Securities Commission

The recent criticism of the Securities Commission, particularly in relation to the finance company collapses, is justified. The commission has disappointed investors in several areas as it has a tendency to promise too much and deliver too little.

The organisation’s primary purpose is “to strengthen investor confidence and foster capital investment in New Zealand by promoting the efficiency, the integrity and cost effective regulation of securities markets”.

It aims to achieve this through enforcement, recommending law changes, issuing rule exemptions, authorising and approving market participants, co-operating with international agencies and promoting public understanding of markets.

The commission has been given a huge number of tasks on a tiny budget and it has failed to achieve all of its goals. This has contributed to the bias towards residential property in New Zealand and the small size of the NZX relative to GDP.

The Securities Commission of New Zealand was established in 1979 under the Securities Act 1978. At the time the sharemarket was remarkably similar to a West Coast mining town during the 19th century gold rush. The market was characterised by widespread insider trading, market manipulation, poor disclosure and the sale or purchase of assets to listed entities by controlling shareholders at either inflated or depressed prices respectively. The NZX was almost totally unregulated but there was a great expectation that the commission would clean up the wild west show.

However, the organisation was given limited powers and its main focus has been on recommending law changes rather than enforcement. Colin Patterson, the first chairman, wrote that his first priority was to devise regulation governing the advertising of public offerings and to tighten the requirements regarding the content of prospectuses.

That was written in 1979 yet, in light of the finance company collapses, the commission has made limited progress in both these areas since then. The commission made numerous law reform recommendations in the early 1980s but most of them ended up in the rubbish bin because of strong opposition from the financial establishment. Senior finance industry participants had a strong disdain for Patterson’s proposals because they were making huge money under the unregulated model.

This unregulated environment led to the disastrous boom and bust of the 1980s. While brokers made big money, a large percentage of investors lost their shirts and have subsequently shunned the sharemarket in favour of residential property.

The commission’s culture was established in its early years under Patterson and it has never really changed. The organisation is predominantly a law reform body rather than a traditional regulator and investors are continually disappointed by its performance because it gives the impression that it is an enforcer. Securities law is based on the concept that “sunlight is the best disinfectant”.

In other words we have a disclosure regime, which means that prospectuses contain full – and easy to understand – information. Individuals then make their investment decision based on this information.

The commission has a limited enforcement role, this is left to private individuals and companies by way of civil action through the courts. The issue of enforcement has come to a head with the collapse of a number of finance companies that sourced funds from elderly and inexperienced investors.

The commission is responsible for determining the content of prospectuses and investment statements. Many finance company prospectuses are extremely difficult to read and investment statements are virtually worthless because they contain no substantive financial information.

Capital + Merchant Finance’s prospectus is a typical example of the confusion and complexity evident in many prospectuses. The company, which is in receivership, had two types of debenture stock:
* Capital Secured Debenture Stock – used to offer mortgage finance where the facility was limited to a maximum of 66.67 per cent of the value of the property as evidenced by an independent registered valuation.
* Investment Debenture Stock – where there was no particular credit criteria.

According to the September 2007 prospectus, “All mortgage facilities granted by Capital + Merchant Finance utilising capital secured debenture stock are insured by way of mortgage indemnity insurance and mortgage impairment insurance policies underwritten by certain syndicates at Lloyd’s of London. Facilities granted utilising investment debenture stock do not have the benefit of insurance cover”.

Capital secured debenture stock should be safe but in another section of the prospectus there is a note indicating that it ranks behind another security. This note is extremely difficult to understand and only the more experienced analysts would have been able to ascertain the risk associated with the capital secured debenture stock.

The receivers’ first report indicates that the insurance cover may be worthless and the capital secured debenture stock may not be secured by first mortgages.

Why hasn’t the commission insisted that every prospectus and investment statement include a simple table showing the ranking of all borrowings and another table outlining the company’s clear lending policies, type of loans, security of these loans and insurance cover?

The commission seems to be putting far more emphasis on the raft of new rules to be introduced on February 29 than on the finance company collapses. This is consistent with its role as a law reformer rather than an enforcer.

The new regulations are as follows:
* Insider trading will be a criminal offence punishable by up to 5 years’ imprisonment and a fine not exceeding $300,000 or both. A body corporate will be liable for a fine of up to $1 million.
* Market manipulation will also be a criminal offence with the same penalties as insider trading.
* Substantial security holding disclosure breaches will also be a criminal offence with fines of up to $30,000. There can also be additional civil penalties of up to $1 million.
* Investment adviser and broker disclosure requirements will come under the Securities Market Act 1988. Non-disclosure will become a criminal offence with a fine up to $300,000. There will also be civil remedies.
* The definition of advertising widens and articles and comments on KiwiSaver must refer to the investment statement and must be consistent with the registered prospectus.

Most of these new regulations are 25 years too late. But the interesting point is who is going to enforce the new rules as New Zealand doesn’t have a regulator with strong enforcement powers? The answer is the Securities Commission. The commission will be given “extensive public enforcement provisions”, yet when one reads through these powers it is very difficult to see the organisation becoming a top class enforcement agency.

The organisation’s attitude is best summed up in a piece on finance company collapses in its January 2008 Bulletin. According to the commission, investors have to sue for compensation for loss caused by the misleading statements in, or omissions from, the prospectus. However, under law changes that came into force in October 2006 the commission can take action regarding prospectuses issued after that if it “concludes that this would be in the public interest and in the interests of investors”.

If the commission is serious about its enforcement role why doesn’t it start with Capital+Merchant Finance or one of the other recent finance company collapses?