Speeches: Fourth Round Table on Capital Market Reform in Asia

Fourth Round Table on Capital Market Reform in Asia
Tokyo, 9-10 April 2002
Organisers: ADB Institute, OECD

MARKET STRUCTURES: Demutualisation, Cross Border Alliances, Mergers of securities and derivatives exchanges

DEVELOPMENTS IN NEW ZEALAND'S SECONDARY MARKET STRUCTURE AND REGULATION: NEW ZEALAND'S APPROACH TO GLOBAL REGULATORY ADVANCES

INTRODUCTION

This is an exciting time to report on developments in New Zealand's capital markets because the structure and regulation of these markets are undergoing profound changes. These changes reflect the increasingly international nature of securities markets and a convergence of international regulatory practice. As borders become less relevant for investment, markets must compete for investors. New Zealand aims to increase confidence in its capital markets by harmonising regulatory standards with international best practice. In particular, New Zealand wants to co-ordinate its regulatory approach with that of its closest economic neighbours.

BACKGROUND - NEW ZEALAND'S CAPITAL MARKETS REGULATION

Since 1978 New Zealand has developed a framework of securities regulation based on the disclosure of information to investors and the market. These rules have covered disclosure of financial and other information about investment products, disclosure by substantial security holders of their interests in public issuers, liability for insider trading, and disclosure by investment advisers and brokers.

As a general rule New Zealand has not imposed industry or occupational licensing on securities market participants. New Zealand's approach to securities market regulation has been described as relatively light-handed in comparison to that of some of our major economic partners. Direct regulation of markets has been the responsibility of self-regulatory organisations such as the New Zealand Stock Exchange (NZSE) and the New Zealand Futures and Options Exchange (NZFOE). This has been seen as appropriate in the context of the small New Zealand market and the high burdens that can be imposed by compliance costs in such a market.

The Securities Commission was established in 1978. It is concerned with the development of markets and practices for investment and savings products. The Commission administers aspects of securities law and can recommend changes to the law and grant exemptions to ensure securities market business is not impeded by inflexible regulation. The Commission has powers to act against illegal or misleading offer documents, to remove and appoint some market intermediaries, and can in some instances take court action to secure compliance with the law.

To date in the secondary market for the most part the Commission has not had a direct enforcement role in the traditional sense. The Commission has a function to review practices relating to securities and to comment on those practices. It undertakes formal inquiries and publishes reports highlighting incidences of market behavior that it considers do not meet the best practice standards that are required of market participants. These reports have been effective both in terms of the reputational risk they present and as useful guidance for market participants more generally.

Some aspects of New Zealand's market regulation, in particular insider trading, do not at present include a role for any public agency to bring court proceedings for breaches of the law. The focus until now has been on the enforcement of rights by shareholders and companies rather than on intervention by the Commission or any other public agency. This has placed the costs of enforcement of rights on affected individuals rather than on taxpayers generally through public enforcement. In practice there have been few successes through private insider trading litigation.

New Zealand's securities regulation has evolved since 1978 to work for a small market with well developed core rules of law to protect the rights of shareholders and other parties to contracts and that seeks to minimise the direct costs of compliance that are perceived to flow from regulation. This approach has evolved in a period of unprecedented freeing up of New Zealand market and monetary controls.

A NEW APPROACH - OVERVIEW OF CHANGES

New Zealand, along with many other countries, is looking at the place of its capital market in a larger regional and global context. It aims to increase domestic and overseas investor confidence in the structures and mechanisms of our markets. The government and the Securities Commission have been considering questions of compliance costs in the wider context of the costs and risks imposed on market participants by a regulatory structure that is seen as unique and that may not inspire the confidence of overseas investors.

It is fair to say that the theories of the market that have driven New Zealand's approach to regulation throughout the 1980s and 1990s are now being assessed with a more critical eye.¹ The international evidence is showing that solid laws and good enforcement provide positive results in terms of capital market development and the ability of issuers within a market to attract outside capital.

Over the past 3 years, as this new thinking on regulation has emerged, so the Securities Commission in New Zealand has changed its approach to market regulation. The government, elected in 1999, signaled its intention for the Commission to have and use powers making it a more effective enforcement agency.

The changes are not just legislative. Even before any law changes have come into effect the Commission has taken the decision to significantly increase its enforcement efforts. In 1999 the Commission put around 31% of its total resources into enforcement of the law. This has steadily increased, and for the second half of 2001 45% of total expenditure was committed to enforcement, an increase of more than 45% on the 1999 figure.

The changes described in this paper have been both market driven and policy driven. This process is well underway. This is an opportune time to report on progress and developments, on reforms that are before our Parliament, and on more that are planned.

As local market changes occur and there are ongoing changes to world markets, the New Zealand government and the Commission are considering the future regulatory structure of New Zealand's capital markets. These could feature a demutualised exchange and they will feature vastly increased access by investors to information, reliable and otherwise. There will be increased opportunities for direct investment in the markets in New Zealand and overseas. Market institutions must look beyond New Zealand borders to present investment choices for New Zealand investors and opportunities for overseas investors and companies. It is clear that effort must be directed to examining overseas developments to ensure that New Zealand market regulation conforms with best international practice.

This last year has seen the government, in consultation with the Securities Commission and others, produce a legislative package that gives new enforcement powers to the Securities Commission, adds a specific function of reviewing activity on stock exchanges, and promotes a mechanism for cross-border recognition of overseas securities regulation. These changes represent New Zealand's response to the same challenges of changing markets, changing institutions, and changing investment environment that are faced by every country in the Asia-Pacific region.

The New Zealand response is particularly relevant to other smaller economies in the region. It aims to make the New Zealand market attractive to overseas investors and cost-effective for local and international firms. The response seeks to recognise New Zealand's place in a trans-Tasman, Asian-Pacific, and global marketplace. It aims to ensure that New Zealand maintains appropriate standards of regulation to protect the interests of investors.

DEMUTUALISATION OF THE NEW ZEALAND STOCK EXCHANGE

Demutualisation of stock exchanges is happening worldwide. The NZSE was formed in 1981 by legislation that amalgamated the regional (mutual) stock exchange associations that had operated in New Zealand since around 1870. Almost 130 years later in 1999 the NZSE announced that it was seeking the introduction of legislation into Parliament to allow its members to vote on demutualisation of the exchange.

The New Zealand Stock Exchange Restructuring Act 2002 became law in late February this year. This law does not demutualise the NZSE, but provides a mechanism whereby the Members of the exchange can vote on demutualisation. This law had been introduced into Parliament as a Private Bill, a type of legislation that is intended for law changes that affect only specified individuals. The Bill was promoted by the NZSE, and did not require formal government policy approval.

Concerns were voiced about the regulatory and public policy implications of demutualisation of the national stock exchange. The Parliamentary Select Committee which examined the Bill recognised that the legislation, although presented as private law, raised a number of complex issues of wide public interest. The Committee recognised the advantages of demutualisation in allowing the NZSE the flexibility to operate in a changing financial environment, to explore options for operation offshore, and to expand its operations into new financial products. It noted that a company structure, particularly one with a public shareholding, could increase the transparency and accountability of board operations compared with those of a mutual organisation. However the Select Committee also recognised the important role of the NZSE in the New Zealand economy as a facilitator of investment in New Zealand business. It emphasized the importance of conformity by New Zealand's capital markets to best international practice.

The particular concerns that arose in the debate on the demutualisation of the NZSE were questions of conflicts between the commercial and regulatory roles of the exchange and administration of a securities market as a public good while trying to operate as a successful commercial enterprise. These are, not surprisingly, issues that were identified in the June 2001 IOSCO Technical Committee Report on Exchange Demutualization as having arisen in connection with stock exchange demutualisations in other jurisdictions.

The response to these issues has been in two parts. First, the Select Committee recommended that the demutualisation legislation be amended to address these matters in the particular context of the NZSE demutualisation. Secondly, and in conjunction with the New Zealand government's stated desire to increase confidence in the New Zealand securities markets, new legislation has been drafted to strengthen the regulatory environment in which stock exchanges will operate in New Zealand.

The response adopted by New Zealand builds on the experiences of other countries. In some ways, however, the New Zealand approach differs from that taken by several jurisdictions in our region. Parliament did not seek to impose direct regulatory control on the corporate governance of the exchange. It has not required government appointments to the NZSE Board, or government approval of directors' appointments. The New Zealand view has been that the corporate structure of any exchange company following demutualisation is principally a commercial matter for the NZSE. Indirect regulation affecting corporate governance has been imposed by the ownership cap required under the legislation, which is intended to act to provide protection against "capture" of the NZSE by any single interest. Beyond this, however, the corporate structure and control of the NZSE has been left as a matter for the demutualised exchange entity.

The Commission recognises the distinction that should be drawn between the commercial and regulatory functions of a demutualised exchange.² While the governance structure of the exchange as a company is not considered to be a matter for direct government control in New Zealand, the regulatory governance mechanisms set out in the Business and Listing Rules of the exchange for monitoring compliance by listed issuers and brokers and for enforcement of those rules will be of great interest to the Securities Commission as it advises the Minister on approval of the rules.

At present the Listing Rules of the NZSE are monitored and enforced by an independent Market Surveillance Panel that operates under delegation from the NZSE. The Panel's members are appointed by the NZSE Board (from nominations made by the Panel), but cannot be removed by it. A similarly created Disciplinary Committee has responsibility for resolving complaints and enforcing the Business Rules.

If the NZSE corporate entity decides to list on its own market this will trigger provisions in the new rules that will empower a Special Division of the Panel made up only of persons independent of the NZSE to assume all the powers of the exchange in relation to its own listing. This Division will not derive its powers through delegation from the NZSE Board, but directly from the exchange company's listing agreement. It is expected that in this way there will be complete disassociation of the regulatory and commercial roles of the Exchange. This is an innovative approach to a problem that has been encountered by all demutualised exchanges, and one the Commission will watch with interest.

The Select Committee reporting on the NZSE restructuring legislation added that although the changes introduced by the Bill would apply only to the NZSE, it considered it important that any other stock exchange operating in New Zealand be subject to similar restrictions. It recommended the government consider introducing more general legislation to address these matters in the wider context of New Zealand's capital markets. The Select Committee welcomed any measures to increase investor confidence while minimising compliance costs for investors, listed companies, and stock exchanges.

WIDER REFORM OF NEW ZEALAND'S MARKET LAWS

New Zealand's desire to have attractive capital markets that conform to international best practice has led to legislation before Parliament that will have a significant impact on the regulation of secondary markets. The wider reform package includes a number of specific measures to strengthen the regulation of secondary securities markets in New Zealand. This new Bill, the Securities Markets and Institutions Bill, provides for:

Two reforms in particular are important. Comprehensive international research on the use of laws to support securities markets by Professor Bernard Black of Stanford University identifies key legal and institutional preconditions for strong securities markets. Professor Black argues that there are two essential prerequisites for strong public securities markets. He summarises his findings saying:

This research suggests that continuous disclosure and insider trading legislation need particular attention in a market. The legislation currently before the New Zealand Parliament will create a statute-backed continuous disclosure regime that aims to ensure investors have access to material information about the business of listed companies. The obligations in the law are supported by powers for the Securities Commission, if necessary, to halt trading in a company's shares for a period to allow the market to become informed.

The government intends to conduct a full review of New Zealand's insider trading laws and other market conduct laws such as those relating to market manipulation. However, this will take time. In the meantime the reform package before Parliament will strengthen the enforcement mechanisms underlying current insider trading laws and other regulatory mechanisms. It does this by giving the Securities Commission a direct ability to take actions for insider trading, and by strengthening the Commission's investigatory and enforcement powers relating to market conduct generally.

Despite the proposed fundamental review of insider trading laws it was considered important as an immediate step to increase the enforceability of our laws. Recent evidence suggests that enforcement is the most important feature of market conduct laws. A survey of the insider trading regulation of 103 countries has found that it is the enforcement, not simply the existence of insider trading laws, that tends to have a positive effect on investors' confidence and that acts to lower the cost of equity in a country's markets.⁴ So, although there is a likelihood of first principles reform of New Zealand's market conduct laws as a result of imminent public debate on matters of market manipulation and insider trading laws, the government has decided to immediately increase the Securities Commission's ability to enforce insider trading law and other market conduct laws.

These reforms will ensure New Zealand's securities laws conform more closely with the regulatory environments of our nearest neighbours. Importantly they will permit the market regulator to act to combat market malpractice and provide assistance to our colleagues in other jurisdictions. The reforms signal a change in the emphasis for the Securities Commission from a monitoring, oversight, and law reform body to an enforcement agency with an explicit responsibility for securities exchanges.

These reforms aim to provide best practice legal and regulatory mechanisms to address potential risks of securities markets generally and of markets with demutualised exchanges specifically. The reforms recognise and address the potential for greater perceived conflict between regulatory and commercial roles in markets operated by demutualised exchanges.

Importantly, under both the specific demutualisation law and the general reforms, the NZSE and other securities exchanges will retain the core role as "front-line" regulators of their markets. A survey of stock exchanges by BTA Consulting carried out in 2000 returned overwhelming support for this approach.⁵ It showed that demutualised exchanges value their regulatory role as an important aspect of their ability to attract issuers and investors, and so generate a commercial return. The recent report of an Australian Senate Committee into aspects of that country's financial markets framework received evidence from the ASX that market operators have a strong vested interest in the efficient and robust regulation of the markets they provide.⁶ Retention of a self-regulatory role by an exchange permits the entity closest to the market to be responsible for the day-to-day surveillance of activity on that market and to take the lead role in ensuring compliance with the rules of the market.

New Zealand's securities exchanges will retain the role of front-line regulator of their markets but these reforms will involve the Securities Commission through its enforcement of continuous disclosure and its ability to direct companies and exchanges and to halt trading. These powers will, if necessary, be used to ensure that the interests of investors are protected in the New Zealand market.

The Bill envisages that exchanges and the Securities Commission will enter into agreements relating to information sharing and reporting of breaches of rules or laws. This allows a flexibility in the approach taken to each exchange and each market. It also provides transparency and certainty between the self-regulatory body and the market regulator regarding the responsibilities of each towards the market. This is important. There is a responsibility on regulators to be clear about their expectations of exchanges and to provide certainty to market participants about the administration of the rules of the market. A key complaint that has emerged from overseas exchanges that have demutualised is that regulators have not always been prepared for the challenges of demutualisation and have created difficulty for exchanges trying to meet all their stakeholders' expectations by constantly moving the regulatory target.⁷ Certainty is vital in the commercial environment. New Zealand has the benefit of the experiences of others and the Commission will aim to ensure that a consistent and clear message of expectations to New Zealand exchanges is provided.

STOCK EXCHANGE MERGER?

In 1999 the NZSE and the ASX discussed a possible merger of the two stock exchanges. The talks concluded in early 2001, with a decision taken by both parties not to proceed further at that time.

The decision not to proceed with a merger was stated to be principally a commercial one. The parties could not agree on a model for merger that would provide appropriate returns to the interests represented by each exchange. However, during this period of merger talks between the two exchanges, officials and the securities commissions in New Zealand and Australia held a series of discussions to assess the likely legal and regulatory implications of any merger. The first focus here was on regulatory barriers that might exist, and the manner in which these could be overcome. It became clear that a merger of exchanges would present a significant regulatory challenge. Such a merger, to be effective, would probably require settlement of a single regulatory regime to apply to the merged exchange. In evidence recently given to an Australian Senate Committee the Chief Executive Officer of the ASX described the difficulties associated with agreeing on a single regulatory regime that could operate in two countries as "the show-stoppers"⁸.

It became clear that a merger of exchanges across borders requires a high degree of similarity in the detail of the laws affecting each market. This requirement is driven by the need for traders, brokers, and listed entities to be able to operate seamlessly and effectively in both jurisdictions. The Australian Senate Committee that recently examined the regulatory framework in Australia agreed that these challenges at present appear to make cross border trading alliances a more realistic way of obtaining the benefits of exposure for investors and listed entities to overseas markets.⁹

The Sydney Futures Exchange (SFE) and the New Zealand Futures and Options Exchange have been merged at a corporate level since 1997. However, the operational framework adopted there was essentially to run the two exchanges as separate entities, each subject to dual regulation. The Sycom� trading system now used by both exchanges has the capability to allow New Zealand dealers and clients to access SFE products on their screens in New Zealand, but in order to allow this the SFE applied for designation as an authorised futures exchange in New Zealand. Similarly the NZFOE obtained exempt market status to allow it to operate its screens in Australia. Dealers who wish to access the screens of both NZFOE and SFE have had to be authorised participants, affiliates, or dealers of both exchanges. Each exchange complies with the regulatory requirements of its home regulator and reports to that regulator.

Within the self-regulatory framework and largely professional market of futures dealing this operation has been relatively successful (although for operational cost reasons further restructuring appears to be afoot). While the takeover of NZFOE by SFE was a corporate merger it has operated in fact more like a trading alliance, with the systems of each exchange available to access, trade, and settle contracts on either exchange. The effective settlement of contracts has been made possible by the common use of one clearing house, based in Sydney, the cross-trading by adoption of nearly identical trading rules, and by the use of a common electronic trading and settlement system. It appears that these factors, the alliance-style framework adopted, and the purely bilateral nature of futures contract trading (involving only participants, and not separately regulated listed entities), have permitted this merger to work largely without difficulty. It is doubtful whether the NZFOE/SFE experience could be applied in a more general sense to provide a model for cross-border mergers given the particular circumstances of the elements of commonality pre-merger, and the "alliance" nature of the operational arrangements post-merger.

ALLIANCES AND CROSS BORDER CO-ORDINATION

There seems to be a general consensus that one of the main barriers to inter-jurisdictional mergers is the need to achieve cross-border co-ordination of securities market regulation. This has been presented also as a relevant consideration when attempting to secure a trading alliance between exchanges in different countries. It is clear that the degree of co-ordination needed is less for an alliance than for a merger, and as with the ASX-Singapore Stock Exchange alliance, differences can be accommodated in extra-legal regulatory tools, such as by adapting the listing or business rules of one or both exchanges.

The question of co-ordination is of broad importance. As securities markets have become international there is a demand for greater access by investors to international markets at lower cost. Electronic communication networks, internet trading, and alternative trading platforms have increased the exposure of investors to the market. This increases both opportunity and risk. It is important that regulation does not hinder the growing cross border activity. Indeed it should, where possible, encourage it. At the same time it is important that regulation does maintain adequate protection for investors. One means of reducing the costs associated with cross-border investment is to co-ordinate domestic laws, and conform with accepted international best standards.

These are challenges that face virtually all jurisdictions. However a balance is needed in any approach to co-ordination of regulation. Local laws must always be drafted for local conditions. A small market particularly must consider the costs associated with new regulation, and the impact of these costs on the market and its participants. The interests both of investors and of issuers must always be kept in mind. Compliance costs for issuers will ultimately be passed to investors.

Despite the need to consider local conditions there are compelling arguments particularly for a small economy to conform its regulation to best international standards and to the standards of its major economic partners. Recent economic research shows that strong capital markets tend to be those that provide comprehensive protection for outside investors¹⁰. In this sense the term "outside" refers to all non-insiders, those who must incur significant search costs to learn about the value of a potential investment.

The argument simply put is that these protections are necessary to produce the confidence among non-insiders that investment in the market is worthwhile. This seems even more compelling when applied to overseas investors. These investors always have additional search costs to become familiar with the jurisdiction. Every aspect of the regulatory regime of a small market that operates in an unfamiliar manner (from the point of view of overseas investors) imposes higher costs on potential investors as they seek to understand the regulatory risks that may be associated with investment in the market. This is so regardless of the quality of the outcome that arguably is produced by the differential approach. The smaller economy needs to be careful that by differentiating it does not impose costs so high that overseas investors will be discouraged.

The current reform of New Zealand's capital market regulation has looked closely to our nearest neighbour, Australia. This is consistent with obligations under three bilateral agreements between Australia and New Zealand. The first of these was the Australia and New Zealand Closer Economic Relations Trade Agreement (CER), signed in July 1982. Since that time both governments have signed a Memorandum of Understanding on harmonisation of business law in 1988 and a further MoU on business law co-ordination in 2000. The 2000 MoU, with its focus on co-ordination rather than harmonisation, recognises a number of approaches to co-ordination, including harmonisation but also, importantly, mutual recognition.

This most recent MoU sets a clear and ambitious goal, "that in any given situation a firm will only have to comply with one set of rules and will have certainty as to how those rules will apply and will only have to deal with one regulator". The work programme that has stemmed from this MoU includes:

It will be some time yet before these goals attained. But first steps have been taken in the securities arena. The Securities Markets and Institutions Bill provides an ability for the government to exempt from registration a stock exchange that is licensed and regulated in another jurisdiction. Before doing this the Minister must be satisfied that an exemption would be in the public interest, having regard to the regulatory regime that applies to the overseas exchange. Such an exchange, although exempt from the regulatory steps required for registration in New Zealand, would be treated as a registered exchange for all purposes, including insider trading and disclosure laws, and the obligations to co-operate with the Securities Commission. This approach will, it is hoped, provide the security of a regulated environment for investors without imposing the compliance costs associated with registration in New Zealand.

Against the background of the specific treaty relationship with Australia that has led to initial work on co-ordinating securities laws a mutual recognition framework is being created under the current New Zealand law reforms. This framework relates to primary market offerings rather than to secondary trading. This may be useful to other countries in this region as an example of how a comprehensive mutual recognition mechanism could work to ease the regulatory challenges associated with international alliances and other cross-border arrangements for securities firms.

The Securities Markets and Institutions Bill sets up a mechanism whereby the New Zealand government can make regulations for the recognition of cross-border offers of securities that are made under the law of another jurisdiction. These regulations will be able to recognise specific jurisdictions, or specified products within a jurisdiction. Additional conditions can be imposed to fill gaps between regulatory regimes, or to ensure that New Zealand investors are fully informed of the nature of an offer. Importantly, the new law will have criminal offence provisions where an issuer operating under a recognition regime fails to meet a condition of the exemption regulations. This will allow New Zealand courts to take appropriate action where an offer has not complied with the law of an overseas country.

Recognition regime regulations for any jurisdiction will be permitted only if the government is satisfied that this is appropriate having regard to the securities laws of that other country and the interests of New Zealand investors. The government will be required to consult with the Securities Commission before making any regulations.

As well as allowing for the recognition of overseas laws, the reforms provide for "application regimes" to be created by regulation. The application regime mechanism is designed to allow the government to make regulations to be used in conjunction with another country operating a recognition regime, and will work to apply New Zealand law, under certain conditions, to an offer made to the public in that other country. This will allow New Zealand regulators and the courts to have regard for the welfare of both New Zealand investors and those in other countries to whom an offer based in New Zealand is to be made.

Lastly, the legislation provides a streamlined means for enforcement by local courts of pecuniary penalties imposed by an overseas court on any person for contravention of the overseas country's securities law, where the law is recognised in New Zealand government regulations. This will allow New Zealand courts to enforce either criminal or civil penalties imposed on a person by the overseas court. Where the penalty has been imposed by an overseas court on a person in New Zealand this will in some cases require recognition by New Zealand courts of the authority of an overseas court to extend its criminal jurisdiction to a person in New Zealand.

Measures such as these challenge traditional notions of jurisdiction and even sovereignty. While similar results can be obtained under European Union legislation, that occurs in the context of treaty arrangements and laws recognising the general competence and authority of a supra-national governmental framework. Recognition and application regimes such as that being created in New Zealand do not require such a framework. They will however require that both New Zealand's securities law and that of any other participating country provide robustly for the interests of investors, and do so in a manner that is broadly compatible with other jurisdictions. The Commission will await with interest the first mutual recognition regimes to be set up under the new legislation.

CONCLUSION

Changes to international markets in the last few years have placed demands on regulators to simplify and increase access for investors and for issuers to international markets. The recognition and application regimes New Zealand is creating, together with the embracing of more familiar market regulation, will allow first steps to be taken in this direction. If successful it may be that similar recognition regimes are possible in relation to secondary market trading, including to the operation of stock exchanges and other trading platforms. Ultimately the Commission would like to see that regulatory barriers cannot be held up as the "show-stoppers" to the commercial expansion plans of any exchange or trading firm.

A priority for New Zealand, like many other countries, is to make its markets more attractive to overseas investors. The government and the Securities Commission aim to reduce the perceived risk associated with unfamiliar regulatory structures for overseas investors while remaining cogniscent of the need to limit compliance costs. The government and the Commission are implementing changes to increase the confidence of domestic and overseas investors in the regulatory standards applying in the New Zealand market and the committed enforcement of those standards.