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Review of the Securities Regulations 1983

PROPOSALS FOR CHANGE

The Ministry and the Commission have developed proposals for change to the Regulations based on experience of their operation and suggestions received from stakeholders. The proposals are characterised by a number of key themes, which are discussed below. This is followed by a detailed description of the proposals for change.

Modernisation, increased flexibility and technological neutrality

As outlined earlier, the Securities Regulations need revising in light of the considerable changes in the capital markets environment since the Regulations were originally implemented. The current Regulations contain some outdated terminology. Some of the underlying assumptions about the nature of securities offered and the entity offering the securities are no longer always appropriate. In some areas the Regulations operate to restrict the use of electronic technology or electronic commerce.
It is important that investors are provided with information that is both accessible and appropriate for the investment. It is also important that the Regulations do not operate to restrict the growth of electronic commerce as it applies to capital markets. These factors are important as they contribute to the efficiency of capital markets. In order to achieve this efficiency, the proposals include changes to make the Regulations more flexible in a constantly changing environment, while maintaining appropriate disclosure to investors.

Clarification and simplification of definitions and substantive provisions

In places, it is unclear how the Regulations should be applied. Where practicable, unclear definitions and substantive provisions will be amended to ensure they effectively and clearly implement the policy of the provision. Increased clarity in the Regulations will reduce uncertainty and associated legal costs for issuers. It will also help to ensure that investors receive consistent and appropriate information in offer documents.

Financial information

As a general principle, we think there should be no fundamental difference in the information content between financial statements presented in offer documents and financial statements presented to shareholders in an annual report. Both sets are historical but aid users in making decisions about the future. In the case of financial statements in offer documents the decision is whether to invest or not to invest. In the case of financial statements in annual reports, the decision may be whether to sell or hold. Users of financial statements are making investment decisions at a specific point in time based on historical information that will affect their future. If specific future oriented information is considered to be important to investors, this should be prescribed as prospective financial information.
It is therefore proposed, as a general principle, that financial statements required by the Regulations should be prepared in accordance with the Financial Reporting Act 1993 as if they required registration under that Act. This will mean that financial information disclosed in offer documents will continue to reflect Generally Accepted Accounting Practice ("GAAP") as it develops over time. Also, it should assist investors and analysts if concepts and terminology are used consistently in relation to disclosure under the Securities Regulations and disclosure under the Financial Reporting Act.
In applying that general principle, certain key points of difference between the current prescription and GAAP arise. These differences and our proposals for dealing with them are discussed in this paper. Our basic premise in this regard is that Regulations should not provide ad hoc financial reporting requirements if the decision is to move towards compliance with GAAP. Currently, Regulations provide for disclosure, not measurement or recognition, of transactions. Our preference is to make our views and concerns known to The Institute of Chartered Accountants of New Zealand ("ICANZ") through our comments on exposure drafts of accounting standards and by working with ICANZ on matters which we consider to be important. Having said this, we do not discount the possibility that the Regulations may call for disclosure of additional or alternative information to that required by GAAP in order to achieve the objectives of securities regulation, and it may be necessary to provide explicitly for this in the Regulations.

Removal of duplication of definitions in the Act and Regulations

There is currently considerable duplication of definitions in the Securities Act and in the Regulations. At one time the drafting philosophy was to repeat definitions so that the subordinate legislation could be read in a meaningful way on its own. However, that philosophy has not been consistently applied in the Regulations. Some definitions are not replicated, and of those that are some are identical and some differ. This can be confusing.
There seem to be two approaches to dealing with this:
- to review the definitions and where necessary make particular alternative arrangements for dissimilar definitions; or
- to revoke all replicated definitions that are identical.
We welcome your views.
A number of stakeholders have also raised specific issues in relation to particular definitions that appear in both the Act and the Regulations. The Ministry, in consultation with the Commission, will consider these issues in the context of its work on the Business Law Reform Bill to be introduced in 2001.

Removal of obsolete references

There are a number of areas in the Regulations where obsolete references are made. These include references to companies registered under the Companies Act 1955 and some transitional provisions.
It is proposed that these references will be revoked.

SPECIFIC PROPOSALS

The Securities Regulations 1983

Regulation 2(1)

Regulation 2(1) sets out the definitions of terms used in the Regulations. There are several proposals for change to definitions in this Regulation.
1. Some definitions in the Regulations are also in the Act. These include: associated persons, Commission, company, contributory mortgage, debt security, equity security, holding company, interest in a superannuation scheme, issuer (although the extended definition effect of section 6(7) in the Securities Act will need to be considered in any proposal for change), life insurance company, life insurance policy, manager, participatory security, promoter, superannuation scheme, superannuation trustee, trust deed, unit, unit trust and unit trustee.
  - We propose to review or revoke these definitions as discussed in paragraph 29 above.
  The term "trading exchange" and its definition, and paragraph (a) of the definition of the term "holding company", are obsolete.
  - We propose to revoke them.
2. If the decision is to adopt GAAP, all accounting terms used in the Regulations should be defined by reference to GAAP.
  - We note that the definition of the term "intangible assets" may require review in light of any amendment to the provisions of the Regulations in which it appears.
3. The definition of "immediate relative" refers to the "spouse" of a person but not to de facto or same sex partners. There does not appear to be any reason for this distinction, although it does give certainty in that a person is either married or they are not. Presumably the intent of the provision is to capture close personal relationships with persons in whose economic welfare one is likely to have a strong interest, which could equally apply to de facto and same sex partners.
  - It is proposed that the definition of "immediate relative" be extended to include de facto and same sex partners, subject to review to ensure that the definition can be expected to apply with reasonable certainty.
4. The term "qualified audit report" in the Regulations includes an auditor's report that is not qualified but refers to an uncertainty which, in the opinion of the auditor, is fundamental. This definition is not consistent with the Auditing Standards, which do not require an auditor to issue a qualified audit report for a fundamental uncertainty that is adequately disclosed in financial reports. It has been suggested that the term "modified audit report" be used to refer to audit reports that refer to a fundamental uncertainty.
  We think that information that an issuer is facing a fundamental uncertainty, for example, a going concern uncertainty, is important information to investors and should be brought to their attention. We think the fact that a qualified audit report was issued is important information for investors. This is so particularly where the full financial statements are not readily available to investors, for example, in the case of historical summary financial information. However, we do not think that it is useful for the Regulations to specify new terminology to describe such audit reports.
  - It is proposed that no change be made to the term.
5. The term "returns" in the Regulations, in relation to a security, includes payments of any kind, whether in the nature of capital, income, benefits or otherwise.
  The definition of "returns" in the Regulations is similar in concept to the idea of a "distribution" under the Companies Act 1993. Because the Companies Act 1993 relies on a solvency test and no longer requires capital to be maintained before distributions are made, a distribution may include a return of the amount invested as well as a return on the amount invested. This means that for certain entities, the notion of "capital maintenance" is no longer as relevant as it was in the past.
  There is no definition of "returns" in GAAP. However, in financial terminology, "return" normally relates to money earned on an investment and does not include a return of all or part of the amount invested. Further complications arise when promoters or issuers express returns to investors in percentage terms and include a return of the investment, or part of it, in expressing that percentage rate of return. We think that this has the potential to confuse or mislead.
  - We propose that the Regulations include a definition of the term "rate of return". We are interested in receiving comments on how this should be formulated and whether this would be helpful.
6. The term "life insurance company" in the Regulations is wider than the definition in GAAP and does not require an issuer of life insurance policies to come under the Life Insurance Act 1908. This means that those entities which are not "life insurers" as defined in GAAP but which issue life policies would not need to comply with FRS-34 "Life insurance business".
  - This issue may need to be kept under review to bring the two definitions closer together, and we welcome any comments on it.
7. The term "group" in the Regulations is defined differently than in GAAP. GAAP defines "group" to comprise "the investor, subsidiaries, in-substance subsidiaries and associates" (SSAP-8 and SSAP-17).
  In the First Schedule, "group" refers to the "issuing group" which is defined as "the issuer of the securities and all subsidiaries of the issuer at the specified date" (Regulation 2(1)). The term "subsidiary" has the same meaning as in section 2(1) of the Financial Reporting Act 1993.
  The above definition would, it appears, exclude associates from the consolidated financial statements that are required to be disclosed by the Regulations. In addition, it would require all subsidiaries at the specified date to be consolidated. ED-84 "Consolidating investments in subsidiaries" proposes to prohibit an investor from consolidating temporarily controlled subsidiaries (i.e. those subsidiaries that the investor is obligated to or plans to relinquish control within one year). This is not a current requirement of SSAP-8. Deferring to GAAP would mean that in future, not all subsidiaries of an issuing group would necessarily be consolidated.
  In the Second Schedule, "group" refers to the "borrowing group" which is defined as "the issuer of the securities and all guaranteeing subsidiaries at the specified date" (Regulation 2(1)).
  This definition, which includes a guaranteeing in-substance subsidiary, would, however, exclude all non-guaranteeing subsidiaries, non-guaranteeing in-substance subsidiaries and associates, although the debt issuer's investments in non-guaranteeing subsidiaries and associates are recognised as such in the financial statements of the borrowing group. Clause 32 of the Second Schedule also explicitly excludes the use of the equity method of accounting. The effect of this is to exclude the equity accounted results of associates in the consolidated financial statements of the borrowing group. The definition of borrowing group may make it difficult for some debt security issuers to use GAAP financial statements for prospectus purposes.
  In the Third Schedule, the financial statements are those of the "scheme". "Scheme" is defined as "the arrangement or scheme to which the security relates" (Regulation 2(1)).
  There is no equivalent definition of a "scheme" in GAAP. The closest definition would be the definition of "entity" which means "any legal, administrative or fiduciary arrangement, organisational structure or other party" (SAAP-8 and FRS-34). In practice, in many cases, the scheme's financial statements are extracts from a reporting entity's financial statements (for example, the manager's financial statements) in respect of that scheme. We may need to do more work on this.
  - Having said that, we welcome comments on the following points:
    
    How should investments in non-guaranteeing subsidiaries be treated for the purposes of the Regulations?
    
    Does clause 4 of the Second Schedule, which relates to guarantors that are not part of the borrowing group, provide for adequate disclosure? In particular, should full financial statements of a guarantor that is not a guaranteeing subsidiary be disclosed? Should the requirements be any different where the guarantor is the issuer's parent company?
8. The term "equity method of accounting" in the Regulations is defined by reference to GAAP. Currently, there is an exposure draft ED-81 which proposes to make changes to the manner in which equity earnings from associates are disclosed in financial statements. ED-81 proposes that the investor recognise the complete equity earnings from the associate in its pre-tax operating surplus "above the line". These proposals are inconsistent with the requirements of the Schedules which require the disclosure of investment revenue from "associated bodies corporate" "above the line" and other surpluses or deficits that result from using the equity method of accounting "below the line".
  We understand that there is also a proposal by accounting standard setters to abandon the use of the equity method of accounting.
  - This issue may need to be reviewed depending on the outcome of the GAAP proposals.
9. The Regulations require realised gains and losses to be distinguished from unrealised gains and losses. GAAP does not require such a distinction. For example, Regulations require, where material, the disclosure of the amount of foreign exchange gains or losses recognised in the Statement of Financial Performance, distinguishing between realised and unrealised gains and losses. GAAP does not require the realised component to be distinguished from the unrealised component where foreign exchange gains and losses are to be credited/debited to the Statement of Financial Performance.
  A similar requirement exists in Schedule 3A (unit trusts) and Schedule 3B (life insurance policies) and Schedule 3C (superannuation schemes) which requires realised net gains or losses on investments to be distinguished from unrealised net gains and losses on investments. The Commission has given an exemption to superannuation schemes from having to distinguish between the realised and unrealised components on the basis that FRS-32 "Financial reporting by superannuation schemes" does not require such a distinction. FRS-34 "Life insurance business" also does not require the components of the net gains and losses on investments to be distinguished between realised and unrealised.
  - Should the regulations defer to GAAP in this matter?
10. Financial Reporting Standards apply where the application is of material consequence to the users of the financial report. As we understand the position this includes prospective investors in the reporting entity. Each Financial Reporting Standard provides that it "shall apply to all financial reports where such application is of material consequence. A statement, fact, or item is material if it is of such a nature or amount that its disclosure, or the method of treating it, given full consideration of the circumstances applying at the time the financial report is completed, is likely to influence the users of the financial report in making decisions or assessments".
  In the Regulations, there is no overall materiality criterion. In instances, the Regulations do include the words "where material" in relation to specific disclosure requirements. It is assumed that, in all other instances, disclosures should be made whether or not material. It is possible that the adoption of GAAP will mean that some disclosures will not be made where the items are not material.
  - Should the Regulations defer to GAAP in this matter?

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