Recent comments from the Financial Markets Authority's (FMA) Chief Executive, Sean Hughes, suggest that the regulator is keen to step up its efforts to protect the investing public from risks associated with non-traditional investment products, such as commodity based or foreign exchange schemes. As part of this message, Mr Hughes has drawn attention to the new designation power that the FMA will have once the Financial Markets Conduct Bill (FMC Bill) has come into effect. In this update we comment on the designation power and its potential use not only for investor protection, but also for providing clarity for market participants.
The nature of the problem
A range of investment schemes have sprung up in New Zealand in recent years that have been subject to limited or no regulatory oversight. Unsurprisingly, the FMA is concerned with the associated risks to investors, and is sending a warning signal that it is willing to use its full range of powers to stop this trend.
Under the current Securities Act regime the boundary between regulated and unregulated offers is often uncertain, a point which the Capital Markets Development Taskforce noted in its 2008 report. The Securities Act 1978 contains a number of exemptions and exclusions, but these have been assembled over time and are not easy to understand. The highest profile example of this ambiguity is probably the failed Blue Chip property development, where the Supreme Court ruled that the products offered were securities for the purposes of the Securities Act 1978 and that the Blue Chip developers had acted in breach of the Securities Act 1978. To reach this stage, however, took a group of investors four years and determination in the face of adverse rulings from the High Court and the Court of Appeal.
This degree of uncertainty presents difficulties for bona fide issuers and their advisers. It also creates, as noted by Mr Hughes, the incentive for designing and marketing products that are promoted as investments, but are not subject to the general rules governing persons seeking to raise funds from the public.
The designation power in the FMC Bill
The designation power, which is contained in the FMC Bill at clauses 533 to 537, gives the FMA the power to designate investment products as being financial products for the purposes of the FMC Bill, and hence provide a range of protections for investors. Dealings in financial products are subject to fair dealing rules as set out in Part 2 of the FMC Bill, and making regulated offers of financial products triggers disclosure requirements under Part 3 and governance requirements under Part 4.
Essentially the designation power enables the FMA to give binding rulings on what investment products are to be regulated by New Zealand's financial markets legislation, and hence the FMA's own oversight. The possibility for the market regulator to give binding rulings has been discussed for some time - the former Securities Commission published a discussion paper on the subject as far back as 2000. The primary advantage of such a power is an ability to have a binding determination issued by the relevant decision maker in a timely manner, as opposed to the delays associated with the Court process.
The key concept to remember with the designation power is that the FMC Bill retains the use of the term "security" as an outer boundary for products that may be regulated. For the purposes of the new legislation the concept of a security is any arrangement or facility that has, or intended to have, the effect of a person making an investment or managing a financial risk (see clause 6 of the Bill for the full definition). This means that products can be divided into three general categories:
- One of the four categories of financial products that are defined in the Bill and regulated (equity, debt, managed investment schemes, and derivatives)
- Products that come within the definition of security for the purposes of the Bill, and so could be designated as financial products by the FMA
- Products that are not securities for the purposes of the FMC Bill, and so are outside the scope of the designation power.
If the FMA were to become aware of an investment product that raised concerns, but did not come within the existing defined categories of financial product, it would be likely to consider the following steps:
- Is the investment product a security as defined in the legislation?
- If so, does the FMA consider it appropriate to make the product subject to regulation, bearing in mind the FMA's statutory purpose of promoting confident and informed investor participation in the financial markets?
Other uses of the designation power
In addition to investor protection the designation power also has the potential to be used to assist innovation in the financial markets, which is also one of the purposes of the legislation.
A frequent concern for market participants is lack of certainty on how securities legislation might apply to proposed new products. The ability of the FMA to provide designations and/or give no action letters would be of assistance here. If it were willing to use its statutory powers in this manner, the FMA would be able to give definitive answers to market participants in these circumstances as to how their proposals would be treated.
In addition to the designation power, there are other tools the FMA might use to regulate offers of this kind.
In many cases, investment products are bundled with one or more financial services, which are regulated, imposing regulatory oversight. For example, while a simple sale of precious metals is outside the scope of the Securities Act 1978 at present and would appear outside the scope of the designation power in future, many schemes promoted to investors involve financial services such as the provision of financial advice, custody services, or leveraged finance or derivatives, thus triggering regulatory obligations.
Further to this, where no such regulated product or service can be identified, the FMA has stated in the past that it is willing to issue public warnings, to make clear to investors the regulatory status of what they might be signing up for.
Given the strong signals the FMA has sent out, it appears likely that the full range of tools stand ready to be used.