Further changes to the FMC Bill

Further changes to the FMC Bill

Introduction

Commerce Minister Craig Foss recently announced further changes to the Financial Markets Conduct Bill (“FMC Bill”) that is currently going through the last stage stages of the Select Committee process. The FMC Bill has been described as a once-in-a-generation rewrite of securities law with the objective of ensuring that investors are better informed (and offered better protections).

The Minister’s announcement said that the additional changes, which are in the form of a Supplementary Order paper (“SOP”) are aimed at ensuring that disclosure rules are clear and cover all forms of financial markets services. The majority of the changes proposed by the SOP are minor and/or technical in nature. . The changes in the SOP can be seen as a response to the submissions on the FMC and the ongoing dialogue with a number of interested parties. Importantly, the SOP can probably also be taken as the last word on a number of issues – and further substantive changes to the FMC Bill are now unlikely.

Key changes

An outline of the key changes is that they:

• Align the purpose statements: Further alignment is made of the purpose statements of other financial markets legislation, including the Financial Advisers Act 2008 and Financial Markets Supervisors Act 2011, with the purposes of the FMC Bill. This is described as being a signal to the FMA, investors, market participants and the courts that all of the ‘core’ financial markets legislation contribute to the same broad outcomes.

•  Raise minimum investment threshold: Raise the threshold for the existing exclusion from a ‘public’ offer for investors who make a minimum investment from $500,000 to $750,000. This is on the basis that significant time has passed since the $500,000 threshold was set – and that raising the bar reduces the risk that retail investors are inappropriately denied the protection of the disclosure regime.

•  Expand regulation-making powers: The FMA’s regulation-making powers are expanded to deal with circumstances where an offer is excluded from the disclosure regime – to enable the FMA to provide for limited disclosure and other safeguards (e.g. investor certificates) to be provided.

•  Provide more on DIMs: Providing for further regulation of discretionary investment management, custody and broking services – which may extend to including mandatory audit and assurance and client reporting ( in the interests of ensuring that investor assets are being adequately safeguarded).

•  Address disclosure of equity derivative positions: As a response to a Takeovers Panel recommendation, an amendment has been made to the “substantial product holder” disclosure requirements (Part 5 of the FMC Bill) to also require disclosure of long equity derivative positions that are referenced to securities of listed issuers.

 Alignment with consumer law

As a general observation, ideally Supplementary Order Papers introduced after a bill is reported back from Select Committee after extensive public submissions should be a vehicle for minor or technical changes (such as improvements to drafting, consequential or consistency changes) – rather than a vehicle for introducing substantive changes. I am aware that, for a variety of reasons, this is not always possible . However, it appears that, in the case of the FMC Bill, as a result of further discussions with the Commerce Commission, FMA and government officials, a number of policy changes have been made in the interests of better alignment with consumer law.

Specifically, Cabinet has changed its position on including a general carve-out from the application of sections 9 to 11 (misleading and deceptive conduct) and 13 (false or misleading representations) of the Fair Trading Act 1986 in relation to financial products (and associated services). As a result, the SOP provides that:

•  Section 5A of the Fair Trading Act (no liability if not liable under securities laws) is to be repealed – so that the Commerce Commission can take proceedings in relation to financial products and services under the Fair Trading Act provisions, but only with FMA’s consent.

•  This is to be balanced by a ‘double jeopardy’ provision to be added to the Fair Trading Act – so that a person cannot be ordered to both pay a pecuniary penalty, or be liable for a fine under the FMC Bill and be subject to fine under the Fair Trading Act for the same conduct.

•  Amendment to Part 2 of the FMC Bill (which bring across the general prohibitions on misleading and deceptive conduct from the Fair Trading Act to apply to financial markets) to ensure that they are as close as possible to the equivalent Fair Trading Act provisions – to minimise the cost of complying with overlapping laws.

•  Importantly, this latter change includes the addition of (new) ‘unsubstantiated representation’ provisions – for better alignment with the Consumer Law Reform Bill, which is itself still a work in progress, and which will introduce parallel measures into the Fair Trading Act. In short, it will be a contravention of Part 2 of the FMC Bill to “make an unsubstantiated representation” in respect of financial products or financial services and in connection with any dealing in financial products or the supply of (or promotion by means of supply or use of) financial services. And a representation is “unsubstantiated” if the person “did not have reasonable grounds for the representation, irrespective of whether the misrepresentation is false or misleading”. This is a potential new head of liability which is controversial in a consumer law context – and there is no apparent supporting analysis for dragging this new head of liability (and the attendant compliance burden) into a securities law framework.

 Provision for relief from certain contraventions by directors

The SOP provides scope for regulations to provide relief from clause 509A (which treats directors as having contravened where there is defective disclosure) to prescribe circumstances where directors are deemed not to be contraveners in the case of the defective disclosure: The policy explanation for this change is that it is aimed at preventing unjustified compliance costs being incurred in some circumstances for extensive due diligence processes that some directors may otherwise require in order to manage the risk of potential liability under clause 509A.

No specific details are given as to what the prescribed circumstances may be, although the Cabinet paper provides the example of the recent proposal in Australia to remove similar deemed civil liability provisions for directors in the case of “simple” corporate bonds. The Cabinet paper indicates that, in Australia, the deemed directors’ liability provisions are viewed as an impediment to the development of a retail corporate bond market. I also note that the Cabinet paper also suggests that the deemed liability provision in clause 509A may not be appropriate for offers by local authorities and other public bodies – and I am aware of examples where sign-offs by elected members has been a roadblock to the greater access to local authority bond programs.

Territorial scope

The territorial scope of Part 2 (including the misleading or deceptive conduct provisions) is defined by reference to whether the person who carries out the conduct outside New Zealand is resident, incorporated, or carrying on business in New Zealand. However, the SOP extends that reach to refer to persons registered under the FSP Act (so that conduct outside New Zealand by these persons may be within the territorial scope of the provisions).

The provisions in Part 5 of the FMC specifying the territorial scope of the insider trading, market manipulation, continuous disclosure, substantial product holding, and directors’ and officers’ disclosure provisions are amended to clarify that they cover conduct both inside and outside New Zealand in certain cases. An updated Chinese wall defence to the insider trading provisions is also included. The general intent is to ensure that these provisions apply to overseas conduct which affects New Zealand traded securities.

Governance

The previous provision that an issuer may refuse to provide information to its supervisor or, in some cases, the FMA where to do so would be likely to incriminate is removed. In its place is a restriction on the use of such a report as evidence in a criminal proceeding against the issuer.

Changes are made to the related party rules for managed investment schemes to clarify the relevant thresholds and limit exceptions. Specifically, the definition of “related party” is amended (along the lines of the equivalent provision in the Corporations Act 2001 (Australia)) so that it captures persons who were related parties in the previous 6 months or who believe, or have reasonable grounds to believe, that they are likely to become related parties in the next 12 months. In a similar vein, the exclusion in clause 160 for certain registered bank investments with related parties is also to be limited to investments made “in the ordinary course of business” in debt securities and simple bank products (i.e. excluding, for example, currency forwards).

Discretionary Investment Management Service (DIMS)

A number of changes have been made to the treatment of DIMS under the FMC Bill and the move to transfer the regulation of most DIMS that are provided to retail clients from the Financial Advisers Act 2008 to the FMC Bill. These changes, which are thought to be a response to the collapse of Ross Asset Management, include a harmonisation of regulation of DIMS under the FMC Bill with that under the Financial Advisers Act to limit the risk of regulatory arbitrage. The SOP seeks to achieve this aim by:

•  providing that FMA will only authorise AFAs to provide DIMS (or other particular types of financial adviser services) if FMA is satisfied the AFA meets any requirements prescribed in the regulations;

•  providing for the conditions and conduct obligations for AFAs who offer DIMS under the Financial Advisers Act to match the requirements under the FMC Bill;

•  requiring custody to be independent of the AFA unless the FMA’s authorisation specifically allows;

•  providing for regulations to restrict the scope of DIMS that can be provided by AFAs under the Financial Advisers Act;

•  removing the residual ability of qualifying financial entities to provide DIMS under the FAA, so that the only corporate licence for DIMS is under the FMC Bill; and

•  clarifying that DIMS licensees will be acting as brokers under the Financial Advisers Act to the extent that they receive investor money, and that these broker obligations can be enforced under the liability regime in the FMC Bill.

The changes included conduct obligations, so that the obligations of an AFA providing a DIMS to retail clients include requirements to:

• act honestly in providing the service;

•  act in the best interests of the client; and

•  not make use of information acquired through the service to gain an improper advantage or cause detriment to the client,

 as well as requirements to have a client agreement with each retail client (which must include a written investment authority).

 Other changes to Financial Advisers Act

In addition to the changes in relation to DIMS noted above, the changes proposed to the Financial Advisers Act (many, it appears, as a response to the Ross Asset Management collapse) include:

•  The self-certification process for an ‘eligible investor’ to be classified as a wholesale client under the Financial Advisers Act is to be more closely aligned with the equivalent certificate required under Schedule 1 of the FMC Bill.

•  Amending the definitions of “client money”, “client property” and “broking service” so that it is clear that a broking service includes custodial services.

•  Trust account obligations for brokers are extended to apply to both retail and wholesale clients (previously they were confined to retail clients) – and extended to add a requirement to provide confirmations of holdings to clients (or other prescribed persons).

Enforcement

Changes have been made to the FMA’s powers to make orders to permit stop orders, direction orders, and unsolicited offer orders to be made by FMA if it is satisfied that a provision is likely to be contravened by a person in the future, whether or not the person has previously contravened the provision and whether or not there is an imminent danger of substantial damage to any person if the provision is contravened.

Regulations

Custodians and broker services: Regulations will permit more specific reporting and other duties on custodians of scheme properties to be prescribed. This may include mandatory audit, assurance, and client reporting. We assume this is a response to the Ross Asset Management collapse.

Schedule 1 changes – disclosure exclusions

A number of key amendments to the disclosure exclusions in Schedule 1 of the FMC Bill are proposed, including:

•  Wholesale investors: Increasing the minimum subscription exemption threshold for ‘wholesale’ investors from $500,000 to $750,000 on the basis that significant time has passed since the $500,000 threshold was first set and this change reduces the risk that retail investors are inappropriately denied regulatory protections. However, the Cabinet paper notes that there was little industry support for a change on the basis of the consultation in the context of the FMC Regulations and the $500,000 threshold lines up with that in Australia.

•  Listed securities: Clarifying that the carve-out in the case of an offer of quoted securities offered by way of sale.

•  Local authorities: Removing the exclusion for offers of debt securities by local authorities.

•  Contributory mortgages: Removing the exclusion for offers by lawyers of interests in contributory mortgages – on the basis that, if the carve-out is to continue, it should be the subject of (regulatory) exemption only.

•  Limited disclosure by PDS: Clarifying that where some limited disclosure is prescribed by regulations, it may be in the form of a (modified – and not full) PDS.

•  Certifications: Making changes to the certification processes for certain exemptions – for example, by clarifying the meaning of independence where the certificate is to be given by an independent person.

Transitional provisions

Amongst the changes to the transitional provisions are:

•  extending the transitional period to register a prospectus in relation to securities on “continuous issue” under the Securities Act from 12 months to 2 years; and

•  removing the ability to make a private offer under the carve-outs for ‘eligible investors (being the two limbs – wealthy or experienced investors) with immediate effect once the FMC Bill comes into force.

 Timeline

The market understanding of the timeline is that:

•  The FMC Bill is likely to be passed in the next month or so; and

•  The new legislative regime law is likely to come into effect in the second quarter of 2014 – subject to a number of transition periods.

In order to achieve this timeline, an exposure draft of the regulations required to make the FMC Bill “work” is likely to be circulated in the last quarter of this year.

Final thoughts

Apart from the multitude of consequential changes that are a natural by-product of such a major piece of legislation, there are some worrying signs in the SOP. In particular, I am concerned about the manner in which the SOP seeks to introduce major new policy – in the form of a new ground for director liability for “unsubstantiated representations”. On the face of the wording in the SOP, and the supporting material, the policy justifications for introducing what appears to be a novel concept of liability into securities law regime are difficult to find.

The objective of securities law has been to enable investors to make informed investment decisions (and not be misled). Investment products are not consumer goods and it is difficult to see that there are many parallels between the two legislative regimes. For example, it is difficult to see how an investor suffers a loss as a result of true, yet unsubstantiated, representation. And there has been a growing, and in moderation, useful trend for offer documents to describe the market in which an issuer operates, including a description of the business opportunities as well as the risks in a generic manner. It seems unrealistic to suggest that issuers should be exposed to liability (and therefore required to undertake extensive due diligence and verification) for matters that are truthful, and not material (or indeed materially misleading) because they may be unsubstantiated to the extent of the core disclosures in the offer document.

If you would like more information about any of the matters discussed in this note, please contact me.