Ann: WAV/RULE: FNZ: Special Division of the NZ Ma

• Release Date: 21/02/12 12:35
• Summary: WAV/RULE: FNZ: Special Division of the NZ Markets Disciplinary Tribunal
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FNZ
21/02/2012 10:35
WAV/RULE

REL: 1035 HRS SmartFONZ

WAV/RULE: FNZ: Special Division of the NZ Markets Disciplinary Tribunal

Special Division of the NZ Markets Disciplinary Tribunal
Review of Waivers Granted to Smartshares Limited

Background

1. Smartshares Limited (Smartshares) is the manager of five exchange traded
funds listed on the NZSX market: the NZX Australian 20 Leaders Index Fund,
the NZX MidCap Index Fund, the NZX 50 Portfolio Index Fund, the NZX
Australian MidCap Index Fund and the NZX 10 Fund (the Funds).  Smartshares is
wholly owned by NZX Limited (NZX).

2. Each Fund is required under the terms of its trust deed to track the
performance of its associated index by holding securities (Fund Securities)
on the index in the appropriate weightings.

3. In September 2010, NZX launched a central counterparty clearing and
settlement system (CSS).  The clearing house operator, New Zealand Clearing
Limited (CHO), is the central counterparty for the settlement of trades of
financial products on NZX's markets. Transactions are settled onto the
depository, operated by New Zealand Depository Limited (CDO).  The entities
which operate the CSS are ultimately wholly owned by NZX.

4. Smartshares uses the services provided by the CSS, including the
depository holding legal title to the Fund Securities, lending Fund
Securities through the depository and buying and selling Fund Securities on
market through an NZX Market Participant.

5. Smartshares, as manager of the Funds, applied to the Special Division for
rulings and waivers to permit these transactions as they arguably fell within
the ambit of NZSX Listing Rules (the Rules) 9.1.1 and 9.2 because Smartshares
and the entities which operate the CSS are Related Parties for the purposes
of the Rules.

6. On 2 September 2010, the Special Division granted waivers to Smartshares
to permit the proposed transactions involving the CSS. A copy of that
decision can be viewed at http://www.smartshares.nzx.com.

7. Following the granting of these waivers and the introduction of securities
lending by the Funds, the Special Division considered it appropriate to
review the circumstances regarding its decisions dated 14 October 2004 and 29
March 2005 which granted waivers (the Waivers) so that the Board of
Smartshares is not required to include a minimum number of Independent
Directors as specified under Rule 3.3.1(c), nor to comply with the associated
procedural requirements in Rules 3.3.2 to 3.3.4 for determining independence
and the appointment process.

8. In coming to the decision to grant the Waivers in 2005, the Special
Division noted amongst other things that:

"These GIFs [the Funds] are passive index funds.  As such they track the
relevant Index. The discretions of NZXFM [now Smartshares] in respect of the
investment decisions of the GIF are strictly limited to following the Index.
Accordingly much of the role of the Manager is undertaken automatically.
There are significantly fewer strategic decisions for Directors of NZXFM to
make than are made in a listed company.  It was accepted by NZXR and the
Special Division concurs that there are unlikely to be decisions for
Directors to make in respect of each GIF that could be influenced by any
relationship contemplated in the definition of Disqualifying Relationship.
The issue that Listing Rules 3.3.1(c) to 3.3.1C are intended to address is
not present."

9. The Special Division's review considered whether the introduction of
securities lending by the Funds through the CSS now required Smartshares'
directors to exercise some measure of discretion which could be influenced by
the Related Party relationships between Smartshares and the entities which
operate the CSS.

10. The Special Division sought submissions from Smartshares to inform its
review. On 17 September 2010, Smartshares submitted that an amendment to the
Waivers was unnecessary for the following reasons:

a. The introduction of securities lending through the CSS does not amount to
a material change to the nature of the business or operations of the Funds.
Smartshares is still required to acquire and dispose of securities to ensure
that the Funds track their relevant index and Smartshares is only able to
lend securities that have been acquired in order for the Fund to track the
relevant index.  When the index changes, and a security is no longer required
to be held in the Fund, Smartshares is required by the trust deed to recall
any lent securities in order to dispose of the holding as required to track
the index;

b. Securities lending through the CSS has been structured so that there is no
discretion in the management of securities lending through the CSS.  To
achieve this, the custodian must make 50% of the value of each Fund Security
available for lending and then must monitor ongoing changes to the Funds'
portfolios to ensure that at no stage more than 50% of the value of any
particular Fund Securities is lent.  If less than 50% is available to lend
then this is regularly topped up again to the 50% limit.  Because there is no
discretion there is no leeway for Smartshares' decisions to be influenced by
the Related Party relationship.

c. Smartshares had to obtain an amendment to the Securities Act (Group
Investment Index Fund) Exemption Notice 2002 (the Notice) in order to allow
it to conduct securities lending through the CSS.  The Commission extended
the application of the Notice to index funds that lend securities through the
CSS on the basis that no discretion in lending is permitted.  As a
consequence, the Notice was drafted so that the exemptions only apply to
funds that:

"lend securities in accordance with -
(a) the rules of a settlement system; and
(b) a process that -
(i) is fully, or predominantly, automated; and
(ii) involves no discretion on the part of the [manager or the trustee]."

In order to remain within the terms of the Notice, Smartshares is required to
conduct securities lending in a manner that involves no discretion.  If
Smartshares operates outside the exemption, then it will not comply with the
Securities Act 1978 when offering Fund units to the public for subscription.

d. Investors' exposure to market risk is not affected by securities lending
through the CSS.  Particular additional risks arise for the Funds from
securities lending through the CSS.  These potential risks are set out in the
offer documents for the Funds, which the Special Division has seen and
approved.

e. The terms on which Fund Securities are lent through the CSS are set out in
the Clearing and Settlement Rules and the Depository Operating Rules.  These
terms apply to all persons who lend securities through the CSS.  Any costs
associated with lending securities through the CSS are met by Smartshares out
of its management fees and do not affect returns to investors. For this
reason the relationship between Smartshares and the companies operating the
CSS will not affect investors' returns.

11. The Special Division then met with Smartshares to discuss how securities
lending was being managed.  Smartshares also provided additional information
in October 2010 on the entities in the NZX group that operate the CSS, and in
particular the governance and capital arrangements for those entities.

12. Based on the information the Special Division had thus far received, it
understood that in practice the Directors of Smartshares had no discretion to
adjust the level or cease securities lending through the CSS, irrespective of
adverse market conditions, the decisions of others to cease to lend or other
circumstances. If the trust deeds for the Funds permitted Smartshares to
exercise an investment discretion then the exemptions in the Notice would not
apply. The Special Division asked Smartshares to confirm whether its board is
actually legally obliged not to exercise any such discretion or whether it
has committed itself not to exercise any discretion that might be available,
regardless of the circumstances that might arise.

13. Smartshares subsequently submitted the following:

a. Smartshares has no investment discretion, and the introduction of
securities lending has not changed this.  However, Smartshares has other
powers and discretions in respect of the Funds that are not related to
investment of the Funds.  For example, the FONZ trust deed provides in clause
16.3(c):

The Manager shall be entitled to make any reasonable decision, designation or

determination not contrary to this Deed which it may determine is necessary
or
desirable in interpreting, applying or administering this Deed or in
administering,
managing or operating the trust and agency relationships to be governed by
this Deed
and the Fund.

Smartshares has not fettered its ability to take action in reliance on
provisions of this nature in relation to securities lending.

b. We understand the Special Division is questioning how Smartshares would
react to an event involving the CSS that posed a significant risk of material
loss to the Funds, for example, the failure of CHO and whether the Related
Party relationships would influence how Smartshares would act. We do not
think that there is a real conflict of interest issue here.  Even if there
were, we do not think that having an Independent Director on the board of
Smartshares is a practical means to protect investors from this perceived
conflict.  We think that the type of scenario that you are referring to would
involve some kind of catastrophic event, for example, where a number of
Clearing Participants fail, leading to the failure of CHO.  Leaving aside the
issue of the unlikelihood of such an event, we think it is unlikely that the
removal of the Funds' securities from the lending pool would make much
difference in this type of scenario.  Securities lending is a means by which
liquidity is provided to assist Clearing Participants to meet their
obligations to deliver securities.  But securities lending is not fundamental
to the ability of CHO to meet its obligations to Clearing Participants.  We
can think of no reason why CHO would put pressure on Smartshares to retain
securities in the lending pool in this type of scenario.

c. Where issues arise in relation to the Funds, Smartshares is required under
the terms of the trust deeds to consult with the relevant trustee, who owes
particular duties to unit holders under the trust deeds.  We do not see how
having an independent director would provide any additional comfort
concerning the management of this perceived conflict of interest.  In our
view the cost of having an Independent Director would not bring particular
benefits to unit holders and would unnecessarily increase the costs of
administering the funds.

d. We note the reasons given in the Waivers from the requirement to have
Independent Directors, in particular the reference to there being fewer
strategic decisions for directors of Smartshares to make, and also to there
being less likelihood for decisions to be influenced by relationships
contemplated in the definition of Disqualifying Relationships. We do not
think that this theoretical conflict means that there is an increased
likelihood that decisions of Smartshares directors will be influenced by the
relationship with CHO.

14. The Special Division notes that the most recent advice of Smartshares is
that it does retain the ability to exercise discretion to reduce the level of
securities lending, if circumstances suggest that this is the most prudent
action.  The Special Division's concern is whether the ability to exercise
such a discretion coupled with the Related Party relationships between
Smartshares and the entities that operate the CSS means that the Waivers
should no longer apply.

15. In this regard, Smartshares has submitted that:

a. There is no real conflict of interest because the likelihood of a
catastrophic event (i.e the failure of CHO) is low and, in any event, the
availability (or otherwise) of securities lending would not affect such an
event;

b. The trustees of the Funds protect unitholders and no additional protection
would come from the appointment of an Independent Director; and

c. The theoretical conflict of interest will not increase the likelihood that
Smartshares' directors will be influenced because of the Related Party
relationships.

Decision

16. Based on the information provided, the Special Division considers that
the Waivers should continue to apply to Smartshares for the following
reasons:

a. The Special Division accepts Smartshares' submission that there would be
no purpose or need for NZX or CHO to influence Smartshares to continue to
lend securities, so Smartshares should be at no greater risk of loss than any
other unrelated participant lending securities through the CSS;

b. The likelihood of an event occurring that would require the exercise of a
discretion by Smartshares relating to securities lending is very low;

c. The directors of Smartshares must, notwithstanding the Related Party
relationship, always act in the best interests of Smartshares and its
unitholders; and

d. The exercise of any discretion by Smartshares to reduce securities lending
must occur under the terms of the trust deeds notwithstanding the Related
Party relationships. The presence of an additional independent director is
unlikely to add significant protection to the mechanisms that are already in
place to address conflicts of interest.

17. The Special Division has sought and received written confirmation from
the directors of Smartshares that:

a. The possibility of conflicts of interest between it and the entities which
operate the CSS in respect of securities lending as discussed above are
noted; and

b. Smartshares has procedures in place which would require a review of
engaging in securities lending in the event of adverse market conditions to
ensure that the securities lending remains in the best interests of
unitholders.

Ends
End CA:00219790 For:FNZ    Type:WAV/RULE   Time:2012-02-21 10:35:54