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Brief Counsel

Crime and punishment in the draft Financial Markets Conduct Bill

05 September 2011

A key objective of both the establishment of the Financial Markets Authority (FMA) and the general review of securities law is to persuade retail investors that they can have confidence in the regulatory framework and that misconduct will be punished.

The draft Financial Markets Conduct Bill (the draft Bill) creates an enforcement system which relies primarily on civil remedies, reserving criminal sanctions for egregious conduct and for “knowing” and “reckless” behaviour.  The remedies are flexible, calibrated to the severity of breach. 

The draft Bill has, however, moved away from the February Cabinet decision to focus liability for product disclosure on the issuer and instead extends onerous disclosure standards to underwriters and a broader range of market participants involved in the issue. 

This change could undermine the objective of the Bill to develop New Zealand capital markets.

Overview

The draft Bill:

  • includes infringement notices for minor contraventions, as an alternative to a summary offence
  • applies civil pecuniary penalties for many contraventions — for example, a minor and careless, but not reckless and intentional, misstatement in a product disclosure statement (PDS)
  • contains broad prohibitions on misleading or deceptive conduct, backed by a range of civil remedies to ensure correction, or compensation for loss, and
  • reserves criminal sanctions for egregious violations of the law, where the conduct was deliberate and reckless — for example, knowingly and recklessly making a misleading or deceptive statement in a PDS, or insider trading.

Infringement notices

For minor "compliance" type breaches, the FMA will be able to issue an infringement notice — a securities law "speeding ticket" in a prescribed sum of up to $20,000.  An infringement fee will be payable to the Crown, and will not result in a conviction. 

For disputed matters, the FMA will be able to revoke the infringement notice or the notice may be challenged in the District Court under the Summary Proceedings Act.

Alternatively, as now, the FMA could pursue a summary offence where the Court can award a fine of up to $50,000 if a person is found guilty.

Civil pecuniary penalties

A civil pecuniary penalty is a fine imposed by the High Court.  The standard of proof is on the balance of probabilities, and the matter will proceed as a civil proceeding rather than a criminal case.  A penalty may be sought alongside other civil remedies, such as a compensation order. 

Two levels of penalty are envisaged.  Less serious breaches will attract penalties of up to $200,000 for individuals and $600,000 for corporates.  Examples specified in the Bill are:

  • failure to secure the consent of each director and of any other prescribed person before lodging a PDS
  • failure to notify the offeror immediately on becoming aware of defective disclosure in a PDS or register entry
  • offering a financial product in the course of an unsolicited meeting, telephone call or other electronic communication
  • failing to disclose a substantial holding or plus 1% changes to a substantial holding, and
  • failure by a licensed market operator to notify the FMA of any suspected contraventions and of any disciplinary action taken.

More serious breaches will attract a penalty of the greater of (i) the consideration for the relevant transaction, (ii) three times the gains made or the losses avoided through the transaction, or (iii) up to $1 million for an individual and $5 million for a company.  Examples are:

  • failure to prepare, lodge or issue to investors a PDS (if the contravention is knowing or reckless, it will attract a criminal sanction)
  • failure to include in a PDS all material information, or to meet the prescribed requirements relating to form and presentation
  • failure to honour either the five working day (extendable to 10 by the FMA) waiting period restriction or any minimum subscription conditions before accepting applications to invest
  • insider trading
  • market manipulation
  • breach of continuous disclosure rules, and
  • trading in regulated financial products without a licence or holding out that one is licensed when one is not.

A full list of the civil contraventions and penalties is available here.

Civil liability and remedies

The general prohibition on misleading or deceptive conduct

Part 2 of the draft Bill contains broad prohibitions on misleading or deceptive conduct, or false or misleading representations, in trade in relation to dealings in financial products and the provision of financial services.  

The provisions are not limited to retail dealing, and are modelled on sections 9 to 13 of the Fair Trading Act 1986, and section 12DA of the Australian Securities and Investments Commission Act 2001.

The Fair Trading Act will no longer apply to conduct that contravenes Part 2.  The FMA will be responsible for enforcement rather than the Commerce Commission. 

This Part is a powerful foundation for the FMA to make direction orders under section 438 requiring compliance or corrective disclosure and prohibiting the distribution of misleading documents, or to seek Court intervention to make compensation orders.

Product disclosure liability – a flawed regime

The Part 2 prohibitions will not apply to misleading PDS or register entry disclosure, as the draft Bill contains a separate regime in Part 3. 

However in our view the regime is flawed by imposing liability on too broad a range of market participants, and setting too onerous a disclosure standard.

The February Cabinet Paper said:

There is strong anecdotal evidence that the preparation of disclosure documents is sometimes seen as an exercise in risk management and fear of liability, rather than a genuinely useful mechanism for conveying information….The risk of liability arguably encourages issuers to add in unnecessary matters, due to concern around potential liability for missing issues out.

The Cabinet Paper observed that under current law directors are liable for most breaches, but that under the new regime issuers will have primary liability for contraventions in relation to the issue of securities. 

Unfortunately this has been lost sight of in the draft Bill which, in section 462, puts liability for defective disclosure on:

  • the offeror (and issuer, if different) 
  • each director at the time of the contravention
  • an underwriter (but not a sub-underwriter) who is named in the deficient PDS or the register entry
  • anyone named in the document who consented to the misleading statement or to other material on which the misleading statement was based, and
  • every other person that contravenes the disclosure obligation. 

“Contravene” has a wide definition which includes a person who aids, abets, counsels, procures, or is “in any way, directly or indirectly, knowingly concerned in, or a party to” the contravention.

This language is wide enough to cover investment bankers, lawyers, accountants and other professional advisers. 

Inclusion of underwriters and professional advisers will increase underwriting and other transaction costs.  In Australia a similar approach to share and debt security issuance has resulted in expensive disclosure document litigation against professional advisers – for example Ingot Capital Investments v Macquarie Equity Capital Markets, where the advisers proved the statements made were not misleading, but only after a 108 day trial.  Significantly, in Australia liability for defective managed investment scheme and derivative product disclosure statements is focused is on the product issuer, and directors are liable only if the issuer does not pay.

MED is consulting on two possible disclosure standards for disclosure of all “material information”:

  • Option A: information that a reasonable person would expect, if it were publicly disclosed, to have a material effect on the demand for the financial product on offer, and
  • Option B: information that a reasonable person would expect would, or would be likely to, influence persons who commonly invest in financial products in deciding whether to acquire the products on offer.

In either case, information would only be material if it relates to the financial products on offer, or the particular issuer or offeror, rather than financial products, issuers or offerors generally.

In Australia, the disclosure standard for shares and debt securities is all information that investors and their professional advisers would reasonably require to make an informed assessment of the rights and liabilities attached to the securities, and the assets and liabilities, financial position and performance, profits and losses and prospects of the issuer.  Issuers must disclose what they know, or ought to know having made reasonable enquiries, which gives rise to significant due diligence processes, as issuers and advisers seek to minimise liability for defective disclosure. 

By contrast, for managed investment products and derivatives, the Australians have a "directed disclosure" regime focused on information the issuer actually knows that might reasonably be expected to have a material influence on the decision of a reasonable retail investor to acquire the product.  Disclosure content for simpler products is largely prescribed.

In our view, thought should be given to applying different “materiality” requirements to different types of product as what is appropriate for genuine (equity) fundraising is not automatically appropriate for managed investment products and derivatives.

There is a real risk that, at least for managed investment products and derivatives, the less onerous (but still appropriate) Australian liability regime and disclosure standards could encourage issuers to prepare disclosure documents under Australian law and offer into New Zealand under the mutual recognition of securities regime – which would undermine the draft Bill objective to develop New Zealand financial markets. 

Civil remedies

The draft Bill largely carries forward the broad range of civil procedures and remedies available under the Securities Markets Act.  These include:

  • a declaration of contravention – made by the court on the application of the FMA if the court is satisfied that a breach has occurred.  These orders have the status of conclusive evidence in any subsequent application for compensation or other order of the court, so can facilitate investors later claiming losses once the FMA has established a breach
  • a pecuniary penalty order (discussed above) – these are made on the application of the FMA and may be issued where the court is satisfied that a contravention has occurred, except for contraventions relating to misleading or deceptive conduct.  Any penalties must be applied first to pay the FMA’s actual costs in bringing the proceedings, and
  • orders to refund money or return property to an aggrieved person or to vary an agreement or any collateral arrangement or to require the offender to take any action the court thinks fit to reinstate the parties as near as possible to their former positions.  They may also restrain the exercise of rights attached to financial products, or their transfer, acquisition or disposal. 

The draft Bill carries forward controversial existing powers for the FMA to seek High Court orders freezing assets while it carries out an investigation, or pursues civil proceedings.

Compensatory orders

These can be applied for by the FMA or any other person. 

Importantly investors will not need to prove actual reliance on a defective PDS or register entry, as section 463 contains a rebuttable presumption that materially adverse misstatements have caused a financial product’s loss in value.  Under the current law, investors may find it difficult to prove they have relied “on the faith” of a misleading prospectus.

Criminal offences

A four tier system of criminal sanctions is envisaged depending on the seriousness of the misconduct.

​Tier ​Sanctions
​1 A fine under the Summary Proceedings Act of not more than $50,000 or an infringement notice from the FMA.
2​ Prison for up to 3 years and a fine of up to $200,000 (or both) for an individual; a fine of up to $600,000 for a company.​
3​ Prison of up to 5 years and a fine of up to $500,000 (or both) for an individual; a fine of up to $2.5 million for a company.​
4​ Prison for up to 10 years and a fine of up to $1 million (or both) for an individual; a fine of up to $5 million for a company.​
 

A full list of the criminal misconduct related to each tier of offence is available here.

Criminalisation of director duties

The Bill currently contains criminal sanctions for serious and deliberate contravention of directors’ duties to act in good faith and in the best interests of the company and in relation to reckless trading.  The draft Bill notes that these provisions may ultimately be included in a separate Bill to amend the Companies Act rather than in the securities law reform legislation.

As noted in our Brief Counsel of August last year on directors’ duties, this aspect is controversial, with some submitters (including Chapman Tripp) expressing concern that public enforcement might discourage individuals from taking up directorships.  The Minister considers that this risk can be avoided by only criminalising egregious and intentional misconduct.

No action statements

The draft Bill proposes to amend the Financial Markets Authority Act to make it clear that the FMA has a function of making "no action" statements — stating whether or not, or in what circumstances, the FMA intends to take or not take action over a particular state of affairs or particular conduct. 

This mechanism is to be welcomed as it should give market participants some level of certainty that the FMA will take no further action in relation to a matter — although it will not bind third party claimants.

For further information, please contact the lawyers featured.

 

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