GLOSSARY OF KEY TERMS AND ABBREVIATIONS
Advisor
An individual who has been accredited and approved by NZX to advise clients on any of the markets provided by NZX.

Annual Regulatory Report
An annual report required of NZX Discipline under the NZX Discipline Rules.

Appointed Solicitor
NZX Solicitor who acts as a liaison between NZX and the Special Division.

Business Rules
The rules made by a securities exchange that govern the conduct of business on securities markets operated by the securities exchange and persons authorised to undertake trading activities on those securities markets.

Client and Market Services
Formerly known as Listed Company Relations - a team which deals with company announcements.

Conduct Rules
The Participant Rules and Listing Rules of NZX.

FSAP
Financial Sector Assessment Programme, conducted by the International Monetary Fund.

Futures and Options Participant
A Futures and Options Firm, Futures and Options Introducing Broker or a Futures and Options Advisor designated by NZX as such under the NZX Futures and Options Rules.

IOSCO
International Organization of Securities Commissions.

IOSCO Principles
IOSCO's Objectives and Principles of Securities Regulation (October 2003) which are accepted as the international standards for securities regulation by the IMF and the World Bank.

IOSCO Report
Issues Arising From Exchange Evolution - Final Report (November 2006) by the Technical Committee of IOSCO.

Issuer
Any entity which is or has been listed on the NZSX, NZAX or the NZDX.

Listing Rules
Rules made by NZX that govern the conduct of Issuers listed on NZX's markets, approved as Listing Rules under the Securities Markets Act 1988.

Listing Subcommittee
A committee of four persons, any two of whom may be used by NZX Regulation to review offer documents in assessing listing applications.

MAP
Market Announcements Platform.

Market Participant
An organisation accredited by NZX to participate in the markets that NZX operates.

Market Supervision Group
A group within NZX led by the Head of Market Supervision comprising two teams - NZX Regulation and Participant Compliance.

NZAX
New Zealand Alternative Stock Market.

NZSE
New Zealand Stock Exchange (the former name of NZX).

NZSX
New Zealand Stock Market.

NZX Discipline
A disciplinary body constituted by NZX under the NZX Discipline Rules.

NZX Discipline Rules
The NZX Discipline Rules as made by NZX.

NZX Regulation
A team within NZX's Market Supervision Group which focuses on regulation of Issuers.

NZX
New Zealand Exchange Limited.

Participant Compliance
A team within NZX's Market Supervision Group which focuses on regulation of Market Participants.

Participant Rules
Rules made by NZX that govern the conduct of business on securities markets operated by NZX and persons authorised to undertake trading activities on those markets, approved as Business Rules under the Securities Markets Act 1988.

Review Period
2006 calendar year.

SMARTS
Securities Markets Automated Research Trading and Surveillance - the real-time electronic market surveillance system that generates alerts indicating unusual trading.

Solicitor's Handbook
Procedural handbook used by NZX Solicitors in processing applications and regulating Listed Issuers under the Listing Rules.

Special Division
The division of NZX Discipline that exercises the powers and functions of NZX in relation to NZX or a related entity as a Listed Issuer.

Sponsor
An entity or partnership which is approved by NZX to assist a prospective NZAX Issuer in the listing or quotation of securities.

Structure of NZX and its markets

Structure of NZX and its markets

EXECUTIVE SUMMARY

The Securities Commission has reviewed NZX's performance of its regulatory functions as a registered exchange under the Securities Markets Act 1988. This review, the second oversight review of NZX conducted by the Commission, focussed on NZX's arrangements in the 2006 calendar year for discharging its obligations.
We report on NZX's performance under the following headings:
- Conflict management
- The NZAX market
- NZX's frontline regulation
- NZX Discipline
- The Special Division
- Recommendations arising from the review of the 2005 calendar year
The Commission's overall conclusion is that NZX is satisfying its obligation to operate its markets in accordance with its conduct rules.
NZX's performance as a registered exchange is good. However, the Commission has made recommendations for improvements in relation to a number of areas. These recommendations are set out below.
The Commission has communicated its concerns and recommendations to NZX, NZX Discipline and the Special Division. Responses of the parties in regard to the recommendations and the Commission's view on those responses are set out below.
NZX, NZX Discipline and the Special Division have already agreed to take specific action in response to certain recommendations and have committed to do so by 30 September 2007. If NZX, NZX Discipline and the Special Division take these actions within the stated timeframe, the Commission believes this will address those recommendations.

Findings and recommendations

Conflict management

For-profit exchanges face particular risks as a result of their competing commercial and regulatory interests. NZX is aware that some parties perceive that NZX is subject to conflict between its commercial and regulatory functions and the risks that arise from such conflict. The Commission is satisfied that NZX has satisfactory practical measures in place to address those issues at this time. However, these measures do not mean that these risks are not relevant to NZX.

NZX considers that ensuring the proper regulation of its markets is in NZX's best interests as it engenders confidence which subsequently increases investment in the markets. Nevertheless, the existence of these incentives does not mean there is not an inherent conflict of interest. The Board of NZX accepts that there is a conflict that theoretically could arise due to its listed company status, and the Board states that it believes that this conflict is appropriately managed, and that the conflict is kept under review at the Board level. The Commission welcomes these comments from NZX.

NZX should ensure that the Board is provided with relevant and up-to-date information on conflict management in relation to for-profit exchanges and that this information is subject to regular discussion at Board meetings.
NZX should ensure that the practical measures used to ensure the practical separation between its commercial and regulatory functions have reference to the information in relation to for-profit exchanges the Board receives on conflict management.

NZX has agreed to prepare a Board paper updating the Board on the IOSCO Report and arrangements that other for-profit exchanges have implemented to manage conflicts (to the extent this information is publicly available). The Board has determined to discuss this matter each November at its annual two-day Board strategy review. NZX has also agreed to have regard to this information in its practical measures to ensure separation between its commercial and regulatory functions.

The NZAX market

The Commission does not have any recommendations in this area. The Commission is satisfied that NZX is applying rigorous regulatory standards to the NZAX despite its smaller size and less demanding Listing Rules. However, the Commission is concerned that the lack of understanding about the lower-cost NZAX regime may disadvantage the NZAX in market competition with other sources of capital, such as unregistered exchanges and private equity. The Commission considers that education of Sponsors and NZAX Issuers as to the regulatory differences between the NZAX and the NZSX should be a priority for NZX. The Commission anticipates that the recently commenced education programme will help to achieve this. The Commission is concerned that there may be an element of misunderstanding about the NZAX Listing Rules and the effect of those Listing Rules and that this has been entrenched since the NZAX was created. The Commission is pleased that NZX has undertaken the review of the NZAX market and supports the actions it has taken to address the issues which were identified out of that review.

NZX's frontline regulation

The Commission does not have any recommendations in this area. NZX is taking appropriate action to minimise the risk of non-compliance through various mechanisms, including waivers, education initiatives and using disciplinary proceedings as a deterrent. The Commission is satisfied that the processes and procedures which NZX uses to enforce compliance with the Listing Rules and Participant Rules in respect of admission of Issuers or approval of Market Participants are satisfactory and applied properly.

NZX Discipline

The Commission is satisfied that NZX Discipline is independent of NZX and is producing work of a high standard. However, the Commission did identify some issues in the course of the review. In particular, the Commission was concerned to find that NZX Discipline had sought an advance opinion from NZX on the procedure which it proposed to follow in a matter before it. The Commission considers this was inadvisable.

The Commission is concerned that Market Participants who have been found to have breached the Participant Rules are not being identified. Not only is publication a significant tool in deterring breaches, but it is also imperative that NZX Discipline be seen to be sanctioning Market Participants for any breaches. The Commission believes that market confidence will be increased if NZX Discipline is transparent in naming Market Participants who have breached the Participant Rules.

The Commission found during the review that NZX Discipline had ruled on the scope of its review powers under the NZX Discipline Rules. This ruling was contrary to submissions by NZX, which would have narrowed the scope of the review power. Subsequently NZX has sought to amend the relevant NZX Discipline Rule, effectively overturning NZX Discipline's ruling for future cases. The NZX Discipline Rules do not at present give NZX Discipline any formal role in reviewing amendments. The Commission has concerns about the impact of this on NZX Discipline's autonomy and considers that NZX Discipline should be given an advisory role in determining any changes to the NZX Discipline Rules.

It appears to the Commission that although NZX Discipline has stated that it does not feel its access to resources is in any way limited by NZX, and NZX has repeatedly asked NZX Discipline whether it requires further resources, that NZX Discipline in fact requires more resources in order to action non-urgent work within reasonable timeframes. The Commission is concerned at extensive delays which have occurred in two matters in particular, the first of which is the review of the NZX Discipline Rules and the second of which involves a third party.

The Commission also considers that it would be valuable if information about the role, membership and mandate of NZX Discipline were more readily available to the market. Although information is provided in the Annual Regulatory Report, the Commission does not consider that this is sufficient.

NZX Discipline should ensure that, when determining the procedure to apply to a proceeding before it, it treats all parties evenly.
NZX Discipline should be seen to be transparent in exercising its discretion whether to publish decisions which identify Market Participants who have breached the Participant Rules. Where a Market Participant's details are not published, NZX Discipline should disclose its reasons for withholding this information.
NZX and NZX Discipline should review the NZX Discipline Rules in order to give NZX Discipline input into its own Rules, and amendments arising from this review should be included in the amendments which are presently being considered by NZX Discipline.
NZX Discipline should review its resource requirements and structure, and communicate its needs to NZX, so that delays in dealing with non-urgent work are minimised or removed.
NZX should provide more information about the role, membership and mandate of NZX Discipline on its website. In particular, the contact details for NZX Discipline should be included on the NZX website.

NZX Discipline agrees that it should treat all parties evenly.

NZX has agreed to provide more information about the role, membership and mandate of NZX Discipline on its website.

The Special Division

The Commission is satisfied that the Special Division is operating effectively. In particular, the Commission noted one disciplinary matter regarding a subsidiary of NZX that arose during the review period. It appears that the Special Division endeavoured to act in a way that was consistent with NZX Regulation's approach and further, that it sought advice on the course of action it should take.

The Commission considers that it would be valuable if information about the role, membership and mandate of the Special Division were more readily available to the market. Although some information is provided on the NZX website concerning the role of the Special Division, it is not extensive or easy to find.

NZX should increase the amount of information it provides about the Special Division and make it easier to find. In particular, the contact details for the Special Division should be included on the 'Contacts' and 'Supervision of NZX' pages of the NZX website.

NZX has agreed to provide more information about the Special Division on its website, in consultation with the Commission.

Recommendations arising from last review

The Commission made 21 recommendations in the course of the last review. NZX had responded to some of these prior to the report being published, and responded to the remainder on 7 December 2006. The recommendations, NZX's responses and any additional comments from the Commission are included in this report ************************at page 25********************.

INTRODUCTION

This is the second oversight review of NZX's performance of its regulatory functions as a registered exchange under the Securities Markets Act 1988 and covers the 2006 calendar year.
The first review of NZX focussed on the activities of NZX more generally. The report provided a general overview of the business and processes of NZX and its regulatory function. The 2006 review updates progress made from the first review, and focusses on three specific areas: the management and operation of the NZAX market, the admission or approval of Issuers or Market Participants, and NZX's role in minimising the risk of non-compliance with the Listing Rules and Participant Rules. These three areas reflect the areas in which the Commission considered deeper review and analysis would be valuable.
NZX has obligations under section 36G of the Securities Markets Act 1988 to secure compliance with its Listing and Business Rules, and to perform any obligations that lie on NZX under those rules.
The Commission has statutory functions to review practices relating to securities and activities on securities markets, and to comment on these. In relation to NZX, performance of these functions requires the Commission to keep under review and comment on NZX's performance of its obligations as a registered exchange.
The Terms of Reference for the Commission's review, along with the scope of and the background to the review and the process that we followed, are set out in the Appendix to this report.
The report contains six sections with the following headings:
- Conflict management
- The NZAX market
- NZX's frontline regulation
- NZX Discipline
- The Special Division
- Recommendations arising from the review of the 2005 calendar year.

CONFLICT MANAGEMENT

In the 2005 oversight review, the Commission considered the conflict inherent in a demutualised exchange between its regulatory and commercial functions. The Commission's report stated:

"The Board of NZX has told the Commission that whilst it does not consider that such a conflict in fact exists, NZX and the NZX Board are aware that the perception of such a conflict can exist and is held in some quarters. The NZX Board considers that addressing this perception is important and it is engaged to ensure that the perception of such a conflict is addressed, including by keeping under review its regulatory structures and their position within the organisation."

The Commission considered that there was in practice effective separation between NZX's supervisory functions and its corporate activities at the time of the 2005 oversight review. However we considered that this issue was of ongoing relevance to the oversight review process. Accordingly, this issue was specifically addressed again during the 2006 oversight review.
In November 2006 the Technical Committee of IOSCO released a report entitled 'Regulatory Issues Arising From Exchange Evolution - Final Report'. The IOSCO Report discusses the implications and impact of a changing environment on the regulatory role of stock exchanges. A number of key issues were identified, including the need to balance the commercial and public interest functions of a demutualised exchange. While the Commission notes that conflicts arise in other ownership structures as well, in this report we comment only on the conflict that is particular to demutualised, listed stock exchanges.
In particular, the IOSCO Report identifies a potential cause for concern in the following terms:

"for-profit exchanges may reduce the resources they devote to regulation. Worse, they may place insufficient value on the regulatory process, fail to sustain a strong regulatory culture and be less willing to co-operate with their supervisory authorities and other regulatory bodies."

The Commission acknowledges that it did not find any evidence that NZX was undervaluing its regulatory function in any of the ways outlined in this quote.
The Board of NZX has stated that it accepts that there is a conflict that theoretically could arise due to its listed company status, and in that respect the Board acknowledges the statements in the IOSCO report concerning conflicts that exist in a for-profit exchange environment. The Commission welcomes these comments from NZX. The Board has stated it believes that in the current circumstances the conflict is more theoretical than real.

Autonomy of the regulatory function

Information obtained during the 2006 oversight review demonstrated that NZX views its regulatory function as an integral part of the NZX business. In particular, NZX noted it is devoting sufficient resources to regulation and has satisfactory physical separation between its regulatory and commercial teams. NZX does not consider that creating an organisationally separate regulatory function is an appropriate course of action at this time. NZX has concerns that separation would make the commercial arm of NZX more vulnerable to takeover and would diminish the reputation of the NZX business.
However, NZX does have various mechanisms in place in order to increase the autonomy of NZX Regulation, including:
1. physical separation of NZX Regulation staff from non-Regulation staff through the structure of the NZX offices;
2. a secure hard drive for NZX Regulation files which cannot be accessed by non-Regulation staff;
1. the Head of Market Supervision is provided with time at each Board meeting so that she can raise any concerns without the CEO present; and
1. NZX Regulation, NZX Discipline and the Special Division have open-ended budgets, to allow for the execution of their regulatory functions without financial constraints.
During the review period NZX made a number of organisational changes. In respect of the regulatory function specifically, NZX moved the Client and Market Services team from the Market Supervision Group to the Information and Fund Businesses Group. However, this team still performs a regulatory function and works closely with the Regulation team. The Commission does not believe that this materially changes the treatment of the regulatory and commercial functions.
The Commission notes that the IOSCO report does not go so far as to recommend that exchanges adopt a particular structure. However, the Commission intends to keep the risks identified in that report under review and expects NZX to do the same. Notwithstanding this, the Commission considers that the mechanisms currently in place are functioning as intended and are satisfactory at the present time.

Commercial pressure to reduce regulatory standards

It was noted by NZX in the course of the review that some companies perceived the regulatory requirements for listed companies, including the Listing Rules and requirements pursuant to the Securities Markets Act 1988, as a barrier to listing or an undesirable consequence of listing. The Commission considers that in light of the availability of alternative vehicles for capital-raising in New Zealand markets there is a risk that NZX will feel commercial pressure to reduce regulatory standards. This type of commercial pressure was identified in the IOSCO report as potentially giving rise to a 'race to the bottom' in regulatory standards.
The Commission notes however, that there are checks and balances on any proposal to amend the Listing Rules, including comments from the Commission itself.
NZX is firmly of the view that membership of a regulated market is a benefit to companies. It increases investor confidence in a company and increases a company's ability to communicate clearly and effectively with its investors. The Commission agrees membership of a regulated market can be a significant benefit.
NZX particularly noted that the regulatory function, and the effective operation of that function, contributed positively to NZX's commercial reputation and brand. The Commission sought information about how NZX positively promoted its regulatory function. NZX demonstrated it was providing stakeholders with information explaining the benefits of listing on a regulated market. For example, NZX staff presented seminars at which Issuers were invited to tell the story of their listing and the benefits arising from that. The Commission is satisfied that NZX is acting appropriately and proportionately to improve stakeholders' perceptions of the regulatory requirements of the Listing Rules as a benefit. It considers this may further reduce the risk that NZX will face commercial pressure to diminish regulatory standards.

Recommendations

For-profit exchanges face particular risks as a result of their competing commercial and regulatory interests. NZX is aware that some parties perceive that NZX is subject to conflict between its commercial and regulatory functions and the risks that arise from such conflict. The Commission is satisfied that NZX has satisfactory practical measures in place to address those issues at this time. However, these measures do not mean that these risks are not relevant to NZX.
NZX considers that ensuring the proper regulation of its markets is in NZX's best interests as it engenders confidence which subsequently increases investment in the markets. Nevertheless, the existence of these incentives does not mean there is not an inherent conflict of interest. The Board of NZX accepts that there is a conflict that theoretically could arise due to its listed company status, and the Board states that it believes that this conflict is appropriately managed, and that the conflict is kept under review at the Board level. The Commission welcomes these comments from NZX.

NZX should ensure that the Board is provided with relevant and up-to-date information on conflict management in relation to for-profit exchanges and that this information is subject to regular discussion at Board meetings.

NZX should ensure that the measures used to ensure the practical separation between its commercial and regulatory functions have reference to the information in relation to for-profit exchanges the Board receives on conflict management.

THE NZAX MARKET

Review of the NZAX

During the review period NZX undertook its own review of the NZAX market. The NZAX market is designed to provide an alternative market for smaller Issuers. Accordingly, it incorporates a number of changes from the structure, rules and trading environment of the NZSX.
NZX consulted with a wide range of stakeholders including NZAX Issuers, Sponsors, Market Participants and Advisors, in relation to the performance and design of the NZAX market. NZX received a good level of feedback to its review, and a number of outcomes were identified. NZX reported on the outcomes as follows:
1. few NZAX Issuers had a clear understanding of the distinction between the NZAX and NZSX rule structures and how those differences can be used to better meet the business objectives of the NZAX Issuer. This was identified as a problem stemming in part from lack of information dissemination by the Sponsor network and NZX, and the present rule set;
2. stakeholders more generally, including legal advisors, did not have a good understanding of the differences introduced by the NZAX structure and rules;
1. many stakeholders did not believe the Sponsor concept had broadened the number of organisations bringing companies to market, despite the significant number of organisations who had been approved as Sponsors;
1. the NZAX trading microstructure was not considered to have provided the desired improvement in the underlying liquidity in the NZAX market;
2. stakeholders were satisfied with the foundation of the NZAX Listing Rules, being continuous disclosure and governance requirements, and raising capital in the NZAX market is widely viewed as efficient and cost-effective;
3. the majority of stakeholders considered the NZAX market lacked profile after an enthusiastic launch.
Following this review, NZX developed a number of initiatives to address the issues arising from the review. It reported these to the market in a release dated 31 August 2006. The trading structure of the NZAX was proposed to be changed to be in line with the NZSX, and changes to the 'tick size', or the minimum amount that the price of a share on the market can change, and an extension to trading hours were effected on 2 October 2006. The removal of the anonymous call auction became effective on 19 March 2007.
The Sponsor network was identified as containing a high proportion of effectively inactive Sponsors. NZX held seminars for Sponsors to better educate them on the special nature of the NZAX and has said it intends to review the number of Sponsors.
NZX also identified that although stakeholders were of the impression that the NZAX Listing Rules were virtually indistinguishable from the NZSX Listing Rules, in fact the issue appeared to be the level of understanding of the differences. NZX has undertaken an education initiative to further explain the differences between the Listing Rules. NZX has sought to amend the NZAX Listing Rules to reflect the format of the NZSX Listing Rules, so that the differences between the Listing Rules are more easily identified. These amendments came into effect on 1 March 2007. NZX has also formulated an ongoing plan to improve the profile of the NZAX market.
The Commission is pleased that NZX undertook a review of the NZAX and is endeavouring to distribute more information about the NZAX and raise its profile. The Commission is concerned that there may be an element of misunderstanding about the NZAX Listing Rules and the effect of those Listing Rules and that this has been entrenched during the period since the NZAX was created. The Commission notes that the NZAX faces pressure due to the ability of unregistered exchanges to operate in New Zealand.

Standards applied to the NZAX market

We reviewed several files in which NZAX Issuers made applications under the Listing Rules. The Commission noted that although the requirements under the NZAX Listing Rules are somewhat less demanding than those under the NZSX Listing Rules, the Market Supervision team applied the correct processes and reviewed documentation with the same level of rigour. The Commission is pleased to see that NZX makes the same effort to enforce the NZAX Listing Rules despite the smaller size of the market

Recommendations

The Commission does not have any recommendations in this area. The Commission is satisfied that NZX is applying rigorous regulatory standards to the NZAX despite its smaller size and less demanding Listing Rules. However, the Commission is concerned that the lack of understanding about the lower-cost NZAX regime may disadvantage the NZAX in market competition with other sources of capital, such as unregistered exchanges and private equity. The Commission considers that education of Sponsors and NZAX Issuers as to the regulatory differences between the NZAX and the NZSX should be a priority for NZX. The Commission anticipates that the recently commenced education programme will help to achieve this. The Commission is concerned that there may be an element of misunderstanding about the NZAX Listing Rules and the effect of those Listing Rules and that this has been entrenched since the NZAX was created. The Commission is pleased that NZX has undertaken the review of the NZAX market and supports the actions it has taken to address the issues which were identified out of that review.

NZX'S FRONTLINE REGULATION

Minimising the risk of non-compliance

The Foreword to the NZX Listing Rules states "Risk of non-compliance with the Rules is one of many risks market participants must assess in valuing investments, but compliance is mandatory and NZX will endeavour to minimise the risk of non-compliance", and further, "the Rules are not intended to result in merit regulation by NZX of issuers availing themselves of market facilities. A regulatory approach based on attempted merit assessment of issuers by NZX would offer a spurious assurance to investors."
During the course of this oversight review the Commission sought further information on how NZX endeavoured to minimise the risk of non-compliance. It is apparent that, although NZX does not undertake active supervision of the Listing Rules it does endeavour to minimise the risk of non-compliance in a number of ways, including:
1. issuing reminders of periodic obligations such as Half-Yearly Reports;
2. using the consequences of breaching the Listing Rules as a deterrent;
1. encouraging self-reporting of breaches by using this as a mitigating factor when seeking penalties from NZX Discipline;
1. ensuring that market infrastructure is applied which allows NZX to monitor trading activity and identify potential breaches;
2. ensuring that Market Participants, the public, and other stakeholders are able to communicate any potential breaches to NZX;
3. utilising detailed checklists and other documentation to check required disclosure documents.
The Commission is satisfied that NZX is endeavouring to minimise the risk of non-compliance with the Listing Rules. We note that NZX does not merit regulate (in that it does not attempt to determine whether a security listed on its markets is a good investment). The Commission considers that this is appropriate and notes that it is consistent with international practice. The Commission believes that the Foreword of the Listing Rules is clear about the scope of NZX's actions and the fact that risk does exist despite the role of NZX as the frontline regulator of the NZX markets.
NZX granted waivers and made rulings over the review period. Waivers and rulings minimise the risk of non-compliance as they recognise that the Listing Rules cannot contemplate every commercial arrangement and that technical breaches may therefore arise. The Commission considers that NZX used its discretion to grant waivers and make rulings appropriately during the review period and that the decisions which were released clearly set out the grounds for reaching the decision and any conditions attached. This provides a valuable precedent to other parties who seek similar waivers or rulings. The Commission found that NZX uses these precedents when considering applications, leading to consistency across the decisions.
The Commission also notes that during the review period NZX amended Participant Rule 17.10, which now requires market participants to report any breaches by themselves or another market participant. NZX did not consider that instances of self-reporting had increased over the review period.
NZX provides ongoing education to Issuers and Market Participants about their obligations under the Listing Rules and Participant Rules, through the Issuer Relation Updates, monthly Market Insight document, seminars, guidance notes, forums such as the Legal and Advisory Board, Listed Companies Association and the Securities Industry Association, and the Top Tips document and practice notes.

Admission of Issuers

NZX Regulation is not involved in seeking companies who may wish to have securities quoted on an NZX market. The Market Supervision team reviews documentation required by the Listing Rules to be provided by companies when they seek listing or quotation. There are set procedures and checklists which NZX staff are expected to refer to when reviewing this documentation. Commission staff reviewed several files in relation to listing and are satisfied that NZX staff had access to these procedures and checklists and used them to review the documentation.
NZX Regulation staff did attend three listing presentations in the course of the review period. It was clear that these staff were presenting information about the regulatory requirements and obligations of listing.

Approval of Market Participants

NZX Participant Compliance has an established procedure for approving Market Participant applications in the form of a checklist and any follow-ups required. During the course of the 2006 review a number of applications were reviewed and there was no deviation from this procedure.
The current procedure is the same as was observed during the 2005 review. The Commission is satisfied that these procedures were consistently applied.

Recommendations

The Commission does not have any recommendations in this area. NZX is taking appropriate action to minimise the risk of non-compliance through various mechanisms, including waivers, education initiatives and using disciplinary proceedings as a deterrent. The Commission is satisfied that the processes and procedures which NZX uses to enforce compliance with the Listing Rules and Participant Rules in respect of admission of Issuers or approval of Market Participants are satisfactory and applied properly.

NZX DISCIPLINE

NZX Discipline is an independent body constituted under the NZX Discipline Rules. Its principal function is to hear and determine, without bias and after giving the parties fair consideration, various matters under NZX Discipline Rule 1.1, including matters involving Market Participants, Issuers, and Futures and Options Participants.
The Commission considered the overall management and processes of NZX Discipline in the course of the 2005 review. The Commission considered that this body should be subject to further review in the course of this oversight review, because of its important role in the NZX regulatory structure.
As noted in the course of the last review, the Commission appreciates the work undertaken by NZX Discipline and the professionalism displayed by its members in addressing issues brought to them for consideration.

Matters considered

It is key to the effective functioning of the NZX regulatory function that NZX Discipline is seen to be acting as an independent tribunal. The Commission is satisfied that NZX Discipline is independent from NZX. However, the Commission did identify some issues in the course of the review.
The Commission reviewed copies of all decisions taken by NZX Discipline and the supporting documentation kept on file by NZX Discipline. In the review period, NZX Discipline considered 10 matters, comprising five matters under the Listing Rules, four under the Participant Rules, and one review of a decision by NZX Regulation. NZX Discipline also published its first Annual Regulatory Report as required by the NZX Discipline Rules.
The Chairman of NZX Discipline noted the outstanding effort by NZX Discipline's members and reported that he considered NZX Discipline had satisfied its functions well during the review period. The Commission also received feedback on the Discipline process from NZX staff members which was generally positive.
The Commission does have some concerns about the amount of information that is available to the public about the role and responsibilities of NZX Discipline. The Commission is of the view that NZX Discipline is a key part of the NZX regulatory structure, and that information regarding NZX Discipline should be readily available to the public on an ongoing basis, rather than just in the Annual Regulatory Report.

Process and procedure

The Commission noted that there had been an increase in the number of cases which NZX was seeking to settle rather than taking to a summary or full hearing by NZX Discipline. It was noted that NZX Discipline plays a role in approving settlements, and the Commission is satisfied that NZX Discipline exercises independent judgment as to the form and quantum of penalties reached by settlement.
Some issues were identified around the length of time NZX Discipline had taken to respond to two issues which required its attention. NZX Discipline recognised that delays had occurred, but this appeared to be related to a lack of resources to deal with the issues (arising in part from the part-time nature of the Discipline members' roles) rather than a lack of knowledge or expertise.
In particular, the Commission notes that NZX Discipline has been in receipt of a policy paper prepared by NZX regarding changes to the NZX Discipline Rules for approximately ten months. The Commission is concerned that NZX Discipline has not yet addressed this issue and considers that the process should be expedited. The second issue involves a third party in the form of an NZSX-listed Issuer, and the Commission is concerned that the delays in the matter may have reflected poorly on NZX Discipline in the market. Apart from these two matters, NZX Discipline adhered to the timeframes set down in the NZX Discipline Rules.
We note that NZX has repeatedly asked NZX Discipline whether it is adequately resourced and that it has not received requests for further resources. The Commission considers that this issue needs to be readdressed by NZX and NZX Discipline.
It was noted in the course of the file review that NZX Discipline was aware of the need to remain independent from NZX when determining the procedure that it would take when considering matters. The Commission observed that in the course of NZX Discipline consulting with parties on matters, NZX and NZX Discipline had occasional differences of opinion on the correct procedure to be followed in a matter and noted that NZX Discipline's response to NZX concerns was robust and measured. NZX Discipline also noted that it had sought and received independent legal counsel where it considered it was necessary.
There was an instance during the review period where NZX Discipline was required to determine the procedure for a matter appearing before it. NZX Discipline formed a view on what the procedure would be and drafted a letter to both NZX and the other party setting out its view. However, before contacting both parties via this original letter, NZX Discipline contacted NZX Regulation, allowing NZX Regulation to express an opinion on the proposed approach before it was communicated to both parties. The Commission believes that this course of action was inadvisable. However, the Commission notes that in the event the other party's submissions on the proposed approach to the procedure were adopted and that NZX Discipline is sensitive to the need to be seen to be acting impartially.

Publication of decisions

Under Part 11 of the NZX Discipline Rules, NZX Discipline has the discretion to hand down various penalties, including a private reprimand and/or issue a public statement regarding the breach. The Commission also refers to Rule 5.17 of the NZX Discipline Rules, which sets out the process for publication of the statement of reasons of NZX Discipline in reaching a decision and awarding a penalty.
It appears to the Commission that rather than applying its discretion under the NZX Discipline Rules, NZX Discipline is instead applying a blanket policy across every decision. NZX Discipline very rarely publishes the names of Market Participants who have breached the Participant Rules and instead generally provides an anonymous notification of the breach to other Market Participants, as well as imposing a monetary penalty against the Market Participant.
NZX Discipline withholds publication of Market Participant details due to concerns about the impact on investor confidence in the profession. NZX Discipline believes that media attention arising from the release of NZX Discipline decisions may be disproportionate to the breach. NZX Discipline is concerned that media attention on breaches by Market Participants may give the impression that the industry has widespread problems and that subsequently investors may be less inclined to rely on firms which have suffered negative press. NZX Discipline considers this may create commercial pressure for firms. However, NZX Discipline publishes the decisions it reaches in respect of Issuers (although we note that it has withheld confidential or commercially sensitive information where appropriate). The Commission does not consider that there are grounds for a distinction to be drawn between Issuers and Market Participants in terms of publication by NZX Discipline.
The Commission considers that publication of the names of Market Participants who are guilty of breaches of the Participant Rules will not have the effect anticipated by NZX Discipline. In fact, the Commission considers that publication has significant benefits. The risk of being publicly censured is a strong deterrent to Market Participants. In addition, public confidence is likely to be advanced if the Participant Rules can be seen to be enforced in respect of particular Market Participants.
The Commission considers that market confidence in the ability of NZX Discipline to properly sanction those Market Participants who commit breaches should be a paramount concern for NZX Discipline. Accordingly, the Commission considers that publication of Market Participant details where they have committed a breach should be the default position, and be deviated from only in exceptional circumstances where serious confidentiality, commercial sensitivity or public interest factors required this, or where the breach is merely trivial. In the interests of transparency, where a Market Participant's details are not published NZX Discipline should disclose its reasons for withholding this information. The Commission does not consider that publication of anonymous cases in the NZX Discipline Annual Regulatory Report is sufficient to satisfy this, as it does not address the question of which Market Participant is responsible for which breach.

Amendments to the NZX Discipline Rules

The Commission noted that during the review period NZX Discipline had reached an interpretation of the NZX Discipline Rules which did not accord with the intention of NZX when the NZX Discipline Rules were drafted. NZX's proposed changes to the NZX Discipline Rules are presently being reviewed by NZX Discipline and the Rule which was the subject of NZX Discipline's interpretation has been redrafted to reflect NZX's intention rather than NZX Discipline's interpretation. The Commission notes that in the absence of an amendment to the NZX Discipline Rules, interpretations by NZX Discipline provide a binding precedent for future applications. The actions of NZX in seeking to amend the NZX Discipline Rules in this way have highlighted to the Commission an unforeseen impact on NZX Discipline's autonomy.
While the Commission recognises that NZX may make amendments to the Listing and Participant Rules, including the NZX Discipline Rules, (subject to ministerial approval and other checks and balances), we are concerned that an otherwise binding interpretation of the NZX Discipline Rules can be overcome in this way. The NZX Discipline Rules do not at present give NZX Discipline any formal role in reviewing amendments. The Commission has concerns about the impact of this on NZX Discipline's autonomy and considers that NZX Discipline should be given an advisory role in determining any changes to the NZX Discipline Rules.
It seems anomalous that NZX, appearing as a party to a discipline proceeding, has the ability to change the rules which govern the processes and procedures of NZX Discipline without the consent of NZX Discipline. The Commission is concerned that the autonomy of NZX Discipline may be adversely affected.
The Commission intends to examine in detail any changes to the NZX Discipline Rules that come before it during the disallowance process, to determine whether such changes may have the tendency to undermine NZX Discipline's autonomy and are therefore not in the public interest. The Commission will seek the views of NZX Discipline in this process. The Commission notes that the NZX Discipline Rules are currently being reviewed and considers that this provides an excellent opportunity for NZX and NZX Discipline to incorporate the changes necessary to give NZX Discipline more input into amendments to its Rules.

Recommendations

The Commission is satisfied that NZX Discipline is independent of NZX and is producing work of a high standard. However, the Commission did identify some issues in the course of the review. In particular, the Commission was concerned to find that NZX Discipline had sought an advance opinion from NZX on the procedure which it proposed to follow in a matter before it. The Commission considers this was inadvisable.
The Commission is concerned that Market Participants who have been found to have breached the Participant Rules are not being identified. Not only is publication a significant tool in deterring breaches, but it is also imperative that NZX Discipline be seen to be sanctioning Market Participants for any breaches. The Commission believes that market confidence will be increased if NZX Discipline is transparent in naming Market Participants who have breached the Participant Rules.
The Commission found during the review that NZX Discipline had ruled on the scope of its review powers under the NZX Discipline Rules. This ruling was contrary to submissions by NZX, which would have narrowed the scope of the review power. Subsequently NZX has sought to amend the relevant NZX Discipline Rule, effectively overturning NZX Discipline's ruling for future cases. The NZX Discipline Rules do not at present give NZX Discipline any formal role in reviewing amendments. The Commission has concerns about the impact of this on NZX Discipline's autonomy and considers that NZX Discipline should be given an advisory role in determining any changes to the NZX Discipline Rules.
It appears to the Commission that although NZX Discipline has stated that it does not feel its access to resources is in any way limited by NZX, and NZX has repeatedly asked NZX Discipline whether it requires further resources, that NZX Discipline in fact requires more resources in order to action non-urgent work within reasonable timeframes. The Commission is concerned at extensive delays which have occurred in two matters in particular, the first of which is the review of the NZX Discipline Rules, and the second of which involves a third party.
The Commission also considers that it would be valuable if information about the role, membership and mandate of NZX Discipline were more readily available to the market. Although information is provided in the Annual Regulatory Report, the Commission does not consider that this is sufficient.

NZX Discipline should ensure that, when determining the procedure to apply to a proceeding before it, it treats all parties evenly.

NZX Discipline should be seen to be transparent in exercising its discretion whether to publish decisions which identify Market Participants who have breached the Participant Rules. Where a Market Participant's details are not published, NZX Discipline should disclose its reasons for withholding this information.

NZX and NZX Discipline should review the NZX Discipline Rules in order to give NZX Discipline more input into its own Rules, and amendments arising from this review should be included in the amendments which are presently being considered by NZX Discipline.

NZX Discipline should review its resource requirements and structure, and communicate its needs to NZX, so that delays in dealing with non-urgent work are minimised or removed.

NZX should provide more information about the role, membership and mandate of NZX Discipline on its website. In particular, the contact details for NZX Discipline should be included on the NZX website.

THE SPECIAL DIVISION

As in the last review, the Commission found that the Special Division was working well and enforced the separation between the commercial and regulatory functions of NZX. The Special Division acted independently of NZX and did not encounter any resourcing issues over the period. The Special Division also indicated that it was satisfied with the outcome of actions taken in response to the recommendations made in the context of the 2005 oversight review.
The Commission noted that NZX should set an example of full compliance with all lawful directions or requests of the Special Division during the 2005 oversight review. We note that this issue did not arise during the 2006 review period.

Independent solicitor and autonomy

As a result of the recommendations made by the Commission in the last review, the Special Division contracted an independent solicitor, rather than relying on an NZX Regulation solicitor. In the course of the current oversight review, the Commission queried whether this increase in autonomy had been successful. Both NZX and the Special Division reported that the use of the independent solicitor had been successful in promoting the independence of the Special Division.
The Commission had also recommended that a communication strategy about the role of the Special Division should be developed and implemented, including the publication of separate contact details for the Special Division. NZX issued a press release with this information in it. However, the Commission notes that the separate email address has not been utilised, and considers that this reflects the difficulty in finding the email address. The Commission notes that besides a link to the original press release at the very bottom of the NZX homepage there is no other place on the NZX website which sets out the Special Division's contact details, although there is a page which discusses the Special Division and the supervision of NZX. The Commission considers that better dissemination of information about the Special Division would be useful in educating the market about the various and separate roles of NZX, NZX Discipline and the Special Division.

Disciplinary action in respect of NZX

During the review period a subsidiary of NZX, Smartshares Limited, breached the Listing Rules by not providing a preliminary announcement or half-yearly report for the six month period ended 30 September 2006 in respect of the NZX Australian 20 Leaders Index Fund (also known as smartOZZY) within the timeframes required under the NZSX Listing Rules. NZX has systems which alert it the day before an Issuer's report is due. In this case however, due to a clerical error, it was not identified for some months that smartOZZY's announcement and report were late. This is a substantial period and the Commission is concerned that this was able to occur. The error was identified by Smartshares and notified to the Special Division.
The Special Division initially contacted Smartshares and requested certification from the directors that all material information in respect of smartOZZY had been disclosed to the market. Smartshares was granted two weeks to provide the half-yearly report. The Special Division subsequently suspended trading in smartOZZY securities until the report was provided. The trading halt was used appropriately, in the Commission's view, to encourage production of the report by Smartshares in a timely manner, and did in fact result in such report being published expeditiously. The Special Division took disciplinary proceedings against Smartshares, which were settled. Smartshares was required to pay a $10,000 penalty to an organisation approved by the Special Division for the purpose of market education, and the application of funds was not to relate to expenditure that would customarily be made by Smartshares or NZX.
The Commission notes that there was no direct precedent available to the Special Division to draw from as NZX Regulation has not had to deal with a breach by a passive fund. However, it appears that the Special Division endeavoured to act in a way that was consistent with NZX Regulation's approach and further, that it sought advice on the course of action it should take.

Recommendations

The Commission is satisfied that the Special Division is operating effectively. In particular, the Commission noted one disciplinary matter regarding a subsidiary of NZX that arose during the review period. It appears that the Special Division endeavoured to act in a way that was consistent with NZX Regulation's approach and further, that it sought advice on the course of action it should take.
The Commission considers that it would be valuable if information about the role, membership and mandate of the Special Division were more readily available to the market. Although some information is provided on the NZX website concerning the role of the Special Division, it is not extensive or easy to find.

NZX should increase the amount of information it provides about the Special Division and make it easier to find. In particular, the contact details for the Special Division should be included on the 'Contacts' and 'Supervision of NZX' pages of the NZX website.

RECOMMENDATIONS ARISING FROM THE REVIEW OF THE 2005 YEAR

Update on progress made in implementing the recommendations

The Commission made a total of 21 recommendations in the course of the 2005 review. We report on NZX, NZX Discipline and the Special Division's progress in implementing these recommendations.

Market Supervision Group (general)
- NZX should introduce and communicate a formal policy for all Market Supervision staff concerning identifying and declaring personal conflicts of interest.

NZX has created and communicated a formal policy regarding conflicts of interest within the agreed timeframe.

Supervision of Market Participants

NZX should take disciplinary action against Market Participants who commit repeat breaches of the Participant Rules.

As a general principle NZX agrees that, where a participant has failed to implement an agreed action point related to a breach of the Participant Rules identified on inspection, this is a matter generally deserving disciplinary action. However, there are always going to be circumstances that mean departure from this general principle is desirable. For this reason NZX disagrees with a recommendation that would require all repeat breaches noted on inspection (or otherwise) to be referred to NZX Discipline, and it believes it should deal with matters on a case by case basis.

The Commission's 2006 review of NZX practices in respect of participants satisfies us that NZX is taking an appropriate disciplinary approach to participant compliance.

Supervision of Listed Issuers

NZX should consider enlarging the membership of the Listing Subcommittee to address potential issues arising from conflicts of interest.

NZX appointed two extra members to the Listing Subcommittee within the agreed timeframe.

NZX should ensure that NZX Regulation adheres to its established procedures for timely appointment of and consultation with division members, to avoid delays in addressing applications.

NZX reiterated its policies for appointment of divisions to NZX Regulation staff, and compliance with the process is now monitored by the Group Leader and Business Leader of the Market Supervision Group.

NZX should ensure that the delegation of decision-making authority and the accountability for decisions made by NZX Regulation divisions are clearly recorded.

NZX revised the delegations of decision-making authority and accountability within the agreed timeframe.

NZX Discipline

NZX and NZX Discipline should together review the administrative support and resource arrangements in place for NZX Discipline. These resource arrangements should be reviewed regularly to ensure that NZX Discipline receives all the resources it requires to enable it to continue to carry out its functions effectively.

NZX and the Chairman of NZX Discipline have agreed on a suitable fee for administrative time spent by the Chairman and have created a framework for discussing NZX Discipline's resource requirements.

NZX should establish a periodic review of NZX Discipline members' fees and consult with NZX Discipline members on this. The NZX Discipline Rules should entrench that the fees for members of NZX Discipline may not be reduced by NZX.

The current review of the NZX Discipline Rules incorporates proposed changes to the treatment of Member's fees. The Commission notes that the Chairman of NZX Discipline agrees with this approach. The proposed amendments to the NZX Discipline Rules are currently with the Chairman of NZX Discipline for comments. The proposed changes had not come into effect at the date of this report.

NZX Discipline should publish its Annual Regulatory Report annually.

NZX Discipline agrees that the annual report should be published annually and will advise the Commission if this will not be achievable. The Commission expects that the report will be published annually.

Special Division

The Special Division, as a body, should determine whether the Special Division has jurisdiction to deal with matters referred to it. Any delegations from the Special Division to its Chairman should be formally recorded.

The Special Division has determined that any questions of jurisdiction will be determined by the Division as a whole. Any delegations will be documented.

Given the important role of the Special Division in respect of NZX's compliance as a Listed Issuer, the Special Division should take steps to ensure that it is fully aware of the powers available to NZX Regulation under the Listing Rules in respect of other Listed Issuers, and should exercise those powers as appropriate in relation to NZX as a Listed Issuer.

The members of the Special Division have been provided with all relevant regulatory material by NZX and have stated their willingness to take independent legal advice where necessary.

Given NZX's position as both a Listed Issuer and regulator of all other Listed Issuers listed on its markets, NZX should set an example of full compliance with all lawful directions or requests from the Special Division.

NZX does not believe it must comply with every request or direction from the Special Division. NZX considers that as other Issuers are not required to comply with every direction from NZX, the recommendation amounts to an unequal treatment of NZX. NZX therefore did not agree to implement this recommendation as stated above. However, the Commission is satisfied that during the 2006 review period the relationship between the Special Division and NZX was good, and that NZX provided all information that was requested.

As stated in the 2005 review, the Commission considers that in practice NZX does have the power to compel production of information by refusing to grant waivers if relevant requested information is not provided.

The Commission remains of the view that NZX should set an example of full compliance with all lawful directions or requests of the Special Division.

The Special Division should discuss its resource requirements with the Board of NZX. The NZX Board should have a formal guarantee of funding for the Special Division should the Special Division need to take NZX to NZX Discipline.

The Board of NZX has provided confirmation to the Special Division that it is authorised to incur expenditure on behalf of, or in the name of, NZX.

NZX and the Special Division should develop and implement a communication strategy about the role of the Special Division. Communication should include publication of separate contact details for the Special Division.

NZX has established an email address for the Special Division: info@specialdivision.co.nz. The address is published on the NZX website via a link to the press release at the bottom of the NZX homepage. Email sent to this address is automatically received by all four members of the Special Division and its counsel. The Commission is concerned that this has not been effective and has made recommendations to address this issue again.

A press release concerning the role of Special Division was created by NZX and released via MAP and posted on the NZX website.

The Special Division should formalise its delegation to the appointed solicitor and should receive regular reports on work dealt with by the appointed solicitor under delegation.

The Special Division has engaged the services of a senior lawyer on a contract basis. Certain delegations have been made to this lawyer pursuant to that contract, and the Special Division receives reports from the solicitor in respect of the exercise of those delegations.

The Special Division should have and use the same procedures manuals in respect of NZX's compliance as a Listed Issuer that are used by NZX Regulation in respect of all other Listed Issuers. The Special Division should satisfy itself that the appointed solicitor uses the NZX Regulation procedures, including where matters are delegated to that solicitor.

The lawyer contracted to the Special Division must use the NZX Regulation Solicitor's Handbook and conduct precedent searches in LRS and i-Search. As stated above, the members of the Special Division also have copies of all relevant regulatory material. The solicitor provides overflow assistance to NZX Regulation from time to time and accordingly considers waiver and ruling applications for other Issuers. She is accordingly very familiar with NZX Regulation precedents.

The Special Division should settle internal procedures that it would use, including procedures for communicating with the market, in dealing with a serious compliance matter regarding NZX.

The Special Division has settled procedures that it will use to communicate with the market in the event of a compliance matter regarding NZX.

The Special Division has also settled the procedures for dealing with a breach of the Listing Rules by NZX, including referral to the Securities Commission under the Securities Markets Act 1988.

The Special Division should formalise its expectation about the referral of data generated by the SMARTS market surveillance system concerning NZX's listed securities. Where alerts from SMARTS are below the threshold set by the Special Division for referral to it, the appointed solicitor should regularly advise the Special Division of the number of such alerts received in the period and a summary of any alerts that were not referred.

All SMARTS alerts are to be referred to the Special Division. NZX has amended its procedures manual to reflect this.

To avoid a situation of conflict for the appointed solicitor, the appointed solicitor should have no role in matters that raise contentious issues, including complaints handling (beyond an initial transmittal of a matter to the Special Division). The Special Division should engage external advisers to assist it in dealing with such matters and be funded to do so. The external advisers should have access to NZX's facilities and regulatory precedents and be able to consult with NZX Regulation.

The Special Division has appointed a senior lawyer on a contract basis. No NZX staff provide services to the Special Division.

NZX should either formally assure the Special Division that the appointed solicitor will not perform any corporate advisory work for NZX or should revisit the use of an NZX Solicitor for the appointed solicitor role.

The Special Division has appointed a senior lawyer on a contract basis. No NZX staff provide services to the Special Division.

The Special Division should report to NZX Discipline all material findings that it makes. NZX Discipline should incorporate that information into its published Annual Regulatory Report.

The Special Division will table a written report to NZX Discipline's annual meeting. NZX Discipline and the Special Division will also discuss the nature of the update to be included in the NZX Discipline annual report.

Governance

Given the risk of lack of clarity regarding roles in responding to a crisis, the Commission recommends that responsibilities of the CEO and Head of Regulation for exercising delegated powers be reconsidered by the Board of NZX to ensure that the responsibilities are clarified.

NZX continues to be of the opinion that its current delegations are effective in a crisis. The Board will keep the matter under review. In the interim, the Head of Market Supervision is now provided with time during each Board meeting where the CEO is not present, in order to enable her to raise any issues with the non-executive members of the Board. The Commission is comfortable with the progress being made in respect of this matter.

CONCLUSION

The Commission's overall conclusion is that NZX is satisfying its obligation to operate its markets in accordance with its Conduct Rules.
The Commission expects that future reviews of NZX will follow a similar format to the 2006 oversight review, in that they will focus on particular issues regarding NZX's performance of its statutory functions. The Commission believes that annual reviews of NZX are valuable because they allow the Commission and the market to receive information about NZX's performance on a regular basis.
The Commission's concerns and recommendations recorded as a result of this review, NZX's actions and response to these recommendations, and relevant intervening matters, will be reviewed next year.

APPENDIX

Scope of review

Section 36G of the Securities Markets Act 1988 says that NZX must operate each of its securities markets in accordance with approved rules for that market. The Conduct Rules include Listing Rules, and Business Rules that govern the conduct of persons authorised to undertake trading activities on the market.
NZX's obligations under section 36G are to secure compliance with its listing and business rules, and to perform any obligations that lie on NZX under those rules. To do this, NZX has established a Market Supervision Group with responsibilities for discharging NZX's regulatory function. The NZX Discipline Rules establish a dedicated body, NZX Discipline, to determine questions of non-compliance with the listing or Business Rules. Decisions can be appealed to the Appeal Panel. An independent body, the Special Division of NZX Discipline, exercises the powers and functions of NZX in relation to NZX as a Listed Issuer and its related entities.
The Commission has statutory functions to review practices relating to securities and activities on securities markets, and to comment on these. In relation to NZX, performance of these functions requires the Commission to keep under review and comment on NZX's obligations as a registered exchange. The oversight review was conducted under sections 10(b), 10(c) and 10(caa) of the Securities Act 1978.
The Commission's Terms of Reference for the review were:

The Securities Commission ("the Commission") is conducting an oversight review of New Zealand Exchange Limited ("NZX") under sections 10(b), 10(c) and 10(caa) of the Securities Act 1978. The purpose is to review NZX's performance of its co-regulatory function, in particular its obligations under section 36G of the Securities Markets Act 1988 and, in respect of futures and options dealers, NZX's regulation of dealers under its Futures and Options Participant Rules.

In particular, in respect of the 2006 calendar year, the Commission will review the following aspects of NZX's activities:
1. the management and operation of the NZAX market, including resources, practices and procedures, and the ongoing maintenance of that market;
2. the processes undertaken by NZX in considering the admission or approval of listed issuers and market participants to its markets, and any particular issues which arise as a result of those processes; and
1. NZX's role in minimising the risk of non-compliance by listed issuers and market participants in relation to their obligations under the Listing Rules and Participant Rules;

The Commission's review will consider any new developments in relation to the following areas:

supervision of market participants and enforcement of the Participant Rules;
supervision of listed issuers and enforcement of the Listing Rules;

allocation of human, technological and financial resources as it affects performance of the regulatory functions of NZX;

internal practices and procedures associated with investigations, price enquiries, complaints-handling and referrals;
discipline practices, procedures and resources;
arrangements for market infrastructure development and maintenance;
Special Division practices, procedures and resources; and
corporate governance arrangements, including board composition, policy setting, crisis response and oversight of executive management, with reference to regulatory standards relating to governance of demutualised exchanges under IOSCO and other international principles.

The review may also consider any issues arising in the course of the review in relation to the above areas.

The Commission's review will consider the progress made by NZX (up to the date of the Commission's report on this oversight review) towards implementing the Commission's recommendations set out in its report dated 26 September 2006.

AND accordingly, will obtain, consider and utilise information for the purposes of any recommendation, report or comment the Commission may decide to make under sections 10(b), 10(c) or 10(caa) of the Securities Act 1978 in relation to the above matters.

SUBJECT to the Commission's discretion to amend these Terms of Reference as it may consider fit.

December 2006

Background to review

In 2002 the Securities Markets and Institutions Bill created a co-regulatory regime for registered exchanges. NZX is the only registered exchange in New Zealand. Under the co-regulatory regime it is intended that the Commission monitors the performance of NZX's statutory responsibilities.
In 2003 the International Monetary Fund conducted a Financial Sector Assessment Programme (FSAP) review of New Zealand. The FSAP measured New Zealand's framework of securities regulation and its operation against the Objectives and Principles of Securities Regulation published by the International Organization of Securities Commissions. The IOSCO Principles include principles for self-regulatory organisations.
One of the recommendations in the FSAP report was that the Commission develop a formalised oversight plan for regulated exchanges, providing for risk assessment criteria and periodic inspections that take into account best practices for self-regulatory organisations and exchanges. It recommended that there should be public disclosure summarising the objectives of the oversight plan and of the key findings of such reviews. The Government response noted that the Commission had decided to develop a formal oversight plan for regulated exchanges and had informed NZX.
Demutualisation and listing of stock exchanges has been an emerging phenomenon overseas in the past decade. In all cases we have seen, regulatory structures have been put in place accompanying such moves, reflecting the core importance of stock exchanges to countries' capital markets and broader economies. In New Zealand these regulatory structures include an ownership cap, regulatory review of exchange rules, and oversight by the Commission. Different approaches have been taken in various jurisdictions overseas. The approach taken in New Zealand was settled after consideration of international models existing at the time, and the particular circumstances of the New Zealand markets. It has not been a part of this review to reconsider these arrangements.
However, as encouraged by the FSAP review, we have looked to the emerging high-level standards in overseas jurisdictions to gain an insight into best practices for exchanges. We have taken into account the report of the FSAP inspectors, the IOSCO Objectives and Principles of Securities Regulation, and the methodology used for assessing compliance with these standards, in particular the principles applying to self-regulatory organisations.
The Commission has also looked to the legal obligations of exchanges in similar jurisdictions to gain an understanding of the expectations that overseas investors in particular are likely to have for the conduct of a registered exchange. While there are differences in the approaches taken by each jurisdiction, there are a number of standards that can be taken from an overall assessment of the IOSCO Principles and overseas law and practice. These suggest that a stock exchange should:
1. meet and maintain adequate standards of integrity and fitness to operate a market;
2. develop rules for the conduct of listed issuers and market participants;
1. develop and operate fair procedures for the enforcement of its rules;
1. conduct a fair, orderly, informed, and efficient market;
2. maintain effective trading, clearing, and settlement systems;
3. have adequate capacity to carry out its regulatory functions and enforce its rules; and
4. have procedures in place to manage conflicts of interest.
Development of rules is addressed in New Zealand under the statutory approval and disallowance process for conduct rules. The IOSCO Principles also address competition issues, which are outside the remit of the Securities Commission. The remaining matters have been addressed in this review.
The oversight review conducted this year is the second oversight review of NZX conducted by the Commission. The review focussed on the 2006 calendar year.

Process

The Commission requested information from NZX under section 36ZK of the Securities Markets Act. Section 36ZK says that a registered exchange must give the Commission (or any person authorised by the Commission) information, assistance, and access to the exchange's facilities if the Commission reasonably requests it to carry out its functions.
The Commission sent questionnaires to NZX, NZX Discipline and the Special Division seeking information the Commission considered necessary to effectively evaluate NZX's performance of its regulatory functions. The questionnaires covered the areas identified in the Terms of Reference.
The Commission requested copies of any procedures manuals and process documents that evidenced NZX's policies and procedures for each of the areas covered by the questionnaires. Where written procedures and policies were not available, we requested written explanations and information from NZX in response to each specific information request.
NZX provided information in response to the questionnaires, including procedures manuals and process documents where relevant. Questions relating to NZX Discipline and the Special Division were answered by the Chairs of those bodies.
Commission staff selected and reviewed a sample of NZX's files across a range of regulatory activities.
Commission staff conducted interviews with NZX personnel and Board members. Commission staff also interviewed the Chairman of NZX Discipline and the Chairman of the Special Division. A total of 11 interviews were conducted and the interviews were recorded.
Confidentiality and privacy orders were in place throughout the review.

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