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The effects of the credit crisis on the trans-Tasman environment,
and the New Zealand response

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

Australasian Compliance Institute - New Zealand Financial Sector Forum
Auckland

27 August 2009

Introduction

It's a pleasure to be here this morning to talk to an audience that understands the role of sound regulation, ethics, governance and risk management in building fair, transparent markets.

We live in interesting times.

The current market turmoil isn't just front of mind for those of us whose work revolves around financial markets; it also concerns market participants and consumers the world over. What we do now or don't do will have repercussions for generations to come.

I want to emphasise, though, that the bulk of the Commission's work is not dominated by crisis response.

We were well on course to bring this country's securities markets up to international standards long before there was any hint of a crisis. We were then and are now focused on putting in place the kind of sound regulatory framework every capital market needs.

Several other work streams are not crisis-oriented. One flows from the finance company failures. Within a couple of years, 29 New Zealand finance companies here either collapsed or froze repayments. This preceded the global crisis, and occurred in products beyond the coverage of our regulatory framework. Blame cannot be laid at the door of factors originating overseas. They were domestic in origin.

A third stream involves a major review of our establishing Act, which will look at the entire regulatory landscape and the Commission's role in it. Again independent of the crisis, we are making significant progress towards a virtual trans-Tasman market.

A fifth stream of work is, however, a crisis response. With credit channels constrained, companies are having difficulty raising funds from banks. Our work in this area focuses on allowing companies to more easily raise capital through securities markets.

Although most of our work is not generated by the crisis, it has to be said that New Zealand, along with everywhere else, is experiencing aftershocks, which are likely to go on for some time.

Lessons from the global credit crunch

While the origins of the crisis lay largely in imbalances between world global markets, the mischief at its heart occurred largely in under- and unregulated financial products. It emerged in off balance sheet vehicles, and mortgage-broking houses and entities beyond regulatory reach. It was particularly a response to the behaviour of intermediaries driven by conflicts of interest, malpractice, and unethical behaviour. Then, with investor confidence in freefall, the markets followed, leading to a hemorrhage of value in every country.

Both Australian and New Zealand governments announced guarantees for bank deposits, and in this country, also for non-bank deposit takers, such as finance companies. The goal was to engender confidence in the banking system, and especially in deposits.

Too often, policymakers and commentators see financial stability as the domain of banking and prudential supervision frameworks. Yet one thing the global crisis has clearly demonstrated is that capital markets form a vital part of the equation.

There's strong evidence that a well-functioning financial system is an important pre-condition for economic growth. At least as important as the banking system. A soundly regulated capital market is complementary to a soundly regulated banking system. Institutions matter, markets matter.

When capital markets wither, so does economic growth, bringing an avalanche of concomitant miseries. I had occasion to point out this link earlier in the year to the Job Summit. Economic constriction can lead very quickly to decisions to cut jobs. One way to turn that trend around is to keep liquidity flowing and businesses productive by encouraging investment. Another way is by ensuring we have a sound regulatory framework in which investors can have confidence.

Investor confidence is an elusive and fragile phenomenon. Nevertheless, evidence indicates it can be positively impacted by the governance of entities and institutions in valuation processes, market transparency, and transparent public interest oversight of standard setters. It can also, of course, be negatively impacted by the absence of these things.

Market confidence, in other words, is directly related to structures and concepts within the remit of market regulators.

It's important, though, to find a balance between appropriate market interventions that give investors confidence in a level playing field, and not stifling innovation. I want to touch on both these aspects - what surveillance and enforcement work we have undertaken to ensure everyone plays by the same rules, and what we have done to make it easier, in very difficult times, for businesses to raise much-needed capital.

At its most fundamental level, though, our work in both areas is driven by the need to build confidence, so it's this aspect I want to address first.

Why confidence matters

Every country's economy relies on a well-functioning financial system. One that allows businesses to borrow and raise capital by issuing securities; allows markets to trade securities in a fair, transparent and efficient manner; allows investors to have confidence in the rules of the game.

It's plain to see why confidence matters when we have all seen the evidence of what happens when it all but evaporates.

This country's household investment is heavily weighted towards real estate. We have a very low level of capital market investment. In its most recent report (July), the Capital Market Development Taskforce noted that, whereas average household equity investment in nine comparable countries is 29%, in New Zealand households it is a mere 12%.

The G-20 acknowledges that world economies will not grow again until domestic lending and international capital flows are restored, and this depends in large part on investor confidence.

Confidence is private, individual, intangible; but, when a critical mass experiences its increase or its loss, it can manifest as a powerful, public, measurable and far-reaching force. It translates into the type of herd behaviour that has been observed in a number of contexts, including the market. Behavioural economics has something to teach us here. Once loss-of-confidence behaviour is underway, the effects it creates doubles-back with many times more impact, to be met with more fear and even more pronounced behaviour.

The reverse of the current crisis situation also applies. Investors confident of appropriate laws and regulations, who act without fear, do what we need them to do: they invest. Their investment produces a healthy securities market, and that, in turn, produces a growing economy.

On a world scale, New Zealand's is a small economy. We need foreign investment. That is a fact of life. So it's critical we be seen around the world as a world-class securities market in which foreign investors can have confidence. A large part of the Commission's role, therefore, is working to enhance confidence both at home and abroad.

When I emphasise how vital investor confidence is I don't want to be misunderstood as declaring that investment should be bullet-proof. It isn't, nor should it be, and it's not the job of the Commission to strive to make it so.

As I mentioned at the outset, though, the massive loss of confidence that precipitated the current crisis originated mainly in unregulated and under-regulated products. Regulatory coverage was less than ideal, less than consistent, and much less than was needed to keep securities markets on an even keel.

The investor confidence/financial market stability nexus is crucial, and one a regulatory approach can definitely impact.

Commission work to enhance investor confidence

Sound law and regulation alone are not enough. As the Capital Market Development Taskforce has noted, research shows that good laws not enforced or not enforced promptly can have a detrimental effects on capital markets. Surveillance and enforcement, then, are a crucial part of our work.

Surveillance, oversight and enforcement

Surveillance and enforcement are an often unseen aspect of our role yet they account for well over a third of our total resources. They include monitoring securities market activity, investigating suspected breaches of the law and taking action to enforce it.

It's important also to note what this work does not include.

We cannot prevent companies collapsing. In the wake of the finance company collapses, some people were mistakenly claiming it was our responsibility to have prevented them occurring. It wasn't and it never has been. We cannot intervene to stop a company from failing. That is entirely outside our mandate.

The Commission's task is to ensure all relevant information is properly disclosed so that the prudent investor can assess their own risk in light of the offered return. Our powers extend to investigating whether or not offer documents, such as prospectuses, investment statements and moratorium proposals, are misleading. Once the offer is allotted, oversight of the product passes to trustees for the life of the investment, and we have no other role.

Our domestic work over the last year has been dominated by the aftermath of the finance company collapses. Together the companies held around $1.5 billion of investors' money. Only a small proportion of the New Zealand capital market but entailing shocking individual losses and having serious implications for general investor confidence. Since the collapses occurred in what was then an under-regulated sector of the securities market, they were entirely a home-grown phenomenon, pre-dating and independent of the global crisis.

A good deal of our recent work has been investigating and, in some cases, prosecuting, directors whose actions - or inactions - led to the collapses.

Before June last year, the Commission itself could not take criminal prosecutions. Instead it investigated potential breaches of the law then referred them to the Registrar of Companies for further action. Prosecutions currently underway include 160 charges against 13 directors of eight companies. These cases were investigated by the Commission, with the Registrar laying charges.

The Commission itself is currently pursuing 71 charges against nine directors of two companies. The Serious Fraud Office has achieved one conviction based on work done by the Commission. The Commission has also taken a successful insider trading action that saw those responsible settling for around $28 million, which is being paid to investors. Over the last year, the Commission carried out 88 surveillance exercises.

Taking a snap-shot of our work in July this year - we wrapped up a total of 12 enforcement cases. In that one month this involved:

• a successful prosecution by National Enforcement Unit for various securities-related reaches
• fraud charges being laid by Police
• four companies correcting misleading or illegal disclosure and offering to refund investors' money
• one company withdrawing its offer altogether
• one company providing additional disclosure to correct misleading information
• one company being warned about disclosure obligations, and
• three cases closed with insufficient or no evidence of any breach.

These were all formal actions requiring the opening of a file. They didn't include work like dealing with investor inquiries, minor surveillance activities, issue inquiries and liaising with other regulators.

Oversight of the NZX's regulatory role is also an important part of our work in this area. We conduct an annual review of its work, and one is underway now. NZX has suggested to the Capital Market Development Taskforce, however, that the Commission take over parts of its regulatory remit. This will be considered in the Securities Act review.

As I noted before, markets cannot thrive on the basis of regulation and enforcement alone. We also undertake development work in other areas, the biggest for us by far right now being implementation of two new Acts.

Financial adviser industry reforms

Some of you may be aware that in 2003 this country's financial sector was thoroughly reviewed under a programme developed by the IMF and the World Bank. Australia's financial sector was reviewed in the same way two years later. The aim here, as elsewhere, was to examine our regulatory framework in order to determine key vulnerabilities. New Zealand received what was basically a good report.

However we were recommended to do further work on regulating financial intermediaries. The report highlight a gap in our regulatory framework related to the mis-selling of products in the finance advisor industry. Well-regulated, professional advisers are important to investor confidence in capital markets.

The financial adviser industry reforms now underway, then, are a direct outcome of that assessment carried out six years ago.

The Financial Advisers Act passed late last year will bring us up to international standards in this area. It will be operational by the end of 2010. Australia has been regulating its financial advisers for some time, and what's done there has been influential in drawing up plans for our regime.

Advisers are many investors' main point of contact. The new law makes the Commission the industry's main regulator. Advisers will have to reach specified standards of competence, professional conduct and disclosure, and be responsible for the quality of their advice to clients.

The Financial Service Providers (Registration and Dispute Resolution) Act, also passed late last year, requires providers to be on a national register and enrol with an independent resolution services. This ensures that, should things go wrong, consumers will have access to low-cost redress.

I daresay you can imagine the intensity of our programme over the next 18 months as we work alongside the industry and others to implement this new regime. The results, though, will pay huge dividends in investor confidence.

Other developments

In September last year, Parliament passed The Reserve Bank of New Zealand Amendment Act. This made the Reserve Bank the prudential regulator of non-bank deposit takers, which include finance companies.

The Commission continues to be responsible for formulating, administering and enforcing deposit takers' disclosure requirements.

The Reserve Bank can now require information from deposit taker trustees in order to develop and enforce minimum prudential and governance requirements and administer credit rating requirements. It is working to develop and introduce new regulations that will introduce consistent standards for key risk areas such as financial strength (capital), access to cash (liquidity) and lending to associated parties. These new rules are expected to be introduced in 2010.

Also underway is a wide review of the Securities Act, which is the Commission's establishing law. This will assess the entire regulatory landscape, and look at the way forward for the Commission and related organizations. The Act has, as the Minister of Commerce noted, served us well for 30 years, but it has not kept pace with market developments.

The review will focus on four key areas:

• what securities law is trying to achieve and how to make it effective
• how to ensure investors get all relevant information, but no more than they need
• producing clear, consistent requirements for offering managed funds, and
• making sure regulatory bodies are appropriate to needs.

Finally, on Monday, Cabinet agreed to measures designed to improve trustee supervision of issuers. It will see trustees licensed by the Commission, according to stringent requirements on matters like their infrastructure, monitoring systems and processes, and financial strength. We will be able to intervene if trustees are not doing their job appropriately.

Commission work on easing restrictions on raising capital

I'd like to move now to the second area of work I mentioned at the start - what the Commission does to help companies survive the credit constraints. The Capital Market Development Taskforce pointed out in its July report that we are seeing an economy-wide de-leveraging that includes banks. As credit becomes less available or available only at a higher price, firms are more likely to turn to capital markets to raise debt, and particularly equity.

Not surprisingly, companies have reported considerable difficulty in raising and rolling over finance in the last couple of years. It's important to ensure regulations don't impede access to funds. We have been working with the Government and the Capital Market Development Taskforce to make it easier and less costly for them to do so. We have a strong interest in helping deep, liquid capital markets that enjoy investor confidence.

I've mentioned the taskforce a couple of times now, and I'd like to tell you a little more about this important industry-led body.

Capital Market Development Taskforce

It was set up in by the Ministry of Economic Development in July last year, in response to the financial crisis, and tasked with producing a blueprint and action plan to develop New Zealand's capital markets. It is examining the current state of our capital markets, the international context, future risks and opportunities, and key changes necessary to deliver this country the best possible financial system.

Late last year, the taskforce issued an interim report that observed the New Zealand economy was being pushed into recession. In this environment, it said, access to capital was key to business survival. While the Government was undertaking a range of interventions to lessen the impact of the crisis, capital markets were an important piece of the whole, and it was therefore critical to do everything possible to improve businesses' access to capital and reduce the costs of raising it.

The taskforce recommended immediate action on a range of policy changes based on two principles.

The first related to the fact that market participants already have all the information they need from firms compliant with continuous disclosure. The information is in the public domain. This makes the requirement to produce new and additional offer documents unnecessary, merely delaying the raising of capital and adding to its cost.

A simpler offer document contains all the relevant information potential investors need without undermining their protections. Interestingly - in terms of what I'll have to say later - the taskforce noted that some proposals in this area drew on the Australian regime.

The second principle underlying the taskforce's recommendations is that, in a number of cases, existing exemptions under which firms are able to issue securities without offer documents can be simplified and clarified.

To the extent that these dealt with listed companies, the taskforce's recommendations build on the continuous disclosure regime, which requires issuers to keep the market fully and promptly informed.

New Zealand's regulatory framework, the taskforce has said, must encourage "productive, creative behaviour while discouraging ‘gaming' activity". It's a view the Commission totally endorses.

Exemptions

One way we were able to respond immediately to taskforce recommendations was by exercising our power to grant exemptions. Exemptions allow issuers to reduce the costs of attracting new and overseas investment to our markets. Something that's been particularly important in the last year, when economic conditions have made fundraising imperative. Exemptions and authorisations are based on the policy of the law while also meeting the needs of the market.

Last financial year, we received 50 applications altogether, and granted 42.

For many companies the fastest way to raise capital is by making a placement to institutions. Under the NZX Listing Rules a company can issue up to 20% more of its shares already on issue by way of a placement, without shareholder approval, so long as the new issue is fair and reasonable to the company and its existing shareholders.

An issue arises here, though - wholesale placements can have the effect of diluting the shareholdings of those who can't participate. It is up to company directors to form a reasonable opinion on the benefits of the capital raising and possible positive and negative effects on existing shareholders. In fact, we have seen directors taking great care in trying to strike the right balance.

A 2005 Commission class exemption permitted all listed companies to offer shares to existing shareholders by sending out just a simple document. This describes the offer and its pricing, and includes a certificate from the directors that they have disclosed all price-sensitive information to the market.

The class exemption allows companies to raise up to $5,000 per shareholder per year using these plans. A similar Australian exemption also had a $5,000 annual limit. Late last year, however, the Commission and Australian Securities and Investments Commission (ASIC) published discussion documents looking for feedback on a possible increase in our respective class exemptions.

A number of comments pointed out the benefits of maintaining parity with Australia, especially given the introduction last year of the mutual recognition regime for trans-Tasman securities offerings, something I will come to later.

The Commission has now settled the policy for a new class exemption that will raise the annual limit under the class notice to $15,000. Terms will remain broadly as they are now. However, with the higher limit we will not be allowing the exemption to be used by any issuer whose securities have been suspended for more than five days in the previous year. This reflects the fact that many suspensions are due to underlying disclosure issues, and this allows the Commission to satisfy itself that disclosure is up to date before allowing these offers to proceed.

Meanwhile, the Commission has granted exemptions to several individual issuers on the same terms as the existing class exemption, but with annual limits of $12,500 per shareholder.

We gave these exemptions high priority because share purchase plans help issuers raise capital quickly. Also because using share purchase plans following placements is in the best interests of all investors. In each case, the share purchase plan, sometimes in conjunction with a further top-up plan for some larger (non-retail) shareholders, has greatly increased the opportunity for shareholders to subscribe to further shares. It also allows up to 95% of shareholders to avoid any dilution of their holding as a result of the earlier share placement.

We have granted two class exemptions for deposit guarantee schemes. We also issued a related note to ensure individual investors get clear, consistent information about the scheme and how it affects their investment.

Late last year we granted a temporary exemption to allow managed funds, under certain conditions, to keep offering securities for three months on existing prospectuses. We granted a new notice and approved a new code of practice for venture capital fund-raising class exemptions.

We granted particular US- and UK-incorporated issuers a class exemption from certain financial reporting requirements, allowing them to use their overseas GAAP-compliant statements. We reviewed the longstanding class exemption for Australian-registered managed investment schemes, and revoked the notice. This followed the introduction of regulations for trans-Tasman mutual recognition of securities offerings, which I'll come to in a minute.

We undertake five-yearly reviews of our class exemption notices to ensure they remain useful, and relevant for market conditions. The next review will take place in 2012. Meanwhile, our class exemption consultation has received strong support for continuing and expanded operation of the notices.

Having referred several times now to links between Australia and New Zealand, I'd like to turn to what I believe is an important way forward - mutual recognition of regulatory frameworks between jurisdictions. I'd first, though, to put this into its international context.

Beyond national borders: trans-Tasman mutual recognition

It's vital that New Zealand contributes to the setting of international standards for securities markets. We want to be a standard maker, not merely a standard taker. As a small, open market, we need to reflect these standards in our regulations in order to attract capital.

New Zealand is one of 109 members of the International Organisation of Securities Commissions (IOSCO). This organisation is the world's recognised standards setter for securities regulation. Its reach extends to more than 95% of the world's markets, and its standards on information sharing form the planks for jurisdictions to undertake their own mutual recognition regimes. Both Australia and New Zealand play a significant role in this organization.

Mutual recognition doesn't demand that countries adopt identical legislation. Instead, it allows domestic laws and regulations to reflect national imperatives while simultaneously offering the capacity for cross-border cooperation and enforcement. Enforcement follows the offer, so the home jurisdiction of the offeror can be enforced into the host jurisdiction, thereby enhancing market liquidity and resilience.

Here in Australasia we are ahead of the rest of the world. In June 2008, a landmark trans-Tasman mutual recognition of securities offerings regime came into force. It allows issuers to offer securities in both countries using the same offer documents, with minimal additional obligations. Its benefits lie in promoting investment between countries, enhancing competition in capital markets, reducing business costs and increasing investor choice.

The results to date are encouraging, with 40 issuers from Australia and New Zealand making use of the regime. Early indications from ASIC research suggest that, as envisaged, many issuers are achieving real cost savings.

Mutual recognition in this area is only one item in a raft of moves towards closer economic relations between the two countries. I believe this exciting concept can be extended across the whole panoply of trans-Tasman financial services.

In regulating financial advisers, for example. Australia has regulated this sector for a number of years and, as I explained earlier, the Securities Commission is currently working to put the financial adviser law in place here.

Our two countries' sector regulation is similar, creating an opportunity for trans-Tasman cooperation and enforcement. We have made great progress in cooperating on enforcement activities, which means any law-breakers who believe they can escape the consequences by hopping across the Tasman will be sorely disappointed.

New Zealand and Australia have strong economic ties, and we are currently working towards a single economic market. Mutual recognition is a significant step towards achieving it. The New Zealand Government has a memorandum of understanding with the Australian that aims at improving the trans-Tasman business environment.

At last week's Australia New Zealand Leadership Forum meeting, ASIC chair Tony D'Aloisio and I informed government and business leaders of significant progress in the ASIC/New Zealand Securities Commission relationship that will eventually give us a virtual trans-Tasman regulatory framework.

Mutual recognition is something of a moving target. Each jurisdiction will be continually making changes to its own regulatory framework, so mutual recognition relies on strong, trusting communication between them.

Worldwide mutual recognition is still a long way off. However, other countries have taken steps via bilateral and multilateral agreements, and these are edging towards a broader mutual recognition approach.

Conclusion

Twenty-first century regulators need a complete view of world markets to offer any chance of achieving and preserving stability. Oversight of systemically important institutions alone isn't enough. The crisis has proven only too painfully that our regulatory coverage of markets is imperfect. I believe that securities market regulators along with prudential regulators must address this threat.

We need to understand the risks inherent in new entities and products. We need to understand what effect new developments might have on stability, perhaps by encouraging formation of unsustainable bubbles. Knowing where and how bubbles might arise and whether or not they might have global consequences is another step towards not repeating past mistakes. IOSCO plays an important role here.

Work at the Commission continues to bring New Zealand's regulatory framework up to world standards. At the same time, we have done what we can to ease the pressures on business.

Confidence remains the key. Market stability will not return until we see restored confidence in capital markets and in the way the market players conduct their business. Restoring that confidence demands globally coordinated securities regulation and supervision, plus strong, independent, well-funded regulators at the domestic level.

Thank you.

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