1

CHAPTER ONE

1.0 INTRODUCTION

The Capital Market is part of the financial system that provides funds for long-term development

of the economy. Kenya’s history with respect to the development of the capital market can be

traced back to the 1980s when the then Government saw the need to structure and put into effect

policy reforms to foster sustainable economic development with an efficient and stable financial

system in the country. This in particular was to enhance the role of private sector in the

economy, reduce the demand of public enterprise and to enhance capital market development1.

The Nairobi Stock Exchange has a long history that can be traced to the 1920s .According to

Rose.w. Ngugi2 there was no formal market governed by rules and regulations but trading was

based on gentle mans agreement where standard commissions were charged and client obliged to

honour their contractual commitment of making good delivery and settlement of relevant costs.

There was no physical trading floor or specialized stock brokers .Share trading was a part time

job for accountants, auctioneers, estate agents, and lawyers who met to exchange prices in hotels

over a cup of coffee. The NSE was constituted in 1954 as a voluntary association of stockbrokers

registered under the Societies Act and had the duty to develop the stock market and regulations.

The evolution of the stock market shows the changes in institutional and policy environment as

efforts made to facilitate the growth of the market.

1
Rose .W. Ngugi 2003 “Development of the Nairobi Stock Exchange: A Historical Perspective” Available at
<http:// www.pdf.usaid.gov/pdf-docs/PNADSO81.pdf> assessed on 4th November 2011/3:00 pm.
2
Ibid.
 2

There was need for the regulation of the market to protect investors both local and foreign so as

to encourage their participation and enhance the development of the financial market. Investor

confidence would enhance their participation and saving in the market and thus foster capital

accumulation and efficiency in investment and real sector development3.

The main objective of the 1954 NSE was to improve the facilities available, sell and purchase of

shares etc. After the establishment of NSE a self regulatory framework was adopted with the

objective of developing the stock market and was embodied in the rules and regulations of 1954.

The regulatory framework provided the layout for operations of stockbrokers and trading

activities with the objective of developing the market, to give effect to the regulations the market

came up with a committee and gave it powers to govern the exchange and oversee members

activities, investors and listed companies.

The period after independence saw the government adopt the Kenyanisation policy with the main

objective of transferring economic and social control to the citizens by ensuring that majority of

business were in the hands of citizens except where some overriding national advantage was

otherwise demonstrated. In addition to protect foreign investors the Government passed the

Foreign Investment Protection Act of 1964.

In the 1980 the then Government saw the need to design and implement policy reforms to foster

sustainable economic development with an efficient and stable financial system. The policy

reforms were:

3
Ibid
 3

1. The need to enhance the role of private sector in the economy.

2. To reduce the demand public enterprise on the exchequer.

3. To rationalize the operations of the public enterprise sector to broaden the base of

ownership and enhance capital market development.

4. To offer long-term credit this was because the commercial banks could not support and

sustain a desirable economic development.

In 1984 a study4 on the development of money and capital market in Kenya was jointly

undertaken by the Central Bank of Kenya and the International Finance Corporation so as to

make recommendation on ways of ensuring active development and Strengthening of the

financial sector. Their finding culminated when the Government committed itself to the creation

of a regulatory body for the capital market through Sessional Paper no 1 of 1986 “Economic

Management of Renewed Growth.

The finding of the CBK and IFC led to the establishment Capital Market Development Advisory

Council in 1988 with the duty of: working out the necessary modalities including the drafting of

the bill that will lead to the establishment of the Capital Market Authority, which was to provide

the necessary oversight of the market and ensure its stability, to promote and facilitate the

development of an orderly capital market in Kenya. The bill was passed in Parliament and

4
Centrel Bank of Kenya and The International Finance Corporation (1984),The Development of Money and Capital
Market . Available at <http:// www.cma.or.ke/index.php?option=com-content&task=view&id16&Itemid=36>
accessed on 10th January 2012.
 4

subsequently came into effect through Presidential assent in 1989.The objectives of the Act listed

in section 11 shows that the mandate of the committee was met5.

The Capital Market Authority Act helped to meet the mandate of the CMAC in various ways.

The committee was to establish a body with the responsibility of promoting and facilitating the

development of an orderly capital market, section 11(1) (a) met that obligation6.

In addition the CMAC was to provide an oversight of market activities and to protect investors

by operating a comprehensive fund to cushion them against loss arising from licensed brokers

this was articulated in the CMA as brought out by section 187.

The committee was to establish a regulatory body to oversee the activities of the market this is

reflected by section 5 of the Act. The Act provided an appropriate legal framework for the

management of the capital market8.

The objective of the Act in section11 shows that the CMA helped to meet the mandate of the

CMAC and it provides an appropriate legal framework 9. The NSE is a corporate entity with

5
The Capital Market Act, Cap 485A s 11.
6
Ibid.
7
The Capital Market Act, Cap 285 ASection 18. (1) the establishment of a Fund to be known as the Investor
Compensation Fund for the purposes of granting compensation to investors who suffer pecuniary loss resulting from
the failure of a licensed stockbroker or dealer to meet his contractual obligations and paying beneficiaries from
collected unclaimed dividends when they resurface.
8
The Capital Market Act Cap 485A Section 5. (1) provides for the establishment of the Capital Markets Authority.
(2) The Authority shall be a body corporate with perpetual succession and a common seal and shall be capable in its
corporate name of -
(a) suing and being sued;
(b) taking, purchasing or otherwise acquiring, holding, charging and disposing of both movable and immovable
property;
(c) borrowing and lending money;
(d) entering into contracts; and
(e) doing or performing all such other things or acts necessary for the proper performance of its functions under this
Act which may lawfully be done by a body corporate..
9
The Capital Market Act Cap 485A s 11
 5

limited liability. The owners of the NSE are stockbrokers yet they participate in its management

thus violating the principle laid in Salomon V Salomon10.

The CMAC should have demutualized the NSE. Sam Mensah in his paper Demutualizing

African Stock Exchange: challenges and opportunities, defines demutualization as a term that

denotes the change in the legal status of a stock exchange from a mutual association with one-

vote per member to a company limited by shares with one vote per share with majority decision

making, with separate trading rights from ownership11

The effect of demutualization was that the stock market moves from being a closed Market

(members only)to an open market where shares are sold to the public.

According to the World Bank and IMF12. The key topics to security market regulation and

Developments include:

1. Demutualization

2. Creation of an integrated regulator and supervisor

3. Enforcement and the exchange of information

10
(1897) A. C 22 H.L.
11
Sam Mensah, Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January.
12
World Bank and International Monetary Fund (2005) Financial Sector Assessment . World Bank: NewYork
 6

According to Micah Cheserem13, the Authority aims to achieve its targets by pursuing the

following objectives and guiding principles:

1. Promoting investor education and public awareness

2. Enhancing utilization of information and communication technology

3. Modernizing capital markets infrastructure and institutions infrastructure

4. Establishing a robust and facilitative regulatory framework that conforms to International

best practices etc

1.1 BACKGROUND OF THE STUDY

The Nairobi Securities Exchange has witnessed rogue stockbrokers and the perfect examples are

Nyaga Stockbrokers, Francis Thuo Stockbrokerage firms and Discount Securities ltd, even

though the Capital Market Authority Act was in place and regulates their activities . When

Francis Thuo brokerage firm was suspended, several complaints were raised to the Capital

Market Authority board about Nyaga Stockbrokers when it was evident that their operational

capital was on the negative but made gains from illegal trade in clients shares to prop up their

operational capital but nothing was done to address the complaints. The perpetrators had their

way and haven’t been charged in a court of law thus destroying investor confidence

One of the pillars of a well-structured securities exchange is a strong and efficient regulatory

organ, this helps build investor confidence, ensure security of investment and punish market

players who do not abide by the co-values of the market which include:

13
Mr. Micah Cheserem , ‘The Capital Market Authority Launches Its Strategic Plan And The Service Delivery
Charter’ Daily Nation 22nd May 2011, 34.
 7

1. Integrity

2. Transparency

3. Accountability

4. Fairness etc.

Lack of openness in the activities of the stock market destroys the saving culture among Kenyans

this is why there is a need for demutualization and proper regulation of its activities, the

punishment of law breakers and particularly the withdrawal of their practicing license.

This typical example of Kenya needs to be looked into urgently and the demutualization of the

NSE offers a better solution, accompanied by proper regulation to ensure that investors are

protected and encouraged to invest.

Trading at the stock market may be by Electronic trading system or by organized securities

exchange and they both need to be regulated in their respective application especially the

electronic trading system because there is no need for brokers to send their staff to the floor to

trade but trading is carried out in their offices by the use of wide area network 14.This system has

merits and demerits in their application and thus proper regulation need to be in place to govern

the people using it.

14
Fredric . S. Mishkin and Stanley. G. Eakins “Financial Market and Institutions’’.(8th ed,2009) New York:
Pearson international.
 8

One of the issues affecting the stock market in everyday activities is the information gap and

insider trading and they in particular hinder a free and fair market and its development .They

need to be looked into and this can be well taken care of by demutualization because it has

advantages and they include the following but will be discussed in greater length later. This are:

1. It enhances competition in trading issues

2. Promote investor participation in decision making

3. Globalization and consolidation

4. Raises resources for capital investment

5. Improved governance

6. Enhanced integrity

7. Better regulation

The above background clearly shows that there is need for demutualization of the stock market

In-order to promote investor confidence both local and international and thus lead to economic

growth and improve living standards of the people .

 9

1.2 STATEMENT OF THE PROBLEM

The presence of a legal framework15 has not shielded the occurrence of illegal

activities that have negative effect on investor confidence. They include:

1. Insider trading

2. Lack of transparency

3. Information gap.

It is for these reasons that this study will purpose to examine in greater detail how the Capital

Market Authority can be made more effective and transparent by the surveillance of its day-

today activities, monitoring all transactions, guarding against profiting unreasonably and how it

can suspend brokers for violation of the Authorities laws and regulations. Owing to the

challenges facing the stock market proper regulations of the key players is important to enable

proper functioning of the authority and to deal with rogue brokers

Electronic trading system also presents a greater challenge to the market and this study will look

into ways of regulating it and whether it is an efficient mode of trading .This study will also look

into the two types of trading, these are the organized securities exchange and over-the counter

market.

15
Capital Market Act Cap 485A
 10

1.3 PURPOSE OF STUDY

The main objective of the study is to examine how demutualization of the stock market will

promote investor confidence. It will look into the regulation of the stock market paying focus on

the Capital Market Act16and how it provides for the market regulation and why there has been

failure of prosecution of law breakers.

With demutualization new regulation will have to be in place and in this study I will focus on the

major regulations e. g all listed companies will have to file a registration statement and to issue

prospectors that detail the recent financial history of the company when issuing new

stocks17surveillance of day-to-day trading activities, certain level of approved conduct ,monitor

all transactions to guide against unfair trading practices, monitor broker-dealer activity, guard

against illegal business etc.

I will also look into the various ways of punishing brokers or dealers who violate laws that

regulate the market, look at the different methods of carrying on business .I will examine the

objectives and principles of securities regulation which are:

1. Protect investors

2. Ensuring that the markets are fair ,efficient and transparent

3. Reducing systemic risk

16
The Capital Market Authority Act, s 11 (1)
17
Ibid
 11

1.4 RESEACH QUESTION/HYPOTHESIS

1. Why is there a need for demutualization?

2. How will it promote investor confidence?

3. Is the Capital Market Authority Act sufficiently regulating the the activities of

stockbrokers?

4. There is a significant co-relation between demutualization of the stock market and

positive investor confidence to invest.

5. Is there an advantage of the different modes of stock exchanges that will warrant its

Application?

1.5 LITERATURE REVIEW

Several writers have written books and articles touching on demutualization of stock exchanges

and how it will promote investor confidence.

Sam Mensah, emphasizes on the merits and demerits of demutualization. He then goes ahead to

list and discuss the factors that lead to demutualization to include: Improved governance,

investor participation, competition, globalization and consolidation and the unlocking of stock

exchange value.

He argues the demutualization will improved governance of stock exchanges in that they will

have a different governance structures in which outside shareholders are represented by boards

of directors and thus enhance decision making contrary to mutual association model which

functions well if an exchange is a provider of trading services with limited competition and the
 12

interests of members are homogeneous. If greater competition exists and the interests of

members diverge from one another and from the exchange, the mutual governance model

consensus decision-making becomes slow and cumbersome.

He further states that demutualization will promote Investor Participation in that the stock

exchanges must be responsive to the needs of its many stakeholders, including participating

organizations, listed companies, and institutional and retail investors. Exchanges may perceive a

need to shift power within the exchange from one group of members to another and to afford

institutional customers direct access to exchange facilities. This separating of trading rights from

ownership may be a politically and economically feasible way to affect such a shift.

He states that demutualization will enhance competition among exchanges due to the widespread

use of technology e.g. the use of Alternative Trading Systems (ATS) and Electronic

Communication Networks (ECN), driven by technological innovation that have allowed efficient

and effective matching of buy and sell orders of customers at lower transaction costs, while

offering transparency, trader anonymity and extended trading hours.

He states that exchanges have been pushed to demutualize as a result of global competition for

order flow and the search for greater revenues. This is aimed at maximizing competition and

according to IOSCO demutualization in emerging markets has been driven by the increasing

competition among the securities markets. Demutualization is seen as a catalyst to transform the

stock exchange business model to facilitate a more effective response to competition etc.

He goes on further to state that even though demutualization has many advantages but is also not

immune to demerits and states them to include: The limitations include: poor regulatory
 13

framework, poor market infrastructure in developing countries, illiteracy and the negative

implications of rogue stockbrokers.18

According to the World Bank and IMF they argue that demutualization will enhance investor

confidence. They state the core objectives of securities market regulation to be: protecting

investors, ensuring that the markets are fair, efficient and transparent and lastly the reduction of

systemic risk. They also state the guiding principles of securities regulation to include the

principle of: regulation of the regulator, self-regulation, cooperation, issuers, collective

investment schemes, market intermediaries and those of secondary markets19.

According to Fredric. S. Mishkin and Stanley. G. Eakins, they contribute to this study by

arguing that trading at the stock market may be by Electronic trading system or by organized

securities exchange and they both need to be regulated in their respective application especially

the electronic trading system because there is no need for brokers to send their staff to the floor

to trade .This system has merits and demerits in their application and thus proper regulation need

to be in place20. This will promote investor confidence.

18
Sam Mensah, Demutualizing African Stock Exchange: Challenges and Opportunities: Cairo, Egypt: 9th
Annual Conference of the Stock Exchanges Association, 2005 Available at
<http:www.filestudy.com/Demutualizing-African-Stock-Exchanges-Challenges-and-Opportunies-
DOC.html> Accessed on 12th January.

19
World Bank and International Monetary Fund (2005) Financial Sector Assessment. World Bank: NewYork.
20
Fredric. S. Mishkin and Stanley. G. Eakins (2009) “Financial Market and Institutions’’.8th edition New York:
Pearson international.
 14

There is also the need to examine the historical background of the NSE and according to Rose

W. Ngugithere was no formal stock market governed by rules and regulations in the early 1920s

but trading was based on gentle man’s agreement where standard commissions were charged and

client obliged to honour their contractual commitment of making good delivery and settlement of

relevant costs. There was no physical trading floor or specialized stock brokers .Share trading

was a part time job for accountants, auctioneers, estate agents, and lawyers who met to exchange

prices in hotels over a cup of coffee 21 .This enables us understand the evolution of the NSE p to

date.

According to Central Bank of Kenya and the International Finance Corporation they state

the historical background on the origin of the Capital Markets Act. They undertook a research so

as to make recommendation to the Government on ways of ensuring active development and

Strengthening of the financial sector. Their findings culminated with creation of a regulatory

body for the capital market through Sessional Paper no 1 of 1986 “Economic Management of

Renewed Growth and ultimately the establishment Capital Market Development Advisory

Council in 1988 with the duty of : working out the necessary modalities including the drafting

of the bill that will lead to the establishment of the Capital Market Authority to provide the

necessary oversight of the market and ensure the stability, promotion and facilitate the

development of an orderly capital market.

Tarus .D.K., Ekai,R.T and Bitok, J.K. Discuss the factors that affect the development of

stock markets. They state that the stock market offers a range of securities that induce people to

21
Rose .W. Ngugi 2003 “Development of the Nairobi Stock Exchange: A Historical Perspective” Available at
<http:// www.pdf.usaid.gov/pdf-docs/PNADSO81.pdf >assessed on 4th November 2011/3:00 pm.
 15

invest and thus enhance their current income .It provides an avenue where capital is transferred

from less productive use and direct them to more productive uses. It enables investors to achieve

a return and create wealth and at the same time provide borrowers with capital thereby

permitting adjustment to be made in the wealth composition, this will tend to increase the

efficiency with which capital is used or which directly influences the economic growth 22 . To be

able to meet these functions of the stock markets there is need for demutualization.

Joshua Abor in his article define Investment banks as non-deposit taking institutions that advise

on offers of securities to the general public or a section of the public, corporate financial

restructuring, takeovers, mergers, privatization of companies, underwriting of securities, etc.

They can also engage in the business of a stockbroker, a dealer, and fund manager of collective

investment schemes and provider of contractual portfolio management services. He states the

role of Investment banks as underwriting, distribution of securities, helping companies design

deals and the securities to finance them, and then use their brokerage arms to sell the securities to

the investing public, both retail and institutional. He then goes ahead to discuss the significance

of I.B to include: bringing together entities in search of capital and investors who have the

money and want to invest, usually institutional investors, intermediation function in all market

economies, they help with the identification of potential targets which meet the commercial

needs of their clients. They thus advice the company on the best way to go so as to meet its goal,

they help in coordinating the work of the other advisers involved in the transaction eg those who

prepare the documentation for the acquisition and effecting them; financial experts who advise

22
Tarus .D.K.,Ekai,R.T and Bitok, J.K. (2007):A Critical Analysis of Factors Affecting the Development of
Emerging Stock Markets ;A Case Study of Nairobi Stock Exchange, Kenya. :African Journal Of Business and
Economics 1
 16

on the financial reporting aspects of the transaction, and tax consequences; brokers, who advise

on shareholder aspects and how the market as a whole is likely to receive the transaction.

1.6 SIGNIFICANCE OF THE STUDY

The significance of this research in our modern society faced with harsh economic reality of

unemployment, inflation, etc will be important. The government encourages people to invest and

this study is meant to make people to invest at the stock market by showing the significance of

demutualization.

In addition it will lead to public understanding on the activities of the stock market and show that

there is need for better regulation of the stock market with reference to Nyaga Stockbrokers and

how earlier demutualization would have avoided there collapse. This research will also look into

the different types of stocks so as to enable the public make informed choices before buying

shares.

This study also seeks to show the public that by investing they are securing their future thus the

need to promote investor confidence. I will also looks at how the Capital Market Act 23regulates

the activities of brokers and deal with prohibited businesses.

1.7 SCOPE OF THE STUDY

23
The Capital Market Authority Act Cap 485A S.22 which provides for disciplinary action by the securities
exchange. Where a securities exchange reprimands, fines, suspends or expels or otherwise take disciplinary action
against a member or a listed company .It shall within 7 days give notice to the Authority in writing, giving
particulars including the name of the person ,the reason for and the nature of the action taken.
 17

In this study I will focus on the Capital Market Act24. The Nairobi Securities Exchange and

Stockbrokers.

1.8 RESEACH METHODOLOGY

In undertaking this study I will use secondary sources of information, this is particularly because

of time constraint and most information on the subject can be found widely in secondary sources.

1. Books.

2. Journal Articles.

3. Newspaper Articles.

4. Legislations.

5. Internet Articles.

6. Case law.

CHAPTER TWO

24
The Capital Market Act Cap 485A
 18

2.0.1 A STUDY OF THE LEGAL FRAMEWORK REGULATING THE NSE

The history of the Nairobi Securities Exchange formally the Nairobi Stock Exchange can be

traced back to the 1920 as was discussed in chapter one. In 1954 the NSE was constituted as

voluntary association of stockbrokers and registered under the Societies Act. The establishment

of a regulatory framework was driven by the need to develop the stock market and regulate its

activities.

In 198425a study on the development of money and capital market was jointly undertaken by the

Central Bank of Kenya and The International Finance Corporation so as to make

recommendation on ways of ensuring the development and strengthening of the financial sector.

Their findings resulted in the creation of a regulatory body for the capital market through

Sessional paper no 1 of 1986.

The findings of the CBK and IFC led to the establishment of the Capital Market Development

Advisory Council26 and charged with the duty of drafting a bill that will lead to the

establishment of the Capital Market Authority. The bill was passed in parliament and

subsequently came into force in 1989 through Presidential assent and it provides for the

licensing of security markets though so far its only the NSE that has been licensed.

25
Ibid
26
Rose .W. Ngugi 2003 “Development of the Nairobi Stock Exchange: A Historical Perspective” Available at
<http:// www.pdf.usaid.gov/pdf-docs/PNADSO81.pdf> assessed on 4th November 2011/3:00 pm.
 19

2.1.0 THE CAPITAL MARKET ACT

The Capital Markets Act27 is an Act of Parliament meant to develop the capital market by

establishing both Institutional and legal framework to govern the capital market. The Act aims

to regulate the activities of capital market and its Intermediaries in an attempt to meet the

objectives laid down in section 11 of the Act.

Part six (vi) of the Act28 deals with insider trading, this is taking advantage of information that is

not available to the public but available to the insiders. The Act prohibits dealing in securities of

a company on the basis of unpublished price sensitive information.

2.1.1. CAPITAL MARKET AUTHORITY

The Capital Market Act29 establishes the Capital Market Authority30 which is a body corporate

with perpetual succession and a common seal and capable of suing and being sued, entering into

contracts, borrowing and lending money etc.

The objectives31 of the Authority are clearly laid down in the Act:

Firstly it shall be to develop all aspects of the capital market with particular emphasis on the

removal of impediments to and the creation of incentives for long term investment in productive

enterprises. This function reflects the objectives that led to the establishment of CMA in 1990 as

per the recommendation by the CBK and IFC in 1984 and amplified by the government through

Sessional paper no 1 of 1986.

27
The Capital Market Act Cap 485A
28
The Capital Market Act Cap 485A s 32 and 33
29
The Capital Market Act Cap 485A s 5
30
ibid
31
The Capital Market Act Cap 485A s 11
 20

Secondly, the Authority shall facilitate the existence of a nationwide system of stock market and

brokerage services so as to enable wider participation of the general public in stock market.

Thirdly, the Authority’s function shall be to create, regulate and maintain the market in which

securities can be issued and traded in an orderly, fair and efficient manner through the

implementation of a system in which the market participants are self regulatory to the maximum

practicable extent. This is further amplified by part six of the Act that prohibits against insider

trading.

Fourthly, the Authority aims to protect investors’ interest. This is aimed at encouraging

investors’ confidence and thus attracts more investors both local and foreign.

Fifthly, the Authority shall facilitate a compensation fund to protect investors against financial

lose that may arise due to failure of a licensed broker or dealer to meet his or her contractual

duty.

Sixthly, it shall develop a framework to facilitate the use of electronic commerce for the

development of capital markets in Kenya this was implemented in 2007 and is currently being

applied at the NSE. The use of electronic commerce has many advantages including time

efficiency, faster transactions, proper data storage etc.

 21

Further the use of electronic commerce 32 shall be construed to mean the use of information

technology to effect linkage among functions provided by licensed persons or other market

participants for the dissemination and transfer of market information to a wider number of users

within and between networks, offer distribution or delivery in electronic form securities or

services ordinarily provided by licensed persons ,execution of securities transactions without the

need for parties to the transaction being physically present at the same location.

In 200733 Kenya implemented the use of Electronic Trading System, this eradicated the need for

brokers to send their staff to the trading floor to conduct their business thus making trading faster

and reduces crowding at the trading floor.

In order to achieve its objectives the Authority may perform the following functions34:

a). Advice the Minister of Finance on all aspects of the development and operation of capital

market.

b). Implement government policies with respect to the capital market.

c). Employ officers and servants as may be necessary for the proper discharge of functions

of the Authority.

d) Impose sanctions for breach of the provision of the Act or regulations. These sanctions

include financial penalties, mitigation of effects of the breach, restitution, compensation

etc.

32
The Capital Market Act Cap 485A s 11 (b)
33
Nairobi Securities Exchange, How does the Nairobi Securities Exchange work .Available at
http://en.wikipedia.org/wiki/Nairobi-Stock-Exchange Accessed on 10th January 2012.
34
The Capital Market Act Cap 485A s 11 (b)
 22

The Authority35 can also grant license to any person to operate as a stockbroker, dealer or

investment bank or authorized securities dealer and ensure the proper conduct of their business,

this aims at removing impediments and to facilitate the proper functioning of the capital market.

The Authority36 can also in consultation with the Minister formulate rules, guidelines and

regulations for the purpose of carrying out its objectives to regulate the:

a) Listing and de-listing of securities.

b) Disclosure about securities transactions.

c) Keeping and proper maintenance of books, records and accounts and audit by person

approved or licensed by the Authority and regular reporting by such persons to the

Authority.

d) Procedure for the participation of foreign investors in the stock market etc.

The Capital Market Authority37 also has the power of entry and search for the purpose of

determining the affairs of a person licensed under the Act and if an officer is satisfied that

person has breached the provision of the Act he may apply to the Magistrate for a warrant to

search the premises of that person and the magistrate may authorize the officer to search the

premises at reasonable hours.

2.1.2. COMMITTEE ESTABLISHED BY THE C.M.A.

The Authority38 can also establish a committee with powers as the Authority may deem

appropriate to grant it so as to execute its duties. This committee can hear and determine
35
The Capital Market Act Cap 485A 23- 25
36
The Capital Market Act Cap 485A 36
37
The Capital Market Act Cap 485A 13A
38
The Capital Market Authority established under section 5 of the Capital Market’s Act.
 23

complaints from shareholders, a company listed at the exchange. It may also make

recommendation with respect to assessing and awarding compensation in respect of applications

made.

2.1.3. INVESTOR COMPENSATION FUND BOARD

The Investor Compensation Fund Board was established under the Act 39 to grant compensation

to investors who suffer pecuniary loss resulting from the failure of a licensed stock broker or

dealer to meet their contractual obligation. It also pays beneficiaries from collected unclaimed

dividends where they resurface.

2.1.4 CAPITAL MARKET TRIBUNAL

The Act further establishes a tribunal known as Capital Market Tribunal 40 with the powers

similar to the High Court of Kenya. This tribunal was established to hear and determine

complaints from any aggrieved party not satisfied with the findings of the Capital Market

Authority or The Investor Compensation Fund Board. This tribunal may require the Authority or

the I.C.F.B to give reasons for its action or decision and may affirm or set aside such action or

decision.

2.2.0 THE NAIROBI SECURITIES EXCHANGE.

2.2.1INTRODUCTION

39
The Capital Market Act Cap 485A s 18A .
40
The Capital Market Act Cap 485As 35A.
 24

A stock market or securities market 41 is a public entity for the trading of a company’s stocks at

an agreed price; these are securities listed on the stock exchange as well as those only traded

privately.

The stocks42 are listed and traded on the stock exchange which is entities of a corporation or

mutual organization specialized in the business of bringing buyers and sellers of the organization

to a listing of stocks and securities together. Participants at the stock market range from small

individuals stock investors to large hedge fund investors. Their orders normally end up with a

professional at a stock exchange, who executes the so quoted orders.

Stock exchanges vary, there some which are physical locations where transactions are carried out

on a trading floor in that stock brokers meet face to face this is based on the open outcry method.

This type of auction is used in stock markets and commodities exchange where traders may enter

verbal bids and offers at the same time on the contrary the stock exchange may be composed of a

network of computers where the traders execute their transactions electronically.

2.2.2 HISTORICAL DEVELOPMENT OF NAIROBI SECURITIES EXCHANGE

The Nairobi Stock Exchange has a long history that can be traced to the 1920s when Kenya was

a British colony. In 1951 an estate agent called Francis Drummond established the first

professional stock broking firm. He then approached the then Minister of Finance Sir Ernest

Vasey and sold him the idea of setting up a regional stock market (East Africa Stock Exchange)

and the Minister was impressed by the idea. In 1953 the two approached the London Stock

41
Princeton Review, Career tips: Stock broker. <Available at http://
www.Princeton.review.com/careers.aspx>.accessed on 10th February 2012.
42
Ibid
 25

Exchange officials who accepted to recognize the setting up of NSE as an overseas stock

exchange. According to Rose.w. Ngugi43 there was no formal market governed by rules and

regulations but trading was based on gentleman’s agreement where standard commissions were

charged and client obliged to respect their contractual commitment of making good delivery and

settlement of relevant costs. There was no physical trading floor or specialized stock broker,

share trading was a part time job for accountants, auctioneers, estate agents, and lawyers who

met to exchange prices in hotels over a cup of coffee.

The NSE was constituted in 1954 as a voluntary association of stockbrokers registered under the

Societies Act. Its duty was to develop the stock market and its regulations. The evolution of the

stock market shows changes in institutional, regulatory and policy environment in an effort to

facilitate the growth of the market.

The policy frameworks were:-

1. The need to enhance the role of private sector in the economy.

2. To reduce the demand public enterprise on the exchequer.

3. To rationalize the operations of the public enterprise sector to broaden the base of

ownership and enhance capital market development.

4. To offer long-term credit this was because the commercial banks could not support and

sustain a desirable economic development.

43
Rose .W. Ngugi 2003 “Development of the Nairobi Stock Exchange: A Historical Perspective” Available at
<http:// www.pdf.usaid.gov/pdf-docs/PNADSO81.pdf> assessed on 4th November 2011/3:00 pm.
 26

In 1984, a study44on the Development of money and the Capital market in Kenya was jointly

undertaken by the Central Bank of Kenya and the International Finance Corporation mainly to

make recommendation to the Government on ways of ensuring active development and

Strengthening of the financial sector. Their findings culminated with creation of a regulatory

body for the capital market through Sessional Paper no 1 of 1986 “Economic Management of

Renewed Growth and ultimately the establishment Capital Market Development Advisory

Council in 1988 with the duty of : working out the necessary modalities including the drafting

of the bill that will lead to the establishment of the Capital Market Authority to provide the

necessary oversight of the market and ensure the stability, promotion and facilitate the

development of an orderly capital market.

The institutional framework under the CMA is found in the objectives of the Act 45 . The Capital

Markets Act helped to meet the mandate of the CMAC in various ways. The committee was to

establish a body with the responsibility of promoting and facilitating the development of an

orderly capital market ,section 11(1) (a) met that obligation .In addition the CMAC was to

provide an oversight of market activities and to protect investors by operating a comprehensive

fund to cushion them against loss arising from licensed brokers this was articulated in the CMA

as brought out by section 18 .The committee was to establish a regulatory body to oversee the

activities of the market this is captured by section 5 of the Act. The Act provided an appropriate

legal framework for the management of the capital market. The objectives of the Act in section

44
Central Bank of Kenya and The International Finance Corporation (1984) The Development of Money and
Capital Market . Available at <http:// www.cma.or.ke/index.php?option=com-
content&task=view&id16&Itemid=36> accessed on 10th January 2012.
45
See Capital Market Act Cap 485A s 11
 27

11 show that the CMA helped to meet the mandate of the CMAC and it provides an appropriate

legal framework.

2.2.3 OWNERSHIP OF THE NSE

The ownership of the Stock Exchange may be: Mutual or corporate with shareholders.

2.2.3.1 OWNERSHIP OF A MUTUAL STOCK EXCHANGE

The most distinguishing feature of a mutual stock exchange is that its owners are the managers at

the same time. The owners do share the gains of the enterprise in proportion to their ownership

interest in the exchange. Decisions making are usually made on a one member, one vote basis

and often are made by committees of representatives of member firms.

Due to this ownership structure the rights of individual owners may not be freely tradable or

exchangeable and on cessation of membership, those rights are forfeited. This type of ownership

has disadvantages in that there is prevalence of fraud in mutual stock exchanges as NSE chief

executive officer Peter Mwangi46 stated that the office of the brokerage firms remains the last

unsealed loophole for fraud given that the trading and settlement systems are automated. Other

disadvantages include poor governance, lack of investor participation, abuse of insider

information, since its owners and the managers are the same there’s lack transparency etc. These

features show that mutual stock exchanges affects investor confidence and there’s need for

demutualization as will be discussed in the importance of demutualization.

46
Peter Kiragu, ‘NSE to shed off its broker club tag’ Nairobi Star 16th July 2009, 17
 28

2.2.3.2 OWNERSHIP OF A DEMUTUALIZED STOCK EXCHANGE

Demutualized stock exchanges are organized as corporations with share capital in which the

owners, principal decision-makers and customers are three separate groups. Decision-making

power and implementation is vested in a board of directors who are subject to election and

removal by shareholders.

The voting rights of shareholders usually are proportionate to their economic interest in the

corporation, one share one vote. Ownership rights are distinct from trading privileges.

Demutualization is basically a plan that will see membership of the exchange move from the

hands of brokers into being a public-owned entity owned via shares or guarantee.

2.2.3.3 THE PROCESS OF DEMUTUALIZATION

The process of demutualization takes place with the written approval of the Capital Markets

Authority .It starts with the exchange making an application to the Authority for approval for the

conversion to a company limited by shares. The application must be accompanied by the

following documents:

(a) A valuation of the Exchange.

(b) The proposed authorized and paid-up capital of the Exchange with the number of shares

to be issued.

(c) The names of members of the Exchange proposed to be the initial shareholders of the

Exchange and the number and value of shares to be allotted to each such member and a
 29

shareholders resolution providing for reduction of the total shareholding to less than 40%

in less than 3 years from the date of conversion.

(d) The number and value of shares to be allotted to and held directly or indirectly by the

Government of Kenya and the CMA Investor Compensation Fund being not less than

20% of the total shareholding.

(e) The proposed names of directors of the post-conversion Board of the Exchange.

(f) The proposed plan for the separation of the commercial and regulatory functions of the

Exchange.

(g) The memorandum and articles of association of the Exchange.

(h) A detailed five year development plan for the Exchange together with the capital

expenditure estimate and the sources of finance.

(i) The manner in which the rights and liabilities of the existing members will be treated.

(j) Operational Manuals to guide the Exchange’s self-regulatory functions detailing the

functions to be performed by the exchange and a budgetary plan to effectively cater for

those functions and ensuring the functional and physical separation of commercial and

regulatory functions.

(k) New rules and where appropriate amendments to existing Exchange’s rules necessary to

implement demutualization.

(l) The last audited financial statements of the Exchange and proforma financial accounts.

(m) Any other information that the Authority may require in writing.
 30

Upon the receipt of application the Authority may, if it deems necessary in the interest of the

capital markets, make appropriate amendments to any of the submissions made but must inform

the Exchange of such amendments or provide the exchange with an opportunity to be heard and

within thirty days of receipt of the information submitted by the exchange the Authority shall

then approve and communicate to the exchange on the following:

(1) The revaluation of the assets and liabilities of the exchange.

(2) The authorized and the paid up capital of the exchange.

(3) The names of members of the exchange proposed to be its initial shareholders.

(4) The number of shares that may be allotted to each member of the exchange for

consideration other than cash.

(5) The names of the proposed post-conversion directors of the exchange.

(6) The plan for the separation of the commercial and regulatory functions of the exchange;

(7) The memorandum and articles of association of the Exchange.

(8) and lastly the approved development plan.

After being granted the approval then within thirty (30) days the exchange shall take the

necessary steps:

Firstly it shall adopt in a meeting of its members by a special resolution of the approved

Memorandum and Articles of association that will guide the exchange. Secondly, it shall adopt

the proposed allotment of shares to the members approved to be the initial shareholders. Thirdly,
 31

adopt and appoint the directors as the post-conversion board .Lastly it shall adopt the approved

paid up share capital.

On meeting all the requirements, the exchange shall then apply to convert itself within 30 days

by lodging with the Registrar some relevant documents that is:-

(a) A copy of the Authority’s written approval.

(b) Copies of special resolutions passed in accordance with the Articles of Association of the

Exchange before the Conversion Date approving the conversion of the exchange to a

company Limited by shares and adopting the amended memorandum and articles.

(c) A copy of the memorandum and articles of the Exchange approved by the Authority and

duly amended in accordance with the Companies Act to reflect that it is a company

limited by shares on the lodgment of the above documents and upon being satisfied as to

their completeness, the Registrar shall register the documents accordingly and inform the

Authority of such registration within 7 consecutive days and within 14 days the Authority

shall by notice in the Gazette appoint a conversion date by which day the conversion will

take effect and issue a certificate of registration to the Exchange as evidence of its change

in status from a company limited by guarantee to a company limited by shares.

2.2.4 THE ROLE OF NAIROBI SECURITIES EXCHANGE.

The stock market offers a range of securities that induce people to invest and thus enhance their

current income. It provides an avenue where capital is transferred from less productive use and

direct them to more productive uses. It enables investors to achieve a return and create wealth

and at the same time provide borrowers with capital thereby permitting adjustment to be made in
 32

the wealth composition, this will tend to increase the efficiency with which capital is used or

which directly influences the economic growth47.

The Nairobi Securities Exchange deals in the buying and selling of securities issued by publicly

listed and quoted companies and the Government. The main functions that the Nairobi stock

exchange plays and continues to play is that it promotes the culture of saving among people.

Institutions exist where savers can safely invest their money and earn a return. This is an

incentive to people to save more.

Secondly, the NSE assists in the shift of dormant savings to investments in productive

enterprises as an alternative to keeping the savings idle. It should be known that in as much as an

economy can have savings. The lack of mechanisms for channeling those savings into activities

that generate reasonable income would lead to waste of those savings. Therefore, even if a

culture of saving were to be encouraged, the lack of developed financial markets may lead to

economic downfall thirdly, the N.S.E assists in the rational and efficient allocation of capital.

The fact that capital is scarce means systems have to be developed where capital goes to those

seriously in need of it. An effective and robust stock market sector will have the expertise, the

institutions and the means to prioritize access to capital by competing users so that the economy

manages to realize maximum output. If an economy does not have efficient financial markets,

there is always the risk that scarce capital could be channeled to non-productive investments as

opposed to productive ones, leading to wastage of resources and economic decline.

47
Tarus .D.K.,Ekai,R.T and Bitok, J.K., ‘A Critical Analysis of Factors Affecting the Development of Emerging
Stock Markets : A Case Study of Nairobi Stock Exchange’ (2007) Kenya African Journal Of Business and
Economics 1.
 33

Fourthly, the NSE promotes higher standard of accounting, resource management and

transparency in the management of business. This is because financial markets encourage the

separation of owners of capital on the one hand, from managers of capital, on the other. This

separation is important because were cognize that people who have the money may not

necessarily have the best business ideas, and people with the best ideas may not have the money

and because the two need each other, the stock exchange becomes the link this will be better

achieved through demutualization of the stock market .This will be dealt with in the next chapter.

Fifthly, the stock exchange improves the access to finance of different types of users by

providing the flexibility for customization. This is made possible by the fact that financial sector

allows the different users of capital to raise capital in ways that are suited to meeting their

specific needs.

Sixthly, the stock exchange provides investors with an efficient mechanism to liquidate their

investments in securities. The very fact that investors are certain of the possibility of selling out

what they hold, as and when they want, is a major incentive for investment as it guarantees

mobility of capital in the purchase of assets.

Seventhly, the stock exchanges provides for mobilization of savings for investment in

productive enterprises beneficial to the economy as an alternative to putting savings in bank

deposits, purchase of real estate and outright consumption ,purchase of vehicles etc.

Eighthly the stock exchange provides for growth of other financial sectors such as .insurance,

pension and provident fund schemes which nurture the spirit of savings and can additionally

participate in buying and selling of shares at the stock exchange. These financial sectors then use
 34

the money from investor’s such as the insured to engage with the NSE and thus safeguard the

insured’s interest.

Ninthly and importantly they check against inflation by helping the government to meet its

policy objectives of low interest rates, in that the strength of the local currency can be monitored

on a day to day basis, thus cushion against the depreciation of the shilling that may negatively

affect the economy at large. The global financial markets have become increasingly interlinked

so have the interest rates, inflation and foreign exchange rates. For example, higher domestic

interest rates may attract foreign financial investment and thus have a positive impact on the

value of the local currency.

Tenthly, the stock market provides for better capital management in that it provides for the

separation of the owners of capital from the managers of capital; a very important process

because owners may not have the expertise to manage capital investment efficiently or at the

interest of investors who want to make a profit. The stock exchanges encourage higher standards

of accounting to resource management and public disclosure which in turn affords greater

efficiency in the process of capital growth.

They also facilitate equity financing as opposed to debt financing. Debt financing has been the

undoing of many enterprises in both developed and developing countries especially in

recessionary periods.

The stock market also create a platform for the improvement of access to finance for new and

smaller companies that are developing and need capital to expand. This is made possible through
 35

the Alternative Investments Market Segment (AIMS) or through Venture Capital institutions

which are fast becoming key players in financing small businesses. Lastly the Stock exchange

encourages public floatation of private companies which in turn allows growth and increase of

the supply of assets available for long-term investment.

From the above discussion it is evident that the establishment of an efficient stock market is

indispensable for any economy growth of a country or United States.

2.3 .0 THE SECURITY MARKET SECURITY DEALERS

The main market intermediaries in the Kenyan capital markets that are licensed by the CMA

include48: Stockbrokers, Stock Dealers, Investment Banks, Fund manager etc. In this research I

will tackle Stockbrokers and Investment Banks

2.3.1 STOCKBROKERS

These are security market dealers and they play a very important role at the NSE. They are

discussed in detail below.

2.3.2 A BRIEF HISTORICAL BACKGROUND OF STOCK BROKERS IN KENYA

48
The Capital Market Act Cap 485A s 23. (1) No person shall carry on business as a stockbroker, dealer, investment
adviser, fund manager, investment bank, authorized securities dealer, authorized depository, or hold himself out as
carrying on such a business unless he holds a valid license issued under this Act or under the authority of this Act.
(2) No person shall carry on or hold himself out as carrying on business as a securities exchange registered venture
capital company, collective investment scheme, central depository or credit rating agency unless he is approved as
such by the Authority.
(3) A person approved by the Authority to carry out any business required by this Act to be approved shall comply
with all requirements of the Authority and pay an annual fee to the Authority at such rate as the Authority may
prescribe.
(4) Nothing in this section shall be construed as limiting the powers of the Authority to approve or license any other
person operating in any other capacity which has a direct impact on the attainment of the objectives of this Act.
 36

According to Rose.w Ngugi49 the NSE history can be traced back to the 1920 with no formal

market governed by rules and regulations but trading was based on gentle man’s agreement

where standard commissions were charged and client obliged to honor their contractual

commitment of making good delivery and settlement of relevant costs, this shows that stock

broking in Kenya can be traced back to the 1920 .There was no physical trading floor or

specialized stock brokers .Share trading was a part time job for accountants, auctioneers, estate

agents, and lawyers who met to exchange prices in hotels over a cup of coffee.

Stock broking in Kenya can thus be clearly traced back to 1951 when an estate agent called

Francis Drummond50 established the first professional stock broking firm. He then approached

the then Minister of Finance Sir Ernest Vasey and sold him the idea of setting up a regional stock

market (East Africa Stock Exchange) and the Minister was impressed by the idea. In 1953 the

two approached the London Stock Exchange officials who accepted to recognize the setting up

of NSE as an overseas stock exchange.

A stockbroker51 is a market professional who buys and sells securities on behalf of clients at a

Stock Exchange in return for a brokerage commission after executing the contractual obligation.

Stock brokers must be licensed by the Capital Market Authority 52and be a member of the Nairobi

Stock Exchange.

Main requirements to be licensed and to carry on the functions as a stockbroker include:

49
Rose .W. Ngugi 2003:“ Development of the Nairobi Stock Exchange: A Historical Perspective” Available at
<http:// www.pdf.usaid.gov/pdf-docs/PNADSO81.pdf> assessed on 4th November 2011/3:00 pm.
50
Ibid.
51
The CMA Hand Book “The Organizational setup of the CMA” Available on <http:// www.cma.or.ke/index.php
>accessed on 12th November 2011/ 4:25 pm
52
The Capital Market Act Cap 485A s11 (3)(e)
 37

a) A certificate of Incorporation and Memorandum and Articles of Association that is it

must be incorporated as accompany under the laws of Kenya.

b) Must have a detailed business plan of its activities such as Kestrel Capital (East Africa)

Ltd a leading stockbroker on the Kenyan Stock market for foreign and local institutional

investors offers a range of the following services: Stock broking on NSE, bond trading,

commercial paper placing, company and market research, corporate finance advisory,

investment advisory, public offering of shares and bonds, privatization and IPO’s,

Mergers and acquisitions etc.

c) Lodgment of a security of Kshs1.5 million or such higher amount with a securities

exchange or a central depository (or such other amount as the Authority may determine,

taking into account the financial position and settlement record of the applicant) or

provide a guarantee in a form acceptable to the Authority from a bank.

d) Paid up share capital of more than Kenya Shillings five million and not less.

e) The amount of shareholders funds shall not be below Kshs5 million at any time during

the license period.

f) The minimum paid up share capital shall be unimpaired and shall not be advanced to

directors or associates of the stockbroker.

 38

g) The working capital shall not be below 20% of the prescribed minimum shareholders’

funds.

h) Unsecured advances, loans and other amounts to directors or associates shall in aggregate

not exceed10% of prescribed shareholders’ funds at any time.

i) The ratio of the stockbroker’s bank overdraft to the paid capital shall not exceed 20% at

all times.

2.3.3 THE FUNCTIONS OF STOCK BROKERS AT THE NSE

Stockbrokers play an important role at the NSE they are in charge of providing correct and

complete information to investors. This is a very important role in that it involves the investors’

money and thus the information given must be correct.

There are some frauds committed by stockbrokers which include unfair investment advice, high

lucrative investment banking fees, certain issuers and suggests customers according to that bias

instead of current results; contradictory investment advice is when a broker gives contradicting

advice to different customers and acquires or sells securities in his/her account before completing

the same deals for clients; among others.

A stockbrokerage firm may also perform the functions of an investment bank .Their role at the

NSE include:
 39

1. When transactions occur at the stock market funds are normally exchanged, to effect this

the stockbrokers aid their clients to execute the transaction.

2. Stock broking.

3. Bond trading.

4. Commercial paper placing.

5. Company and market research.

6. Corporate finance advisory.

7. Investment advisory.

8. Public offering of shares and bonds

9. Privatization

10. IPO’s

Initial Public Offering (IPO) is whereby the shares of a company are issued to the public for the

first time. This is when the company wants to raise capital by selling its shares. There are many

decisions that have to be made before engaging in it. They include:

The amount to be raised in the process: this is basically the capital that the company wants to

raise so as to finance its activities.

The type of securities to be issued to the public: At this stage the company considers the best

security to offer for example bonds, bills or other innovative types which may include various

combinations of securities usually called exotic securities. The choice of security and method of

sell are very vital and thus stock brokers need to advice clients accordingly.
 40

Competitive bids versus a Negotiated deal: The Company is faced with a number of challenges

whether it should offer a block of securities for sale to the highest bidder? Or should it negotiate

a deal with the stockbroker? Competitive bids normally are used by large well-known firms

whiles negotiated deals are used by small firms.

Selection of a leading stock broker firm: at this point the company must decide on the stock

broker firm to use in raising the needed capital and it tends to have other implications on the

success of the IPO process. Reputable investment banks target more established firms whiles

other investment banks are good at speculative issues or new firms going public.

2.4.0 INVESTMENT BANKS

2.4.1 INTRODUCTION

Investment banks53 are non-deposit taking institutions that advise on offers of securities to the

general public or a section of the public, corporate financial restructuring, takeovers, mergers,

privatization of companies, underwriting of securities, etc. They can also engage in the business

of a stockbroker, a dealer, and fund manager of collective investment schemes and provider of

contractual portfolio management services.

Investment banks work with companies, governments, and institutional investors etc to raise

capital and provide investment advice. Investment banking means the underwriting, distribution

of securities, helping companies design deals and the securities to finance them, and then use

53
Joshua Abor: The role of Investment Banks in raising capital in Ghana .Available at <http://www.financialanalyst
.org./The role of Investment Banks in raising capital in Ghana. PDF> . Accessed on 20th November 2011/ 10 am.
 41

their brokerage arms to sell the securities to the investing public, both retail and institutional. The

investment banking industry plays a very important role in economic development of a country.

2.4.2 ROLE OF INVESTMENT BANKS

Investment banks play54 very important role in the countries development in respect of

investment advice ant the actual realization of the investment transaction and all necessary

assistance.

Firstly it brings together entities in search of capital and investors who have the money and want

to invest, usually institutional investors.

Secondly, investment banking industry plays an important intermediation function in all market

economies.

Thirdly, using the information they have on the industry sector, they help with the identification

of potential targets which meet the commercial needs of their clients. They thus advice the

company on the best way to go so as to meet its goal.

Fourthly, they help in coordinating the work of the other advisers involved in the transaction eg

those who prepare the documentation for the acquisition and effecting them; financial experts

who advise on the financial reporting aspects of the transaction, and tax consequences; brokers,

who advise on shareholder aspects and how the market as a whole is likely to receive the

transaction.

54
Ibid
 42

Investment banks carry on several cross-cutting functions by advising corporations on how to

issue and fulfill their objectives. They achieve these functions in 3 main ways:

a) Origination.

b) Underwriting.

c) Distribution of stock.

Origination; this is basically the provision of investment advice, information and assistance in

preparation and disclosure of relevant documents. It may pertain M and A

Mergers and Acquisitions

This is whereby the client company seeking the investment banks advice wants to expand by

acquiring another business. This is because of various reasons: Firstly, the company may want to

improve the types of products that it produces so as to have market monopoly in the production

of those products. This gives the company more power over those products.

Secondly, the company may seek M and A so as to bar its competitor from acquiring the

business in question. This is basically to prevent competition and enhance the companies’ power

and monopoly.

Thirdly, the company in question may seek M and A so as to complement existing products that

it produces. This will increase the range of products it produces because they will be marketed

under one name.

Fourthly, the company may seek M and A so as to increase its business' geographical boundaries

and cover a wide area. This is in the company’s quest to increase in size and productivity.
 43

Fifthly, the integration may seek to increase the monopoly of the company in terms of acquiring

supply of raw materials or customers and thus increase the company’s profitability.

Underwriting: This is the process whereby the Investment Bank guaranties that all the stocks

that have been issued will be bought at the stock market and if not it will then take them up and

pay the issuing company on the basis of the unsold stocks. There are two important ways of

effecting this, the firm commitment of the investment bank and the commitment of the

investment bank to honor the underwriting agreement.

The commitment agreement requires the investment bank to fully guaranty that it will shoulder

all the risks that may arise in the issue of shares. Secondly, the best efforts agreement absolves

the investment bank from any risks in the issue. Due to this underwriting agreement, the

investment bank guarantees to help sell at least a minimum amount of the shares with any unsold

amounts returned to the issuing firm. Where the investment bank is not able to sell the minimum

quantity agreed upon, the whole issue is cancelled and reissued when the market is ready to

accommodate the issue.

Distribution: This is the spreading of issues to a wide range of shareholders that is the issuing

firm aims to reach as many investors as possible with its security. It plays a very crucial role in

that the issuing firm assumes the responsibility of issuing the securities of the specific company.

2.4.3 .REGULATION OF INVESTMENT BANKS AND STOCKBROKERS BY KENYA

ASSOCIATION OF STOCKBROKERS AND INVESTMENT BANKS AND THE CMA.

2.4.3.1 REGULATION UNDER KASIB

 44

The KASIB55 is an association that represents the interests of Kenyan stockbrokerage and

investment banking companies. The members are governed by a code of ethics intended to safe

guard the investment service providers at the securities market, by ensuring professionalism,

high ethical standards and fair play while carrying out their professional activities. The

paramount objective of the Code is to promote and uphold good business conduct, ethics,

professionalism, transparency and discipline amongst members of KASIB at all times in order

to ensure provision of quality professional investment services to both local and foreign

investors. .

At the beginning it was founded as an Association of Kenya Stockbrokers (AKS) but later

changed its name to KASIB in order to accommodate the interests and aspirations of investment

banks that also operate as stockbrokers.

They have seats at the NSE and are holders of their respective licenses as investment banks and

stockbrokers from the Capital Markets Authority which is the industry regulator. KASIB was

established with the aim of upholding good practice and promoting high professional standards

in the Kenyan stockbrokerage industry. This is through constant consultations with stakeholders

and by continuously assessing avenues through which the industry can be strengthened and by so

doing accelerate the growth of our stock market. KASIB also brings perspective and clarity to

the industry's complex issues for the purpose of encouraging the investing public to engage more

in the stock market. KASIB plays an important role in ensuring that the grievances and

aspirations of its members are addressed by facilitating forums and consultative meetings

through which solutions can be found.

55
KASIB, .Brief History on KASIB 2009.Available at<http://www.kasib.co.ke/aboutus.php> .Accessed on 23rd
March 2012/11 am
 45

2.4.3.2 REGULATION OF INVESTMENT BANKS AND STOCKBROKERS BY THE

CMA.

Licensing

The CMA provides for their regulation mainly licensing and disciplinary action .This is reflected

in the Act in that for a person to carry on business as a stockbroker, investment adviser, fund

manager, investment bank, authorized securities dealer or hold himself out as carrying on such a

business such a person must have a license 56. This aims at eradicating rogue intermediaries and

licensing genuine ones who comply with all requirements of the Authority57.

An intermediary can apply for the renewal of a license within three months but not later than one

month prior to the expiry of the license and may be required to supply further information as the

authority considers necessary in relation to the application 58 but the Authority may refuse to

grant or renew a license but for it to do so, it must first afford the applicant or holder of a license

an opportunity of being heard.

Disciplinary action

Where the Authority is satisfied that a licensed person : Acted in contravention of any provision

of this Act or any rules or regulations made there under since the grant of a license, ceased to
56
The Capital Market Act Cap 485A s 23. (1)provides that no person shall carry on business as a stockbroker,
dealer, investment adviser, fund manager, investment bank, authorized securities dealer, authorized depository, or
hold himself out as carrying on such a business unless he holds a valid license issued under this Act or under the
authority of this Act.
57
Section 23(2) provides that person shall carry on or hold himself out as carrying on business as a securities
exchange registered venture capital company, collective investment scheme, central depository or credit rating
agency unless he is approved as such by the Authority.
58
Section 24. (1) provides that an application for a license or for the renewal of a license shall be made to the
Authority in the prescribed form and shall be accompanied by the prescribed fee and in the case of an application for
the renewal of a license, may be made within three months but not later than one month prior to the expiry of the
license.
 46

qualify for such a license or is guilty of malpractice or irregularity in the management of his

affairs59, the Authority may take disciplinary action against that person so as to correct the

conditions resulting from any contravention of any provisions of this Act or any rules or

regulations made and to come into compliance with the provisions of the Act or any rules or

regulations made suspend or impose, restrictions or limitations on the license granted to the

person60 additionally the Authority may impose sanctions or levy financial penalties for the

breach of any provisions of the Act 61 such as.

(i) a public reprimand;

(ii) Suspension in the trading of a listed company’s securities for a specified period;

(iii) Suspension of a licensed person from trading for a specified period;

(iv) Restriction on the use of a license;

(v) Recovery from such person of an amount equivalent to two times the amount of the

benefit accruing to such person by virtue of the breach;

(vi) The levying of financial penalties in such amounts as may be prescribed;

(vii) Revocation of the license of such person;

59
The Capital Market Act Cap 485A s 25(4) provides that where the Authority is satisfied that a licensed person
has -
(a) acted in contravention of any provision of this Act, or any rules or regulations made there under; or
(b) has since the grant of a license, ceased to qualify for such a license; or
(c) is guilty of malpractice or irregularity in the management of his affairs,
60
Section 24 (3) the Authority may -
(i) direct the person to take whatever action the Authority deems necessary -
(A) to correct the conditions resulting from any
contravention of any provisions of this Act or any rules or regulations made there under; and
(B)to come into compliance with the provisions of this Act or any rules or regulations made there under; or
(ii) suspend or impose, restrictions or limitations on the license granted to the person.
61
See section 25A
 47

CHAPTER THREE

DEMUTUALIZATION

3.0 DEFINITION

Traditionally, the stock markets have been mutual organizations owned by its members and

operated on a not-for-profit basis in that any profits made by the stock exchange are returned to

members. There are differences in the manner in which stock exchanges are operated and

regulated. They differ in terms of the role of the board and the staff of the exchange, the powers

of the chief executive and chairman and the composition and powers of exchange committees.
 48

Exchanges have a variety of voting structures and the balance of power between different users

varies among them as well.

There are different ways in which external bodies and public interest representatives are able to

influence the policies of the exchange. Legal and regulatory frameworks vary considerably, as

does the degree of oversight of exchanges by government or their designated regulatory

authorities. Membership may be open to any persons who satisfy stipulated requirements or it

may be closed. If membership of an exchange is acquired through seats on the exchange, the

seats are usually not freely transferable

Perhaps the most distinguishing feature of the traditional stock exchange structure is its

cooperative governance model; the close identity between ownership of the organization and the

direct use of its trading services. The owners of the mutual enterprise are also its customers.

Owner/customers may share in the net gains of the enterprise in proportion to their ownership

interest. Decisions are usually made democratically, on a one member, one vote basis and often

are made by committees of representatives of member firms.

The ability to influence the decisions of the exchange is thereby separated from the level of

economic interest a member has in the exchange. Ownership rights may not be freely tradable or

exchangeable and on cessation of membership, those rights are forfeited. Because the

Organization’s constituting documents may adopt a non-profit objective and prohibit the

distribution of surpluses, mutually owned exchanges are seldom able to raise capital from anyone

other than their members.

 49

In contrast, demutualized organizations are organized as corporations with share capital in which

the owners, principal decision-makers and customers are three separate groups. Decision-making

power is vested in a board of directors who are subject to election and removal by shareholders

and this power is exercised on a day-to-day basis by the management of the corporation. The

voting rights of shareholders usually are proportionate to their economic interest in the

corporation: one share, one vote. Ownership rights are distinct from trading privileges. For-profit

corporations may raise new capital from a variety of sources62.

As has been discussed above it can be thus concluded that demutualization is literally the process

of changing an organization from its mutual ownership structure (only a members club) to a

share ownership structure that is open to the general public. The process entails first converting

memberships into shares which step may or may not be followed by a public issue of those or

treasury shares.

3.1 IMPORTANCE OF DEMUTUALIZATION

Demutualization of the Nairobi Securities Exchange has many advantages that cuts across all

sectors of the society.

3.1.1 PROMOTE INVESTOR PARTICIPATION

62
Sam Mensah,Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January
 50

Firstly, demutualization of the Securities Market will promote investor participation 63 at the

market by a wide angle in that the separation of trading rights from ownership may be politically,

economically and socially important in attracting investors.

Politically, the management of a mutual securities exchange can be easily manipulated by

legislation, in some developing countries if the exchanges enjoyed a legal or decreed national

monopoly, government-appointed officials and stakeholder representatives were often

represented on the board. While in the short-run such appointments may have proved conducive

to mitigating entrenched vested interests, this will thus negatively affect the exchange and at the

long-run these can prove counter productive leading to unhealthy government interference. With

demutualization the public will participate in the day to day affairs of the exchange thus avoid

manipulation by the government and the affairs of the exchange will be made public during

general meetings64.

In the social angle, due to the many advantages that come with demutualization the members of

the general public will be attracted to invest at the securities market thus promoting investor

confidence.

Economically, demutualization brings with it many advantages that cut across the society in

general. A financial sector that is properly reformed and managed will attract investors that is

both local and foreign, this will in turn lead to more people investing their extra money in the

securities exchange thus promoting economic development of the state and thus lead to improved

living standards of its citizens.

63
Sam Mensah Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January
64
Charles Amo Yartey and Charles Komla Adjasi Demutualization: Promoting Stock Market Development In
Africa 2007 Available in <http://www.evancarmicheal.com/Africa-Accounts/1667/vii-B.htm>. Accessed 1st
March 2012/1:00pm
 51

Further, stock exchange that is a mutual associations of traders and brokers only allow members

the exclusive rights of access to trading systems and platforms. Under this mutual structure,

exchanges enjoyed quasi or full monopoly on trading and they derived profits from the

intermediation of nonmember transactions. Since members under the mutual structure were

owners of the exchange, they imposed rights to trading and disallowed direct access to the

trading floor to any outsiders. Brokers inadvertently resisted changes if these entailed additional

costs, loss of revenue or competitive threat. This resistance eventually impeded the ability of the

company to react quickly to a rapidly changing market environment This position is greatly

altered by demutualization in that the public will be allowed to participate in the management of

day to day thus bringing in changes that will lead to investor confidence and participation at the

securities market.

Secondly, demutualization leads to improved governance 65 this is particularly because with it

comes a different governance structure66 in which all the parties and in particular the external

shareholders are to be represented in the board of directors thus participate in its management

and thus gain knowledge of the securities exchange. This will make decision making be faster

and easy and respond quickly and decisively to the changes in the market this will additionally

make the demutualized exchange to be answerable to their shareholders.

65
Sam Mensah, Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January
66
Shamshad Akhtar, Demutualization of Stock Exchange: Problems, Solutions and Case study (Ed, 2003) Asia:
Asian Development Bank.
 52

Thirdly, a demutualized securities exchange enables the management to make decisions67 and

take actions that are in the best interest of the customers and the exchange itself. Strategic

decisions will also be made by the management in a much more efficient manner

Fourthly, with demutualization there will be clear separation of ownership and trading rights this

will lead to greater independence from its members thus proper regulation. The ownership

interest will thus be aligned with those of the exchange.

3.1.2 COMPETITION

Due to the technological advancement and in particular the use of Alternative Trading Systems

(ATS) and the Electronic Communication Networks (ECN) this have allowed efficient and

effective matching of buying and selling orders of customers while offering transparency 68,

trader anonymity and extended trading hours this in turn promote competition at the securities

exchange in addition electronic trading leads to participation of both local and foreign investors.

This electronic trading also leads to proper time management because brokers don’t have to be

physically present at the trading floor and also lead to faster conclusion of transactions.

3.1.3 UNLOCKING STOCK EXCHANGE VALUE

Demutualization creates the opportunity to unlock the value of a stock exchange through the

realization of the value by the listing of the exchange. In a majority of exchanges, the value of

the exchange is usually distributed to member brokers. Demutualization and the listing provide

an exit mechanism for the brokers to sell down equity thereby broaden the shareholders vase and

decoupling of broker interest from that of the exchange.

67
Sam Mensah, Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January.
68
Gary S. Lesser, Roth IRA Answer Book, (6th Ed 2009). New York: Aspen Publishers.
 53

3.1.4 GLOBALIZATION AND CONSOLIDATION

Traditionally exchanges did not encounter meaningful competition from exchanges in distant

places. National exchanges developed when the telegraph and telephone made it easier to deal on

a distant exchange. Modern telecommunications have enabled issuers and investors to access

foreign capital markets with ease69. As nationality has become less of a defining characteristic of

capital markets, global centres have grown in importance, and the relevance of national

exchanges has been challenged.

Strategic alliances and consolidations are also affecting capital markets and exchanges globally.

Mergers among stock and derivative exchanges promote competitive landscape and create super-

exchanges. The merger of NASDAQ and the American Stock Exchange (Amex) for instance,

created an exchange with a market capitalization of US$1.9 trillion offering an unprecedented

variety of products. These alliances are motivated by a variety of factors. Scale is increasingly

important, particularly in leveraging technology costs and other investment opportunities.

Through alliances, exchanges seek to attract more investors by harmonizing distinct trading

environments and by offering greater product variety.

3.1.5 RESOURCES FOR CAPITAL INVESTMENT.

A competitive stock exchange must be able to respond quickly to global competitive forces and

technological advances. With the capital raised from an Initial Public Offer (IPO) or private

investment and a heightened awareness of accountability to stakeholders 70, a stock exchange

69
Shamshad Akhtar, Demutualization of Stock Exchanges : Problems, Solutions and Case study (Ed, 2003) Asia:
Asian Development Bank.
70
Gary S. Lesser, Roth IRA Answer Book, (6th Ed 2009). New York: Aspen Publishers.
 54

should have both the incentive and the resources to invest in the competitiveness of its

information systems. To be competitive, products and services must not only be timely and cost-

effective, but also reliable. One of the drivers of stock exchange demutualization is screen

trading, which has replaced floor trading on most exchanges. Once customers have direct access

to screens, exchange memberships no longer have as much economic value and clearing firms

rather than traders become a dominant force in exchange activities. Also, the move from floors to

screens has required considerable capital investment.

Demutualization offers an opportunity to buy out trader interests since they are no longer

necessary and shift power to other firms, while raising capital for continued modernization of

trading information systems71.

3.2 THE IMPLICATIONS OF DEMUTUALIZATION

As has been clearly discussed above, the transformation of a stock exchange from being a mutual

association to Demutualized association comes with some implications that will be discussed

below.

This transformation of exchanges from mutual to demutualized structure involves two key

features:

(a) Change in the ownership structure.

(b) Change in legal as well as organizational form.

(c) Management

(d) Membership and decision making

71
Sam Mensah , Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January
 55

(e) Regulation

3.2.1 OWNERSHIP STRUCTURE

Traditionally, the ownership structure of the stock exchange was a mutually held organization

whereby members were privileged to enjoy rights of ownership but with demutualization coming

in and in turn leads to the transformation of the organization from being a mutual member-based

to demutualized exchange and involves issues of transferability of ownership from members to

nonmembers thus better governance72.

As a result of this there is need of conversion of existing member seats by monetizing these and

assigning a certain value per seat. Once this is done, the members can opt to convert their

membership to share ownership or to sell off their interest to nonmembers or the members may

opt to retain their share ownership. This secures the company from bankruptcy since the share

holders would come in to pay the debt as per the shares the hold. In Macaura vs North

Assurance Com ltd73court stated that the plaintiff wasn’t eligible for compensation but the

company. This is because the plaintiff had incorporated the company yet he was its founder.

A listing of the shares in the exchange facilitates the unlocking of the members' equity and buy

out of the interest of the traders, while leading to the monetization of the value of the members'

seats this implies that the then allows the free transfer of shares, rather than membership rights.

To avoid stock exchanges operating in special or limited interest securities regulators are often

72
Charles Amo Yartey and Charles Komla Adjasi Demutualization: Promoting Stock Market Development In
Africa 2007 Available in <http://www.evancarmicheal.com/Africa-Accounts/1667/vii-B.htm>. Accessed 1st
March 2012/1:00pm
73
(1925) A.C 619
 56

forced to place restriction on ownership by one holder or a group of holders. This limit on

ownership stakes could affect potential take-over by other exchanges.

As has been seen above its clear that with demutualization the ownership of the organization

moves from only a selected few to a company limited by shares with one vote per share and in

turn a majority decision making with the separation of trading rights from ownership

3.2.2 LEGAL AND COMPANY STRUCTURE

Most stock exchanges are registered as private limited companies with a paid-up capital base,

while others operate as member associations or cooperative arrangements. This means that most

of the exchanges are legal entities registered as private limited companies.

The legal and company structure for the demutualized exchange is based on considerations

similar to that for any profit-making company including decisions on number of shareholders,

voting procedures, limitation of liability to the number of shares one has, accounting and

reporting requirements and distribution of dividends to the existing shareholders74.

3.2.3 MANAGEMENT

Demutualization leads to improved management75 of the stock exchange and as had been

discussed above this is particularly because there comes into play a different management

structure in which all the parties and in particular the external shareholders are to be represented
74
Ibid.
75
Charles Amo Yartey and Charles Komla Adjasi Demutualization: Promoting Stock Market Development In
Africa 2007 Available in <http://www.evancarmicheal.com/Africa-Accounts/1667/vii-B.htm>. Accessed 1st
March 2012/1:00pm
 57

in the board of directors thus participate in its management. This will make decision making be

faster and easy and respond quickly and decisively to the changes in the market and additionally

make the demutualized exchange to be answerable to their shareholders.

3.2.4 MEMBERSHIP AND DECISION MAKING

As had been discussed at the introduction to demutualization, traditionally, the stock markets

have been mutual organizations owned by its members and operated on a not-for-profit basis in

that any profits made by the stock exchange are returned to members but with demutualization

the outside shareholders are thus represented in the board of directors and participate in decision

making76.

There are different ways in which external bodies and public interest representatives are able to

influence the policies of the exchange. Legal and regulatory frameworks vary considerably, as

does the degree of oversight of exchanges by government or their designated regulator

authorities. Membership may be open to any persons who satisfy stipulated requirements or it

may be closed. If membership of an exchange is acquired through seats on the exchange, the

seats are usually not freely transferable.

3.2.5 REGULATIONS

Demutualization raises many issues that concern the regulation of the organization at large and

should be noted that a demutualized exchange will to perform its regulatory duty, establish a

separate regulatory body or it can out source its regulation to a third party this will guard against

conflict of interest but this raises many issues and the major one is the role of the government in

76
Sam Mensah,Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January
 58

regulating private stock exchanges?77. Stock exchanges normally operate as self-regulatory

organizations in trading, market manipulation and membership.

Trading: with respect to trading the organization usually sets rules for trading and mechanisms

to effect the enforcement of the rules.

Membership: The organization has to establish rules that guard and govern the conduct of

members and monitor compliance with the laid down rules and regulations.

Market manipulation: The organization usually carry out surveillance of the trading systems to

avoid negative detrimental actions that will negatively affect the organization and also to avoid

abuse.

3.3 CHALLENGES AND OPPORTUNITIES FACING THE STOCK MARKET

The performance and success of stock markets all over the world both in developed and

developing countries but mostly the developing countries is faced with some impeding factors as

was discussed by Sam Mensah78.

The limitations include:

(a) The Macroeconomic setting

(b) Regulatory Framework

(c) Market Infrastructure

(d) The Human Resource Base

77
Ibid.
78
Sam Mensah, Demutualizing African Stock Exchanges :Challenges and Opportunities:
Cairo,Egypt:9th Annual Conference of the Stock Exchanges Association,2005 Available at
<http:www.filestudy.com/Demutualizing-African-Stock-Exchanges-Challenges-and-
Opportunies-DOC.html> Accessed on 12th January
 59

(e) The Investor Base

3.3.1 THE MACROECONOMIC SETTING

Many economies of the world are characterized by macroeconomic instability this in turn

undermine investor and issuer confidence thus dampening the business flow to stock exchange.

This is basically brought due to high fiscal deficits, inflation and fast depreciating exchange rate

and high interest rates at the market79.

3.3.2 REGULATORY FRAMEWORK

This is brought about due to lack of robust regulatory framework not because of lack of proper

laws, rules and a regulatory agency but the shortage of experienced supervisors and the absence

of a strong culture favoring compliance with the laid down regulatory framework and its proper

implementation.

3.3.3 MARKET INFRASTRUCTURE

Some stock markets are small thus have minimal or unavailable resources for the acquisition of

key infrastructure80 needed for market operations this is basically both technology and norms.

This affects the markets that lack the capital and thus can’t be at par with the developed stock

markets.

3.3.4 THE HUMAN RESOURCE BASE

79
Ibid.
80
Ibid.
 60

With respect to demutualization, the exchanges require better sound management and proper

decision making but due to the lack of experts in this field in some countries, the stock market

faces many challenges81.

3.3.5 THE INVESTOR BASE

Some stock markets are characterized by a small number of investor base thus lack of sufficient

capital, investments or savings to finance the development of the market82.

3.4 ADVANTAGES OF INCORPORATION.

The incorporation of the NSE would make it a limited liability company 83. The liability of a

shareholder would be limited to the value of shares one owns.

The advantages of incorporation are:

1. Limited liability.

2. Holding property: A company is a separate legal entity and can hold property on its own

name.

3. Perpetual succession: They would continue to exist as intended by the law and the

dependents step into the shoes of their guardians.

4. Transfer of shares: The shares or rights of any member can be easily moveable provided

by the Articles of the company84.

5. Borrowing facilities: A company can borrow money easily as compared to an individual.

This is because a company can create a floating charge over any property of the

company.
81
Ibid.
82
Ibid.
83
The Companies Act Cap 486 s 4 (2) (a).
84
The Companies Act Cap 486 s 70.
 61

6. Suing and being sued: A company can sue or be sued under its own name85.

7. Legal personality: his is a fundamental attribute of incorporation and all the other

advantages flow from it. A company is regarded as a legal person distinct and separate

from others and capable of enjoying rights and duties.

CHAPTER FOUR

DEMUTUALIZATION TO PROMOTE INVESTOR CONFIDENCE

4.0 INTRODUCTION

Demutualization is expected to solve mutual structure problems by opening up trading rights,

admitting new trading partners, and broadening ownership such that the public can invest in

exchanges. The absence of these in mutual exchanges tends to breed poor governance structures.

In a mutualized exchange, traders and brokers enjoy monopoly power through exclusive rights

and access to trading systems, resulting in a protection of vested interests for traders. In a

demutualized exchange there is a vote per share and once incentives for equity stakes to

nonmembers exists there is separation of powers. Decision making is on ownership structure not

trades intermediation. Thus, demutualization induces better corporate governance systems. In

addition, undue governmental influence in mutual exchanges in Africa is likely to be absent in

85
The Companies Act Cap 486 s 16.
 62

demutualized exchanges since appointment of government officials become unnecessary due to

the fact that a demutualized exchange is a private company86.

The demutualization of the NSE will promote investor confidence to invest their money in

various ways and in turn lead to the economic growth of the state. It gauges the optimism of an

economy or a securities market. Positive investor confidence is theoretically a good sign for

stock prices in that if consumers are more confident, they will buy more shares, and company

sales and profits will rise87.

Nairobi Securities Exchange has witnessed the devastating effects of rogue stockbrokers’ such as

Nyaga Stockbrokers, Francis Thuo Stockbrokerage firms and Discount Securities ltd though the

Capital Market Act, the Capital Market Authority Board and other players were in place. When

Francis Thuo brokerage firm was suspended, several complaints were raised to the Capital

Market Authority board about Nyaga Stockbrokers when it was evident that their operational

capital was on the negative but made gains from illegal trade in clients’ shares to prop up their

operational capital but nothing was done to address the complaints. The perpetrators had their

way and haven’t been charged in a court of law thus destroying investor confidence.

Lack of openness in mutual exchanges destroys the saving culture among Kenyans this is why

there is a need for demutualization and proper regulation of its activities, with severe punishment

of non-compliant members and particularly the withdrawal of their practicing license and

payment of fines.

86
Charles Amo Yartey and Charles Komla Adjasi Demutualization: Promoting Stock Market Development In Africa
2007 Available in <http://www.evancarmicheal.com/Africa-Accounts/1667/vii-B.htm>. Accessed 1st March
2012/1:00pm
87
Investor Glossary, Confidence Indicator2004,.<http://www.investorglossary.com/confidence-indicator
htm>.assessed on 1st March 2012
 63

4.1 HOW DEMUTUALIZATION WILL PROMOTE INVESTOR CONFIDENCE

Demutualization will promote investor confidence in various ways:

Firstly, with demutualization the public will participate in the day to day affairs of the exchange

thus avoid manipulation by the government and the affairs of the exchange will be made public

during general meetings. This is basically because with demutualization, there will be a clear

separation of ownership from trading rights at the securities market88.

Secondly, a stock exchange that is a mutual association only allows members the exclusive rights

of access to trading systems and platforms. Under this mutual structure, exchanges enjoyed

quasi or full monopoly on trading and they derived profits from the intermediation of

nonmember transactions. Since members under the mutual structure were owners of the

exchange, they imposed rights to trading and disallowed direct access to the trading floor to any

outsiders. This impeded the ability of the company to react quickly to a rapidly changing market

environment but this will be altered by demutualization in that the public will be allowed to

participate in the management of day to day thus bringing in changes that will lead to investor

confidence and participation at the securities market89.

88
Charles Amo Yartey and Charles Komla Adjasi Demutualization: Promoting Stock Market Development In
Africa 2007 Available in <http://www.evancarmicheal.com/Africa-Accounts/1667/vii-B.htm>. Accessed 1st
March 2012/1:00pm
89
Sam Mensah, Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th
Annual Conference of the Stock Exchanges Association,2005 Available at
<http:www.filestudy.com/Demutualizing-African-Stock-Exchanges-Challenges-and-Opportunies-
DOC.html> Accessed on 12th January
 64

Thirdly, demutualization leads to improved governance90 particularly because with it comes a

governance structure in which all the parties and in particular the foreign and local shareholders

are to be represented in the board of directors thus participate in its management. This will make

decision making be faster, easy and respond quickly and decisively to the changes in the market.

Additionally, due to the separation of trading rights from ownership, the appointed managers will

be answerable to the shareholders and the general public and in turn promote investor

confidence.

Fourthly, a demutualized securities exchange enables the management to make decisions and

take actions faster91with the best interest of the customers, the exchange and the general public.

Fifthly, with demutualization there will be clear separation of ownership and trading rights this

will lead to greater independence from its members thus proper regulation. The owners’ interest

will thus be aligned with those of the exchange.

Demutualization enhances competition due to the technological advancement and in particular

the use of Alternative Trading Systems (ATS) and the Electronic Communication Networks

(ECN) which have allowed efficient and effective buying and selling orders of customers while

offering transparency, trader anonymity and extended trading hours 92. This will in turn promote

competition at the securities exchange in addition promote the participation of both local and

foreign investors. Due to the returns and profits made the investors will be encouraged to invest

thus promote investor confidence.

90
World Bank and International Monetary Fund (2005) Financial Sector Assessment. World Bank: NewYork
91
Sam Mensah, Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January
92
Fredric . S. Mishkin and Stanley. G. Eakins (2009) “Financial Market and Institutions’’.( 8th ed )New York:
Pearson international
 65

Demutualization creates the opportunity to unlock the value of a stock exchange 93 through the

realization of the value by the listing of the exchange. In a majority of exchanges, the value of

the exchange is usually distributed to member brokers. Demutualization and the listing provide

an exit mechanism for the brokers to sell down equity thereby broaden the shareholders vase and

decoupling of broker interest from that of the exchange.

Traditionally exchanges did not encounter meaningful competition from exchanges in distant

places94. National exchanges developed when the telegraph and telephone made it easier to deal

on a distant exchange. Modern telecommunications have enabled issuers and investors to access

foreign capital markets with ease. As nationality has become less of a defining characteristic of

capital markets, global centers have grown in importance, and the relevance of national

exchanges has been challenged to be competitive and this will in turn promote investor

confidence.

Strategic alliances and consolidations are also affecting capital markets and exchanges globally.

Mergers among stock exchanges promote competition 95 and create super-exchanges e.g. the

merger of NASDAQ and the American Stock Exchange (Amex) for instance, created an

exchange with a market capitalization of US$1.9 trillion offering an unprecedented variety of

products. These alliances are motivated by a variety of factors e.g. the need to attract investors.

Through alliances, exchanges seek to attract more investors by harmonizing distinct trading

environments and by offering greater product variety.

93
Sam Mensah, Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January
94
Ibid.
95
Ibid.
 66

One of the drivers of stock exchange demutualization is screen trading, which has replaced floor

trading on most exchanges. Once customers have direct access to screens, exchange

memberships no longer have as much economic value and clearing firms rather than traders

become a dominant force in exchange activities. Also, the move from floors to screens has

required considerable capital investment.

Demutualization offers an opportunity to buy out trader interests since they are no longer

necessary and shift power to other firms, while raising capital for continued modernization of

trading information systems.

As had been discussed at the introduction to demutualization, traditionally, the stock markets

have been mutual organizations owned by its members and operated on a not-for-profit basis in

that any profits made by the stock exchange are returned to members but with demutualization

the outside shareholders are represented in the board of directors and participate in decision

making with regards to the ownership structure, members’ seats are monetized and values

assigned per seat. Members then either keep or sell shares. Ownership restrictions are placed (for

example, 5-10 percent non-controlling stakes) on individuals and groups to prevent potential

takeovers by other exchanges. The legal and organizational change normally entails the

exchange becoming a typical profit making company with limited liabilities and abiding by

company laws96.The participation of external shareholders will promote investor confidence in

that the decisions made will be made public via circulars and newspapers. Additionally foreign

96
Charles Amo Yartey and Charles Komla Adjasi Demutualization: Promoting Stock Market Development In
Africa 2007 Available in http://www.evancarmicheal.com/Africa-Accounts/1667/vii-B.htm. Accessed 1st March
2012/1:00pm
 67

investors will feel that their interests are represented and thus promote confidence in them to

invest at the NSE.

Demutualization raises issues that concern the regulation of the NSE and it should be noted that a

demutualized exchange will perform its regulatory duty, establish a separate regulatory body or it

can out source its regulation to a third party this will guard against conflict of interest 97 but this

raises many issues and the major one is the role of the government in regulating private stock

exchanges?. Undue governmental influence in mutual exchanges in Africa is likely to be absent

in demutualized exchanges since appointment of government officials become unnecessary due

to the fact that a demutualized exchange is a private company 98 . Stock exchanges normally

operate as self-regulatory organizations in trading, market manipulation and membership, with

respect to trading the organization usually sets rules for trading and mechanisms to effect the

enforcement of the rules.

Membership: The organization has to establish rules that guard and govern the conduct of

members and monitor compliance with the laid down rules and regulations. Demutualization will

make decision making public and thus lead to compliance of the rules and regulations.

Market manipulation : The organization usually carries out surveillance of the trading systems to

avoid negative detrimental actions that will negatively affect the organization and also to avoid

abuse of investors’ funds but with the public participating in management and decision making,
97
Sam Mensah Demutualizing African Stock Exchanges :Challenges and Opportunities: Cairo,Egypt:9th Annual
Conference of the Stock Exchanges Association,2005 Available at <http:www.filestudy.com/Demutualizing-
African-Stock-Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January
98
Charles Amo Yartey and Charles Komla Adjasi Demutualization: Promoting Stock Market Development In Africa
2007 Available in <http://www.evancarmicheal.com/Africa-Accounts/1667/vii-B.htm>. Accessed 1st March
2012/1:00pm
 68

manipulation will be a thing of the past. Demutualization also increases access to services of the

exchange and removes excessive investment costs for fund holders. For instance, brokers usually

package non-trade related fees (research, computer systems and IPO access) into institutional

traditional commissions often known as “soft commissions” or “bundled commissions” and pass

on to clients. With demutualization, fund holders can directly access such information without

the use of brokers99.

Risks are inevitable in any business but with demutualization the board establishes a framework

for risk management100. These risks are continuously established and managed by the relevant

department

99
Ibid
100
Greenwich Trust Limited, Demutualization of stock Exchanges. Available at
<http://www.greenwichtrustgroup.com/superadminpanel/newspaper/GreenwichweeklyReport>12022011.pdf
.Accessed on 10th February 2012.
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CHAPTER FIVE

5.0 CONCLUSION

Globally, stock markets and emerging markets have recognized the need to generate profit while

corresponding to social pressures such as demutualization so as to compete with others fairly. In

most stock markets, trading occurs in only a few listed stocks and other securities and thus

account for a considerable part of the total market capitalization.

The analysis in this dissertation shows that the demutualization of securities markets have been a

surprisingly important source of finance for funding the capital market, long term financing of

listed companies as well as the building and improvement of investor confidence.

Demutualization offers a lot of advantages in relation to the demand and growth of the financial

market thus the securities market all over the world as well as in Kenya have made important

contributions to corporate growth in the recent period and the future is more promising for

corporate world in general in general.

From this study I found that there are various ways through which the demutualization of the

NSE will promote investor confidence. This transformation of exchanges from mutual to

demutualized structure involves some key changes which include: Change in the ownership

structure, change in legal as well as organizational form and management, expanded membership
 70

to include the general public and improved decision making , this will guard against insider

trading , lastly demutualization would foster improved regulation of the NSE.

Demutualization of the NSE is not immune to limitations that must be addressed. These

limitations include: conflict of interest issues as the enforcement of regulations can prove costly

and may lead to loss of business and there is also divergence of interests between the

shareholders and the members. The Macroeconomic Setting many economies of the world

including Kenya are characterized by macroeconomic instability this in turn undermines investor

and issuer confidence thus dampening the business flow to stock exchange.

Regulatory framework: This is brought about due to lack of robust regulatory frameworks not

because of lack of proper laws, rules and a regulatory agency but the shortage of experienced

supervisors and the absence of a strong culture favoring compliance with the laid down

regulatory framework and its proper implementation.

Market infrastructure: Some stock markets are small and thus have minimal or unavailable

resources for the acquisition of key infrastructure needed for market operational growth this may

be basically both technological and legal. This affects the markets that lack the capital and thus

can’t be at par with the developed stock markets.

The Human Resource Base: With respect to demutualization, the exchanges require better

sound management and proper decision making but due to the lack of experts in this field in

some countries, the stock market faces many challenges.

The Investor Base: Some stock markets are characterized by a small number of investor base

thus lack of sufficient capital, investments or savings to finance the development of the market.
 71

The economic stability and growth, well developed banking sector, and good quality institutions

play an important role in the NSE.

5.1 RECCOMMENDATION

The demutualization of stock exchanges faces a number of challenges that need to be addressed

before they could enter a new phase of rapid economic growth due to the advantages that come

with demutualization.

Firstly, the demutualization process of the NSE ought and must take into account the

stakeholders’ interests and be implemented in a manner that is fair, credible, transparent,

equitable, neutral and supports the current economic transformation agenda of government and

the general population. This is necessary so to build and foster confidence in the exercise and

create a strong platform for consolidating the gains for global competitiveness.

Secondly, demutualization and integration should be effected under a special legislative

framework and the two should take place simultaneously because they play a big role in

catalyzing and promoting investor confidence.

Thirdly, no person should be allowed to own either directly or indirectly more than 5% of the

holding shares with or without approval except the government. This is aimed at avoiding

monopoly issues that may be an impediment to the enhancement of investor confidence.

Fourthly, the employment of qualified expert should be on strict merit basis as a measure to

strengthen and improve governance of the NSE and to ensure that market operations are

conducted with a high level of transparency, and in accordance with the highest global standards.
 72

Fifthly, demutualization of securities exchange has the positive potential to fast-track the

development of the exchange and deepen the capital market, improve its corporate governance

and competitiveness, demutualization cannot in itself serve as the magic pill for all operational

lapses in an exchange therefore the right expert should be employed to run the NSE.

Sixthly, there is need integration of stock markets in East Africa. Regionalization of stock

Exchanges in East Africa would address the problem of low liquidity. This would be possible

through the harmonization of relevant trade legislations and the cooperation of the community

states.

Seventhly, the most critical issue is the need to eliminate existing impediments to institutional

development. These includes a wider dissemination of information and education of the public

on these markets, the implementation of a robust and up to date electronic trading systems, and

the adoption of central safe depository systems. This would enhance investor confidence.

Eighthly, there is need for proper accounting frameworks, private sector credit evaluation, and

public sector regulatory oversight so as to promote investor confidence.

 73

BIBILIOGRAPHY

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Shamshad Akhtar. (2003): Demutualization of Stock Exchanges: Problems, Solutions and Case
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 74

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<http://www.greenwichtrustgroup.com/superadminpanel/newspaper/Greenwichweekly
Report>12022011pdf. Accessed on 10th February 2012.
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 75

6. KASIB, Brief History on KASIB 2009,. Available at<

http://www.kasib.co.ke/aboutus.php> .Accesse on 23rd March 2012/11 am.

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10 Sam Mensah Demutualizing African Stock Exchanges: Challenges and

Opportunities:Cairo,Egypt:9th Annual Conference of the Stock Exchanges
Association,2005 Available at <http:www.filestudy.com/Demutualizing-African-Stock-
Exchanges-Challenges-and-Opportunies-DOC.html> Accessed on 12th January.

11 The CMA Hand Book “The Organizational setup of the CMA” Available on <http://
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