By W A Wijewardena –
A child’s guide to forensic audit reports – Part III
Asani, the bright AL student and Sarath Mahatthaya, her grandfather, have been having frequent interactive conversations on issues that have risen to the boiling point in Sri Lanka’s society. They started a fruitful discussion on one such issue, namely, the forensic audit reports prepared by two audit firms of international repute – BDO India and KPMG India – at the instance of the Monetary Board, the corporate body that owns the institution known as the Central Bank of Sri Lanka. These reports have been highly technical and, therefore, had been beyond the comprehension of even the educated that have not been familiar with the operation of bond markets. Hence, it carried the risk of some uninformed readers picking up numbers from here and there and using them against their political rivals. In the first conversation, Sarath Mahatthaya clarified to Asani that the loss calculations done by forensic auditors for both pre-2015 and post-2015 periods have been fictitious and imaginary and could be refuted by other analysts. In the second conversation, he disabused her mind about the role of the Monetary Board in handling the funds of EPF. Special attention was paid to the fact the in making investments or raising funds for the government, the Monetary Board and the Central Bank officers could make genuine mistakes since they were making all these choices in a world of uncertainty. Having recognised this reality, the Parliamentarians in 1949 and 1971 had given full protection to the Monetary Board members and the Central Bank officers from legal action on two counts. First, no legal action should be taken against any mistake done in good faith. Second, if there is any loss or damage, the Bank should indemnify them. It is only the acts of misconduct or wilful default that warrant disciplinary or legal action. Hence, the Monetary Board has to carefully assess all acts purported to have been committed in the Bank and identify genuine mistakes from wilful mistakes before proceeding with further action on the findings of forensic audit reports. They continue their conversation further.
Asani: Since the loss calculations are defective and auditors have not been fully conversant with the Monetary Board’s role in EPF, shouldn’t we dismiss all the reports, Grandpa?
Sarath Mahatthaya: It’s not like that. Though they’ve been weak in these two respects, they’ve been strong in identifying the irregularities in share market investment by EPF after around 2011 and bond market investments after 2015, the Monetary Board should have a close look at them. On one side, it should identify culprits and weed them out. On the other, it should take preventive action to ensure the non-recurrence of them in the future.
A: How does this EPF investments in the share market come about? Isn’t it against the statutory mandate of the Monetary Board?
S: As I mentioned earlier, the original EPF Act enacted in 1958 had authorised the Board to invest the surplus funds of members in securities and sell them in the market. But securities had not been defined in the interpretation section of the Act. In a way, that was not necessary because in 1958 the only securities available in the country was the government securities. There was no open stock market for rupee companies in old Ceylon and share transactions were done as private transactions through share brokers. But since then commercial practices in the country had undergone significant changes. When the Employees Trust Fund was set up in early 1980s permitting the working class of the country to own company shares, the ETF Act defined securities broadly to include not only the government securities but also private bonds and debentures and company shares.
Clearly, by late 1990s there was a necessity to have a relook at the definition of securities in the light of the changed commercial practices and the replacement of the hitherto existed non-tradable rupee securities issued by the government with tradable Treasury bonds. So, the Monetary Board which had a long consultation with the Attorney General was informed that the term securities in the original EPF Act includes private debt securities and shares as well. But AG advised the Board to take all those preventive measures to assure the safety of those investments when investing in private debt securities and shares.
A: What were the safeguards which the Board introduced to protect the monies of EPF members in line with AG’s advice?
S: While keeping the final approval power with itself, it delegated the authority to make investment decisions, subject to its approval before investment or subsequent ratification if investment could not wait until the next Board meeting, to an Investment Committee headed by the Deputy Governor in charge of EPF. This Committee came up with an Investment Policy Statement that broadly defined the purpose and the limits of investing in company shares or private debt securities. Accordingly, the approved statement by the Board imposed several limitations on itself. One was that not more than 2% of the total funds of EPF should be invested in company shares. Another was that of the issued share capital of a company, only up to 5% should be held by EPF since it didn’t have intention of managing companies. Thus, EPF was made a passive investor in the market. Another important limitation was that EPF should not invest in tradable shares of any financial institution which is being supervised the Board. The reason was that since the Board had access to internal information relating those banks and finance companies, the public would wrongly conclude that the Board had bought or sold those shares after knowing of their internal secrets. A fourth one was to establish a reserve fund out of the current earnings of EPF to absorb any loss arising from such investments. Therefore, there were some broad protection measures introduced by the Board to protect the monies of the members.
A: The Auditors had faulted the Board for investing in the non-tradable shares of Regional Development Banks. Isn’t it a violation of its own restriction on investing in the shares of financial institutions that are being supervised by the Board?
S: That was not a decision made by the Board but one that had been dictated to it by Parliament when it enacted the Regional Development Bank Act in 1997. That Act had wanted EPF to invest in the share capital of RDBs along with the People’s Bank, Bank of Ceylon and National Savings Bank. Thus, the Board did not have a choice but to comply with it. But as soon as it became practicable, the Board sold those shares back to the Government at a profit and got itself freed from that responsibility. Apparently, the auditors had not been properly apprised of this.
A: The forensic audit report number 3, authored by KPMG India, has extensively highlighted the EPF’s investments in the banking and financial firms deviating from the Board’s earlier resolution to refrain from doing so. Should the Board be faulted for this?
S: The Board has all the freedom to change its investment policy at any time if it desires to do so. Hence, you cannot fault it for changing its earlier stance after 2010. But in those investments, the Board has gone up to close to 10% of the issued share capital of leading private commercial banks like HNB, DFCC, Commercial Bank, Sampath Bank, NDB and Seylan Bank.
It appears that the Board has done this not to augment the earnings of the members but to enable the government to take over the management of these private banks through the share market. This has been done by getting the government institutions functioning under the Ministry of Finance like NSB, ETF, and Insurance Corporation together with EPF to own majority shares in those banks. It has enabled the Ministry of Finance to appoint majority of directors to these banks and in some cases to nominate the Chairman as well. This isn’t an advisable course of action which the Monetary Board would have taken. It’s a de facto nationalisation of private banks and therefore, Sri Lanka has no more a banking sector owned by the private sector. It also creates a problem for the Board to conduct its financial sector stability policy. This is because it now has to favour the banks which are owned by EPF and the other governmental bodies. It has reduced the Board to the awkward position of playing two conflicting roles. That is to function as a player by owning their shares, on the one hand, and as a referee in playing its role as a deliverer of the financial system stability, on the other. From the point of other banks, it denies them of equal opportunity in competing in the market which analysts call ‘denying a level playing field’ for them.
Everyone expected that the government that came to power in 2015 promising the delivery of good governance would reverse it. But what they did was to continue to enjoy this new power of managing the private banks as well. Since these banks account for a total of 85% of the banking sector assets, one can say that Sri Lanka doesn’t have a private sector owned banking system but a system managed by the state.
A: The integrity of EPF’s investment in certain types of shares has also been questioned by forensic auditors. This has happened from 2010 onward and continued till end 2016. Doesn’t it dent the reputation of the Monetary Board as a professional body?
S: Yes, it’s actually a misuse of Board’s powers relating to EPF. It’s apparent that, from the evidence unearthed by KPMG India, there has been serious violation of the investment powers of the Board. The current Monetary Board cannot just ignore it and allow its good name to be tarnished. All these cases have to be further investigated and appropriate action should be taken prevent the reoccurrence of such events.
One consolation is that EPF’s equity portfolio has on a net basis generated a marginal gain of just 1%, according to 2016 numbers, for the members. However, this is a gain down from the 6% in the previous year. Since an investor cannot bring about profits from each type of investments he has made, what should be looked at is the overall profitability. In that context, the Treasury bond portfolio of EPF will generate a gain of 11% for members when the bonds mature in the future over their purchase costs. Hence, on balance one can say that EPF’s investment portfolio is not that bad. But these numbers are now dated since they pertain to 2016 and we’re now in 2020. To make a proper analysis, one needs to have updated numbers.
A: KPMG India has also implied that some of the investments made by EPF in listed and unlisted shares have been made by the Monetary Board by yielding itself to the pressure coming from outside. This isn’t a good certificate for the Board, is it, Grandpa?
S: Yes, there have been some investments which raise this issue. For instance, EPF’s investments in the loss-making Sri Lankan Airlines, property developer Canwill Holdings, and hoteliers Jetwing Symphony and Weligama Hotel have been made, according to KPMG India, without proper pre-analysis. These investments amounting to some Rs. 6 billion have not brought in any dividend to EPF. Even the Auditor General has repeatedly categorised these investments as non-earning investments. Of them, EPF has exited Sri Lankan Airlines by selling the shares back to the Treasury. A similar arrangement should be made with the Treasury regarding the Canwill Holdings, since it is owned by the Treasury. Some investments can backfire but the correct strategy should be to exit them as quickly as possible.
A: What about the EPF’s dealings in the bond market in the post 2015 period? Have these investments been made safely?
S: This period has been covered by BDO India in its 4th report. One can say that its analysis in this report is a fairly acceptable one. It has drawn attention to many instances where EPF has not bid at the primary auction though it had been given a seat in the auctions as a special participant by the Monetary Board in 1997. The findings made by Auditors have been a further elaboration of what had been revealed in the evidence placed before the Presidential Commission and subsequent investigations by CID. The Auditors have documented the foot-trail of certain Treasury bonds which have been purchased by Primary Dealer PTL from the primary auction at a low price and landing them on EPF through a series of transactions done with a network of primary dealers at a higher price. These have been done almost on the same day within a time gap of a few minutes in most of the cases. Since they have been purchased by EPF from the secondary market at prices significantly above the face value, the yield rate had been lower than the primary market yield rate, on the one hand, and will bring in a loss to it at the time of maturity when the Public Debt would pay only the face value. This is a matter for the current Monetary Board to take disciplinary action against those employees who have been a yielding hand to the ominous scheme perpetrated by the primary dealer concerned.
A: So, what is your overall assessment of the forensic audit reports, Grandpa?
S: Except report number 3 and a part of report number 4, all others contain refutable analyses. Even the findings in those two reports have been in public knowledge for some time and one cannot give credit to forensic auditors for bringing them to light. It’s now questionable whether the current Monetary Board has undertaken a worthwhile exercise by spending Rs. 275 million for producing these reports.
*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at email@example.com