Presentation by Sean Hughes to the 7th Annual Securities Law Update

11 July 2011

Thank you for inviting me to speak today.

It's a great pleasure to be here with you all as Chief Executive of New Zealand's new Financial Markets Authority.

FMA's establishment on 1 May marked what I believe is a quantum leap forward in the regulation of New Zealand's financial markets. Our establishment is a significant milestone, and one I am confident has marked the start of a new era.

FMA enjoys greatly enhanced powers of regulation and enforcement over a broader range of financial markets entities. Our powers include important changes to the governance of KiwiSaver and superannuation schemes. We also oversee registered securities exchanges and we're responsible for the regulation of financial advisers and financial service providers. We will add trustees and statutory supervisors to that list on 1 October, and auditors, including overseas auditors, from 1 July next year.

One thing that distinguishes FMA from other regulators is that we have twin statutory objectives: to promote and facilitate fair, efficient and transparent markets, and to grow New Zealand's capital base. Several weeks ago I attended a number of VIP meetings in Sydney, and it was this dual aspect to our mandate that fascinated the people I met.

It positions FMA not just as a regulator but as an economic ambassador for New Zealand, charged with enabling growth and capital development.

Under New Zealand's twin peaks regulatory model, FMA sits alongside the Reserve Bank - whose powers have also been extended to cover finance companies, building societies, credit unions, and the insurance industry. The Reserve Bank and we are determined to ensure the success of this new model.

Of course, FMA's establishment is by no means the end of the Government's reform agenda. The current review of New Zealand's securities laws is evidence of that, and while we're on the subject, I'd like to take a moment to comment on the new director liability regime approved by Cabinet in May.

Under current law, there are significant criminal penalties - up to five years in jail - for misstatements in offer documents, regardless of whether the company directors were intentionally dishonest or merely careless. [No doubt, we're all aware of this level of penalty because of the outcome of the Nathans trial announced on Friday; it's very likely the three directors found guilty face jail time.]

The proposed new regime as part of the securities law review will mean a more tiered, and sophisticated, approach to directors' liability, making far greater use of civil remedies including compensation and civil penalties enforceable by FMA. It also reserves criminal liability for really egregious conduct such as the issuing of intentionally misleading disclosure documents.

By reserving criminal penalties for truly reprehensible breaches, the new regime should be more fair and proportionate. And with effective enforcement by FMA, the range of available civil remedies will ensure there are adequate incentives for good corporate government by directors - and greater protection for investors.

Over the past 20 years, while working in financial markets risk management, enforcement, and litigation, most recently for ASIC, the Australian securities regulator, I've heard of lots of analogies for the role of regulators. They've been likened to an ambulance at the top of the cliff - and an ambulance at the bottom of the cliff. They've also been likened to an air traffic controller and to a sheriff…

But I like to describe our role as that of a sports coach and referee. We help the players understand the rules so they know how to play the game safely, and we check to see they're playing by the rules. When there is foul play, we put up the red flag and send the player off the field. If their conduct is so out-of-line, we'll advocate for a season ban. We're constantly analysing the play, and we advise the national body on how the rules might be changed in order to improve the way the game is played. 

Our focus is to ensure there is a level playing field and that the risks are obvious to all who enter the arena.

The reality is that capital markets are risky. And not everyone is careful. Companies do fail and investors do get hurt. Creditors are left unpaid. Employees are exposed and vulnerable. That's the nature of capital markets. Through good market regulation and oversight, we might be able to reduce the chances of this happening, but we cannot prevent it nor will we. That is not the role of a regulator in a developed market economy and nor should it be. It is not our job to provide a capital guarantee for failed investment outcomes or flawed investor decisions.

There will always be an element of risk in securities market participation and this will never change despite all the regulation, close supervision and resources in the world. Risk-taking, in the right circumstances and with the right resources and controls, is appropriate and I encourage it as an enabler of capital growth and innovation. Apple, Microsoft, Google were once all high-risk companies.

That said, I am not an advocate of the efficient markets theory of minimalist regulator. When a company hits the wall because its directors and management have been asleep at the wheel - or worse, because they've bailed out the door and let their investors take the impact - then we will see what action FMA can take. We will and are taking action.

Rebuilding confidence in our capital markets will be a significant challenge for FMA - particularly with retail investors. As we all know, investor confidence has been shattered by the Global Financial Crisis and, in New Zealand, by the collapse of so many finance companies, affecting $8.5 billion of investors' money.

I read recently that just before the 1987 sharemarket crash, 26 percent of household assets were directly invested in New Zealand's equity markets. As at the end of 2010, this share had plummeted to 7 percent.

This is an extremely concerning state of affairs and a situation we need to turn around. There is still plenty of evidence to suggest New Zealanders' love affair with property and bank term deposits remains unchanged. Let's stop the decay now. Let this year mark the baseline from which New Zealand's flight from the capital markets halts, and begins a long, steady, permanent and sustainable improvement.

Investor confidence, and understanding of the importance of asset class diversity, is absolutely critical if New Zealand is to develop the kinds of vibrant capital markets needed to attract investment in our productive industries, and to lift the country's economic performance.

Market participants need to be subject to clear rules so that investors can be confident that those rules will be actively and consistently enforced. Investors also need to be able to access relevant information about investing wisely and well.

Neverthless, there are questions in my mind about the value of a disclosure regime aimed particularly at retail investors. What is the role of the regulator in relation to retail investor participation? Does it conflict with our objective to promote market growth? Are all investors equally competent to understand what issuers tell them? Are all products suitable for the retail market? Should investors enter a market without a basic comprehension of what they are acquiring? Should regulators leave the wholesale or institutional markets alone?

There's been a debate in the international regulatory community in recent years about how far you go in regulating offers to the public. At one extreme, some jurisdictions argue that the most complex and sophisticated products should be banned from offer to the public. In New Zealand, we are not following this radical banning of products to the retail public - but should we be thinking about it?

It's clear that FMA faces some very significant challenges and I do not underestimate the scale of the task ahead. Only in March, a Morningstar global study of investor experience in 22 countries rated New Zealand last with a D-minus. The report said New Zealand scored worst because of its low rating in disclosure as well as regulation and taxation.

Morningstar did acknowledge that New Zealand was moving to improve its performance with the creation of FMA and the securities law review. But what this demonstrates is that the eyes and expectations of the global investment community are on New Zealand and FMA's work. And we not only have the major task of restoring investor confidence among New Zealand investors but internationally as well!

We are certainly mindful of the high expectations held both by Government and of the market for our success going forward. I welcome that challenge, and I'd like to talk now about some of the work we have underway.

FMA is little more than two months old. And even though we're very new, we've had an exceptionally busy time, with a great deal of media interest in both our establishment and in the early use of our powers.

As of today, we are bedding in a new organizational structure that covers our broader responsibilities and powers, and an expected growth in size from around 80 staff to about 120, split between Wellington and Auckland. I am in the final stages of interviewing a range of candidates, culled from 250 applicants, from New Zealand and abroad, for the seven key positions that will make up my leadership team.

On our very first day of business we used our new powers to take action against Bernard Whimp, putting a stop to the misleading offers to shareholders he had made. Since then we have warned investors to be wary of the unacceptable behaviour of a Mr Patrick Diack, a sales agent in Wellington - and warned SuperLife, the company whose KiwiSaver products he sells, about the need to overhaul its sales practices. At one point last month, we issued an interim stop order against GFNZ Group, formerly Geneva Finance, to prevent it from issuing securities while it was in breach of its banking covenant.

We worked closely with the Serious Fraud Office on investigations into Aorangi Securities Limited, and announced the decision for the SFO to pursue charges under the Crimes Act - and for FMA to withdraw on the basis that a separate prosecution by us would incur an unnecessary doubling of public expense.

Little more than a week ago, on 1 July, important protections for retail investors went live with the start of the new financial adviser regime. Up until last week, anybody could hang out a shingle saying they were a financial adviser. Not any more.
All advisers are now regulated, and FMA licenses and monitors three levels of financial advisers - Authorised Financial Advisers, Registered Financial Advisers, and advisers working for Qualifying Financial Entities. Under the new rules, advisers must only recommend investments and products that suit their clients' situation and needs. They have a duty of care for their clients' interests.
The new regime is designed to weed out poor performers and to lift the professional standards of the advisory profession. As our ad says, cowboys belong in the movies - not the financial markets. We want the cowboys gone.

And on Friday, we welcomed the guilty verdict in the Nathans trial for which my staff led the prosecution. We believe this outcome sends a strong message around New Zealand's boardrooms of directors' responsibility to ensure investors are given accurate, truthful and complete information. It makes clear that directors have a personal duty to ensure disclosure document do not mislead or deceive, and that's a duty they cannot delegate to others. Directors need to form their own opinions.

One of the top priorities for FMA's Board has been determining an effective approach to enforcement. A great deal of work is going on in establishing how we want to proceed. We are hopeful that our enforcement strategy will be finalized and ready to be shared publicly in the next few weeks. In the meantime, I can give you some insight into the principles that underpin our approach.

The first point to make is that for the first time New Zealand has a fully-fledged financial services law enforcement body operating in the capital markets. This means no disrespect to our predecessor bodies at the Ministry of Economic Development or more especially the Securities Commission, which started off life as a policy-making and exemptions-type organization with limited enforcement and investigatory powers. Added to that, we've been given some very powerful new tools of which the most significant and controversial is s34.

So this is new for everybody, not least for FMA staff.

First, FMA will focus its energy not across every act of misbehaviour or insignificant breach but primarily on those areas where the failings are deliberate or reckless, and where the perpetrator set out to deliberately mislead or deceive investors.

Our enforcement approach must be guided by our mandate to grow New Zealand's capital base. So the sort of conduct likely to attract our attention is conduct that would undermine that objective. That's why we took early action against Mr Whimp, Mr Diack and SuperLife, and GFNZ Group etc.

Under our enforcement policy, we will make full use of the range of tools available to us. Public attention tends to focus on our legal tools - criminal or civil court proceedings or settlements. But there are a range of administrative tools available to us too, such as fines, forced disclosures, enforceable undertakings, blocking issues or granting exemptions. We can also make strategic use of communications by using the media and other outlets to draw the public's attention to our warnings or to suspicious activities we are concerned about.

Second, FMA has inherited a number of finance company cases and investigations from the Securities Commission and our MED predecessors.  We have, as a matter of urgency, applied a robust "triaging" process to these cases as a way of prioritising our workload.

Obviously, cases already before the courts must be pursued and we will meet court deadlines, and prosecute those matters to the best of our ability - as we did in the Nathans trial. Where possible, we will add additional resources to enhance our prospects of success.

For matters not yet before the courts, we are near the end of a detailed forensic analysis of each case, assessing how it meets our new strategic priorities.

Among the questions we are asking are: What is the current state of the investigation? How many people are affected and to what degree? What additional evidence needs to be gathered in order to bring those matters to trial? Are there any alternative remedies including new civil remedies we previously did not have? Are there other agencies that have an interest in the case and who might also pursue matters to achieve similar or even better outcomes? Is it in the public interest to pursue this case, and what chance is there of recovering a sizeable or significant proportion of lost funds?

In some matters, the outcome of this process means that we will progress things more aggressively, more quickly and in a more targeted fashion than perhaps in the past. And that's a good thing.

Inevitably, however, there will be some matters that will not be progressed at all either because there are other avenues of redress for those who have lost funds, the impact does not meet our strategic objective, or where other regulators or agencies are better placed to take a lead role.

We have already announced our decision to withdraw from two cases - the Insured Group civil proceedings, and the Aorangi Securities investigation, believing the SFO was the better agency to lead the criminal charges there. And we hope to be able to publish soon how we intend to proceed on the remaining 24 finance company cases on our books.

The fact of the matter is: we cannot run every case, nor pursue every breach. To do so would jeopardise any prospect of us achieving our forward-looking agenda. We also need to be responsible in our use of public resources, and we will not pursue matters where there would be a disproportionate cost versus the likely outcome.

That said, we will retain our discretion to step outside our own guidelines on the odd occasion. There will be times when it is important for us to take a stand, to test the law, and to use particular cases to check that our analysis or interpretation of the law is correct.

It is our intention to be bold. There must always be cases we are prepared to lose, provided there is a cogent reason and lesson to be extracted that benefits the whole market.

Any litigation is by its nature risky, and we cannot predict the outcome of matters that will be determined appropriately by an independent judicial body. This means that where it's possible for us to resolve matters without redress to court, we will apply commercial common sense and seek tailored remedies that match the severity of the breach.

Some have said that we've had an easy start by inheriting a large number of existing cases and investigations from Securities Commission. I disagree.

What we have inherited is a large number of matters that relate to events that occurred some years ago and are yet to be resolved. That's an unfortunate byproduct of the number of finance companies that collapsed. It would be far better to have fewer of those matters and therefore to have more time, energy and resources to devote to new investigations that better fit our strategic objectives.

Our targets for surveillance will follow a similar path. We will focus our compliance monitoring on both newly licensed entities, and on existing regulated entities to ensure they are meeting their obligations and that investors are receiving the services and disclosure they are entitled to receive.

Newly regulated entities such as financial advisers can expect that we will pursue a measured approach to surveillance. This will give them an opportunity to understand, and reach full compliance with, their obligations before we take a tougher enforcement approach.

For entities that have been under regulatory supervision for some time, we will be much less lenient.

Most importantly, we will never be soft on conduct that is deliberate or reckless or that is intended to deceive or defraud innocent third parties of their funds.

An important new aspect of our work is the establishment of a strategic market intelligence function. We need to build this from scratch yet we are determined to have it fully operative by the end of winter.

Our aim is to bring together a range of different information sources from across the market, and from within FMA and other government agencies, to start to build a picture of where the most risky behaviours are occurring.

It's critical that we develop strong information-sharing arrangements with the Serious Fraud Office, the Police, and other investigatory bodies. In part, this will allow us to identify which is the most appropriate agency to lead an investigation. Other important sources of intelligence about fraud and illegal activity are our fellow regulators overseas, especially ASIC in Australia.

We want our intelligence function to apply an economic and financial lens to analysing potential risks to New Zealand's financial markets, as well as a legal and compliance view. And we want it to keep us informed of global best practice on financial markets regulation.

This is new ground for us and there are obvious challenges. To what extent will market participants be willing to openly discuss borderline practices with us given our regulatory role? How can we quickly identify regulatory gaps being exploited by "periphery riders" before damage is done?

Stakeholder research we've carried out has made clear to us some of the emerging risks we need to put on our radar. The practices of some KiwiSaver providers and financial advisers, property bubbles, speculative trading, technology-driven products and products with unclear custody ownership are on the list. 

Deepening our organisational capabilities, so we have the skills to do this enforcement and monitoring work, is a priority for us. We want FMA to be known as an organisation that understands the industry it regulates, and can talk in the same language as market participants. We want it to be respected for its competence and professionalism. We want to increase our familiarity with the markets and products on offer so we can ask the right questions and hold a more effective conversation with stakeholders and investors.

To do this, we need to lift our internal capability and as I've mentioned we are in the middle of recruiting additional expertise right now. It will also be important that we work with external service providers, such as law firms and forensic accountancy firms.

There may be other ways we can bring in new talent. Perhaps there are successful private sector people out there in the later stages of their careers who might want to "give something back" by working for a public agency? Perhaps there are industry participants interested in public sector secondments?

Obviously, we must be mindful of conflicts of interest, and there will be occasions when it is inappropriate for someone from a private firm or other agency to be carrying out work on behalf of FMA. However, we will take a balanced approach to using our resources, and where it is appropriate for us to bring in specialist expertise we will do so.

By virtue of our greatly expanded responsibilities and powers, and the greater lineup of laws we enforce, the nature of the relationship between regulator and the market is changing. It's becoming much closer.

The Financial Advisers Act, the Securities Trustees and Statutory Supervisors Act, the auditor regulation legislation and changes to the Securities Markets Act in relation to markets and exchanges - these all signal a closer supervisory relationship between FMA and the market. And the securities law review is only going to take this further with Cabinet having now agreed to the licensing of funds managers and derivatives issuers.

Fundamentally, what it means is that people in the market can expect to have regular and ongoing contact with FMA. They can expect to see more of us. In the past, when it was the Securities Commission, if you heard from us something had gone wrong. Now people can expect an ongoing relationship with us. We want that and we welcome it.

And what can you expect of us? You can expect more guidance and more communication. An early priority is guidance on our expectations for prospectuses and disclosure documents.

And you can expect more timely action. When our market intelligence function is up and running, be assured that we will be quicker to act - we will not hesitate to take enforcement action where it's needed. We will test our new powers.

In conclusion, I want to emphasise that in this work, we're reliant on you - all of you in this audience today, and your friends and colleagues - to help us, and to point us in the right direction.

FMA is not an island. We cannot be everywhere in the market. We will be a team of 100-or-so people in a market of thousands. We need your input to help us best target our activities and to tell us what's really going on.

We're all in this together. For those of you in the legal, financial markets policy-making and broader corporate governance areas, this is a wonderful time to be in New Zealand.

You have an active engaged regulator, a committed government, an impatient and exasperated populace, and a new set of laws that we are keen to use.

It's a great moment in history for all of us to be part of the journey to lifting the standard in our market, and encouraging investors to come back in.

END