INTRODUCTION
Lithuania’s securities market originated in 1993 with the adoption of regulatory acts of law and the establishment of agencies essential for the functioning of the market. Market capitalisation and turnover have since risen, as have the number of financial intermediaries. With the bourse trading system and its legal basis undergoing constant improvements, the market increasingly attracts the interest of local and foreign investors.
However, companies still have great difficulty raising funds through securities issues, while most ventures find it altogether impossible. On the other hand, investors are very limited in their choices: six stocks are listed on the blue-chip Official List and 47 issues on the Current List of the National Stock Exchange. The main problems of the capital market stem from the absence of institutional investors, petty regulatory constraints on market participants (investors, issuers and traders) and a state policy impeding market development. The current analysis addresses the most pressing problems of the national securities market and proposes ways of solving them.
The problems analysed in this study are divided into two categories – general and specific. The general problems arise from the fiscal, monetary, privatisation, social security and healthcare policies pursued by the state. The special problems originate within the securities market and are caused by the regulation and taxation of market participants’ operations. In this study, the special problems are categorised according to their effect on market participants – issuers, financial intermediaries and investors. The influence of the general economic situation in the country on capital market development is not analysed, as a solution to the problems raised in the analysis would speed up capital market development irrespective of the state of the national economy.
GENERAL PROBLEMS
State fiscal policy
Lithuania’s fiscal policy is based on an ill-defined role of the state, flawed principles of budget formation, revenue and expenditure imbalance, and a state financial system segmented into separate monetary funds. These features make the national fiscal policy less transparent, encourage tax hikes and increase the state’s borrowing needs.
The current fiscal policy heightens the risk of capital market investments, makes the country less investment-attractive, and increases borrowing costs. Because the treasuries market is so appealing, due to its profitability and safety, it absorbs investor capital, essentially diverting investment flows away from the private sector securities market.
The government has embarked on budget and tax reforms as well as spending cuts in order to restructure the financial system, but the pace and extent of the changes is insufficient.
A fast-track, comprehensive reform of the national financial system would help create more favourable conditions for the development of the capital market and the national economy as a whole. To achieve this goal, it is necessary to revise the functions of the state in favour of the private sector where the latter is capable of performing these functions. It is also essential to eliminate flaws in budget formation without delay, consolidate the state monetary funds into a single fund approved through legislation, adopt laws setting limits on the rate and volume of borrowing in proportion to GDP, and to form a state revision fund to ensure compliance with the commitments undertaken.
These measures would increase the transparency and openness of the state financial system, reduce the state’s need to borrow, and boost investor confidence in state finances and, consequently, the capital market. As a result, borrowing costs would drop, making it easier for companies to tap into the securities market.
State monetary policy
Seeking to integrate with the European Union and the European Monetary Union, Lithuania will have to repeg its national currency, the litas, from the US dollar to the common European currency, the euro. The Bank of Lithuania has announced that the litas will be pegged to the euro no earlier than mid-2001. It will be pegged to the euro at whatever rate is valid on that day. . In addition, a memorandum between the government and the International Monetary Fund stipulates that no changes will be made in the existing currency board arrangement as long as the memorandum is in force. However, rising speculation about possible litas devaluation indicates that these safeguards are inadequate. Uncertainty undermines the potential of both state and private sector entities to borrow in the national currency.This uncertainty also increases investment risks and borrowing costs. The situation would become more certain if the Litas Credibility Law provided a timetable for the repegging of the litas to the euro and set a rate of exchange that would be in force after the peg is implemented. This would cause speculation to subside, facilitating corporate debenture issues in the national currency and reducing borrowing costs.
State property privatisation
There are several methods of privatizing the shares of state-owned companies: public offerings on the stock exchange, public auctions, public tenders or direct negotiations. As a rule, only smaller, less attractive stakes are sold on the bourse, because privatization officials consider the other methods superior.
LFMI research shows that the privatisation of state-owned shares on the stock exchange does not require any additional material or time expenditure for setting up privatisation bodies. The bourse system ensures transparent privatisation, a wider circle of potential investors (both Lithuanian and foreign) are involved, and investors are free from any additional requirements. This privatisation method ensures the best possible results, while at the same time encouraging capital market development. Therefore, it is expedient to privatise state-held shares exclusively through the stock exchange, applying the other methods only in exceptional, clearly regulated cases.
Social security and healthcare policy
The state social security and healthcare policy is based on compulsory social and health insurance for workers and redistribution of money through state monetary funds. It is not based on any insurance principles. The existing system suffersfrom a permanent lack of funds caused by inefficient financial management, large-scale redistribution, unreasonably high state liabilities and adverse demographic trends.
The system is not viable, therefore any reforms aimed at increasing compulsory insurance premiums, expanding the base number of insured individuals, or transferring a portion of social insurance proceeds to private pension funds would amount to mere face-lifting, and would put off the solution of the problems for the foreseeable future. These problems should be tackled by making essential changes in the system, whereby social security and healthcare insurance would be carried out by private insurance companies and pension funds.
The proposed changes would boost people’s old age incomes and improve the quality of insurance services. The assets of insurance companies and pension funds would flow into the capital market, consequently reducing the likelihood of problems in the state’s financial system, minimising their repercussions for the capital market, and speeding up capital market growth.
SPECIAL PROBLEMS
Issuers
Face Value of Shares
Clause 2 of Article 32 of the Law on Corporations, as well as some EU directives, require that the issue price of shares should not be lower than their face value. At present, the market price of 40 out of the 53 issues listed on the Official and Current lists of the National Stock Exchange is lower than their face value.
The current face value of company shares was determined largely by the compulsory revaluation of capital issued in the past. But this in itself did not increase the companies’ equity. Various financial crises and the situation on the domestic and export markets have also affected the market value of shares.
At present, a company can reduce the face value of its equities and to restore the balance between their face and market value only by the amount of sustained losses. As a result, it is not possible for the company to reduce the face value of its shares in order to match the market value, or to release an equity issue if the market price of the company’s shares has dropped below the face value due to factors beyond the company’s control.
In order to restore balance between the face value of shares and their market price, and to enable companies to adjust the value of their equity to match the market, the Law on Corporations should be amended to allow a general meeting of shareholders to lower authorised capital by the difference between the book value of the company’s equity and its market price as established by independent valuators. This would make companies more flexible in positioning themselves in the changing environment. They would not longer have to look for loopholes in the law and would have better prospects for tapping into the capital market.
Shares with no face value should be allowed in the near future. This would enable companies to sell their shares at market prices without any additional effort and would simplify securities accounting in view of the growing use of such shares in the world.
Restrictions on reorganisation into private limited companies
Article 2 of the Law on Corporations stipulates that a private limited liability company cannot have more than 50 shareholders. Many companies exceeded this limited in the initial stages of privatisation and as a result had to reorganise themselves into corporations, i.e. public limited companies. The new status required them to comply with particularly extensive regulations and reporting requirements.
Reporting issuers must register their securities with the Securities Commission, provide information about their issues, make regular reports, announce essential events and provide other information to market watchdogs and the mass media. They are also subject to mandatory independent audits.
According to the data of the Lithuanian Securities Depository, a significant amount of corporations have a rather low number of shareholders, with their capital concentrated in the hands of several individuals. Most of these companies have made no public issues and have no plans of doing so in the future. Some of these corporations would prefer to go private, but are held back by their high number of shareholders. Major shareholders of such companies find it extremely difficult to buy up shares from small shareholders as the latter are unwilling to sell due to the low prices of the stocks.
The new version of the Law on Corporations stipulates an increase in the maximum number of shareholders in a private company shareholders from 50 to 100. However, the number of shareholders does not indicate whether or not a company is in fact public. The only criterion necessary is whether the company chooses to float its securities or sells them exclusively to selected investors. Thus, the increase in maximum shareholder head count cannot solve the problem. It would be appropriate to abolish the limitation altogether and to treat any company that has never made public issues as a private company.
As compared to public limited companies, the rights of the shareholders of private limited companies are more restricted, because any sale of shares must be authorised by the board of directors or, in the event of its absence, by a general meeting of shareholders. In addition, the market for these shares is very limited. Therefore, it is necessary to create a mechanism to protect small shareholders when a public limited company decides to reorganise into a private limited company. In such cases, it would be expedient to apply the procedure of an official buyout offer whereby the main shareholders are required to officially offer to buy shares from small shareholders.
The proposed changes would help reorganised companies, and save both money and time, while the (potential?) of capital market institutions could be directed towards servicing genuinely public companies and developing the market.
Settlements with the state paid in shares
Article 13 of the Law on Corporations allows companies that have no losses to settle with the state and municipal budgets in the form of shares issued specifically for that purpose. Under the law, the state must buy the equity issue at face value even when the market price of the company’s shares is below face value.
A supplement to the law, the government decision On the procedure of tax-payers’ settlements with the state (municipal) budget, funds and the budget of the state social insurance fund in the form of shares and property, envisages that this procedure “is applicable to tax-paying companies which have markets for their products as well as realistic business plans to develop their operations, preserve existing jobs and create new jobs, but which lack funds to pay taxes and fines”.
If a company has a realistic business plan, it should not face problems in issuing securities or taking bank loans. Thus, this service provided by the state does not aim to help companies meet their liabilities before the state, but rather it aims to create conditions better than those on the market. When presented with this option, companies are reluctant to make efforts to attract capital on the market. This signifies a step backwards toward state ownership which curbs the potential of the capital market.
Although this settlement option is deemed temporary under the law, there is no guarantee that its validity will not be extended indefinitely, which makes it necessary to abolish this clause without delay. This would prod companies to make better use of the resources available and successfully sell their securities on the market, giving a boost to the market itself as well.
Changes in majority vote rules
An amendment of 19 March 1998 to Article 20 of the Law on Corporations stipulates that as of 1 May 2001 decisions on company reorganisation, changes in company bylaws, increases in authorised capital and other key decisions can only be adopted at a general meeting of shareholders by a majority vote of 3/4 instead of the current 2/3.
The amendment claims to protect the interests of small shareholders better. However, large shareholders will be able to retain company control by increasing their stakes through the acquisition of publicly traded shares or portions of new equity issues, rendering the measure ineffective for all intents and purposes. Furthermore, the decision restricts the actions of large stockholders, makes them change their investment plans, causes uncertainty, increases investment risks and artificially encourages concentration of shares.
The new version of the Law on Corporations submitted to parliament no longer contains this provision. It is essential that the Seimas approve the change and that similar mistakes are not repeated in the future. This would boost investor confidence in the state and bring forward the expansion of the national capital market.
Shares of agricultural workers
Clause 37 of the Law on Corporations defines a peculiar type of equity – shares of agricultural workers. The law limits the circulation of these shares. In some companies, such shares account for up to half of authorized capital. This type of share is intended to enable producers of agricultural products to participate in the management of food processing industries. Nevertheless, the measure has failed to solve farmers’ problems. Restrictions on the circulation of agricultural workers’ shares prevent them from selling their holdings at market prices. It is necessary to abolish the category of agricultural producers’ shares and leave it up to their holders to decide at their own discretion whether they want to keep them or sell them. The new draft Law on Corporations submitted to parliament no longer contains this provision.
Disclosure requirements
According to the Regulations of the registration and circulation of securities, operating companies must publish a prospectus or memorandum in order to sell a securities issue.
Along with basic information about the company and its new issue, the prospectus or memorandum must also provide information about the company’s sales markets, competition, real estate, suppliers, staff, their salaries, etc. Much of the information required is the same information contained in regular reports and essential event announcements published in the media. These requirements do not improve the quality of information provided to investors, but they do make documentation drafting more money- and time-consuming.
In issuing securities, it should be enough to disclose basic information about the company and its issue, as well as presenting a summary of essential events that have taken place since the last regular report. While preserving the same level of security for investors, this would enable companies to reduce their issue costs, accelerate fund-raising and direct their cost and time savings towards the search for new solutions.
Financial intermediaries
The activities of financial intermediaries are regulated by the Law on Public Circulation and a series of rules set by the Securities Commission. The regulations aim to ensure that the market functions correctly and that investors’ interests are protected. However, they are stringent and detailed, requiring great accounting expenditures and restricting the freedom of transactions between financial intermediaries and their clients – so much so that some brokerages have been forced to introduce minimum commission charges for small clients or are refusing to serve them at all. The most problematic are the petty regulations regarding? order receipt and execution, delays in introducing electronic signatures, and unreasonably high requirements on initial brokerage equity.
Regulation of receipt and execution of orders
According to the Regulations of the receipt and execution of client orders approved by the Securities Commission, an investor must first conclude a contract with a financial intermediary before he is able to carry out securities transactions. The contract must carry a clear definition of the services the financial intermediary is about to provide to the client. In order to carry out multiple transactions with the same issue, the investor must send a written order to the financial intermediary, who must register the order and return a copy to the client. This must be done every time the investor wishes to complete a transaction. If the client is unable to submit an order in writing, the rules allow him to do it in some other form. But in this case, the contract must identify the individual trader who will be working with the client.
These requirements are intended to protect investors’ interests, but in fact, rather than provide protection, they restrict the operations of the investor and the financial intermediary, prolong transactions, increase transaction costs and may prevent orders from being executed on time. Relations between the investor and broker should be and are based on mutual trust. The needless formalities are making foreign investors refuse the services of Lithuanian intermediaries and turn to Estonian brokerages instead.
The petty regulation regarding the receipt and execution of orders should be abolished. Order processing requirements set out in the general provisions of various acts of law and in the professional ethics code are sufficient to provide adequate protection for investors. Meanwhile, the formalisation of contracts could be carried out in keeping with the Code of Civil Procedure. This would cut correspondence and accounting costs, reduce commissions and ensure faster services.
Electronic signature
In Lithuania, only orders concluded in writing are valid, as opposed to electronic signatures that have been introduced in many countries. Electronic signature provides a faster and more cost-effective method of concluding securities transactions via telecommunications networks and speed up the operations of financial intermediaries without compromising the security of investors.
An electronic signature bill has already been drafted. However, it has yet to be discussed in the Seimas, and additional bylaws will have to be drafted in order to implement it. The drafting of these bylaws must be sped up, and this law must be adopted and implemented immediately. These measures would make electronic trading services available sooner, and investors would be able to conclude transactions with considerable savings in both time and money.
Capital requirements
In order to protect the interests of investors and to comply with EU directives, brokerages are required to meet certain initial equity requirements. According to the Rules of initial equity requirements for brokerages approved by the Securities Commission, the initial owners’ equity of brokerages of the A, B and C categories should be not lower than 730,000, 125,000 and 50,000 ECU, respectively.
The owners’ equity requirements in the EU were established in light of the capitalisation and turnover of the Union securities market as well as the ability of EU traders to operate throughoutthe Union. The capitalisation and turnover of the Lithuanian securities market are significantly lower, therefore the application of the same requirements is irrational and unduly costly.
It is necessary to reduce the existing owner’s equity requirements and start complying with EU directives only after the Lithuanian securities market has become part of the EU market and when Lithuanian financial intermediaries are able to operate throughout the EU on an equal footing. While preserving investors’ security, this measure would open the market for new public traders, boost competition, improve the quality of services and cut costs.
Investors
Capital gains tax on inherited securities
Clause 2 of the Regulations of the calculation of capital gains income, calculation and carrying forward of losses defines capital gains as income earned from the sale of securities minus the price of their acquisition, the commission, and any acquisition-related taxes. Meanwhile, the acquisition price of inherited securities is only defined as the sum of the commission and taxes related to the assignment of ownership rights. As a result, an heir who sells inherited securities will be subject to a higher tax rate on capital gains than the former owner would have been. Consequently, the procedure of taxing capital gains makes securities investment less attractive as a long-term saving instrument and encourages greater reliance on other long-term saving instruments. When calculating the purchase price of inherited securities, the regular procedure should be applied, i.e. the purchase price should be the sum of the acquisition price, the commission and inheritance taxes.
Reinvestment of capital gains
Clause 8 of the Regulations of the calculation of capital gains income, calculation and carrying forward of losses requires that capital gains or a portion of them reinvested in other securities should be subtracted from taxable income. However, reinvestment has to take place in the same year that income is derived. This limits investors’ opportunities, because the best time to sell securities may fall, for example, on December of the current year, while the best time for reinvestment may be, for example, February the following year. It is necessary to allow one year for reinvestment of capital gains in other securities, starting from the day the capital gains were earned. In this case, tax returns should indicate that capital gains are to be invested in securities. If they are not, they would be subject to income tax for the following year.
The notion of reinvestment itself is elusive. It is not clear whether it is only capital gains that have to be reinvested or whether they can be used for consumption, making the reinvestment from other income later on. If the requirement is to invest capital gains only, then it is impossible to control this process. In the event reinvestment is made from other earnings, then it does not seem to fit the definition of reinvestment.
Expediency of the capital gains tax
The main purpose of the capital gains tax is to equalise the conditions of taxing dividends and capital gains in order to ensure the principle of tax neutrality. However, tax neutrality is impossible to achieve when numerous tax exemptions, different tax rates, etc. are in place.
Another objective of the tax is to expand the tax base. Efforts to boost budget revenues through a tax which could be avoided and entails great expenditure are irrational.
The capital gains tax not only fails to achieve its objective, it also reduces incentives to invest in securities because the procedure of calculating and filing income tax returns places high demands on market participants in terms of money and time. Any improvements in the existing tax administration would be a mere face-lift and would not eliminate the flaws inherent in the system. It is therefore likely that abolition of this tax would be more beneficial for both investors and the state.
Income declaration
Provisions of Article 8 of the Law on the Declaration of Income for the Acquisition of Expensive Property and Other Acquired or Transferred Funds of the Residents of the Republic of Lithuania prohibit the selling of securities when their value is higher than the minimum property value that must be declared unless the buyer has filed an income declaration.
This provision of the law is impossible to adhere to when transactions take place on the stock exchange, as the parties are not known beforehand when trading is done on the central market. In cases when income earned from the sale of securities is reinvested or securities are swapped, income used for the acquisition of securities has already been declared, making the requirement to declare income each time unreasonable.
The requirement to file an income declaration when valuable property is purchased should be repealed. Income should be declared once a year and only when the sum of money deposited in a personal account equals or exceeds the minimum value of property subject to income declaration. This change would fall short of a total elimination of compulsory income declaration, but it would help reduce the frequency of declarations and make them more cost- and time-efficient for investors.
Value-Added Tax
The financial services provided by financial institutions operating under the laws On Public Circulation of Securities, On Pension Funds and On Investment Companies are subject to Value-Added Tax. According to Clause 5 of Article 4 of the Law on VAT, financial services provided by insurance, banking and other credit institutions, including operations involving securities, are exempt from VAT. As a result, unequal tax conditions have been created for financial institutions. This shortcoming should be eliminated by amending the VAT law and the government decision On Value-Added Tax, specifying the services that are not subject to the tax.
According to Clause 5 of Article 4 of the Law on VAT, the circulation of securities is not subject to the tax. When calculating the tax, the turnover of securities is consequently attributed to the goods and services that are exempt from VAT. If a company’s turnover consists only of goods and services subject to VAT, then the VAT payable to the budget is calculated by subtracting the purchase VAT from the sale VAT. However, if the company’s turnover also includes items exempt from VAT, then not all of the purchase VAT can be subtracted from the sale VAT, but only a part of it, proportional to the share of the VAT sales in the total revenue. As a result of the flawed proportional approach in the calculation of VAT, companies have to pay higher taxes which may exceed their return on investment. This situation calls for immediate improvements in the VAT calculation system.
Regulation of insurance company investments
Articles 54 and 55 of the Law on Insurance set guidelines for the investment of insurance companies’ authorised capital and reserves , while the finance minister decrees the amount of investments. Insurance companies are only allowed to invest their authorised capital in government and municipal bills, real estate and timebank deposits. Reserves can be invested in company securities and mortgage loans.
The chosen course hardly reduces investment risks to the minimum. Investments in treasury bills or real estate are more risky than investments in the securities of some Lithuanian or foreign companies. Investment risks would be minimised by the requirement of a diversified investment portfolio.
It is necessary to enable insurance companies to invest the funds of both their authorised capital and reserves in the securities of private sector companies. The regulation of the types and amounts of investment should be replaced by the requirement of a diversified investment portfolio. Such changes would not impair the security of insurance companies’ investments. Further, these changes would accelerate capital market development and provide an incentive for new institutional investors to emerge.
Regulation of public holding companies
The Law on Investment Companies regulates the activities of public holding companies. The law imposes an array of restrictions on holding companies: company directors must have a qualification certificate recognized by the Securities Commission, as well as work experience in banks or financial institutions. Also, shareholders have no privileged subscription rights to new equity issues. The law regulates the types of securities holding companies can invest in, as well as the amount they may invest. Also, restrictions on the establishment of holding companies are imposed.
The main purpose of holding companies is to earn a profit from the operation of the subsidiary companies rather than from trade in securities. The operational risks of holding companies are different from the risks of variable capital or private limited investment companies. Therefore, the requirements set out in the Law on Investment Companies merely restrict the operations of holding companies and burden market regulators with additional paperwork.
It would be expedient to regulate holding companies under the Law on Corporations, leaving only the existing disclosure and stake disposal requirements. In order to prevent holding companies from abusing the system by taking up securities trading, restrictions should be imposed on their ability to control, for any extended period of time, securities that are nonessential in the management of the issuer. The proposed changes would simplify the establishment, reorganisation and operation of public holding companies while at the same time reducing the regulatory workload.
Restrictions on pension fund risks
Clause 1 of Article 6 of the Law on Pension Funds contains risk-limiting requirements for pension funds: capital adequacy, liquidity and a maximum open position in foreign currency.
These requirements were originally designed for commercial banks as their operations and risks differ from other types of legal entities. Pension funds are designed to accumulate retirement income for fund participants by investing their premiums in securities. Unlike commercial banks, pension funds can make precise estimates of the time and amount of future disbursements. They do not re-lend funds but invest them, which eliminates the need for any liquidity or capital adequacy requirements. The maximum open foreign currency position limits investments abroad even though investments in Lithuania may be more risky. The security and liquidity of pension funds’ investments is also guarded by the diversified investment portfolio requirement contained in the law.
All the existing requirements except the diversified investment portfolio should be lifted, especially in view of the fact that insurance companies operating under a similar model are free from such restrictions. While still ensuring the same level of security for pension funds, this would reduce regulatory paperwork, make pension funds more flexible and free their assets. Meanwhile, the participants of pension plans would enjoy the benefit of greater retirement incomes.
Restrictions on pension fund investments
Clause 3 of Article 35 of the Law on Pension Funds provides that the Securities Commission can restrict pension funds’ investments in deposits and securities of commercial banks. In keeping with this provision, the Securities Commission has issued a decision On restrictions on the investment of pension plan assets. It imposes limits on the amount of investments in securities depending on their type, issuer and country of origin.
The subjectively introduced restrictions on investment volumes do not increase pension funds’ investment security, but limit their ability to invest in risk-free securities irrespective of their type, issuer or country of origin. The requirement of a diversified investment portfolio is enough to boost investment security, and any additional requirements should be abolished. This measure would create better conditions for pension funds to adapt to changes on the market, make “internal” issuers more efficient, reduce the workload for regulatory agencies and enable pension plan participants to earn greater retirement incomes.
Fixed return rate requirement Under Clause 2 of Article 32 of the Law on Pensions, pension funds must undertake a commitment to a certain annual rate of return on each type of pension plan. The rate is fixed by the funds themselves. This requirement burdens pension funds with a liability which is difficult to predict in advance and increases risks. In addition, this is only a token requirement as pension funds are in a position to fix a zero rate of return. Consequently, this requirement serves no purpose.
