Financial Markets Conduct Bill – Reported Back

FMC Bill reported back26 September 2012

Financial Markets Conduct Bill – Reported Back

Introduction

The Financial Markets Conduct Bill has been reported back from the Commerce Select Committee. Introduced after a large amount of work, including that of Rob Cameron’s CMD Taskforce, the FMC Bill was touted by the then Commerce Minister, Simon Power, as a “once-in-a generation” rewrite of New Zealand’s securities laws.

The FMC Bill seeks to reform the regulation of financial market conduct- governing the way in which financial products are offered, promoted, issued, and sold, and the ongoing responsibilities of issuers (as well as secondary market conduct – dealing and trading).

Whilst the FMC Bill, as reported back, contains a large number of (mostly) minor, technical, amendments proposed to improve clarity and workability of the legislation, perhaps the most significant changes are those to the liability regime. In this regard, the FMC Bill contains a two-tier liability regime which make a distinction between:

• Criminal liability – for offences.
• Civil liability – in the form of pecuniary penalties (payable to the Crown) as well as compensation payable to affected parties; and

Importantly, the FMC Bill makes a clear distinction between the liability of those with primary (disclosure) obligations such as the issuer and its directors and those who are merely accessories (e.g. experts and advisers). This is not without its difficulties as some of the language used does not make the distinctions between primary and secondary (accessory) involvement as clear as it should be in order to enable meaningful demarcations to be made in practice.

Equally significantly, the Committee has rejected strong submissions that the primary exposure of the issuer’s directors should not be automatic. I am a supporter of the view that (ideally) director liability should hinge on knowledge or involvement. As a consequence of declining to make this step-change from the current regime, the focus for directors (as it is at present) will be on the availability of defences.

Criminal liability

The Committee recommended amendments to Part 7 (Enforcement and Liability) to establish a separate criminal liability for a director of an offeror where there is a disclosure defect (e.g. a false statement in a disclosure document) that is materially adverse from an investor’s point of view. The offence would be committed only if the Crown could prove a “guilty mind”. That is, if the offer took place with the director’s authority, permission and the director knew of, or was reckless as to whether there was a defect. This would move the focus of criminal liability to be in line with the Crimes Act.

In the case of accessories to an offence, the Committee also seeks to line up with the ordinary rules under Part 4 of the Crimes Act. That is, a person who promotes an offer would be liable for a false statement made by an offeror if, for example, the promoter committed or omitted an act for the purpose of aiding any person to commit the offence.

The Committee states it belief that the liability regime should not discourage capable prudent people from becoming directors with overly punitive sanctions, and companies should be able to attract directors with diverse skills and backgrounds. Consequently, while directors should supervise capital raising and exercise due diligence regarding offer documents, they should be able to focus mainly on business strategy and supervising management, rather than on compliance and liability. However, directors should be liable for civil pecuniary penalties and to compensate investors that lose money if they fail to perform their duties, but should not be liable to imprisonment where there is no “fault” element.

This move is in line with one of the themes emerging from the FMC Bill, that the primary remedies for inadequate disclosure should be civil rather than criminal.

Civil liability—liability of accessories

The Committee recommended that a new term (“involvement in a contravention”) be used to refer to the behaviour of accessories in the civil context. In doing so, the objective is to clarify the application to people who were, for example, knowingly concerned in, or party to, the contravention. The “involvement in a contravention” test is seen by the Select Committee as appropriate with a sufficiently high threshold.

The Committee also noted the concern that professional advisers might risk being involved in a contravention in the course of their normal activities. In its report, it states that it does not expect this to happen. Instead, it says that the test is consistent with equivalent provisions in Australia and in other New Zealand laws (e.g. the Commerce and Fair Trading Acts). For a person to be involved in a contravention, it would need to be proved that he or she was an intentional participant in the primary contravention with knowledge of all the essential facts.

The Committee dealt with the concern that some of the available defences are more suitable for the primary offender rather than for accessories. This, could lead to expensive and inefficient efforts in risk management (limitation). As a result, Committee has sought to broaden the range of defences available to accessories – including a ‘reasonable reliance’ defence (and a defence of taking reasonable and proper steps to ensure compliance).

Also, a recommendation is made to change the FMA’s power to provide for orders to be made preventively when provisions are likely to be contravened – enabling the FMA to take a more proactive approach in the event of a likely contravention.

Defences to civil liability

The Committee demonstrated that it had considered the theme that emerged from many of the submissions about the risk of frightening off suitable candidates for the boardroom. Specifically, the Committee’s report notes that:

“We believe that the liability regime should not discourage capable prudent people from becoming directors with overly punitive sanctions, and companies should be able to attract directors with diverse skills and backgrounds. Although directors should supervise capital raising and exercise due diligence regarding offer documents, they should be able to focus mainly on business strategy and supervising management, rather than on compliance and liability. Directors should be liable for civil pecuniary penalties and to compensate investors that lose money if they fail to perform their duties, but should not be liable to imprisonment where there is no fault element. “

The defences to civil liability in the FMC Bill specify the minimum standard of behaviour or actions that must have been demonstrated to avoid liability. In recommending changes to include defences that apply to disclosure contraventions the Committee noted that it considers it is necessary for the primary contravener to have a ‘reasonable reliance’ defence if it reasonably relied on a person other than a director, employee, or agent; if:

• (in relation to disclosure) it made all the enquiries that were reasonable in the circumstances and believed on reasonable grounds that the disclosure was not defective; and,
• (in the case of a new circumstance that should have been disclosed) it was not aware of the matter.

This change gives a director of the contravener access to these defences, and to a defence if he or she took all reasonable and proper steps to ensure that the company complied. However, the Committee noted that making out such a defence should not be easy. Instead, a defendant would have to provide proof – they could not simply claim that the defence applies.

Presumption that contravention caused loss

The FMC Bill presumes that, when financial products decline in value as a result of a material defect in disclosure (e.g. a materially misleading statement), the investor would be treated as suffering a loss unless the decline in value was proved to have had another cause. However, this is limited to causation, and the Committee has recommended changes to make it clear that it is still up to a Court to determine the amount of the investor’s loss (for which compensation is payable).

Indemnities and insurance

For a New Zealand company and its directors, the indemnity and insurance restrictions would be governed by the Companies Act. This is to remove duplication and potential conflict between pieces of legislation.

Directors’ assets

The Committee notes the concern that directors might be unable to pay penalties or compensate investors, because their assets are tied up in trusts. However, it says that the use of trusts for asset protection (and ‘trust busting’) is beyond the scope of the FMC Bill.

Relationship with Fair Trading Act

Part 2 of the FMC Bill replicates key parts of the Fair Trading Act and applies them to financial services and products. However, misleading and deceptive conduct in relation to investment products and financial services would be governed by the FMC Bill not the Fair Trading Act.

The Consumer Law Reform Bill (which is currently before the Commerce Committee) may generate the need for further changes to Part 2 of the FMC Bill to ensure consistency with the relevant parts of the Fair Trading Act.

Discretionary investment management services (DIMS)

The Committee recommended clarification of the boundary between the DIMS covered by the FMC Bill and those that fall under the Financial Advisers Act 2008. These include making it clear that providing the client with multiple options in a model portfolio, or allowing investors to make minor modifications to such a portfolio, would not constitute a personalised DIMS.

Also, a DIMS licence would not be needed for DIMS that are not retail services under the FMC Bill, rather than relying solely on the exclusion under the Financial Advisers Act. Retail services would exclude services provided only to wholesale investors. And a DIMS licensee with a corporate licence should be allowed to provide financial advice under that licence to the extent that the advice is given in the ordinary course of, and incidentally to, providing the DIMS under its licence (e.g. in relation to selecting investment options, reinvestment, and switching).

Treatment of derivatives—disclosure

Changes are recommended to clarify the provisions relating to derivatives, to make it clear that a product disclosure statement could be lodged for a derivative product type, rather than for each individual derivative contract. This would ensure that when issuers of derivatives made offers to many investors, each offer would not require a separate product disclosure statement. A summary of recommendations on derivatives is provided by the Committee’s report.

Treatment of derivatives—new exceptions

Schedule 1 of the FMC Bill outlines the provisions relating to disclosure requirements and exclusions. As such, it provides an exclusion from providing a product disclosure statement to an investor for an offer of financial products where the minimum amount payable by the investor is at least $500,000 (this is a carry-over from the Securities Act – intended to provide a bright-line test for offers to wholesale investors). To provide an equivalent exclusion for derivatives, which seldom require large up-front payments, an exclusion has been added for derivatives with a minimum notional value of $5 million.

Schedule 1 exclusions (continued)

Schedule 1 also provides various disclosure exclusions for investors who are considered to be capable of looking after themselves or where full product disclosure is otherwise not needed. Changes are proposed for two particular exclusions:

• reducing the criteria applicable to a wholesale investor to three, of which the investor must meet one, simplifying the identification of sophisticated investors.

• reducing the threshold for a ‘large’ person (for the wholesale investor exclusion) to net assets of $5 million or turnover of $5 million in each of the past two years (from total assets of $10 million or turnover of $20 million over the past two years).

A new exclusion for offers of financial products of the same class as quoted financial products is proposed – because the continuous disclosure obligations of a listed issuer would ensure that the market had already priced the risk associated with these products.

Principal purpose of superannuation schemes

The FMC Bill seeks to change the current law so that the sole purpose of a registered superannuation scheme must be to provide retirement benefits. The Committee considered that if a scheme has purposes that are not merely incidental to providing retirement benefits, it should be registered as a standard managed investment scheme. However, some amendments to the application of this rule are proposed to allow existing superannuation schemes (or sections of them) to retain a “principal retirement purpose” if the scheme (or section) is closed to new members – and to allow workplace schemes to provide benefits and allow withdrawals on leaving employment with the relevant workplace or industry.

Other changes include clarifying that the potential for early withdrawal from a KiwiSaver scheme (e.g. to facilitate first-home ownership) is not inconsistent with the sole purpose test.

Related parties for restricted schemes

The FMC Bill places a 5% limit on investments in related parties of restricted schemes. This means that a restricted superannuation scheme provided to a company’s employees could not invest more than 5% of the scheme’s property back in the company.

However, the Committee recommended that the 5% limit apply separately to non-associated persons. This is considered necessary to make it clear that investments in businesses that are each a related party of the scheme but are not associated with each other would count separately for the purposes of the 5% limit. Also, for workability reasons, the 5% limit should apply only to new acquisitions (and schemes would be required to sell-down existing holdings over a 3-year transition period).

Also, related party transactions, employer contributors are to be treated as related parties only for specified employer-related schemes (i.e. those in which the employer is involved – not just as contributor).

Territorial scope

Amendments to the territorial scope provisions of the FMC Bill are made to make them equivalent to the Securities Act, extending the FMA’s stop order powers to apply to any restricted communications distributed to persons outside of New Zealand. Further amendments are also proposed to provide for the FMA to seek civil remedies if there is a contravention of Part 2 in relation to such communications.

The Committee considered that such an extension as needed to allow the regulation of the conduct of New Zealand residents and businesses in respect of their offshore activities in limited circumstances – to facilitate cross-border cooperation, and to regulate externally directed conduct to preserve the reputation of New Zealand issuers or service providers.

Crowd funding

Crowd funding (the pooling of a large number of small contributions to fund a business or project, generally over the internet) is to be facilitated by giving crowd funding intermediaries as an example of a type of licensed intermediary service that may be prescribed under regulations. Regulations would be required to prescribe crowd funding intermediaries as an intermediary service for which providers could apply for a licence. Once licensed, individuals seeking crowd funding through an intermediary service would be exempt from disclosure requirements (subject to certain limited disclosure requirements).

Liability for audit opinions

The Committee notes concerns about liability for audit opinions, such as the routine disclaiming of liability to third parties, but does not recommend amendments (but would like to see wider consultation and policy work in this area).

Licensing

Amendments are proposed to recognise existing licenses under other licensing regimes. This would require the FMA to have regard to whether the applicant was already a licensed provider under the Financial Service Providers (Registration and Dispute Resolution) Act and whether the proposed market service was merely incidental to other licensed services.

Amendments are also recommended to facilitate group licensing by allowing related bodies corporate, not only subsidiaries, to be covered by a single licence where appropriate controls or supervision by the licensee can be demonstrated. The head licensee would remain responsible for the related bodies corporate covered by the licence.

Commencement

It is proposed that the default commencement date of 1 April 2015 be moved out to 1 April 2017. Whilst most of the provisions of the FMC Bill are expected to come into force well before that date but the complex subject matter requires more flexibility to bring some provisions into force later.

Further information

If you would like more information about the FMC Bill, please contact me.