Report No. 10337-EGT

Arab Republic of EgyptReform and Development of the Securities MarketFebruary 15, 1992Industry and Energy DivisionCountry Department II MICROFICHE COPYMiddle East and North Africa Region Report No. 10 3 37 -EGT Type: (SEC)

MERTZ, R. / X36089 / H10091/ MN2IE

FOR OFFICIAL USE ONLY

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CURRENCY EQUIVALENTS

Currency Unit - Egyptian Pound (LE)

LE per US Dollarl(average)

1987 1.521988 2.221989 2.521990 2.711991 2.97

GLOSSARY OF ABBREVIATIONS

ASB - Accounting Standards Review BoardC18 - Committee EighteenCATS - Computer Assisted Traciag SystemCBE - Central Bank of EgyptCDS - Canadian Depository for Securities LimitedCIV - Collective Investment VehiclesCMA - Capital Market AuthorityCML - Capital Market LawCOM - Council of MinistersCR - Commercial RegistrarCSE - Commissioner for Stock ExchangesGCD - General Companies DepartmentHCS - Higher Committee on Stock ExchangesIA - Investment AuthorityIFC - International Finance CorporationIMF - International Monetary FundPRA - Property Registration AuthorityS1ML - Securities Market LawSYN - Professional Syndicate or Chamber of Commerce

.i/ The average 'secondary rate" as cited by the IMF for the year. Theauthorized commercial bank (flexible) rate from July 1986 through March 1988,and the new bank free market rate thereafter. The bank's free market rate wasestablished in May 1987 and gradually absorbed most transactions from theauthorized banks rate until the latter was abolished in March 1988.

FOR OFFICIAL USE ONLY

TABLE OF CONTENTS

PageTitle Number

Chapter I: Conclusions and Recommendations ... . . . . . . . 1

Chapter II: Recent Trends in theEgyptian Securities Market .... . . . .. . 13

Chapter III: The Legal Framework . . . . . . . . . . . . . . . . 29

Chapter IV: Taxation of Financial Assets ... . ...... . . 41

Chapter V: The Institutional Structure . . .......... . 47

Chapter VI: Operational Reform of the Securities Market . . . . 69

Chapter VII: Collective Investment Vehicles . . . . . . . . . . . 76

Chapter VIII: Professional Investment Management . . . . . . . . . 91

Chapter IX: Implementation of the Reform Program ... . . . . . 96

Annexes

I Reports on the Egyptian Securities MarketII-1 Comparison of Banking Sector and Securities Market as

a Relative Source of CapitalII-2 Cairo Stock Exchange - Basic FactsII-3 Publicly Issued and Closely Held Companies Listed on the Stock

ExchangesII-4 Summary of Listed SecuritiesII-5 Representative Securities on Egyptian Stock MarketsIV Comparative After-Tax Rates of Return on Financial AssetsV Approaches to Capital AdequacyVI-1 Example of a Computerized Auction MarketVI-2 Clearance and Settlemn:nt of Securities TransactionsIX Reform Program Implementation Schedule

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bnnk authorization.

Chapter I

Conclusions and Recommendations

Introduction

1.0 The Government of Egypt has been concerned for some time about theneed to reactivate the securities market. Since 1981, many agencies,including the Arab Monetary Fund, the German Gesellschaft fuer TechnischeZusammenarbeit (GTZ), International Finance Corporation (IFC), United StatesAgency for International Development (USAID) and the World Bank, have carriedout studies, at the request of the Government, which analyzed the reasons forstagnati3n in the securities market and made recommendations for reform.2

However, concrete results in reforming the securities market have not beencommensurate with the amount of analytical work done.

1.1 In the past year, the Government has embarked on a broadmacroeconomic, market-oriented reform program, which is boing supported by theWorld Bank, the International Monetary Fund (IMF) and many other multilateraland bilateral institutions. Credit ceilings have recently been instituted toreduce the Government's budget deficit and restrain bank credit. Theseceilings have caused borrowers and lenders to reevaluate their previous over-reliance on the banking sector as a source of finance and to recognize thecritical importance of a revitalized securities market as an alternativesource of capital formation for business. However, there is still a strongbias in favor of the banking sector, which must be changed to reactivate thesecurities market and to bring about a greater balance between t'"ese twosources of capital.

1.2 In order to give urgent attention to reactivation of thesecurities market to support implementation of the privatization program, theGovernment, in December 1990, asked the Bank for recommendations. The Bank'sinitial response was contained in a paper, "Recommendations to the Governmenton the Privatization Program," dated February 15, 1991. In April, 1991,representatives of the Central Bank of Egypt (CBE), the Capital MarketAuthority (CMA) and the World Bank met in Washington and agreed that thefundamental analysis of the problems confronting the securities market inEgypt had been completed by the previous consultant reports and thatpreparation of a comprehensive action program was urgently required to supportnot only the privatization program but also the overall macroeconomic reformprogram. The Governor of the CBE and the Chairman of the CMA requested that

2. These reports are listed in Annex I. An analysis of these reportsindicates a broad consensus in the diagnosis of the nature of the problems andissues. This report takes that broad analytical consensus as a point ofdeparture.

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the Bank send a mission to assist with preparation of an action program forsecurities market reform. 3

1.3 This report is based on the findings of that World Bank mission,which visited Egypt in June, 1991. The report suggests a coordinated strategyfor the reactivation and development of the Egyptian securities market andrecommends a coherent program of legal, institutional and operational reforms,which are expected to take about eighteen months to implement. The reportstarts with a brief history and description of the securities market,recommends a large number of priority aid secondary reforms and outlines awork program to implement these reforms, which weie initiated in late 1991.The implementation schedule is set forth graphically in Table 9.1 in ChapterIX.

1.4 In designing the proposed reform program, careful attention hasbeen -'id to the appropriate sequencing of priority and less urgent reformsand to the need for adequate institutional capacity to administer the programin Egypt. To be successful, the legal, institutional and operational reformswill need to be implemented as a coherent package, though some measures arecritical to establish the framework of the overall program at the outset.Mcst important, are drafting of a comprehensive securities market law,reorganization of the CMA to prepare it for the responsibilities recommendedfor it, tax reform, and establishment of an accounting standards board.Operational reforms at the stock exchanges are recommended to start somewhatlater, followed by a pilot mutual fund and investment management company andthe introduction of measures to improve the efficiency of the securitiesmarket and to protect investcrs.

1.5 Implementation of the reform program will require that theGovernment make some changes in existing practices, procedures and patterns,as well as in the structure of administrative responsibilicy for regulationand development of the securities market. However, implementation of thereform program is expected to result in i) a more efficient securities marketcapable of serving as a revitalized source of capital formation, ii) broaderownership of economic assets, and iii) new types of securities and financialservices, which, overall, will contribute to the creation of a more vibranteconomy. The Bank offers its continued support to the Government for thesucce .ful achievement of this objective.

i/ This report has been prepared by Messrs. Robert Mertz (Task Manager),Gerald Lacoste (Consultant, Legal Reforms), Robert Pardy (CECFP, Institutionaland Operational Reforms), Syed Aftab Ahmed and Arun Sharma (CCMD3, MutualFunds and Professional Investment Management). Ms. Meena Munshi and Ms. JoBischoff provided valuable editorial assistance. Ms. Theresa Hegarty and Mr.Dennis Bailey expertly prepared this document. The authors gratefullyacknowledge the support and assistance of the CBE and CMA in gathering theinformation used in this report and the many helpful comments and suggestionsof numerous persons in Egypt and colleagues at the Bank.

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1.6 Background. The Egyptian securities market, once among theworld's busiest, is not a significant source of capital for business orgovernment today.4 During the past three years, the securities market hasprovided less than five percent, on average, of the new capital required bythe private and public sectors combined. This modest record is all the moresurprising when contrasted with the sudden emergence of the Islamic investmentcompanies (IICsj as significant competitors to the traditional banking system.

1.7 There axe several reasons for the relative insignificance of thesecurities market as a source of long-term capital. Most important is thebias in the tax code against corporate securities. Unless this tax bias isremoved, it will be difficult to develop a securities market capable ofallocating capital efficiently on a risk-adjusted basis. A second majorfactor is the economic dominance of the public sector and the relatively minorrole played by the private sector since the nationalization of most businessesin the 1960s. However, since the introduction of the Open Door Policy in1974, the private sector has increased its share in the ownership ofproductive assets. The relative importance of the private sector and of thesecurities market as a source of capital is expected to grow as a result ofthe renewed emphasis on private-sector led growth in the Government's recentpublic enterprise reform and privatization programs. Another reason for thelimited role of the securities market is the tendency of private investors toselect investments that do not require large pools of capital or widelydispersed ownership. This is due, in part, to the Government's anti-competitive policies, which protect the public sector, and, in part, to theprivate sector's preference for relatively small-scale investments, which canbe owned and managed by individuals. Under these circumstances, the need totap broad public sources of funds has been infrequent and limited, generally,to a few large transactions each year.

1.8 In addition to the macroeconomic constraints mentioned above, thesecurities market has been afflicted for decades by structural deficienciesand practices which have reduced its efficiency and capacit" to mobilizecapital and eroded public confidence in the fairness and transparency of themarket. Inadequate accounting, auditing and financial disclosure practicesneed to be corrected, in parallel with measures to boost liquidity of listedsecurities, and changes must be introduced to improve the fairness, efficiencyand certainty of securities transactions and to protect investors.

1.9 A final reason is that existing incentives promote listing on thestock exchanges instead of broad ownership. Although there are nearly 1,000securities listed, a minority of them trade actively due primarily to the

i/ For the purpose of this report, "securities" are defined as equities andcorporate and government bonds. The "securities market" consists of thoseentities that participate in the issuance and trade of securities, primarilyon the Cairo and Alexandria stock exchanges. This market is distinct from the"capital market," which also encompasses the banking sector. This reportdeals only with reform and development of the securities market.

listing of numerous closely held companies in order to take advantage of taxincentives.

1.10 The main conclusions and recommendations of the report concerningthe legal, tax, institutional and operational aspects of the reform programfollow. Details are presented in the relevant chapters of the text.

Legal Reforms

1.11 Unified Securities Market Law. The present legal foundation ofthe securities market is unnecessarily complex and insufficient in scope. Inordar to end the duplication of responsibilities and simplify the regulatoryenvironment, the report recommends the enactment of a single, comzprehensiveSecurities Market Law (SML) to replace the existing presidential decree (No.520), the Investment Company Law (No. 146 of 1988) and the Stock Exchange Law(No. 161 of 1959), which now provide the legal framework for the securitiesindustry. The new law should be based on the principle of regulation byfunction, as is the case with the banking industry, and should cover theissuing and trading of publicly offered securities, regulation of thesecurities market and of individual and institutional participants who operateir that market as principals or fiduciaries, and the establishment andoperation of mutual funds and professional investment management companies.It will establish the parameters and principles of securities regulation andwill be supplemented by detailed executive regulations.

1.12 The institutional implications of this new law would be profound.It would delegate greater discretionary enforcement powers to the regulatorybody, the Capital Market Authority (CMA), yet expand its function beyondregulation to include the development of an efficient and fair securitiesmarket. This broadening of responsibilities would require more independencefor the management of the regulatory agency and some upgrading of its humanand physical resources if the agency is to discharge its responsibilitiesadequately.

1.13 Specialized Commercial Court. The judicial system is presentlytverloaded and unable to handle efficiently the large number of commercialcases, including those which may be securities-related. The report recommendsthat consideration be given to creating a speciclAzed commercial court tospeed the processing of securities-related cases. Although there are reasonsfor concern about the impact of such a proposal on the unity of the judicialsystem, several countries have considered such a change recently, though nonehas yet agreed to proceed. Details of the proposed legal reforms are includedin Chapter III.

Tax Reforms

1.14 Chapter IV analyzes the distortionary effect of the present taxstructure on alternative financial instruments and concludes that thesedistortions should to be removed in the context of an overall tax reformbefore any meaningful reactivation of the securities market can take place.The present tax structure is skewed in favor of bank deposits and governmentsecurities and contains strong disincentives to invest in corporate

securities. Unless the tax bias against sectrities is removed, it will bedifficult to develop a secuilties market cap.ale of allocating capitalefficiently on a risk-adjusted basis.

f '5 The report recommends that the Government reform the tax code so.at it treats alternative financial assets - bank deposits, governmenteourities, corporate debt and equities - in a neutral manner, without the

current package of distortion-inducing incentives. A thorough overhaul of thetax system is under study by the Egyptian Government. Detailed analysis ofthe tax treatment of the financial sector is being carried out by the Bank andthe Fund. Final recommendations for specific tax reforms covering thesecurities market will be integrated into a coherent, comprehensive tax reformpackage that will be a part of the forthcoming financial sector report.

1.16 Based on the vission's analysis, thi3 report recommends taxneutrality between different types of securities, and more equitable taxtreatment between direct and indirect securities ownership and betweenindividual, institutional and corporate investorp. This report alsorecommends changes in the tax code and in the listing requirements and feestructure of the exchanges to encourage broader share ownership and thedelisting of inactive shares. While these measures may have a somewhatnegative impact on exchange income in the short term, they would lead tohigher fee incomes for the exchanges and higher tax revenues for theGovernment in the medium term as a result of increased trading activity. Forexample, tax and other incentives should be changed to encourage broaderequity ownership and to reduce the number of listed, but untraded, closelyheld securities on the stock exchanges. Finally, in order to encourage thegrowth of "indirect" equity ownership and of professional investmentmanagement, the report suggests that mutual funds be treated as 'pass through'vehicles for tax purposes; the funds themselves would not be taxed on incomeor capital gains, so long as they pay out a minimum percentage of the incomereceived each year to their shareholders.

Institutional Reforms

1.17 The present institutional structure of the securities market isunnecessarily complex with too many regulatory organizations and too manyoverlapping areas of jurisdiction. There is a clear need for substantialinstitutional reform on several fronts. The specific reforms proposed includethe clarification of regulatory responsibility, changes in the legal status,structure, functions and powers of the regulatory agency and the creation ofan accounting standards board. The recommended expansion of the role andresponsibilities of the regulatory agency will require the upgrading of itshuman and technical resources to equip it for its new responsibilitits in thedevelopment and regulation of the securities industry. These reforms arediscussed in Chapter V.

1.18 In order to encourage the priority development of the securitiesmarket, we recommend that all matters related to the development andregulation of the market come under the control of a single government agency.We suggest that this agency be based on the present Capital Market Authority(CMA). The CMA should be responsible for all matters concerning the

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development and regulation of the primary (issue) and secondary (trade)securities markets and all tradable, publicly offered securities, includingdezivative financial instruments, such as options and futures contracts, whichmay be introduced at a later date. The CMA would be responsible to protectinvestors against unlawful or unfair practices and to ensure that relevantinformation is available to them. It would also be expected to advise theGovernment on matters relating to the securities markets, including the taxtreatment of securities and market participants.

1.19 The CHA would derive the authority to carry out itsresponsibilities from the new °acurities Market Law, from other law's under itsjurisdiction, and from any deciees that have the force of law in areas of itsclearly defined authority. Central to the success of the reform program aremeasures to enhance the authority and investigative and enforcement powers ofthe CMA, in order to transform it into a more effective agency.

1.20 In order to invest the CMA with the stature and autonomy necessaryto carry out its responsibilities, we recommend that the management of theagency be given sufficient independence, commensurate with accountability.The chairman of the securities market regulatory authority should be entrustedwith the exercise of all relevant administrative powers to free the ministerto concentrate on major policy and strategy issues. We recommend that theboard of directors be anpointed by the prime minister and be vested with allnecessary powers to manage the CMA. The Chairman and two vice-chairmen shouldbe appointed to fixed, five-year terms, on a full-time basis. Other directorsshould be appointed to five-year terms to serve on a part-time basis, with acycle of rotation for the part-time members. The current arrangement ofcross-board representation between the CBE and CMA should be continued toprovide for consistency and coherence of policies covering the financialmarkets.

1.21 The CMA should have three basic functions regarding the securitiesmarkets: (i) advising the relevant Minister on the authorization ofestablishment of stock exchanges; (ii) approving rules and changes to rulesfor the listing and trading of securities; and (iii) monitoring and enforcingcompliance with listing and trading requirements. We recommend that the CMAbe given unequivocal jurisdiction over the stock exchanges. The marketing ofsecurities would only be permitted on a licensed stock exchange, although suchexchanges might take many forms, including so-called over-the-counter markets.The functions and powers of a stock exchange would be established by the SMLwith certain self-regulatory authority delegated to it by the CMA.

1.22 The functions and powers of the CMA would include monitoring ofthe performance of the exchanges and the enforcement of the regulatioi.requiring exchanges to record and act on client complaints. The CMA wouldalso monitor the compliance by listed companies, direct exchanges to delistsecurities and suspend listing or trading for reasons of noncompliance. Itwould similarly cover the activities of stock brokers and other marketparticipants, such as investment advisors and fund managers.

1.23 We also recommend that the CHA advise the Government on policiesto foster securities market development and take the initiative in theeducation and training of securities industry professionals and investors.Part of the requirement for obtaining a professional license in the securitiesindustry should include specific educational or training qualifications. TheCMA should spearhead the development of suitable courses and course materialsand oversee their implementation. A securities market training program shouldbe established under the aegis of the CMA at a local university or similartraining institute. Foreign technicai assistance would be useful in designingand Implementing this program and is included in the Bank's proposed TechnicalAssistance Project for Privatization and Enterprise Sector Reform. Trainingwould consist primarily of short-term courses and supervised work experiencein Egypt, supplemented to a limited extent by overseas courses.

1.24 In relatior. to companies, four basic activities are relevant:incorporation, registration, maintenance of the public record, and themonitoring and enforcement of compliance with legal requirements regarding theconduct of the affairs of companies. We recommend that the functions of theGeneral Companies Department in this area be brought under the CMA and thatthe committee constituted under Article 18 of Law 159 to deal withincorporation be abolished. Incorporation should be granted to all companiesthat lodge the prescribed documents in proper form, fulfill basic proceduraland qualifying criteria, engage in lawful business and pay the appropriatefee. The Commercial Registrar should continue its role of registering andmaintaining the public record of company documents. This reorganizationconstitutes a substantial reduction in duplication and divided responsibilityand makes the CMA the single point of contact for all matters related tojoint-stock companies.

1.25 Accounting Standards Board. Improved disclosure is thecornerstone of the regulatory approach to be taken by the CMA and to beeffective it must be backed by the establirhment of, and adherence to, anagreed set of accounting and auditing principles and practices. We recommendthat an Accounting Standards Board be established to publish comprehensiveaccounting and auditing standards based on international standards.Enforcement of adherence to these standards will rest principally with theCMA, but the Board and the accounting professional bodies would also work togenerally improve the quality and consistency of accounting and auditingpractices and professional standards.

Operational Reforms

1.26 Reform of the legal framework and of the institutional structurewill be of little value in the absence of improvements in the operationalperformance of major participants in the securities market, at this pointprimarily the stock exchanges and stockbrokers. The present operationalarrangements of the securities market are barely adequate for the current lowtrading volume and will be unacceptable when turnover increases to moderatelevels. The report recommends that current practices and tax incentives,which encourage listing, be reoriented to promote broader share ownership andliquidity; that information about company performance and securitiestransactions be more readily accessible; that the types of financial services

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and securities be expanded; and tbit transaction fees be liberalized in a morecompetitive securities market environment. We also recommend that thesecurities industry be opened to; new entrants in order to benefit from aninfusion of fresh capital and international experience; broader services couldthen be provided to an increasing number of institutional and individualinvestors. The report also proposes two new initiatives in 1992 once thepriority operational reforms have been initiated: a central securitiesclearing house or depository and an investor protection fund.

1.27 Stock Exchanges. The report recommends that the stock exchangesin Alexandria and Cairo should, in principle, be exposed to competition andshould be subject to the new SML, wi-h a grace period of two years to reachfull compliance with the law's requi- ,nts. We recommend that the ownershipand management of the stock exchang ,e entirely in the private sector, withno direct government involvement. Underlying the exchanges' proposed autonomywould be a process of authorization by the CMA, which %ould set the rules ofconduct for the exchanges and monitor the performance of their authorizedfunctions. Independent boards of directors should guide the exchanges, withday-to-day management in the hands of a chief executive officer andprofessional staff. The board should be composed of exchange members andoutside directors in about equal proportion to provide expertise and to helpdispel the view that it operates in a somewhat cloistered manner. Werecommend that the exchanges be given substantial self-regulatoryresponsibility but that this be done gradually against clearly statedperformance criteria. The OMA would retain residual power in all areas ofdelegated responsibility and would monitor the exchanges' performance.

1.28 The report recommends the creation of a unified securities market,whether on one exchange or on several, linked electronically for real-timequotation and trading unity. Such a linkage can be achieved most efficientlyby operating a single, computer-based trading system. However, this is anexpensive step, and it may be some time before volume grows sufficiently tomake this cost-effective. We recommend that computerization of the tradingsystem be implemented when it can be justified commercially and when thebrokerage industry demonstrates a willingness and capacity to modernize itsoperations. An initial step would be to engage consultant assistance toupgrade the manual trading system in a way which is compatible with laterautomation and define the medium-term system requirements of the exchanges.Subsequent steps, such as software or hardware purchases, should proceed onlyafter the CMA judges that the stock exchanges are capable of making effectiveuse of the equipment and have complied with the structural and operationalchan'-- necessary to obtain authorization by the CMA. In the interim, acontinuous link by open telephone line should be maintained during tradingsessions of the two exchanges so that orders can be executed at the bestprice, wherever that price is available.

1.29 We recommend technical assistance to help the stock exchangespromote organizational and operational reforms. The main focus of thistechnical assistance should be the design and implementation of a reformprogram aimed at a unified market and a new management structure so that theexchanges can gain authorization swiftly and operate successfully in the newenvironment. Technical assistance would ajio help exchange members to

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understand the legal, structural and operational changes being implemented andto prepare the business plans necessary for becoming competitive in this newenvironment. The CMA should endeavor to make the exchanges its partners inthe reform of the securities market by ha ing them nominate representatives tothe working groups/committees commenting on the new SML and by participatingin the design and implementation of the institutional and operational reforms.

1.30 Brokerage Services. The report recommends that the brokerageindustry be exposed to greater competition and that barriers to entry bereduced; compliance with adequate professional standards would continue to berequired of the industry. At present the three main barriers to entry intostockbroking are: (i) the legal requirement that brokers must be naturalpersons; (ii) the prohibition on foreign participation in the brokerageindustry; and (iii) the fixed commission structure. We recommend substantialliberalization in all three areas incluling the entry of foreign brokers andindependent brokerage affiliates of banks and the gradual elimination of fixedcommissions to allow greater flexibility in the pricing of brokerage services.

1.31 Clearing and Settlement. We recommend the establishment ofefficient clearing and settlement arrangements. Computerized book-entryclearance would be the most efficient system but would require substantialcomputerization of both stock exchange and brokerage operations. Clearancesoftware and hardware packages are now available, and one of these might bemodified for Egyptian requirements. We recommend that the C.MA and theexchanges take a first step now toward the development of such a system byengaging a consultant in the middle of 1992 to advise on the feasibility ofsuch a system and to draw up system specifications and a modular program ofequipment purchase and installation. Implementation would depend on thecommercial viability of the new system. The system could be operated by theexchanges or by an independent corporation.

1.32 We also recommend establishing an investor protection fund in late1992 to protect investors in the case of the bankruptcy cf a broker. The CMAshould decide whether to establish an insurance-based scheme or a capitalizedfund. While it is likely that a capitalized fund would be the most viablefinancially and give investors a better sense of protection, actuarial andfinancial analysis should be undertaken before making a final decision. TheCMA should have adequate powers to monitor the fund's operation and ensure itseffectiveness. However, the compensation scheme ..hould be owned, financed andadministered independently of the Government.

1.33 The proposed operational reforms would provide for greatercompetition in the provision of securities market services, in order toencourage efficiency and innovation. Technical assistance to key operationalinstitutions is recommended to help build the necessary infrastructure.Details are provided in Chapter VI.

Mutual Funds

1.34 The report recommends the introduction of well regulated andprofessionally managed collective investment vehicles (CIVs), which arecommonly called mutual funds. Mutual funds can serve as excellent vehicles to

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broaden the ownership of economic assets by introducing individual investorsto equity ownership, with risk diversification, at a relatively low cost andwith flexible investment options. We recommend creating a legislative andoperating framework conducive to the establishment and growth of a mutual fundindustry. The Investment Company Law (Law 146 of 1988) does not provide anadequate legal framework for the establishment of mutual funds and does notcover a number of specific issues concerning CIVs. For example, it does notprovide adequate safeguards to protect the interests of investors or adequateflexibility to allow different types of fund structures and investmentproducts. We do not consider modification of Law 146 a feasible optionbecause the law would have to be rewritten too extensively to become aneffective mutual fund law. Since a comprehensive new securities market law isto be written, it would be advisable to prepare a specific law covering mutualfunds, either as part of the new SML or as a separate piece of legislation.

1.35 In order Lo help launch the mutual fund industry, we recommend theestablishment of a "pilot" mutual fund, composed largely of shares inprofitable, joint-venture companies. The only such shares that are nowreadily available are those held by large government-owned financialinstitutions, the four public sector banks, several large insurance companiesand the public enterprises. Consistent with the Government's statedobjectives of divesting public sector holdings to the private sector to reducethe role of the Government in the economy and to privatize its joint-ventureshareholdings, we recommend that the Government direct the state-ownedfinancial institutions and companies to divest these shares to the generalpublic and to the pilot mutual fund, at prices that reflect the "fair marketvalue' of such stocks.

1.36 As a first step toward creating the pilot mutual fund, theGovernment may wish to enlist the assistance of an institution, such as IFC oran establisb'd fund management company, which has considerable experience inpromoting and structuring mutual funds in emerging markets, by awarding it amandate to create a pilot fund and an investment manLgement company in theprivate sector. Once the i gal and tax treatment of a mutual fund andinvestment management company have been clarified, a feasibility study shouldbe carried out to investigate the operational issues involved in fundestablishment and management. IFC has offered to assist with theidentification of consultants and the preparation of terms of reference.Following that, an investment management company should be formed, with theparticipation of local shareholders and foreign technical expertise. The pilotmutual fund would then be created, with its own board of directors.

1.37 Preparatory to privatizationi of the Government's joint-ventureshareholdings, the Government should immediately engage an independentconsultant to conduct an objective analysis and valuation of the shares of aselect group of 15-20 profitable joint-venture companies in the portfolios ofthe public sector banks, insurance companies and other state-owned companies.This study would provide an independent valuation benchmark for the Governmentto use in the divestiture of its joint-venture shareholdings.

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1.38 We also recommend that the Government consider encouraging thecreation of a country fund. Such funds have been utilized by a number ofdeveloping countries to mobilize long-term external resources for the privatesector. Country funds may appeal to nonresident nationals, especially ifappropriate tax incentives are provided. A properly structured country fundcould attract substantial capital from nonresident Egyptians, particularlythose in the low-tax Gulf jurisdictions. However, a country fund investing inlisted securities will face the same liquidity constraint as the pilot fund.Therefore, at this point, we recommend establishing an overseas-listed countryfund to invest in the shares of joint-venture companies currently held bystate-owned financial institutions. Detailed recommendations are included inChapter VII.

Professional Investment Management

1.39 The development of professional investment management services inEgypt is essential if the mutual fund industry is to develop and mobilizeresources on any significant scale for the productive sectors. It isextremely important to ensure that CIVs are managed only by well-capitalized,reputable professional investment management firms, employing well-qualifiedpersonnel of unquestionable integrity. The professional management of fundportfolios could help overcome any possible misgivings that may have resultedfrom the experience with Islamic investment companies during the 1980s.

1.40 The current legal framework does not provide for the adequateregulation of investment management services. The report recommends that theproposed Securities Market Law, or a separate law on investment management,cover all material aspects of this field to ensure that an efficient, ethicaland well-regulated profession develops. The basic principles underlying theprudential regulation of professional management services include efficient,simple and fair licensing procedures for all firms and employees, soundfinancial criteria and standards of integrity and professional competence forinvestment managers.

1.41 The law should provide for a broad definition of investmentmanager to cover all persons engaged in providing investment advice for a fee.We recommend including comprehensive disclosure provisions to help prevent thedissemination of false or misleading information by investment managers inrespect of their own services and activities, or in respect to financialassets under their management. The law should also provide safeguards alongthe lines of general prohibitions and effective sanctions against insidertrading and other conflicts of interest. To this end, the law should requirethat investment managers provide detailed information on the amount ofbrokerage paid to different brokers, the basis of broker selection and thenature of any affiliation between a brokerage firm and the investment company.The law should provide the regulatory authorities with powers to prevent fraudand to investigate and prosecute suspected offenders. However, we recommendthat the actual level of management fees be left to market forces, althoughthe law should provide broad guidelines on the method of fee computation sothat investors can compare and detect excessive fees. Detailedrecommendations are included in Chapter VIII.

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Implementation of the Reform Program

1.42 Completion of the fundamental components of the reform program isexpected to take about one and a half years, beginning in late 1991, althoughmuch of the work would be completed in 1992. The report recommends theestablishment of a small work team, composed of local and foreign experts, todraft a new securities market law and executive regulations. This work needsto be carefully coordinated with the harmonization of laws affecting businessand investment, including Laws 159, 230 and 203, among others, to ensureconsistency in the securities-related aspects of the establishment and fundingof businesses, as well as to provide a coherent framework for the securitiesindustry. The new SML is targeted to be introduced to the Parliament in June1992. We also recommend that foreign consultants be engaged to assist in thedesign and implementation of the institutional and operational reforms of theCMA, the stock exchanges, the brokerage industry and creation of an AccountingStandards Board. The report recommends that this work be under the overallmanagement of a steering committee comprised of the CMA, the CBE and the WorldBank group. Other interested parties may wish to participate. These issuesare discussed in detail in Chapter IX.

1.43 On a preliminary basis, the cost of the reform program isestimated to be about US$3.7 million, divided as follows between the keyelements of the program.

D Legal Reforms US$0.4 million* Institutional Reforms US$2.6 million

Operational Reforms US$0.5 millionMutual Fund and InvestmentManagement Company USSO.2 million

Total Cost US$3.7 million

The total figure includes training for the staff of the regulatory agency,stock exchanges and other securities market professionals, estimated to costabout US$1.1 million. This training is expected to take place primarily inEgypt, with supplementary training in the United Kingdom and the UnitedStates. It also includes consultant assistance to i) determine the computerhardware and software necessary to integrate the collection of data onsecurities market transactions, corporate ownership and company registration;ii) disseminate this data to potential users, including the regulatory agency,i-Lvestors and the financial press; and iii) create a modular computerizedclearance and settlement system and a centralized securities depository.

1.44 A number of bilateral and multilateral development agencies haveexpressed interest in working with the Government and the Bank on thesecurities market reform program. These agencies have concurred with thelogic of carrying out the reforms as a coordinated package under a singleumbrella project. The level and modalities of potential donor support willneed to be arranged as soon as the substance and work schedule of the reformprogram have been agreed between the Government and the Bank.

Chapter II

Recent Trends in the Egyptian Securities Market

Background

2.0 This chapter seeks to put recent trends in the securities marketin perspective in order to set the stage for the major sections of the report,which set forth in detail the proposed reform program. It describes thereasons for the relatively underdeveloped state of the securities market,including the historical development of the market and the renewed growth ofissue and trading volume during the 1980s, obstacles to sustained futuregrowth of the market and the characteristics of representative securitieslisted on the exchanges. It ends with a brief comparison of the recentdevelopment of securities markets in other countries which have carried outmacroeconomic and securities market reform programs.

2.1 In contrast to the period prior to nationalization of the Egyptianeconomy, when it was the preeminent source of funding for business, theEgyptian securities market is not a significant source of capital for businessand government today. As Table 2.1 shows, this market has been the source ofless than five percent, on average during the past three years, of new fundingprovided to the private and public sectors by the capital market as a whole.

Table 2.1: Relative IMRortance of the Securities Marketas a Source of Capital: 1987/88-1989/90

--- 1987/88 --- --- 1988/89 --- --- 1989/90---Z of X of X of

LE MM Total LE MM Total LE M Total

A. Banks

Loans by Banking Sector 5,900 52 4,742 43 8,846 52GOE Securities Purchased/Issued by Banks 4.900 43 5.984 55 7.354 44Total Banks 10,800 95 10,726 98 16,200 98

B. Securities Market

Quoted GOE Bonds Issued 0 0 7 0 260 2Equity Subscribed 568 5 238 2 408 2Total Securities Market 568 5 245 2 668 4

Grand Total Capital Raised 11,368 100 10,971 100 16,868 100

Source: Central Bank of Egypt, Annual Report

Moreover, it has been the source of only about one percent of new funding tothe private sector. This latter figure is in sharp contrast to the 1958-1961period when the securities market provided between 25Z-50% of new capitalraised by the private sector (see Table 2.2). (Further details are provided

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in Annex II-1). The reliance on bank credit has resulted ir. an unhealthy andunsustainable preponderance of debt in the financing of business; equityaccounted for only 3.1 percent of total capital formation in the 1987/88-1989/90 period, or LE 1.2 billion of the total LE 39 billion raised by theGovernment and the private business sector.

2.2 The mLiest record of the securities market is all the moresurprising when contrasted with the emergence of the Islamic investmentcompanies (IICs) as significant competitors to the traditional banking systemfor a period of time during the 1980s.1 Within a few years time, thesecompanies gathered an estimated US$7.5 billion equivalent from some 500,000resident and nonresident investors. By comparison, over the past 17 years,the 2 stock exchanges have raised a total of perhaps LE 5 billion in equityfor listed companies from a few thousand individual and institutionalinvestors.

Historical Development of the Securities Market

2.3 Economic Dominance of the Public Sector. There are many reasonsfor the relative insignificance of the securities market as a source of long-term capital. Most important is the economic dominance of the public sectorand the relatively minor role played by the private sector since thenationalization of most businesses in the 1960s. The public sector has beenlargely financed by the National Investment Bank and by government-ownedcommercial banks, bypassing the securities market as a source of capital.

2.4 The next few paragraphs describe the historical development of thesecurities market from its creation in the late nineteenth century until 1990.Knowledge of its historical development is essential to understanding theposition of the market today and the obstacles to its reform and reactivation.Table 2.2 summarizes the relative importance of the securities market as asource of capital prior to nationalization, its subsequent eclipse and therenewed growth of trading activity in the late 1980s.

2.5 Prior to Nationalization. Following the introduction of a courtsystem and commercial laws to oversee the activities of the publicshareholding companies being established during the second half of thenineteenth century, the first stock exchanges in the Middle East wereestablished in Alexandria and Cairo in 1883.2 By 1900, there were aome 230

,1/ It has been estimated that total deposits of the IICs in 1988 amountedto as much as US$ 5.5 billion, one third of commercial banking deposits, andthree times the value of all listed securities at the end of 1989, whenconverted to US dollars at the prevailing foreign exchange rate. For ananalysis of these companies, see the informal World Bank sector report (No.EM3IE:ISR-4), "Islamic Investment Companies," December 20, 1988.

21 See the report prepared by the Economic and Social Commission forWestern Asia, Financial Markets and Investment Promotion in the ESCWA Region.

(continued...)

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joint-stock companies with paid-up capital of LE 29 million.3 Corporatefinancing and stock market activity fluctuated during the first half of thetwentieth century, largely in response to changing international influences onEgypt's cotton-dominated economy. By 1958, the number of joint-stockcompanies had increased to 925. All of these companies offered shares to thepublic by prospectus: some 275 were listed; most were actively traded.

2.6 During tha period following World War II, the private sector ledthe diversification of the Egyptian economy into consumer products,intermediate goods and even some consumer durable including fertilizer,automotive and refiigerator assembly, plastic products, paper; glass, cement,pharmaceutical, copper and detergents.4 Many of these companies werefinanced through the stock market. Between 1952 and 1955, for example, 56 newcompanies were listed on the exchange, with total paid-in capital of LE 18.4million.5 In 1958, an additional 36 companies were floated, with total paid-in capital of LE 9.5 million. Market activity peaked during the 1950s: in1595, turnover amounted to LE 115 million, equivalent to 30% of the marketvalue of listed securities, with as many as 1,000 transactions daily.6

2.7 Nationalization. The successive waves of Egyptianization,nationalization, sequestration and expropriation of foreign and Egyptian-ownedproperty between 1957-1963 radically changed the structure of the economy andhad a devastating effect on the securities market. The number of listedcompanies fell from 275 in 1958 to just 55 in 1975. Turnover declined from LE66.7 million in 1958 to about LE 4 million, on average, between 1963-1974, theyear in which President Sadat introduced the "Open Door Policy."

2.8 The number of active stock brokers dwindled along with transactionvolume. From 76 brokers, representing 47 brokerage offices in Alexandria andCairo, in the late 1950s, the number of active brokers declined to just 15 bythe late 1980s. Despite the devastating effect on the stock market, theexchanges remained private sector institutions and were neither nationalized

J( ...continued)United Nations Economic and Social Council, February 1990, pp. 42-49 andAntoine W. van Agtmael, Emerging Securities Markets: Investment B.nkingOpportuinties in the Developing World, Euromoney Publications, London, 1984,pp. 169-170 for a brief description of the past history of the Egyptiansecurities market.

i/ K.M. Barbour, The Growth. Location & Structure of Industry in Egypt,Praeger, New York, 1972, p. 57.

i/ Robert Mabro, The Egyptian Economy. 1952-1972, Oxford, 1974, pp.142-3.

The Stock Exchange Yearbook of Egypt, various annual editions, 1952-1958.

§/ National Bank of Egypt, Report of the 56th Ordinary General Meeting(1955), 1956 and interviews, Cairo Stock Exchange, October, 1991.

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or closed, except for a two-month period following the Expronriation Law of1961, though a government supervisor was introduced to monitor tradingactivity.7 In fact, beginning in 1964, the dwindling number of brokers wereactually kept going by a modest annual subsidy from the Ministry of Economy,the Central Bank and the four nationalized commercial banks in the form of asalary paid to the brokers as an advance of commissions earned from thenegligible amount of trading carried on by the four banks.8

2.9 There were three reasons for the declining importance of thesecurities market following nationalization. First, the state, not theprivate sector, became the leading proponent of economic development and theleading industrial investor. The Economic Organization, established assequestrator of nationalized properties, the General Organization for theExecution of the Industrial Five-Year Plan (the al-Nasr Group), and the newlycreated Ministries of Finance and Planning initiated the concept of stateinvestment and five-year economic planning cycles. State investments werefinanced through state-controlled resources: the budget, loans from the fourlarge nationalized commercial banks, international development assistance,state-directed investments by nationalized financial institutions, such as theSocial Insurance Organization, state pension funds and insurance companies,and by substantial public borrowing. Only the latter passed indirectly, andin small part, through the securities market in the form of governmentdevelopment and housing bonds.

2.10 Second, the level of planned industrial investment by the statedwarfed anything the private sector had managed before and was, arguably,beyond its resource limits. The first Five-Year Plan, beginning in 1960/61,envisioned industrial investments of LE 439 million.9 Indicative of theshift away from private sector investment (and plunging private sectorconfidence in the economy), net bank and non-bank credit to the private sectorfell LE 11 million in 1962, while public sector credit increased by LE 76million. 10

2.11 The result of rising state investment in the productive sectorsand nationalization of the banks was that the banking system took control ofsavings mobilization. The decision to channel savings through the banks wassupported by the tax code. Controls were imposed over the distribution of

Z/ As an indication of the deteriorating business prospects of the privatesector, the ratio of market value of stocks to nominal value fell from 146% atthe end of 1960 to 97X at the end of 1962. Central Bank of Egypt (CBE),Economic keview, 1961 and 1962.

t/ CBE, Economic Report, 1978, vol. XVIII, #1, pp. 1-5.

i2/ CBE, Economic Report, 1961, vol. 1, #4, p. 525. Compare this to therelatively modest new issue volume on the stock market in the early 1950s ofLE 6-10 million annually.

.O/ CBE, Economic Report, 1963, vol. II, #2, p. 183.

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corporate profits during the 1960s ard 1970s. Although these controls wereloosened following the introduction of the Open Door Policy in 1974, all formsof bank deposits were exempted from the tax on movable capital and thepersonal income tax by virtue of the new tax law passed in 1977.11 Thisexemption was also expected to apply to dividends on the basis of parity.However, it was only partially extended to dividends with the passage of a newtax law (Law # 157) in 1981. With tax exemptions for income earned from bankdeposits and interest on Government bonds, this tax system - which remains ineffect today - has been well suited to financing the public sector andmobilizing savings through the banking system, but it has discriminatedheavily against corporate securities and development of the securities market.

2.12 Third, the nationalization policy did not extend to smallbusinesses - those with under fifty employees - and these remained active inthe private sector. What remained of the private sector after nationalizationconcentrated on light industry, trade and services; focusing on a scale ofinvestment which did not require it to mobilize resources on the securitiesmarket or to share ownership with non-affiliated individuals. Despite theuninviting business environment, small-scale industries managed to hold theirown, and even to grow, in the local and export markets during the 1960s and1970s. However, the aggregate share of the private sector in total industrialinvestment continued to decline, averaging only 4% between 1970-74.12

2.13 With the state in control of most of the medium and large-scaleindustries in the modern sector, the private sector which had utilized thesecurities market was eclipsed and the importance of that market as a sourceof capital declined, from 56.2% of net external private sector capital raisedin 1961 to less than 2% from that year on. Henceforth, the private sectorrelied on internally generated funds and banks and there is no record of newcorporate securities being issued during the 1964-1974 period. Stock marketcapitalization as a proportion of GDP declined, from 12% of GDP in 1958 toonly 1% of GDP in the 1970s and early 1980s (see Table 2.2).

Reactivation of the Securities Market

2.14 President Sadat's "Open Door" Policy in 1974, designed to giverenewed encouragement to the growth of private sector business activity andinvestment, finally began to have a positive impact on stock market activity

I/ The present tax treatment of financial assets is contained in a seriesof tax laws and decrees passed in 1977 and 1981. For example, decree # 385 of1977 freed the distribution of corporate profits from governmental controls.Law # 27 of 1977 contained the tax exemption for bank deposits. In 1981,dividends paid on listed shares were partially exempted from personal andcorporate income tax. See the CBE, Economic ReRort, 1978, volume XVIII, # 1,pp. 1-5 for the tax laws of 1977.

IV Ikram, op.cit., pp. 246-53.

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Arab R,-ublic of Egypt

Table 2.2 Summary Stock Exchange Statistics: 1953-1990............................ .............................................................. ......

(mitlions unless otherwise noted)

1953 1958 1961 1975 1980 1985 1989 1990> .... .......... .......... ....... .......... .. .. ... . ....... .......... .......

Number of ListedCoxqanies (#) 211 275 261 55 61 318 510 573

Number of Shares Listed (#) 22 48 65 21 48 242 358 373

Market Capitalization (LE) 91 170 175 49 130 1874 4384 5274

Market Turr.over (LE) 16 30 39 8 11 63 204 342

Turnover Ratio 17.58% 17.65% 22.46% 16.94% 8.31% 3.36% 4.64% 6.48%

Yearend FX Rate (LE per USS) 0.35 0.35 0.35 0.39 0.70 1.33 2.56 2.87

Average FX Rate (LE per USS) 0.35 0.35 0.35 0.39 0.70 1.30 2.52 2.71

Gross Domestic Product (LE) a/ 950 1,329 1,459 4,886 15,470 32,516 64,688 84,748

Market Capitatizationas percent of GOP 9.58% 12.79% 11.99% 1.00% 0.84% 5.76% 6.78% 6.22%

Net Change Bank Credit (LE) b/ *5 26 6 294 -222 1,861 3,098 4,026

Value of Shares Issued (LE) c/ 5 10 8 1 4 33 32 40

Shares Issued as a Percentof New Capital Raised in Year n.m. 26.76% 56.20% 0.20% *1.83% 1.74% 1.01% 0.98%

Sources: Capital Market Authority, Cairo and Alexandria Stock Exchanges,and IMF, "International Financial Statistics".

a/ data are for GNP in 1953, national income in 1958 and GOP in foLlowing years, as calculatedby the IMF, except for 1990 which is a World Bank estimate.

b/ net change from previous year in "claims on the private sector" as recorded by the IMF, IFS. A breakin comparability in 1980.

c/ paid-in capitaL of joint stock companies, new issues and capital increases.

Nov. 21, 1991MN21Ec:\lotus\egtsumn.wkl

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in the early 1980s. Trading volume picked up gradually, only reaching itspre-nationalization level, surpassing LE 100 million, in 1986. Table 2.3summarizes the growth in trading volume and value s4nce 1986. Further detailscovering the 1981-1990 period are provided in Annex II-2.

Table 2.3: Cairo and Alexandria Stock Exchanges: Turnover 1986-1990(million)

AverageAnnual

1986 '987 1988 1989 1990 Change (X)

Number of Shares (#) 7 10 7 9 14 18.9%Value of Transactions (LE) 122 186 134 229 341 29.3%

Source: Capital Market Authority

Obstacles to Sustained Future Growth of the Market

2.15 For several reasons, reactivation of the securities market has notresulted in a more liquid market. First, the supply of large publicly issuedcompanies has grown slowly. During the 1980's, the number of such companiesrose from 55 to 155. At the same time, there are nearly 400 enterprises ownedby the government, which have continued to rely on government-controlledsources of funding. Despite measures to encourage an increasing privatesector role in the economy since the mid-1970s, the Government is only nowbeginning to take the first steps to start selling state-owned enterprises.The relative importance of the private sector and of the securities market asa source of capital is expected to grow as a result of the renewed emphasis inthe Government's reform program on private sector-led growth and a verysubstantial increase in the supply of corporate securities as a result of theconversion of nearly 400 public enterprises into joint-stock companies andtheir listing on the exchanges.

2.16 Second, despite private sector investment amounting to severalbillion pounds since 1974, private investors have continued to preferinvestments which can be owned and managed by an individual or his immediatecircle of family and friends. The need to tap brnad public sources of fundshas been limited generally to a few large trans.;_.tions each year. Informationabout the registration and incorporation of businesses during the 1980s putsinto perspective the limited role of the securities market in the funding ofnew businesses (see Table 2.4). These figures demonstrate that aninsignificant percentage - less than 0.1 percent - of the companies registeredduring the 1982-1990 period required a publicly recorded capital subscriptionby more than one person. Even in these cases, the amount of equity capitalwas not large and was usually supplied by a very small group of investors.The average capitalization of the more than 1,150 joint-stock companiesincorporated between 1982-1990 was about LE 1 million per company.

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Table 2.4: Company Registration and Incorporation: 1982-1990

Through May Total----1989---- ----1990---- ----1991---- -1982-1990-

X of I % o f X ofLO. Total UL. Total ie. Total No. Total

Tndividually OwnedCompanies Registered 12,371 97.4 12,589 97.8 5,149 97.9 164,749 98.8

Incorporated Companies

Joint-Stock Companies 174 1.4 171 1.3 72 1.4 1,154 0.7Limited Liability Companies 153 1.2 113 0.9 38 0.7 773 0.5Partnerships I nil 0 nil 0 nil 2 nil

Total 12,699 100 12,882 100 5,259 100 166,678 100

Source: Genoral Registry Department, Statistics Section.

2.17 Dominance of Closely Held Listed Companies. Third, unlike theperiod prior to nationalization, when all listed companies had to be offeredto the public by prospectus to qualify for listing, reactivation of the marketin the 1980s has been led by the rapid addition of closely held companies toexchange listing. Of the nearly two thousand joint-stock and limitedliability companies established since 1982, nearly 70 percent were smallenough to be financed privately without recourse to a public securitiesoffering. Only about 30 percent of these companies issued shares listed onthe stock exchanges. About 80% of the 418 companies listed between 1980-1990were closely held (those with 15 shareholders or less), the result of taxincentives introduced by the new tax law in 1981, which promote the formationof joint-stock companies and the listing of their securities without concernfor the number of shareholders involved or the objective of promoting broadsecurities ownership.13 By 1990, in terms of capitalization, closely heldcompanies accounted for 64% by value of all listed securities.

2.18 Even among publicly issued companies, a small number of "founders"own most of the shares. In the case of 106 public offerings by prospectusduring the 1982-86 period, founders' shares comprised 54 percent of totalshares issued. Founders' shares are far less likely to be traded than thoseheld by public or institutional investors. Due to the "inside" nature oftheir ownership structure, the listing of both closely held and founders,shares has added little to the supply of tradeable securities or to a morebroadly distributed public ownership uf economic assets. (Annex II-3illustrates the relative importance of publicly subscribed and closely heldcompanies listed on the stock market).

2.19 Lack of Market Liauidity. The prevalence of closely heldcompanies and founders' shares on the exchanges is one of the major reasonswhy the securities market, despite the large number of securities listed,

13/ Closely held companies with as few as three shareholders may apply forstock exchange listing, pay an annual listing fee (minimum LE 4,000) and,thus, qualify for tax exemptions and incentives.

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lacks sufficient liquidity at present to serve as an attractive source ofcapital, with both ease of entrance and exit for investors and issuers, or asan attractive business opportunity for market intermediaries. In any givenyear, only about 20% of listed securities trade (Annex II-4 providesstatistics about market liquidity during the first half of 1991). For manycompanies there is simply no market; in many cases, listed shares haven'ttraded in years, some as far back as 1959. The result is a narrow base oftradeable securities and relatively few daily transactions, only 20-30 onaverage.14 The listing of untraded securities constitutes an obstacle tosustainable long-term growth of the market, since it consumes the scarceadministrative resources of the market without adding to liquidity.

2.20 The reactivation of the market has highlighted a number of otherstructural deficiencies and practices which have afflicted it for decades,reduced its capacity to mobilize capital and eroded public confidence in thefairness, efficiency and transparency of the market. These deficienciesinclude: inadequate prudential regulation of the market due in large part to afragmented legal and institutional framework (see Chapters III and IV); anexcessive number of listed, but untraded securities; the fee structure of theexchanges and barriers to the introduction of new types of securities andinvestment services (See Chapter IV); inadequate capitalization of securitiesmarket intermediaries; an obsolete manual trading system that does not promotetransparency and efficiency in securities market operations; uncertain andcumbersome clearance and settlement procedures; and inadequate accounting,auditing and financial disclosure practices, as well as scanty informationabout the market. These shortcomings have been studied by the Governmentsince 1981, with the assistance of bilateral and multilateral developmentagencies, and recommendations to overcome them form the body of this report.Those which are not discussed later in the report are summarized in thefollowing paragraphs.

2.21 Listing Requirements. The existing exchanges in Cairo andAlexandria are viable only because listing fees are inflated artificiallythrough the requirement that all incorporated companies must be joint-stockcompanies and must apply for listing on both exchanges within three years ofprofitable operation. They are also encouraged by the tax benefits oflisting. Yet, these tax incentives represent a revenue loss to the Treasurywithout the public policy benefit of securities market development.15

Instead of broadening share ownership or increasing liquidity, they have hadthe opposite effect.

1.4/ "Cote Officielle," the daily journal of the Cairo stock exchange, June3, 1991. The similarity in volume between primary issues and secondary marketturnover is another indicator of the lack of liquidity in the Egyptian market.During the 1988-90 period, aggregate turnover was LE 1.4 billion, only 16percent greater than the aggregate new issue volume of LE 1.2 billion.

15/ Horch, op. cit., p. 55.

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2.22 Fee Structure. The listing of closely held companies hasgenerated a profitable level of fee income for the exchanges; about 70% oftotal exchange income, on average, in 1989 and 1990 derived from listing feespaid by closely held companies.16 Market participants - the exchanges andthe active brokers - stay in business at such a low level of turnover becauseof a schedule of fixed registration fees and commissions. In fact, only onenew broker has entered the business in the past ten years. Given the leanyears of the 1960s and 1970s, the exchanges and brokers are reluctant toaccept a modified structure of negotiated commissions and fees designed topromote an increase in transaction volume.

2.23 Capital Adequacy. Given the experience of the past three decadesof operation and uncertainty as to ownership rights of the stock exchanges,neither the exchanges nor the brokers have reinvested in their businesses.The capital of all market intermediaries - whether investment banks, stockexchanges, brokers or custodians - is inadequate to enable them to dischargetheir respective responsibilities. This is a major obstacle to an improvementin the operational efficiency of the market and in the provision of areasonable standard of client services. The Stock Exchange Law (# 161 of1957) is silent on the capitalization of the exchanges and requires only thatbrokers possess capital of at least LE 10,000 (only US$ 3,000 equivalent).Actual average capitalization of the 15 active brokerage firms is about LE55,000, less than US$ 20,000 at the current exchange rate. Accordir.g to thelaw and, in practice, the inevitable result of inadequate capitalization,securities transactions must be settled in an exchange of securities for cashpaid on a simultaneous basis, without any legal mechanism for the extension ofcredit. The inability to offer credit and the scant capital resources of thebrokerage firms limit the potential transaction volume which brokers couldhandle without additional capital. It also restricts severely their abilityto provide investor services of even the most basic sort common to mostsecurities markets, including regular statements of account, custody,securities related research and information on securities market activity.Since all trades must be made on a spot basis, neither futures nor optionscould be traded so long as such a system is in operation.

2.24 Trading System. Price discovery and execution of bids and offersare manually posted on the floor of the stock exchanges during an abbreviatedthree hour daily trading session. The public record of these transactionsconsists of a brief, inadequate summary of daily activity published by theCairo stock exchange, and a short feature in a few daily newspapers. Althoughthe government commissioner sits physically on the floor during trading hoursto monitor trading activities, an image persists that securities trading isdominated by insiders and has inadequate safeguards to protect thetransparency of the trading process or the rights of minority shareholders.This image is given credence by the occurrence of covert takeovers without anylegal requirement to notify the public or existing shareholders of the buyer'sintentions or to provide equal access to the resultant price appreciation.This image is reinforced by the rapid growth of over-the-counter or "marriage"trading which constituted between 40% and 55% of total turnover during the

&/ Data supplied by the Cairo Stock Exchange, October 1991.

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1988-1990 period.17 "Marriage" trades are arranged by a broker betweenprivate parties "off-the-floor" of the exchange. No mechanisms exist for suchtrades to be made available through the floor of the exchange to all buyersand sellers for public notification of material information such as takeoverbids, or to protect minority shareholder rights through a transparent tradingprocess which builds public confidence in the fairness of the market.

2.25 Clearance and Settlement. The transfer of securities ownership isan awkward manual process at present. Securities move physically betweencustodians and must be returned to their respective corporate headquarters orauthorized signatories to be re-registered in the name of the new owner.According to market participants, this process may take 45-60 days, duringwhich securities may be held without adequate protection against physical lossand are unnegotiable by the new owner for an extended period. This cumbersomeprocess entails risk of physical loss, delay and high cost.

2.26 Custodial Services. Though they may not trade securities onbehalf of clients, except through an authorized broker, public sector banksprovide custodial services for client's securities at their major branches.This service includes timely filing of coupons for dividend and interestpayments and handling transfer procedures. One of these banks has over 5,000custodial securities accounts. Brokers have neither the facilities nor thecapital to offer custody, though some do so on an informal basis or whilewaiting to gather securities to send for re-registration. As presentlystructured, securities custody is deficient. The CMA has no power tosupervise this service by banks and its power vis-a-vis brokers is ill-defined. Capital adequacy standards do not yet apply.

2.27 Inactive Institutional Portfolio Management. The portfoliomanagement practices of institutional investors contribute to the lack ofmarket liquidity. Public sector banks and insurance companies tend to buysecurities when they are issued and hold them. While they may be stymied byan inability to sell even a small block of securities in some cases withoutseriously affecting their realizable market value, by investment guidelines tohold minimum percentages of certain securities in some cases, and by ashortage of suitable alternative investments, there is little evidence thatany institution actively manages its portfolio to maximize its total return.Some of the smaller institutions, including private sector insurance companiesand pension funds, reportedly endeavor to manage their portfolios moreactively, but are restricted by the lack of a liquid market for most sharesand the severe limitations of inadequate accounting, auditing and financialdisclosure practices and the general lack of reliable and timely informationabout public or private sertor companies. These problems need to be correctedin parallel with the introduction of any measures to boost liquidity.

2.28 Financial Disclosure. Current practice constitutes an enormousobstacle to investment. Financial information about securities is inadequatein all forms, whether prospectus disclosure, periodic financial reports, ortimely disclosure of material events such as insider trading, take-overs and

D1/ Cairo Stock Exchange, trading data.

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mergers. Prospectus disclosure is too brief, general and legalistic.Periodic information is published infrequently and then too late to be ofmaterial value to investors. There are no requirements concerning publicationand dissemination of material information. The information which is publishedin the press has little relevant data on trading volume, prices, financialperformance and critical ratios that are common elsewhere. Consequently,whether justified or not, there is a widespread perception that the securitiesmarket is subject to sharp trading practices and manipulation based on insiderknowledge and self-dealing. This is not an environment which instills publicconfidence or attracts public support or interest, particularly given the sadexperience of the public with the Islamic investment companies in the late1980s.

2.29 Accounting and Auditing Standards and Practices. The content,accuracy and consistency of published financial statements is unsatisfactory,due in large part to flexible and inconsistent accounting practices. Thepublic sector follows a consistent set of accounting principles, the UniformCode of Accounts, under the watchful supervision of the Central AuditOrganization. Accounting practices in the private sector vary greatly betweencompanies; the Company Law (#159 of 1981) only requires companies to adopt"recognized" accounting standards but does not define those standards. Thereare also material differences between accounting practices and thepresentation of financial statements in the private and public sectors whichmake for inconsistency and lack of comparability between the accounts ofprivate and public sector firms. These differences will become material withthe listing of nearly 400 government-owned companies as a result of therecently enacted Public Business Sector Law (#203 of 1991). With regard to theaccounting and auditing profession, there is presently no accounting standardsboard or similar governmental or professional agency which defines licensingcriteria or sets and enforces standards of professional and ethical conduct.Setting and enforcing standards of professional practice would help boostinvestor confidence.

2.30 Limited Number of Investors. Given the lack of liquidity createdby the combination of closely held companies and founders' shares, it is notsurprising that there are not a large number of active shareholders. Whilethe Cairo Stock Exchange does not release actual numbers, institutionaltrading reportedly accounts for about 90X of average daily volume and thereare a limited number of such investors. Custodial records of the four publicsector banks, which handle most securities custody, indicate that the numberof institutional and individual investors exceed 5,000. The estimate that asmany as 500,000 people invested with the Islamic investment companies and theinflow of some US$ 8 billion in private capital during 1991 suggests stronglythat the most serious obstacles to renewed growth of the securities market areneither the lack of investors nor the shortage of liquid capital, but therelatively unattractive after-tax rates of return available on corporatesecurities and serious deficiencies in the operation and regulation of themarket.

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Characteristics of Listed Stocks and Bonds

2.31 The next three paragraphs describe some of the broadcharacteristics of stocks and bonds listed on the stock market. Annex II-5provides finanrial and market data from the latest available year (1989 or1990) on some 55 representative securities in 17 economic subsectors.Preference in selecting companies for this annex was given to the mostactively traded securities that had paid a dividend in the past 12 months.The sample includes primarily publicly issued companies, but also many closelyheld companies.

2.32 Disregarding the securities at the extreme ends of the sample, themarket indicators of the 50 equities largely fall in the following ranges:

a dividend yield 7%-15% (pre-tax)* dividend payout ratio 25%-75% of net income* price/earnings ratio 2-7 times earnings* closing price to book value 0.3-1.8 times book value*annual change in average share price -10% to +60%* total return (latest year) -6% to +75%

2.33 While ic is difficult to generalize because many of these sharestrade infrequently, the broad market aggregates suggest that the local stockmarket reflects a generally bearish outlook for the Egyptian economy over thenext few years. Dividend yields, which range between 7 percent and 15 percentpre-tax (which may be about 5 percent to 10 percent net of tax, assuming a 33%tax rate), are not competitive with yields on alternative fixed incomeinvestments and reflect concerns about the sustainability of currentdividends. The high dividend payout ratios reflect the high effective taxrate levied on dividends (see Annex IV), the lack of opportunities forprofitable reinvestment within the company and the cheaper after-tax cost ofdebt to corporations. The low price/earnings ratios reflect relatively highinflation, concerns about earnings stability and poor growth prospects, with ashrinking, domestic middle class market for many companies. The very lowprice-to-book value ratios (for most companies they are less than 1.0) mayreflect the expectation of poor growth prospects, near-term uncertaintiesassociated with the Government's reform program and the use of inflation-adjusted accounting for many companies. Finally, total return (dividends plusshare price movement) is negative in real terms on an after-tax basis for allbut about 20 percent of the companies in the sample. Since most companieshave not paid a dividend in years, and may not have traded in the past year,there is good reason for the low market indicators relative to othersecurities markets.

Comparison with International Markets

2.34 While the aggregate numbers show a rapid growth in stock marketactivity since 1986, turnover remains small for a country the size of Egypt.A comparison of basic indicators between Egypt and several other developingcountries (see Table 2.5) provides conclusive evidence that because of thesedeficiencies, the apparent growth in market aggregates masks a market that isactually illiquid, weak and shallow relative to other markets.

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Table 2.5: International Stock Market Comparators - 1990

EgzPt Jordan Turkey Brazil l/ Korea

GDP ($MM) Li/ 25,699 3,869 96,648 182,723 236,880MarketCapitalization ($MM) 1,837 2,001 19,065 16,354 110,594

Market Capital/GDP (X) 7.1% 51.7% 19.7% 9.0% 46.7%Value Traded ($MM) 119 407 5,841 5,598 75,949Turnover Ratio (X) 6.5% 20.3% 30.6% 34.2% 68.7%Listed Companies (#) 573 105 110 581 669Market P/E Ratio -./ 6.4x 8.2x 22.5x 5.3x 21.5x

Source: IFC, "Emerging Stock Markets Fact Book, 1991.'

a/ For Egypt, 1989 GDP.b/ Sao Paulo market only.,/ Average of a sample of forty five listed securities.

As only one example, in Jordan, a nation of only 3.5 million people, with justover 100 listed companies, turnover on the Amman Financial Market amounted toover US$400 million equivalent in 1990, more than three times the combinedturnover of the Cairo and Alexandria exchanges in that year.18

2.35 Listing of Foreign Currency-Cenominated Shares. Despite its manylimitations, in one regard, the Egyptian market is already fairlyinternationalized, due to the introduction of foreign currency-denominatedshares in 1977 designed to attract non-resident Egyptian capital and toprotect it against subsequent adverse movements in the foreign exchange rate.This has been a positive development. Although most of the capital investedhas been Egyptian-owned, the issuance of foreign currency-denominatedsecurities has helped to effectively internationalize the local securitiesmarket. In part as a result of depreciation of the Egyptian pound, by 1990,the value of foreign currency-denominated shares on the stock market exceeded50% of total market capitalization. In that same year, turnover (by value) offoreign currency-denominated shares amounted to 55 percent of total equitiestraded. This development augurs well for the growth of Cairo as a regionalmarket, though it serves as a warning that the majority of equity is now heldand traded by investors who will be particularly concerned about theGovernment's policies and regulations with regard to foreign exchangetransfers and withholding taxes, as well as its overall management of theeconomy.

2.36 Despite the deficiencies which must be overcome in the localmarket, the experience of international markets gives grounds for optimismthat the Egyptian market could improve dramatically if the Government'scomprehensive reform program is enacted successfully and completely. While no

II/ Amman Financial Market, The Thirteenth Annual Report. 1990, Amman,Jordan, 1991, pp. 14-5.

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two countries are identical, Turkey is one country in the region which offersan interesting example of the potentially positive impact of economicliberalization and securities market reform on reactivation of the securitiesmarket. In the 1985/86 period, Turkey implemented a comprehensive economicreform program, as well as a securities market reform program, with World Bankand IMF support. As Table 2.6 shows, within five years the number of listedcompanies had nearly tripled, market capitalization had grown by a factor oftwenty, and daily market turnover had grown to a level twice the total annualturnover in 1986.

Table 2.6: International Stock Market Growth Indices: 1986-1990

----------------US$ Million----------------

Index (Year of Reform) 1986 1987 1988 1989 1990

EGYPT (Cairo only/1991)Market Capitalization 1,716 1,826 1,760 1,841 1,833Annual Turnover 180 167 115 140 237Turnover Ratio (Z) 10.5% 9.1% 6.5% 7.6% 12.9%No. of Listed Companies (#) 387 430 483 510 573

INDONESIA (1988)Market Capitalization 81 68 253 2,254 8,081Annual Turnover 1 3 4 541 3,992Turnover Ratio (%) 1.2% 4.4% 1.6% 24.0% 49.4%No. of Listed Companies (#) 24 24 24 57 125

TURKEY (1985/86)Market Capitalization 935 3,221 1,135 6,783 19,065Annual Turnover 13 115 101 798 5,841Turnover Ratio (%) 1.4% 3.6% 8.9% 11.8% 30.6%No. of Listed Companies (#) 40 50 50 50 110

VENEZUELA (1988)Market Capitalization 1,510 2,278 1,816 1,472 8,361Annual Turnover 52 148 221 93 2,232Turnover Ratio (%) 3.4% 6.5% 12.2% 6.3% 26.7%No. of Listed Companies (#) 108 110 60 60 66

Source: IFC, "Emerging Stock Markets Factbook, 1991".

2.37 The experience of several other developing countries confirms thatthe Turkish experience is not unique; a major economic reorientation of aneconomy and a favorable investment climate for foreign and local capital cantransform a local securities market from dormancy to vibrancy in a few yearstime and the securities market must be prepared in advance to handle thisincreased activity. Egypt, poised at the first steps of its own economicreform program should consider the impact of the Turkish reforms on that

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securities market, and the similar experience of other countries recently, andprepare for the reactivation of its own market by a comprehensive overhaul ofthe tax, legal, institutional and operational elements of the securitiesmarket, as described in the following chapters of this report.

Chapter III

The Legal Framework

Background

3.0 The present legal framework of the securities market is bothunnecessarily complex and inadequate for the proposed reform program. Themain securities market laws and regulations need to be reformed in a mannerthat is comprehensive and consistent across the whole field of securitiesmarket activities.

3.1 There are several laws and regulations that, at present, regulatethe securities market; each deals with only limited aspects of the market orwith a specific group of participants. The most important agency entrustedwith regulation of the market place, the Capital Market Authority (CMA), wascreated by Presidential Decree (No. 520 of 1979) and shares itsresponsibilities with other government departments. For example, Decree 520did not establish the CMA as the single regulatory authority over the stockexchanges; it shares that regulatory authority with the Commissioner for StockExchanges by virtue of certain provisions of Law 161 of 1957 (amended in1981). Previous efforts to streamline authority and avoid overlappingresponsibility have been piecemeal, and there is a clear need now, as afoundation for a comprehensive reform program, to unify all laws dealing withthe securities market into one new law and to bring all institutions underthis law. A unified law dealing with the securities market would giveregulatory power to a single authority, the CMA, thus helping to rationalizethe legal, institutional and operational aspects of the securities market.Redundancies in laws, regulations and regulatory functions would be eliminatedin the reform process.

Principles of the Legal Reform Program

3.2 In order to eliminate the present duplication of responsibilityand authority in the legal and institutional areas, the regulation of thesecurities market should be established on the principle of function. Bankingactivities, for example, would continue to be regulated under the Banking Law;the securities activities of banks and other market participants wcald comeunder the new securities market law.

3.3 The new laws and regulations should be responsive to marketchanges and facilitate the development of lawful activity. Thus, the lawsshould state principles and intentions, be permissive rather than prohibitiveand establish certainty as to rights and obligations. Authorization of anoffering should not be based on an assessment of commercial merit but shouldinstead require sufficient disclosure to allow an investor to make his ownevaluation of merit. Finally, the laws and regulations should allow opencompetition in the provision and pricing of market services so that allmarkets are contestable rather than closed.

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3.4 The new legal framework proposed for the securities marketencompasses two principal components: the enactment of a new Securities MarketLaw (SML) and the creation of a new judicial body. The new law would regulateboth the instruments and the participants in the market and would lay thelegal foundation upon which the reformed Capital Market Authority wouldfunction. The new law would establish a regime of civil liability moreaccessible to investors, as well as penal sanctions to enforce the applicationof the law. The new judicial body would, as an independent and specializedtribunal, adjudicate all administrative, civil or penal matters arising fromsecurities market activities.

The Securities Market Law (SML)

3.5 Scope and Applicabilitv. The SML would apply to all types ofsecurities, such as the shares and bonds of any incorporated entity andgovernment securities, and to all participants in the securities market. Thelaw would be "open ended" in order to encompass securities not currentlytraded in Egypt, such as rights and warrants, and new types of securitiescommonly created in other markets, such As commodity, financial and othertypes of futures contracts. The law would also regulate options tradeable inorganized markets, investment contracts, shares or units of mutual funds andother forms of collective investment vehicles (CIVs), as well as theactivities of professional investment managers and advisors. (For legalaspects of mutual funds and investment management, please see Chapters VII andVIII). The CMA should be empowered to add other types of securities to thelist by decree, should there be a need to do so.

3.6 Equity securities will be required, as at present, to be issued inregistered form. This facilitates monitoring of compliance with disclosurerequirements such as the insider reports mentioned below. It would also easethe transition to a modern clearance and settlement system as recommended inChapter VI. Other forms of securities, such as bonds, may be issued in bearerform.

3.7 Bank deposits, including long-term certificates of deposits issuedby banks and other short-term instruments, would not be covered by this law.These instruments, although important in the overall context of the capitalmarket, are not considered to be within the securities market. As a result,they would continue to be regulated by the Central Bank.

3.8 Other exemptions, from either prospectus or registrationrequirements, would be provided under the overall jurisdiction of the CMA.For example, although the issuance of government bonds would not be subject toprospectus requirements, trading in these securities by the public would beregulated, requiring government securities brokers to comply with relevantbrokerage and exchange regulations.

3.9 Regulations Pertaining to Securities. The regulations in the newlaw pertaining to securities would cover the information that must be providedabout the securities themselves, their issuers, insider ownership and tradingand certain other transactions, such as take-over bids. These aspects aredescribed in greater detail in the following paragraphs.

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3.10 Distribution of Securities - Prospectus. The new law shouldstipulate that no security may be offered to the public until a prospectus,which discloses all material facts likely to affect the market price of thesecurity, has been filed with and approved by the CMA. The law would setforth the contents of the prospectus, including the pricing and description ofthe security being offered; the use of the proceeds from the issue; the planof distribution; the risk factors that an investor should take into account;the business of the issuer; the legal and financial structures of the company;a description of the main assets; any important legal proceedings pending inthis business; the disclosure of the promoters' names and remuneration, ifany; the names of directors and senior executives, together with theirremuneration and any loans made to them; material contracts in progress; thenames and shareholdings of insiders; a list of subsidiaries; and the name ofthe dealer(s) offering the securities and the description of any relationshipit may have with the issuer. It should also state the name of the auditor andprovide recent audited financial statements. The prospectus must be full,true and plain so that an investor has all the relevant information on whichto base a decision to buy the security being offered.

3.11 The SML would provide for certain exemptions to the general rulescovering prospectuses. Because of their nature, some securities would notrequire a prospectus, such as government bonds and securities offered bygovernment agencies or bearing government guarantees. Other securities may beoffered without a prospectus because of the nature of the transaction, forexample, private placements offered to sophisticated purchasers. Securitiesbought under the latter type of exemption would not normally be resold withouta prospectus, unless another exemption were to be found in the law or were tobe granted by the CMA.

3.12 The law would provide for the clearance of a prospectus by theCMA, according to certain general principles, before it could be circulated tothe public. The CMA has raised the issue of whether the regulatory authorityshould concentrate solely on enforcing adequate disclosure of materialinformation - the so-called disclosure approach - or endorse the merits of apublic offer, known in the US as the "blue sky" approach.

3.13 Regulatory authorities in several countries, including the UnitedStates, only enforce provisions concerning the quality and accuracy of theinformation disclosed in a prospectus and do not pass on the merits of theissue or on the quality and character of the person/corporation making theoffer. This approach assumes that an investor, being adequately informed andadvised, is capable of deciding whether or not to buy a specific security. Italso rests on the principle of government nonintervention in deciding on theeconomic, financial or other merits of commercial activities and,consequently, on the belief that approval to float or list a security shouldnot rest with a government's determination of its social or financial worth.

3.14 By contrast, the "blue sky" approach implies that the regulatoryagency has examined a security and decided that it merits being offered toinvestors. Under this system, even if all of the information required hasbeen provided, a regulatory agency may refuse to approve a prospectus. Manyregulatory authorities screen securities on the basis of their merits in order

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to protect investors. A state may bar a security from being offered in thestate if the regulatory authority determines, for instance, that the price orunderwriter's compensation is excessive, inordinate options have been issuedto insiders or underwriters, or other terms of the offering are unfair toinvestors. Even in the US, whera the Federal Securities and ExchangeCommission acts as a "disclosure" type agency, about one half of theindividual states have enacted laws that give their state securitiescommissions "blue sky" powers. In Canada, all provincial securitiescommissions are of the "blue sky" type. Many developing countries haveadopted this approach.

3.15 We recommend, however, that the new law empower the CHA to followa disclosure approach to the approval of a prospectus. Despite the importanceof the regulatory agency's role in protecting investors against fraud andother securities related risks, regulatory approval following "blue sky"provisions does not ensure protection. Rather, the diligent enforcement andmonitoring of disclosure provisions, coupled with certain prosecution offraudulent or other unlawful activities under the Securities Market Law, canbe expected to be equally effective at protecting the interests of investors.Such protection will, however, require substantial improvement in accountingand auditing standards and practices, better financial disclosure, trainingfor the staff of the CMA and stronger enforcement powers for that agency, allof which are part of the reform program. We believe that implementing thesereforms will ultimately provide adequate investor protection withoutestablishing a precedent of government approval, with its attendant risks ofabuse of power or overreliance on the Government by the securities industryand the investing public.

3.16 According to the law, any security being offered to the publicwould require an adequate prospectus. However, the new law should permit theuse of several different types of prospectus, including "draft," "short form"and "shelf," in addition to the regular form. A regular prospectus would bethe one generally used by an issuer to offer securities to the public.Normally, a draft prospectus would be submitted to the CMA for review andcomments. Once the CMA was satisfied that the prospectus complied with thelaws and regulations in force, and that it contained the required information,it would clear the draft prospectus, which could then be distributed to themarket.

3.17 Other types of prospectus may be expected to be used lessfrequently. For example, a short form prospectus, which contains much lessinformation than a normal prospectus, would be used only by large issuers thatcome regularly to market and whose securities are actively traded on secondarymarkets. These issuers would need to maintain a permanent record on file atthe CMA with all relevant information, such as financial statements, pressreleases, annual reports, etc. When the short form prospectus is prepared,reference would be made to information in the public record and not includedin the prospectus. A shelf prospectus is a document that is prepared andcleared with the CMA in anticipation of a future securities issue. When thereis a window in the market for an issue to be distributed, the shelf prospectuswould be updated quickly, with information on the securities being offered,and released to investors.

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3.18 General publicity and advertisements concerning securities beingoffered or traded would also be regulated. The basic principle would be thatno advertisement or publicity could be made before a prospectus had beenapproved by the CMA and that the content of a prospectus could not bedistorted in subsequent advertisements or other publicity by either newinformation or the omission of material facts likely to affect the value orprice of the security.

3.19 Financial Disclosure Requirements. Companies that issuesecurities to the public would be required to adhere to certain legalrequirements concerning the content and frequency of the financial informationthat they report to the CMA, the securities market and to the holders of thosesecurities. Issuers of publicly offered securities would have to publishaudited annual financial statements and unaudited interim statements on aquarterly or semi-annual basis. The content and comparability of thosefinancial statements would be established by regulation. It is recommendedthat, in the absence of generally accepted and uniform accounting and auditingstandards and practices, the CMA be empowered to prescribe those standards sothat the information disclosed is comparable with the financial statements ofother companies. Once generally accepted standards have been established, andare being subscribed to in practice, the CMA's role would be reduced primarilyto monitoring compliance. In addition, the law would provide for the CMA toregulate, until an effective Accounting Standards Review Board or alternativehas been established, the conduct of accountants and auditors authorized toservice publicly held companies. The law would also provide for annual reportsby corporate managements to shareholders; these would contain financialstatements and management's analysis of the company's financial condition andits operating results.

3.20 Timely Disclosure. A material change in the affairs of apublicly held company would have to be disclosed immediately through a pressrelease filed with the C&A and disseminated through the stock exchanges andthe press. Disclosure could be temporarily delayed if publication could bedetrimental to shareholders. However, information should not be withheld iftrading is occurring, or is suspected to be occurring, on the basis of theundisclosed information, or when the circumstances justifying nondisclosurehave ceased to exist.

3.21 Proxy Material. Whenever a meeting of shareholders would becalled, the management of the issuing company would be required to send out aproxy circular containing all relevant information regarding the meeting to beheld and updating the general information concerning the affairs of theissuer. This would be done sufficiently in advance to enable shareholders tounderstand the issues and to vote their shares.

3.22 The proxy circular issued by management would have to beaccompanied by a proxy that is revocable. The circular would have to giveadequate information on the outstanding voting securities and the principalholders of those securities. It would also state the names of the personsproposed by management to be elected as directors; the individual remunerationof the five highest paid senior executives of the issuer; any loans to seniorexecutives; and a description of plans to compensate executives, particularly

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any compensation due to them in the event that their employment is terminatedor the control of the issuer changes hands. It would also contain informationon insider and related-party transactions. The proxy circular would alsoprovide material information relating to agenda items of the annual genieralmeeting of shareholders, such as the auditors proposed for the coming fiscalyear.

3.23 In addition, any person or group requesting the proxies ofshareholders to vote at a meeting would be required to send a circular withthe proxy solicitation material explaining their/its intentions and their/itsrelationship to the issuer.

3.24 Insider Reports. Insiders are a company's directors and seniorofficers, persons (individuals or corporate bodies) controlling at least 10%of the voting shares of an issuer, as well as other persons closely related tothe insiders, such as senior executives of insider companies or subsidiariesof the issuer. Insiders would be required to report to the CMA, at the end ofeach month during which they have traded, the transaction price and the numberof shares bought and/or sold. As insider trading information is relevant tothe market, the CMA should regularly publish aLl information filed on insidertrading.

3.25 Take-Over Bids. Any person or group of persons acquiring 20percent or more of the voting shares of an issuer wou'ld be deemed to effect atake-over bid. Although certain transactions would be exempt from thispresumption, such as trades at market price in the normal course of business,any offer deemed to be a take-over bid would have to be made to allshareholders and for the same consideration. These very important provisionsin the securities market law are essential for the fair and equal treatment ofall shareholders.

3.26 An individual or group making a take-over bid (the "offeror")would be required to send to all holders of voting securities, with its offer,a circular describing the offeror; the entity for which it is making its bid(the "offeree"); the conditions of its offer; the relationship between it andthe offeree, if any; and other relevant information as stipulated by the SMLand subsequent regulations designed to help shareholders reach a decision asto the value and desirability of accepting the offer.

3.27 The board of directors of the target company would also berequired to send a circular to shareholders containing the most recentinformation on the affairs of the target company, together with itsrecommendation, if any, as to the offer. However, the board may refrain fromrecommending any course of action if it states its reasons for doing so.

3.28 The law must also provide for sufficient time to enableshareholders to tender their shares or for competing bids to be launched.Similar provisions would also apply when an issuer offers to repurchase itsshares in order to take a company private.

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3.29 Regulating Market Participants, The new SML would provide for thelicensing of individuals and firms as securities dealers or brokers andinvestment advisors in order to protect investors in their relationships withsecurities market intermediaries. The law would establish several categoriesof licensing and would provide certain criteria to be met in order to obtain alicense. For example, some dealers might be licensed to carry on all types ofsecurities-related activities; others might be licensed only to sell mutualfunds or only for international operations. Persons acting on behalf of acorporate body would be licensed individually, and the principals of suchfirms would remain responsible to the public and to the CMA for the actions oftheir employees.

3.30 The law would provide for certain exemptions to the licensingrequirements, for example, for persons trading with sophisticated purchasers,i.e., banks, investment companies, insurance companies, large pension funds,etc.

3.31 The law would stipulate the principles that licensees must followin the conduct of their business with the investing public. First, a licenseeshould know the objectives of its clients and respect them in its dealingswith, or on behalf of, its clients. Special provisions should be made fordiscretionary accounts handled by brokers. Second, rules concerning conflictsof interest would be needed to protect the public. For example, the interestsof clients must always take precedence over a dealer's own transactions; rulesto that effect would constitute a code of ethics for dealers and otherlicensees. Third, the law should provide for networking arrangements allowingbrokers and dealers to use the synergies afforded by acting in concert withother financial intermediaries, such as banks or insurance companies. It isrecommended that banks not act directly as market intermediaries because ofthe inherent conflict of interest they would face as financial intermediaries.(A market intermediary generally acts as an "agent" for its client while afinancial intermediary usually establishes a creditor-debtor relationship withits client). By creating subsidiaries and establishing networkingarrangements, banks would be able to serve their clientele, avoid any conflictof interest and reduce the risks affecting their capital base.

3.32 Brokers and dealers would be allowed to trade for their ownprofessional accounts provided they followed the rules against conflicts ofinterest and gave priority to clients' orders. They would also be authorizedto keep free credit balances in their clients' accounts, provided they paidadequate interest on such sums.

3.33 Stock Exchanges and Other Self-Regulatory Organizations. The newlaw would authorize the CMA to delegate some of its powers and authority toself-regulatory organizations (SROs). Such organizations are called SROsbecause their own bylaws and rules provide for the specific regulation oftheir members (admission, conduct, discipline, rules of operations, etc.).The existence of self-regulatory functions is important because it shifts someof the regulatory responsibility and cost that would otherwise be carried bythe CMA to market participants. For example, disciplinary functions and someinvestigative powers may be delegated to avoid overlapping of functionsbetween the CMA and the stock exchanges. The CMA would monitor and review, if

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necessary, the exercise of the powers delegated to the SROs. To carry onbusiness in Egypt, a stock exchange or a security clearing-house would have tofirst be licensed by the CMA before it could operate as a self-regulatoryorganization. No professional association would be authorize. to regulate thetrading activities of its members without prior authorization as an SRO bv theCMA. Transitional measures would have to be introduced to allow the existingstock exchanges enough time to comply with the new law and to adapt theirbylaws and rules.

3.34 The rules and bylaws of the SROs would provide (i) open membershipto any person fulfilling the conditions of admission set by the SROs; (ii)equal access to services for every member; and (iii) guidelines for thediscipline of members and their employees. These rules and bylaws would beapproved by the CMA in advance and would not limit competition, unless the CMAso authorized in order to protect the interests of investors. Eliminatingfixed commission rates on transactions is an issue that will certainly bedebated under the latter principle. In the USA, Canada and many othercountries, the transition from fixed commission rates to negotiatedcommissions was met with resistance from the exchanges and members of thebrokerage industry, although this opposition did not prevent the widespreadadoption of negotiated rates. We recommend adopting a system of negotiablerates to foster competition between members of the exchanges, to avoidsubsidizing inefficient members and to encourage diversification in accordancewith free market principles. However, it may be desirable to achieve thisgoal gradually to permit the development of a presently meager investmentcommunity into one of greater stability and substance.

3.35 The new securities market law and the rules of the stock exchangeswould need to provide for compulsory arbitration of disputes among members andbetween brokers and their clients. Arbitration decisions, as well as exchangedecisions affecting its members, would be appealable to the CMA or to thespecial judicial body, depending on the type of decision to be reviewed.

3.36 Finally, the law should give the CMA the authorltvA to compel alllicensees to be members of an indemnity fund, recogni::ed by the CHA. Thisfund would serve as a guarantee for clients against ary losses caused by thebankruptcy of their broker or dealer. However, this fund would not covermarket risks, and investors should be so informed.

3.37 The Securities Market Regulatory Agency. The new SML wouldconstitute the legal foundation of the reformed CMA. One of the principalpurposes of the new law would be to clarify the role, powers and function ofthe regulatory agency. The law would give the CMA the authority to formulateregulations according to the principles established in the SML and outlinedabove, such as the content of a prospectus, rules on take-over bids, licensingrequirements, etc. The CMA would also be authorized to issue guidelines orpolicy statements to inform the market about its exercise of discretionarypowers.

3.38 Status and Accountability of the CMA. The CMA must be a fullyautonomous body in order to assure the marketplace that it is independent inits administration of the law and in its use of the wide discretionary powers

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provided under the law. However, the CMA would still be accountable toParliament through its Minister. Members of the board of directors of the CMAand its personnel would need to have complete immunity for acts performed ingood faith in the exercise of their functions. Members of the board shouldbe, and should be perceived to be, independent of any institutionalaffiliation because of their quasi-judicial functions; thus, a code of ethicsand strict conflict of interest rules would need to be promulgated for themembers of the board and the personnel of the CMA.

3.39 Discretionary Powers of the CMA. In administering the SML, theCMA would have broad discretionary powers. It would also have the power toexempt any person or category of persons from the requirements of the law, andalso, in specific cases, the authority to deny the use of exemptions providedin the law. In addition, the CMA would need to be able to order any person tocease trading in any or all securities and to request the Central Bank tofreeze bank acco-cnts of persons under investigation.

3.40 Regulatory Powers. The power to audit licensed persons and toinvestigate persons suspected of breaches of the law should be wide in orderto enforce securities market regulations. In its administration of the law,the CMA would be authorized to delegate some of its powers to a member of itsboard, to a staff member and to the SROs. Finally, the CMA would be entitledto intervene and have "good standing" in any proceedings related to theapplication of the SML.

3.41 Class Action Suits. The new law would provide the CMA with thepower to institute class action suits on behalf of investors, especially incases of insider trading where damage awards may double or quadruple theprofits realized on illegal trades.

3.42 Hearings. Decisions and Appeals. All decisions by the CMA wouldbe made by at least two members, unless this power was delegated to anindividual. In the case of a tie, the chairman would have a casting vote.

3.43 The CMA would have the power to call witnesses and to compel themto testify at its hearings and investigations. It would also review alldecisions rendered under a delegation of authority, either on the request ofaffected parties or by its own motion. All decisions by the CMA would besubject to appeal, except the agency's refusal to grant an exemption to arequirement provided for by the law.

3.44 Administrative Recourse. The CMA would have wide administrativepowers: to suspend or cancel licenses and the trading rights of individuals orcorporations; to stop market activity in a particular security; and to imposedisciplinary sanctions, including administrative penalties and fines.Administrative recourse by the CMA is essential for the proper regulat!on ofthe market.

3.45 Civil Recourse. Investors who are sold securities without aprospectus or with a prospectus containing false or misleading infoLmationwould be granted the right to sue for damages, as well as the right to havetransactions rescinded or prices modified. In such cases, the burden of proof

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would be shifted from the com',lainant to the defendant, once it was proventhat a prospectus was not given as required or that it contained false ormisleading information.

3.46 Penal Recourse. The SML would provide for penal sanctions, suchas fines or even imprisornment, to be sought by the CNA against those whobreach the law. CMA legal staff could prepare such cases but criLminal caseswhich were expected to seek a prison sentence might have to be turned over tothe General Prosecutor to be tried in a Penal Court, according to the EgyptianCivil Code. At present, the prosecutor may decide, in his sole discretion,whether or not to pursue a case. In order to underline the significance offraudulenit behavior, we recommend that the Government consider whether or notsecurities market cases should be handled in the same manner as casesinvolving customs, with the General Prosecutor being required to take up thecase.

3.47 The CMA should have the proper legal staff to prosecute offendersand to intervene in certain civil cases. Both civil and penal matters wouldbe heard by the specialized judicial body set up by the new law, as describedbelow.

New Judicial Body

3.48 The judicial system in Egypt is time-consuming and inefficient dueto the large number of cases and the lack of expertise in commercial andcorporate matters. This inefficiency can hamper the functioning anddevelopment of the securities market and shake investors' confidence in theability of the CMA to enforce the law and to discipline misconduct. The needfor a specialized body to adjudic-ate matters rising from securities marketactivities has been voiced by many observers, from both the private and publicsectors. The main drawback to setting up such a body relates to concernswithin the judicial system and the public service about the negative impact ofestablishing a separate court to provide special treatment for one segment ofthe economy. We recommend that the proposal for a new judicial body be putforward, pending further research into the legal implications of the newstructure.

3.49 The purpose of this new judicial body would be to arbitrate andadjudicate administrative, civil or penal matters arising from the operationof the securities market and covered by the new law. Criminal matters wouldstill be handled by the General Prosecutor in the regular courts that dealwith criminal cases, even though they may be related to the securities market.

3.50 The new judicial body should initially consist of judges withexpertise in commercial matters, seconded from the judicial system, and legalstaff of the CMA who are empowered to prosecute administrative, civil andpenal matters. Eventually, specially trained judges would be appointed tothis judicial body, and a collective expertise would evolve to handlesecurities market matters.

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3.51 As a tribunal of the first instance, the new body would sit inpenal proceedings brought by the CMA for alleged breaches of the SML and incivil suits among investors and market participants. In other matters, suchas the review of decisions made by the CMA, the stock exchanges or other SROs,it would sit as a review court at the request of affected parties. Decisionsof the new body would be subject to further review by the regular Court ofAppeals.

3.52 International practice has not yet recognized such a tribunal.The concept, however, has been put forward in several countries as an answerto unacceptable delays in court processing of securities-related cases incivil, penal and administrative matters, to the multiple judicial controlsover the securities markets, to the lack of specialization of prosecutors andjudges in securities market issues and to remove conflicts of interest whichmay occur when a regulator has the power to both investigate and imposepenalties on market participants. For example, a proposal to establish a newjudicial body within the existing legal system was made in France, in 1989.Officials at the Commission des Operations de Bourse, the securitiesregulatory agency in France, stated that the proposed reform was not acceptedbecause of political criticism, primarily from the established judicialsystem, in particular, the Conseil d'Etat (Council of State).

3.53 If, after thorough review, it is determined that it is notfeasible to establish such a body due to political or legal reasons, the CMAitself could act as a review tribunal for the decisions of the stock exchangesand other SROs. In summary, the CMA would need to be given very substantialand effective powers to intervene in the marketplace in order to ensure properenforcement of the new market rules.

Amendments to Existing Laws

3.54 The overlapping and redundant provisions of existing lawsapplicable to the securities-related activities of companies cause significantinefficiencies at the level of the companies and regulatory bodies. In orderto achieve the legal and institutional reforms proposed in this report,amendments to several laws and regulations are needed to (i) reduceunnecessary or redundant regulatory controls; (ii) allocate appropriatefunctions to each regulatory authority; and (iii) abandon unnecessary controlsby the authorities where market forces or ex-post facto review by the courtscould achieve a sutisfactory check-and-balance system.

3.55 The Stock Exchange Law (Law 161 of 1957). With the enactment ofthe new SML, stock exchanges will be regulated only by the CMA. Thus, Law 161of 1957 concerning the stock exchanges should be abolished, and the provisionsof that Law that are to be kept in force should be integrated into the SML.The most important changes which need to be introduced relate to governmentsupervision of the exchanges, the opening of the exchanges to new entrants,the ownership and management of the exchanges, the granting of self-regulatoryauthority to the exchanges, and the operation of the secondary market. Thesechanges are important for the efficient functioning of the market.

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3.56 The ComRany Law (Law 159 of 1981). The Company Law should besubstantially amended in order to vest in the Companies Department allfunctions concerning incorporation and registration, whether companies arepublicly traded, closely held or investment companies under Law 230 of 1989.The section of Law 159 dealing with the functions actually performed by theCompanies Department or by Committee 18 that are relevant to the securitiesmarket would be abrogated and transferred, as amended, to the SecuritiesMarket Law.

3.57 The Commercial Register Law (Law 34 of 1976). This law should beamended to make the Commercial Registrar the only government body authorizedto maintain the public record of companies and to enforce their compliancewith the legal requirement to notify the Registrar's office of changes in thepublic record on a complete and timely basis.

3.58 The Investment Law (Law 230 of 1989). The Investment Authoritywould be relieved of several functions with regard to companies establishedunder this law. It would refocus its activities on investment promotion andleave other functions to the CMA, the Commercial Registrar and the CompaniesDepartment.

Chapter IV

Taxation of Financial Assets

4.0 The tax structure for securities market instruments should bedesigned to ensure that incentives for firms to raise resources from themarket and for investors to buy securities are not distorted by the taxtreatment of competing financial assets.1 For tax incentives to bemeaningful, the general tax collection system must be effective since taxconcessions are not attractive if taxes are easily evaded.

4.1 The basic principle for the taxation of financial assets should bethat all assets are treated in a nondiscriminatory, neutral manner. Taxtreatment should not distort the risk/reward relationship between differentfinancial assets, which should be the principal basis of "rational" decision-making by investors in selecting among alternative financial assets.

4.2 The present tax structure in Egypt results in serious distortionsin this risk/reward relationship. Income from the least risk-bearingsecurities (Treasury bills and bank deposits) is substantially exempt fromtax, while dividend and interest income on higher risk securities (corporatebonds and shares) is subject to various kinds of tax. The result is agenerally declining after-tax yield curve with regard to term and risk. Thesedistortions are illustrated in Table 4. Detailed calculations are included inAnnex IV.

4.3 The present tax system makes corporate bonds and equitiesgenerally unattractive to investors. To attract investors, corporate issuerswould have to offer substantially higher rates of return than bank deposits orTreasury bills (T-bills) to compensate for the higher risk of their bonds orequities. For equities, any calculation is complicated by an investor'sinterest in total return (dividend plus capital gain). Considering dividendsalone, the nominal pre-tax dividend yield received by an individual investoron a listed security would be reduced by about 25 percent by the effective taxtreatment, while the reduction in yield for a corporate bond would be about15%. Since dividends are paid out of after-tax income, while interestpayments are deductible, the cost of equity to a corporate issuer would bealmost twice the cost of bank borrowing given the corporate tax rate of 42%.For similar reasons, individual investors will not purchase corporate bondsunless returns are higher, on a risk-adjusted, post-tax basis, than thoseavailable on bank deposits, T-bills and government bonds. These distortions

I/ Detailed recommendations constituting a comprehensive tax reform packageare to be included in the Bank's forthcoming financial sector report. Thischapter contains the calculations of the securities market mission regardingthe taxation of investment in alternative financial assets and itsrecommendations regarding the taxation of alternative financial assets. Theserecommendations are consistent with the recommendations in the financialsector report. They are included here in order to provide a comprehensiveview of the obstacles to reform of the securities market.

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are a cause for serious concern, both because there is a critical need todevelop the corporate securities markets, after years of dormancy, as analternative source of capital to the banking system, and because the tax-induced cost of raising capital through the securities market would now behigher for many businesses than through the banking sector. The followingparagraphs give a brief description of the tax treatment of the four mostimportant investment instruments in Egypt.2

Table 4: Representative After-Tax Yieldson Alternative Financial Assets

(% per annum)

NominalTyRe of Security/Income Pre-tax Yield Individuals Corporations

Bank Deposit Interest 17.3 17.3 16.5Treasury Bill Interest 19.0 19.0 18.2Housing Bond Interest 9.9 9.9 9.5Development Bond Interest 9.5 9.5 9.1Corporate Bond Interest

(hypothetical) 19.0 15.9 17.4Common Stock Dividend 7.8 6.1 6.7

Source: Bank staff calculations

4.4 Treasury Bills and Government Bonds. Interest income fromgovernment bonds and T-bills is exempt from income and movable capital taxesfor individuals. Corporations pay income tax on only 10 percent of theinterest income received; these securities are exempt from the tax on movablecapital. At present, the net-of-tax yield on 90-day maturity T-bills isaround 19 percent for individuals and about 18 percent for corporations. Thecurrent yield on 10-year fixed rate development and housing bonds rangesbetween 9 percent and 10 percent for individuals, and about 40 basis pointsless for corporations. However, these securities are rarely traded.

4.5 The weekly auction of T-bills initiated in February 1991, whichsince mid-June, 1991 has amounted to about LE 500 million per week, is arecent example of the bias in the current tax code which favors savingsmobilization through the bar'ing system instead of the securities market. Inlate June, 1991 less than 5 percent of T-bills were being subscribed byindividuals, largely because the minimum purchase amount has been set at LE25,000, about US$7,500 equivalent. By comparison, in the U.S., T-bills may be

2/ For more detail, see Hans Horch, "Corporate Securities MarketDevelopment Issues," April 30, 1991. pp. 13-21 and pp. 33-40 and the otherdocuments listed in Annex I. For analytical convenience, the normalphenomenon of a yield curve in interest rates has been disregarded. Inpractice, this would result in greater differentials then those cited in thetext.

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purchased in $1,000 increments. One way to give individual investors a chanceto buy these tax-favored securities would be to reduce the minimum purchaserequirement to LE 1,000 and extend the maturities offered to attract thesubstantial savings of small investors; the bills should also be tradeable,either on the stock exchanges or through electronic book entry by securitiesdealers.

4.6 Bank Deposits. Interest income on bank deposits is treated thesame as interest income on T-bills, exempt for individuals and exempt to 90percent for companies. At present, the after-tax yield on a 7-month bankdeposit is 17.25 percent for individuals and about 16.5 percent forcorporations.

4.7 Corporate Debt Securities. The market for corporate debtsecurities has been dormant for decades. At present, there is only onecorporate debenture outstanding, the 50-year Credit Foncier bonds issued in1951 (see Annex II-5). Analysts have attributed this to the tax treatment ofsuch securities and to the Civil Code, issued in 1948, which placed a cap of 7percent on interest payable (article 227).3

4.8 Despite the tax incentives available, the effective tax rate on ahypothetical corporate bond at present would be about double the tax rate forindividuals and corporations on bank deposits and government bonds (see AnnexIV), though about one third less than the effective tax rate on dividends.For an individual, interest income from corporate debt instruments is subjectto general income tax, at rates ranging from 8 percent to 65 percent, and tothe tax on movable capital at 32 percent. However, individuals would bepartially exempt from both taxes if the bond were listed on a stock exchangeor offered for public subscription by a joint-stock company listed on anexchange. If the bond were issued by a local, listed joint-stock company, theonly portion subject to the tax on movable capital would be the amount above anominal interest rate set periodically by the CBE, currently the T-bill ratefor a comparable maturity. In practice, this exemption may need to bemodified to be applicable to long-term bonds since T-bill maturities do notyet extend beyond 90-180 days. For corporate investors, interest income fromcorporate bonds is taxed at the normal corporate income tax rate (minimum 32percent), subject to a 90 percent exemption. In addition, corporate debtsecurities are subject to an annual stamp duty of 1.2 percent on par value,which is reduced to 0.8 percent of fair market value in the case of listedsecurities.

4.9 Under the current tax system, a hypothetical corporate bond wouldneed to offer a coupon rate of about 17 percent to match the after-tax yieldto individuals on a tax-free 9-10 percent development or housing bond, plus anadequate risk premium. In order to match the after-tax yield on a T-bill, acorporate bond would need to offer a coupon rate of about 23 percent, a levelabout 6 percent per annum above the current medium-term bank lending rate,which may be an unacceptable alternative to a corporate borrower. Unless the

.i/ See, for example, Horch, "Corporate Securities Market DevelopmentIssues," 1990, pp. 43-48.

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after-tax cost to a corporate borrower is roughly similar to the cost of termborrowing from a bank, a supply of corporate debt securities is unlikely todevelop. In addition, unless the after-tax, risk-adjusted neturn to anindividual or corporate investor is roughly equivalent to the yields ongovernment bonds or bank deposits, investors will show littie interest in suchsecurities.

4.10 There are two positive non-tax measures which would help activatethe corporate bond market. The most important would be to eliminate the legalobstacle of the 7 percent interest rate ceiling. This legal restrictionappears to relate only to personal obligations and should not affect corporatedebt. Although the issue of interest rate ceilings might be sociallysensitive, many municipal and state jurisdictions in the US faced similarpressures during the credit crunch of the early 1980s and most eliminatedcredit ceilings on all forms of consumer and business borrowing as thepreferred alternative to continued market regulation. Less preferable wouldbe some form of periodic rate setting as set forth in the new Investment Law(No. 146 of 1988). An effort has been made to deal with this prohibition bygiving the CBE and CMA the authority in Law 146 to set a variable interestrate for corporate bonds from time to time on the basis of market conditions,effectively permitting floating rate notes. However, this artifice appearsnot to apply to fixed-rate securities with which the market may be morefamiliar. Moreover, many investors may prefer the certainty of a known incomestream to the unpredictability of a floating rate note, even at the cost ofsomewhat lower interest income. Frequent regulatory interventions might notcompensate adequately for the uncertainty of such a mechanism. Therefore, werecommend that the Government seek an early removal of any legal impedimentsto the issuance of corporate debt in the context of the general liberalizationof interest rates and the overhaul of the legal aid institutional framework ofthe securities market now taking place. A second measure would be theestablishLient of a credit rating agency, such as Moody's or Standard andPoors, along the lines familiar to most developed market economies. Theratings of such an agency would be a useful independent valuation bench marsfor individual and institutional investors interested in corporate securities,particularly corporate debt issues.

4.11 Equities. Dividend income in the hands of individuals is subjectto general income tax, with an exemption of 50 percent for dividendsdistributed by joint-stock companies listed on a stock exchange. Dividendspaid by listed, Egyptian joint-stock companies are not subject to the tax onmovable capital. Corporations pay income tax on only 10 percent of thedividend income received, except for dividends on founder's shares, which aretotally tax exempt. In addition, equities are subject to a 1.2 percent or 0.8percent stamp duty on the par value or "fair market value" of unlisted andlisted shares, respectively. Capital gains on equities are presently notsubject to taxes for individuals, but are taxed as normal income forcorporations.

4.12 Conclusions and Recommended Tax Strategv. The present taxstructure is skewed in favor of bank deposits and government debt securitiesand contains strong disincentives to invest in corporate securities. Unlessthe tax treatment of financial assets is relieved of its current distortionary

- 45 -

influences, the objective of developing a vibrant securities market capable ofefficiently allocating capital will be difficult to achieve. In order toallow the optimum development of the securities market and the marketallocation of capital resources on the basis of normal, risk-adjusted factors,free from tax-induced distortions, we recommend that the Government adopt atax regime that treats alternative financial assets in a neutral manner. Thesecurities market mission was unable to estimate the potential impact on taxrevenues from an extension of tax neutrality to all financial assets due toinsufficient data; it was judged, however, that the loss in tax revenues wouldprobably not be significant for the next several years.

4.13 Measures to Broaden Securities Ownership. Several of the taxincentives currently being offered have aimed at, or have had the effect ofpromoting listing on the stock exchanges. As the data in Chapter IIdemonstrate, they have not had the effect of broadening share ownership orincreasing liquidity, but rather of promoting the dominance of closely heldcompanies on the exchanges in terms of listed issues and total capitalization.The principal tax incentives utilized include: i) the partial exemption fromindividual and corporate income tax, and from the tax on movable capital, forinterest income and dividends paid by listed corporate equities anddebentures; ii) the reduction of the annual stamp duty of 1.2 percent on mostcorporate securities to 0.8 percent on the shares of a listed joint-stockcompany or a listed corporate debenture; and iii) a deduction based on afirm's paid-in capital multiplied by the T-bill rate. These incentivesrepresent a revenue loss to the Treasury without the public policy benefit ofsecurities market development.

4.14 In order to develop the securities market and to promote broadpublic ownership of securities, we recommend that if such incentives are tocontinue, they apply only to securities which are broadly issued and remainbroadly owned, for example, by more than a minimum number of unaffiliatedshareholders, perhaps 300. This would withdraw the present listing-orientedincentives from nearly 400 closely held companies that are now listed on theexchanges but have 15 shareholders or less. Such a change could reduce theincome of the stock exchanges from listing fees - their major source of income- by as much as 80 percent unless these companies choose to expand theirnumber of shareholders in order to preserve the incentives. However, manyclosely held firms are unlikely to desire to become publicly owned. Thischange may well encourage the delisting of many closely held, untradedsecurities which would free the exchanges to concentrate on what should betheir primary objective: providing an efficient and fair trading forum.Because of the potential impact on the income of the exchanges, we recommendthat this change be announced immediately, but that it take effect at the endof the next tax year. To compensate for the loss of revenue, the exchangesshould alter their fee structures Li order to derive more income fromtransaction-related charges, such as a nominal transfer tax or fee. This typeof income would grow in direct proportion to the growth of trading activity,effectively linking exchange income with its primary business purpose.Finally, the Investment Law (#230 of 1979) and the Company Law (#159 of 1981),which require companies established under these codes to seek exchange listingwithin a fixed time period, should be amended to end compulsory listing ofcompanies.

- 46 -

4.15 Tax on Capital Gains. The taxation of capital gains in equitymarkets varies widely among different countries. Some countries do not taxcapital gains, while others levy rates as high as 65 percent. One advantageof exempting investors from a capital gains tax is that it simplifies the taxtreatment of income from the direct ownership of shares. The other, and moreimportant, benefit is the increased incentive for investors to participate inthe equity market. In view of the need to stimulate demand for equities inEgypt, increase government revenues and, in harmony with the principle of taxneutrality, we recommend that corporations (individuals are presently exempt)be exempt from the capital gains tax if individuals remain untaxed for suchgains.

4.16 Taxation of Mutual Funds . Mutual funds represent the collectiveinvestment of individual investors and should be taxed with this considerationin mind. Consistent with the principle of tax neutrality, the basis of taxtreatment of mutual funds should be that the tax payable by an investor onidentical income is the same whether he has invested directly in the security,or through a mutual fund. Mutual funds should be treated only as "passthrough" vehicles; the funds themselves should not be taxed on income orcapital gains, so long as they transfer a minimum percentage - say 90 percent- of the income received each year to their shareholders. These shareholderswould be taxed on the income received, according to the tax laws in effect.Mutual fund management companies would still be taxed at prevailing corporatetax rates on their income from management fees and returns on their owncapital.

Chapter V

The Institutional Structure

Introduction

5.0 Present Situation. The institutional structure of the securitiesmarket is presented in Diagram 1. The securities market is, at present, anunnecessarily complex network with too many regulatory organizations and toomany cross relationships.

5.1 Proposed Reforms. The proposed institutional reforms recommend amajor structural realignment that will reduce the number of regulatoryorganizations, cross relationships and duplication among agencies, whileproviding comprehensive coverage and simpler, improved management. Diagram 2captures the essence of the proposals.

Institutional Structure

5.2 Ministerial ResRonsibilitv. The principal objectives in decidingon the appropriate lines of ministerial responsibility are to ensure thatsecurities market development and regulation (i) receive sufficient support atthe cabinet level; (ii) are effective and coordinated with the Government'sother economic and financial policies; (iii) receive sufficient governmentdirection and review; and (iv) are coherent and consistent.

5.3 In order to achieve these objectives, we recommend thatresponsibility for all matters related to the development and regulation ofthe securities market remain under the control of one minister. Progress indeveloping the securities market would be hindered if political responsibilitywere dispersed; divided responsibility would be likely to lead to conflict,duplication and uncertainty.

5.4 The minister's securities market responsibilities need to besimple, clear and unified in order to be effective. His task would be madeeasier by unifying the securities market administration under one authority,eliminating peripheral or duplicated regulatory functions impinging on coresecurities market tasks, thereby faciliting his concentration on matters ofpolicy and strategy.

5.5 The minister's principal task would be to oversee theinstitutional accountability of the CMA by setting the major policy directionof the authority and working with other members of the cabinet and theauthority's chief executive to devise the authority's work strategy andmonitor its implementation. If the minister were involved in administrativematters, it would reduce the authority's regulatory autonomy. For thisreason, the minister should not be involved in regulatory decisions exceptperhaps for the most significant decisions such as the authorization of astock exchange.

EXISTING INSTITUTIONAL STRUCTURE

reports to PRIMEMINISTER

HIGHER COMMITTEE Chairman of reports considers CO WITTEE 18ON STOCK EXCHANGES i to incorporation'---'

_ ~~~~~~~~~~~~~~~~~applicationsmember MINISTER OF

of ECONOMYreports to (in p rinciple)

COMMISSIONER FOR -------------- --------- members memberSTOCK EXCHANGES of of

reports to coammunicatesmember of (in practice) reports reports reports decision to

board to to toI ~~~~~~regulates , !

STOCK EXCHNGES j< CAPITAL MARKET INVESTMENT COMPANIESAUTHORITY AUTHORITY DEPARTMENT

membersof

regulates 4- FSTOCK BROKERS I< ' ,,

eglae I CHAMBER OF CONMMRCEIr ,r~~~egulae

PUBLICLY OFFERED < certifier thatCOMPANIES company is a member

registers company COMMERCIAL REGISTRARand allocates number

and holds copy of documents

holds copy of PROPERTY REGISTRATIONcompany documents AUTHORITY

oa

g

- 49 -

DIAGRAM 2

REFORMED INSTITUTIONAL STRUCTURE

PRIMEMINISTER

CABINEMINISE

REPORT TO

CAPITAL INVESTMENTMARKET AUTHORITY AUTHORITY

REGULATES|EXCHANGES |c - IN RELATION

TO INVESTMENTPROMOTION

BROKERS c -

REGULATESPUBLICLYOFFERED cCOMPANIES

LAW 230COMPANIES

CLOSELYHELD COMPANIES

COMMERCIAL 1REGISTRAR J

REGISTERS ANDINCORPORATESAND MAINTAINSPUBLIC RECORDFOR ALL COMPANIES

- 50 -

5.6 Regulatory Authority. The principal objectives in deciding on asuitable administrative structure are to ensure that securities marketdevelopment and regulation (i) are consistent and comprehensive, both incontent and application; (ii) are effective and efficient; (iii) have adefinite focus and direction; and (iv) are proactive rather than reactive.

5.7 In order to achieve these objectives, we recommend that allmatters related to the development and regulation of the securities marketcome under the control of one government authority. The continued dispersionof administrative responsibility will only hinder progress in the reform anddevelopment of the securities market.

5.8 Selection of the Regulatory Authority. We have assumed that theauthority taking the central role in regulating the securities market will bebased on the present Capital Market Authority (CMA). This body already hasresponsibility for many of the functions recommended for the regulatoryauthority and has experienced management and staff. It should be noted,however, that substantial reform of the CMA is envisaged as part of theoverall reform program to create a more effective agency to both regulate andencourage the development of the securities market.

5.9 Scope of Responsibility. The CMA should be responsible for allmatters concerning the development and regulation of the primary and secondarysecurities markets. It should also have responsibility for tradablederivative financial instruments, such as share options, and for futurescontracts, whether finance-based, such as stock index futures, or commoditybased. In relation to these instruments and markets it should haveresponsibility for the regulation of the activities of all participants suchas brokers, dealers, and advisers, securities custodians, transfer agents, ormarket providers. Where these activities are carried on by financialinstitutions such as banks or insurance companies regulated under other laws,the securities market activities of these institutions should be regulatedunder the SML and be the responsibility of the CMA. The CMA would derive theauthority to carry out its responsibilities from the new SML, which will bedrafted as part of the reform program, from the other laws under itsjurisdiction and from any decrees that have the force of law in areas of itsclearly defined authority.

5.10 The principal responsibilities of the CMA would be to:

(a) develop and maintain efficient primary and secondary securitiesmarkets;

(b) protect investors against unlawful or unfair practices; and(c) ensure that investors have sufficient information on which to base

a decision to invest or disinvest.

5.11 The CMA would exercise these responsibilities with regard to thefollowing:

(a) the issue and trading of publicly offered equity and debtsecurities of corporations and the trading of government debtsecurities;

- 53 -Table 5.1

MAJOR POWERS AND FUNCTIONS OF GOVERNMENTIN RELATION TO COMPANIES AND SECURITIES

PRESENT POSITION

Power or Function Status1 Government Agency2

P A D C G I CC P H CR B U M C A R 1 R C S

____________________ S_ P A D 8 A S E

Approval of incorporation of companies X X X X X X X3

Maintenance of register of company records X X X X X X x

Maintenanc, of register of periodic reports lodged by oompanies X X X X X

Approval of prospectuses X X

Investigation of breaches of prospectus or public offer procedures X X X X

Exercise of discretionary exemptions from the law = e

Authorization of stock exchanges X

Regulation of stock exchanges X X

Approval of takeover documents X

Approval of modiflcations to stock exchange rules X X X x x

Order to suspend trading on stock exchange X X X x

Ucensing of securitihts broker/dealers and related functions X

Market surveillanee X X X X

Monitoring of oompliance with the law bV securities dealers X x x X

Monitoring af compliance with the law by listed companies X jX

Approval of accounting principles and auditing standards X_

Monitoring of compliance with accounting and auditing standards xtxs

PR$ . Presnt ASS a Absent DUP a Duplicated

CMA a Capital Market Authority CCD a General Companies Department IA a Investment Authority CR = Commercial RegistrarCIS * Committee Eighteen PRA a Property Registration Authority HCS a Higher Committee on Stock ExchangesCSE a Commnisioner for Stock Exchanges

Has coordination rather than approval power but It assent Is required.

4 There are as yet no agreed principles and standards but the CMA exercises a limited compliance power under Laws 146 and 159.

' SimUar stustion to note 4.

- 54 -Table 5.2

MAJOR POWERS AND FUNCTIONS OF GOVERNMENTIN RELATION TO COMPANIES AND SECURITIES

PROPOSED POSITION

Power or Function Status1 GovernmentAgency 2

P A D C C AR B U M R SS S P A B

Approval of Incorporation of companies X x

Maintenanoe of register of company records X X

Maintenanon of register of X Xperiodio reports lodged bV companies

Approval of peospeotuses x x

Invetigation of breaches of prospectus or public offer procedures x x

Exercise of disoretionary exemptions from the law X X

Approval of takeover documents x x

Approval of modifications to stock exchange rules X X

Order to suspend treding on stock exchange x x

Ucensing of securities broker/dealrs and related functions x x

Market survellace X X

Monitoring of compliance by securities dealers X - - X =

Monitoring of complianoe by listed companies x x

Approval of aocounEng prnciples and auditing standards x x

Monitoring of comnplianoe with accounting and auditing standards X X X

Enforcement of accounting and auditing standards X _ X _

-

POU * Preent AU1 a Absent DUP a DupHcated

' - CaPtal MIk t Authority CR * Commeibisl Registrar ASB - Accounting Standerds Review Board

- 55 -

5.24 Incorporation and Registration. Five agencies are presentlyinvolved in the incorporation and registration of a company: (i) the GeneralCompanies Department (GCD), a unit of the Ministry of Econom: , (ii) theGeneral Authority for Investment and Free Zones (GAFI), which reports to thePrime Minister but is nominally under the authority of the Minister ofEconomy; (iii) the CMA, which comes under the authority of the Minister ofEconomy; (iv) the Commercial Registrar (CR), a unit of the Ministry of Supplyand Domestic Trade; and (v) the Property Registration Authority (PRA), a unitof the Ministry of Justice. The five agencies coordinate the exercise oftheir di.scretionary powers through Committee 18, on which each has arepreseotative. This process is cumbersome and should be changed.

5.25 As a matter of principle, the incorporation of a company shouldfollow from administrative authorization on the basis of compliance withclearly established (and rather few) legal requirements, which are part of thenormal corporate registration process. It should not require the exercise ofdiscretionary power by a government agency based on the form or nature of thecompany or its business, and it should not require ministerial decision.Incorporation is a straightforward matter that involves no policyconsiderations.

5.26 In line with this, the authorization of incorporation should arisefrom the registration of a company, and not be a separate step. If a companylodges the required documents and otherwise complies with the law, aregistration number should be allocated and a certificate issued. Companyregistration, confirmed by the allocation of a number and the issuance of acertificate, should be conclusive evidence of incorporation. This is the mostcommon approach in other countries and would be effective and efficient inEgypt.

5.27 The Government of Egypt may wish to regulate or prohibit theconduct of certain types of business. This report recommends such regulationin respect to some financial sector activities. However, such regulationshould arise from laws enacted to deal with those activities and not from thelaw providing for incorporation. This approach is in line with overseaspractices and consistent with the recommendations of the Private SectorRegulatory Study currently being prepared by a World Bank mission.

5.28 The registration function is presently carried out by the CR.Having filed copies of all relevant documents with one of the above agenciesin order to gain approval for incorporation, a company must lodge the samedocuments with the CR. At present, registration seems to add little ofsubstance to the process: a check is made to ensure that the relevant Chamberof Commerce approves of the registration, that authorization by the Lawyer'sSyndicate has been obtained and that the stated business address is correct.A number and a certificate are then issued, completing registration.

5.29 A fifth government agency, the PRA, then becomes involved. Inorder to complete incorporation, a company files with the PRA a copy of itsincorporation documents with the relevant authorizations and registrationnumber. The primary function of the PRA is to maintain a record of titles andliens related to moveable property. The filing of company documents appearsunnecessary for this function.

- 56 -

5.30 We, therefore, recommend that the CR have complete authority overthe incorporation and registration of companies of any kind; that registrationand incorporation be a single step, with registration being conclusive proofof incorporation; and that registration be granted to all companies that lodgethe prescribed documents in proper form, fulfill basic procedural andqualifying criteria, propose to engage in a lawful business and pay theappropriate fee. The GCD, the General Investment Authority, the PRA, theCommittee 18 and the chamber of commerce should have no role in eitherincorporation or registration.

5.31 Maintenance of the Public Record. Here, unlike incorporation andregistration, it may be relevant to consider the form or nature of a companyor its business in allocating regulatory responsibility.

5.32 At present, the CR maintains the public record of all incorporatedand unincorporated company documents. The registrar is in the process ofcomputerizing its records, including the establishment of a national registeraccessible from any of the registrar's offices in the governorates. Thiscomputerization is sorely needed as the register is presently kept manuallyand separately in each governorate, with national consolidation only in Cairo.

5.33 The registrar monitors companies to ensure that its records are upto date. It does not monitor the conduct of registered companies or enforcetheir compliance with the requirements of the company law.1

5.34 The GCD keeps a duplicate of the CR's records for all companiesand partnerships. It has a monitoring and enforcement program to keep itscompany records up-to-date and a program to ensure compliance with company lawin the conduct of a company's affairs.

5.35 The CMA is responsible for these functions in relation to joint-stock companies, and for these it keeps the same documents as the other twoagencies.2 The CMA keeps computer-based records of the companies and has astructured monitoring program to ensure compliance with reporting and withconduct requirements, but the records and monitoring procedures requireupgrading. The CMA also produces market and sectoral performance data basedon an analysis of company financial returns.

5.36 The GAFI is responsible for these functions in relation to Law43/230 companies. It keeps computer-based records and has a rudimentarycompliance program to keep the records up-to-date. Its conduct monitoring is

)1/ The Company Law (Law 159 of 1981) regulates the conduct of companyaffairs in such things as the keeping of a register of shareholders, thekeeping of accounts and records, the procedures for holding shareholdersmeetings and so forth.

2/ Publicly offered companies are those that are offered to the public forsubscription and require a prospectus.

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extensive but focuses almost exclusively on licensing and operationalcompliance rather than on compliance with company law.

5.37 It is doubtful that any other country divides responsibility forthese functions in the way that Egypt does. International practice varies.Some countries restrict the coverage of the securities market agency topublicly offered companies and leave private or closely held companies toanother agency. Since the number of closely held companies is usually farlarger than publicly offered companies, the decision often rests on whetherthe workload in covering closely held companies can be handled by thesecurities market agency without distracting from its principal securities-market-related tasks. Of course, the reverse is not true: consolidating theregistration of publicly offered companies in the agency that registers andmonitors closely held companies would not o-erwhelm that office. The level ofmarket knowledge and the types of skills needed for the two agencies aredifferent, however, and this could cause the securities market tasks to beperformed inadequately.

5.38 Other countries keep all company records together under oneagency, arguing that it is more efficient and certain to go to one place toregister a company or to compile basic company information in a standardformat, no matter the kind of company or the pattern of shareholding. Anotherargument is that these records are used by more than one agency; for example,it is often important to the securities market agency to check the records ofclosely held companies in order to trace the ultimate ownership of shares inpublicly held companies.

5.39 Some division of responsibility is, in fact, the norm. Thedivision is usually based on the nature of the company, as in Egypt, but thepresent Egyptian system divides the functions among too many agencies, and forreasons not relevant to the functions performed. Therefore, we recommend thatthe CR be responsible for maintaining the public record and monitoring andenforcing compliance with legal requirements regarding the notification ofchanges in the information required for the public record for all registeredor incorporated companies, sole traders and partnership; and that the CMA beresponsible for ensuring that all joint-stock and limited liability companiesand partnerships comply with all legal requirements, except those related tothe public record.3 Bringing limited liability companies and partnershipsunder the jurisdiction of the CMA is important for its capacity to monitorshareholdings in publicly offered companies and to facilitate investigation ofbreaches of the SML.

5.40 This arrangement has many advantages. It reduces the number ofgovernment bodies involved. It divides responsibility so as not to overwhelmone agency, avoids duplication and provides a clear focus for the activity ofeach agency. It makes clear the locus of responsibility for each function and

i/ In the prosecution of matters under its jurisdiction, if the CMA becomesaware of a breach of the public record requirements, which are under thejurisdiction of the CR, it should notify the CR and should bring forward ajoint prosecution.

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allows for a performance assessment of relevant agencies. The reformedstructure is illustrated in Diagram 3.

5.41 The GAFI was conceived as a "one-stop shop" to promote investmentby Law 230 companies. Removing it from incorporation, registration and theenforcement of compliance with company law does not diminish that role.Rather, in association with the introduction of a small negative list as partof the SAL-supported reform program, it frees the GAFI to refocus itsactivities on investment promotion and any special ownership, capitalstructure or operational requirements of Law 230 companies.

5.42 The proposed changes will require amendments to several existinglaws and decrees, including the Company Law (Law 159), the Investment Law (Law230) and the Commercial Reporter Law (Law 34). These changes may beintroduced along with the drafting of the new Securities Market Law in 1992 aspart of the overall harmonization and rationalization of the legal frameworkfor business, which is part of the SAL-supported program in 1992/93. Thesechanges will also require administrative restructuring and the upgrading ofskills and equipment, particularly in the CR.

5.43 When the foregoing reforms are implemented, the CMA will have norole in relation to incorporation and registration of companies and themaintenance of the public record. The basic function of the CMA in relationto companies will therefore be:

(a) in relation to the issue of securities:

(i) approving prospectuses; and

(ii) monitoring compliance with public issue procedures,including the prohibition on making a public offer without aprospectus.

(b) in relation to the trading of securities :4

(i) monitoring compliance with prescribed share registrationprocedures;

(ii) monitoring compliance with prescribed mergers andacquisition procedures; and

(iii) disclosure by insiders and substantial shareholders.

(c) in relation to the conduct of the affairs of comRanies:

4/ This section deals with the company aspects of this topic; the marketaspects are dealt with in a subsequent section.

Flow Charts Comparingthe Present and ReformedIncorporation Procedures

PRESENT REFORMED

conpany preparescomipany charter and other | company company prepares charter

documents and . and other documents andor or lodges them at one lodges them

of three bodies.Investment Authority Commercial company is registered

or Register and incorporated anddocuments with registered

or L J Companies Department number are lodged with

Capital Market documents are con-.>; gAuthority sidered and passed

to committee fordecision

Committee 18

if approved, the Capital Market Authoritycompany takes

Chamber of Commerce documents for Lnand Lawyers' Syndicate endorsement

if endorsed,documents are lodged

Comnercial Register and registeredand = _ number issued

documents withProperty Registration registered number

Authority lodged

e:

OQ10Q

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(i) monitoring compliance with prescribed requirements forinternal management and the conduct of shareholder and boardmeetings;5 and

(ii) monitoring the keeping of accounts and records andpublishing periodic reports and financial statements.

(d) in relation to all the above:

(i) making and publishing rules and legal interpretations;

(ii) granting exemptions from the law in specified cases; and

(iii) monitoring, investigating and prosecuting breaches of thelaw.

Markets

5.44 The CMA will have three basic functions in relation to thesecurities markets: (i) the authorization of the establishment of securitiesmarkets such as stock exchanges; (ii) the approval of rules and changes torules for the listing and trading of securities; and (iii) the monitoring andenforcing of compliance with listing and trading requirements.6

5.45 These tasks are presently divided between the Minister of Economy,the Commissioner for Stock Exchanges, the boards of directors of the Cairo andAlexandria Stock Exchanges and the CMA. Decree 520 appears to give the CMAthe central role, but the Commissioner for Stock Exchanges also appears tohave the central responsibility.7 The CMA deals with these problems in apractical way by having the Commissioner for Stock Exchanges appointed as astaff member, thus asserting its jurisdiction over the exchanges. This is notan appropriate long-term solution because the continuation of the statutoryrole of the commissioner creates uncertainty as to ultimate authority. Theposition of Commissioner for Stock Exchanges should be abolished, and the CMAshould have unequivocal jurisdiction over the stock exchanges.

5.46 The minister may need to have a role in the administration of theSML in relation to the power to grant (and withdraw) authorization to operatea stock exchange. Even then, it is not necessary for the minister to retain

l/ Note that this does not include such things as labor practices,marketing or taxation. These matters are not covered under the company andsecurities laws administered by the CMA. The coverage of fraud and othercriminal code matters is less clear-cut, as discussed in Chapter III.

i/ The term "securities" includes options and futures, and the term"securities market" includes markets in those instruments as well.

7/ Decree 520, Article 2, paragraphs 3 and 4, and Article 3. Also Law 161(as amended), Articles 102 and 103.

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that power, though it is common in other countries. The usual justificationis that establishing an exchange is such a substantialstructural change thatit deserves the attention of the government, not just a decision of theadministrative body. This would be a reasonable position in the Egyptian caseand would be consistent with the principle that the minister's involvement inadministrative decisions should be limited to only the most important matters.

5.47 Stock exchanges provide such services as are allowed in theircharters and under their authorization by the securities market law. Theseconsist primarily of trading, trade reporting, clearing and settlementservices; the admission of securities to listing; the admission to membershipin the exchange; and the disciplining of exchange members.8 The current law(Law 161) prohibits the marketing of securities except on a recognized stockexchange, although such exchanges may take many forms, including the so-calledover-the-counter markets. The extent of the functions and powers of the stockexchanges as self-regulatory organizations would be established by the newSML, as determined from time to time by the CMA. The Authority could delegatecertain regulatory roles to the exchanges; however, the CMA would retainresidual regulatory power and would monitor the exercise of delegated powersby the exchanges. In this way, the stock exchanges would be able to developas self-regulatory organizations at a pace that matched their capacity toexercise the heavy responsibilities entailed.

5.48 Once the roles of the minister, the Commissioner for StockExchanges and the stock exchanges are reformed, the basic functions and powersof the CMA with regard to the ma-kets would be as follows:

(a) in relation to the authorization of securities exchanges and overthe counter markets:

(i) advising the minister on his power to grant authorization toestablish an exchange;

(ii) monitoring compliance with the terms of such authorization;

(iii) advising the minister on the amendment, suspension orwithdrawal of authorization; and

(iv) monitoring compliance with the prohibition to operatewithout authorization.

(b) in relation to the approval and modification of self-regulatoryrules for the listing and trading of securities:

(i) approving the rules and changes to the rules for the listingor trading of securities before such rules come intooperation;

t./ Operational reform of the stock exchanges is discussed in Chapter VI.

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(ii) monitoring the performance of the exchanges in theadministration of their listing and trading rules; and

(iii) requiring the exchanges to keep a record of clientcomplaints and provide it semi-annually to the CMA, alongwith a record of the outcome of the exchange's considerationof each complaint.

(c) in relation to monitoring and enforcement:

(i) monitoring the compliance by members of the exchange withtrading rules;

(ii) monitoring the compliance by listed companies with listingrules;

(iii) directing exchanges to delist, suspend listing or suspendtrading of any security or class of securities for reasonsof noncompliance by the relevant company or for theprotection of the investing public and the maintenance ofconfidence in the market in general; and

(iv) delegating to exchanges such of its powers and functions asthe CMA determines is appropriate and monitoring theexercise of that delegated authority by the exchanges.

(d) in relation to the financial protection of investors:

(i) approving the establishment and maintenance of an insurancecontract or capital fund of adequate size to protectinvestors in case of the failure of a stockbroker;

(ii) approving the rules and changes to the rules for the paymentof compensation to investors;

(iii) monitoring the number and nature of claims made forcompensation and the outcome of such claims; and

(iv) deciding necessary changes to the rules or practice ofcompensation.

5.49 Foreign Securities. In the exercise of its functions in relationto markets, the CMA will have the power to authorize listing on Egyptianmarkets of securities issued in other countries. The principle which shouldguide the CMA is the quality and compatibility of the regulatory regime of thecountry in which the security is issued and of the stock exchange on which thesecurity is traded. When the CMA judges that Egyptian investors would beadequately protected by the operation of the regulatory regime of the foreignjurisdiction it may authorize the distribution and trading of such securitiesin Egypt.

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Market Participants

5.50 The CMA would have three basic functions in relation to marketparticipants:

(a) with regard to the licensing of market participants, such as stockbrokers, investment banks and other securities underwriters, andfiduciaries, such as custodians, investment managers and advisors,these functions and powers would include:

(i) granting licenses;

(ii) maintaining a register of licensed bodies or persons;

(iii) restricting, suspending or withdrawing licenses; and

(iv) monitoring and enforcing the prohibition on dealing oradvising without a license.

(b) with regard to monitoring and enforcing compliance with licenseconditions, these functions and powers would include:

(i) requiring the filing and close examination of the annualaudited financial statements of license holders, includingadherence to prudential rules;

(ii) requiring the annual filing of a signed statement by alllicensed persons that they have been at all times throughoutthe year in compliance with the conditions of their license;and

(iii) conducting a program of on-site audits of compliance withlicense conditions, which would cover each licensed personat least once every two years.

(c) with regard to monitoring and enforcing compliance with thepublished rules of conduct, these functions and powers wouldinclude:

(i) requiring the production and use by each license holder9 ofa "good-practice" handbook, which operationalizes the rulesof conduct of the CMA and the relevant self-regulatoryorganization10;

(ii) requiring each license holder to keep records of a kind andin a form specified by the CMA to allow audits of compliancewith the rules of conduct;

.2/ Where several license holders have formed a partnership or corporationonly one set of guidelines need be produced for use by the firm.

1Q/ Self-regulatory organizations may issue rules of conduct of the same orhigher standard as those in the law or issued by the Authority.

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(iii) requiring each license holder to keep, and to provide semi-annually to the CMA, a record of all client complaints madein writing to the license holder and the outcome of thelicense holder's consideration of each complaint; and

(iv) conducting a program of on-site audits of compliance withthe rules of conduct, which will covar each license holderat least once every two years.

5.51 Casital Adequacy. Each license holder will be subject to capitaladequacy requirements appropriate to the type of business in which it engages.The CMA would rigorously enforce these requirements as part of the programdescribed in (b) above. Drawing on the standards proposed by theInternational Organization of Securities Commissions, the basic elements ofthe capital adequacy requirements should be:

(a) solvency and liguidity of a license holder must be maintained atall times at a level sufficient to meet its obligations given therisks it faces in its particular business;

(b) marketable securities held by a license holder as part of itsasset base must be marked to market to give a true picture of thelicense holder's asset position; and

(c) the capital required to be held by a license holder will becalculated or. the basis of the risks the license holder faces,including:

(i) a base requirement reflecting the scale and type of businessconducted;

(ii) a position risk requirement reflecting price volatility ofparticular securities or of concentrated holdings;

(iii) a settlement risk requirement reflecting the risk of non-performance of obligations owed to the license holder.

Approaches to capital adequacy requirements are discussed in more detail inAnnex V.

Market DeveloRment

5.52 The Government, through the CMA, should take a clear leadershiprole in developing the securities market. The CHA has made a start in thisdirection, and its efforts have borne fruit. However, CMA resources have beenstretched by the demands of investigating and prosecuting the failed fund-receiving companies. Decisive leadership at this point would be one of themost effective market development initiatives the Government could take.

5.53 The development of the securities market should be one of theprincipal objectives of the new CMA. It should pursue this objective throughthe exercise of its functions and powers in all areas of its responsibility.One significant way for the CMA to realize its development objectives is

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through its role as policy advisor to the Government. The CMA should not onlyaddress matters that are specifically part of the SML but should also reviewand recommend changes in economic, financial and tax policies and in theregulation of financial institutions (for example, insurance and banking).

Education and Training

5.54 As part of its development role, the CMA should take theinitiative in education and training. Educational programs should focus onfour categories of person: (i) persons licensed under the SML; (ii) the staffof the CMA; (iii) other securities market professionals; and (iv) the generalpublic, whether existing or potential investors. The CMA and USAID havediscussed a possible project to initiate a program of practical, market-oriented training and education, which merits further development and support.

5.55 The CMA should spearhead the development of suitable courses andcourse materials and oversee their implementation. Without CMA involvement,there may be little commitment to develop a strong training program, and anyprogram would run the danger of lacking relevance to market practice. Werecommend the use of existing training facilities, such as the Business Schoolof the American University in Cairo, Cairo University, other academic ortraining institutions, such as the Banking Institute or management trainingcenters. International technical assistance would be useful in designing andimplementing the program and is included in the Bank's proposed TechnicalAssistance Project for Privatization and Enterprise Sector Reform.

5.56 A securities market training program should be establishedoffering a range of lectures and courses. The program need not have premisesof its own; it could operate in one of the existing colleges in Cairo, or onAuthority premises. The program would need to have an advisory committee,business plan, budget and one or two permanent staff. It should call on awide range of educators, trainers and business leaders to provide the contentand staff the faculty of its training programs. The chairman of the CMAshould be the chairman of the advisory committee, and four or five othermembers should be drawn from the business and professional community.

5.57 Licensed Persons. Part of the qualifications for gaining alicense would be the completion of specified educational or training coursesof professional quality. These would not be restricted to one set of courses- there would be multiple avenues to qualification. A degree in business oraccounting and several years of relevant work experience would be an importantavenue for qualification; however, the institute could offer specializedsecurities market courses, which would complement basic educational orpractical experience. Such courses should be tailored to the needs ofprofessionals in various areas of securities market activity, such asstockbroking, investment advice, or funds management.

5.58 Staff of the CMA. The staff of the CMA will be called on toimplement an ambitious reform program and to effectively administer the newregulatory structure, once established. Part of the consultant-supportedorganizational review provided to the CMA will be the design of a trainingprogram to meet the needs identified. At this stage, it can be predicted that

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the staff will need training in two forms: on-the-job, task-specifictraining; and background skills training. The first of these will focus onfinancial analysis, share trading monitoring methods, investigation techniquesand preparing prosecutions. The second will provide an introduction tosecurities market operations, the types and characteristics of differentsecurities, basic computer skills and English language training. The languagetraining is important to give staff access ro the large literature onsecurities market topics and to equip them to benefit from overseasexperience.

5.59 Priority in training will be given to strengthsning those unitswithin the new CMA structure engaged in monitoring, investigation andprosecution activities; and in policy-oriented activities, such as preparationof the CMA's rules and regulations concerning the securities markets.

5.60 There will be some overseas training. Participation in thistraining will require advance proficiency in the relevant language ofinstruction, which in most cases will be English. It will be of two kinds.The first and most important will be internships at relevant securitiescommissions or stock exchanges. These will be coordinated through theinternship program of the International Organization of Securities Commissionswhich is based in Canada. The second will be attendance at courses orseminars such as the one offered annually by the United States Securities andExchange Commission.

5.61 Market Professionals. Practicing lawyers, accountants, investmentadvisors and other business professionals should be offered refresher courseson market reforms and current practices. For example, accountants may need toattend courses on investment advisory practices, and lawyers may wish toattend courses on securities market law. The objective in offering thesetypes of courses would be to raise the general level of professional practicein the securities market.

5.62 Investors. Investors and potential investors would benefit fromintroductory and advanced lectures and courses on general investment topics.Such courses can act as promotional and educational tools. No course canensure that an investor will make the right investment decisions, so toopromotional a slant and direct investment advice should be avoided. Becauseinformation disclosure is a key part of an investor protection strategy,investors need to be equipped with basic market knowledge, including how tointerpret prospectuses and periodic financial statements from companies.

Accounting Standards Review Board

5.63 The regulatory practice of the CMA would be based on thedisclosure of information by companies to investors. Disclosure requirementswould include detailed prospectuses and periodic financial reports.Underlying these disclosures there must be an agreed set of accounting andauditing principles and practices. Without this foundation, the value of theinformation disclosed would be greatly diminished.

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5.64 There are two accounting professional bodies in Egypt and, to adegree, international accounting principles are followed, even though thereare two different accounting methodologies in use, one for public sector andone for private sector companies. However, the standards in accounting aregenerally not high, and adherence to standards is, in effect, an optionalchoice. The result is a mixed and confusing presentation of financialinformation, with little reliance placed on the figures presented. Thedevelopment of the securities market will be greatly retarded while thisremains the case. The addition of some 400 public sector companies to listingon the stock exchanges will compound the existing disparities in thecomparability of financial information on companies. We recommend stronglythat all listed companies be required to apply a common set of accountingprinciples.

5.65 Given the importance of the need to upgrade and unify accountingpractices, a highly qualified and reputable body is required to assumeresponsibility for this task. We recommend that an Accounting StandardsReview Board be established with these aims: (i) to publish comprehensiveaccounting and auditing standards; (ii) to enforce adherence to thesestandards; and (iii) to improve the quality and consistency of accounting andauditing practices generally.

5.66 The board should be headed by the chairman of the CMA and consistof four other members drawn from the accounting and business communities. TheCMA should second to the board a staff of two or three persons and facilitiesto conduct its business.

5.67 The board's first task should be to publish a handbook of agreedaccounting standards that are to be applied by publicly o,fered companies intheir public disclosure statements. This is the first priority for the board,and it should move promptly to publish those standards that are agreed uponand follow up on those over which there is some disagreement. The work of theEgyptian Institute of Accountants and Auditors, which has been supported byUSAID, may be an appropriate platform from which to launch this work.

5.68 The board's second task should be to foster adherence to theagreed standards. Each year, the board should review the accountingdisclosures of a selected group of companies. It should provide the presentaccounting professional bodies with a statement of the findings of its reviewand request that those bodies take any appropriate disciplinary action againsttheir members. To publicize and reward correct practices, it could also makea public award to those accountants who achieve the highest standard ofconsistency, clarity and adherence to the standards and point out thoseinstances where accountants have failed to achieve a satisfactory standard.

5.69 Cases that should be investigated and prosecuted for breaches oftha law should be referred to the CMA; the board should provide expert adviceto the CMA in such cases.

5.70 This division of responsibilities is recommended so that the boardand the professional accounting bodies adopt a more rigorous self-regulatoryrole. At the same time, the CMA should remain closely involved in the

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development and enforcement of accounting standards and, especially, in theprosecution of breaches. Experience in other countries suggests that self-regulatory accounting organizations are often slow to take legal action whenit is warranted.

5.71 We recommend the establishment of an administrative unit withinthe CMA to provide staff support to the board. Because two accountingprofessional bodies already exist, and the professional expertise of the boardwill reside more in its members than its staff, an entirely new administrativeapparatus seems unwarranted.

Chapter VI

Operational Reform of the Securities Market

Introduction

6.0 The operational reforms described in this chapter relate to fourprivate sector institutions, two of which are now in operation: theAlexandria and Cairo stock exchanges and the stock brokers; and two that thereport recommends be established: a central securities clearing house and aninvestor protection fund.

6.1 There are serious deficiencies and gaps in the operationalcapacity of the existing institutions. If the securities market is toadequately fulfill its function in the finance system, these lacunae must beaddressed. Underlying the reforms recommended here is the belief that theprivate sector should provide most of the infrastructure for dealing insecurities, take considerable responsibility for self-policing and marketdiscipline and make a substantial input to government policy. The regulatoryinstitutions described in the preceding chapter form part of the enablingenvironment for securities market development and regulation. The privatesector provides the entrepreneurial drive and the institutions that constitutethe securities industry.

6.2 In essence, the reforms recommended provide for (i) greatercompetition in securit_es market services in order to encourage efficiency andinnovation; and (ii) technical assistance to key operational institutions tohelp them build the necessary infrastructure.

Stock Exchanges

6.3 Barriers to Entry. The present stock exchanges in Cairo andAlexandria should be exposed to competition. This can be achieved by makingthe market that provides stock exchange services contestable. New entrantsshould be allowed under law and encouraged in practice. The present stockexchange law does not provide for the authorization of new exchanges nor forthe disciplining or deauthorization of exchanges if they fail to meet adequateoperational standards.

6.4 The new SML proposed in Chapter III provides both these powers.The present exchanges should be made subject to that law, with a grace periodof two years to be in full compliance with the law's requirements. Failure tomeet the standards at the end of the grace period should make the exchangesineligible for authorization and subject to prosecution if they continue tooperate as unauthorized exchanges.

6.5 Such an approach provides two avenues for improvement in stockexchange services. First, the threat of possible new entrants combined withthe two-year deadline for compliance with the law provides a considerable spurfor improved performance by the existing exchanges. Second, new entrants withthe necessary capabilities zay come forward to provide superior services.

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6.6 OwnershiR and Management: Goveri-uent Role. The current stockexchange law provides for the government appointment of several members of thestock exchange board of directors. There is no justification for such arequirement if there is an adequate authorization and supervision system. Thestock exchanges should be entirely private sector operations.

6.7 A stock exchange is, in essence, a private sector vehicle toprovide financial services. An exchange normally undertakes some quasi-regulatory functions, but underlying these are contractual arrangementsbetween the members of the exchange and the listed companies. The Governmentdoes not need to have a direct involvement in the operation of the exchange.The exercise of the quasi-regulatory functions required by the Government anddelegated to the exchange are best left unambiguously in the exchange's handsso it is clear that responsibility and accountability lie with the exchange,not with the Government. Having a government representative on the exchangeand government appointees on the board blurs the lines of responsibility andauthority. Underlying the exchanges' proposed autonomy would be a process ofauthorization by the CMA, which would set the rules of conduct for theexchanges and monitor the performance of their authorized functions.

6.8 Management. The effective management of the stock exchanges in anenvironment of increased turnover and competition requires strong leadership.The board of directors should take long-term management decisions and set thedirection for the exchange. To allow them to do this effectively, day-to-daymanagement should be in the hands of a skilled chief executive officer andprofessional staff. Board members should not be encumbered with operationalresponsibilities. The board should be made up of exchange members and outsidedirectors in about equal proportion to bring added expertise and newperspectives. Outside members could also help dispel the impression that theexchanges currently operate in a fairly cloistered manner. The outsidedirectors should be drawn from experienced business people among the companieslisted on the exchanges and from institutional investors and relevantprofessional groups, such as from accounting and banking.

6.9 Self-Regulatory Responsibilities. The degree to which theexchanges are given self-regulatory responsibilities should be matched bytheir demonstrated capacity to carry out these responsibilities. The long-term goal is to give the exchanges substantial regulatory responsibility, butthis should be done gradually under clearly stated performance conditions.The CMA would retain residual power in all areas of delegated responsibilityand would monitor the performance of the exchanges.

6.10 The areas of responsibility most commonly delegated are:(i) monitoring compliance by listed companies with periodic and continuinginformation reporting requirements; (ii) monitoring to detect marketmanipulation by exchange members or investors; (iii) monitoring compliance byexchange members with the prudential requirements and rules of conduct oftheir licenses; and (iv) adjudicating broker-client disputes.

6.11 Unified Market. The two existing exchanges in Cairo andAlexandria are viable only because listing fees are artificially inflatedthrough the requirement that closely held companies list on the exchange to

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gain access to a tax exemption. When this subsidy is removed, the AlexandriaStock Exchange will not have sufficient trading activity to remain viable, andthe Cairo Stock Exchange will have to improve its efficiency and gain incomefrom new sources to compensate for the potential loss in revenue. In anycase, it will be undesirable to have the market split once increased tradingvolume renders the present informal inter-market trading arrangementsineffective at keeping pace with trading activity.

6.12 For a country the size of Egypt, even with substantially greatertrading volumes in the future, there should be only one securities market,whether on one exchange or on several exchanges linked for real-time quotationand trading unity. Such a linkage is achieved most efficiently throughoperating a single, computer-based trading system. However, this is anexpensive step, and it may be some time before it is cost-effective. In theinterim, a continuous link by open telephone line should be maintained duringtrading sessions of the two exchanges so that orders can be executed at thebest price, wherever that price is available.

6.13 Trading System. The present trading arrangements on the twoexchanges are adequate for the very low volumes currently traded, but theywill not support the expected increase in turnover nor provide an adequatemonitoring mechanism for the CMA. As a consequence, the CMA should plan forand guide the upgrading and streamlining of the trading and trade-relatedsystems. This may involve the gradual computerization of some processes.

6.14 The basic elements of a trading system are: order taking androuting, price discovery, order matching and trade execution. All of thesefunctions could be computerized, and various proprietary systems areavailable, which could be customized for Egyptian requirements. The exactextent of computerization should be based on commercial and regulatoryconsiderations.1

6.15 It is not yet clear what trading volume will develop in the shortto medium term, although it is expected that the privatization program willbring considerable investor interest. It is certain that the present tradingarrangements will need to be improved and it is likely that somecomputerization would be beneficial.

6.16 For this reason, we recommend that work begin early on upgradingthe manual trading system in a way which is compatible with later automationand that the computerization of the trading system be implemented in stages,as it can be justified commercially and once the active stockbrokersdemonstrate a willingness and capacity to modernize their operations. Theinitial step should be for the CMA to engage consultant assistance to definethe medium-term system requirements of the exchanges. This should be carriedout by June 1992 at the request of the CMA and with the cooperation of thestock exchanges. The results of the study could be made available to otherpotential exchange operators as well.

1/ A description of a benchmark computerized trading system is given inAnnex VI - 1

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6.17 Involving the current exchange members in identifying the needsand opportunities for modernization of the exchanges is a significant earlystep in engaging them in the process of reform. Subsequent steps, such assoftware or hardware purchases, would proceed only after the CMA judged thatthe stock exchanges were capable of making effective use of the equipment andwere making the structural and operational changes necessary to obtainauthorization as an exchange under the SML.

6.18 Technical Assistance with the Reforms. Notwithstanding the needfor the exchanges to demonstrate the desire and ability to change, it would beprudent to provide them with assistance to reform their organization andmanner of operation. The new legal structure would dramatically alter theframework in which the exchanges operate, and assistance with the necessaryadjustments is justified on the basis of equitable treatment in amelioratingthe negative impacts of the change. Any assistance offered, however, needs tobe balanced by the understanding that the present position gives the existingexchanges a competitive edge in taking up the new opportunities offered. Asecond reason for giving assistance with the transition is to build on theexisting infrastructure of the exchanges, even if this may be modest relativeto future needs. The main asset of the Cairo Exchange, its building, may besubject to disputed ownership, but there are substantial capital reserves thatcould be applied to securities market development.

6.19 The CMA should agree on a reform agenda and a timetable forspecific reforms with the management of the exchanges and then monitor theprogress toward these objectives. The CMA should retain control of anyoutputs from the assistance program so that these may be made available toother parties if the exchanges do not make satisfactory progress.

6.20 The primary focus of the technical assistance should be to provideconsultant suipport to the exchanges to help them develop (i) an understandingof the legal and structural changes being implemented; (ii) a strategy andbusiness plan to position the exchanges to take advantage of the changes;(iii) a unified market if multiple exchanges continue to exist; and (iv) a newmanagement structure, expanded membership and revised listing and tradingrules so that the exchanges can gain authorization and operate successfully inthe new environment.

6.21 The CMA should endeavor to make the exchanges its partners in thereform of the securities market. It can effectively do this by consultingthem about the changes being proposed and asking tl-e exchanges to nominaterepresentatives to the committees charged with drafting the new SML anddesigning the institutional and operational reforms. In addition, theexchanges ought to be provided with systematic consultant assistance toassimilate and act on the changes taking place.

Brokerage Firms

6.22 Stockbrokers, like the stock exchanges, should be exposed tog eater competition. The mission was told of several high-quality local andoverseas firms that were considering entering st. kbroking in Egypt. Their

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entry to the field should be facilitated in order to bring new skills,attitudes and capital to the brokerage industry.

6.23 At present there are three main barriers to entry intostockbroking: (i) the legal requirement that stockbrokers must be naturalpersons (i.e., not an incorporated body); (ii) the prohibition on foreignparticipation in the stockbroking industry; and (iii) the fixed commissionstructure. There should be substantial liberalization in all three areas.

6.24 Limiting stockbrokers to natural persons limits the financialcapacity of brokers to undertake new forms of business, such as underwriting,or to improve their business facilities through investment in back-officeequipment. At present, stockbrokers overcome this impediment to a degree byforming a type of partnership arrangement, but this appears not to allow thescale of operation required. Incorporated bodies, whether limited liabilitycompanies or public companies, should be allowed to be brokers.

6.25 The prohibition on foreign participation in stockbroking should beremoved to allow the resources of the established, high-quality overseas firmsto be used to develop the Egyptian market. The long-term goal should becomplete openness to foreign participation, but it may be desirable to reachthat goal in steps by first allowing local joint ventures, then allowing asmall number of fully foreign owned firms and, finally, after some years,allowing general foreign ownership. This would allow the Egyptians to gainthe benefit of foreign capital and expertise before facing the full force offoreign competition.

6.26 Finally, the fixed commission structure, which is in effect atpresent, should be phased out to allow greater flexibility in the pricing ofbrokerage services. Stockbrokers may then target their business to particularclients or particular services and charge an appropriate competitive fee.Competition in pricing is a key element of diversification of services and ofimprovements in service quality. Because this is a substantial change frompresent practice it should be phased in over a 12 to 24 month period.

Clearance and Settlement

6.27 The transfer of securities ownership and the correspondingpayments are exceedingly cumbersome on the exchanges at present. When thevolume of trading increases even moderately, the system will requireupgrading. This process should be started now in anticipation of expandedturnover.

6.28 A computerized book-entry clearance system would be the mostefficient but would require substantial computerization of both stock exchangeand brokerage operations. This is a costly process and would not be justifiedcommercially until trading volume reached a considerably higher level.However, such systems are now the norm in developed markets and are the trendin emerging markets. As with computerized trading systems, clearance software

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and hardware packages are now offered by a number of providers and one ofthese could be modified for Egyptian requirements.2

6.29 We recommend that the CMA and the exchanges take a first steptoward the development of such a system by engaging consultant support to drawup system specifications and advise on the feasibility of a modular program ofequipment purchase and installation. It is possib'.e that trading volume willnot reach the required level for some years and that the actual purchase andinstallation of the system may need to be delayed. However, it may be morecost-efficient to use off-the-shelf technology now to install such a systemearly. This has the advantage of allowing system de-bugging at relatively lowlevels of turnover.

6.30 The system could be operated by the exchange or by an independentcorporation. The second course may be preferred as it would allow th.:involvement of other important parties to the clearance and settlementprocess: listed companies, large investors and banks.

6.31 Several interim improvements should be made. At present, sellinj-and buying brokers hold scrip or cash from their clients and pursue theirpost-trade claims individually against each other. Actual settlement is donethrough the exchange clearing office on a net basis. This system should bemodified to centralize the process more, to give greater security and to easeclearance. This could be achieved by having the exchange provide a number ofservices for its members that are currently performed individually. Thecustody of client scrip and funds and the settlement of trades could behandled by the exchange. Even client accounts could be kept by the exchangeso long as complete confidentiality could be assured. Another labor and timesaving service would be to provide a central courier service for the pickupand delivery of scrip between brokers and clients.

6.32 At a minimum, the present paper-based system should be streamlinedthrough the specification and enforcement of appropriate rules regardingrecord keeping, good scrip handling practices, speedy trade matching and mis-matching resolution, adherence to reasonable time limits for clearance andsettlement (say, trade day plus 3) and registration (say, settlement day plus14). Achievement of the last objective may require the appointment ofindependent transfer agents. This would bring Egypt up to average emergingmarket standards.

Investor Protection Fund

6.33 There is, at present, no independently managed fund or insurancescheme to protect investors from the failure of a broker. It is asserted thatany client suffering damage from the failure of a broker would be fullycompensated by other brokers, and there has not been an instance of bankruptcyamong the 15 active brokers for many years. While this may be so at the

2.! An outline of the elements of a book-entry clearance and depositorysystem is given in Annex VI - 2.

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present very low levels of market activity, broker failures will become morelikely as trading lavels increase.

6.34 The CHA should decide whether to establish an insurance-basedscheme or a capitalized funi. It is likely that a capitalized fund would bethe most viable and give investors a better sense of protection, but actuarialand financial analysis should be undertaken before making a final decision.This analysis should be undertaken in mid-1992 by qualified consultants.

6.35 If a capitalized fund is to be established, it should be wellcapitalized, and its capital should be adjusted in line with trading volumeincreases. It should be funded by the brokers, although initially someexternal assistance may be required to establish it on a solid footing.

6.36 The CMA should have adequate powers to monitor the fund'soperation and ensure its effectiveness. However, the compensation schemeshould be owned and administered independently from the Government. Themanagement of the scheme and decisions about compensation are essentiallyprivate sector contractual matters between the exchange, its broker-membersand investors. The Government's role should be limited to ensuring thatinvestors are sufficiently protected and equitably treated.

Chapter VII

Collective Investment Vehicles

Background

7.0 Need for Collective Investment Vehicles. The recent experiencewith "fund receiving companies," as well as the current financial sectorsituation in Egypt, points to a clear need for the introduction of well-regulated and professionally managed collective investment vehicles (CIVs).CIVs, which are commonly called mutual funds, offer many advantages toinvestors, including risk diversification, professional portfolio management,generally low transaction costs and flexible investment options. Suchinvestment vehicles can contribute to the development of the securities marketby stimulating demand and by encouraging greater responsiveness and disclosureon the part of investee companies.1

7.1 Constraints to the Development of Mutual Funds in Egypt. Thecurrent environment is not conducive to the establishment of mutual funds. Asdescribed elsewhere in this report, a number of constraints, such as thelimited supply of debt and equity securities, the lack of professionalinvestment management skills and an unfavorable tax structure, have to becorrected before the establishment of such vehicles would become feasible.Moreover, the existing legal framework is not appropriate for the developmentof a sound, efficient and viable mutual fund industry.

Legal Framework For The Mutual Fund Industry

7.2 The Investment Company Law (Law 146 of 1988) was intended toregulate the activities of the fund receiving companies and does not providean adequate legal framework for the establishment of mutual funds. The basicprinciple underlying the formation of mutual funds and similar collectiveinvestment vehicles is that they only invest in financial assets on behalf oftheir shareholders. Such assets are managed by professional investmentmanagers whose activities are governed under either a separate law or by themutual fund law itself. Laws governing CIVs need to ensure that theiractivities are conducted with a reasonable degree of prudence to protect theinterests of investors. CIVs are highly specialized vehicles and raise anumber of issues regarding legal form, management structure andqualifications, investment restrictions, redemption rules, etc.. Law 146 doesnot address these issues adequately, and we recommend that a new law beenacted to govern the establishment and operation of CIVs. The modificationof Law 146 would not be a feasible option because the law would have to beextensively rewritten to become an effective mutual fund law. Moreover, thepresence of existing provisions along with the provisions necessary toregulate mutual funds would make the law extremely confusing and cumbersome.

1/ For a full discussion of the advantages and types of collectiveinvestment vehicles, see A.K. Sharma, "Collective Investment Vehicles: ABackground Paper," International Finance Corporation, Washington, D.C., 1990.

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7.3 New Mutual Fund Law. A new mutual fund law could be included as apart of the new securities market law or could be enacted as a separate pieceof legislation. In the United States, for instance, mutual fund laws areseparate pieces of legislation and are not included in the basic lawregulating the securities market. However, a number of countries have enactedcomprehensive securities laws, which also govern mutual funds and professionalinvestment management. For example, the Financial Services Act (1986) in theUnited Kingdom governs the securities markets and mutual funds. Poland andIndonesia have recently adopted comprehensive securities laws with separatechapters regulating mutual funds and professional investment managers. Acomprehensive securities law incorporating provisions for regulating mutualfunds and professional investment managers would be appropriate for Egypt fora number of reasons. First, since a comprehensive new securities market lawis going to be drafted, the coverage of mutual funds and investment managementcould easily be incorporated into that law. It would be more efficient interms of actual drafting and processing to have one law rather than two.Second, a comprehensive law would provide regulatory simplicity, consistencyand clarity and make it easier to harmonize mutual fund regulation withgeneral securities market regulation. This is essential because theactivities of mutual funds are considerably affected by the securities laws.

Basic Principles of Mutual Fund Regulation

7.4 The law regulating mutual funds must provide a conduciveenvironment for the development of a sound, competitive and efficientindustry. It must, therefore, provide adequate safeguards to protect theinterests of investors who place their resources with mutual funds, yet itmust also provide adequate flexibility to allow different types of fundstructures and investment products so that vehicles can be established to meetdifferent market needs. The principal elements that should be covered by thenew legislative framework regulating mutual funds are described below.

7.5 Legal Forms of Mutual Funds. A wide variety of legal forms areused to establish mutual funds, among which the most common are joint-stockcompanies, unit trusts, publicly incorporated companies, fixed capitalcompanies and variable capital companies. The use of different forms ofmutual funds in different countries is motivated by the applicable legalframework, tax regime and, in some cases, the investment objectives of thefund. In the case of Egypt, the joint-stock company would seem to be the mostappropriate legal form since company law is well developed. The corporateform provides for effective representation of shareholder interests throughthe board of directors. The establishment of funds as unit trusts should alsobe considered, provided the trust law is adequately developed.2

7.6 Licensing Procedures. Licensing procedures for mutual funds mustbe designed to ensure that only sound and viable sponsors are permitted toestablish mutual funds. The licensing process must be efficient and fair, and

2/ Unit trusts provide investors pro-rate shares, known as "units," intheir investment portfolios. The activities of the unit trust are governed bya trust deed between the trustees and the fund manager.

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the information requirements for license applications mus; be clearlystipulated in secondary regulations. A time limit on the processing oflicensing applications should be imposed to limit procedural delays. Personsto whom licenses are refused should be given a reasonable opportunity toappeal their case. The licensing authority for mutual funds should rest withthe CMA.

7.7 Fund Structure. The law 3hould provide for a two-tiered fundstructure. The fund itself should be either a joint-stock company or a unittrust with its own board of directors. The management of the fund's assetsshould be vested in a professional fund manager, which would be a separatelyincorporated joint-stock company. The fund manager would handle the assets ofthe fund under the terms of a management contract (discussed in more detail inpara. 7.9 below). The fund's board of directors would be responsible forreviewing and monitoring the performance of the management company. The two-tiered structure provides an independent check on the management company,which should help to ensure that it complies with the terms of the managementcontract, and protects the interests of the fund's shareholders.

7.8 Composition of the Board of Directors. One of the main objectivesof the two-tiered structure is to ensure that the fund's board of directorsacts as a check on the performance and actions of the management company. Thelaw should stipulate that the majority of the fund's directors can not beemployees of, or affiliated with, the management company to ensure that theboard retains its independence and to limit potential conflicts of interest.A certain proportion of the board should consist of persons without anyinterest in the fund. In the United States, for example, not more than 60percent of a fund's board may consist of persons with an interest therein.The law should also prohibit certain types of "affiliated persons" fromserving on a fund's board in order to prevent potential conflicts of interest.Examples of such affiliated persons would be professional brokers orunderwriters of the fund's securities.

7.9 Investment Manazement Contracts. Under a two-tiered structure,the management company would invest the fund's assets on behalf of the fund'sshareholders under a management contract with the fund. The shareholders needto ensure that the management contract is not detrimental to their interestsand that they retain some leverage over the management company. The lawshould require that management contracts describe precisely the remunerationpaid to the management company, be subject to renewal at periodic intervals(preferably annually) and be terminable at the option of the fund's board ofdirectors (after a certain notice period). All management contracts should beapproved by a majority of the fund's board of directors who are neither partyto the contract or have any interest in the contract.

7.10 Matters Reguiring Shareholder ADDroval. In order to protect theinterests of the fund's shareholders, the law should stipulate that certainfundamental changes must be approved by a majority of the shareholders castingvotes at the annual shareholder's meeting. These would be any changes in theinvestment policy, the fund manager, the frequency of calculating net assetvalue and any other modifications resulting in additional charges to the fund.

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Basic procedures to be followed for convening a general meeting of the fund'sshareholders should also be laid down by the law.

7.11 Matters Reguiring Aporoval of the Regulatory Authority. In orderto ensure that changes detrimental to the interests of a fund's shareholdersare not made following the initial sale of the fund's shares, prior approvalof the CMA should be required for certain fundamental changes in the structureand functioning of a fund. Changes that should require prior CMA approvalinclude changes in the manager of a mutual fund, changes in the fund custodianand changes in the management control of the fund manager itself.

7.12 Minimum CaRital Requirements. Two principles underlie thestipulation of minimum capital requirements. One is that a fund must attain acertain size to be viable. The other is that the persons in charge ofsponsoring/managing a fund should be financially sound and should have areasonable stake in any fund they sponsor. The management company must alsobe adequately capitalized. This is necessary to ensure that the fund attainsa viable size. For example, in Canada, fund sponsors are required to invest aminimum of US$130,000 equivalent and are not permitted to redeem their sharesunless subscriptions amounting to US$425,000 equivalent have been receivedfrom other investors. If the sponsor is not able to provide the initialinvestment, a minimum of US$425,000 equivalent has to be received from otherinvestors during the initial offering period. In the United States, thepromoters/sponsors of a fund must invest a minimum of US$100,000 in the fundbefore it can be offered to the public.3

7.13 Public Offering of Funds: Proper Disclosure. Proper and fulldisclosure of all material information is essential to protect the interestsof investors. All publicly offered funds must be subject to the requirementsof proper disclosure through a prospectus, which must be approved by the CMA.The law should also empower the CMA to specify the information required to bedisclosed in the prospectus. The prospectus should contain, inter alia, thefollowing information: the investment policy of the fund; risk factors; feespaid to the management company; rules for asset valuation and computation ofnet asset value; the composi:ion of the board of directors and theiraffiliations; custodial and agency arrangements and the expected feestructure; rules regarding the distribution of dividends and capital gains;and procedures for the redemption of securities. In addition, all salesliterature, such as mailers, brochures, copies of advertisements and pamphletsmust be filed with the CMA prior to issue. The law should authorize the CMAto call for any additional information it may deem necessary. The CMA wouldbe authorized to restrain the mutual fund from offering its securities if, inthe Authority's view, the prospectus or other sales literature contained falseor misleading information.

7.14 Private Placement. Some types of specialized funds are suitableonly for sophisticated investors because of their high risk. Such funds arenormally placed privately with a limited number of large, so-called

2/ The capitalization requirements of the management company are discussedin Chapter VIII on professional investment management.

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sophisticated investors. The law should allow such funds to be offered toinvestors on a private placement basis, but, at the same time, conditions mustbe imposed to ensure that such funds are sold only to sophisticated investors.This is usually done by prescribing a maximum limit on the number of investorsin private placements and a minimum amount to be subscribed by each investor.The maximum number of investors should be limited to 250-300, and the minimumsubscription should be set within a range of US$100,000-US$300,000. The lawshould also require the issuer to file the placement memorandum of the fundwith the CMA.

7.15 Periodic Disclosure of Information to Shareholders. Mutual fundsshould be required to provide periodic disclosure of information toshareholders in the form of audited annual and unaudited quarterly or half-yearly reports, which would also be filed with the CMA. The financialstatements included in the annual report should be audited by a certifiedaccountant and prepared in accordance with internationally accepted accountingprinciples. The law should also require periodic audits of the fund's booksand records by independent outside auditors. The annual report should bepublished within three months of the close of the financial year, while theinterim reports should be published within two months of the end of thereporting period. The law should empower the CMA to specify the informationto be provided in these reports. Specific items of information required couldbe listed in the executive regulations issued following the promulgation ofthe law.

7.16 Open- and Closed-End Funds. An important structural issue relatesto open- and closed-end types of funds. Open-end funds allow investors toredeem holdings in a fund at any time during the life of the fund. In closed-end funds, redemption is possible only on dissolution of the fund. Inpractice, open-end funds announce specific periods during which redemptionrequests will be accepted and processed. In developed markets, dailyredemptions are common, and, in the US, the law requires funds to offer dailyredemptions. The main advantages of an open-end fund are greater liquidityfor investors and the possibility of devising a variety of divestment plans.Since investors can redeem their certificates at net asset value with the funditself, there is no need to list these funds on the stock exchange. Open-endfunds, in principle, are more effective in stimulating market activity, asthey continually invest the proceeds received from new investors and sellassets to meet redemption demands; this is in addition to their normalportfolio activity. However, a major constraint to the establishment of open-end funds is the need for adequate market liquidity for assets. Open-endfunds may run into difficulties in thin markets, such as Egypt, as they maynot be able to divest their assets rapidly enough to meet redemption demands;attempts at large and rapid divestment could cause the prices of holdings todecline significantly.

7.17 Closed-end funds offer investors ar. exit mechanism by listingtheir certificates on the stock exchange so that investors can sell theirholdings in the fund to other investors. This allows the fund's portfolio toremain invested as liquidations are not needed to meet redemption demands.The advantage of a closed-end structure is that it allows the fund manager totake a long-term view and obviates the necessity of forced sales of

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investments. Thus, there is greater flexibility for the fund manager intiming his investment/divestment decisions. Such funds are, therefore,particularly appropriate in thin nmarkets. A closed-end structure is alsopreferred by many governments for country funds as this structure ensures thatfunds remain invested in the host country for a certain period of time. Theprincipal disadvantage of the closed-end structure is the possibility that thesecondary market price of the fund's shares may vary from its net asset value.If the serondary market price is at a discount to net asset value investorsare at a major disadvantage since they will be unable to realize the actualvalue of their holdings in the fund.

7.18 We recommend that the law allow for the creation of open- andclosed-end funds and different variants of these two forms. Such variantscould include funds that are closed initially but opened after expiry of acertain number of years and funds that are closed for purposes of redemptionbut are permitted, under certain conditions, to accept fresh capitalcontributions. The main reason for a flexible approach is the need to allowfor the creation of different fund structures to meet changing market needs.

7.19 Prudential Investment Guidelines: ExRosure Limits. Theprudential management of investment funds is critical to protect the interestsof investors. Fund managers should not take excessive risks that exposeinvestors to losses. Although fund management contracts usually specify therisk parameters to be observed by the fund manager, the law itself shouldprovide for prudential guidelines to ensure that, regardless of the terms ofthe management contract, a basic modicum of prudence is exercised by fundmanagers, at least for publicly offered funds sold to retail investors.Investment guidelines should cover the types of financial assets in which afund would be eligible to invest. In the case of publicly offered funds,where safety of principal would be a paramount concern, investment should belimited prim. tly to securities that are liquid and of a reasonably highquality. Guidelines relating to the prudential management of mutual fundsshould also limit different types of exposure. We recommend the followingmaximum exposure limits:

(a) securities issued by one issuer - 5 to 10 percent of fund assets;

(b) shares of large exposures (5 percent or more of assets) to singleissuers in the total portfolio - 35 to 40 percent of assets;

(c) investment in shares/units of other funds - not more than 5percent of own assets;

(d) investment in government and government-guaranteed secur.ities - noprudential limit is needed but a limit to such investments may bewarranted, except for government bond funds, to ensure thatinvestments are made in privately issued securities; and

(e) investment in funds managed by the same management company -generally prohibited. The law should empower the CMA to grantexemption in special cases.

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7.20 Guidelines are also necessary to ensure that mutual funds remainpassive investors and do not exercise a controlling influence over theirinvestee companies. This is necessary to preserve their character ascollective investment vehicles. If they were to acquire controlling stakes intheir investments, they would effectively become holding companies. The lawshould, therefore, prevent mutual funds from purchasing securities for thepurpose of acquiring control over issuers.

7.21 Prohibition of Certain Types of Transactions. The prudentialmanagement of mutual funds rcquires that certain types of transactions, whichcan be characterized as excessively risky, be prohibited. The law shouldprohibit transactions that include speculation on the foreign exchange market,commodity trading, forward dealing, options, futures, atc., unless a fund isspecially constituted for this purpose. The fund should not be allowed toborrow money, other than a limited amount for transitional periods, to covertemporary liquidity constraints. Mutual funds should also be barred frommaking loans.

7.22 Trading and Portfolio Turnover Guidelines. The manner in which afund manager trades the portfolio has important implications for the safety offund assets. The law should, therefore, prohibit short sales, trading onmargin, the lending of securities, the guaranteeing of securities of othercompanies and any activities that could endanger the interests ofshareholders. Strong provisions against potential conflicts of interest andaffiliated tzansactions should also be incorporated in the law.

7.23 Guidelines for Dividend Payments to Investors. The law shouldrequire that a fund distribute at least 90 percent of its net current incomeas dividends to shareholders. The basic reason for this provision is that amutual fund is a pass-through vehicle and should be taxed as such. Retentionof current income by the fund would provide tax deferral to irnvestors. If theremuneration of the fund manager is linked to the net asset value of the fund,there is an incentive for the fund manager to retain income in the fund.Funds should also be required to pay dividends only out of undistributed netincome and not from any other source. The reason for this provision is toensure that all distributions are bona fide, and that the fund is not used asa channel to evade taxes.

7.24 Calculation of Net Asset Value. The net asset value of a fundmust be computed in a manner that is fair, realistic and standardized acrossthe industry. The law should, therefore, specify the manner in which net assetvalue is to be computed, the minimum periodicity of the calculation (at leaston a weekly basis) and the manner of its dissemination to the general public.Guidelines for the computation of net asset value should include alltransactions up to the date of computation. Basic standards for securitiesvaluation, particularly for securities with limited liquidity, should bespecified by law. The law should require that the valuation procedures usedby a fund are disclosed in its prospectus.

7.25 Maintenance of Proper Books of Accounts and Records. The lawshould require that mutual funds maintain proper books of accounts andrecords. It should empower the CMA to sjecify what records are to be

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maintained and for how long. The destruction and falsification of recordsshould be made a penal offence under the law.

7.26 Regulations Governing Custodians and Other Agents Hired by theFund. A fund will normally hire custodians, transfer agents, administratorsand other such agents to handle the administrative work associated with itsoperations and the safe custody of its assets. The custodian is particularlyimportant as it serves as another source of protection for the interests of afund's shareholders. The role of the custodian is particularly important whenthere is a single-tiered fund structure, as in Europe, but it is alsoimportant under a two-tiered structure when the custodian is responsible forthe physical movement and safekeeping of a fund's assets. The law shouldspecify the qualifications for entities wishing to act as fund custodians sothat only reputable and financially sound institutions are allowed to carryout this sensitive task. The law should also specify the basicresponsibilities and duties of custodians to be incorporated in custodianshipagreements so that a certain standard of care and diligence becomes mandatoryon the part of those providing such services.

7.27 Reulations Regarding Redexmption of Shares. The law shouldspecify the minimum standards for the redemption of shares of open- andclosed-end funds. Well-defined rules are necessary to protect investorsagainst any unnecessary delays on the part of mutual funds, to redeem sharesand to establish standards for the frequency with which mutual funds would berequired to offer redemptions. The law should set minimum standards regardingthe ongoing sale of shares by open-end funds so that new investors in a fundare protected. Such standards should cover issues such as transit losses ofinvestor funds, entitlement to interest on amounts placed with a fund pendingthe issue of shares and the expeditious transmittal of redemption orders fromselling agents to the fund.

7.28 Powers of the Regulatory Authorities. As issuers of securities,mutual funds would be subject to the overall provisions of the SecuritiesMarket Law. The law should provide special powers to the CMA to supervisemutulal funds effectively, including the power to make rules, give orders,subpoena witnesses, levy fines, call for information and prescribe theinformational returns and statements to be filed periodically by mutual funds.

DeveloDment of a Mutual Vi"nJ Industry in EgyDt - A Suggested Approach

7.29 Mutual funds can play an important catalytic role in stimulatingthe development of the Egyptian securities markets and can make an importantcontribution to the privatization and financial restructuring of state-ownedenterprises. Different types of mutual funds can be created to meet differentneeds. The Government should adopt a flexible approach that permits thecreation of a variety of funds and fosters an environment conducive to theiroperation. The development of a sound and efficient mutual funds industry ispossible only if certain basic prerequisites are met. These are brieflydiscussed below.

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7.30 Increased Supply of Securities. Mutual funds offered to thegeneral public are viable only if there is an active securities market. Asdescribed in Chapter II, the supply of securities in the local markets isextremely limited. In addition to the impact of the present tax structure, amajor reason for the relative inactivity of the securities market is thetendency of institutional investors, such as commercial banks and insurancecompanies, to hold on to their large inves-.uent portfolios over the long term.The reluctance to sell their holdings is understandable: there are limitedopportunities to reinvest the sales proceeds in alternative securities, giventhe scarcity of secondary market supply. Supply constraints have also beencreated by the reluctance of closely held companies to offer their shares tothe public and by their ability to claim publicly held status and utilize taxconcessions given to publicly held companies without actually being widelyheld.

7.31 A major step toward increasing the supply of shares in the stockmarket would be to limit tax and other incentives to those companies that makea genuine public offer of their shares and remain widely held.4 Anotheruseful step would be the divestiture by state-owned financial institutions ofa major portion of their equity holdings in joint-venture companies in Egypt,a priority objective of the Government's privatization program (see belowparas. 7.45-46).

7.32 Equitable Tax Treatment. Rational and equitable tax treatment ofmutual funds is essential to their development. Such funds should be treatedas pass-through vehicles for tax purposes. Investors should receive the sametax treatment regardless of whether they invest in shares directly through thestock exchange or through a mutual fund. Failure to treat funds as pass-through vehicles will handicap the establishment of mutual funds since manyinvestors will not wish to be taxed twice on an investment they could makedirectly and be taxed on only once.

7.33 Tax reform also affects the supply of underlying assets in which afund's resources are invested. The distortionary treatment of alternativefinancial assets by the present tax system poses a significant obstacle to thedevelopment of a more active securities market. The implementation of therecommendation in Chapter IV on tax neutrality among financial assets wouldmaterially assist in the development of the mutual funds industry.

b./ Tax reform measures that would make equity financing more attractiveand, thereby, contribute to increasing the supply of equities are described inChapter IV. Tax reform proposals concerning mutual funds are being preparedas part of the World Bank's Financial Sector Report w:.ich will be presented tothe Government during the Spring of 1992.

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7.34 Introduction of Foreign Technical Know How. Mutual funds arehighly specialized investment vehicles, and the specialized skills needed forthe creation of a viable mutual fund industry are not presently available inEgypt. Overseas participation in the development of mutual funds would allowthe necessary skills to be developed locally. Regulations on taxes and onforeign exchange repatriation designed to attract overseas participation are,therefore, necessary.

7.35 Creation of an ADpropriate Regulatory Frameworh. Until the newregulatory framework has been created and the new law covering mutual funds isenacted, the Government could consider granting financially sound sponsorspermission to establish mutual funds, subject to conditions similar to th.3provisions of the proposed mutual fund law. These funds would automaticallyfall under the purview of the mutual fund law, when it comes into effect, andwould be relicensed thereunder. The rationale for this approach stems fromthe need to initiate efforts to develop mutual funds as soon as possible,without waiting for the enactment of a comprehensive securities law, which isnot expected before mid-1992.

7.36 Custodial Services. The provision of custodial services formutual funds is another important prerequisite for the development of theindustry. Custodial arrangements are important to ensure that monies andsecurities owned by funds are under the control of a reputable, neutral,outside party acting as trustee under the aegis of a custodial agreement.Banks in Egypt should be able to provide custodial services for mutual fundssince they already provide securities custody to institutional and retailclients. However, early measures to artomate and improve securities transferprocedures, as discussed in Chapter VI, would also facilitate theestablishment of mutual funds.

Selection of ADDroRriate Tvpes of Mutual Funds

7.37 The Government should adopt a flexible approach by permitting theestablishment of different types of funds to meet different market needs. Theprincipal types of mutual funds that would meet Egypt's needs are describedbelow.

7.38 Venture-Capital and Restructuring Funds. Venture-capital fundswould provide a new source of capital to finance investments in high-risk,entrepreneurial start-ups or the expansion of such ventures in the privatesector. Specialized funds focused on restructuring and turnaround investmentswould provide capital for the financial restructuring and privatization ofpublic sector companies. Their activities could be extended to entiresubsectors of the economy, if combined with appropriate financial, technicaland managerial expertise.

7.39 The basic strategy of such funds would be to invest in a limitednumber of high-risk ventures, usually with a substantial minority position,but with active representation by fund managers or their appointedrepresentatives on the boards of directors of their investee companies. Thefund managers would play a proactive role by closely monitoring investmentsand would expect to provIde or arrange for appropriate technical and

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managerial assistance to companies in their portfolio in areas such as productdesign, marketing, etc. Such an approach could be especially valuable to suchsectors as textiles, garments, electrical industries and food processing.Appropriate managerial ind technical expertise would need to be combined withfinancial management skills in establishing such funds.

7.40 This type of fund is oriented toward high returns over the longterm through capital appreciation. During the period of company start-up andexpansion, most of the income generated would be retained to financeoperations; dividend distributions would be limited. The principal source offund income would be the increased value of its shareholdings, which would berealized either through divestment on the stock market or through other exitmechanisms, such as sales to other investors, including the management (andemployees) of the investee company.

7.41 Venture-capital and restructuring funds are only suitable forinvestors able to assess the risks involved and absorb any losses that mayoccur. Investors in such funds would have to be motivated by the prospect ofabove-average, long-term capital gains rather than by regular current income.These investment preferences are usually found only among sophisticated, largeinvestors, and these funds would only be suitable for private placement with alimited number of such investors. Such funds would be closed-end instructure, given their relatively illiquid portfolios.

7.42 The Government should encourage overseas participation in venturecapital and restructuring funds to attract the expertise needed for themanagement of such funds, which is not currently available in Egypt.Internationally reputed venture-capital firms should be permitted to establishspecialized venture-capital and restructuring fund management companies,either independently or in association with local institutions. This wouldallow the transfer of highly specialized skills to Egypt and would stimulatethe development of a local venture-capital industry. Venture-capital andrestructuring funds should be permitted to be sold to overseas investors, bothnonresident Egypt!.ans and foreign nationals. This would attract additionalcapital to finance enterprise privatization and restructuring.

7.43 Funds Offered to the General Public. Funds offered to the generalpublic need to be structured in a more general manner in terms of theirapproach to investment. The closed-end format would be most appropriate atthe initial stage in the development of mutua, funds, since the liquidity ofunderlying assets would be limited. Open-end funds could be established whensufficient liquidity developed. Even hybrid structures could be used wherebya closed-end fund was opened after sufficient liquidity developed orredemptions were permitted at well-spaced intervals. At this point, however,the fund most suitable for public offering in Egypt would be one invested ingovernment-owned shares in joint-venture companies.

7.44 Establishment of a Pilot Mutual Fund. In order to help launch themutual fund industry, we recommend the establishment of a "pilot" mutual fund,composed largely of shares in successful, profitable existing joint-venturecompanies. Establishing such a fund would require direct governmentassistance at the outset, since the only readily available sources of supply

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of these shares are the large government-owned financial institutions,including the four public sector banks and several large insurance companies.Government assistance may be necessary to secure the divestment to the fund ofa substantial part of the portfolios of these institutions since they mayprefer to retain their positions. However, some of them have expressed awillingness, in principle, to sell a portion of their holdings at a fair priceto help establish a mutual fund industry. These actions would be consistentwith the Government's stated objectives of divesting public sector holdings tothe private sector to reduce the role of the Government in the economy and toprivatize its joint-venture shareholdings.

7.45 If it is to be successfully established, the pilot mutual fundneeds to have access to a sufficient number of good quality shares at fairprices. A balanced portfolio of good quality shares is essential to provide acompetitive rate of return for the fund and to ensure that the large number ofsmall, first-time investors expected to participate in the fund earal a profit.A favorable investment experience is likely to have a positive demonstrationeffect, encouraging other mutual fund sponsors to come forward, buildingconfidence in the public mind about the efficacy and benefits of collectiveinvestment vehicles and generating support for privatization. We recommendthat, as part of the privatization of its joint-venture shareholdings, theGovernment direct the state-owned financial institutLons to divest a portionof the shares of Law 43/230 companies in their portfolios to the generalpublic and to the pilot mutual fund, at prices that reflect the "fair marketvalue" of such stocks. Divestiture, in part, to the public at large iscritical to success, for without greater liquidity, mutual funds too would beunable to adjust their portfolios as a result of changing assessments of acompany's prospects. The following paragraphs describe the steps recommendedto establish a pilot mutual fund.

7.46 Award of Mandate and Conduct of Feasibility Study. In view of thecomplexity of the preparatory work involved, the extended time period overwhich the work will be carried out, and the importance of coherent andconsistent implementation, the Government may wish to award a mandate to aninstitution, such as IFC or an established international mutual fundmanagement/holding company, to prepare and establish a pilot mutual fund and aprofessional investment management company. The next step would be to carryout a study of the operational issues involved in setting up a mutual fund andinvestment management company. This should be done by a specialistconsultant. IFC has offered to assist with the identification of consultantsand the preparation of terms of reference. The study should examine thespecific constraints to establishing a mutual fund and investment managementcompany in Egypt, including the tax status of mutual funds and investmentmanagement companies, legal issues relevant to the establishment of such avehicle, potential market size and absorptive capacity of the market, channelsof distribution, measures to provide secondary market liquidity for fundshares, transaction costs and other expenses. The feasibility study shouldalso examine the availability of potential local partners for an investmentmanagement company, the required levels of remuneration and legal andoperational issues.

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7.47 Establishment of a Fund Management ComRany and Mutual Fund. Aninvestment management company, with the participation of a foreign technicalpartner, a local partner and possibly IFC should then be formed. At the sametime, the pilot mutual fund, possibly in the form of an independent, privatesector joint-stock company, should be created, with its own board ofdirectors. The promoters of the management company would sponsor theformation of the fund as a corporate entity but would not have majoritycontrol of the board. Board members should be eminent members of the Egyptianfinancial community, well known to the general public. They would benominated initially by the fund's sponsors and elected by the shareholdersafter the fund had been offered publicly. The fund management company and theboard of directors would enter into an investment management contract toestablish and operate the pilot fund.

7.48 Divestiture of Government-Owned Joint-Venture Shares. Divestingthe government's shares in joint-venture companies to the public throughpublic offerings and to the fund will be the other critical element in theprogram. This element needs to be carried out in harmony with theGovernment's overall privatization program. The first step would be a decreefrom the Prime Minister, as the concerned Minister for the Public EnterpriseSector, instructing public sector financial institutions and state-ownedcompanies to sell their joint-venture shareholdings within a certain timeperiod. Without this Government sanction, the program will not get started.The guidelines for the sale of these shareholdings should be issued by theGovernment at the earliest possible date. However, the managements of theindividual holding companies and their affiliated companies would be expectedto organize and execute the details of the individual tran3actions: sharevaluation, prospectus preparation, sale through public offar, or negotiationof sale price if to a single party, with the assistance o. financialinstitutions experienced in such transactions. The Government would monitorthe performance of the companies to ascertain that they were proceedingexpeditiously to sell their shares and conforming to the policy guidelines onsuch transactions.

7.49 We recommend that the organizational unit overseeing theGovernment's public enterprise reform and privatization program, the PublicEnterprise Office, include one specialist who would be responsible forpreparing and implementing the privatization program of the Government'sjoint-venture shareholdings. He should have a mandate to work with theholding and affiliated companies which directly own these shareholdings tcidentify 15-20 companies as an initial tranche for divestiture within thefirst year, and to organize the preparation and execution of the transactions,including the identification of funding to carry out the preparatory work.Coordination with the mutual fund company about the identity of potentiallyattractive shareholdings would be important for the success of this criticalGovernment privatization target.

7.50 Identification of Companies and Portfolio Valuation. Themanagement of the holding and affiliated companies would identify theshareholdings which are to be sold to the fund and the general public.Selectivity is critical. Only companies that offer good investment prospectsshould be chosen. An initial group of about 15-20 large to medium-sized

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companies should be shortlisted on the basis of their current profitability,international competitiveness and good future prospects. Independentconsultants should then conduct an objective analysis and valuation of theshares identified for sale to the public and the mutual fund. Tne mutualfund's management would be expected to carry out its own independent valuationof prospective investments as a basis for negotiation or bidding for sharesbeing sold.

7.51 Divestiture to the Public. Under guidelines issued by theGovernment, and probably in harmony with the Tenders Law (No. 9 of 1983),unless an alternative procedure is to be followed, the managements of theholding and affiliated companies would prepare a divestiture strategy for theshares to be sold to the public. In most cases, these sales would besecondary offerings of shares in joint-venture companies held by one or moreshareholders (public sector financial institutions/other public sectorcompanies) through which the gcvernment now holds its shares. The strategywould cov;er such issues as pricing, market timing, and individual orcollective offers. The individual companies, acting independently or in agroup, would hire financial institutions to assist them with prospectuspreparation, pricing, distribution arrangements and other matters connectedwith the secondary sales. The overall targets of the divestiture programshould be prepared and announced annually by the PEO and individual sales ofshares should be given wide publicity.

7.52 Acauisition of Shares by the Mutual Fund. The mutual fund couldalso acquire a certain portion of the shares being divested in selectedcompanies. The proportion of shares acquired by the fund, the prices at whichthe sales would be made and the timing of the sales would need to benegotiated between the fund and the selling companies. There are severalpossible approaches which the fund might follow and each will have to beevaluated by the fund's management in light of applicable law on the sale ofgovernment shares. For example, the joint-venture shares could be sold on afirm commitment basis to the fund before being offered to the public, or atthe time of the public offer as a portion assigned to institutional investors,or even after the shares had been sold to the public and were quoted. As topricing, the fund could buy the shares at a negotiated price different fromthe public offer price or, at the public offer price, or if it were to buy theshares after they had been sold to the public and were quoted, at the marketprice. The fund will need to confirm that these options are acceptable underthe Tenders Law (and other applicable Laws), which may require that the sharesbe offered at book value instead of at a "fair market price." The fund wouldalso have the option not to invest if it could not agree on the sales price orif the divestiture program were not implemented.

7.53 Capitalization of the Mutual Fund. Two approaches could be usedto capitalize the fund. One would be based on an accumulation of committed.pre-negotiated purchases. In this case, the fund manager would reachconclusive purchase agreements, roughly equivalent to the fund's expectedcapitalization, and then offer share certificates to investors through aprospectus-based offering. The offering could be underwritten by privatefinancial institutions with possible external assistance, if necessary.Proceeds of the offering would be used to acquire the shares at the pre-

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negotiated prices. Shares of the pilot mutual fund would then be listed onthe local stock exchanges. Alternatively, the fund could first be capitalizedby selling shares to investors up to a predetermined amount for the purpose ofgradually accumulating shares in the government's holdings as they becameavailable, as set fortr. in the prospectus. In the interim, the proceeds ofthe fund's offering would be invested in money market instruments and otherfinancial assets. In the event that the fund's resources could not beinvested, it might have to be dissolved and the money returned to investors.This possibility would need to be disclosed clearly in the prospectus. Whileeither strategy would be practical and acceptable, the second approa_h mightonly be suitable if there were a firm commitment on the size and timing of thedivestiture of the government's shareholdings.

7.54 Country Funds. Country funds have been utilized by a number ofdeveloping countries to mobilize long-term extein:al resources for the privatesector. They are usually closed-end vehicles designed to invest in listed orunlisted securities. They are generally incorporated in internationallocations that offer liberal tax regimes and, if closed ended and publiclyoffered, are listed on one or more major, international stock exchanges.Country funds can also appeal to the nonresident nationals of a country,especially if appropriate tax incentives are provided. For example, aproperly structured country fund could attract substantial capital fromnonresident Egyptians, particularly in the low-tax Gulf jurisdictions.Country funds investing in listed securities can only be established whensufficient secondary market supplies become available. At this point, theGovernment could consider establishing an overseLs-listed country fund, whichwould invest in the shares of joint-venture companies currently held by state-owned financial institutions. The successful establishment of such a fundwould depend on a number of factors, including prevailing international marketconditions. In order to ensure the coherent and consistent implementation ofthis complex project, the Government may consider awarding a mandate toprepare and establish such a fund to an institution, such as IFC, which hasconsiderable experience in promoting and structuring country funds in emergingmarkets. The Arab Monetary Fund and UNDP have discussed with the CMA and CBEthe idea of funding such a study.

Chapter VIII

Professional Investment Management

Background

8.0 Need fog Professional Investment Management Services.Professional investment management services are not well developed in Egypt atpresent for a number of reasons. The Egyptian capital market has been dormantfor several years, and investment alternatives have been extremely limited.This has restricted the scope for active portfolio management, and the demandfor such services has not been significant. Although state-owned commercialbanks and insurance companies have large portfolios, they have not managedthem actively and have essentially bought equities and held on to them. Inaddition, over 300 employers offer occupational pension plans to theiremployees. Nearly all of these plans are managed "in-house" with littleapplication of modern portfolio management techniques. The 15 brokers on theCairo and Alexandria stock exchanges provide investment advice to clients onan ad hoc basis but do not offer portfolio management services. Moreover, thecapacity of the brokers for securities analysis is quite limited; almost allof them operate as individuals and have very scarce capital and institutionalresources. Finally, there are several investment companies, but they do notoffer portfolio management services to clients.

8.1 The development of professional investment management services inEgypt is critical to the Government's program for the reform of the securitiesmarket. Such services are essential if the mutual fund industry is to developand mobilize resources on any significant scale for the productive sectors.It is extremely important to ensure that collective investment vehicles aremanaged only by well-capitalized, reputable professional investment managementfirms, employing well-qualified personnel of unquestionable integrity. Recentexperience with the fund receiving companies in Egypt has demonstrated clearlythe need to ensure that only reputable and qualified persons, closelymonitored by their boards of directors and a regulatory authority, should beallowed to manage the assets of collective investment vehicles.

8.2 Potential for Investment Management Services. As the securitiesmarket develops, there is likely to be an increasing number of investmentalternatives available to individual and institutional investors, which willcreate opportunities to achieve higher, risk-adjusted returns through activeportfolio management. In a reactivated securities market, several sources ofdemand for professional investment management services are likely to emerge.Institutional investors, such as insurance companies and employers offeringpension plans, could contract out all or part of their portfolios toprofessional managers for more effective deployment. Large corporations,endowment funds, private foundations and high net worth individuals could alsobe future sources of demand for such services.

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Legal Framework for Professional Investment Management

8.3 The current legal framework does not provide for the adequateregulation of investment management services. The Investment Company Law (Law146 of 1988) only regulates specific types of companies and can not serve as abasis for regulating investment management as an independent profession. Anew law covering all material aspects of this field should be enacted toensure that an efficient, ethical and well-regulated profession develops. Thebasic principles of prudential regulation of the profession and the law'srecommended coverage are outlined below.

Basic Principles of Prudential Regulation

8.4 Licensing Procedures. All firms, and all employees acting onbehalf of a firm in activities related to investment management, would belicensed to engage in this profession, according to established criteria.These criteria would include tests of financial soundness, personal integrityand professional competence.

8.5 Financial Soundness. The regulations of the SML pertaining toprofessional investment management should permit only well-capitalized,financially sound and reputable firms to act as investment managers. The newlaw should stipulate an appropriate minimum capital requirement for investmentmanagers. This minimum capital requirement must be a continuing requirement,which would have to be maintained by all licensees. In Germany, for example,fund management companies must be capitalized at a minimum of DM 5 million(US$3 million equivalent); in Italy, the minimum capital requirement is 2billion lire (US$1.5 million equivalent).

8.6 Integrity of Licensee, The integrity of professional investmentmanagers is extremely important - though difficult to regulate - as thej areoften entrusted with discretionary management authority over large sums ofmoney, and any default by them in their discharge of fiduciaryresponsibilities may affect a large number of people. The screening processfor licensing investment managers should attempt to disqualify all personswhose integrity may be in doubt, and the licensing authority should reservethe right to refuse licenses to persons or firms who have been involved incriminal or other activities indicating questionable integrity. Individualsemployed by firms to act as investment managers, as well as the firmsthemselves, should be held liable for their actions. A lack of individualliability under the law may create an incentive for excessive risk-taking orfor other actions that could be detrimental to the interests of clients.

8.7 Professional Competence. Persons and firms entrust their assetsto professional managers in the belief that the latter are competent to managetheir assets. The professional competence of investment managers is critical.It is, therefore, essential that the SML stipulate that investment managersmeet certain minimum professional qualifications before they are licensed tooffer management services. The qualifications themselves need not bestipulated in the law, but the law should empower the regulatory authority toset these qualifications and modify them as necessary.

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8.8 Efficiency and Fairness of the Licensing Procedure. Althoughlicensing requirements are imposed to serve important ends, theirimplementation may become an obstacle to the growth of the industry, defeatingthe very purpose for which they were introduced. It is, therefore, of theutmost importance to ensure that licensing procedures are efficient and fair.The licensing process should be simple and transparent and not favor anyparticular person, or class of persons, or any institution, or class ofinstitutions. The license application form should call for all relevant itemsof information, including the types of advisory services to be offered; thetypes of investments covered by the investment manager; the types of clientsto be serviced; the methods of investment analysis; strategies and sources ofinformation to be employed; the educational standards prescribed by themanager, if the manager is a firm, or the educational/professionalqualifications, if the applicant is an individual; other business activities;other securities industry activities and affiliations; audited financialstatements, if the applicant is a firm; any participation or interests by themanager in other securities transactions; the minimum size of assets to bemanaged; and procedures for disclosure of information to clients.

8.9 A common mechanism to ensure the speedy processing of licenseapplications is to stipulate a maximum time limit for a decision by thelicensing authority, after which approval of the application is assumed. Toensure that applicants receive a fair hearing and that applications are notrejected on unreasonable grounds, the licensing authority should be requiredto state the reasons for rejection of an application, and the authority'sdecision should be appealable to a higher administrative or judicialauthority.

8.10 Protection of Investors and the General Public. Once investmentmanagers are licensed, their activities need to be monitored and supervised toprotect the interests of investors and the general public. This can beaccomplished by stipulating prudential controls, requiring advisors tomaintain proper records open to examination and separating an investor'saccount from those of other investors and of the investment manager. TheSecurities Market Law should cover, inter alia, the issues outlined belowregarding professional investment management.

8.11 Definition of Investment Manager. The definition of investmentmanager should be broad enough in scope so that all persons who may be engagedin providing investment advice for a fee are covered by the law. Exemptionsmay be given later when appropriate, but the basic definition should be asbroad as possible. Only firms should be licensed to act as investmentmanagers, and a distinction should be made in the definition between firms andindividuals employed by such firms, or acting on their behalf, as investmentadvisors. Individual, self-employed licensees would be difficult to monitorand, if permitted, would demand lower capitalization requirements.

8.12 Maintenance of Books and Records. The law should require thatprofessional investment managers maintain proner books and records and makethem available to the regulatory authority for examination. A requirement tofurnish extracts and copies from these records to the regulatory authorityshould also be incorporated in the law. The requirement to maintain proper

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records should include the following aspects of the investment manager'sbusiness activities:

* cash and bank transactions;* assets, liabilities, capital and reserve accounts, audited

financial statements and internal audit records;* written communications of investment advice to clients;* documents of discretionary authority;* transaction records relating to the purchase and sale of

securities on behalf of clients; and* transaction records for dealings made on the investment manager's

own account.

8.13 Disclosure Provisions. The law should include comprehensivedisc.losure provisions to help prevent the dissemination of false or misleadinginformation by the investment manager regarding its own services andactivities, as well as in respect of the financial assets under itsmanagement. Investment managers should be required by law to provide everyclient with detailed background information about the professionalqualifications and previous experience of its staff and its businesspractices. Such information must be provided to potential clients beforeentering into a management advisory contract. The law should also impose afiduciary duty on investment managers to bring to the notice of their clientsany material changes that may occur in this information during the life of thecontract.

8.14 Brokerage Placement. Investment managers often deal in largevolumes of securities and, in most ii- inces, extensively employ the servicesof brokers. This opens up the poss'...DL.ty for abusive trading practices(churning of portfolios, artificial pricing) and collusion with brokers, whichcould be detrimental to the interests of investors. The law should,therefore, require that investment managers provide detailed information onthe amount of brokerage paid to different brokers, the basis of brokerselection and the nature of any affiliation between a brokerage firm and theinvestment company. Transaction records should make a reference to thebrokers used.

8.15 Anti-Fraud Measures. Given the often large sums entrusted to thediscretion of Investment managers, it is vital that the opportunity for fraudbe minimized. The law should provide the regulatory authorities with widepowers to prevent fraud and to investigate and prosecute suspected offenders.Anti-fraud provisions in the law relating to professional iaivestmentmanagement should cover the following principal areas:

* false and misleading statements by the investment manager or itsstaff;

* nondisclosure of key information, such as fees earned beyond acertain amount;

* unwarranted trading of the portfolio to increase brokerage costs;a.d

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abuses of conflict of interest, for example nondisclosure of thefirm's status as a principal when selling/buying securities fromthe client for the manager's own account.

8.16 Segregation of Client Accounts. Investment managers deal with alarge number of clients, and it is important that individual client accountsbe kept separate from each other and from the accounts of the manager. Thelaw should require3 that all securities held on account of clients besegregated and that separately numbered accounts be established for eachclient's funds. The maintenance of accounts and securities held in custodymust be verified periodically by independent accountants and statements ofsuch verification supplied to the regulatory authority. In addition,statements of accounts should be supplied to clients at least once a quarter.

8.17 Neutral Treatment of Client Accounts. Tnvestment managers wouldbe permitted to manage accounts of more than one client. However, the lawshould contain a provision specifying that the manager not favor the interestof one client over another.

8.18 Fees. The actual level of investment management fees should beleft to market forces, but the law should provide broad guidelines on themethod of fee computation so that managers do not charge excessive fees fortheir services and so that the basis for fee computation is transparent. Feesand the manner of their computation should be included in the informationprovided to clients prior to the signing of investment management contracts.

8.19 Inside Information. As managers of large portfolios, investmentmanagers may achieve substantial influence in the corporate sector and may beable to obtain access to inside information on some stocks. In order toprevent the misuse of such information, the law should provide for safeguardsalong the lines of general prohibitions and effective sanctions againstinsider trading.

8.20 Administrative Penalties for Violations. The law should empowerthe regulatory authority to 'Levy penalties on those who violate the provisionsof the law or the decrees of the regulatory authority. Such poaers couldinclude:

* the denial of operating licenses;* the restriction, suspersion or revocati i of licenses; and* the iwDosi.$on of fines.

8.21 Appeals. The regulatory authority would be required to give theperson subject to disciplinary action a reasonable opportunity to plead hiscase before arriving at a decision. The decision of the authority would beappealable to a higher administrative authority and a court of law.

Chapter IX

Implementation of the Reform Program

9.0 The implementation of the fundamental components of the proposedreform program is expected to take about 21 months, beginning in late 1991.We recommend the establishment of a small work team, composed of local andforeign experts, to draft a new securities market law (also covering mutualfunds and investment management) and its executive regulations. This S.ar

needs to be carefully coordinated with the harmonization of Laws 159, 230 and203, among others, to ensure consistency in the securities-related aspects ofthe establishment and funding of businesses, as well as to provide a coherentframework for the securities industry. The new SML is targeted to be approvedby the Parliament in mid-1992. Foreign consultants should be engaged toassist with the design and implementation of the institutional and operationalreforms of the CMA, the stock exchanges and the brokerage industry. Werecommend that the design and implementation of the reforms be under theoverall guidance of a steering committee comprised of the CMA, the CBE and theWorld Bank group, in order to maintain the cohesiveness of the reform program.Other interested parties may wish to participate.

9.1 Implementation Timetable. The following bar chart summarizes theexpected timing of each component, the sequencing of priority and secondaryreforms with regard to the technical assistance, and the overallimplementation schedule of the reform program.

9.2 The timing of the preparation and implementation of the variousproject components is expected to be as follows. Further details are providedin Annex IX.

(a) Legal Reforms

prepare terms of reference for consultant assistarce October 1991appoint work team and consultant November 1991complete first draft of Securities Market Law February 1992begin draft amendments to other legislation March 1992begin draft Executive Regulations to SML March 1992promulgate new SML June 1992issue Executive Regulations to SML September 1992complete legal reforms December 1992

(b) Institutional Reforms

(i) Reorganization of the CMAprepare terms of reference for consultant assistance October 1991begin consultant institutional analysis April 1992complete consultant study June 1992beg8n consultant implementation support July 1992begin computer acquisition/installation July 1992complete consultant implementation support December 1992complete computer acquisition/installation December 1992

SECURITES MARKET REFORM PROGRAM

Implementation Schedule for Technical Assistance

1991---- - 1992 - 1993O N D J F M A M J J A S O N D J F M A M J J A S O N-D

A. Legal Reforms

1. Draft New Securities Market Law -2. Draft Executive Regulations -3. Review Existing laws

B. Institutional Reforms

1. Reorganization of the CMA training until September 1994 2. Accounting Standards Review Board

C. Operational Reforms

1. Stock Exchanges ,-- - J2. Clearing House/Depository , .= implementation depending on results of study3. Investor Protection Fund ----- a -

D. Mutual Funds & Investment Manasement

1. Institutional Portfolio Valuation2. Establishment of Investment

Management Company3. Establishment of Pilot Mutual Fund e_*__

MN2IEFebruary 25, 1992M:\EGT\PA186\IMPLSCHD.SMR

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(ii) Accounting Standards Review Boardprepare terms of referance for consultant assistance November 1991begin consultant institutional analysis April 1992complete consultant study June 1992begin consultant implementation support July 1992complete consultant implementation support December 1992

(c) Operational Reforms

(i) Stock Exchangesprepare terms of reference for consultant assistance October 1991begin consultant institutional analysis June 1992complete consultant study August 1992begin consultant implementation support October 1992complete consultant implementation support June 1993

(ii) Clearing House/Depositoryprepare terms of reference for consultant assistance October 1991begin consultant institutional analysis June 1992complete consultant study August 1992begin consultant implementation support Depending on Study Results

complete consultant implementation support Depending on Study Results

(iii) Investor Protection Fundprepare terms of reference for consultant assistance October 1991begin consultant analysis June 1992complete guarantee fund feasibility study August 1992begin consultant implementation assistance October 1992establish investor protection fund November 1992

(d) Mutual Funds and Investment Managementbegin institut'onal portfolio evaluation May 1992complete portfolio valuation June 1992prepare terms of reference for consultant assistance April 1992begin feasibility study June 1992compl3te feasibility study July 1992establish investment management company September 1992establish pilot mutual fund December 1992

(e) Trainingbegin analysis of securities market

training requirements January 1992begin in-house and overseas training for CMA,

stock exchanges and brokers June 1992complete tr ining programs September 1994

9.3 A descriptien of the work program of the various components iscontained in the following paragraphs.

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9.4 Work Program for Legal Reforms. Preparing the legal reforms isexpected to take about 13 months beginning in November 1991; the draft SML isplanned to be presented to Parliament no later than May 1992, for adoption byJune 1992. This timetable is tight, resulting from the priority beingaccorded to the securities market reform program by the Government, andassumes that the legal team will work nearly full time on the assignment.

9.5 The team assigned to this task should consist of:

* a lawyer from the Egyptian private sector with experience incommercial and corporate law;

* a lawyer from the State Council;

* representatives of the CMA and CBE; and

* a legal consultant with substantial international experience inthe practice of securities law and the drafting of securitieslegislation.

9.6 The Egyptian members of the team would have primary draftingresponsibility for the law, under guidelines agreed with the legal consultant.They would be expected to submit drafts for review by the legal consultant andto draw on the consultant for textual support in areas of need. The full teamwould expect to meet every six to eight weeks, for three or four days, tofinalize the text and harmonize it with the chapters already drafted.Drafting the new SML is expected to take about 8 months; drafting theexecutive regulations should take about eight months; and drafting theamendments to other relevant laws is expected to cover the year of 1992 whenthe laws concerning business are to be harmonized in draft.

9.7 The first draft of the SML is intended to be prepared before theinstitutional and operational reforms are initiated in order that theregulatory scructure being established is clear. Coordination among thedrafters of the legislation and the authorities entrusted with the overallreform program will be crucial. A target date of December 1992 is notunrealistic for completion of the legal reform, provided funding, manpower andpolitical will are all present in a timely fashion.

9.8 Work Program for Institutional Reforms. The institutional reformprogram, excluding the training component, is expected to be designed andimplemented over about a 12-month period, beginning in April 1992. Thecomponents of the institutional work program are described below.

9.9 The first component of the program is the reorganization of theCMA. There are seven subcomponents to this program. The first coversconsultant support for detailed specifications of an organizational structure,measures to improve its financial and administrative autonomy, a managementinformation system and computer and training requirements. Thesespecifications would derive from the organizational relationships, functionsand powers detailed in Chapter V of the report and would be developed in closeconsultation with the CMA and relevant government officials. This is a three-

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month task, which would have as its main output a detailed description of chenew structure and equipment and a work plan for implementation. The secondand third subcomponents are consultant support for the implementation of thespecified plan. These are concu-;rent six-month tasks, which would have astheir main outputs the physical reorganization of the CMA and the trialrunning, customization and debugging of new management inf- mation systems.The fourth subcomponent is the purchase of computer equipment and its deliveryand physical installation. The timing of this component depends on progressin the previous two subcomponents. The fifth subcomponent is the provision oftraining for the staff of the CMA and for securities industry professionals.It would run for about 24 months, starting in June/July 1992. The outputwould be high quality training courses leading to improved staff skills andbetter informed securities market participants. The final subcomponent isoverseas-based training for selected CMA staff in the form of internships atsecurities commissions and stock exchanges. Four internships, each of twomonths' duration, are envisaged over a two-year period. They would complementand build on CMA staff training conducted in-house.

9.10 The second component of the institutional reform program is theestablishment of an Accounting Standards Review Board. This component cot-Idbe undertaken by the consultants who assist with the CMA reorganization or bya different team of specialists. Separate resoucce estimates have beenprovided to highlight its importance. Implementation would follow the patternof the first three subcomponents of CMA reorganization and could be subsumedinto them.

9.11 Work Program for Operational Reforms. The operational reformsdescribed in Chapter VI are expected to take about 12 months to complete,starting in June 1992. The first component of this work program is consultantassistance to the stock exchanges to enable them to restructure in light ofthe new legal framework, to adopt new listing and trading rules and to obtainauthorization as a stock exchange from the CMA. This will require anestimated 4 man-months, spread over 12 months, starting in June 1992. Themain outputs would be a proposed new management structure, a business plan forthe exchanges and proposed listing and trading rules. This component would bevery "process oriented" so that the new structure and rules would be devisedwith the full involvement of the present exchange members. For that reason,it is expected to be conducted over a long period.

9.12 The second component of the program is the establishment of moreefficient clearance and settlement arrangements. Consultant services would beused to help design the specifications for a computer-based system, beginningin June 1992. It is recommended that implementation of this component bedelayed to allow a more accurate assessment of likely trading volume andconsequent demand on the clearance system.

9.13 The final component is the establishment of an investor protectionfund to protect investors in the case of the failure of a broker. Consultantsupport would be required for about two months to examine the feasibility ofan insurance oI' capital-based fund and to specify the size of the fund needed,an appropriate management system and compensation rules. Implementation ofthis component wo.aild be delayed until late 1992.

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9.14 The persons responsible for the institutional and operationalreforms should remain in close contact with representatives of marketparticipants. A broad, on-going consultative p-acess involving all constituentelements of the securities industry would be a desirable vehicle to solicitadvice and build consensus for change during the design and implementation ofthe reform program.

9.15 Technical Assistance Costs and Funding. The preliminary estimateof the cost of the overall securities market reform program is about US$3.7million. The estimated cost of the key elements of the reform program is asfollows:

* Legal Reforms US$0.4 million* Institutional Reforms US$2.6 million* Operational Reforms US$0.5 million

Mutual Fund and InvestmentManagement Company USS0.2 million

Total Cost US$3.7 million

9.16 These cost estimates are calculated on the basis of foreignconsultant costs at approximately US$25,000 per man-month and domesticconsultant costs at approximately US$12,500 per man-month. These estimatesinclude a recommended training program for staff of the regulatory agency,stock exchanges and other securities market professionals, at an estimatedcost of about US$1.1 million. This training is expected to take placeprimarily in Egypt, with supplementary training in the United Kingdom and theUnited States. It also includes professional analysis and recommendationsregarding the appropriate computer hardware and software necessary tointegrate the collection of data on securities market transactions, corpL rateownership and company registration, as well as the dissemination of this datato potential users of such information, including the regulatory agency,investors and the financial press. The estimated cost of computerization isUS$1 million, but this figure would be further refined by a consultant'sanalysis of the computerization needed for the stock exchanges, the CMA andthe centralized clearance system.

m:\egt\pal86\document.new

- 102 -

Annex I

Bibliography

ReRorts on the Egyptian Securities Market

1. Infoiaal Working Group on Capital Markets Issues, "Paper on CapitalMarkets Development", March 1991.

2. Jose da Silva Lopes (Consultant), "Issues in the Financial Sector",World Bank Mission Report, 5/15/90.

3. Hans Horch, "Corporate Securities Market Development Issues", World BankMission Report, 4/30/90.

4. Hans Horch, "Securities Market Development Issues", Spring 1990. (?)

5. USAID, "Summary of Recommendations to Capital Markets Authority ofEgypt", June 1986.

6. "Report and Recommendations on Development of Capital Markets in Egypt",International Finance Corporation, 1/28/81.

B:\Rtports

- 103 -

ANNEX 11-1

Arab Republic of Egypt

Securities Market Reform Program

Comparison of Banking Sector and Securities Merketas a Relative Source of Capital

1987/88 1988/89 1989/90--------LE Million--------

Loans By Banking Sector.......................

Commercial Banks 1/ 3,522 3,328 6,951Investment & Business Banks 2/ 1,782 658 1,083Specialized Banks 3/ 596 756 812

----- ........ .......

Total 5,900 4,742 8,846

TO:

Government Sector (59) 635 2,430Public Sector Companies 1,886 1,493 2,844Private Business Sector 3,131 2,639 3,196other 942 (25) 376

Total Bank Loans 5,900 4,742 8,846

Securities Issues

Quoted Government Bonds 0 7 260Non-quoted Government Bonds 4,485 5,314 6,431GOE Investment Certificates 415 670 923

Total Government 4,900 5,991 7,614

Private Companies (Equities)............................

Public Subscription 76 63 56Clcsed Subscription 4/ 492 175 352

Total Private 568 238 408

Total Securities 5,468 6,229 8,022

Grand Total 11,368 10,971 16,868

Source: Central Bank of Egypt, Annual Report, 1988/89 and 1989/90.

1/ Four public sector banks and private joint-venture banks.2/ 33 private joint-venture banks and foreign bank branches.3/ Four development, agricultural and real estate banks.4/ Includes $150 million at an average FX rate of LE 2.2041 in 1987/88

and S46 million at an average FX rate of LE 2.62 in 1989/90. Thesefigures represent authorized, not paid-in capital.

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- 104 -

Anntx II- 2Page 1 of 2

Arab Republic of Egypt

Securities Market Reform Program

Cairo Stock Exchange - Basic Facts Annual--- -- -- --- ------ ------ ------ Growth

RateA. LISTING 1981 1983 1985 1987 1988 1989 1990 (X)

1. Number of Listed Companiesa. Publicky Issued Companies a/ 45 68 109 130 147 149 155 15%b. Private ("Ctosed") Companies 19 87 210 300 337 361 418 41%

c. Total 64 155 319 430 484 510 573 28%

2. Number of Shares Listed 0# MM)a. Pubticly Issued Companies a/ 73 117 192 227 234 239 244 14%>. Private ("CLosed") Comannies 3 29 50 108 113 118 129 52%

c. Total 76 146 242 335 347 358 373 19%

3. Value of Shares Listeda. Publicly Issued Companies

- LE shares (LEMM) 118 305 602 827 893 934 999 27%- USS shares (USS MM) 47 147 2r8 321 321 321 323 24%- Other FX shares (UKL MM) 2 2 2 2 2 2 2 0X

b. Private ("Closed") Companies- LE shares (LEMM) 11 340 642 1042 1210 1383 1666 75X- USS shares (USS MM) 20 140 430 606 603 613 579 45%Other FX shares (UKL MM) - - 1 1 1 1 1 n.a.

c. Total Companies- LE shares CLEMM) 129 645 1244 1869 2103 2317 2665 40%- USS shares CUSS MM) 67 287 688 927 924 934 902 33%- Other FX shares (UKL MM) 2 2 3 3 3 3 3 5%

B. TRADING b/

1. Yearly Turnover (LE MM)a. On the Floor 5 13 37 112 81 102 195 52%b. Off the Floor 0 2 21 62 41 75 127 89%c. Total 5 14 58 174 121 177 322 61%

2. -.verage Monthly Turnover (LE MM)a. On the Floor 0 1 3 9 7 8 16 51%b. Off the Floor 0 0 2 5 4 6 11 76%c. Total 0 1 5 14 10 15 27 60%

3. Average Monthly Number ofCompanies Traded (#) 25 40 51 63 68 68 69 12%

a/ Includes 32 nationalized public sector enterprises with remaining private shareholdingsb/ Number of shares and turnover have been divided by two to eliminate double-counting.

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- 105 -Annex II- 2Page 2 of 2

Arab Republic of Egyp.

Securit'as Market Reform Program

Cairo Stock Exchange - Basic Facts Annual---------------------------------- Growth

RateC. RECENT IAING STATISTICS 1981 1983 1985 1987 1988 1989 1990 (X)

.... .... . .... .... . .... .... . .... ...... .. ..... ..... ......

1. Number of Transactions (#)

On the FLoor - LE Shares Data for 1981-1987 5645 4901 5755 1%Off the FLoor - LE Shares 183 260 309 30%

Total - LE Shares are not available 5828 5161 6064 2%On the Floor - FX Shares 453 428 370 -10%Off the Floor - FX Shares 42 60 159 95%

Total - FX Shares 495 488 529 3%

Total Transactions 6323 5649 6593 2%LE Shares as % of Totat 92% 91% 92%

2. Number of Shares Traded (# MM)

On the Floor - LE Shares Data for 1981-1987 3 3 9 73%Off the Floor - LE Shares 1 2 2 9%

Total - LE Shares are not available 4 5 10 56%On the Floor - FX Shares 2 2 5 71%Off the Floor - FX Shares 0 0 2 159%

Total - FX Shares 2 2 7 90%

Total Transactions a/ 6 7 18 68%LE Shares as % of Total 68% 71% 59%

3. Turnover (LE/USS MM)

On the Ftoor - LE Shares Data for 1981-1987 34 47 90 39%Off the Floor - LE Shares 20 55 41 27%

Total - LE Shares are not available 54 103 131 34%On the Floor - FX Shares 21 23 39 22%Off the Floor - FX Shares 9 9 30 48%

Total - FX Shares 30 31 68 31%

Average LE/US$ Exchange Rate 2.22 2.52 2.71

Total Transactions (LE MM) a/ n.a. n.a. n.a. n.a. 122 182 316 37%LE Shares as % of Total 44% 57% 42%

a/ Number of shares and turnover have been dividel by two to eliminate double-counting.

Source: Cairo Stock Exchange

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- 106 -

Annex II-3

Publicly Issued and Closely HeldCompanies Listed o. the Stock Exchanges

(million of units)

1990 asX of

1987 .198 1989 1990 Total

A. Publicly Issued Companies

Number of Companies (units) 120 132 147 155 27XNumber of Shares 214 227 234 244 65XCapital in LE 754 830 893 949 361Capital in US Dollars 321 321 321 323 361Capital in UK £ 2 2 2 2 67XCapital in DM 0 0 0 0 n.a.

B. Closely Held Companies

Number of Companies (units) 277 309 343 418 73XNumber of Shares 62 109 115 129 351Capital in LE 914 1,062 1,238 1,666 641Capital in US Dollars 452 608 608 579 64XCapital in UK £ 1 1 1 1 33XCapital in DM 1 1 1 1 1001

C. Total Companies

Number of Companies (units) 397 441 490 573 1001Number of Shares 276 336 349 373 1001Capital in LE 1,668 1,892 2,131 2,665 1001Capital in US Dollars 773 929 928 902 1001Capital in UK £ 3 3 3 3 1001Capital in DM 1 1 1 1 1001

Source: Cairo Stock Exchange

- 107 -

Annex 11-4

Page 1 of 3Arab Republic of Egypt

Securities Market Reform Program

Summary of Listed Securities

No. of FX- X of FX-

Number of Number of Number X Traded DenominatedDenomfnatedSector Companies Shares Traded in'91 in 1991 Shares Shares

A. BANKINGOfficial List 41 87 35 40% 40 46%Provisional List 17 40 11 28% 20 50%

....- - .... -- .... ...... .

Total 58 127 46 36% 60 47%

B. FINANCE & INVESTMENT

Official List 8 14 7 50% 8 57%

Provisional List 22 40 6 15% 21 53%.. .... .... .... . .. .. .... ........

Total 30 54 13 24% 29 54%

C. INSURANCE

Official List 2 2 1 50% 1 50%

Provisional List 2 2 1 50% 0 0%.. ....... . .. . .... . .... .... .......

TotaL 4 4 2 50% 1 25%

D. TRANSPORT

Official List 11 11 2 18% 6 55%

Provisional List 4 5 2 40% 2 40%..... .... -- - . . - .... ... .

Total 15 16 4 25% 8 50%

E. HOTELS & TOWRISM

Official List 13 23 3 13% 11 48%

Provisional List 29 47 2 4% 22 47%.. .. --- --- .... ...

Total 42 70 5 7% 33 47%

F. LAND & REAL ESTATE

Official List 51 75 18 24% 25 33%Provisional List 67 100 8 8% 37 37%

Total 118 175 26 15% 62 35%

G. FOO0 INDUSTRIES

Official List 36 73 18 25% 31 42%

Provisionat List 30 48 4 8% 17 35%a...l ...1 .... ... 8 48 40

Totat 66 121 22 18X 48 40X

- 108 -

Amex 11-4Arab Re._.lc of Egypt Page 2 of 3

Securities Market Reform Program

Suammry of Listed Securities

No. of F*- X of FX-

Number of Number of Nunber X Traded DenominatedDenominatedSector Companies Shares Traded in'91 in 1991 Shares Shares

H. METAL.S & ENGINEERINGofficial List 22 38 13X 17 45XProvisional List 27 45 11X 21 47X

Total 49 83 10 12% 3d 46%

I. CHEMICALS & PAPER

Official List 13 22 6 27X 9 412Provisional List 19 27 4 15X 9 33X

Total 32 49 10 20X 18 37X

J. TEXTILES & CLOTHtNGOfficial List 15 20 7 35X 5 25XProvisional List 9 17 1 62 7 41X

Total 24 37 8 22% 12 322

K. CONSTRUCTION &

REFRACTORY MATERIALS

Official List 29 55 13 24X 24 44XProvisional List 27 47 2 4X 23 49%

Total 56 102 15 15X 47 46X

L. MINING, METALS

& PETRC.EUMOf'icial List 10 13 2 152 4 31%Provisional List 3 6 1 17% 3 502

:.al 13 19 3 16X 7 37X

M. PUBLISHINGOfficial List 2 3 1 33X 1 332Provisional List 3 6 1 17X 3 50X

Total 5 9 2 22X 4 44X

N. RETAIL TRADEOfficial List 17 21 3 14% 4 19%Provisional List 27 32 7 22% 3 9%

Total 44 53 10 19% 7 132

- 109 -

Annex 11-4Page 3 of 3

Arab Republic of Egypt

Securities Market Reform Program

Suniary of Listed Securities

No. of FX- % of FX-Number of Nunber of Number X Traded DenomfnatedDenominated

Sector Companies Shares Traded in'91 in 1991 Shares Shares

0. PHARMACEUrICALS &MEDICAL SERVICESOfficial List 8 18 9 50% 9 50%Provisionat List 11 18 1 6% 7 39%

Total 19 36 10 28% 16 44%

P. FOREST PROOUCTSOfficial List 2 4 0 0% 1 25%Provisional List 6 10 1 10% 5 50%

. .. . .... .... . .... .... . .... ... ....

Total 8 14 1 7% 6 43%

0. INFORMATION &CONSULTING

Official List 4 5 2 40% 2 40%Provisional List 16 24 2 8% 10 42%

Total 20 29 4 14% 12 41%

R. GRAND TOTALSOfficial List 284 484 132 27% 198 41%Provisional List 319 514 59 11% 210 41%

Total 603 998 191 19% 408 41%

Source: Cairo Stock Exchange

c:\lotus\securite.wklMN21E

January 20. 1992

Amex 11-5Pfge 1 of 4

Arab Repulbc of Egypt

Securities Market Reform Program

Representative Securities on Egyptian Stock Markets AsvualA. Equities Average Change in Total

-------- Date of Average Latest Price/ Ctosing Average ReturnLatest Latest Latest Latest Dividend Dividend Share Per Share Earnings Price to Share (Latest

Trade Date Name of Lcpany Per Value Price Dividend Dividend Yield Payout Price Earnings Ratio Book Value Price Year)... . . .. -- - - - - - - - - - - . - - - - - - - -- - - - - - - - - - - - - - - - - - .. ...... - - - - -- - - - -- ...... .

BANKS5.16.91 Giza National Bank for Dev. LE 10 LE 7.62 LE 2.88 1.17.91 37.8X 67% LE 10.37 LE 4.29 2.4x 0.4x 3.4X 41.216.2.91 Egypt Workers Bank LE 4 LE 4.50 LE 0.648 5.20.91 14.4X 551 LE 4.92 LE *.14 4.3x 0.7x 1.71 16.11S.21.91 ft Bank LE 7.25 LE 45.62 LE 4.38 5.12.91 9.61 29X LE 34.96 LE 11.83 3.Ox 1.6x 31.31 40.9%6.2.91 faisal Islamic S 100 S 120 S11.59 1.8.91 9.71 951 S 133.95 $12.14 11.Dx 1.2x n.a. 9.7X6.3.91 Al-Watany Bank of Egypt LE 7 LE 8.20 LE 0.85 7.8.90 10.41 57% LE 7.81 LE 1.48 5.3x 1.4x -2.5% 7.4S

FlNANCE 5 INVESTMENT COMPANIES5.6.91 Saudi-Egypt for Inv. & Finance LE 6.2 LE 2.68 LE 0.32 6.28.90 11.9% 80% LE 2.83 LE 0.40 7.1x 3.3x -10.7% 1.2X3.13.91 * Egypt Abroad for Inv. & Dev. LE 10.00 LE 6.00 LE 0.73 7.24.90 12.21 831 LE 6.64 LE 0.88 7.5x 1.6x 50.41 62.61

INSURANCE5.6.91 Mohandes Insurance Co. LE 10 LE 27.40 LE 5.09 1/ 1.16.91 18.61 781 LE 22.34 LE 6.54 3.5x 1.1x -24.7% -6.1%3.24.91 * Delta Insurance Company LE 4 LE 13.30 LE 2.80 2/ 1.15.90 21.21 1321 LE 10.40 LE 2.12 4.9x 2.1x 1601 1811

TRANSPORT3.3.91 Canal Shipping Agencies LE 1 LE 37.92 LE 2.99 12.30.90 7.9% n.a. n.a. n.a. n.a. n.a. no change 7.9%9.4.90 National Navigation Co. S 100 S 100 S 10 6.29.90 10% 28% S 100 S 35.71 2.8x 0.5x no change 281

HOTELS/TOUR I SM5.30.91 Egyptian Hotel Co. (Hilton) LE 4 LE 22.90 LE 1.66 1.24.91 7.21 35.8% LE 21 LE 4.64 4.5x 1.3x n.a. 7.2%2.20.91 Eg. Co. for Int. Tourism Projects LE 5 LE 5 LE 2.94 6.26.90 58.81 82.51 LE 5 LE 3.36 1.5x 0.7x n.a.3.11.91 * Karoan Co. for Hotels & Tourism LE 100 LE 125 n.d. n.a. n.a. n.d. LE 111.25LE 1.80 61.Bx 1.2x 201 201

TEXTILES & CLOTHING5.30.91 Oakhalia Spiming & Weaving LE 1 LE 11.02 LE 0.70 1.23.91 6.41 9% LE 9.01 LE 9.15 1.Ox 0.3x 831 89.416.3.91 Kabo LE 1 LE 19.50 LE 1.24 1.20.91 6.41 6.9% LE 16.24 LE 18.00 0.9x 0.2x 22.51 28.916.2.91 United Arab Spinng & Weaving LE 1 LE 15.12 LE 1.03 1.24.91 6.81 18.51 LE 11.08 LE 5.57 2.Ox 0.4x 27.71 34%

Annex 11-5

Page 2 of 4Arab Republic of Egypt

Securities Market Reform Program

Representative Securities on Egyptian Stock Markets AriuaA. Equities Change in Total

Date of Average Latest Average Closing Average ReturnLatest Latest Latest Latest Dividend Dividend Share Per Share P/E Price to Share (LatestTrade Oate Name of CoqPan Per Vatue Price Dividend Dividend Yietd Payout Price Earnings Ratio Book Vatue Price Year).. ........................... ........... ---- ---- ---- ........... ...... --------. . ... .......... ........ --------. .--- -- --- - - -------- ........... ......... ............ ...LAND & REAL ESTATE

5.23.91 United Housing and Devetopent LE 1.25 LE 4.17 LE 0.51 2.21.91 12.2% 55.6% LE 2.77 LE 0.87 3.2x 0.8x 23.2% 35.4%5.27.91 Cairo Co. for Housing & Dev. LE 1 tE 2.54 tE 0.24 1.30.91 9.4% 42.9% LE 2.20 LE 0.56 3.9x 0.5x -9.6% -0.2%5.21.91 Eastern Co. for Housing LE I LE 1.38 LE 0.02 4.1.1 1.4% 6.1% LE 0.94 IE 0.33 2.8x 0.4x 64% 65.1%4.9.91 Egyptian Co. for Seed Production LE 10 LE 17.50 LE 2.50 3.26.90 14.3% 21.6% LE 14.96 tE 11.60 1.3x 0.3x 32% 53.6%1.1.91 Eg. Group for Const. & Dev. tE 50 LE 25 LE 8.26 1.2.90 33% n.a. n.s. n.a., n.a. n.a. n.a. 33X

FOWD INDUSTRIES

6.3.91 Cairo Pouttry tE 2 tE 3.80 LE 0.50 6.15.90 13.2% 20.7% tE 4.17 tE 2.42 1.7x 3.7x -11.6% 1.6%6.3.91 Nisr for Soft Drinks tE 2 tE 3.15 tE 0.20 7.26.90 6.3% 55% LE 2.25 LE 0.36 6.2x 0.5x -15.7 -9.4%1.6.91 Kato Ararotic tE 10 LE 12.50 tE 4.34 8.29.89 34.7% n.a. n.s. n.a. n.a. n.a. n.a. 34.7%1.21.91 * Mansoura Pouttry LE 100 tE 100 tE 12.35 7.9.90 12.4% 82% LE 109.75LE 15.14 7.2x 0.8x .9X 3.4%

MEtALS & ENGINEERING

5.30.91 EL laco tE I tE 2.30 tE 0.194 2.4.91 8.4% 13% LE 1.91 LE 0.26 7.3x l.Ox 43.$X 52.2%5.30.91 East Auto tE 4 LE 10.20 tE 0.60 10.25.84 n.a. n.a. tE 7.07 toss n.a. 1.8% 100% 100%9.11.89 * Misr Panet tE 10 LE 10 LE 2.50 6.30.89 25% n.a. n.a. n.a. n.a. n.a. n.a. n.a.3.3.91 * dvance Industries & Services LE 5 LE 2.50 LE 0.30 8.15.90 12% 38% LE 2.50 LE 0.84 3.Ox 0.4x n.a. 12X

CHEMICALS 9 PAPER5.30.91 Misr Chemicat Industries LE 4 LE 5.80 IE 0.40 2.7.91 6.9% 50% tE 3.62 tE 0.80 4.5x 0.8x 41.5% 48.4%6.3.91 tima Fertilizer LE 2 tE 3.04 (8) IE 0.23 2.24.91 7.6% 742 LE 2.24 LE 0.31 7.2x 0.3x -0.42 7.2%5.30.91 RAKTA tE 2 LE 5.50 tE 0.43 1.24.91 7.8% 47% LE 3.86 LE 0.91 4.2x 0.7x 31.9% 39.7%6.3.91 Abu Kir Fertitizer tE 4 tE 22 (0) LE 0.08 2.3.91 0.4% 3.7% LE 12.95 tE 2.17 6.Ox 1.8x 58% 58.4%9.29.87 * Chtoride Egypt LE 100 LE 100 (0) LE 28.14 1.28.90 28.1% n.a. n.a. n.a. n.a. n.e. no change 28.1%5.12.91 * Inter. Chemicats & Synthetic LE 100 tE 100 LE 8.90 7.1.90 8.9% 95% LE 100 LE 9.40 10.6x 0.9x n.a. 8.9%

Detergents Inc.3.20.91 * Egyptian Packing LE 10 LE 11 LE 2.38 n.a. 21.6% 70% tE 10 tE 3.42 2.9x 0.9x no change 21.6%

Amex 11-5

Page 3 of 4Arab Repiblic of Egypt

Securities Market Reform Program

Representative Securities on Egyptian Stock Markets ArnualA. Equities Average Change in Total

Date of Average Latest Price/ Closing Average ReturnLatest Latest Latest Latest Dividerd Dividend Share Per Share Earnings Price to Share (Latest

Trade Date Name of Company Per Value Price Dividend Dividend Yield Payout Price Earnings Ratio Book Value Price Year).......... ................ ---------... ------ . ......... .. ....... . --------.. .-- - --.....- --- - -- -- - ........ . . ........... . ........ ------- ............... ...... .... ....... ...

BUILDING & REFRACTORY MATERIALS

6.30.91 Ceramics and Porcelain LE 2 LE 17.10 LE 1.40 1.30.91 8.2X 402 LE 11.55 LE 3.51 3.3x 0.7x 38.82 47X5.23.91 Arab Ceramic LE 4 LE 5.70 (B) LE 0.95 3/ 7.22.90 16.7X 84X IE 6.18 LE 1.13 5.5x 1.2x 16.5X 33.221.29.91 Arab Alumirmun IE 10 LE 19 LE 6.88 4.23.90 36.22 902 LE 19 IE 7.67 2.5x 1.Ox no change 36.2X6.2.91 National Cement Company LE 2 LE 1.74 LE 0.09 1.28.90 5.22 900W LE 1.89 LE Q.01 189x 0.8x 40.72 45.9X6.3.91 Suez Cement LE 4 LE 6.20 LE 0.98 6.17.90 15.82 92.5X LE 4.51 LE 1.06 4.3x 1.1x 9.5% 25.3X

MINES, METALS £ PETROLEUSM6.3.91 Egypt Iron and Steel IE 2 IE 1.27 LE 0.11 2.17.91 8.72 752 LE 1.31 IE 0.15 9.Ox 0.6x 5.32 14.023.10.91 Petrojet LE 400 LE 380 net LE 20 12.5.90 5.32 502 LE 400 LE 39.65 10.1x 0.2x no change 5.321.10.91 * Nile Mining LE 100 LE 81 (net) LE 19 7.24.90 192 992 IE 100 IE 19.20 S.Ox 0.8x no change 192

PUBLISHING

5.19.91 Scribe Egyptian IE 4 IE 6.58 LE 0.668 4.14.91 9.22 392 LE 6.02 LE 1.68 3.6x 1.3x lo.7X 25.92

RETAIL TRADE

5.20.91 Egyptian Markets IE 1.20 LE 6.35 LE 0.65 5.20.91 10.22 702 LE 3.89 LE 0.86 4.5x 2.9x 65.72 75.9X12.18.90 Egyptian House IE 4 LE 11.20 LE 2.28 7.28.90 20.42 97X IE 11.08 LE 2.34 4.7x 1.Rx 10.52 30.9211.6.90 ^ National Trade & Agencies LE 5 LE 3.75 LE 0.37 7.21.90 102 92X LE 3.75 LE 0.40 9.4x 0.7x no change 102

PHARMACUTTICALS

6.2.91 Hoechst (Orient) LE 4 LE 5.20 LE 0.744 7.25.90 14.32 39X LE 5.75 LE 1.88 3.1x 0.4x -28.62 -14.326.3.91 Pfizer (Egypt) LE 4 IE 18.0 (B) LE 2.84 4/ 6.26.89 15.8X 662 LE 22.31 LE 2.00 11.2x 1.6x -10.62 5.224.14.91 Advanced Biochemical Industries LE 10 LE 17.00 IE 1.18 5.5.90 6.92 842 LE 17.00 LE 1.41 12.1x 0.7x +21.42 28.3212.10.90 Swiss Pharmacuticals LE 4 IE 7.70 IE 0.20 6.1.87 n.a. n.a. LE 7.73 loss n.a. 1.8x -9.42 -9.42

INFORNATION & CONSULTING COMPANIES5.30.91 Advanced Technology Company IE 10 IE 12.52 IE 0.88 12.12.90 7.02 20X IE 13.18 IE 2.64 5.Ox 1.1x 11.72 18.721.15.91 * Giza Systems l.E 100 LE 100 LE 9.90 7.1.90 9.42 692 IE 100 LE 13.55 7.4x 0.9x n.a. 9.42

Annex 11-5

Arab RepubLic of Egypt Page 4 of 4

Securities Market Reform Program

Representative Securities on Egyptian Stock Markets

B. Bonds Last Yield Current

----- Nominal Latest Trade Current to Tax Yield Net

Type Name of Security Value Coupon Price Date Yield Maturity Status of Tax a 33X.... ---------------------- ------ ------ .... ------ -------- ------ --....

Govt. Bond Housing Bond 8% of 1992/2007 LE 100 8% LE 81.00 5.28.91 9.9% 10.51% non- 9.9%

LE 8.00 12.01.06 taxable

Govt. Bond National Development Bond 9 1/2% $100 $9.50 $100 1.1.91 9.5% 9.5% non- 9.5%

taxable

Govt. Bond National Dev. Bond of 12.1.2000 $100 S4.469 S102.49 6.2.91 8.94% 8.55% non- 8.94%

variable taxable

Corp. Bond Credit Foncier Egyptien-1951-2001 LE 10 LE 0.21 Le 11.38 6.2.91 1.8% ? taxable

T-Bill Government of Egypt - 90 Days LE 25,000 19% par weekly 19% p.a. 19% p.a. non- 19%

taxable

Source: Cairo Stock Exchange

* Denotes security traded on the provisional list. All other trades on the official list.

1/ Cash and stock dividends of LE 1.76 and LE 3.33 per share, respectively.

2/ Cash and stock dividends of LE 0.80 and LE 2.00 per share, respectively.

3/ Same as but with LE 0.28 and LE 0.67 as the two numbers.

4/ Same as but with LE 1.51 and LE 1.33, as the two numbers.

a:\stock.wkl

MN21E

July 26, 1991

Arab Republic of Egypt Annex IVPage 1 of 2

Securities Market Reform Program

Comparative After-Tax Rates of Return on Financial Assets**INDIVIDUALS** (LE)

A. Bank Deposit 1/ B. Treasury Bill C. Development Bond7-month CD 90-Day July 1985 a 9.5%Interest a 17.25% p.a. Interest a 19% p.a. Coupon 9.5% p.a.

Principal Amount 1,000 Principal Amount 1,000 Principal Amount 1,000Interest Earned 173 Interest Earned 190 Interest Earned 95General Income Tax 2/ no tax General Income Tax 2/ no tax General Income Tax 2/ no taxMovable Capital Tax 3/ no tax Movable Capital Tax 3/ no tax MovabLe Capital Tax 3/ no taxStamp Duty 4/ no tax Stamp Duty 4/ no tax Stamp Duty 4/ no taxExemptions 5/ n.a. Exemptions 5/ n.a. Exemptions 5/ n.a.Total Tax Payable 0 Total Tax Payable 0 Total Tax Payable 0Net Income 172.50 Net Income 190.00 Net Income 95.00Effective Tax Rate (X) 0% Effective Tax Rate (X) 0% Effective Tax Rate (%) 0%Effective Rate 17% Effective Rate 19% Effective Rate 10%of Return (X) of Return (X) of Return (X)

D. Housing Bond E. Listed Corporate Bond F. Listed Common Stockof 1992/2007 (Hypothetical) Mohandes InsuranceCoupon a 8% p.a. Interest a 19% p.a. June 3, 1991 data...................... ...................... ----------------------

Principal Amount 1,000 Principal Amount 1,000 100 shares a LE 22.60 2,260 4,Market Price a 6.3.91 810 Interest Earned 190 Dividend 6LE1.76/share 176Interest Earned 80 General Income Tax 2/ 22.75 General Income Tax 2/ 19.74General Income Tax 2/ no tax Movable Capital Tax 3/ 0.00 Movable Capital Tax 3/ 0.00Movable Capital Tax 3/ no tax Stamp Duty 4/ 8.00 Stamp Duty 4/ 18.08Stamp Duty 4/ no tax Exemptions 5/ 22.75 Exemptions 5/ 19.74Exemptions 5/ n.a. Total Tax Payable 30.75 Total Tax Payable 37.82Total Tax Payable 0 Net Income 159.25 Net Income 138.18Net Income 80.00 Effective Tax Rate (x) 16% Effective Tax Rate (%) 21%Effective Tax Rate (%) OX Effective Rate 16% Effective Dividend 6%of Return (X) Yield (%)Effective Rate 10%

of Return (X) Nominal Dividend Yield 8%

1. Current rate on a seven-month bank deposit.2. General income tax a 25% after deduction of applicable tax on movable capital and stamp duty; no personal allowances considere3. Tax on movable capital a 32 applicabte to interest income only. In principle, the only portion taxable is the amount above thinterest rate declared by the Central Bank of Egypt (currently the Treasury bitl rate) of a period equal to that of the bond.Deposit interest from accredited banks is exempt for corporations, as is one half of the interest and dividend incomefrom listed bonds and equities of local joint-stock companies.

MN21ESeptember 16, 1991c:\lotus\taxcalc.wkl

Arab Republic of Egypt Annex IVPage 2 of 2

Securities Market Reform Program

Comparative After-Tax Rates of Return on Financial Assets**CORPORATIONS** (LE)

A. Bank Deposit 1/ B. Treasury Bill C. Development Bond7-month CD 90-Day July "IdS a 9.5%Interest a 17.25% p.a. Interest @ 19% p.a. Coupon 9.5% p.a............................. ---------------------- ----------------------...... ........................

Principal Amount 1,000 Principal Amount 1,000 Principal Amount 1,000Interest Earned 173 Interest Earned 190 sinterest Earned 95Corporate Inc. Tax 6/ 7.25 Corporate Inc. Tax 6/ 7.98 Corporate Inc. Tax 6/ 3.99Movable Capitol Tax 3/ no tax Movable Capital Tax 3/ no tax Movable Capital Tax 3/ no taxStamp Duty 4/ no tax Stamp Duty 4/ no tax Stamp Duty 4/ no taxExemptions 5/ n.a. Exenptions 5/ n.a. Exemptions 5/ n.a.Total Tax Payable 7.25 Total Tax Payable 7.98 Total Tax Payable 3.99Net Income 165.26 Net Income 182.02 Net Income 91.01Effective Tax Rate CX) 4% Effective Tax Rate (X) 4% Effective Tax Rate (X) 4%Effective Rate 17% Effective Rate 18% Effective Rate 9%

of Return (X) of Return (X) of Return (X)

D. Housing Bond E. Listed Corporate Bond F. Listed Common Stockof 1992/2007 (Hypotheticat) Mohandes InsuranceCoupon a 8% p.a. Interest @ 19% p.a. June 3, 1991 data

Principal Amount 1,000 Principal Amount 1,000 100 shares a LE 22.60 2,260 UnMarket Price B 6.3.91 810 Interest Earned 190 Dividend SLE1.76/share 176Interest Earned 80 Corporate Inc. Tax 6/ 7.98 Corporate Inc. Tax 6/ 7.39Corporate Inc. Tax 6/ 3.36 Movable Capital Tax 3/ 0.00 Movable Capital Tax 3/ 0.00Movable Capital Tax 3/ no tax Stamp Duty 4/ 8.00 Stamp Duty 4/ 18.08Stamp Duty 4/ no tax Exemptions 5/ n.a. Exemptions 5/ n.a.Exemptions 5/ n.a. Total Tax Payable 15.98 Total Tax Payable 25.47Total Tax Payable 3.36 Net Income 174.02 Net Income 150.53Net Income 76.64 Effective Tax Rate (%) 8% Effective Tax Rate CX) 14%Effective Tax Rate (X) 4% Effective Rate 17% Effective Dividend

of Return CX) YieLd (%) 7%Effective Rate 9%

of Return (%) Nominal Dividend Yield 8%

4. Stamp duty B 1.2% on market value of equities (publicly issued) only5. Exemption up to LE 3,000 of amounts invested in goverrunent bonds not included. One ialf of dividends received on

listed shares of joint-stock companies is exempt from individual general income tax. For companies, exempt if founder's shares6. Corporate tax rate @ 40% plus a 2% surcharge. Only 10% of interest earned and dividends received are taxable.

MN21ESeptember 16, 1991c:\lotus\taxcalc.wk1

- 116 -

Annex VPage 1 of 3

APPROACHES TO CAPITAL ADEOUACY

2. The Technical Committee of the International Organization ofSecurities Commissions has produced the following summary of approaches tocapital adequacy regulation.

LiLuiditv and Solvency

2. A capital adequacy structure for securities firm. should coverboth securities and non-securities activities and shovld cover liquidity andsolvency. Lack of liquidity can cause difficulties for a firm because itmight not be able to meet its liabilities as they fall due. Furthermore,given the risks in the activities of securities firms, significant losses canoccur quickly causing difficulties for a firm. Therefore, some regulatorystructures provide that a firm at all times should be able to meet allliabilities including all claims by customers and counterparties.

3. The Technical Committee acknowledges the existence of twodifferent methods of addressing liquidity. In the larger markets, thestandard, after the proposals recently announced by Japan, will be a netliquid assets test for securities firms. The objective of this test is that afirm should be able to wind down quickly it activities and repay all of itsliabilities including the claims of other securities houses and customers.Under this requirement, which is a combined test of liquLdity and solvency, afirm at all times must have liquid assets which exceed it. total liabilitiesby a sufficient margin to cover the risks to the firm's net worth. Securitiesand commodities positions are market to market daily which prevents thesecurities firm from storing up losses which could lead ultimately to itsfailure or bankruptcyl

4. A key feature of the net liquid assets approach is that allintangible, non-marketable, and illiquid assets, such as goodwill and

2property, are deducted from capital . Most unsecured receivables are treatedas illiquid assets and, therefore, are also deducted from capital.

5. An alternative approach to the net liquid assets test is to treatliquidicy as an additional risk faced by the firm. This has led somecountries to set a ratio of liquld assets to short-term liabilities as part ofa number of ratios linking the capital of the firm to the risks faced. Forexample, a firm could be required to hold liquid assets which exceeded the

1 If a firm incurs substantial losses, it might have to take actionsuch as liquidating some positions or increasing its capital in order toremain in compliance with a net assets test.

2 Some regulators make some allowance for property which secures aloan.

Annex V- 117 - Pase 2 of 3

total of all liabilities with a maturity of less than one year. This wouldensure that the firm had adequate day to day liquidity while it remained inbusiness, but it would not provide that the firm could meet all claims bycustomers and market counterparties. Countries that use this approach haveseparate solvency requirements. These solvency requirements are designed toprovide that a firm has sufficient capital to cover the risks to its networth. It is also important in this approach that securitLes and commoditiespositions are marked to market daily so that losses are not etored up.

Risk-Based Reauirements

6. It is essential that firms have sufficient capital to coverfluctuating risks such as position and settlements risks3 plus a cushion tocover risks that are not measurable4 One approach would be to require firmsto have such a high capital base that this alone would provide adequatecapital to cover these risks. This approach has the disadvantage that, ingeneral, firms would have to nold capital substantially in excess of the risksthat they were facing. Capital in excess of these risks would have to be heldto provide that a firm had the necessary capital to allow for extremepositions which might be taken both in terms of the size of particularsecurities. Furthermore, unless there were strict limits on the size ofpositions taken, there would also be the danger that with a sudden change inmarket conditions a firm's capital base could be endangered.

7. In view of the disadvantages of the above approach, the TechnicalCommittee strongly favors the adoption of risk-based requirements with acushion of capital to cover unmeasurable risks. The advantage of a risk basedapproach is that it provides that firms hold a level of capital appropriate tothe amount of risk. Thus, the capital requirements are neither too severe,which would increase costs for the firms and affect their efficiency, nor tooslack, which would enable firms to run excessive risks relative to theircapital and leave the markets vulnerable to the failure of participants. bymaking allowance for techniques such as hedging, this method also has thebenefit of encouraging firms to engage in risk reduction techniques whichfurther help to reduce risk in the markets.

3 Of course, the level of risk associated with the conduct of aninvestment business (such as position risk and settlement risk) can varydepending upon the nature of the securities market and related clearance andsettlement systems. Securities regulators would, of course, take thesedifferences into account in establishing the risk-based standards.

4 Different ways can be used to provide for this cushion. Forexample, one country ties the required cushion to a firm's volume of businessmeasured by criteria such as customer receivables, total liabilities (otherthan subordinated liabilities), or position risk. Other countries tie it to aproportion of firm expenditures (e.g. one quarter of a firm's expenditures).

Annex V-1l18 - Page 3 of 3

Minimum Reouirements

8. It is appropriate to require firms wishing to enter the industryto demonstrate a level of commitment by requiring them to meet certain minimumcapital requirements. The Technical Committee's view is that these minimumrequirements should not be uniform for all firms. Some countries believe thatsubstantial minimum capital requirements are necessary to enhance confidencein the financial safety of the markets. However, since a principal effect ofa minimum requirement is that it acts as a barrier to entry, too high arequirement could adversely effect competition in the marketplace. To addressthis concern, the Technical Committee believes that differential minimumcapital requirements should be based on the type of business being conductedby the firm. In general, higher minimum capital requirements should beimposed on firms which hold customer funds and securities or engage in tradingactivities for the firm's account.

Definition of Caoital

9. The Technical Committee notes that different approaches to thedefinition of capital are used ..n different regulatory regimes. A number ofthe countries which currently have capital requirements which are closely tiedto the risks associated with a securities firm's business allow firms to useboth short-term and long-term subordinated loans5in addition to owner'sequity, as capital to cover these risks. Some of these countries also makesome allowances for bank guarantees as a substitute for capital. This enablesa firm to meet its fluctuating risks, and if a firm were to fail, thesubordinated loans or funds called for under the guarantees would be used tomeet the claims on the firm by customers or counterparties. Subordinatedloans are permanent capital in the sense that repayment to the lender is notallowed if its would result in a firm's capital falling below a threshold setabove its required capital. In all regulatory systems, though, the degree towhich these forms of capital or substitutes for capital can be used is limitedrelative to owner's equity. Some systems, however, do not make allowances forsubordinated loans or guarantees. The Technical Committee recognizes that atpresent the definition of capital varies between systems to reflect theirdiffering regulatory structures.

AMENDMEN EGPSeptember 18, 1991

5 Short-term and long-term subordinated loans are permitted ascapital under certain conditions. Subordinated loans are subordinated to theclaims of all present and future creditors, including customers.

- 119 -

Annex VI - 1

Example Of A Computerized Auction Market

1. Thc CATS (Computer Assisted Trading System) of the Toronto Stock Exchangewas launched on 1 8th November 1977 and is thus the first automated market systemintroduced by a stock exchange. It has been used as a model in a number of developedand developing country markets.

2. Price auotation and trading characteristics. CATS is a screen-based system whichprovides continuous price quotations based on the auction principle. It shows the size oforders and the prices for each security and the identity of the intermediary who inputs thebuy and sell orders in question. The screen for each security also shows the last fivetrades (amount, price, time). Thus, the CATS market is fully visible.

3. Automated order execution. Each order that is entered into CATS is executablewhich means that any buy (sell) order which is matched by a corresponding sell (buy)order in amount and price is automatically executed. Once orders are executed, printedtrade confirmations are immediately sent to both the buying and selling brokers and arecord is kept for the clearing system. For a selected number of CATS shares there is aguaranteed order execution for client orders of up to 599 shares with designated marketmakers providing the counterparty of the deal.

4. Clearing and settlement. The ciearing and settlement process in Canada iscentralized for the country as a whole and hence is separated from the stock exchanges.Stock exchange member firms use the custodial and clearing facilities of the CanadianDepository for Securities Limited (CDS), an organization sponsored by the financialcommunity. CDS is a highly computerized book-entry system for securities clearing whichworks on the "delivery against payment" principle. Delivery and payment is on a netbasis, which means that for each broker and each deal CDS is the counterparty. As aresult, a clearing system member has only one cheque and one specific security position todeliver to, or to receive from, the CDS on any settlement date.

5. Market surveillance. The market surveillance system provides extensive automatedmarket surveillance facilities. The system contains pre-set parameters for price andvolume for every security. Any trading activity exceeding these limits is immediatelysignalled to the supervisors so that an investigation can be initiated. Computer-generatedtrading reports are available for daily, weekly and monthly analyses -, that possible insidertrading operations, market manipulation and other questionable tradinsi can be identified atan early stage. Among the parameter monitored are:

* intra-day fluctuations of price and volume to immediately identify unusualmovements;

* real-time information on large-block trades;* quote and trade comparison for compliance with trade reporting rules;* price and volume changes before and after news releases by listed

companies to identify possible insider trading.

The System permits the implementation of trading and quotation halts if importantcompany news is pending or if price and volume movements are unusual.

CHAPTER6.EGTAugust 9. 1991

- 120 -

Annex VI - 2

Clearance and Settlement of Securities Transactions

1. A clearance system determines what securities trading counterparties owe andwhat they are due to receive. Clearance is followed by settlement - the exchange ofsecurities and funds to complete the transaction.

2. There are three types of clearance and settlement system: (i) trade for trade; (ii)daily netting; and (iii) continuous net settlement.

3. Trade for trade is the most fundamental form of clearance. The buyer ensures thatcash or a cash equivalent is available for the seller and the seller answer that the securitiesare held in deliverable form. The two then exchange securities and funds through sameagreed mechanism. The identity of the counterparty is known and exposure to variouscounterparties can be monitored. But because the trade for system is essentially one longchain of trades settlement conditions have to be fulfilled at every link in the chain for it tohold: when one transaction collapses, others are affected.

4. Where trading volume is large, some form of netting system is needed to reducethe number of clearance transactions .equired and therefore reduce the likelihood of failedtransactions passing down the chain. There are two types of daily netting: (i) bilateral;and (ii) multilateral. Under bilateral netting each party has one net clearance a day witheach counterparty. Multilateral netting nets the transactions in each securities so thatparties have one net clearance a day covering all buys and sells in that security. Becausethe counterparty to the original trade may not be the counterparty to the clearancetransaction there is a need for some form of trade guarantee. Usually the clearanceagency enforces collateralization requirements

5. Continuous net settlement is a refinement of multilateral daily netting. It is anessential improvement once trading volume increases. In continuous net settlement, dailynetting is employed and all open transactions at the end of the day are offset against thenext day's trades. One of the major tenets of the system is that the clearing agencyinterposes itself between the counterparties, becoming itself the counterparty to eachtransaction. Individual parties to a trade are protected; they are assured that regardless ofthe default of a counterparty, their trade will settle.

6. Continuous net settlement may be on a "rc'ling" or an "account day" basis. In thelatter all trades in a certain period settle on a spacific day while in the former all tradessettle a set number of days after the day they are transacted.

7. The most efficient clearance arises with continuous net settlement on a rollingbasis. A financially sound clearance agency is required to ensure adequate tradeguarantee, and the agency and its counterparties must themselves be automated andefficient.

8. The exchange of physical share certificates adds to the complexity of the processand makes it more difficult to obtain the maximum efficiency gains possible. For thisreason, some form of book entry clearance is desirable. This may be achieved in twobasic ways: (i) immobilization; or (ii) dematerialization. In the first, share certificates areretained but are held in a central depository; in the second share certificates are eliminatedand entitlement to shares is evidenced solely by the book entry account.

CHAPTER6 . EGT

LEGAL REFORM IMPLEMENTATION - PRELIMINARY ESTIMATES

COMPONENTAITEM TIMING DURATION RESOURCES COST SOURCE(begin) (months) (staff (USO OOOs)

months)

1. Drafting new Securities Market Law (SML) December 71991

i) Consultant to World Bank 4 200 (per diem:2)ii) Egyptian private sector lawyer 0 0 (per diem:1.4)iii) Officials - high level -

1 from CMA 4 N/A1 from CBE 4 N/A

2. Drafting Executive regulations to SML 1992March 6

i) Consultant to World Bank 2 100ii) Egyptian private sector lawyer 1 25iii) Officials - high level -

1 from CMA 2 N/A1 from CBE 2 N/A

3. Drafting amendments to related laws March 9(company law, investment laws, etc.)

i) Consultant to World Bank .5 25ii) Egyptian private sector lawyer 2 50iii) Official - high level -

1 from CMA .5 N/A1 from CBE .5 N/A

e x

ol

ult

INSTITUTIONAL REFORM IMPLEMENTATION - PRELIMINARY ESTIMATES

COMPONENT/ITEM TIMING DURATION RESOURCES COST SOURCE(begin) (months) (staff (USD 000s)

months)

1. RE-ORGANIZATION OF CMA 1992

(a) Consultant study (overseas consultant): March 3 7 175

(i) new organizational structure(ii) computer requirements(iii) training requirements

(b) Implementation support June 7 3 75(overseas consultant):

(i) new structure implementation(ii} computer acquisitionAinstallation

(c) Implementation support June 7 7 90(domestic consultant):

(i) new structure implementation(ii) computer acquisition/installation

(d) Computer equipment acquisition/installation: June 600

(i) hardware- PCs >- LAN - peripherals l x

xI-;

INSTITUTIONAL REFORM IMPLEMENTATION - PRELIMINARY ESTIMATES

COMPONENT/ITEM TIMING DURATION RESOURCES COST SOURCE(begin) (months) (staff (USD 000s)

, _ _ months) ___ j _ _ _

(d) Computer equipment (cont.l: 1992

ii) Software- MIS June 400- companies register- market monitoring- investigation support

(e) Training - in-house:

i) general securities markets topics June 24 6 75

ii) surveillance I investigation August 24 10 250

iii) computer use September 24 5 125

iv) language September 24 4 50

(f) Training - overseas September

i) securities commissions 3 x 2 6 90

ii) stock exchanges 2 x 2 4 60

2. ACCOUNTING STANDARDS REVIEW BOARD

Establishment of the Board is to be included in Marchthe implementation support given under 1 (a), (b) >and (c) above. _ l l l_l _l__

o xI-

OPERATIONAL REFORM IMPLEMENTATION - PRELIMINARY ESTIMATES

COMPONENT/ITEM TIMING | DURATION RESOURCES COST | SOURCE(begin) (months) (staff (USD 000s)

months)

1. STOCK EXCHANGES 1992

(a) Implementation study and support June 12 6 150(overseas consultant)

Ii) restructuring in light of new law(ii) new listing and trading rules(iii) specification of trading system

requirement.

2. CLEARING HOUSE/DEPOSITORY

(a) Implementation study (overseas consultant): June 6 3 75

(i) viability(ii) capital requirements(iii) ownership(iv) structure and systems

(b) Implementation support Uncertain 6 3 75

3. INVESTOR PROTECTION FUND

(a) Implementation study and support(overseas consultant): June 2 2 50

(i) feasibility of fund or insurance?(ii) capital requirements(iii) ownership and management(iv) payment rules and systems

o x

MUTUAL FUND/INVESTMENT MANAGEMENT COMPONENT - IMPLEMENTATION

COMPONENT/ITEM | TIMING DURATION | RESOURCES | COST SOURCE(begin) (months) (staff (USD OOOs)

l _________________________ _________________________ ____________ ______ _ m o n th s)hs )

1. Drafting new Mutual Fund Law November n.a. n.a. n.a.1991

- covered by draft Capital Market Law

2. Valuation of Institutional Portfolios April 1992

- consultant to Bank or IFC 3 3 75

3. Feasibility Study of Mutual Fund Establishment June 1992 Arab MonFund/UNDP

- consultants to IFC 2 2 50

4. Feasibility Study of Investment ManagementCompany Estab. June 1992

- consultants to IFC 2 2 50

OQ ¢tJ X

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