F MARKETS CONDUCT ILL

FINANCIAL MARKETS CONDUCT BILL

Briefing 4 to Commerce Select Committee

14 August 2012

Investment Law Competition, Trade and Investment Branch Economic Development Group Ministry of Business, Innovation & Employment PO Box 1473 Wellington New Zealand http://www.mbie.govt.nz

http://www.mbie.govt.nz/

MBIE-MAKO-17891731

The Chair

COMMERCE COMMITTEE

1. This is officials‟ 4th briefing on the Financial Markets Conduct Bill.1 It is the report back referred to at recommendation 2 of the Officials‟ Report.

CRIMINAL LIABILITY OF DIRECTORS

2. The liability regime is fundamental to the Bill. It sets out the circumstances where liability arises for contraventions, including when investors may seek compensation and when company directors and others may be criminally prosecuted for their conduct.

3. In the Initial Briefing, we noted that director liability concerns the appropriate role of directors in relation to offer documents. The liability regime for directors is designed to fulfil a number of key objectives:

The regime should not discourage capable prudent people from becoming directors through overly punitive sanctions, and companies should be able to attract directors with a diversity of skills and backgrounds;

Directors should be able to focus mainly on business strategy and supervising management, rather than on compliance and minimising liability;

Directors should supervise capital raising and exercise due diligence in relation to offer documents;

Directors should be liable for civil pecuniary penalties and compensate investors that lose money if they fail to perform their duties; and

Directors should not be liable to imprisonment where there is no fault element.

4. A criminal offence typically comprises a physical element (e.g. conduct or a circumstance in which conduct occurs) and a fault element in respect of that physical element (e.g. intention, knowledge, recklessness, or negligence). If a fault element is not required to be proven by the prosecution for a physical element, the offence is one of strict liability. In respect of a strict liability offence, the legislation may instead contain a defence. A fault element can either be subjective (e.g. the person intended, knew, or was reckless) or objective (e.g. the person ought to have known or was negligent).

5. The offence in the Securities Act 1978 for misstatements in offer documents is a strict liability offence. Directors and promoters (including the directors of a promoter that is a company) are liable for a significant (5-year) imprisonment without the Crown having to prove a fault element. Instead each director and promoter has a defence if they had reasonable grounds to believe, and did believe, that the statement was true. The issuer is not criminally liable under section 58, but has potential liability under other provisions.

6. The Bill moves the focus of criminal liability towards the issuer and includes fault elements for the significant offences. The provisions generally use knowledge or recklessness as the fault elements. Knowledge or recklessness is the fault element in the Crimes Act offence for a false statement made by a promoter.2 It is also the fault element in the equivalent Australian legislation.3

1 The previous briefings were the “Initial briefing”, “Briefing 2” and “Officials’ Report”. 2 Section 242. Section 242 also requires a fault element of intention to induce in respect of the conduct of distributing a statement – which is unnecessary here because a person using a PDS must be taken to have intended investors to invest. 3 See Australian Corporations Act 2001, s1311 and schedule 3, and the Australian Criminal Code Act 1995. Note, however, section 1041E of the Australian Corporations Act 2001, which sets out a strict liability offence for false or misleading statements.

Financial Markets Conduct Bill – Briefing 4

MBIE-MAKO-1789173 2

7. In the Officials‟ Report, we made a number of recommendations relating to the criminal liability of the primary person in contravention and persons who are parties to offences. We also made recommendations relating to defences for civil liability for the primary contravener, its directors and persons involved in the contravention. We left the issue of criminal liability of directors for this report back.

8. The Committee received a number of submissions on the appropriate fault element for criminal liability for directors under the Bill. Submitters focussed on whether recklessness was an appropriate fault element for the serious criminal offences in the Bill (in particular clauses 35(3) 40, 488 and 489). Submitters generally suggested that using recklessness as a fault element was either too low a threshold or too uncertain. Submitters either preferred knowledge alone (noting that it includes wilful blindness) or suggested that there should be a requirement to prove dishonesty.

9. As noted in the Officials‟ Report, we disagree that the meaning of recklessness is unclear. Recklessness is a standard fault element in the criminal law. Its meaning is clear and well-established. There must be “foresight of dangerous consequences that could well happen, together with an intention to continue the course of conduct regardless”.4 It is a subjective fault element. It is not sufficient to prove that there was a risk or that the accused should have perceived a risk.

10. The Bill does not criminalise reckless conduct or risk-taking generally. The Bill imposes criminal consequences only where a person is reckless as to a particular circumstance that attracts liability, such as whether a statement in a PDS is materially misleading or whether disclosure is required to be made to a person.

11. Appendix 1 contains a diagram illustrating director liability for misstatements in offer documents and Appendix 2 contains simplified liability examples. The appendices compare liability under the current law and the Bill as proposed to be amended (including under the interim drafting for defences).

Defective disclosure – clauses 488 and 489 and directors’ offences

Recommendation

1 We recommend that a director of an offeror should be criminally liable for defective disclosure under the Bill where:

1.1 the act or omission that constituted the contravention took place with the director’s authority, permission, or consent; and

1.2 the director knew or was reckless as to the defect in the offer document.

2 We also recommend that:

2.1 section 242 of the Crimes Act is retained in its current form, subject only to the consequential amendments in Schedule 4 of the Bill; and

2.2 the physical elements of the defective disclosure offences require an accused’s knowledge or recklessness to be in respect of a material defect, to closely align with section 242(2).

Comment

12. The key change in the Bill is that the issuer and director are criminally liable for misstatements in disclosure documents, but only if the Crown proves a subjective fault element. This reduces the scope of criminal exposure, but the maximum punishment is increased to 10-years imprisonment or a $1 million fine for an individual and a $5 million fine for a body corporate. Promoters are only liable as accessories under the normal rules in the Crimes Act for parties to offences.

4 R v Harney [1987] 2 NZLR 576 (CA) at 579


MBIE-MAKO-1789173 3

13. In the Officials‟ Report, we presented 3 options for director liability for the Committee‟s consideration:

a. The Bill could provide that a director is criminally liable for the acts of the offeror only if the director has actual knowledge that the statement is false or misleading. If the director knew that the statement was false, the director would need to take action to stop the wrongful conduct or resign.

b. The Bill could establish a separate physical element that the director is liable for, such as authorising the misstatement. This is essentially how section 242 of the Crimes Act works: a director who concurs in the making of a false statement by the offeror is liable if the director knows or is reckless as to whether the statement is false in a material particular.

c. The Bill could establish a legal duty on the director to supervise the offering process, and provide that a major departure from the standard of care expected of a reasonable director is an offence. The punishment for that offence would be lower than for knowing contraventions, perhaps up to (one-year imprisonment).

14. Most submitters are likely to prefer the first option. This option does, however, make directors less accountable for serious misconduct. Against that, directors will still face potential civil liability under the Bill for failing to exercise due diligence and criminal liability under the Crimes Act for reckless conduct.

15. Option c would represent a significant policy shift in the Bill for criminal liability to something more like the current regime, albeit requiring an objective fault element of gross negligence (i.e. a major departure) before criminal liability arises. Some directors might find option c attractive, as it more clearly states what is expected of a director. It also covers directors who abrogate all responsibility. This option, however, lowers the bar for criminal liability compared to recklessness, as proof of conscious risk-taking by the director would not be required.

16. We recommend option b. We indicated that we were likely to recommend this option when we presented the Officials‟ report. Option b reflects the policy development leading to the Bill and the policy intent behind clauses 488 and 489. We still consider that knowledge or recklessness are the appropriate fault elements for serious offending under the Bill. This reflects the existing criminal law in section 242 of the Crimes Act, which has been applied by the courts in recent prosecutions of the most culpable finance company directors.

17. Under option b, a director who avoids being part of the approval process for a PDS may be able to avoid criminal liability, even if they know about a defect. A director in this situation is, however, likely to be civilly liable (including being liable for pecuniary penalties) under the Bill and potentially be subject to a banning order.

18. We recommend that section 242 of the Crimes Act is retained as a backdrop in its current form, subject only to the consequential amendments in Schedule 4. Section 242 will provide:

242 False statement by promoter, etc

(1) Every one is liable to imprisonment for a term not exceeding 10 years who, in respect of any body, whether incorporated or unincorporated and whether formed or intended to be formed, makes or concurs in making or publishes any false statement, with intent—

(a) to induce any person, whether ascertained or not, to acquire any financial product within the meaning of the Financial Markets Conduct Act [2012]; or

(b) to deceive or cause loss to any person, whether ascertained or not; or

(c) to induce any person, whether ascertained or not, to entrust or advance any property to any other person.

(2) In this section, false statement means any statement in respect of which the person making or publishing the statement—

(a) knows the statement is false in a material particular; or

(b) is reckless as to whether the statement is false in a material particular.


MBIE-MAKO-1789173 4

19. In our view, given that only the most culpable persons have been convicted under section 242, changing it substantively would send the wrong signal. We also note that section 242 is significantly broader in scope than the proposed clauses 488 and 489 of the Bill, as it applies to:

false statements in an advertisement that is intended to induce a person to subscribe for financial products;

false statements that are intended to deceive or cause loss or induce a person to entrust or advance property generally; and

any person who concurs in the making of a false statement, rather than just directors.

20. Given the continuation of section 242, an offence in the Bill for defective disclosure that covers the same conduct is arguably superfluous. If the Bill‟s offences cover the same ground but are harder to prove than the Crimes Act, prosecutors would use the Crimes Act instead. Under our recommendations, the physical elements of offences in the Bill will, however, be tailored to the Bill‟s disclosure requirements, so we expect it will be used.

21. A physical element for the offence in clause 488 will be that the offer is made in circumstances where:

a. the PDS or register entry contains a statement that is false or misleading or likely to mislead where the statement is materially adverse from the point of view of investors;

b. the PDS or register entry omits information that it is required to contain under the Bill that is materially adverse from the point of view of investors; or

c. a new circumstance that is materially adverse from the point of view of investors has arisen that has not been disclosed in the PDS or register entry.

22. Clause 488 differs from section 242, which requires the offer to be made in circumstances where a statement is „false in a material particular‟. We recommend that it is made clear that the accused‟s knowledge or recklessness must be in respect of a material defect, to closely align with section 242(2). In the Bill this equates to, for example, knowledge that a statement in a PDS is false or misleading in a material particular. An equivalent physical element will be prescribed for the offence in clause 489.

23. We recommend that a physical element for a director for defective disclosure should be the conduct of giving authority, permission, or consent to making or continuing with the offer. This may require proof of more active involvement than „concur‟ in section 242 (which means agreeing with the happening of some event). We consider that this approach is preferable in the context of the expected role of directors under the Bill.

No disclosure document or no disclosure to retail investors – clause 35(2) and 40

24. The Bill also criminalises failure to have a disclosure document at all or failing to give a disclosure document to a retail investor. Under the Bill, knowing or reckless contravention of these provisions by the offeror has lower maximum penalties of up to 5-years imprisonment for individuals and a $500,000 fine, or $2.5 million for a body corporate. The policy rationale for the offence is that if there is no (or an insignificant) penalty for not complying at all, then non-compliance becomes a preferable option.

25. On balance, we recommend that directors are only liable for an offeror‟s failure to comply with these obligations as a party to the offence. The difference is that the law expects, and should expect, directors to be personally responsible for authorising defective disclosure documents. It makes less sense to require a director to be directly personally responsible as a result of his or her office for the failure of the offeror‟s processes of ensuring that a PDS is always provided to retail investors.

26. On that basis, directors will not be specifically identified in clauses 35(3) and 40. Directors may still be liable as parties to the offence by the person in contravention.


MBIE-MAKO-1789173 5

Advertising

27. We note that unlike the Securities Act, the Bill does not criminalise false statements in advertising. Under the Bill, these are covered by Part 2, and a breach of those provisions can lead to significant civil pecuniary penalties and compensation. Section 242 of the Crimes Act continues to apply to false statements in advertising. We do not recommend changes to this approach.

MBIE-MAKO-17891736

Criminal: Securities Act s58. Up to 5-years imprisonment. Strict liability. Director has a defence if had reasonable grounds to believe and did believe statement was true.

APPENDIX 1: COMPARISON OF DIRECTOR LIABILITY FOR MISSTATEMENTS IN OFFER DOCUMENTS

Strict liability Physical and fault elements required

(Physical element with defences) (Reckless, knowing, intentional)

Current

Law

FMC Bill

Civil: Pecuniary penalties plus compensation. Strict liability. Director has a defence if had reasonable grounds to believe and did believe statement was true.

Problematic because of strict liability and narrow defences.

Criminal: Crimes Act s242. Up to Ten-years imprisonment where proof of intent to induce, the director makes or concurs in the making of a false statement by the

company, and the director is knowing or reckless in respect of the false statement.

Civil: Pecuniary penalties plus compensation. Strict liability for contravention, but with defences for directors who:

make all inquiries that are reasonable in the circumstances and believe on reasonable grounds that the statement is not false or misleading;

reasonably rely on another person (including other directors, advisers and employees of the company); or

take all reasonable and proper steps to ensure that the company complies.

Retains strict civil liability, but with broader defences.

Criminal: FMC Bill: Up to ten-years imprisonment where the director authorises, permits, or consents to the company offering under the document and is knowing or reckless in respect of a misstatement.

Criminal: Crimes Act s242 (essentially unchanged). Ten years imprisonment where proof of intent to induce, the director makes or concurs in the making of a false statement by the company, and the director is knowing or reckless in respect of the false statement.

Criminal liability requires proof of a subjective fault element, and excludes negligence.

MBIE-MAKO-17891737

APPENDIX 2: LIABILITY EXAMPLES FOR MISSTATEMENTS IN OFFER DOCUMENTS

The examples set out below are simplified and are for explanatory purposes only. They assume that facts are able to be proven. In a real life example, the choice of charges would be determined by the evidence available at the time the charges are laid (criminal) or when the statement of claim (civil) is filed.

EXAMPLE 1 – FINANCE COMPANY X LIMITED

A finance company, X Ltd, raises money from the public continuously and lends it to property developers. The company has five directors. Two are non-executive directors and three are executive directors, one of whom is also the CEO.

The board of the company resolves to approve the offer document and the company gives disclosure documents to investors. The document states that the company does not lend to related parties.

In fact, the company makes a sizeable loan to a related party, which becomes insolvent and is unable to pay the loan back. The company continues to use the same disclosure document to raise funds from the public before, during and after the related party transactions.

Two of the executive directors (A who is the CEO, and B) have full knowledge of the related party transaction.

The other executive director (C) knows of the loan, thinks it is probably to a related party, but chooses to approve the offer document when it is considered by the board.

The two non-executive directors are unaware that the loan is to a related party.

One non-executive director (D) makes no inquiries concerning the disclosure document or the loan book of the company.

The other non-executive director (E) has sought assurances from management that there are no related party loans and is given this assurance, and has no knowledge of the loan.

Criminal Liability

A B C D E X Ltd

Current5 x

FMC Bill6 x x

Civil Liability

A B C D E X Ltd

Current x x

FMC Bill x

5 Section 58 and 59 of the Securities Act 1978. Section 58 does not apply to X Ltd. 6 Clause 488 of the FMC Bill.


MBIE-MAKO-1789173 8

Comment

Securities Act 1978

The two dishonest executive directors (A and B) are criminally liable for the untrue prospectus under s58 of the Securities Act 1978. This carries a maximum of 5-years imprisonment.

The other executive director (C) is also criminally liable for the untrue prospectus under s58 of the Securities Act 1978.

Director D will be criminally liable under s58 of the Securities Act 1978, as D did not make appropriate inquiries and cannot rely on the defence that D honestly believed on reasonable grounds that the prospectus was correct.

Director E made inquiries. It is likely that E has reasonable grounds for believing that the prospectus is correct, and is unlikely to be criminally liable.

All directors except E are liable for civil pecuniary penalties (unless convicted of an offence) and compensation to investors under s56 of the Securities Act 1978.

X Ltd is criminally liable under s59 for the lesser offence of offering in contravention of the Act, which carries a maximum penalty of $300,000.

X Ltd is not liable for civil pecuniary penalties or for compensation.

Crimes Act 1961

As directors A and B have knowledge of the illegal behaviour, they are likely to be criminally liable under s242 of the Crimes Act, which carries a maximum penalty of 10-years imprisonment.

As C was aware of the risk and decided to go ahead anyway, C is also likely to be considered to be reckless and liable under s242. This would, however, depend on the exact circumstances of the case.

The non-executive directors D and E do not meet the knowing/reckless threshold so are not criminally liable under the Crimes Act.

Financial Markets Conduct Bill

The two dishonest directors A and B have knowledge or are at least reckless as to the misleading content of the PDS, and so are criminally liable and face a maximum of 10-years imprisonment. They would also be liable for civil pecuniary penalties (unless convicted of criminal offences) and compensation.

As Director C was aware of the risk and decided to go ahead anyway, C is also likely to be considered to be reckless and criminally liable. This would depend on the exact circumstances of the case.

The non-executive directors D and E do not meet the knowing/reckless threshold, so are not criminally liable.

Director D made no inquiries and so did not exercise due diligence in relation to the offer. D will be liable for civil pecuniary penalties (unless convicted of criminal offences) and compensation.

Director E is likely to have made all inquiries that were reasonable in the circumstances and believed the statement was true, or to have reasonably relied on the management (i.e. employees of the company) and will not be civilly liable.

X Ltd will be criminally liable and liable for civil pecuniary penalties (unless convicted of criminal offences) and compensation.


MBIE-MAKO-1789173 9

EXAMPLE 2 – Y LIMITED’S IPO

A privately held company Y Ltd conducts an initial public offering (IPO) to sell some of its shares to the public. The directors establish a due diligence committee, comprising one director, senior staff members and professional advisers, and carry out a thorough due diligence process in accordance with best practice to ensure that the offer documents are correct. Despite this, the offer documents do not include information about a material change in the company‟s circumstances since the last balance date. The share price drops significantly when the error is discovered after the shares have been issued.

Criminal Liability

Directors Y Ltd Senior staff Advisers

Current (?) x x

FMC Bill x x x x

Civil Liability

Directors Y Ltd Senior staff Advisers

Current (?) x x x

FMC Bill x x x x

Discussion

Securities Act 1978

All directors are criminally liable under s58 unless they show that they had an honest belief on reasonable grounds that the statement was true. Criminal liability will depend on the evidence the directors raise in their defence.

All directors would be liable for civil pecuniary penalties (unless convicted of criminal offences) and compensation under s56 unless they show that they had an honest belief on reasonable grounds that the statement was true.

Y Ltd and all directors are criminally liable under s59 for the lesser offence of offering in contravention of the Act, unless, in the case of the directors, the Court is satisfied that the contravention did not take place with his or her knowledge or consent. This carries a maximum penalty of $300,000.

Y Ltd is not liable for civil pecuniary penalties or compensation.

The senior managers and advisers would not be criminally liable in the absence of knowledge that the offer document was misleading. They would also not be liable for civil remedies.

Crimes Act 1961

No parties would be criminally liable, as there is no knowledge or recklessness in respect of the error.


No parties would be criminally liable, as there is no knowledge or recklessness in respect of the error.

The directors and Y Ltd would not be liable for civil pecuniary penalties or for compensation. This is because they would be able to use the defences to rely on a robust process for the offer documents.


MBIE-MAKO-1789173 10

The senior managers and advisers would not be civilly or criminally liable in the absence of knowledge that the offer document was misleading. This is because senior managers and advisers are only liable if they are „involved in a contravention‟, which requires that they know the essential aspects of the misleading conduct, and are a conscious or intentional participant in it. They also have reasonable mistake and reasonable reliance defences, and a defence if they took reasonable steps to ensure Y Ltd complied.

EXAMPLE 3 – Z LIMITED AND Z FUNDS LIMITED

Z Ltd is a large financial institution. It offers a range of managed investment products to the investing public that are managed by subsidiary companies, including Z Funds Ltd. Z Funds Ltd is the issuer and manager of unit trusts, while Z Ltd arranges for the units to be sold through its branch network.

Z Ltd, whose board comprises 6 directors, is primarily concerned with governance and oversight of the Z Ltd group. Z Funds Ltd has its own board comprising directors A, B and C. A, B and C are all senior employees of Z Ltd, but not directors.

Z Funds Ltd‟s due diligence committee (which includes A, B and C) completes a due diligence report for each offer document prior to the document being distributed. Z Ltd‟s board receives reports and recommendations from Z Funds Ltd that confirm that the disclosure documents are compliant.

In preparing an offer document for Z Funds Ltd, director A knows that a false statement is included in the offer document. Director B considers that it may be false, but does not make further enquiries. Director C does not consider the document line by line, but asks questions of the directors and employees who do.

The board of Z Funds Ltd approves the publication, and confirms to Z Ltd‟s board that the offer document is compliant. The board of Z Ltd accepts the confirmation. As a result, a materially deficient offer document is distributed through Z Ltd‟s branches.

Criminal Liability

Z Ltd Directors of Z Ltd

Z Funds Ltd

Director A Director B Director C

Current x(?) x(?) x(?)

FMC Bill x x x

Civil Liability

Z Ltd Directors of Z Ltd

Z Funds Ltd

Director A Director B Director C

Current x(?) x(?) x x(?)

FMC Bill x x x

Discussion

Securities Act 1978

Under s58 of the Securities Act the material deficiencies would constitute an untrue statement, and potential criminal liability for every person who signs the prospectus. For the purposes of the Securities Act Z Funds Ltd is the issuer, Z Ltd is a promoter, and every director of Z Ltd is also a promoter. This means that the prospectus will have been signed by, or on behalf of, A, B and C, Z Ltd and Z Ltd‟s directors. Z Funds Ltd will not have signed.

Directors A and B will be criminally liable under s58 and will not have a defence.


MBIE-MAKO-1789173 11

Director C has a defence to s58 if C‟s belief in the truth of the statements was reasonable, based on C‟s involvement in the due diligence process. Z Ltd and its directors will have the same defence if their belief in the truth of the statements was reasonable.

Z Funds Ltd will have potential criminally liability under s59, the lesser offence of offering in contravention of the Act. This carries a maximum penalty of $300,000. Z Ltd, its directors and director C would also have potential liability under s59, but have a defence if the contravention did not take place with their knowledge or consent.

The directors of Z Funds Ltd and (as promoters) Z Ltd and its directors could all face potential civil liability. Directors A and B are unlikely to have a defence to civil liability. The others have a potential defence of reasonable belief in the truth of the relevant statements. Z Funds Ltd would not face civil liability.

Crimes Act 1961

For the purposes of s242 of the Crimes Act, Z Funds Ltd has published a false statement. Director A, who knew that the offer document contained a false statement, would be liable under s242 for concurring in the making of the statement. Director B, who had concerns but did not act on them, could face criminal liability for being reckless as to the truth of the statement, depending on B‟s particular state of mind.

Director C, who neither knew of, nor was reckless as to, the inclusion of the false statement would not face liability under s242. Likewise, while Z Ltd and its directors will have published or concurred in the publication of the untrue statement, none will have the necessary knowledge or recklessness to be liable under s242.


A key difference between the two pieces of legislation is that the FMC Bill does not carry over the concept of promoter. As a result, Z Ltd and its directors do not face criminal liability under the FMC Bill unless they are parties to the offence under the rules in the Crimes Act.

Each of directors A, B and C would have substantially the same risk of criminal liability under the Bill as they do under s242 of the Crimes Act. A knows so is liable, B may be reckless and so will be liable. C will not be liable.

Z Ltd and its directors would not face civil liability under the Bill because they would not have the necessary knowledge to be involved in Z Funds Ltd‟s contravention.

Z Funds Ltd and directors A and B would not be civilly liable. C would have defences to civil liability, either that he or she made all inquiries that were reasonable in the circumstances and believed the statement was true, or had reasonably relied on the other directors or employees.

Documents

F MARKETS CONDUCT ILL