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Brief Counsel

Taking up arms for the investor – FMA’s power to litigate

21 September 2010

The legislation to set up the Financial Markets Authority (FMA) creates a new right for the regulator to initiate or take over legal proceedings against financial market participants on behalf of investors.

The provision is modelled on Australian law.

This Brief Counsel compares the New Zealand approach with the Australian model and looks at the lessons to be drawn from the Australian experience.

Policy considerations

The new power is delivered via the Financial Markets (Regulators and KiwiSaver) Bill, introduced into Parliament last week, and is based on s 50 of the Australian Securities and Investments Commission Act 2001 (ASICA). 

The policy intention is two-fold:

  • to provide a remedy for small-scale retail investors who lack the resources to fund expensive litigation by themselves.  In such situations, the FMA will be able to step in and provide a regulator-backed class action proceeding to pursue the wrongdoing, and
  • to restore public faith in financial markets and in the regulatory regime which governs them.  As the explanatory note to the Bill makes clear, there is a strategic dimension in ensuring that the new “super-regulator” possesses, and is seen to possess, strong enforcement powers. 

But, inevitably, there are risks associated with the change. 

As we observed in an earlier Brief Counsel, there is a danger that directors and other decision-makers will become excessively cautious in their decision-making, or be deterred from taking up these roles at all.  Although no new obligations are imposed on them through the Bill, the likelihood of civil litigation has clearly increased.  Quite apart from the deep pockets of a government regulator, the FMA’s decision to take action is explicitly guided by different criteria from those that will inform a private individual’s decision to seek redress in the same situation.

Subpart 3 in detail

Parties

Clause 34 of sub-part 3 of the Bill provides that the FMA may “exercise the right of action a person (person A) has against a specified person by commencing and controlling specified proceedings against the specified person”.  Alternatively, it may take over such proceedings.

A “person” is defined in the Interpretation Act 1999 to include “a corporation sole, a body corporate, and an unincorporated body”.  The capacity to act on behalf of a company thus allows the FMA to bring the equivalent of a derivative action against the directors of that company.  As discussed below, “person A’s” consent is not required to proceed.

A “specified person” denotes anyone who is or has been a “financial markets participant”, any qualified auditor, and any expert who makes an untrue statement in a prospectus or advertisement.  “Financial markets participant” is further defined to include all financial service providers, as well as controlling owners, directors, senior managers and holding companies of such financial service providers.

“Specified proceedings” include civil proceedings under any financial markets legislation and any other proceedings seeking “damages or relief for fraud, negligence, default, breach of duty, or other misconduct”.  This second limb will cover not only common law actions such as negligence but also statutory duties and offences contained in legislation such as the Companies Act 1993. 

As identified in our Brief Counsel on the Bill last week, the FMA will have responsibility for enforcing a broad range of statutes to the extent they apply or relate to financial markets participants.  This is clearly a significant expansion of the existing jurisdiction of the Securities Commission.

Where the FMA exercises its power to commence or take over proceedings, the High Court may under clause 40 of the Bill appoint the FMA to represent any other person who has “the same or substantially the same interest in relation to the subject-matter of the proceeding”.  The language of this section – “same or substantially the same” – echoes s 173 of the Companies Act (relating to representative actions) and is similar to s 33C of the Federal Court of Australia Act 1976 (Cth) (“same, similar or related circumstances”).  It is broader than HCR 4.24 (which currently allows for representative actions for “persons with the same interest in the subject matter”).1

Process

Any exercise of the power to take proceedings must arise as the “result of an inquiry or investigation carried out by the FMA” and must be considered by the FMA to be in the public interest. 

The Bill does not specify that the investigation must be completed before the power is exercised.  Equivalent statutory language in Australia has been interpreted as not requiring completion.  In practice, however, this requirement is likely to be easily achieved.

Leave will be required from the High Court where person A objects to the proceedings or where proceedings have been initiated and the FMA is taking them over.

In these circumstances, person A will have an opportunity to be heard by the Court before leave is granted.  To grant leave, the Court must be satisfied that it is in the public interest for the FMA, not person A, to control the proceedings.  It is important to note, however, that there is also a provision allowing the Court to grant interim relief to the FMA before any of these procedural requirements have been fulfilled.

In granting leave, the Court has a broad discretion to make orders relating to the conduct of proceedings.  The Court can require person A to provide information or assistance to the FMA, order that they meet the costs of the proceedings, and require that any costs award be directed to person A’s shareholders or creditors. 

The Court’s consent is also required to “settle, compromise or discontinue” any proceedings.  Australian practice in this area is for settlement agreements to be concluded and then placed before the Court for approval, which is normally forthcoming.

The ‘public interest’ requirement – NZ and Australia

ASICA provides simply that ASIC can begin proceedings where “it appears to ASIC to be in the public interest”.  The extent of the discretion granted to ASIC by this provision was considered by the Full Federal Court in Australian Securities Commission v Deloitte Touche Tohmatsu2

In that case, the Court held that while ASIC’s decision to take action was judicially reviewable, s 50 “was intended to confer an extremely wide discretion3 and that any assessment regarding whether the action was in the public interest “was essentially one of fact and degree, and by its very nature it will be something that is not easily susceptible to judicial review”.

The New Zealand Bill is different to ASIC in two important respects which indicate the Government intends the FMA to be more rigorously controlled. 

The FMA can exercise this power only where it “considers” this will be in the public interest.  This is slightly less subjective than the “where it appears to ASIC” test applied in Australia.

Further, and unlike the Australian legislation, the Bill explicitly stipulates the factors the FMA must consider in making this judgement.  Clause 34(4) provides that the FMA must have regard to its “main objective”: to “promote fair, efficient and transparent financial markets”.  It must also consider:

  • the likely effect of the proceedings on the future conduct of specified persons in connection with the financial markets
  • whether exercising the powers is an efficient and effective use of the FMA’s resources
  • the extent to which the proceedings involve matters of general commercial significance or importance to the financial markets
  • the likelihood of person A commencing the proceedings (if those proceedings have not yet been commenced) and diligently continuing the proceedings, and
  • any other matters it considers relevant.

Regulatory approaches to securities markets – NZ and Australia

Although Australia has had a provision equivalent to s 50 on its books since 1961, and the section in its current form since 1989, the power has been relatively rarely used (only 21 times between 1991 and 2007). 

ASIC has, however, been making more use of it in recent years, most notably in its ongoing pursuit of the directors of the Westpoint Group and related entities to recover some of the A$388 million lost by investors after the collapse of the property development company in 2006.  To date, five separate settlements have been reached in the litigation.

The low earlier use rate reflects the existence in Australia of both a civil and criminal penalty regime, which allows ASIC to pursue breaches of directors’ duties and other market misconduct directly.  Historically, ASIC appears to have preferred these mechanisms to s50. 

Also potentially relevant is the availability and higher frequency in Australia of private class action proceedings, especially since the Australian High Court declared in 2006 that private litigation funding was not an abuse of process.4

The current enforcement powers of the Securities Commission are more circumscribed than those available to ASIC, and relate only to breaches of the Securities Act 1978 and Securities Markets Act 1978.  Breaches of those Acts allow the Commission to commence proceedings seeking declarations of contravention, pecuniary penalties and compensation for investors.  Such prosecutions are ongoing.  Private derivative actions by shareholders are also currently available under the Companies Act 1993 but are relatively rare.

Conclusions

The expanded powers proposed for the FMA are another step along the path from treating securities trading as a purely private realm toward viewing a well-functioning and transparent securities market as a public good that requires policing and enforcement by state agencies. 

This policy shift has been given impetus by the fall-out, both economic and political, of the finance company collapses and the global financial crisis.  The Government is resolved that the enforcement capability of the new “super-regulator” will be sufficient to match the high public and media expectations the FMA is likely to face.

The more rigorous “public interest” test envisaged in the Bill may limit the situations in which legal action can be pursued here compared with Australia.  But this effect may be more than outweighed by the comparative lack of enforcement alternatives in New Zealand, which may lead to sub-part 3 being used more extensively than the equivalent provisions across the ditch.

Our thanks to Michael Dobson for writing this Brief Counsel.

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Footnotes

  1. Interestingly, the inclusion of this provision anticipates a broader review of the rules relating to private class actions currently being considered by the Rules Committee and Ministry of Justice.
  2. (1996) 70 FCR 93; (1996) 138 ALR 655; (1996) 21 ACSR 332; (1996) 14 ACLC 1486
  3. Ibid.
  4. Campbells Cash and Carry Pty Ltd v Fostif Pty Ltd (2006) 229 CLR 386; 229 ALR 58.

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