Financial Markets Conduct Bill

  • enacted

Commentary

Recommendation

The Commerce Committee has examined the Financial Markets Conduct Bill and recommends that it be passed with the amendments shown.

Introduction

The main purposes of the Financial Markets Conduct Bill are to promote and facilitate the development of fair, efficient, transparent financial markets and to promote the confident and informed participation of businesses, investors, and consumers in the financial markets. The bill seeks to achieve these ends by reforming the regulation of financial market conduct. It seeks to govern the way financial products are offered, promoted, issued, and sold, and the ongoing responsibilities of those who offer, issue, manage, supervise, deal in, and trade them. It also seeks to regulate the provision of certain financial services.

This commentary covers the key amendments that we recommend to the bill. It does not cover the large number of minor or technical amendments proposed to improve workability, drafting, clarity, and legal efficacy. These amendments include

  • an exception to the prohibition of offers in the course of unsolicited meetings, to allow authorised financial advisers to continue their established business practice in this respect (clause 26A(2)(b))

  • allowing requests for relevant information to be made all the way up the chain of ownership to trace interests in listed issuers, and allowing requests to be made for purposes other than substantial security holdings (clause 284)

  • removing the requirement in clauses 287 to 290 for public issuers to maintain a register of substantial product holder disclosures for public inspection

  • a new general offence for false or misleading statements, based on section 377(1) of the Companies Act 1993 (clause 498A)

  • specific requirements for market operators of domestic financial product markets, licensed providers of market services under Part 6 of the bill, and supervisors under the Financial Markets Supervisors Act 2011 to be registered under the Financial Service Providers (Registration and Dispute Resolution) Act 2008 (see proposed changes to clauses 314(c), 322(ba), 394(f), and 646(2) and Part 1 of Schedule 4)

  • amendments to section 14 of the Financial Service Providers (Registration and Dispute Resolution) Act to extend the current bans on persons being directors, senior managers, or controlling owners to include overseas bans (see Part 1 of Schedule 4 of the bill)

  • new transitional provisions for participatory securities that would not be financial products under the bill and for interests in contributory mortgages (clauses 31 and 46 of Schedule 5)

  • shifting various provisions, including shifting provisions on accounting records to a new Part 6A, and shifting transitional provisions to a new Schedule 5.

Liability regime (criminal and civil)

The liability regime proposed in the bill sets out the circumstances where liability would arise for contraventions of its provisions, including those in which investors could seek compensation and in which company directors and others could be criminally prosecuted. While the regime in the bill is fundamentally sound, we recommend a number of amendments to make clear the precise circumstances where liability would arise under this regime.

Criminal liability

We recommend amendments to Part 7 of the bill to establish a separate criminal liability for a director where there is a disclosure defect (for example, a false statement in a product disclosure statement) that is materially adverse from an investor’s point of view. The offence would be committed if the offer took place with the director’s authority, permission, or consent, and the director knew of, or was reckless as to whether there was a defect (see clause 488(1A)). This would function in a very similar way to section 242 of the Crimes Act 1961.

A key change proposed by the bill is to make the offerors of products and the directors of companies criminally liable for inaccurate statements about products in disclosure documents, but only if the Crown could prove a “guilty mind”. This would move the focus of criminal liability towards the offeror; it includes fault elements for significant offences, generally knowledge or recklessness, in line with the Crimes Act offence for a false statement made by a promoter. We understand that recklessness is also a fault element in the equivalent Australian legislation.

In the case of criminal accessory liability, we consider that the ordinary rules under Part 4 of the Crimes Act should apply. Under these rules a person who promotes an offer would be liable for a false statement made by an offeror if, for example, the promoter committed or omitted an act for the purpose of aiding any person to commit the offence.

We believe that the liability regime should not discourage capable prudent people from becoming directors with overly punitive sanctions, and companies should be able to attract directors with diverse skills and backgrounds. Although directors should supervise capital raising and exercise due diligence regarding offer documents, they should be able to focus mainly on business strategy and supervising management, rather than on compliance and liability. Directors should be liable for civil pecuniary penalties and to compensate investors that lose money if they fail to perform their duties, but should not be liable to imprisonment where there is no fault element.

Civil liability—liability of accessories

We recommend that a new term (“involvement in a contravention”) be used to refer to the behaviour of accessories in the civil context (clause 509). This would clarify how the application of the bill applies to people who were, for example, knowingly concerned in, or party to, the contravention. We are satisfied that “involvement in a contravention” is an appropriate test with a sufficiently high threshold.

We are aware of concern that professional advisers might risk being involved in a contravention in the course of their normal activities. We do not expect this to happen. This test is consistent with equivalent provisions in the Australian Corporations Act 2001 and in other New Zealand laws, including the Commerce Act 1986 and Fair Trading Act 1986, and reflects the rules for parties under the criminal law. For a person to be involved in a contravention, it would need to be proved that he or she was an intentional participant in the primary contravention with knowledge of all the essential facts.

In addition, some of the defences in the bill are more suitable for the primary person in a contravention than for accessories. This uncertainty could lead to expensive and inefficient efforts to limit liability risk. We therefore recommend amendments to broaden the range of defences available to accessories, including defences for reasonable reliance and taking reasonable and proper steps to ensure compliance (clause 482E).

In addition, we recommend changes to the Financial Markets Authority’s order powers to provide for orders to be made preventively when provisions are likely to be contravened (clauses 448, 453, and 455). This would allow the Financial Markets Authority to take a proactive approach in situations in which provisions of the bill might be contravened.

Defences to civil liability

The defences part of the civil liability regime specifies the minimum standard of behaviour or actions that must have been demonstrated to avoid liability. We recommend amendments to include defences that apply to disclosure contraventions and more general defences for other kinds of contraventions (clauses 482A to 482C).

We consider it is necessary for the primary contravener to have a defence if it reasonably relied on a person other than their director, employee, or agent; if (in relation to disclosure) it made all the enquiries that were reasonable in the circumstances and believed on reasonable grounds that the disclosure was not defective; and, in the case of a new circumstance that should have been disclosed, if it was not aware of the matter. Our recommended amendment would give a director of the contravener access to these defences, and to a defence if he or she took all reasonable and proper steps to ensure that the company complied.

We consider that these amendments to the provisions for defences to civil liability would provide certainty for those who might be liable under the bill, and make it clear how the defences would work under the legislation. However, we do not consider that making out a defence should be easy. A defendant who wants to rely on a defence under the bill would have to prove it—they could not simply claim that the defence applies.

Presumption that contravention caused loss

As introduced, the bill presumes that when financial products decline in value as a result of a material defect in disclosure (such as a materially misleading statement), the investor would be treated as suffering a loss unless the decline in value was proved to have had another cause. We consider that clause 480 is an appropriate response to the difficulty for investors of proving that defective disclosure caused them loss. However, the provision should relate only to causation, and we recommend amendments to make it clear that the amount of the investor’s loss that should be compensated for is not determined by the clause; it would be up to a court to decide how much compensation would be awarded.

Indemnities and insurance

We recommend amendments to the indemnity and insurance provisions set out in clauses 503 to 506 of the bill, so that indemnity and insurance restrictions regarding New Zealand companies and their directors and employees would be governed by the Companies Act, rather than these provisions in clauses 503 to 506. This would remove duplication and potential conflict in legislation. We believe these amendments would provide a simple regime that would aid compliance.

The provisions would continue to apply to the auditors of New Zealand companies, and to overseas companies and other non-company entities.

We also recommend that the indemnity and insurance provisions be extended to cover licensees (including supervisors) to ensure that the regime is comprehensive, and certain other changes for consistency with the Companies Act.

Directors’ assets

We are aware of concern that directors might be unable to pay penalties or compensate investors, since most directors’ assets can be transferred to trusts. The use of trusts in commercial and asset-protection contexts has implications beyond the scope of this bill.

Relationship with Fair Trading Act 1986

Part 2 of the bill replicates key parts of the Fair Trading Act and applies them to financial services and products. We recommend amending Part 9 (clause 567) so that equivalent provisions in the Fair Trading Act would not apply to financial products and financial services regulated by Part 2 of the bill. This would remove uncertainty over which law applies. Misleading and deceptive conduct in relation to financial services and products would be regulated solely by this legislation. In addition, we recommend amendments to Part 2 of the bill to improve consistency with the Fair Trading Act.

We note that the Consumer Law Reform Bill (which is currently before the Commerce Committee) has implications for Part 2 of the bill. If the Fair Trading Act is amended to include prohibitions on unsubstantiated representations or unfair contract terms, these rules should be replicated in Part 2 for consistency.

Discretionary investment management services

Part 6 of the bill proposes new requirements for providers of discretionary investment management services (DIMS) and other providers of market services. We recommend amendments to clarify the boundary between the DIMS covered by the bill and those that fall under the Financial Advisers Act 2008, and make it less subject to arbitrage. These amendments to clause 573 redefine a personalised DIMS to make it clear that providing the client with multiple options in a model portfolio, or allowing investors to make minor modifications to such a portfolio, would not constitute personalisation.

We also recommend amending the bill (in clause 387A(2)(a)) to exclude from the need for a licence for DIMS that are not retail services under the bill, rather than relying solely on the exclusion under the Financial Advisers Act (see clause 572(1)). Retail services as defined in clause 33A of Schedule 1 would exclude services provided only to wholesale investors. We recommend amendments to ensure that the additional requirements for disclosure, client agreements, and for duties of DIMS licensees and custodians under subparts 4 to 6 of Part 6 apply also in respect of the retail service.

Further, we recommend that a DIMS licensee with a corporate licence under the bill be allowed to provide financial advice under that licence to the extent that the advice is given in the ordinary course of, and incidentally to, providing the DIMS under its licence, for example in relation to selecting investment options, reinvestment, and switching (see clause 390A(1)(b)). We believe these services are integral to providing the DIMS itself.

Treatment of derivatives—disclosure

We recommend amendments to the bill to clarify the provisions relating to derivatives, which differ from other financial products, and the business models through which derivatives are typically offered.

The amendments we propose would make clear that a product disclosure statement could be lodged for a derivative product type, rather than for each individual derivative contract (clause 33A). This would ensure that when issuers of derivatives made offers to many investors, each offer would not require a separate product disclosure statement. We recommend also a requirement that customised terms for specific investors not be disclosed (clause 43(2)). For the purposes of clarity, the bill’s scheme in respect of derivatives is outlined below:

If a derivative were entered into between

  • a licensed derivatives issuer and a retail investor (for example, a bank and a customer), then the issuer must make disclosure because of clause 27, but the retail investor need not because of exclusions in Schedule 1, including clause 35(1)(f).

  • a person who is in the business of entering into derivatives and an investor who is not (for example, an energy company and a retail investor), then the first person needs to be licensed because of clause 387(d) and must make disclosure because of clause 27, but the investor does not because of exclusions in Schedule 1, including clause 35(1)(f).

  • two licensed derivatives issuers (for example, two banks), then disclosure is not required because of exclusions in Schedule 1, including clause 35(1)(f).

  • two wholesale investors (for example, two large energy companies), then disclosure is not required because of the exclusion in clause 3(1) of Schedule 1.

  • two investors who are not in the business of issuing derivatives, then disclosure is not required because of the exclusion in clause 19(1) of Schedule 1.

Treatment of derivatives—new exceptions

Schedule 1 of the bill outlines the provisions relating to disclosure requirements and exclusions. As introduced, the bill provides an exclusion from providing a product disclosure statement to an investor for an offer of financial products where the minimum amount payable by the investor is at least $500,000. This exclusion is carried over from the Securities Act 1978 and is intended to provide a bright-line test for offers to wholesale investors.

This exclusion would not apply to many derivatives, as they seldom require large up-front payments. To provide an equivalent exclusion for derivatives, we recommend that the exclusion in clause 3 of Schedule 1 for offers with a minimum investment of $500,000 be accompanied by an exclusion for derivatives with a minimum notional value of $5 million.

Schedule 1 exclusions

Schedule 1 also provides various disclosure exclusions for offers under Part 3 of the bill. These exclusions would apply for investors who are considered to be capable of evaluating the merits of the offer or accessing the information they need, or where full product disclosure is otherwise not needed, because, for example, of the investor’s size and experience or relationship with the issuer.

We consider that significant changes should be made to two particular exclusions, as follows:—

Clause 36 of Schedule 1 specifies the criteria an investor must meet to be classified as a wholesale investor. We recommend reducing the criteria to three, of which the investor must meet one, simplifying the identification of sophisticated investors.

We recommend reducing the threshold defining a “large” person for the purposes of the wholesale investor exclusion in clause 37 of Schedule 1 to net assets of $5 million or turnover of $5 million in each of the past two years, from total assets of $10 million or turnover of $20 million over the past two years. Few businesses or individuals in New Zealand were likely to meet the higher threshold. We believe that an individual or business meeting the lower threshold is likely to be sufficiently sophisticated to participate in wholesale offers of financial products.

We recommend inserting a new exclusion for offers of financial products of the same class as quoted financial products (clause 18A of Schedule 1). We consider that continuous disclosure obligations to which a listed issuer would be subject would ensure that the market had already priced the risk associated with these products.

Principal purpose of superannuation schemes

The bill as introduced seeks to change the current law so that the sole purpose of a registered superannuation scheme must be to provide retirement benefits (clause 115). If a scheme has purposes that are not merely incidental to providing retirement benefits, we consider it should be registered as a standard managed investment scheme. However, we recommend some amendments to the application of this rule to allow existing superannuation schemes (or sections of them) to retain a “principal retirement purpose” if the scheme (or section) is closed to new members (clause 116(2)); and to allow workplace schemes (as defined in regulations) to provide benefits and allow withdrawals on leaving employment with the relevant workplace or industry (clause 116(3)).

We also recommend changes to clause 114(1) and clause 115(1) to restrict the provision of benefits, as well as redemptions and withdrawals, to the retirement purpose, and also to clarify that the potential for early withdrawal in accordance with the KiwiSaver Act 2006 (for example to facilitate first-home ownership) is not inconsistent with the sole purpose test.

Related parties for restricted schemes

Clause 161 places a 5% limit on investments in related parties of restricted schemes. This means that a restricted superannuation scheme provided to a company’s employees could not invest more than 5% of the scheme’s property back into the company. We support retaining this restriction on related party holdings for restricted schemes, and consider it is set at the appropriate level. It would provide the manager of the scheme with some flexibility to invest in a related party, but avoids excessive related party concentration.

However, we recommend that the 5% limit apply separately to non-associated persons. We consider it is necessary to make it clear that investments in businesses that are each a related party of the scheme but are not associated with each other would count separately for the purposes of testing compliance with the 5% restriction. We also recommend that, for workability reasons, the 5% limit should apply only to new acquisitions (although schemes would be required to sell-down existing holdings to comply with the 5% limit within a transitional 3-year period under clause 36 of Schedule 5).

For the related party transactions provisions generally, we also recommend that employer contributors be treated as related parties under clause 158 only for specified employer-related schemes (that is, those that employers have an involvement in other than merely as contributors) rather than all restricted schemes. These employer-related schemes would be identified at the point of their registration under the bill’s transitional provisions (see clause 21 of Schedule 5).

Territorial scope

We recommend amendments to the territorial scope provisions of the bill to make them equivalent to those in the Securities Act, extending the Financial Markets Authority’s stop order powers in clause 448 to apply to any restricted communications distributed to persons outside of New Zealand (see clause 452A). Further amendments are also proposed to provide for the Financial Markets Authority to seek civil remedies if there is a contravention of Part 2 in relation to such communications.

We consider that the territorial scope of the bill needs to be extended to allow the regulation of the conduct of New Zealand residents and businesses in respect of their offshore activities in limited circumstances. As introduced, the bill does not seek to replicate the existing territorial scope provisions of the Securities Act; we believe it should, to facilitate cross-border cooperation, and to regulate externally directed conduct to preserve the reputation of New Zealand issuers or service providers.

Crowd funding

Crowd funding is the pooling of a large number of small contributions to fund a business or project, generally over the internet. Clause 388 of the bill gives crowd funding intermediaries as an example of a type of licensed intermediary service that may be prescribed under regulations. We recommend that the Government, in due course, consider prescribing crowd funding intermediaries in regulations under the bill as an intermediary service for which providers could apply for a licence. Individuals seeking crowd funding through an intermediary service would be exempt from disclosure requirements under clause 6 of Schedule 1 (subject to limited disclosure and other requirements under clause 26 of Schedule 1).

Liability for audit opinions

We are aware of concern about liability for audit opinions, specifically the routine disclaiming of liability to third parties. We do not recommend amending the bill in this respect, but would like to see wider consultation and policy work in this area.

Licensing

We recommend amendments to the provisions for licensing of market services to recognise existing licenses under other licensing regimes. The amendments under clause 395 would require the Financial Markets Authority, in making its licensing decision, to have regard to whether the applicant was already a licensed provider under the Financial Service Providers (Registration and Dispute Resolution) Act and whether the proposed market service was merely incidental to other licensed services.

We also recommend amendments to facilitate group licensing by allowing related bodies corporate, not only subsidiaries, to be covered by a single licence where appropriate controls or supervision by the licensee can be demonstrated (see clause 398). The head licensee remains responsible for the related bodies corporate covered by the licence.

We considered the desirability of requiring the Financial Markets Authority to treat applicants who were already licensed under other regimes (for example, registered banks) as meeting any equivalent requirements under the bill. We agree that cross-recognition of equivalent requirements is highly desirable, but consider that this is a matter for regulations under Part 6, which would specify the substantive licensing requirements.

Commencement

We recommend that the default commencement date in clause 2(3) be amended from 1 April 2015 to 1 April 2017. We expect that most of the provisions of the bill would come into force well before that date. However, given the complex nature of the reform, we consider that the change to clause 2(3) would allow more flexibility to bring some provisions into force later.

Appendix

Committee process

The Financial Markets Conduct Bill was referred to the committee on 7 March 2012. The closing date for submissions was 26 April 2012. We received and considered 62 submissions from interested groups and individuals. We heard 37 submissions, which included holding hearings in Auckland.

We received advice from the Ministry of Business, Innovation and Employment, with the assistance of the Financial Markets Authority.

Committee membership

Jonathan Young (Chairperson)

Kanwaljit Singh Bakshi

Hon Chester Borrows

Hon Clayton Cosgrove (Deputy Chairperson)

Hon David Cunliffe

Clare Curran

Peseta Sam Lotu-Iiga

Mojo Mathers

Mark Mitchell