Clear signals for future capital markets change – and more quick fixes now

The taskforce charged with boosting New Zealand's capital markets and making it easier for business to raise capital has this week released further quick fixes and views on issues for long-term change.

The Capital Market Development Taskforce, appointed by the government last July, has released a progress report identifying major issues facing New Zealand's capital markets. It builds on its earlier interim report, released last December, adding to the list of quick fixes identified in the interim report and setting the scene for the likely recommendations to be contained in its final reports now due this December.

Taskforce chair Rob Cameron, in releasing the report, noted that the taskforce had big issues to deal with. Not only did it have to identify the issues affecting New Zealand's capital markets but also it spent most of the last year focusing on the development of urgent measures in response to the global financial crisis (GFC). Many of the issues identified by the taskforce are based on relevant industry data, from engaging with industry participants, and from specific commissioned research.

The taskforce has been mindful of the context against which it is reporting. Given the GFC has highlighted a number of deficiencies and vulnerabilities in capital markets generally, the taskforce considered it important to stand back from the GFC and think about how to use this as an opportunity to reshape our capital markets to better serve New Zealand. The progress report notes that it will be important that New Zealand has, and is recognised as having, a robust and certain regulatory regime. This is something the taskforce regards as important given New Zealand's large current account deficit making it critical that our markets are both attractive to international capital as well as being developed to be attractive to a higher levels of domestic savings.

The key issues

The taskforce believes that New Zealand can and should do much better, with many of the issues, identified as evidence that our capital markets are not functioning as well as they could, being matters it earmarks as being within our control. While it continues to develop recommendations for improvement, the primary issues it has identified include:

Thin public capital markets. New Zealand's listed equity markets are described as being relatively small and illiquid with only limited participation by firms in a number of industries. There has been little growth in listings and relatively small amounts of capital raised when compared with Australia and markets further afield. While the attrition rate from the listed market is broadly in keeping with other countries, there have been comparatively few new listings. One feature of the New Zealand listed company market is the tendency to pay relatively higher dividends rather than retaining earnings from reinvestment. Despite the recent flurry of corporate bond issues, the short-term debt markets are dominated by banks with a small domestic corporate bond market largely comprised of infrastructure and SOE issuers with solid credit ratings.
Patchy private markets. The economy is dominated by SOEs which have a higher reliance on bank debt and little access to alternative sources of external funding. New Zealand has one of the most bank-dominated financial systems in the OECD. As a result, some SMEs with high growth potential may be constrained by the availability of funding. Outside the public market, most capital is provided by families and individuals as well as retained earnings and institutions. Few participants rely on outside capital or even outside talent for governance. Also, that there are tensions on both sides of the market with owners sceptical about the benefit of public markets and often little ambition to grow while investors find it difficult to access investment opportunities. While the private equity/venture capital market is developing, private equity fund raising activity is low, with few local investors participating and the private equity market suffering from the number of deficiencies.
Underdeveloped derivatives market. Because of its size, the New Zealand economy is vulnerable to shocks affecting export and import prices, exchange rates, credit conditions and other economic risks. Derivatives provide a way to manage some of these risks. Despite the significance of the primary sector, the range of commodity derivatives is under-developed, making it difficult to manage risk (let alone for these tools to be used to contribute to the functioning of the underlying physical markets by improving liquidity and information flows).
Low levels of investment in capital market products. Putting the low level of household wealth to one side, portfolio composition of New Zealand households is heavily weighted towards housing at the expense of other asset classes. New Zealand has low levels of financial asset holdings and is the only country in the nine OECD countries surveyed to experience a decline in the ratio of household net financial wealth relative to income over the 20 years. The composition of financial asset holdings is also heavily skewed towards low risk/high liquidity assets such as bank deposits and high risk debt. New Zealand households also have the lowest share of financial assets invested in equities. There are a number of reasons for these outcomes including over-investment in the housing sector, underdevelopment of pension funds and widespread mistrust of capital markets (and biases in tax settings).
Non-participation by many co-operatives, government-owned, foreign-owned and other entities. A number of structural features reduce investment opportunities including:
- significant New Zealand export industries based around co-operatives which have chosen not to participate in public equity markets;
- some industries, such as utilities, having significant central and local government ownership;
- many of New Zealand's largest companies are subsidiaries of foreign companies few of which choose to raise equity in New Zealand;
- relative to its size, New Zealand is the headquarters for relatively few global size firms.
Poor regulation of financial intermediary/financial advisory sector. A combination of factors led to finance companies being able to offer lower interest rates than were justified by their risks and engage in practices which raised those risks further. Lack of transparency about fees and the absence of independent supervision led to investor mistrust of managed funds. The Financial Advisers Act 2008 will help address some of these issues.
Outdated regulation and unnecessary compliance costs. The announcement of a root and branch review of the Securities Act is welcomed as an opportunity to resolve the present difficulties of a high-cost disclosure regime which is perceived as providing little guidance for investors and stifles innovation and new entrants.
Inadequate analyst research coverage. The chicken and egg-like relationship between the present low levels of analyst coverage and the cost of this research is noted. Research has been shown to improve liquidity and improve efficiency.
Clearing and settlement infrastructure. The taskforce has commissioned an expert report to consider what system best suits our needs. The report is expected in September or October.
Tax settings. There are concerns about areas where tax policy imposes barriers to capital market activity. Specific issues will be identified for consideration in the context of a wider review of tax policy.
New opportunities. The GFC provides new opportunities and the taskforce is looking for ways in which New Zealand can leverage its competitive strengths to play a greater part in the market for international financial services.

Taskforce final reports

Perhaps the most interesting section of the progress report is that which signals that the taskforce's work to address some of these key issues. It will include recommendations in the following areas in its final reports:

Regulatory changes to improve investor outcomes in financial products and advisory markets. There is a need to improve investor outcomes to generate activity and confidence in capital markets and that trust in issuers and advisers to treat investor ethically underpins outcomes. As a result, there is a need for more principles-based regulation focused on ethical standards for issuers and advisers, rather than black letter law which can be "arbitraged". The taskforce notes five objectives for regulation and specific areas of focus for improving investor outcomes (particularly in clarity and transparency of disclosures as well as the ability to access competent advice, improved investor education and early intervention powers by regulators). It sees the Financial Advisers Act as going a long way to fixing the ills of the advisory sector, noting implementation will be critical.
Improve regulation to reduce costs and uncertainty for issuers. A further list of suggested changes, in addition to the interim quick fixes, are outlined (see table below). The taskforce intends to have input into the root and branch review of the Securities Act review and notes the need to look at the distinction between public and private securities offers and overhaul disclosure obligations.
Tax changes. The taskforce seeks to remove barriers to capital market activity as part of a coherent tax system and will be reporting on tax issues and contributing to the efforts of the government's newly established Tax Working Group.
Rethinking the role of government. The taskforce has signalled that is sees a broader role as being appropriate for the government in some areas, including by:
- leveraging its existing role as a direct participant (through debt issues, SOEs, the NZ Super Fund and VIF);
- leading innovation (through the Reserve Bank and KiwiSaver) perhaps encouraging greater industry research and exploring opportunities for New Zealand to attract a greater share of international financial services business;
- negotiating in international markets to update tax treaties, and achieving further capital markets integration (but advantage New Zealand as a destination); and
- reducing the extent of unwitting (negative) intervention – with the Overseas Investment Act being identified as having adverse consequences for companies and capital markets – which the taskforce is keen to provide further input about.

Principles for improving investor outcomes

Proposal	Discussion
Treating customers fairly
Require all firms participating in the retail investment market (issuers and advisers) to treat customers fairly.	Modelled on UK example Principles based Regularly policed.
Financial advisers
Fiduciary duty to be imposed on financial advisers Restrict the use of the label "independent adviser".	Overseas (US/UK and some Australian) examples Fundamental obligation to act in client's best interests (and address conflicts of interest) Independence label governed by fee structures and absence of restrictions on providing advice on certain products.
Product disclosure
Principles guiding what is effective: Timely, concise, explicit and accessible Provided up-front and jargon free Standardised to enable comparison Consider financial literacy of target audience Mandate one/two page disclosure document More standardised fees disclosure Centralised website for disclosure documents.	Principles to govern the review of disclosure regime Simple document aimed at less sophisticated investors, using standardised requirements Replace the investment statement (which has not achieved its purpose) Greater uniformity of fees disclosure, allowing meaningful comparisons Centralised disclosure to enable better use of comparisons.
Managed funds
Concerns about ownership structures Principle-based disclosure that trustees/directors/managers have done nothing to further their interests or those of the fund at the expense of individual members.	Ongoing enquiry about appropriateness of fund structures Disclosure may be addressed in the context of (generic) principles-based disclosure.

Summary of recommendations to reduce cost of capital raising for small companies and private markets

Proposal	Impact	Ease of implementation
Changes to the Takeovers Act/Takeovers Code
Ensure that joint shareholders are counted as a single shareholder in determining whether the Code applies to unlisted firms and reinstate $20 million asset minimum.	High	Medium
Remove the need for independent adviser's report for small firms (if the first point not implemented).	Medium	Medium
Changes to the Securities Act 1978
Remove the need for exemptions to be gazetted (consistent with Takeovers Panel).	Low	Easy
Allow filing of section 37A(1A) certificates to extend prospectus if material adverse change to financial position.	Medium	Medium
Remove restrictions on pre-prospectus publicity.	Low	Medium
Create statutory exemption for employee share schemes.	Medium	Medium
Remove voiding of (non-public) offers where taken up by a single member of the public.	Low	Medium
Certification of a wealthy person should occur at any time in 12 months pre-subscription (rather than prior to offer).	Low	Easy
Allow $500,000 minimum subscription to be paid in instalments.	Medium	Easy
Remove vendor shareholder liability in IPO exits.	Medium	Medium
Changes to the Securities Regulations and Exemption Notices
Amend the venture capital scheme exemption to increase range of issuers and the (financial) cap.	Low	Easy
Changes to the Limited Partnerships Act 2008
Clarify a limited partnership formed by re-registering a special partnership succeeds to the rights and liabilities of the special partnership.	Low	Easy