Speeches: Analysing the New Role of the Securities Commission

Analysing the New Role of the Securities Commission

Lloyd Kavanagh,
Member, Securities Commission

Companies and Securities Law Update

16 May 2005

The government describes the Securities Legislation Bill as part three of its four-part programme for securities and financial market reform. The first two parts of this programme addressed issues of takeovers law, the reform of the stock exchange, and regulation of listed issuers.

The Bill continues the changes already begun to improve the policing and enforcement of regulation of our capital markets. It increases the scope for public action against conduct that damages the integrity of, or confidence in, the markets. These reforms reflect an increasing awareness that the old model, which relied primarily on private enforcement of civil remedies, was not achieving the public policy objectives. The new Bill requires the Commission to take on new responsibilities.

The Bill also makes significant changes to the basic conduct rules for other market participants - brokers, traders, advisers, and substantial security holders. I will spend some time on key features of these, although I am conscious that other speakers have already commented on those today. But first I would like to provide some background and context to the changes.

The changes to securities law in the Bill are designed to increase investor confidence and market integrity, and so to increase the attractiveness of New Zealand's capital markets to both foreign and domestic investors. Many of the changes in this Bill arise from dissatisfaction, on the part of the Securities Commission and public, with the limitations in our securities law, including the lack of effective public enforcement provisions in some areas.

There has been in some circles a view that "what ain't broke don't need fixin'". Let's be clear - the Commission does not subscribe to the view that all is golden in the New Zealand marketplace. We regularly come across dubious conduct for which there is no clear remedy, or those who are directly affected do not have the means or the motivation to take action. In these cases not only is harm done to the individual issuers or investors who are directly affected, but there is a wider damage to the integrity and efficiency of the markets as a whole.

There is a further issue. New Zealand markets and the New Zealand economy need to be well regarded by the international regulatory and investing community. In 2003 New Zealand's financial regulatory framework was inspected by a team of international experts under the auspices of the International Monetary Fund (IMF). This very detailed Financial Sector Assessment Programme (FSAP) included an assessment of New Zealand's securities regulation measured against the Principles for Securities Markets Regulation set by the International Organisation of Securities Commissions - the IOSCO Principles.

In general the results were positive. But, in reaching its positive conclusion, the IMF recognised efforts made in recent years, and noted that the proposed changes in the current Securities Legislation Bill (which were announced by the government in July 2003) would help to bring our regulation largely into line with international standards. So in part the positive report was given in the expectation that the issues covered by the Bill would in fact be addressed.

Against this background, the Securities Commission supports the changes that are proposed in the Bill. It believes that they will contribute to the integrity of, and confidence in, New Zealand's capital markets - both in New Zealand and overseas. Like others, we expect that the Parliamentary process will tidy-up some drafting points, that is what the process is for. But the main aspects are already clear and the Bill contains important changes with which all participants in the market and their advisers need to be familiar.

The original framework of New Zealand's securities laws was set by the Securities Act 1978, the Securities Amendment Act 1988 (as it was originally called, now named the Securities Markets Act), and the Investment Advisers (Disclosure) Act 1996). The enforcement model under these laws gave the Securities Commission a very limited enforcement role - primarily by means of a "review and comment" power.

US Supreme Court Justice Louis Brandeis wrote in 1913 that "sunlight is the best disinfectant; electric light the best policeman". This idea formed the basis in the 1930s for securities laws in the United States. It remains a catchphrase of the SEC. It is based on the ideas that disclosure of information is the most effective means to boost overall market integrity, and that individuals who have suffered harm will bring legal action to recover compensation to the extent that they consider the harm they suffered justifies the time and expense of legal action. The result was intended to be an effective low cost model.

In New Zealand, securities law focussed on the "sunlight" approach. Any enforcement through the Courts was left primarily to private individuals and companies, by way of civil action; or in limited circumstances by the Registrar of Companies.

Some overseas investors have expressed puzzlement at the absence of a public enforcer in this country. Even in New Zealand this model is not generally well understood. The media and other commentators have lamented on several occasions that dubious behaviour in the securities markets appears to go unpunished, particularly when the miscreant involved is thick-skinned and not easily embarrassed by negative comment.

The Commission itself has been criticized for failure to act, when the truth was it had no power to do so. In practice, in many cases companies and shareholders proved not to have the means or motivation to take action, when it might have been expected - even though they might have a valid complaint. This could occur for a variety of reasons:

In New Zealand and overseas, the effective operation of sound, well-regulated securities markets has now been clearly identified as a public good. This concept recognises the importance of the integrity and efficiency of these markets to a country's economic wellbeing.

The integrity and efficiency of the markets is not an academic issue. To put it very clearly, there is a strong public interest in having effective capital markets, above and beyond the private interests of the individual participants who operate in those markets.

One example is that the cost of capital can be expected to be higher if markets are perceived as operating for the benefit of insiders, or to be subject to market manipulation. As a result the economy may suffer, when companies do not make investments, which would be attractive at a lower cost of capital. Individuals also may be discouraged from investing part of their long-term retirement savings in equity markets because they are concerned about the integrity of those markets. As a result they may put their savings solely into real estate, or persevere with lower yield investments from bank deposits, so that on retirement, many years later, they do not have the level of savings required to sustain their desired standard of living.

Consequently, both here and overseas, there is a diminishing reliance on private litigation alone to enforce the law and deter bad practices. Private litigation alone is not seen to be a sufficient deterrent on those who are prepared to engage in unscrupulous practices.

Reflecting this, the New Zealand Securities Commission's role has changed in recent years to a stronger focus on direct enforcement via legal action, in addition to "review and comment". The government has encouraged this with the first two parts of its programme for securities and financial market reform providing specific powers of civil prosecution and by providing additional funding for the Commission.

The current Bill further increases the Commission's enforcement role. It expands the Commission's powers to take direct prosecutory action against breaches of the law; it introduces criminal sanctions; and it enhances the Commission's ability to act as a litigant by seeking a range of Court orders to correct or penalise misconduct.

The regulatory provisions associated with each of these reforms reflect an intention to equip the Securities Commission to be an effective enforcement agency in respect of securities market conduct in New Zealand.

The lack of any dedicated laws against market manipulation is one of the most obvious gaps in New Zealand's securities markets regulation, when compared with other countries.

The Commission highlighted this shortcoming in its November 2000 report into trading in the shares of Fletcher Challenge Limited. I will spend some time on this case study as it gives a good example of the problem.

This inquiry arose from the accidental disclosure, in 1999, of a draft press statement on the Fletcher Challenge computer network, making it available to all network users. The draft press release related to a still confidential restructuring proposal for the Paper Division of Fletcher Challenge. The draft press release ended up, after passing down a chain of individuals, in the hands of a Mr Hyslop, who had found it on his brother-in-law's desk, and copied it without the brother-in-law's knowledge.

On the information in the document, Hyslop purchased around 300,000 FCL Paper shares - he already owned 50,000.

On 7 May 1999, Hyslop contacted an Auckland journalist. Hyslop met the journalist and gave a copy of the leaked page to him. In addition, Hyslop went to a business services bureau in Auckland. He handed over a copy of the leaked page and a list of fax numbers of share broking firms. Hyslop asked that the page be faxed to each number after 2pm.

Faxing the release to the various broking firms appeared to trigger buying of Fletcher Paper shares, and an accompanying rise in the price of the shares. The next trading day Hyslop contacted brokers and sold 350,000 shares in a number of transactions.

In evidence received in our inquiry, Mr Hyslop said that one of his intentions was to cause a movement in the price of FCL shares by which he could profit.

The Commission concluded that these actions appeared to be a deliberate attempt to manipulate the price of the shares. Plainly this conduct was undesirable in the capital markets, but there was not a clear law against it.

Laws that prohibit manipulative practices in securities markets contribute to investor confidence in a market in a similar fashion to laws against insider trading, and can enhance the integrity and efficiency of those markets.

The Securities Legislation Bill will amend the Securities Markets Act 1988 to implement a substantive market manipulation regime as part of securities trading law. This regime will include a prohibition against false or misleading statements regarding listed securities, and a general prohibition against misleading or deceptive conduct in relation to securities.

The move to have dedicated laws against market manipulation is consistent with securities markets regulation in most comparable jurisdictions, and with IOSCO Principles.

The general dealing misconduct provisions essentially introduce fair trading concepts to securities law, and provide for enforcement of this by the Commission. This change is also a response to demand that the Commission be able to act against misleading behaviour that is not currently covered by securities law - in particular the activities of people seeking to purchase securities. The Securities Act 1978 only covers offers to issue or sell securities.

The general misconduct provision applies not only to securities listed on registered exchanges, but also to securities in general. The Commission will be able to make prohibition and correction orders where any person has contravened these general dealing misconduct provisions, and to seek injunctions if required to halt conduct.

The more specific prohibitions against disseminating false or misleading information to manipulate trading in listed securities, and causing a misleading appearance of trading in listed securities, are backed with civil liability provisions. The Commission will be able to take Court action seeking a declaration of contravention, compensation for affected investors, and civil penalties. The maximum civil penalty that can be awarded in any case is the greater of:

In addition, it will be a criminal offence to knowingly engage in market manipulation, with maximum penalties of 5 years imprisonment and a fine up to $300,000 for an individual, or a fine of up to $1 million for a body corporate.

Changes were made to the insider-trading regime in 2002, principally to allow the Commission to bring a public issuer's cause of action against an insider. This was a crucial step towards addressing the concerns I mentioned earlier. It has allowed the Commission to take legal action in cases where it would not previously have been able to do so.

However, the changes in the Securities Legislation Bill will further strengthen public enforcement of this law.

Importantly, and in line with the policy considerations I have mentioned, the proposed changes to insider trading law, as you have already heard today, go significantly further than addressing enforcement shortcomings.

Our current insider trading regime is based on the premise that insider trading is essentially a wrong committed against a company, and against shareholders in the company, based on breach of confidence and misuse of company information. That reflects the earlier philosophy that did not recognise the impact on the integrity and efficiency of the market itself, and not the impact on the economy as a whole, as I explained earlier.

The regime proposed in the Bill is based on the concept that insider trading is firstly harmful to the integrity and efficiency of the securities market as a whole - as well as being harmful to the company whose information was misused, or the individual shareholders who were on the other side of the trade. What is important under this model is not that the information was sourced from the company. Instead the issue is that the information was the basis of inappropriate trading at an advantage over the market - whatever the source.

Over the years, the Commission has encountered numerous examples of behaviour where is was not clear that the persons involved had engaged in insider trading under the current law, but where, in the Commission's view, the behaviour in question should be considered to be insider trading. Examples of this are set out in our November 2000 report, Insider Trading Law and Practice, and our December 1998 report on trading in the shares of McCollam Printers Limited.

Let me refer back to the Fletcher Challenge case, where people in the market have clearly taken advantage of inside information, but are not liable under insider trading law.

The Commission concluded that Hyslop obtained inside information and used it to his advantage. However, he was not an insider in terms of the law, because of the tightly prescribed definition of "insider". The Commission's conclusions about insider trading liability in the Fletcher Challenge case were constrained by the provisions of the current law that limit liability as an insider to:

The move away from viewing insider trading as primarily a wrong against the company also impacts on the enforcement options. The proposed law recognises that public enforcement is the primary tool for combating insider trading.

The Bill's approach to insider trading is very similar to that taken in Australia. This has attracted a certain amount of attention in the media. Trans-Tasman agreements commit Australia and New Zealand to consider co-ordination of business laws where appropriate, to assist the conduct of business between the two countries. However, this Bill does not represent a wholesale adoption of the Australian law. There are distinctions, introduced both to overcome the difficulties with interpretation encountered in Australia, and to recognise that, in our smaller market, regulation must not have the effect of stifling innovation and enterprise.

An important difference between the New Zealand and Australian approaches is the defence proposed in this law for research and analysis. The defence in the Bill states that a person will not be liable for trading on information if that person can prove on the balance of probabilities that the information was obtained by independent research and analysis, and was not sourced from the public issuer.

The Securities Commission in its comments to the government sought this exception during the consultation process for these reforms. We were concerned that overreaching insider trading legislation can itself act as a disincentive to market research. People who apply effort or skill to acquiring or analysing information so as to trade at best advantage should be encouraged to do so where the information in question is not obtained by misconduct. The Commission wanted to ensure that strengthening the law to capture undesirable conduct would not have the unintended consequence of stifling activities that benefit the market.

I should also comment on the removal of the "safe-harbour" for directors' trading provided by the approved procedures - because that has also attracted comment. The Commission's own thinking on this has developed over time. The current defences in the Securities Markets Act for people who trade in reliance on a procedure approved by the Commission are based on the policy statement accompanying our original recommendations - that directors of companies should be encouraged to hold shares in those companies.

The Commission remains of the view that it is generally desirable for directors to hold shares in the companies they govern - it gives them "skin in the game".

In practice, however, the safe-harbour approach has proven problematic. We have come across examples where directors have complied with the letter of the exemption. Hypothetically, they say, "I sold my shares to buy a bigger and more expensive house. I was not motivated by the fact that I had in my board papers confidential price sensitive information showing the company was in decline. I filled in all the forms at the required times." So, they say, "I have immunity".

In any event, the approved procedures, relying as they do on approval of trading by the company, are conceptually justifiable only in the context of a law that treats insider trading as principally involving a misuse of company information, or a breach of fiduciary duty. Those procedures cannot be justified under a law that is based on market efficiency or fairness. Under that model, directors' trading is required to take place at the times when the market is clearly informed about the company, and when the directors in question are not in possession of inside information. That is the approach that is followed in all the major developed jurisdictions. It operates effectively, with directors being able to own shares in the companies they control, without needing an approved procedure safe-harbour. In addition, for those who are still concerned, the Bill contains an exception for structures that insulate individual trading decisions from the insider.

The Bill proposes new regulation for investment advisers, largely based on recommendations for law reform made by the Commission before the last election. These reforms to investment adviser regulation are not likely to be the last word on this subject as the government has set up a taskforce to consider broader questions about the regulation of financial intermediaries.

Despite this, the changes in the Bill are welcome. They include enforcement powers for the Commission, where it was previously left to individual investors to go to Court to enforce their disclosure rights and recover civil remedies.

The Commission will have the power to ban advertisements by investment advisers where these are deceptive, confusing, or misleading; it will be able to order advisers to comply with their investment adviser disclosure obligations, and to issue corrective statements where they have breached the law. Serious breaches will attract civil penalties, to a maximum of $1 million.

The disclosure rules themselves are to be strengthened. Advisers and brokers will be required to make full disclosure before giving advice, thus doing away with the two stage disclosure required at present. Our experience has shown that too often investors are not receiving important information because they do not know to ask for an adviser's disclosure document. The new disclosure will require advisers and brokers to provide more information about the remuneration they receive. This is deliberately broad, and includes indirect and non-pecuniary benefits that an adviser might obtain from recommending certain products.

These new disclosure requirements will be supplemented by regulations, which can also set out a minimum amount of indemnity cover required by an adviser or broker, or an undertaking by the adviser or broker that there is adequate cover. The regulation-making power will also allow the Government to exempt classes of person, transactions, advice, or broker services, from part or all of the disclosure obligations.

Investment advisers play a key role for retail investors, guiding them in decisions involving substantial sums, including retirement savings. We welcome the fact that this Bill ventures into conduct regulation, albeit only a little way, setting a minimum standard for advisers and brokers through a prohibition on recommending illegal offers. This arises from a recommendation of the Commission following its inquiry into Gideon Investments Pty Limited and Morison Guildford & Associates Limited.

Gideon Investments Pty Limited was a company incorporated in Australia, controlled by Michael Bastion. This company offered securities to people in New Zealand, Australia, and Hong Kong. The securities were offered in New Zealand in breach of the law.

Morison Guildford & Associates Limited was a New Zealand company that provided investment advice, and acted as an investment broker. A large number of Morison Guilford's clients invested in Gideon.

The Gideon investments were promoted on the basis of very little information, promising extravagant returns for investors. The proceeds of the offer were in largely spent by Bastion on horses, and feeding his cocaine addiction.

The Commission's inquiry looked at the role played by Morison Guildford. They appeared to have taken a key role in obtaining investment money from New Zealanders for Gideon. They did not question the lack of offer documents, which would have been expected of competent professional advisers. Their formal evaluation and monitoring of Gideon was close to non-existent and certainly fell short of what might reasonably be expected of a firm offering investment advice to the general public.

We do hope that cases as extreme as this will not occur very often. However, the Commission has seen other examples of New Zealand advisers putting clients into scams that are marketed as investment schemes, without looking for the disclosure documentation clearly required by New Zealand law for a public offer.

The prohibition against recommending an illegal offer of securities will apply where an adviser recommends that a member of the public take up securities, if the offer of those securities is illegal and the adviser or broker knows or ought to know that the offer is illegal.

This prohibition deliberately extends beyond cases where the adviser actually knows that an offer is illegal. It should encourage advisers to lift their game, to think about the duties they owe to clients to understand the products they are recommending, and to be satisfied that offers comply with the law.

Other changes to investment adviser and broker regulation in the Bill include a power for the Court to freeze an investment brokers' accounts or transfer brokers' investment funds into trust accounts. There is also a power for the Commission to apply for banning orders where an adviser has breached disclosure obligations or been convicted of a crime of dishonesty (and range of other circumstances).

Market disclosure of substantial holdings in listed issuers is a vital element of our securities markets regulation. It enhances the integrity of the market by providing transparency about who has control over significant holdings.

Despite the importance of this disclosure, compliance is not always optimal. High Court remedies have always been available for breaches, and thanks to litigation funding the Commission has been able once again to take serious cases to Court. The most recent was last year where we obtained interim orders against the manager of the National Property Trust in respect of relevant interests it held in the trust.

A shortcoming to date in this law has been the lack of any remedy other than High Court proceedings. This makes it difficult to secure disclosure quickly in cases where material information has not been given to the market.

The High Court is also an expensive enforcement option. Like all regulatory agencies the Securities Commission must carefully consider the costs and benefits of taking enforcement action in any case. As with other disclosure laws there is a range of breaches seen by the Commission that warrant remedy, but that may not justify the cost of a High Court action.

For this reason we welcome the introduction in the Bill of administrative orders relating to substantial security holder disclosure. The Commission will be able to order a substantial security holder to give a notice that is required under the Act, or to publish a corrective notice where this is needed. Some recent cases have involved a discussion about the extent to which the current Court orders available for breaches of substantial security holder law can involve a punitive element. It seems settled now that these orders can take into account the need for effective deterrence. The new law will supplement this by giving the Commission the ability to seek a pecuniary penalty, in addition to the civil remedy orders, which are similar to the orders now available.

The Bill mainly addresses securities markets issues, but it also includes an important boost to the Commission's enforcement options under the public offering provisions of the Securities Act.

Both the Commission and financial commentators express frustration at the Commission's inability to take Court action where it considers a prospectus or an investment statement is misleading, once an offer has closed. The only option for compensation at present is a civil action by the investors who have lost money as a result of the misleading offer. As is the case with other private remedies in this area of the law, there has not been a single case reported where an investor has successfully taken action for compensation under these provisions of the Securities Act. The Bill addresses this shortcoming by allowing the Commission to seek civil remedies and penalties where offer documents are likely to mislead investors, or breach the disclosure provisions of the Securities Regulations or Contributory Mortgage Regulations. The Commission will be able to seek a declaration that there has been a breach of the law. Affected investors can rely on this to claim compensation. As is the case for most matters under the Securities Markets Act, the Commission will also now be able to seek civil penalties, to a maximum of $5 million. Directors of issuers will be liable for these penalties. This reform, in our view, addresses a serious gap in the law. Criminal proceedings remain as an option for appropriate cases.

Where a person has been convicted of an offence under the Securities Act or had a pecuniary penalty awarded against them then that person will also be banned for five years from being a manager, director, or promoter of a New Zealand company or issuer.

In addition, where a civil penalty is ordered against someone, or they have persistently breached securities law the Commission will be able to apply to the courts to have that person banned for up to 10 years from being a company director, manager, or from acting as a promoter.

The final change I will mention in the Bill is a welcome one for the Commission in its efforts to review the Securities Regulations, and to streamline prospectus disclosure for issuers.

The Bill amends the regulation-making provisions of the Securities Act to allow regulations under the Act to incorporate by reference approved financial reporting standards, and to require compliance with generally accepted accounting practice. We intend that these changes will help to reduce compliance costs by allowing greater use of general purpose financial reports in prospectuses.

The Securities Commission welcomes the reforms incorporated in the Bill and believes that these are positive steps for New Zealand's capital markets. We believe New Zealand needs to embrace standards for market conduct that have become accepted norms in other capital markets.

A key part of this is credible and effective public enforcement to safeguard the integrity of the market and to provide appropriate investor protection. These issues are important not only for the individuals and companies directly affected by wrongdoing, but for the economy as a whole. There is an important public interest in having efficient and effective capital markets, which command the confidence of issuers and investors alike.

Over the past two years the Commission has received funding to allow us to take on a greater enforcement role. These have enabled us to put in place the framework and skills needed to undertake this increasing work. The Commission's current resources anticipate the further development of this enforcement role that will come from this Bill and we expect to be provided resources that will continue to be needed in the future. This will allow us to take on the new tasks proposed by the Bill. We are ready for the task: we are looking forward to the challenge.