The long-anticipated review of New Zealand’s securities law is now underway with the launch of a 200-page discussion document seeking input on the scale, scope and direction of change.
Major reform is on the cards with the replacement of the Securities Act 1978 and the Securities Markets Act 1988 as well as significant amendment to other legislation.
Submissions to the Ministry of Economic Development (MED) close on 20 August 2010.
This is an important opportunity
A lot is at stake in this review, both legislatively and in terms of the productive capacity of the economy.
The scale of statutory reform is at least equal to the current rewrite of the financial adviser framework - and the lessons of that experience are that it is important to engage early in the debate to maximise the chances of getting the detail right first time round. (The initial legislation in that case has required five subsequent rounds of amendments before it has even come into force, and the inclusion of a special regulation making power to override the Act for more fine-tuning!)
There are also some big and far-reaching decisions on the table. A number of key recommendations from the Capital Market Development Taskforce have been wound into the review, and also in scope are proposals to make it easier for SMEs to raise capital direct from the public – a necessary criterion to achieve the Government’s economic step-change, in our view.
Many of the ideas in the discussion document are heading in the right direction. We are pleased MED has picked up on some of the “15 modest reform proposals” we presented to a Securities Law Conference in August 2008. But the analysis of some key issues – such as the scope of liability and transactional consequences for breach of the laws is disappointing. It also appears that learnings from some useful submissions on MED’s earlier Review of Financial Products and Providers have been lost along the way.
The establishment of the new Financial Markets Authority (FMA) should also mean stronger enforcement of the new regime. So we urge you to engage and will be putting our resources as a law firm into helping to achieve an optimal outcome from the policy-making process.The discussion document is available here.
Key areas of review
The broad areas in which MED is seeking feedback are:
which financial products should be regulated, and how
exemptions for offers to particular classes of investors
disclosure obligations and the regulation of advertising
how to improve the governance of managed funds and other forms of collective investment, and
whether the FMA should be equipped with additional powers, including enforcement of directors’ duties.
Defining regulated financial products
A change of approach is envisaged, where products are regulated according to their economic substance rather than – as now – their legal form or description. For example, redeemable preference shares would be treated as debt securities, rather than equity securities. MED proposes that the new Act regulate only those instruments which are aimed at either generating a financial return or hedging a risk. So, for example, it is proposed (in our view sensibly) that the new Act not apply to co-operatives with notional member shareholding requirements, charities and clubs with a philanthropic focus, and certain entities associated with property developments to facilitate participation in communal facilities.Four categories of financial product are identified: equity, debt, collective investment schemes and derivatives, each of which would have specific disclosure and governance requirements.
Equity instruments would be aligned to the relevant accounting standards and defined as investments in companies and similar entities (such as limited partnerships and industrial and provident societies) that:
evidence a residual interest in the net assets of the entity, and
carry no obligation to deliver cash (or other financial assets).
MED says this would have the following advantages:
matters would be treated the same pre-offer and post-offer
it would provide access to any benefits from improvements in accounting standards, and
it would be less open to manipulation in terms of the legal form of offerings.
MED notes that this may create issues for co-operative company redeemable preference shares and suggests that these could be specifically included within the definition of equity securities in the Act.
Debt securities would be aligned to the accounting standards definition of “financial liability” and would be defined as investments in a company or similar entity that do create an obligation to deliver cash. It could mean public redeemable preference share issues would need to have a trustee appointed.
Collective investment schemes (managed funds, property syndicates and other investments managed on someone else’s behalf) would comprise investments which:
are intended to provide members with benefits of investment management and risk diversification, and
allow investors to withdraw their funds on demand (within a reasonable time), at a price based mainly on the value of the assets owned by the company.
Whether non-pooled investment schemes should be included in this definition is identified by MED as an issue for discussion. The document also suggests that insurance contracts should be defined as collective investment schemes where investment is “a material feature of the contract”.
Derivatives would cover financial products which:
change value in response to changes in a specified benchmark
require no initial net investment or a smaller net investment that would be required for other types of contracts, and
are settled at a future date.
New products and designation powers
To accommodate new products, and to prevent issuers from structuring securities to avoid regulation, it is proposed that the FMA should have the ability to:
“call in” to the regime or designate products which are substantively similar to those specifically covered by the Act but fall outside the legal definitions in the Act, and
shift products from category to category to ensure that they are regulated appropriately.
Such powers would enable some investment schemes, such as the Blue Chip property investment scheme, which may technically fall outside the scope of the Act to be brought under regulatory oversight, and provide flexibility. We would welcome that.
MED is seeking feedback on which of the full and partial exemptions from section 5 of the Securities Act should be carried forward into the new Act. Identified for potential exclusion are land and chattels and professional practices, but some of the most important current exemptions are not mentioned.
Offers to exempt investors
MED considers that the boundaries of the current exemption provisions are uncertain and create unnecessary risks as the consequences of getting it wrong are severe. We strongly agree. Accordingly MED proposes a new set of exemptions for offers where the full regulatory requirements of the Act would be inappropriate. These would exempt offers to:
businesses whose primary business is investment or related activities (ACC, for example, would not be captured by this provision as its principal business is injury compensation but it would be covered by the large entity exemption below)
sophisticated investors (must satisfy at least two of three criteria: either own or manage a portfolio of at least $1 million, have carried out ten or more financial product transactions of more than $2,000 per quarter over the last eight quarters, work or have worked in a capacity that requires significant knowledge of investment in financial products)
large entities (must have any two of gross assets of $10 million, annual turnover of $20 million, 50 or more full time equivalent employees)
individuals making investments of $500,000 or more
relatives within four degrees of blood relationship to the issuer and directors and their spouses
personal friends and close business associates, including directors, senior management, major shareholders of the company or related companies and close relatives of these persons, and
equity offers to employees of up to 15% of assets or 15% of the value of securities of the same class.
Feedback is also sought on whether exemptions should also be extended to:
offers where the investor has been recommended to buy a financial product from an independent financial adviser
small investments up to $2 million and 20 persons over 12 months (based on the Australian provision), and
a prescribed range of circumstances in which the investor can, after seeking independent legal advice, sign a prescribed statement to opt out of the full protections of the Act.
MED also wants input on whether investors should be able to “self-certify” their qualification for an exemption, on how to ensure that self-certification is not abused and on whether there should be a public register of exempt investors.
The suggested exclusions would improve the position under the current Act. But there is still significant scope to improve the proposals. Hopefully, submissions, a fuller comparative law review, and consideration of the unique needs of New Zealand for SME fundraising (while maintaining appropriate investor protections), lead to development of a clearer and more workable final outcome.Unfortunately the current (unique to New Zealand), draconian consequences of a breach of the public/private boundary rendering the whole offer of securities void has only been timidly addressed, by MED’s suggestion that the offer should be voidable, rather than void. In our view this approach means issuers would continue to bear disproportionate risk, and investors could derive unwarranted windfall gains. Other countries adequately approach the consequence of breach through criminal or civil penalties, and a power for the Court to set-aside particular transactions.
A single product disclosure statement (PDS)
MED’s preferred option is to replace the investment statement and the prospectus with a single product disclosure statement (PDS) that would be provided to all investors at point of sale. This would contain only the information considered crucial to an investor’s decision and would be registered with the new internet based Register of Securities to be operated by the Companies Office, agreed by Cabinet in April.
The PDS would be heavily prescribed for mainstream products to promote comparability and would be tailored to different types of financial product and different types of offer. MED anticipates the greatest level of standardisation would be for collective investment statements, as in Australia. Document length would be restricted with a two page summary at the beginning for ease of comparison with alternative offers.
Any additional disclosures referred to in the PDS would be available on the issuer’s website and on the Register (which is expected to comprise searchable fields for, among other things, issuer details, type of security, offer period, terms and conditions, directors and others involved in the offer, summaries of trust deeds and material contracts). Searchers would be able to obtain comparable information, side by side, on a range of investment products.
To keep compliance costs down, matters that are subject to frequent change and are not critical to investor decisions (such as directors’ names and financial statements) could be updated on the Register rather than requiring new print runs of the PDS. But the PDS would have to state the date of publication and where on the Register to look for updates.
Three options are outlined as follows (with MED’s preference in relation to different product types).
A - Issuers are required to provide in the two page summary at the front of the PDS an overall risk assessment – including, for example, the top three to five risks specific to the issuer or its industry, or specific to the securities on offer. The FMA would be able to take action against those who understate the risk of their product. (Proposed by MED for collective investment schemes, derivatives and equity securities.)
B - Issuers are required to apply a risk-meter or other form of pre-determined descriptor with specific risks identified in the body of the PDS. (Proposed for debt securities where the issuer is credit rated, Option A where no rating is available.)
C - Issuers are required to obtain an independent expert’s report on the merits and risks of the offer. This would be summarised in the PDS and available in full on the Register. (Possibility for equity securities instead of Option A.)
The FMA would be required to vet the PDS, including the risk-weighting applied by the issuer, to a much greater degree than provided for in current law and practice.
Key information by product type
The information required in the two page summaries at the top of the PDS would be tailored to the characteristics of the different products.
Equity. Brief description of the business, the type and class of security, the price, whether it will be listed, the dividend policy, how investors can get their money out and a summary of the purpose of the issue (e.g. retiring debt, new acquisitions etc).
Debt. Brief description of the business, type and structure of the security, credit rating (if any), interest rate (or how it is calculated), term and whether the investor can withdraw before maturity, purpose of the issue.
Collective investment schemes. Details of the people involved in the fund’s management, investment options (conservative, growth etc), return objective, what returns will consist of (interest, dividends, rent etc), whether they will be paid out or reinvested or whether that will be optional, asset classes invested in and the percentage range for each class, fees, any minimum contribution levels or rates and how investors may withdraw their funds.
Derivatives. The details of the counterparty, the underlying commodity, index, asset or security, and how the derivative makes/loses value, (potentially) a statement that this is a complex product which should be entered into only with professional advice, and how investors can withdraw their money.
Currently this is required only of listed companies, and for periodic reporting during moratorium proposals. MED considers that extending listed issuer continuous disclosure obligations to all financial product issuers would be a step too far, as the costs would outweigh any benefits. However it does propose some changes in relation to debt securities and collective investment schemes. These are that:
debt issuers be required to update on the Register any material change affecting the likelihood of default (the list of matters has yet to be developed but is likely to include changes to credit ratings, changes to guarantors and significant changes to the terms of the trust deed)
quarterly reporting by collective investment schemes (as agreed by Cabinet in April in relation to KiwiSaver products). This would cover all fees and charges, asset holdings, conflicts of interest and fund returns, ideally both gross and net).
Promoters, experts, ads and celebrity endorsements
Among the issues the review canvasses are:
whether the current definitions and liability attaching to promoters and experts should be changed and, if so, how
whether celebrities endorsing an offer should be liable for the statements they make, and
whether the content restrictions on pre-prospectus advertising should be scrapped.
It is disappointing that MED is proposing to perpetuate the current ‘promoter’ concept. In our experience, the unique New Zealand position of imposing liability on broadly defined ‘promoters’ (and, with entities, their directors), stifles product development and cross border offers.
Conversely, we would welcome abandonment of pre-prospectus advertising constraints (which limit statements about an intended offer to very limited prescribed form statements), in place of a general misleading conduct prohibition, as the antiquated current New Zealand law cannot be easily reconciled with modern information dissemination, particularly over the internet.
Collective investment schemes
This sector is already subject to significant legislative change through the Financial Service Providers (Registration and Dispute Resolution) Act (FSPA), the Securities Trustees and Statutory Supervisors Bill and the recently announced changes to the regulation of retail KiwiSaver schemes.
MED is proposing a standard framework under which all collective investment schemes would have to be registered before offering securities to the public. Such registration would require that the scheme have a fund manager and an independent supervisor both of whom would be registered under the FSPA with the supervisor also licensed in accordance with the regime under the Securities Trustees and Statutory Supervisors Bill. The Unit Trusts Act 1960 is likely to be replaced with a more modern regime.
The fund manager would be the issuer and would be legally responsible for investment decisions, even where this function had been delegated to an investment manager. The supervisor would be responsible for ensuring the fund manager’s compliance with all regulatory and legal requirements and for supervising the custody of the assets. There would be no ability for the fund manager to remove the supervisor unless agreed to by a court.
To help achieve the Government’s goal of establishing New Zealand as a funds management hub, MED suggests creating a dual regime under which schemes which trade domestically would be subject to lighter regulation than those trading internationally.
It says New Zealand will have to better or meet the European Union’s Undertakings for Collective Investment in Transferable Securities (UCITS) if we are to be a successful funds domicile. But the UCITS requirements are very strict and relatively costly. Accordingly MED proposes following the Irish model of applying different regulations to UCITS and non-UCITS schemes. New Zealand investors could still elect to invest in a UCITS scheme if they preferred.
The powers of the FMA
Themes raised in relation to the powers of the FMA are around:
ensuring it has the tools necessary to create certainty. Options include issuing guidance, binding rulings, retrospective exemptions and ‘no action’ letters, and
expanding its ability to take cases on behalf of investors, gather information from issuers and issue infringement notices and administrative penalties.
Like the Commission, the FMA will have the power to grant individual exemptions but – unlike the Commission – it will be able to grant class exemptions for a maximum of one year. Permanent class exemptions will be made by regulation.
We think one year class exemptions are a retrograde step. The current exemption regime (which typically allows class exemptions to be reviewed for appropriateness every five years), works well.
The review considers recent suggestions (including from the current Commission Chair) that the current reliance on private enforcement of directors’ duties is inadequate, and asks whether New Zealand should move to the Australian system where companies enforce the common law duties and ASIC the statutory duties, for which there is a criminal offence provision for more serious misconduct. ASIC can seek:
pecuniary penalties of up to $200,000 against an individual and $1 million against a body corporate
compensation orders on behalf of the corporation, registered scheme or any person, including any profits made from the contravention
prohibitory and mandatory injunctions.
The main arguments for allowing public enforcement are that the company (including a receiver or a liquidator) does not always have the incentive to take cases every time there is serious offending and that for large, closely-held companies, the incentives are very weak indeed.
The main arguments against are that it might discourage people from becoming directors and directors from taking reasonable business risks.
MED says it has not drawn any conclusions to date on this issue. It expresses cautious support for establishing criminal offence provisions, provided they include a “guilty mind” element, and asks for feedback on whether these should include imprisonment as an option.
MED argues that, because convictions will depend on a criminal standard of proof rather than, for civil penalties, on the balance of probabilities and will be targeted at “egregious conduct”, they should not deter good candidates from taking up directorships or make boards unduly risk averse.
The review also proposes increasing the maximum period for regulator-imposed bans to ten years and empowering the High Court to impose indefinite banning orders.
Where to from here?
The discussion document ranges across a very broad territory and contains proposals which have the potential to affect many businesses. For further information, analysis of the implications for your business or assistance with submission preparation, please contact the lawyers on the right.
Our thanks to Roger Wallis and Patricia Herbert for writing this edition of Brief Counsel.