Presentation by Sean Hughes to the Institute of Directors
19 March 2012
Thank you all for the opportunity to speak to you today.
I'd like to talk to you tonight about the role FMA has been playing, and will continue to play, in rebuilding investor confidence in New Zealand's capital markets. It is a new approach and one which, I think it is fair to say, is not universally well understood.
We are at an interesting stage in the evolution of New Zealand's financial markets regulation. In recent weeks various commentators have wondered aloud whether the legislative response to the Global Financial Crisis and the finance company collapses has gone too far. At the Legal Research Foundation conference recently, one speaker expressed misgivings about the so-called "hasty" introduction of "sweeping reforms" and pointed out not every finance company failure involved poor or dishonest governance or management. Already, some advisers are encouraging directors to lobby for a peeling back of regulation and regulatory powers.
We're pleased that the Government has shown its support for our direction of travel through its funding and we welcome bipartisan support in Parliament for the passage of the Financial Markets Conduct Bill.
A return to a light handed regulatory approach is simply not an option. I'll enlarge on that shortly.
The debate, such as it is, has been conducted against the backdrop of the intensive media coverage of the closing arguments in the Bridgecorp trial. Shortly after investors owed $460 million heard they would receive back less than 10c in the dollar, the Crown prosecutor told the Auckland High Court that directors Rod Petricevic and Rob Roest "manufactured a smokescreen of scenarios" to support their claim they knew nothing of Bridgecorp's deteriorating cash flows.
On March 29 the Wellington High Court will sentence the four Lombard directors found guilty last month on charges the company's offer documents misled investors. And in July last year directors of Nathans Finance were sentenced to jail terms after including untrue statements in a prospectus.
The continuing procession of finance company directors before the Courts does nothing to improve market confidence. Nor is it helpful in encouraging diligent, experienced and qualified people from seeking seats at the boardroom table. Does it really tell us very much about how good directors ought to meet their obligations?
FMA inherited the finance company caseload from our predecessor. We had a duty to continue the investigations and identify those cases that had a good prospect of success, and that has formed a large part of our work in our first year.
But going forward, our focus will be on the road ahead rather than what is behind us.
I think we can say that the finance company failures were at least in part a failure of corporate governance. Put simply, many of the directors of these companies, and others involved in their operations, weren't doing their jobs properly. The recent guilty verdicts in the Lombard trial, and the prison terms given to some of the Nathans Finance directors, send a clear message to our corporate community that they have clear responsibilities and a duty to act with diligence and care.
The collapses also highlighted serious mismatching of the risks that investors were prepared to take on and the returns they accepted for doing so. Investors in inadequately capitalised finance companies in some cases accepted interest rates only a couple of hundred basis points above those offered by AA -rated institutions.
It could be argued that, in part, this was a failure of regulatory policy. Under a regulatory regime requiring more rigorous standards of disclosure, investors would have been better-placed to be able to assess the risk / return equation.
It is also illustrates the challenge we face in promoting investor literacy - a subset of the bigger issue of financial literacy. It would be fair to say that investor literacy levels were, and are, low and many investors didn't fully understand the risks they were taking. I'll talk more on that in a moment.
The Global Financial Crisis prompted, in New Zealand and around
the world, a debate on the bigger question of the role of
regulation and the pros and cons of 'light touch' regulation versus
more invasive supervision.
Key to this debate are assumptions around whether markets are inherently stable or unstable, and whether they can be relied on to resolve their own problems through some natural law. In other words, failure is sometimes necessary.
It would be fair to say that there is little faith remaining in the notion of 'light touch' regulation and inherently stable markets in the UK. This sentiment is reflected in the words of Lord Turner, Chairman of the UK regulator, the FSA. He contends that the assumption that markets are inherently stable and the consequences of "political pressures for a light touch regulatory regime," are problematic and unsustainable.
In the New Zealand market we have had a long history of skepticism about the value of regulation - with the common perception it's all about red-tape form-filling demanded by faceless bureaucrats in Wellington.
Indeed, FMA's critics fall into two broad categories - those who think we are doing too little, and those who - as I mentioned a moment ago - argue we are doing too much.
My answer to them is that the efficient markets hypothesis, or "light touch regulation," has been tested and found wanting. In the finance company debacle, it has been shown to have failed a generation of investors.
The establishment of FMA marks a new maturity in how we regard regulation in New Zealand. Our challenge is to deliver tailored oversight of the markets for financial products and services while encouraging smart innovation.
Mature regulators don't see their job as simply enforcing a set of laws which Parliament has passed. FMA has a significant responsibility to assist investors to understand for themselves the risks of any given product offering or advice they receive - and make a decision on an informed basis. We cannot predict the future nor guarantee success, but we want to ensure they are helped to help themselves.
Regulation needs to redress the asymmetry of information so that investors understand risk and make informed decisions. And it needs to bring clarity of expectations and raise the bar on the behaviour of market participants so that investors can rely on the transparency and integrity of the information they are given.
We can also say that the 'principles' based approach we have here and in Australia offers a more flexible regime. It ensures organisations don't spend their time either 'ticking boxes' or innovating to try to get around the rules. They need to adhere to the principles behind the law. To that end, innovation, the staple of any good market, becomes smart innovation with willing and informed participants.
FMA'S ROLE AND POWERS
FMA's establishment in 2011 provides a new legislative landscape for New Zealand's financial markets.
Our Act gives us greater powers of surveillance, regulation and enforcement than our predecessor. We have a wider scope in terms of the people and entities we oversee, ranging from registered securities exchanges, superannuation schemes, issuers and brokers to financial advisers.
Last October we added trustees and statutory supervisors to our list, and we are well advanced in our planning for oversight of auditors of issuers from July this year.
FMA's creation is not the end of the Government's reform agenda for the financial markets.
Last year it also released the draft Financial Markets Conduct Bill, which is the outcome of a comprehensive review of New Zealand's securities laws. The Bill has passed the first reading in the House and has now been referred to the Select Committee.
Draft reforms include:
- changes to disclosure - replacing the requirement for issuers to prepare a prospectus and investment statement with a single product disclosure statement tailored to retail investors
- a modified liability framework for securities law breaches including criminal penalties for the first time for reckless and intentional breaches of directors' duties, as well as civil penalties for misleading information in disclosure documents and advertisements
- a further significant increase in the scope of regulated entities, to include fund managers, independent trustees of superannuation schemes, derivatives dealers and peer-to-peer lenders.
It is interesting to note that the draft Bill alters the thresholds for civil and criminal liability for directors. It states that only the most serious, deliberate, intentional misconduct will attract criminal liability, while in less serious cases it prescribes civil action to recover compensation.
Indeed, some commentators have suggested that, if the Bill was law today, the directors of Lombard Finance would not have been found guilty on criminal charges. Who can speculate? We must not forget though that the Bill does expand civil liability options.
The review is an important piece of work and is being seen as a once-in-a-generation event. All going well, it is expected to be passed this year and come into effect in 2013. Once passed, it is a law that FMA will be almost entirely responsible for enforcing.
WORKING WITH OTHER AGENCIES
In addition to overseeing our own legislation we also work closely alongside our parent, the Ministry of Economic Development, other local regulators such as the Reserve Bank and Commerce Commission, and other agencies such as the Serious Fraud Office, the Commission for Financial Literacy and Retirement Income and the Department of Internal Affairs.
The relationship with the Reserve Bank is absolutely pivotal to the success of the financial markets regulatory model set for us by the Government. Our future action with the Bank must be close, transparent and imbued by a culture of sharing information - not withholding it.
It's true too that our relationship with a specialist investigations and prosecutions body such as SFO is important where and when our work intersects, as it does presently on our remaining finance company investigations. We are cognizant of the need to optimise reasonable and appropriate expenditure of taxpayers' money. This means good cross -agency relationships, co-operation and timely information sharing. It also means sometimes stepping back and taking a lesser role, or stepping up and taking the lead.
FINDING THE SWEET SPOT
So FMA has both an increased regulatory reach and a
better-stocked toolbox. But we're conscious those alone will not
deliver investment markets that are fair, efficient and
FMA's role cannot be to remove risk. Rather it is to sharpen and enhance investors' understanding of the risk / return equation. The theme of behavioral change is an important one. For investors, that means an increased understanding of their own responsibilities and greater financial comprehension and confidence. For the market, it means participants who operate with integrity and transparency and who consistently act in the best interests of their investors.
As I've said, FMA has a role to play in helping investors to make informed decisions. To that end we will be working closely with other agencies such as the Commission for Financial Literacy and Retirement Savings, and with industry. Programs need to address the asymmetry of information and improve confidence - although note that increased confidence needs to be attached to increased knowledge - it's helpful when people know what they don't know.
Another factor critical to helping New Zealanders make sound investment decisions is access to high quality financial advice. Since July 2011, anyone offering financial advice has been required to comply with the Financial Advisers Act, which requires all advisers to provide advice with appropriate care, diligence and skill.
They must ensure products meet their clients' needs and provide disclosure so that clients can make informed decisions about using the adviser and whether to follow the advice. And they have a duty to care for their clients' interests.
FMA's role is to monitor and assess advisers' compliance with these requirements and we are working hard to ensure advisers understand their obligations and are able to fulfil them.
For advisers and the wider market, FMA will work hard to ensure participants understand how we will interpret the rules. Our approach could be described as "swim between the flags."
We will continue providing guidance to the market, working with the media to spread key messages about what we do and why, promoting accessibility for market participants, and looking to develop joint policy initiatives.
We have a mandate to educate the market regarding our expectations. One of the key impacts in our Statement of Intent is to ensure that financial markets participants have clear and well understood responsibilities.
In this regard guidance is critically important.
During 2011 FMA undertook five consultations with the market, regarding financial adviser licensing, KiwiSaver performance fees and the implementation of the Auditor Licensing Act. This year we have undertaken further consultation on auditor licensing and we will issue draft guidance on the use of Alternative Profit Measures in financial reporting.
We have also said we will conduct a second round of consultation regarding our guidance on Effective Disclosure. During the first round, most groups we met agreed guidance was timely and have welcomed the opportunity for engagement. But the feedback did unearth some issues. Effective disclosure is one of the fundamentals of fair, efficient and transparent financial markets and it's critical we take the time to get this right.
The quality and depth of the submissions we've considered so far has been impressive and will result in final guidance that will be markedly different to the first draft.
To be useful and effective our guidance needs to be based on a strong understanding of market fundamentals and commercial realities. We encourage the market to help identify the remaining 'big picture' issues.
We're not out to hang people who are trying in good faith to get it right and exercise proper diligence. Our aim is to assist issuers by signalling FMA's expectations and what we will look at as part of a review of disclosure documents.
Last month a journalist writing about the Lombard verdict heralded "the end of the age of the amateur director." It's an interesting phrase. NZ needs and deserves a high level of professionalism amongst directors, senior management and their advisers. Participants who operate with integrity and transparency, and who act consistently in the best interests of their investors, are an essential element for restored investor confidence.
The behaviour change we're seeking to bring about will not appear overnight. It will require cultural change. And it is not the regulator's responsibility alone. The market has a clear role to play in improving the New Zealand culture and raising the standards of conduct in our markets today.
Of course, no matter how successful FMA's 'top of cliff' work is and how well the market matures, we will never succeed in putting our Enforcement function altogether out of a job.
There will always be innovators, which we encourage. However, high risk innovators will attract our attention.
Innovation is a vital ingredient of any market, including the
markets for financial products. That means that regulators
must adjust constantly to the appearance of new financial products
and markets and new methods of distribution.
Our strategic intelligence function is a core capability for us and one we are investing in - to ensure we have a clear view of trends and developments, and to provide early warning of potential problem areas.
The aim is to be in the market, not outside it, to foster open dialogue and early constructive engagement. We've seen this starting to occur in a number of areas including our consultation on Alternative Performance Measures where companies have signaled a desire to talk through their current practices and understand where they are falling short. They have welcomed a 'quiet word' from us if we're unhappy and they're committed to responding with change. That's a good model.
Our intent is to achieve a level playing field in New Zealand's financial markets where everyone knows the rules of engagement.
To wrap up, New Zealand is well advanced on the journey to rectify the weaknesses and deficiencies exposed by the GFC and restore investor confidence. We have a strong regulatory framework with a 'twin peaks' model, which sees the Reserve Bank in charge of prudential regulation and FMA overseeing conduct. We have more regulatory options than our predecessors and a wider reach in terms of the sectors we regulate.
If I can sound a sound a note of cautious optimism, we are hopeful our education programs, our market consultation, and our guidance and policy notes will bring about a new era of professionalism, good governance and increased confidence.
Our direction of travel is along the regulatory curve to a place where enforcement takes a back seat to actively informed market participants on both sides of the equation.
Stronger regulation, better compliance, and higher standards - these will all help to make New Zealand more resilient in the face of future market volatility.
But we need also to strike the right balance between the costs of regulation and its benefits.
If we get this right, then our capital markets will become places where investors, companies and entrepreneurs can form partnerships that will grow our economic wealth - to everyone's benefit.