The regulatory responses to the issues that arise as a result of demutualization, have varied from jurisdiction to jurisdiction, as they are dependent on the legal framework and regulatory philosophy in place. However, there has been some consistency in dealing with the issues that have arisen, with the general approach tending to keep the self-regulatory function for the time being, while transferring some regulatory functions to the government regulator. The regulatory responses fall into three categories: First, changes to the governance structure to ensure that the public interest is safeguarded and takes precedence over commercial interests; Second, changes to the corporate structure to ensure that the regulatory function specifically continues to be performed and is adequately resourced; and Finally, changes to the regulatory framework to address the conflicts of interest which arise between the exchange upon its listing, and between the exchange and persons dealing with it.
Changes to the Governance Structure
The governance structure of an exchange, whether mutual or for-profit, has a significant impact on its regulatory and commercial performance, as well as its ability to reconcile the competing interests of its managers, owners, various users and potential users of its services. The structure may have an impact on the delivery of self-regulatory functions. Failure in this regard may have a negative impact on the market as a whole, as well as exchanges’ ability to deliver on the public policy objectives set for them by governments.
Given the additional pressures that demutualization creates, the statutory regulator and/or government may enact one or more of the following rules: The board of directors may appoint people to represent the public interest. In some cases, such as Hong Kong, the government is empowered by legislation to appoint a majority of directors (in Hong Kong, 8 out of 15). Furthermore, to address the potential conflict that such directors may face, in reconciling the public’s interests with their duties to shareholders, it may be appropriate to provide a statutory remedy.
In Hong Kong, the demutualization legislation imposes an express duty on the exchange to ensure, so far as reasonably practicable, an orderly and fair market in securities or futures contracts traded on or through the exchange. In discharging this obligation, it is required to act in the interests of the public, having particular regard to the interests of the investing public. Where these interests conflict with any other interests that the company is required to serve under any other law, the former must prevail. Since this obligation applies to the exchange, all directors (and not only those appointed by the government) are placed in the same position.
Changes to the Corporate Structure
Changes may be made to the corporate structure of a group, to ensure that the regulatory function continues to be properly performed (i.e., is carried out independently from, and is not compromised by its commercial operations), and is adequately financed. These actions often involve transferring some or all of the regulatory function to a separate entity, such as:
- another group company with an independent governance structure and budget (as was done with the NASDR/NASDAQ and ASX models);
- another self-regulatory organization (or giving the choice to contract out the performance of the functions to another SRO or retaining it in-house but securing its performance in various ways); or
- the statutory regulator.
In the second case, an assessment must be made of the capacity of the company and its officers, to which the functions are transferred to properly perform them. This may require an assessment of various factors, including: whether the applicant has adequate arrangements in place to operate the market, settle and clear trades, supervise the market, protect retail investors (including compensation funds), and has sufficient resources generally to adequately carry on each of these functions. Even in jurisdictions where the commitment to self-regulation is strong enough, to ensure that there is presently no urge to transfer the regulatory functions to the statutory regulator, it is important to ensure that any restructuring is seen to achieve true independence.
Unless the public perception is one of genuine independence, then the solution is unlikely to last and pressure will mount for a complete transfer of responsibility to the statutory regulator. Ensuring adequate resourcing of the regulatory function may also involve imposing capital adequacy requirements, or requiring the establishment of reserves, much as for financial intermediaries. There is commonly no requirement for an exchange simply to have sufficient financial resources, to conduct its regulatory functions efficiently. Arguably, such a requirement is desirable. In the NASD case, the SEC was able to direct the expenditure of sufficient resources to particular areas of regulation.
Conflicts of Interest
It is now widely accepted that a self-regulatory exchange should not be responsible for its listing or supervise its compliance with listing rules and trading in its securities. What should be done when conflicts arise between the exchange and other exchange users is less clear. However, these may entail treating a business competitor harshly, or a business associate leniently than would otherwise be the case, for example, a listed company or broker setting up a new trading or clearing system. In such cases, powers may be needed to step into the shoes of the exchange and discharge the relevant regulatory function.
In Hong Kong, the demutualization legislation provides that whenever the SFC is satisfied that a conflict of interest exists or may arise, or has existed and may be repeated, between the interests of the exchange and the interests of the proper performance of a regulatory function, the SFC may by notice, direct the exchange to take steps specified in the notice (including steps in relation to any of its affairs, business and property). This is to remedy the conflict, or the matters occasioning the conflict. The exchange may appeal to the Chief Executive in Council but the notice takes effect immediately. It can be presumed that in such instances of conflict, any third party which feels it is being prejudiced, will make this known to the statutory regulator. However, it can also be assumed that a business associate of the exchange, being given a sweet deal by the exchange, will not be so quick to announce it.
Furthermore, there may be some concern that users of the exchange will be tempted to complain too readily, that conflict of interests may arise, and that the exchange becomes increasingly unable to exercise its normal regulatory and disciplinary functions. While responsibility for stepping into the shoes of the self-regulatory organizations and exercising relevant functions may be assumed by the statutory regulator, it would be possible for the regulator to appoint another person to undertake this function on its behalf.