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OVERSIGHT REVIEW OF NZX 2006

28 June 2007

INTRODUCTION

This is the second oversight review of NZX's performance of its regulatory functions as a registered exchange under the Securities Markets Act 1988 and covers the 2006 calendar year.
The first review of NZX focussed on the activities of NZX more generally. The report provided a general overview of the business and processes of NZX and its regulatory function. The 2006 review updates progress made from the first review, and focusses on three specific areas: the management and operation of the NZAX market, the admission or approval of Issuers or Market Participants, and NZX's role in minimising the risk of non-compliance with the Listing Rules and Participant Rules. These three areas reflect the areas in which the Commission considered deeper review and analysis would be valuable.
NZX has obligations under section 36G of the Securities Markets Act 1988 to secure compliance with its Listing and Business Rules, and to perform any obligations that lie on NZX under those rules.
The Commission has statutory functions to review practices relating to securities and activities on securities markets, and to comment on these. In relation to NZX, performance of these functions requires the Commission to keep under review and comment on NZX's performance of its obligations as a registered exchange.
The Terms of Reference for the Commission's review, along with the scope of and the background to the review and the process that we followed, are set out in the Appendix to this report.
The report contains six sections with 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.

CONFLICT MANAGEMENT

In the 2005 oversight review, the Commission considered the conflict inherent in a demutualised exchange between its regulatory and commercial functions. The Commission's report stated:

"The Board of NZX has told the Commission that whilst it does not consider that such a conflict in fact exists, NZX and the NZX Board are aware that the perception of such a conflict can exist and is held in some quarters. The NZX Board considers that addressing this perception is important and it is engaged to ensure that the perception of such a conflict is addressed, including by keeping under review its regulatory structures and their position within the organisation."

The Commission considered that there was in practice effective separation between NZX's supervisory functions and its corporate activities at the time of the 2005 oversight review. However we considered that this issue was of ongoing relevance to the oversight review process. Accordingly, this issue was specifically addressed again during the 2006 oversight review.
In November 2006 the Technical Committee of IOSCO released a report entitled 'Regulatory Issues Arising From Exchange Evolution - Final Report'. The IOSCO Report discusses the implications and impact of a changing environment on the regulatory role of stock exchanges. A number of key issues were identified, including the need to balance the commercial and public interest functions of a demutualised exchange. While the Commission notes that conflicts arise in other ownership structures as well, in this report we comment only on the conflict that is particular to demutualised, listed stock exchanges.
In particular, the IOSCO Report identifies a potential cause for concern in the following terms:

"for-profit exchanges may reduce the resources they devote to regulation. Worse, they may place insufficient value on the regulatory process, fail to sustain a strong regulatory culture and be less willing to co-operate with their supervisory authorities and other regulatory bodies."

The Commission acknowledges that it did not find any evidence that NZX was undervaluing its regulatory function in any of the ways outlined in this quote.
The Board of NZX has stated that it accepts that there is a conflict that theoretically could arise due to its listed company status, and in that respect the Board acknowledges the statements in the IOSCO report concerning conflicts that exist in a for-profit exchange environment. The Commission welcomes these comments from NZX. The Board has stated it believes that in the current circumstances the conflict is more theoretical than real.

Autonomy of the regulatory function

Information obtained during the 2006 oversight review demonstrated that NZX views its regulatory function as an integral part of the NZX business. In particular, NZX noted it is devoting sufficient resources to regulation and has satisfactory physical separation between its regulatory and commercial teams. NZX does not consider that creating an organisationally separate regulatory function is an appropriate course of action at this time. NZX has concerns that separation would make the commercial arm of NZX more vulnerable to takeover and would diminish the reputation of the NZX business.
However, NZX does have various mechanisms in place in order to increase the autonomy of NZX Regulation, including:
1. physical separation of NZX Regulation staff from non-Regulation staff through the structure of the NZX offices;
2. a secure hard drive for NZX Regulation files which cannot be accessed by non-Regulation staff;
3. the Head of Market Supervision is provided with time at each Board meeting so that she can raise any concerns without the CEO present; and
4. NZX Regulation, NZX Discipline and the Special Division have open-ended budgets, to allow for the execution of their regulatory functions without financial constraints.
During the review period NZX made a number of organisational changes. In respect of the regulatory function specifically, NZX moved the Client and Market Services team from the Market Supervision Group to the Information and Fund Businesses Group. However, this team still performs a regulatory function and works closely with the Regulation team. The Commission does not believe that this materially changes the treatment of the regulatory and commercial functions.
The Commission notes that the IOSCO report does not go so far as to recommend that exchanges adopt a particular structure. However, the Commission intends to keep the risks identified in that report under review and expects NZX to do the same. Notwithstanding this, the Commission considers that the mechanisms currently in place are functioning as intended and are satisfactory at the present time.

Commercial pressure to reduce regulatory standards

It was noted by NZX in the course of the review that some companies perceived the regulatory requirements for listed companies, including the Listing Rules and requirements pursuant to the Securities Markets Act 1988, as a barrier to listing or an undesirable consequence of listing. The Commission considers that in light of the availability of alternative vehicles for capital-raising in New Zealand markets there is a risk that NZX will feel commercial pressure to reduce regulatory standards. This type of commercial pressure was identified in the IOSCO report as potentially giving rise to a 'race to the bottom' in regulatory standards.
The Commission notes however, that there are checks and balances on any proposal to amend the Listing Rules, including comments from the Commission itself.
NZX is firmly of the view that membership of a regulated market is a benefit to companies. It increases investor confidence in a company and increases a company's ability to communicate clearly and effectively with its investors. The Commission agrees membership of a regulated market can be a significant benefit.
NZX particularly noted that the regulatory function, and the effective operation of that function, contributed positively to NZX's commercial reputation and brand. The Commission sought information about how NZX positively promoted its regulatory function. NZX demonstrated it was providing stakeholders with information explaining the benefits of listing on a regulated market. For example, NZX staff presented seminars at which Issuers were invited to tell the story of their listing and the benefits arising from that. The Commission is satisfied that NZX is acting appropriately and proportionately to improve stakeholders' perceptions of the regulatory requirements of the Listing Rules as a benefit. It considers this may further reduce the risk that NZX will face commercial pressure to diminish regulatory standards.

Recommendations

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 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.

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