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NZIM Southern Business Forum

Jane Diplock AO
Chairman New Zealand Securities Commission
& Executive Committee, IOSCO

NZIM Southern Business Forum

21 July 2009

Introduction

According to a Financial Times report in April, the end of the world has been cancelled for now. Then, earlier this month, Reserve Bank Governor Alan Bollard noted signs of recovery on the horizon, and said this country was likely to start recovering ahead of the pack.

Close to home comes news that Christchurch is our most recession-proof main centre. Far more Christchurch businesses reported a good year than did businesses in Wellington and Auckland. Similarly, 39 per cent of Wellington businesses and 45 per cent of Auckland businesses reported a downturn, while only 28 per cent of Christchurch business said they were doing worse than last year. Christchurch companies were also more confident of an improvement within the next 12 months.

It's also true that our banks have suffered far less than those overseas. Four of the world's top 11 banks are the Australian banks currently operating here. Our banks enjoy some of the world's highest credit ratings, and, unlike some overseas banks, have not required public money to prop them up although deposits have been guaranteed and credit has been more difficult and expensive to obtain.

Recovery will undoubtedly come, but it needs a healthy corporate environment in which to flourish. I believe good governance is an element crucial to a healthy environment, as well as our best defence against a similar crisis occurring again. So that's what I'd like to focus on today.

First, though, let's look at the crisis, as it's played out overseas and here in New Zealand.

Causes of the global financial crisis

Most of you will be aware of the chain of causes that finally led to the global financial crisis:

• macro-economic fiscal imbalances, which resulted in domestic policies that fostered undisciplined credit
• reliance on continuous growth of asset prices
• opaque markets that developed toxic, over-valued products that failed to reflect concomitant risk
• lack of transparency
• inadequate infrastructure
• investor greed that sought yield without giving attention to due diligence
• markets reflecting perceived rather than true value.

What all these added up was a shocking loss of investor confidence in the markets. A loss whose effects can be seen and felt all around us - at the professional, social and personal levels. I firmly believe that what precipitated that disastrous loss of confidence was the eventual overwhelming by unregulated market forces of traditional, centuries-old standards of conduct.

It's easy for us in New Zealand to point an accusing finger overseas. The interconnection of world markets has never been so painfully obvious. Nevertheless we had a domestic collapse before the onset of the global financial crisis.

Finance company collapses and causes

Over the course of a couple of years, 29 New Zealand finance companies holding around $1.5 billion of investors' money either collapsed or froze repayments. In dollar terms, this represented only a limited section of the capital market, but the failures affected many. Not least because they had a serious impact on investor confidence generally.

This was a truly home-grown phenomenon. No blame can be laid on anyone beyond these shores.

Some of those unlucky investors may be in this room; more of you will know or know of people whose lost money. Some might see 7.5c, 40c or 65c for every dollar they invested.

This is uncomfortably close to home. Not just uncomfortable in the sense that we may have suffered direct losses ourselves or know someone who has, but uncomfortable because we may also know or live near or have done business with one or more of those whose behaviour was responsible for these collapses and their fallout.

The finance company collapses were not just bad luck. Quite often they were precipitated by a negligent failure to act - to do what was required to protect investors and, finally, the companies themselves. This is where corporate governance comes into the picture.

The Commission is committed to enhancing the performance of New Zealand's capital markets by encouraging good market practice via cost-effective regulation.

Our work has shown us again and again that most corporate failures and breaches of securities law are at least partly attributable to what is at some point a failure of governance.

We have seen a good deal of evidence that the root of the finance company collapses could often be found in poor corporate governance.

We have seen failures to ensure accurate disclosure and financial reporting, particularly in relation to party lending and/or asset quality. We have seen poorly capitalised companies without any liquidity buffer against a downturn. We have seen heroic valuations in a declining market.

There have been instances of too few directors, or even sole directors, on boards, as well as periods when boards included no independent directors at all. In some cases, independent directors failed to ensure they were adequately informed, or they took insufficient interest in the business.

Directors are, of course, entitled to receive and rely on expert advice, they should not do so blindly. Directors need to critically assess valuations and other external reports, and exercise common sense and good judgment.

We have seen ineffective audit committees or none at all. And we have seen poor handling of business growth or expansion, and evidence of failure to recognise or act on warning signs in a timely manner.

I am not claiming all finance company failures were attributable solely to poor corporate governance. But in my view this was often a contributing factor. Whether governance systems are rules-based or principles-based makes no difference. What does make a difference is that there are such systems and that they work properly.

New Zealand was caught up in the spirit of the times that too often allowed ethics and good corporate governance to be overwhelmed by the drive for gain. So we too have paid a price by sharing in the general downfall.

What good governance is

Good governance is, quite simply, the codification of sound ethical standards.

John Bogle is one of my colleagues on the international Financial Crisis Advisory Group that reports to the international accounting standards setters and informs the G20 group of finance ministers and central bank governors of its progress. John is the founder and former CEO of Vanguard Group of Mutual Funds in the US, and he has referred to the global financial crisis as "a crisis of ethic proportions".

Good governance, in John Bogle's view, is a common set of guidelines or tools that ensure self-interest does not get out of hand.

As a general principle, good corporate governance requires us to keep in mind that every decision we make, every initiative we institute, should be soundly based not just in the pragmatics of profit but also in decent values.

At a practical level, good governance embodies the following principles:

• fostering and adhering to high ethical standards in every decision we make and every initiative we institute
• ensuring boards are comprised of appropriately experienced, independent, skilled, knowledgeable directors
• ensuring remuneration policies are transparent, reasonable and fair
• ensuring risks are clearly identified and properly managed
• ensuring directors are confident of the quality and independence of auditing processes.

How straightforward and simple these principles sound. The challenge lies in putting them into practice, especially when they are most needed - during a financial crisis.

What's even more challenging is that such principles so often come down to us and our behaviour - what we do, and perhaps even more critically what we don't do, what we avert our eyes from and might be tempted to dodge responsibility for.

Good governance is good business

A further threat to effecting principles of good governance is that, in spite of everything that's happened in the last year or two, their application is still construed by some as business naivété.

We might be tempted to believe, even now, that such values amount to little more than touchy-feeliness, running counter to good business sense. We might hold fast to the idea that profit and principle are, and will always be, in conflict.

I don't merely take issue with that on a personal level. International research has shown it simply isn't true. Fundamental aspects of corporate governance play a key role in corporate performance. In other words, outcomes are, to some extent at least, dependent on values. Good corporate governance pays.

An investor opinion survey published in 2000¹ found that more than 84% of 200 global institutional investors were willing to pay a premium for shares in a well-governed company over one poorly governed but with a comparable financial record. Three-quarters of surveyed investors indicated that, in terms of potential investment, board practices were at least as important as financial performance.

The implications of this and similar studies are profound. By developing good governance practices, managers can add significant shareholder value. Companies not only need to be well-governed, they need to be seen to be well-governed.

Ten years on, and having been hit by the global financial crisis, those figures might be even more impressive. The role of good corporate governance in good business is widely recognized.² While it's impossible to formulate one internationally applicable standard, four elements are fundamental: fairness, accountability, responsibility and transparency.

As the 2002 King Report noted, the 19^th century was the century of the entrepreneur, the 20^th, the century of management. The 21^st century promises to be the century of governance.

As I said, my Commission colleagues and I firmly believe the global crisis and the New Zealand finance company failures were precipitated by a loss of confidence, that was in turn prompted by unregulated market forces overwhelming traditional standards of conduct.

A vital corollary is that the reverse is also true. By restoring professional and personal ethics to corporate governance, we can rebuild investor confidence, which will in turn encourage the flourishing of capital markets. Investor confidence is an essential plank in rebuilding our economy. The upswing we all look forward to will fail to eventuate without investor confidence to prompt it.

Now, more than ever, investors need the assurance of knowing issuers have in place robust corporate governance principles, and that the absence or over-riding of these principles will result in sanctions. This is where the Commission comes in.

We work to strengthen market confidence and foster investment. This, as I emphasised to the Summit on Employment earlier this year, is the only way forward for economic growth, which, in its turn, is a vital step in achieving full employment. The gains to individuals are obvious: confident, knowledgeable investors will be well-placed to benefit individually from the eventual economic recovery.

Before I tell you more about our current work, though, I'd like to explain our role in relation to the finance company collapses.

The Commission's role in the aftermath of the finance company collapses

The Commission is committed to doing everything in its power to encourage good conduct. Something people don't always understand is that the Commission could not have prevented the collapses. We cannot intervene to stop a company from failing. That is entirely outside our mandate.

Neither is it our job to make investment bullet-proof: risk is inherent in any investment and cannot be removed.

The Commission's task is to ensure risks are properly disclosed so the prudent investor can assess their individual risk in light of the offered return. Given cause to investigate we can assess whether or not offer documents such as prospectuses, investment statements and moratorium proposals are misleading.

Once the offer is allotted, this role ceases and we have no other role throughout the life of the investment. Trustees are given oversight of the product and of the behaviour of directors throughout the product's life.

Some collapses, though, as I've suggested, raised serious questions about directors' behaviour. So since the collapses we have been able to do a great deal of work. Where legal and regulatory breaches have occurred, the Commission can, and does, take action.

We energetically pursue those who have broken the law, and cooperate as fully as possible with other regulators. So, as well as carrying out our own investigations, we have been working with the Registrar of Companies, the Serious Fraud Office, receivers and other agencies to determine whether legal action is called for.

In December the Commission laid civil and criminal charges against nine directors of two failed finance companies, Bridgecorp and Nathans Finance. We allege that untrue statements published in their companies' offer documents misled investors.

Under law that came into force early last year, the Commission has the power to take civil action where companies' offer documents were registered or their advertisements distributed after October 2006. We can apply to the court for pecuniary penalty orders and, in some circumstances, for orders to compensate investors. We are determined to ensure that we bring to account those whose actions led to investor losses, and to the ensuing wider loss of confidence in the market.

The Government's wide review of the Securities Act will, among other things, look at fund managers and governance of funds, and consider the role of trustees. It may well be that changes introduce trustee supervision by the Commission. Directors' duties and the enforcement of them are particular issues for us.

The Commission's current work

The need to protect investors must, of course, be continually balanced against business needs. New Zealand businesses have come under a lot of stress from economic conditions caused by the global crisis and they report difficulties in raising and rolling over funds. Consequently, we have been working with Government and with the Capital Market Development Taskforce on proposed reforms to help firms raise capital and reduce associated costs.

Regulations must not impede access to funds. At the Commission we aim to remove unnecessary barriers without compromising investor protection. Our work here includes streamlining the listing rules to which listed companies are subject, and streamlining rules on raising additional funds from existing investors.

Legislation currently before Parliament aims to remove unnecessary impediments to raising capital, while ensuring prospective investors have access to the information they need. It would allow businesses listed on the New Zealand Exchange to use a simplified disclosure prospectus when offering securities to the public, thereby reducing the duplication of information.

We have recently used our exemption powers to allow a number of companies to raise money from the public quickly and cheaply, while still ensuring investors get the information they need.

The finance company collapses have illustrated the need for a comprehensive regulatory framework. A series of government reforms of securities markets have been aimed at bringing New Zealand's framework up to a high standard. These include regulation of financial advisers, prudential regulation of finance companies by the Reserve Bank and the powers for trustees.

This country's disclosure-based regime for securities regulation relies heavily on the honesty, competence and diligence of directors. Effective enforcement deters bad practices and market misconduct. It may also give affected investors a measure of redress. The Commission's enforcement work will focus on requirements for continuous disclosure, and we will work on the design of new, simplified prospectus requirements. Our finance company work has revealed significant mis-selling of financial products.

Implementing a supervisory regime for financial advisers is vital. New law will allow New Zealanders to be confident in the trustworthiness and competence of the financial adviser industry. Advisers are many investors' main point of contact. They must attain high standards of conduct and be accountable to those they advise. By the end of next year, this country's financial adviser industry will be operating in line with international standards.

The ultimate aim of all Commission work is to bring about reforms that will give New Zealand a world-class regulatory environment, thereby earning the confidence of both retail and institutional investors, here and overseas.

International work

Our international role is very important. These days, money moves around the world with a click of a mouse, and this country is only an island in the strictly geographical sense.

It's vital that New Zealand contributes to the setting of international standards for securities markets. As a small, open market, we will need to reflect these standards in our regulations in order to attract capital. That being so, it's crucial that we play a part in setting them. This role also provides an opportunity to work with New Zealand's overseas representatives in making international business and investor audiences aware that ours is a well-regulated market.

New Zealand is one of 109 members of the International Organization of Securities Commissions (IOSCO), whose reach extends to more than 95% of the world's securities markets. As the only recognized international standards-setter for securities regulation, IOSCO is an important part of the global financial architecture. I have the privilege of chairing its executive committee. This position enables New Zealand to be part of setting global standards and reinforces our reputation as a well regulated investment destination.

IOSCO aspires to fair, efficient and transparent global markets, in which investors are protected and systemic risk is reduced. It promotes implementation of its 30 Principles of securities regulation in all member states. It also promotes its Multilateral Memorandum of Understanding (MMOU), which facilitates cross-border exchanges of information and cooperation.

IOSCO believes good corporate governance is critical to the stability of capital markets. By setting high global standards, IOSCO is contributing to greater corporate integrity and excellence in corporate governance.

Conclusion

The world has discovered the hard way that sound ethical practice isn't merely a virtue worth pursuing for its own sake, but an absolute necessity if we want global markets built on strong foundations.

Recovery will come, but it will come more slowly and be less sure without that strong foundation. Sound ethical practice will restore and maintain the balance between hard-nosed pragmatism and traditional standards - a balance that's crucial if we are to regain some semblance of a healthy global economy.

In business, good governance can apply at every level - from the small investor and company director, through to large businesses, politicians and regulators, and regulatory bodies. Chief executive of the UK Financial Services Authority Hector Sants puts it this way: "The structure of governance in financial companies does not need radical overhaul. The attitudes and competence of the individuals who conduct that governance does."

Complying with the law is the minimum requirement. Rather, I urge all market participants to aim for best practice.

Eighty or so years ago, US president Franklyn D Roosevelt said, "We have always known that heedless self-interest was bad morals; we now know that it is bad economics." He was probably right then. He is certainly right now.

Thank you.

1 Cited in Executive Summary of the King Report on Corporate Governance, March 2002.

2 Cited in Executive Summary of the King Report on Corporate Governance, March 2002

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