In two separate initiatives at the end of last year, the New Zealand Government signalled impending law reform that will impact the derivatives industry.
Financial Intermediaries Task Force
The first initiative was the appointment of a task force to review the regulation of financial intermediaries in New Zealand. The role of the task force is to assess the existing regulatory framework for financial intermediaries and to recommend options for reform.
Who Is A Financial Intermediary?
The task force's initial issues paper adopts a very broad definition of financial intermediary. On the face of it financial intermediary could include banks, broker/dealers and consultants, in respect of their over-the-counter or exchange-traded derivatives business.
What Sort Of Regulation Could We Expect?
While it is far too early to try to predict the regulatory model that will result from this review, it is unlikely the industry would become less regulated than it is now. Currently, the regulation of financial intermediaries in New Zealand could best be described as piecemeal, light-handed, disclosure-based and largely self-regulated. In particular, with few exceptions, there is no requirement for financial intermediaries in New Zealand to be licensed.
This is in complete contrast to the comprehensive and more uniform regulatory regime in Australia under the Financial Services Reform Act. While few market participants in New Zealand would wish to see the Australian model adopted here in its entirety, the Government has indicated that compatibility with Australia is important. Given the stated intention of the Governments of both countries to work toward a single economic market, it would come as no surprise to see a new regulatory regime in New Zealand that is a compromise between the current model and the Australian FSRA.
The case for more regulation of financial intermediaries in New Zealand can only have strengthened with the collapse in early September of Access Brokerage Ltd, a discount share broker.
Securities Legislation Bill
* The second initiative was the introduction into Parliament of the Securities Legislation Bill (the Bill).
Highlights include changes to the substantial security holder disclosure regime (addressing the issue in the Perry equity swap case), the purported extension of insider trading rules to cover futures contracts, the imposition of criminal liability for insider conduct and specific market manipulation rules.
Substantial Security Holder Disclosure
* The Bill does not change the substance of the current disclosure obligations, which require disclosure by any person having a relevant interest in 5% or more of the listed voting securities of a public issuer.
There is, however, a significant change to the key relevant interest definition. Specifically, the Bill extends the definition of that term to include circumstances in which a person has a power or control in relation to a security as a result of a so-called practice. Practice includes market practice and persons' practices in dealing with each other.
This change was signalled by the Government following the November 2003 decision of the Court of Appeal in the Perry equity swap case. The decision in that case was that Perry, having sold and subsequently re-acquired shares underlying a cash-settled equity swap, did not retain a relevant interest in those shares. This was because there was no arrangement or understanding between Perry and its counterparty banks for Perry to re-acquire the shares. The re-acquisition was simply the result of the operation of market reality.
The Perry case could well have been decided differently if the Bill were law at the time.
This proposed change should be of concern to equity swap counterparties. In particular, it is disturbing that one market participant could acquire a relevant interest from another even when there is no meeting of the minds between them.
The inherent uncertainty over what constitutes market practice will invariably mean many counterparties will adopt a conservative approach and choose to disclose. Alternatively, other counterparties may seek an exemption from the Securities Commission for equity swaps entered into for financing purposes. The Commission has previously granted such exemptions.
Insider Conduct
The perceived ineffectiveness of New Zealand's current insider trading laws is a well-known fact. No one has been held liable for insider trading under the Securities Markets Act since that Act was passed in 1988.
In an attempt to strengthen the law in this area, the Bill proposes to adopt a regime similar to Australia's (an approach becoming increasingly common in New Zealand's commercial law reform). The new legislation is expressed to focus on the threat insider trading poses to market integrity rather than (under the current law) the breach of fiduciary duty the insider owes to the company. Quite what this policy shift will mean in practice is not clear.
The Prohibitions
The Bill imposes on information insiders a prohibition on certain insider conduct. Specifically, an information insider may not trade, disclose, or advise or encourage others to trade. An information insider is a person who:
* has material information relating to the public issuer that is not generally available to the market; and
* knows, or ought to know, the information is both material and not generally available to the market.
Liability
The Bill retains the current civil liability rules, under which an insider can be liable for up to the greater of the value of the relevant securities and three times the gain made or loss avoided.
However, importantly, the Bill also imposes criminal liability on those who knowingly engage in insider conduct. The maximum penalty is five years' imprisonment and a NZD300,000 fine for an individual and a NZD1 million fine for a company.
Extension Of Rules To Cover Futures Contracts
The insider conduct prohibitions purport to extend to cover trading in contracts on an authorised futures exchange. The Bill's explanatory note suggests this will improve the efficiency of, and investor confidence in, the futures markets.
We describe this as a purported effect because it seems the relevant provisions of the Bill do not achieve the clear effect the drafters intended. Specifically, the insider conduct rules prohibit trading, disclosure, advice or encouragement in relation to "securities of a public issuer". While futures contracts are now expressly "securities", they are not securities "of a public issuer". By way of example, a futures contract on, say, Telecom New Zealand shares is not a security of Telecom New Zealand.
Market Manipulation Rules
New Zealand has no statutory market manipulation rules, other than a little-used section in the Crimes Act 1961 and the general prohibition on misleading or deceptive conduct contained in the Fair Trading Act 1986.
The Bill proposes to make market manipulation a criminal offence, subject to the same maximum penalties as insider conduct. The market manipulation rules, like the insider conduct rules, will also cover dealings in futures contracts.
The Bill introduces three market manipulation offences: making misleading statements; causing misleading appearance of trading; and generally engaging in misleading conduct.
Misleading Statements
The specific elements of this offence are the making of a statement or the dissemination of information where:
* the statement or information is false or misleading in a material respect;
* the person knows, or ought reasonably to know, that this is the case; and
* the statement or information is likely either to induce a person to trade in the securities of a public issuer or to have the effect of increasing, reducing, maintaining or stabilising the trading price.
Misleading Appearance Of Trading
The specific elements of this offence are doing, or omitting to do, anything where:
* the act of omission is likely to create a false or misleading appearance with respect to either the extent of trading or the supply of, demand for, or price or value of, securities; and
* the person knows, or ought reasonably to know, that this is the case.
A person will be presumed to have committed this offence in cases involving what is known as churning (i.e. trading that results in no change of beneficial ownership) or corresponding trades (i.e. where two related parties offer to trade on substantially matching terms).
General Misleading Conduct
The third offence differs from the first two in its generality, in its application to all securities (not just listed ones) and all dealings in securities (not just trading) and in the strict liability it imposes (that is, knowledge is not required). This catch-all offence prohibits a person engaging in conduct, in relation to any dealing in securities, that is likely to mislead or deceive.
Liability for breach of this general prohibition appears to be civil only.
Territorial Scope Of Legislation
A welcome feature of the Bill is its attempt to outline the territorial scope of its provisions. The Bill will overcome any uncertainty through express provisions addressing territorial scope. The territorial scope differs depending on the regime in question. For example, the general misleading conduct prohibition will apply to conduct outside New Zealand by a person resident, incorporated or carrying on business in New Zealand to the extent the conduct relates to dealings in securities within New Zealand.
This week's Learning Curve was written by David Craig, partner at Bell Gully in Wellington, New Zealand.
