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OVERSIGHT REVIEW OF NZX 2006

EXECUTIVE SUMMARY

1. The Securities Commission has reviewed NZX's performance of its regulatory functions as a registered exchange under the Securities Markets Act 1988. This review, the second oversight review of NZX conducted by the Commission, focussed on NZX's arrangements in the 2006 calendar year for discharging its obligations.
2. We report on NZX's performance under the following headings:
   • Conflict management
   • The NZAX market
   • NZX's frontline regulation
   • NZX Discipline
   • The Special Division
   • Recommendations arising from the review of the 2005 calendar year
3. The Commission's overall conclusion is that NZX is satisfying its obligation to operate its markets in accordance with its conduct rules.
4. NZX's performance as a registered exchange is good. However, the Commission has made recommendations for improvements in relation to a number of areas. These recommendations are set out below.
5. The Commission has communicated its concerns and recommendations to NZX, NZX Discipline and the Special Division. Responses of the parties in regard to the recommendations and the Commission's view on those responses are set out below.
6. NZX, NZX Discipline and the Special Division have already agreed to take specific action in response to certain recommendations and have committed to do so by 30 September 2007. If NZX, NZX Discipline and the Special Division take these actions within the stated timeframe, the Commission believes this will address those recommendations.

Findings and recommendations

Conflict management

For-profit exchanges face particular risks as a result of their competing commercial and regulatory interests. NZX is aware that some parties perceive that NZX is subject to conflict between its commercial and regulatory functions and the risks that arise from such conflict. The Commission is satisfied that NZX has satisfactory practical measures in place to address those issues at this time. However, these measures do not mean that these risks are not relevant to NZX.

NZX considers that ensuring the proper regulation of its markets is in NZX's best interests as it engenders confidence which subsequently increases investment in the markets. Nevertheless, the existence of these incentives does not mean there is not an inherent conflict of interest. The Board of NZX accepts that there is a conflict that theoretically could arise due to its listed company status, and the Board states that it believes that this conflict is appropriately managed, and that the conflict is kept under review at the Board level. The Commission welcomes these comments from NZX.

• NZX should ensure that the Board is provided with relevant and up-to-date information on conflict management in relation to for-profit exchanges and that this information is subject to regular discussion at Board meetings.
• NZX should ensure that the practical measures used to ensure the practical separation between its commercial and regulatory functions have reference to the information in relation to for-profit exchanges the Board receives on conflict management.

NZX has agreed to prepare a Board paper updating the Board on the IOSCO Report and arrangements that other for-profit exchanges have implemented to manage conflicts (to the extent this information is publicly available). The Board has determined to discuss this matter each November at its annual two-day Board strategy review. NZX has also agreed to have regard to this information in its practical measures to ensure separation between its commercial and regulatory functions.

The NZAX market

The Commission does not have any recommendations in this area. The Commission is satisfied that NZX is applying rigorous regulatory standards to the NZAX despite its smaller size and less demanding Listing Rules. However, the Commission is concerned that the lack of understanding about the lower-cost NZAX regime may disadvantage the NZAX in market competition with other sources of capital, such as unregistered exchanges and private equity. The Commission considers that education of Sponsors and NZAX Issuers as to the regulatory differences between the NZAX and the NZSX should be a priority for NZX. The Commission anticipates that the recently commenced education programme will help to achieve this. The Commission is concerned that there may be an element of misunderstanding about the NZAX Listing Rules and the effect of those Listing Rules and that this has been entrenched since the NZAX was created. The Commission is pleased that NZX has undertaken the review of the NZAX market and supports the actions it has taken to address the issues which were identified out of that review.

NZX's frontline regulation

The Commission does not have any recommendations in this area. NZX is taking appropriate action to minimise the risk of non-compliance through various mechanisms, including waivers, education initiatives and using disciplinary proceedings as a deterrent. The Commission is satisfied that the processes and procedures which NZX uses to enforce compliance with the Listing Rules and Participant Rules in respect of admission of Issuers or approval of Market Participants are satisfactory and applied properly.

NZX Discipline

The Commission is satisfied that NZX Discipline is independent of NZX and is producing work of a high standard. However, the Commission did identify some issues in the course of the review. In particular, the Commission was concerned to find that NZX Discipline had sought an advance opinion from NZX on the procedure which it proposed to follow in a matter before it. The Commission considers this was inadvisable.

The Commission is concerned that Market Participants who have been found to have breached the Participant Rules are not being identified. Not only is publication a significant tool in deterring breaches, but it is also imperative that NZX Discipline be seen to be sanctioning Market Participants for any breaches. The Commission believes that market confidence will be increased if NZX Discipline is transparent in naming Market Participants who have breached the Participant Rules.

The Commission found during the review that NZX Discipline had ruled on the scope of its review powers under the NZX Discipline Rules. This ruling was contrary to submissions by NZX, which would have narrowed the scope of the review power. Subsequently NZX has sought to amend the relevant NZX Discipline Rule, effectively overturning NZX Discipline's ruling for future cases. The NZX Discipline Rules do not at present give NZX Discipline any formal role in reviewing amendments. The Commission has concerns about the impact of this on NZX Discipline's autonomy and considers that NZX Discipline should be given an advisory role in determining any changes to the NZX Discipline Rules.

It appears to the Commission that although NZX Discipline has stated that it does not feel its access to resources is in any way limited by NZX, and NZX has repeatedly asked NZX Discipline whether it requires further resources, that NZX Discipline in fact requires more resources in order to action non-urgent work within reasonable timeframes. The Commission is concerned at extensive delays which have occurred in two matters in particular, the first of which is the review of the NZX Discipline Rules and the second of which involves a third party.

The Commission also considers that it would be valuable if information about the role, membership and mandate of NZX Discipline were more readily available to the market. Although information is provided in the Annual Regulatory Report, the Commission does not consider that this is sufficient.

• NZX Discipline should ensure that, when determining the procedure to apply to a proceeding before it, it treats all parties evenly.
• NZX Discipline should be seen to be transparent in exercising its discretion whether to publish decisions which identify Market Participants who have breached the Participant Rules. Where a Market Participant's details are not published, NZX Discipline should disclose its reasons for withholding this information.
• NZX and NZX Discipline should review the NZX Discipline Rules in order to give NZX Discipline input into its own Rules, and amendments arising from this review should be included in the amendments which are presently being considered by NZX Discipline.
• NZX Discipline should review its resource requirements and structure, and communicate its needs to NZX, so that delays in dealing with non-urgent work are minimised or removed.
• NZX should provide more information about the role, membership and mandate of NZX Discipline on its website. In particular, the contact details for NZX Discipline should be included on the NZX website.

NZX Discipline agrees that it should treat all parties evenly.

NZX has agreed to provide more information about the role, membership and mandate of NZX Discipline on its website.

The Special Division

The Commission is satisfied that the Special Division is operating effectively. In particular, the Commission noted one disciplinary matter regarding a subsidiary of NZX that arose during the review period. It appears that the Special Division endeavoured to act in a way that was consistent with NZX Regulation's approach and further, that it sought advice on the course of action it should take.

The Commission considers that it would be valuable if information about the role, membership and mandate of the Special Division were more readily available to the market. Although some information is provided on the NZX website concerning the role of the Special Division, it is not extensive or easy to find.

• NZX should increase the amount of information it provides about the Special Division and make it easier to find. In particular, the contact details for the Special Division should be included on the 'Contacts' and 'Supervision of NZX' pages of the NZX website.

NZX has agreed to provide more information about the Special Division on its website, in consultation with the Commission.

Recommendations arising from last review

The Commission made 21 recommendations in the course of the last review. NZX had responded to some of these prior to the report being published, and responded to the remainder on 7 December 2006. The recommendations, NZX's responses and any additional comments from the Commission are included in this report.