New Zealand’s legislative context

Overseas-based fund managers are directing increased attention to New Zealand as a potential market for their financial product offerings. In some cases, these offerings are categorised as wholesale – as opposed to retail - and so it is timely to review the legal position of wholesale financial products in New Zealand. First a terminological issue needs to be cleared up. In New Zealand, retail managed funds that are held and administered on retail investor aggregation platforms (platforms) such as wrap accounts are often loosely called “wholesale funds” and their investors “wholesale investors”, when the correct terminology is “mezzanine products” and “mezzanine investors”.

Mezzanine managed funds belong to a type of retail managed fund that is designed to be operationally compatible with the performance of investment custody and administration functions by platforms. Such financial products are open to direct investment from multiple mezzanine investors who are characteristically investing under professional financial advice. These products are used to group and pool together mezzanine investors’ moneys into bulk accounts managed by platforms for efficiency reasons. The acid test for determining whether a fund is either mezzanine or true wholesale is whether a prospective investor must by law be provided with a product disclosure statement (PDS). If a PDS must be provided, the fund is mezzanine and therefore retail, as is the prospective investor.

True wholesale financial products are never retail or mezzanine financial products. Consequently, wholesale financial products are not required by law to have a PDS and cannot lawfully accept direct investment from retail investors. Nonetheless there have been occasions when retail investors have been encouraged to invest directly into wholesale property investment structures by mislabelling themselves as eligible investors, a legally defined category of wholesale investors. This misuse of the wholesale investor status was so concerning to the FMA that in October 2022 it issued a thematic review on the subject, as is examined further below.

The place to look for the legal status of wholesale financial products in New Zealand is within the country’s financial markets regulatory regime. The Financial Markets Conduct Act 2013 (FMC Act) and Financial Markets Conduct Regulations 2014 (FMC Regulations) are both studded with the word “wholesale”. The word is used primarily in relation to wholesale financial products, but the legislative and regulatory context is surprisingly light on definitions of what constitutes “wholesale”, with the definitions that are provided notably investor-centric and couched in terms of exclusions from the retail financial product regulatory regime. In effect, the legislation determines the structure of the market for wholesale financial products within New Zealand by closely specifying who is permitted to invest in these products.

The FMC Act’s Section 6 Interpretation only links to definitions for “wholesale client” and “wholesale investor” and is otherwise silent on defining wholesale financial products. Wholesale clients are defined in the FMC Act’s clause 4 of Schedule 5 in relation to a financial advice service, or a client money or property service. Wholesale investors are defined in the FMC Act’s Schedule 1, concerned with provisions relating to when disclosure is required and exclusions for offers and services, in relation to either an offer of financial products (Part 1 clause 3) or supply of a discretionary investment management service or any other relevant transaction (Part 3 clause 36).

The FMC Act’s definitions of wholesale clients and investors are all closely similar, with some variation as to the types and numbers of persons included under them. The categories of persons who can be wholesale clients or investors are most comprehensively listed under Schedule 1 clause 3, which also includes a single definition of a specific type of wholesale investment (high value derivatives):

A person is a wholesale investor if—

(a) the person is an investment business (see clause 37); or

(b) the person meets the investment activity criteria specified in clause 38; or

(c) the person is large (see clause 39); or

(d) the person is a government agency (see clause 40).

(3) A person is also a wholesale investor, in relation to an offer of financial products, if—

(a) the person is an eligible investor (see clause 41); or

(b) in relation to an offer of financial products for issue or sale,—

(i) the minimum amount payable by the person on acceptance of the offer is at least $750,000; or

(ii) the amount payable by the person on acceptance of the offer plus the amounts previously paid by the person for financial products of the issuer of the same class that are held by the person add up to at least $750,000; or

(iii) it is proposed that the person will acquire the financial products under a bona fide underwriting or sub-underwriting agreement; or

(c) in relation to an offer of a derivative for issue or sale, the notional value of the derivative is at least $5 million (see clause 49).

The category of eligible investor specifically applies to individual persons. This category is highly restricted under the FMC Act’s clause 41 of Schedule 1 Part 3 (Definitions and certificates for exclusions for offers and services). The FMA’s October 2022 thematic review of the wholesale investor exclusion discussed below has to do with how some wholesale property syndicators were involved with gaming the rules of clause 41 to entice and receive investments from individual persons who were non-compliant with the criteria of that clause and in some cases really retail investors.

Schedule 1’s  clauses 3 and 6, and Schedule 5’s clause 4 can be compared and contrasted with the definitions of a retail investor and a retail service that are provided in Schedule 1, Part 3 clause 35. Notably, clause 35 entails that the presence of a single retail investor within a class of investors will make a service provided to that class into a retail service. Providers of wholesale financial product services should take note of the regulatory risk of supplying such services to even one retail investor.

The possibility of offering wholesale investors access to wholesale financial products via a discretionary investment management service (DIMS – defined in the FMC Act’s Part 6 section 432A) is allowed for in the FMC Regulations. Regulation 194 pertains to the condition for DIMS providers to disclose if the service is wholesale. Regulation 226 covers how client agreements for DIMS must provide for certain matters, including how holdings of wholesale financial products will be dealt with on termination of the client agreement. The latter regulation contains a rare definition within New Zealand’s financial markets regulatory regime in defining wholesale products as “financial products that the investor is eligible to acquire only by virtue of the investor acquiring the products through a DIMS”. However, this definition is so specific to the DIMS context as to have no general application for wholesale financial products.

Whilst this article’s examination of the application of the FMC Act to wholesale financial products has so far looked at how exclusions relating to wholesale clients or investors are embedded in the legislation, there is also a major inclusion that applies to consider. Part 2 Fair Dealing of the FMC Act captures wholesale financial products, including wholesale managed investment products, via its interpretational section 18 application to financial products as defined under the FMC Act’s Part 1 section 7. Of greatest significance to wholesale asset managers in relation to the FMC Act’s Part 2 are the three sections numbered 20, 22, and 23, which are concerned successively with:

• Misleading conduct in relation to financial products
• False or misleading representations
• Unsubstantiated representations

However, Part 2’s section 18 also refers to section 464 of the FMC Act’s Part 8 (Enforcement, liability, and appeals Subpart 1—FMA’s enforcement powers), which deals with restricted communications, effectively advertisements for offers of financial products and services. Section 464 dovetails in with Part 8’s section 462(1)(f), which is concerned with when the FMA may make stop orders in respect of restricted communications. Accordingly, wholesale asset managers should take great care not to breach any of the applicable requirements of the FMC Act’s Part 2 fair dealing requirements during their activities should they wish to avoid regulatory intervention.

IMF recommends change to regulation of wholesale asset managers

The International Monetary Fund (IMF) published a Financial System Stability Assessment (FSSA) for New Zealand in May 2017. This FSSA was influential in drawing attention to wholesale asset managers and invited official consideration of their activities from the perspective of New Zealand’s financial system stability. Notably, the FSSA also drew notice to the unregulated status of custodial services within New Zealand.

The FSSA stated within a broad set of recommendations that:

The reform of securities market regulation significantly improved the [regulatory and oversight] framework, but further enhancements are required. The review of the regulatory framework was instrumental in implementing key reforms, including the establishment of the FMA as conduct regulator. The new regime governs how financial products are offered, promoted, issued and sold, and introduces licensing for providers of certain products, including managers of retail funds. The regulatory perimeter could be reviewed to include wholesale asset managers [our emphasis] and custodians, whose activities will become more relevant as the asset management industry matures, bringing potential new risks.

(FSSA, p. 8)

The FSSA went on to recommend specifically, “Expand the FMA's regulatory perimeter to include licensing and supervision of custodians and appropriate oversight of wholesale asset managers” (Ibid., p. 9).

These recommendations stemmed from the FSSA’s finding (number 35) that:

The overall regulatory framework for asset management is well developed, but there is scope to consider broadening its perimeter. The provision of custody services does not require a license in New Zealand and, therefore, falls outside of direct supervision by the FMA—or by any other authority. The government could usefully require that these entities be subject to licensing and supervision. Also, wholesale asset management activities [our emphasis] are not covered by the FMC Act. This sector may not be significantly larger than the retail sector, but there is insufficient data to assess its risks.

(Ibid., pp. 33-4)

For the purposes of this article, the key takeout from the IMF’s findings in the FSSA is the recommendation that the FMA should receive enhanced oversight of the activities of wholesale asset managers by bringing these managers within the regulatory perimeter, implicitly by extending the ambit of the FMC Act. In other words, a law change leading to a change in the regulatory regime would be required to accommodate the FSSA’s recommendation. Doing so would assimilate, at least to some extent, the legal situation of wholesale asset managers to that of retail managed investment scheme (MIS) managers in New Zealand. The FSSA assessed this recommended objective for the regulator as short-term, meaning to be addressed within the next 1–3 years (i.e., between 2018-20).

To date, the FSSA’s recommended change to the regulatory landscape experienced by wholesale asset managers in New Zealand has not occurred. The FSSA is not quite accurate where it states that wholesale asset management activities are not covered by the FMC Act, as we have already seen above that the FMC Act’s Part 2 fair dealing provisions apply and that the FMC Act and the FMC Regulations contain significant content that is aimed at controlling who can invest in wholesale offerings. The question would be rather which other parts of the FMC Act and the FMC Regulations applicable to regulated offers should be extended out to include wholesale asset management activities, for example concerning fund manager licensing and standard disclosure, governance, and financial reporting requirements.

FMA responds to the IMF’s recommendation

In its Strategic Risk Outlook 2019 (SRO), the FMA responded to the IMF’s concerns about wholesale asset management activities within the New Zealand’s securities marketplace. The SRO “provides [the FMA’s] medium-term view (three to five years) of the most significant risks to and opportunities for promoting fair, efficient and transparent financial markets” (SRO p. 3). Under the heading “Investment Management”, the SRO stated, “Although we only license retail fund managers and not wholesale, we recognise that wholesale and retail investment management are interdependent” (SRO, p. 17). At another point, it is written that:

Outsourcing – prevalence of outsourcing of fund management and the lack of regulatory oversight in wholesale funds [our emphasis] and custody arrangements mean that we may not have a clear view of some stability risks. Some of our concerns relate to smaller funds, which may lack sophisticated risk-management frameworks, and capability and capacity to manage outsourcing risks. 

(SRO, p. 20).

The above statement made within the context of outsourcing clarifies that, according to the SRO, the FMA’s view of wholesale funds is that they underlie retail managed funds that feed into them moneys ultimately sourced from retail investors, as the diagram below illustrates. There is evidently a lack of visibility for the FMA with respect to the wholesale asset management activities underlying such a layered arrangement, wherein the connection between retail investors and wholesale funds is indirect and obscured by intervening retail funds. Consequently, an information gap arises for the FMA in not knowing or being able to obtain as much information about wholesale managed funds as the FMC Act’s regime enables it to do with retail managed funds. This information gap could be rectified by the FSSA’s recommended extension of the regulatory perimeter, although the recommendation was couched widely enough also to cover instances whereby wholesale asset managers invite direct investment into their financial products.

Diagram 1: Relationship between retail investors and outsourced wholesale managed funds

Additionally, in its Annual Corporate Plan 2019/20 (ACP) the FMA again addressed the matter of wholesale asset management activities. As one of the FMA’s “2019/20 activities” the ACP listed “Perimeter – we will monitor activity on our regulatory perimeter to identify risks of harm to customers or market integrity, including activity driven by new technology”, clarifying “perimeter” to mean, “Activity that is carried out by entities that are not authorised or licensed by us, or other activity that is not regulated by us, but which relates to financial markets” (ACP, p. 9). Plainly wholesale asset management activities fall under this description of the perimeter.

Under the heading “Investment Management” the ACP stated about the FMA, “Although we only license retail fund managers and not wholesale, we recognise that wholesale and retail investment management are interdependent, which is why we are also focused on wholesale funds” (ACP, p. 12). However, the nearest that the FMA’s focus on wholesale funds is approached in the ACP is possibly where, under “Sector risks and harms we want to address” it is stated, “Product suitability – poor product design, insufficient or ineffective disclosure of risks, costs or strategies, particularly for complex products, resulting in investors holding unsuitable products” (Ibid.). The matter of product suitability comes up concerning the FMA’s thematic review discussed below.

In respect of the IMF’s FSSA recommendations from 2017, the sole ACP reference thereto, under the heading “Activities for 2019/20” states, “IMF Financial Sector Assessment Program – continuing to follow up on the 2017 IMF recommendations for further enhancement of the regulatory regime, including considering whether there is a case for recommending the establishment of a regulatory regime for custodians” (Ibid., p. 13). Wholesale asset management does not rate a mention.

FMA review of wholesale investing

The most significant piece of work done to date by the FMA on wholesale asset management activities in New Zealand is the Thematic review of use of the wholesale investor exclusion (Review) published in October 2022. The Review does not address the recommendation of the IMF’s FSSA concerning formalisation of an increased regulatory perimeter to enable greater FMA supervision of wholesale asset management activities in New Zealand. Instead, the Review is aimed at exposing and suppressing abuses of the existing regulatory regime applicable to the eligible investor category of wholesale investors and is focused on property syndicates that were being promoted as wholesale financial products.

The FMA put out a media release that contextualised the Review within a background of “complaints made and concerns raised about how such wholesale offers were being promoted, and whether the appropriate investors were being targeted and accepted.” The problem had arisen that wholesale property investment offers were being pitched at retail investors and accepting investments from them, contrary to the FMC Act. In other words, the Review is not evidently a by-product of the FSSA’s concern with extension of the regulatory perimeter with respect to wholesale asset management activities. The nature of the problem that the Review was intended to address arises from existing legislation and is diagrammed below.

Diagram 2: Investor relationships with wholesale investment offers addressed in the FMA’s thematic review

For wholesale asset managers, there are nonetheless some points to take note of in the Review. At the general level, the Review observes that:

The Financial Markets Conduct Act 2013 (FMC Act) prescribes how offers of financial products can be made to potential investors, subject to a number of exclusions. One of these exclusions is for offers made to wholesale investors. Offers to wholesale investors do not require the standard disclosure, governance and financial reporting requirements that apply to regulated offers, on the basis that wholesale investors have sufficient knowledge and experience dealing in financial products to acquire the information they need to enable them to assess the merits of an offer, including the value and risks. 

(Review, p. 3)

This succinct statement of the present regulatory position on wholesale investors (including eligible investors) gives an idea of where carve-outs could occur from exclusions within the Act that would go at least some way to meet what the FSSA recommended for wholesale asset management activities back in 2017.

The Review goes on to state that it is intended to be used as guidance for all wholesale investment offers:

While our review focused on wholesale offers made in connection with property development, the findings above are applicable to all wholesale offers. Having set our expectations, we now expect a higher level of compliance in this space. This includes acting in ways that are properly focused on the outcome that, where the eligible investor certification is used, only investors with sufficient knowledge and experience in dealing in financial products are accepted into the offer.

(Ibid., p. 4)

For any offeror of wholesale financial products, including wholesale managed funds, the warning is clear: no attempts should be made to game the eligible investor criteria to channel retail investor money directly into wholesale investments. The barrier already erected between wholesale investors and retail investors within the FMC Act’s regulatory regime is intended to hold fast without exceptions. This distinction between types of investors of itself requires no extension of the FMA’s regulatory perimeter.

Conclusion

“The offering of wholesale financial products within New Zealand is subject to our country’s financial markets regulatory regime, which is intended to encourage competition and innovation to the benefit of investors,” said Matthew Band, General Manager of Trustees Corporate Supervision at Trustees Executors.

“However, there are important regulatory distinctions between wholesale and retail categories of financial products and investors that need to be understood and taken into account by anyone planning to roll out new wholesale investment offerings in New Zealand.”

“The FMC Act grants wholesale clients and investors significant exclusions from the compliance regime that applies to investors in retail financial products.”

“These exclusions provide wholesale investment offerors a diverse market that features a wide range of potential wholesale investors to do business with, but the exclusions’ boundaries must be carefully observed, particularly with respect to the legislatively defined classes of retail and eligible investors.”

“Moreover, wholesale investment offerors will need to ensure their strict compliance with the FMC Act’s fair dealing provisions, which are vigilantly enforced by the FMA.

“Although the IMF has recommended expansion of the regulatory perimeter in respect of wholesale asset management activities in New Zealand, the legislative environment for wholesale financial products has since remained stable and unchanged.”

“As an experienced trustee of wholesale investment offerings, Trustees Executors is well-placed to assist new wholesale entrants into the New Zealand market to meet their compliance obligations and avoid the pitfalls that the regulatory regime contains for the unwary.”

For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matt Band at [email protected].