Brian Gaynor: Last chance to bring investors in from the cold

The tiny size of New Zealand's capital markets, particularly the sharemarket, is because of a number of factors. But one of the main reasons is that most individuals have lost confidence in the way these markets operate, little attempt has been made to win them back and residential property appears to be safer.

The business sector has failed to recognise the importance of having investor support, from the perspective of raising both equity and debt, and the lack of investor confidence has severely restricted business' ability to raise new funds.

The Capital Markets Taskforce may be the last chance to solve this structural economic problem.

The first faint signs of breakdown in the relationship between issuers and investors occurred during the halcyon days of the 1980s.

This relationship, which should be based on trust as well as commercial considerations, was damaged as promoters and brokers dumped useless companies on an enthusiastic public.

Most senior Stock Exchange members knew that the bubble would burst but there was no leadership from this group. They made no attempt to stop the related party deals, shonky back door listings, creative accounting, insider trading and so on.

There was some heated debate over these issues at the time but Stock Exchange members were making too much money to call a halt to the wild and unsustainable proceedings.

A sharemarket crash is a significant free-market failure, with grave economic and social consequences, and after these failures the Government usually establishes an inquiry to investigate whether any changes need to be made to the regulatory regime. After the 1987 crash there were a number of these inquiries which made recommendations to improve the regulatory structure of the sharemarket and tighten enforcement.

One of the aims of these recommendations was to re-establish the trust between issuers and investors.

But the Business Roundtable was at the zenith of its power and was strongly promoting the idea that there was a small group of businesspeople who created most of the economic wealth of the country and ordinary investors were free-riding on their expertise.

The proposed Takeovers Code was the symbolic battleground for this issue with the Roundtable arguing that minority shareholders should not be automatically entitled to receive the same price in a takeover because they were little more than freeloaders.

The Roundtable received strong support from two powerful government ministers, Ruth Richardson and Bill Birch.

Virtually none of the post-1987 crash proposals were introduced, including the Takeovers Code, and the trust between issuers and investors was not repaired. The assertion that individual investors were free-riders reflected the attitude that the top end of town had towards retail investors.

The 1990s was a lost decade as far as New Zealand's capital markets were concerned with individuals effectively deserting these markets for residential property. The Stock Exchange, which was a strong supporter of the Business Roundtable's point of view, was particularly inept and made no attempt to re-establish trust with the investing public.

Some progress was made after the turn of the century with the introduction of the Takeovers Code, the corporatisation of the NZX and a number of regulatory initiatives.

However one of the problems over the past decade, and during the 1980s, has been the lack of enforcement and the unwillingness of the regulatory bodies, particularly the Securities Commission, to engage with the public.

Confidence and trust in capital markets will only improve if individual investors are convinced that a regulatory agency is determined to protect their interests. Unfortunately commission chairwoman Jane Diplock seems to be far more interested in attending international conferences than communicating with the public and delivering the message that she will go into bat on their behalf.

In July last year the Government finally responded to the lack of growth in our financial markets with the establishment of the Capital Markets Taskforce. This column was highly critical of the taskforce because all of its members were associated with the issuer side of the investment world and it contained no one from the investor side.

The chairman of the Business Roundtable was appointed to the taskforce even though this organisation is a leading reason why we have a regulatory regime that has suffocated our capital markets. The Roundtable successfully argued for a long time that there was no need to introduce more protective legislation because it would increase the cost of doing business and retail investors didn't make a big enough contribution to the investment sector to warrant protection.

The taskforce's terms of reference were also extremely disappointing as there was no specific requirement to investigate why retail investors had deserted our capital markets in droves.

Not surprisingly the taskforce's interim report, which was released just after last November's general election, was a disappointment. It focused almost entirely on the issuer side of the investment equation. It recommended a number of changes which would reduce the requirements to issue a prospectus, erode shareholder rights to approve equity issues and, amazingly, indicated that it was looking at measures that would make it easier for issuers to approve related party transactions.

The taskforce argued that related parties "are often the quickest source, or last source of funding" yet in practice most of the related party deals in this country have seen directors and executives extract considerable value from the issuer. One doesn't have to look much further than the finance company debacle to see this.

The second taskforce report, which was published at the end of July, was a far better document.

One of its priorities was to recommend "changes to laws and regulations to improve investor outcomes". It said there was a long way to go to achieve this and underpinning improved outcomes is investors' ability "to trust issuer and adviser firms to treat them ethically".

One of its proposals was "that the Government introduce a regime that generally requires all firms participating in the retail investment market (eg issuers and advisers) to treat customers fairly".

This is a breakthrough and hopefully we will see the introduction of a requirement that issuers and advisers must have a duty of care towards individual investors.

This would be a significant step forward as long as regulations are put in place to ensure that this objective is complied with.

The taskforce's final report is due before the end of the year but there is no guarantee that it won't switch back again and put the interests of the issuer ahead of the investor. If it does then our capital markets will continue to struggle with residential property remaining the preferred asset class for most investors.

We must wait for the final report but two points are worth noting at this stage:

* The taskforce's job will not be done when its final report is completed because one of the problems is that independent recommendations are not implemented because of fierce political lobbying. It is important that the taskforce sees the process through until its recommendations are implemented because the post-report period is often more important than the report itself.

* It is vitally important that the taskforce recommends that we have a regulatory agency that tells investors that it will go into bat on their behalf and then does so. The unwillingness of our regulatory agencies to enforce the important rules is one of the main reasons why our capital markets have languished.

The Capital Markets Taskforce is probably the last chance to inject some life into the country's financial markets. We are doomed to drop further and further behind Australia if we don't develop capital markets that offer an alternative and attractive option to residential property.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.
bgaynor@milfordasset.com