finance Ordinance 2002, the initial depreciation allowance permissible in respect of leased assets has been enhanced to 50 percent and ceiling on cost of vehicles for depredation allowance has been revised upwards to Rs. 1,000,000. This is expected to further boost the performance of the leasing sector. Despite frequent reduction in interest rates and persistent slow down in economic activity, the leasing sector demonstrated reasonable growth during financial year 2002, as evident from increase in aggregate assets by 8.9 percent to Rs. 47.88 billion. The aggregate equity base improved by 4.9 percent to Rs. 8.5 billion during the year. By the end of financial year 2002, around 78 percent of the assets were deployed in the principal line of business. However, the sector continued to remain highly concentrated as six leasing companies accounted for more than 70 percent of total assets of the sector. Certificates of Investment (COIs) remained a significant source of mobilizing short and medium term funding for leasing companies and as at June 30, 2002, the aggregate amount raised through this source was Rs. 13.53 billion, indicating an improvement of 19.5 percent over the previous year. The maturity period of COIs issued by leasing companies ranges from three months to five years.

Key statistics of the leasing sector as on June 30, 2002, based on audited statements, are given in Table 8.

TABLE 8 Key Statistics of Leasing Sector

In 1997, the minimum paid-up capital requirement in respect of leasing companies was raised to Rs.200 million from Rs.100 million through an amendment in Leasing Rules, 1996. The increase in the capital base was expected to improve prospects for resource mobilization and lead to consolidation in the sector through mergers and acquisitions. Leasing companies, whose capital was below the stipulated level, were advised to enhance their paid-up capital to Rs.200 million within a time span of two years, i.e. by end-October 1999. Later, this deadline was extended to June 30, 2001.

During the year under review, the Commission considered a number of cases regarding enhancement of the capital base and an extended time period for compliance was allowed on a case-to-case basis depending on the viability of plans. As a result, the number of companies compliant with the minimum capital requirement of Rs. 200 million increased to 18 from nine at financial year-end 2001. Another eight are expected to become compliant by June 2003 by way of mergers, issuance of right shares at a discount and issuance of preference shares. By the end of 2003, it is expected that almost all the leasing companies would have met the minimum capital requirement. The enhanced capital base is expected to result in greater financial stability, improved resource mobilization capacity and economies of scale to enable leasing companies to compete effectively with larger financial institutions undertaking leasing business.

The status of compliance of leasing companies with the minimum capital requirement, as on June 30, 2002, is presented below:

TABLE 9 Status of Compliance with Minimum Paid-up Capital Requirment

FULLY COMPLIANT COMPANIES

DEEMED COMPLIANT COMPANIES

During the year under review, leasing companies pursued a number of merger proposals and the Commission accorded in principle 'no objection' to six such schemes of merger/ amalgamation. Of these, the following three schemes have subsequently been approved by the relevant High Courts:

The Commission suspended the permission to issue COIs of two leasing companies during the year under review. This followed the suspension of permission to issue COIs of six leasing companies during 2001. The credit ratings of these companies were below the minimum investment grade and issuance of COIs by such companies was in violation of the Leasing Companies (Establishment and Regulation) Rules, 2000. In case these companies fail to obtain a satisfactory investment grade credit rating within a period of two years, the permission to issue COIs will be cancelled. During the two-year time period, these companies have been advised not to issue any new COIs or rollover the existing COI deposits upon maturity.

During the year under review, licenses to undertake leasing business were accorded to Small Business Finance Corporation, First International Investment Bank Limited and Pak Oman Investment Company (Private) Limited in terms of Rule 18 of the Leasing Companies (Establishment and Regulation) Rules, 2000.

As a result of concerted efforts of the Commission, certain amendments were introduced in the Income Tax Ordinance, 2001 in respect of the leasing sector. Meanwhile, modarabas and other financial institutions undertaking leasing business were allowed, through the Finance Ordinance, 2002, to deduct depreciation from lease rental income derived by such institutions. This amendment is expected to provide a level playing field to all participants in the leasing business.

During the year under review, special audit of a leasing company revealed gross misappropriation and misapplication of funds by its management.

Further, it was observed that the directors had managed the affairs of the company in a manner oppressive to the members and pre-judidal to the public interest.

During the course of the special audit, the management handed over the affairs of the company to a new group in a clandestine manner. The newly inducted directors of the company were required to obtain prior approval of the Commission in terms of Leasing Companies (Establishment and Regulation) Rules, 2000. Although the Commission did not grant approval to the appointment of new directors due to incomplete information about them, the new management, in violation of the legal requirements, went ahead with further changes in the corn position of the board of directors without prior approval of the Commission. This attracted the provisions of Sections 185 and 186 of the Companies Ordinance, 1984. As a result of continuing defaults in observing statutory requirements, a show cause notice was issued in terms of the above Sections to the new management of the company. At the conclusion of the hearing granted to them, the new management agreed to provide to the Commission requisite information about legitimate ownership of the company and credibility of the newly inducted individuals. However, the new management failed to furnish such information and the Commission, therefore, initiated proceedings for appointment of administrator under Section 290 of the Companies Ordinance in respect of the said leasing company.

The case for appointment of administrator under Section 290 of the Companies Ordinance has since been filed in the Sindh High Court and proceedings are currently in progress.

In addition to the above, it became evident that the financial statements issued by the previous management of the leasing company did not present a true and fair view of the company's affairs. Therefore, proceedings against the concerned directors of the company for knowingly and willfully making contradictory and untrue statements in accounts were initiated. These proceedings have been filed under Section 230 (7) (a), read with Section 492 of the Companies Ordinance, 1984 in the Court of Session in Karachi South.

The statutory time limit allowed to leasing companies to enhance their capital to the minimum stipulated level of Rs. 200 million was June 30, 2001. The Commission decided to exercise regulatory forbearance until September 30, 2001 during which time the companies were expected to submit viable, time-bound plans for enhancing their paid-up capital to the requisite level. A few companies, however, did not make any serious attempt to meet the regulatory

requirement. Consequently, show cause notices were issued and opportunities of being heard were provided to the non-compliant companies. These companies were again encouraged to come up with reasonable plans to meet the requirement. Leasing companies that presented viable plans were given further time to implement their proposals. However, four companies failed to provide any workable plan to meet the minimum paid-up capital requirement and the Commission, in exercise of powers conferred under Rule 20 (2) of the Leasing Companies (Establishment and Regulation) Rules, 2000, cancelled their licenses to undertake leasing business.

In terms of Section 158 of the Companies Ordinance, 1984, companies are required to hold their Annual General Meetings (AGMs) within six months of the close of the financial year. During the year, the Commission received applications from five leasing companies for extension in holding of AGMs, out of which two were adjudged to be on inadequate grounds and, therefore, rejected. Appropriate extension was granted to the remaining three companies.

Annual and interim accounts of leasing companies for the year ended June 30, 2001 were reviewed in light of the provisions of the Companies Ordinance, 1984, applicable International Accounting Standards (lASs) and the Leasing Companies (Establishment and Regulation) Rules, 2000. Deficiencies noted were pointed out to the managements of relevant companies for necessary rectification or clarification. Further, as appropriate, these companies were also advised to ensure that such lapses do not recur in future and to give adequate disclosures in their financial statements. A visible improvement in the financial reporting of leasing companies is evident due to enhanced monitoring and surveillance by the Commission.

During the year under review, inspection of books of accounts of a leasing company was carried out under Section 231 of the Companies Ordinance, 1984. This inspection was ordered by the Commission in order to verify that proper books were maintained by the company. The inspection also aimed at ascertaining the accuracy of claims of different financial institutions that the directors of the leasing company were involved in fraudulent activities. On the basis of the inspection, it was concluded that the company had maintained incomplete books of account in contravention of Section 230 of the Companies Ordinance. Further, it was observed that the directors and management of the company were exploiting weaknesses in the internal control system and appeared to be involved in fraudulent activities. In order

to delve further into this matter, an investigation by an independent firm of chartered accountants was initiated in terms of Section 265 of the Companies Ordinance, 1984. The inspectors were required to carry out a detailed investigation to determine the amount misappropriated by the management and to fix specific responsibility on the individuals concerned. In the meantime, findings of the inspection carried out under Section 231 have been forwarded to the National Accountability Bureau (NAB) for appropriate action.

While reviewing the annual audited accounts of a leasing company, it was observed that the company was in a precarious financial position that could lead to insolvency, thereby raising doubts about the company's ability to continue as a going concern. The main reason for the deteriorating financial position of the company was its excessive investments (around 160 percent of its equity) in associated undertakings, which were under severe financial distress and not in a position to repay the leasing company. The Commission proceeded against the management under Section 208 of the Companies Ordinance, 1984 that restricts investment in associated undertakings to a maximum of 30 percent of paid-up capital and free reserves. The directors were duly penalized and also directed to reimburse the losses suffered by the company. Further, the company was directed under Section 472 of the Companies Ordinance, 1984 to make good the default within 30 days.

In addition to the above, an investigation into the affairs of the leasing company was initiated under Section 265 of the Companies Ordinance, 1984 as there were sufficient grounds to suspect that funds of the company had been misappropriated/misapplied and the business of the company was being conducted to defraud its creditors and members. The inspectors have submitted their report to the Commission and appropriate penal proceedings are in progress.

An order under Section 260 of the Companies Ordinance, 1984 was passed against a firm of chartered accountants. The firm, in its capacity as statutory auditors of a leasing company, had failed to discharge its duties in accordance with the provisions of the Companies Ordinance, 1984. Therefore, a fine of Rs. 2,000 was imposed on each partner of the firm for having issued an unqualified audit report to the members of the company despite material misstatements in financial statements on account of certain fake lease transactions.

The modaraba is an Islamic corporate form that is essentially akin to a two-tier fund structure. In a modaraba, one party (the modaraba management company) contributes its skills and efforts while the other (the modaraba certificate holders) provides the required funds. The profits earned in the business are shared between the management company and certificate holders on a pre-determined basis. A modaraba may be for a specific purpose or multi-purpose, and may be perpetual or floated for a specified period.

As on June 30, 2002, there were 46 modarabas in existence, of which 41 were operational with aggregate paid-up capital of Rs. 8.34 billion. Total assets of the modaraba sector stood at Rs. 18.49 billion while the aggregate equity amounted to Rs. 8.35 billion. The difficult operating environment prevailing in the recent past has had an adverse impact on the performance of a number of modarabas. However, despite the persistent economic slow-down, the sector, overall, has performed reasonably well. As per the last audited financial results, the dividend payout of the modaraba sector has been quite encouraging - 19 modarabas paid cash dividend, ranging between 1.5 percent to 46 percent as compared to 15 modarabas that paid dividend between 4 percent to 30 percent during the preceding year. The average payout of the modaraba sector compares favorably with any other segment of the corporate sector and Net Asset Value (NAV) of majority of modarabas remained above par during the year.

Fiscal incentives announced in the Finance Ordinance, 2002 for leasing modarabas are expected to give a significant boost to the performance of the sector through tax deferrals and reduced current tax liabilities. Moreover, better monitoring and surveillance methods, recently instituted by the Commission, have resulted in improved compliance by modaraba management companies with the Prudential Regulations and observance of significantly better disclosure standards.

Key statistics of the modaraba sector as on June 30, 2002, based on audited statements, are presented below.

During the year under review, one modaraba company was registered under the Modaraba Companies and Modaraba (Floatation and Control) Ordinance, 1980 (Modaraba Ordinance). The company intends to float or acquire a multipurpose perpetual modaraba.

The Commission continued its policy of encouraging mergers within the financial sector as these are expected to result in improved economies of scale and operational synergies. During the year under review, Guardian Leasing Modaraba merged with First Providence Modaraba while Ghandhara Leasing Limited merged with AI-Zamin Leasing Modaraba.

The Commission has recently introduced the concept of annual review meetings in the modaraba sector as there is no provision for holding ofAGMs under the Modaraba Ordinance. Annual review meetings were held by modarabas in December 2001, thus providing a forum for the certificate holders to voice their views about the performance of modarabas and the respective management companies.

The Modaraba Wing pursued the Commission's policy of ensuring maximum disclosure of material information through financial statements. In this regard, a circular was issued to all modarabas requiring them to submit quarterly accounts within specified time periods.

The Modaraba Wing, in consultation with the Modaraba Association of Pakistan (MAP), undertook a detailed review of the Modaraba Ordinance and Modaraba Companies and Modaraba Rules, 1981 to propose necessary amendments therein. The proposed amendments cover inter alia the following:

Further amendments have been proposed to require financial statements of modarabas to be prepared in accordance with lASs. In addition, format of auditors' report to the modaraba certificate holders is also proposed to be revised in order to delineate the responsibilities of auditors and management and to ensure that financial statements of modarabas conform with lASs. The amendments are being reviewed by the Ministry of Finance and would be notified in the official Gazette after necessary clearance.

During the year under review, after due process, approval was granted for the appointment of four CEOs and 18 directors in 16 modaraba management companies.

The Prudential Regulations for modarabas were reviewed with a view to reducing information asymmetry. A time-based provisioning criterion has been proposed in the Prudential Regulations to ensure that a true and fair view of the classified portfolio of modarabas is presented in their financial statements.

The Modaraba Wing maintained effective off-site monitoring of the sector by reviewing periodic returns/information submitted by each modaraba. Special audits of four modarabas were conducted during the year and appropriate action underthe law was taken against the concerned management companies and their directors.

Show cause notices were issued to six modaraba management companies and their CEOs and directors to explain their position with regard to violations of the Modaraba Ordinance, Modaraba Companies and Modaraba Rules, 1981 and regulations. After necessary due process, including the opportunity of hearing, the Registrar Modaraba imposed penalties aggregating Rs. 10.61 million, under Section 32 of the Modaraba Ordinance. In addition to the imposition of penalties, warnings were issued to certain modaraba companies for procedural lapses observed in conducting the affairs of modarabas.

During the year, the Modaraba Wing issued directives and obtained undertakings from the management of two modaraba companies to deposit specified amounts misappropriated from the funds of the modarabas.

On account of mismanagement and embezzlement of funds of modarabas, registration of two modaraba companies was cancelled under the provisions of Section 19 of the Modaraba Ordinance. New management companies were appointed under Section 20 of the Modaraba Ordinance to manage and revive these modarabas.

The CEO and directors of another modaraba company were issued a show cause notice for mismanaging the affairs of the modaraba and embezzling its funds. After the charges were established, penalties were imposed and a directive was issued to transfer the management of the modaraba voluntarily to a party that could revive the modaraba. The change of management has taken place with the approval of the Commission.

Criminal complaints under the Modaraba Ordinance have been lodged in the Modaraba Tribunal against certain modaraba companies and their directors for embezzlement of funds and non-filing ofaudited accounts of the modarabas.

The mutual funds industry in Pakistan dates back to 1962 when National Investment Trust Limited (NIT) was set up in the public sector to float the first open-end fund. The aim of this mutual fund was to encourage and mobilize savings that could be channeled into productive sectors of the economy. In 1966, the Government promulgated an Ordinance to set up the Investment Corporation of Pakistan (ICP) and enabled it to float closed-end mutual funds. Subsequently, ICP floated 26 closed-end funds over a period of about 30 years.

In 1971, the Investment Companies and Investment Advisors Rules were framed to facilitate entry of the private sector in the mutual funds industry. These Rules provide the framework and necessary monitoring mechanism for closed-end funds. Until 1996, 13 private sector closed-end mutual funds were floated, three of which have merged during the past two years. For regulation of open-end mutual funds, the Asset Management Companies Rules were issued in 1995. So far, four open-end schemes under the Asset Management Companies Rules, 1995 have been authorized by the Commission.

The total market capitalization of the mutual funds sector was Rs. 26 billion as on June 30, 2002 representing around 6 percent of the total market capitalization of the stock market. Dividend payout by mutual funds showed slight improvement during the year under review, which was largely owing to better equity investment opportunities to mutual funds as a result of favorable stock market conditions.

Key statistics of public sector closed-end mutual funds as on June 30,2002, based on audited financial statements, are given below.