International comparisons of investor protection

Two measures of stock market development discussed so far provide mixed evidence for New Zealand. Although there is low market capitalisation, ownership does not appear to be particularly concentrated by international standards. This section explores existing international measures of investor protection. There is not yet a large body of empirical evidence, but new work by La Porta and co-authors provide useful hints about New Zealand’s investor protection relative to other countries.[15]

La Porta makes a useful distinction between two types of investor protection: private and public.

La Porta makes a useful distinction between two types of investor protection: private and public. Private mechanisms are based on standards for information disclosure and transaction approval – and the ability of minority investors to take court action (typically against firm “insiders”, such as controlling stakeholders and managers or their agents) if these standards are not met. Meanwhile, regulators can serve as public protectors of investor rights by investigating actions contrary to minority interests (again on the part of insiders or their agents), issuing and enforcing remedying orders, and sometimes seeking criminal sanctions in court. This section describes La Porta’s international comparisons of investor protection in each of these broad categories and takes a close look at New Zealand’s relative standing.

Private protection

La Porta constructs an index of private protection for a sample of countries, including New Zealand, using a hypothetical example based on “self-dealing”.

La Porta constructs an index of private protection by asking lawyers in a sample of countries (including New Zealand) about a situation in which a hypothetical "Mr. James" arranges a transaction between two firms in which he has a controlling stake (Djankov and La Porta et al 2006).[16] In this hypothetical situation, there is a clear possibility that the controlling shareholder could arrange the transaction to his personal benefit, at the expense of the minority shareholders of one of the firms – a practice known as "self-dealing". The private protection index reflects the requirements applicable to this transaction in each country:

• Disclosure: How much information does the controlling shareholder have to reveal before the transaction? Does the law require a review by independent accountants or other experts?
• Approval requirements: Can the controlling shareholder or the board of directors (which may have been elected by the controller) approve the transaction without consulting minority shareholders?
• Access to redress in court: How easy is it for minority shareholders to prove wrongdoing in court after the transaction? How easy is it for the minority shareholders to convince the court to void the transaction and hold Mr. James liable for damages?

Figure 3: La Porta’s private protection index: OECD Countries (2003)

Source: Djankov and La Porta et al (2006), “anti-self-dealing index”.

Public protection

La Porta presents a public protection index based on the powers of the regulatory body with responsibility for overseeing the stock market.

Note that none of the components of the private protection index reflect sanctions that might be imposed by a regulator or court on Mr. James for any wrongdoing; as noted above, these measures fall under the rubric of public protection. In a separate paper, La Porta et al (2006) present a public protection index, also based on a set of questions addressed to lawyers around the world, focusing on the powers of the regulatory body (the “supervisor”) with responsibility for overseeing the stock market:

• Independence and focus: Are there any restrictions on the ability of the central government to fire or hire the chief officers of the supervisory body? Is the supervisor able to focus on stock market regulation alone or is it also responsible for other issues such as the banking sector?
• Rule making power: Can the supervisor issue regulations regarding primary offerings or stock exchange listings or does this power reside elsewhere (eg, with Parliament)?
• Investigative power: Does the supervisor have the power to command documents and testimony from controlling shareholders, accountants or other relevant parties?
• Orders: Does the supervisor have the power to order market participants to undertake corrective action (eg, for insufficient disclosure)? Does the supervisor have the power to impose non-criminal sanctions (eg, fines)?

Figure 4: La Porta’s public protection index: OECD Countries (2000)

Source: La Porta et al (2006), “public enforcement index”.

La Porta’s public protection index also reflects the stringency and comprehensiveness of criminal sanctions faced by parties found to have violated laws regarding disclosure and approval of transactions.

New Zealand gets a relatively high private protection score and lower public protection score

Figures 3 and 4 show how New Zealand’s index scores compared to other OECD countries. New Zealand gets the highest score for private protection compared to other countries but ranks near the middle of the pack on the public protection index.

Using the criteria outlined above, we can take a look at why New Zealand scores as it does on La Porta’s public index. Keep in mind that La Porta’s numbers are based on the situation in year 2000. Some significant legislative changes have been launched in New Zealand since then, in particular the 2002 Securities Markets and Institutions Bill; the 2006 Securities Legislation Bill and the Review of the Securities Act of 1978 (currently in progress as part of a broader Review of Financial Products and Providers).[17] It is also important to recognise that La Porta’s criteria are inevitably somewhat ad hoc: a different researcher might have set up slightly different criteria. However, the La Porta data is very useful because it allows for reasonably rigorous international comparisons. With those caveats in mind, I make the following observations about New Zealand’s public protection score:

• Independence and focus: The New Zealand Securities Commission has, since its inception, been closely focused on stock market issues – ie, it does not have responsibility for banking sector supervision as is the case in some other countries. However, La Porta gives the Commission low marks for independence because the government has broad powers to fire and hire Commission members. (Little has changed in this regard since 2000.) However, this is not necessarily cause for concern and may simply be an artefact of a bias in La Porta’s framework. La Porta also gives low marks on supervisory independence to countries with parliamentary systems – notably Canada, Australia, New Zealand and the United Kingdom – while awarding high scores to countries with greater separation between executive and legislative branches of government (eg, the United States, where commissioners are appointed by the president, but approved by the Senate).
• Rule making power: Unlike its counterparts in Australia, the United States and United Kingdom, the Commission has no power to issue its own rules. Parliament retains full responsibility for rule making. This also has not changed since 2000. But while La Porta gives the Commission low marks on rule making powers, there could be advantages where Parliament has overall responsibility, as it is charged with considering wider community and economic interests other than purely regulation of the securities markets and institutions.
• Investigative power: La Porta rates the Securities Commission very highly in this area as of 2000 and the Securities Legislation Bill has since updated the Commission’s powers to summon witnesses.
• Orders: The Commission had very little power in this area as of 2000. The Securities Market and Institutions Bill proposes to give the Commission the power to make a range of orders including prohibition and disclosure orders. The Securities Legislation Bill introduces a further range of banning orders.
• Criminal sanctions: As of 2000, accountants and brokers could not be held criminally liable in the case of a prospectus (or accompanying financial statements) that is misleading or omits material information. The Securities Legislation Bill introduced criminal sanctions for insider trading, market manipulation offences, and investment advisers that recommend illegal offers of securities. Substantial civil pecuniary penalties were also introduced for misstatements in a registered prospectus. Previously the only remedy was compensation for those who suffered loss.