NZLII Home | Databases | WorldLII | Search | Feedback

New Zealand Securities Commission
You are here:  NZLII >> Databases >> New Zealand Securities Commission >> 2005 >> [2005] NZSecCom 9

Database Search | Name Search | Recent Documents | Noteup | LawCite | Download | Help

An inquiry into the performance by NZX of its regulatory functions as a registered exchange during 2003 and 2004 prior to the collapse of Access Brokerage [2005] NZSecCom 9 (13 December 2005)

Last Updated: 10 November 2014

An Inquiry Into the Performance by NZX of its Regulatory Functions as a Registered Exchange During 2003 and 2004 Prior to the Collapse of Access Brokerage
13 December 2005


TABLE OF CONTENTS

GLOSSARY OF ABBREVIATIONS AND TERMS
ACBW
NZX acronym for Access
Access
Access Brokerage Limited (In Liquidation)
ACE
Back office system
CFA
Client funds account / client funds accounting
Chelmer
Financial trading system provider. Provider of ACE back office system
Conduct Rules
The Participant Rules and Listing Rules of NZX
Deloitte
Deloitte Touche Tohmatsu
DMA
Direct Market Access
DVP
Delivery Versus Payment
FASTER
Fully Automatic Screen Trading and Electronic Registration securities transfer system
FIN
Faster Identification Number
NZAX
New Zealand Alternative Market
NZDX
New Zealand Debt Market
NZSE
New Zealand Stock Exchange
NZSX
New Zealand Stock Market
NZX
New Zealand Exchange Limited
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
RFI
Request for Information
SSS
Scientific Software & Systems Limited - provider of back office system
STORMS
System associated with FASTER

EXECUTIVE SUMMARY

  1. The Securities Commission has inquired into the performance by NZX of its regulatory functions as a registered exchange in 2003 and 2004, prior to the default of Access Brokerage Limited (In Liquidation) ("Access") in September 2004.
  2. The inquiry examined the rules, procedures, and practices of NZX relating to broker compliance during this period. The Commission has considered these matters during the development of the NZX's broker compliance programme, when NZX conducted an inspection of Access. This is not a report on the current performance by NZX of its regulatory functions. The Commission recognises that since 2003 NZX has made significant progress in developing its regulatory functions and, in particular, its broker compliance programme.
  3. The Commission's inquiry did not seek to establish the cause of the collapse of Access or any causal link between the action or inaction of NZX and the failure of Access. NZX is bringing disciplinary action against Access and its Chief Executive alleging breaches of the NZX Conduct Rules. The Serious Fraud Office has also laid charges under the Crimes Act 1961.
  4. Prompt and appropriate action by NZX and the Registrar of Companies, immediately following the collapse of the broking firm, minimised harm to the market and clients of Access.
  5. The evidence the Commission has received in this inquiry and its own observations since 2002 indicate that NZX has, since demutualisation, increased its focus on market compliance and that as a result brokers are putting more effort into compliance. The Commission considers this to be a positive step and a key part of NZX's function as a registered exchange. As part of this increased focus on regulatory matters, NZX had decided in 2002 that it should develop an in-house broker compliance programme. The Commission supports this decision.
  6. The Commission concludes that there were shortcomings in the development and early operation of the compliance programme. While the broker compliance plan was put to the CEO and Board for approval, implementation of broker inspection procedures was largely left to NZX staff who were relatively inexperienced in broker compliance programmes. We acknowledge that NZX had difficulty finding such experienced staff at that time. Supervision of the compliance team was inadequate. Issues elevated to the team supervisor and other executive management at times received little response.
  7. A broker compliance programme is not intended to detect fraud. However it is intended to assess compliance with the NZX Rules, in the context of an inspection rather than an audit. Under the NZX Rules client funds must be in a client funds account, segregated from a broker's other bank accounts, and held on trust. Client funds cannot be used for a broker's own purposes except where the NZX Rules expressly permit this. The Commission concludes that when the NZX broker compliance programme was being designed there was a poor understanding of client fund account rules within NZX, which had led to a belief that these rules could not be enforced and to an unwillingness to challenge industry practice. The inspection team received inadequate training in the requirements for trust accounts. Documentation and record-keeping requirements for inspections were not sufficient to allow for peer or supervisory review of the work undertaken. The broker compliance programme did not, in 2003, include adequate measures to assess broker compliance with the client fund account rules. As a result, the Access inspection examined client funds account transactions principally to assess the timeliness of payments due to clients, rather than to identify any misuse of client funds.
  8. Following the collapse of Access, NZX retained Grant Thornton to assess compliance by market participants with the client fund accounting rules. NZX has taken steps to address deficiencies identified in Grant Thonton's report, to further assess the extent of participants' compliance, and to provide guidance to participants on obligations relating to client funds under the Participant Rules.
  9. The NZX Board, as the governing body of a registered exchange, recognises it has a responsibility for the performance by NZX of its regulatory functions. In the Commission's view the regulatory role of the Board of a registered exchange can be considered in four areas: policy setting; discipline; crisis response; and monitoring and oversight of NZX performance of its regulatory functions. The Commission finds that, of these, three areas have been well-addressed by the NZX Board. It has been extensively involved in setting regulatory policy. It remains active in crisis response, which was demonstrated in the days immediately following the collapse of Access. It has established NZX Discipline, an independent body, to hear and determine cases of suspected breaches of Conduct Rules.
  10. In the fourth area, monitoring and oversight of the NZX executive's performance of its regulatory functions, the Commission considers that the NZX Board's policy failed to fully appreciate NZX's role under the co-regulatory framework. In particular, the NZX Board did not maintain appropriate strategic oversight of the broker compliance programme. The Board should have remained informed of the ongoing performance of the broker compliance programme against the strategic plan.
  11. The maintenance of a fidelity guarantee fund raises issues that are beyond the scope of this inquiry. There may be reasons to re-examine the purpose of, and expectations for, a fidelity fund. These are likely to be law reform issues, and it will take time to address them. In the meantime, the Participant Rules contain provision for a Fidelity Fund. Any difference between public expectations for this Fund and its likely application could adversely affect public confidence. The Commission is of the view that the NZX Board should consider its policy concerning the ongoing availability and use of the Fidelity Fund, and how this policy can be communicated to the investing public.
  12. The Commission has not at this time undertaken a detailed review of NZX's current broker compliance programme. However, the Commission is confident that steps taken by NZX since 2003 address many of the issues raised in this report. In particular we recognise NZX has:
    1. established NZX Discipline;
    2. appointed a dedicated Head of Regulatory and Public Policy, whose role is separate from NZX corporate activities;
    1. increased the number and experience of compliance team personnel;
    1. completed inspections of all market participants;
    2. introduced spot inspections for market participant firms;
    3. tightened re-inspection schedules where breaches are found;
    4. introduced new Participant Rules with higher compliance standards;
    5. completed the accreditation process under the new Participant Rules; and
    6. referred several breaches of the Participant Rules to NZX Discipline.
  13. Some matters highlighted in this report should, in the Commission's view, be given further consideration by NZX. The Commission recommends that NZX review the following matters relevant to its regulatory functions:
    1. documentation and guidance on inspection procedures relating to client funds accounts;
    2. record keeping and recording of inspection procedures;
    1. the role of supervisors within NZX;
    1. the role of the NZX Board in so far as this relates to ongoing oversight of NZX's performance of its regulatory functions;
    2. client funds rules, by preparation of a discussion document seeking comment from market participants on whether any further clarification or change is required; and
    3. the Fidelity Fund, to clarify NZX's policies regarding the application of this.
  14. The Commission observes that its inquiry, and this report, arose from the collapse of Access. The focus of the inquiry has been on compliance processes and procedures associated with client funds accounts held by NZX Participants. Under New Zealand law investment brokers other than NZX Participants are not required to hold client funds on trust. Non-NZX investment brokers must simply advise potential clients whether or not their funds will be held on trust. Only NZX Participants must hold client funds in trust accounts. This is a significant legal protection.
  15. NZX is a registered exchange, the only one in New Zealand. This means that NZX Market Participants are, in many areas, subject to higher standards than are most in the advisory industry. The benefit of this is that investors can take confidence that there are intermediaries who are subject to such standards for the protection of investors, and whose compliance is monitored by a registered exchange. This is important not only for investors in New Zealand, but also for the reputation overseas of New Zealand's capital markets. The Commission welcomes the increased focus by NZX on its regulatory functions since its demutualisation in 2002, and since the events detailed in this report. Performance of these functions is a significant contributor to confidence in our country's capital markets.

PART I - INTRODUCTION

  1. On Friday 3 September 2004 NZX was informed by the majority shareholder of Access Brokerage Limited that there was a significant deficit in the firm's client trust account, and that the company was insolvent. Before trading commenced on Monday 6 September 2004, NZX declared Access a defaulter under the NZX Participant Rules. Access was suspended from trading in NZX markets. Later that day Access was placed in interim liquidation. It was placed in liquidation on 8 September 2004.
  2. The events at Access have been investigated by NZX, which must operate its markets in accordance with its Conduct Rules, approved under the Securities Markets Act 1988. NZX has submitted a Statement of Case to NZX Discipline alleging breaches of the Conduct Rules by Access and its Chief Executive, Mr Peter Marshall. There has also been an investigation by the Serious Fraud Office, which has laid charges under the Crimes Act 1961. The work of the liquidator is continuing also.
  3. The Securities Commission has an oversight responsibility in respect of securities markets and registered exchanges. The Commission's inquiry did not seek to establish precisely what caused the collapse of Access: that work is being undertaken by other parties. The Commission's inquiry has focussed on the performance by NZX of its regulatory functions as a registered exchange in relation to events leading up to and surrounding the collapse of Access. Accordingly the report does not seek to imply or suggest that NZX was responsible for the collapse of Access, or that there is any causal link between the action or inaction of NZX and the failure of Access.

The Commission's inquiry

  1. This inquiry has been carried out under sections 10(b), 10(c) and 10(caa) of the Securities Act 1978. These sections provide that it is a function of the Commission to:

10(b)
keep under review the law relating to bodies corporate, securities, and unincorporated issuers of securities, and to recommend to the Minister any changes thereto that it considers necessary
10(c)
keep under review practices relating to securities, and to comment thereon to any appropriate body
10(caa)
keep under review activities on securities markets, and to comment on those activities to the appropriate body

  1. A division of the Commission was appointed to conduct this inquiry.
  2. The Commission inquired into the performance by NZX of its regulatory functions as a registered exchange under the Securities Markets Act 1988. In particular the Commission considered:
    1. steps taken by NZX since the collapse of Access to ascertain whether there are poor practices among NZX Participants in respect of Participant client fund accounting and reporting;
    2. client fund accounting rules and practices under the NZX Conduct Rules, including the treatment of client fund accounts maintained at financial institutions and the presentation of these to clients;
    1. the rules, procedures, and practices relating to participant supervision and inspection by NZX as these applied in the case of Access Brokerage;
    1. the role, sufficiency, and use of the NZX Fidelity Guarantee Fund.
  3. The Terms of Reference of the Commission's inquiry are set out in Appendix A.
  4. The Commission considers that the matters under inquiry raise issues of securities law and securities markets practice upon which it is appropriate for the Commission to comment. The Commission has decided to comment by way of this report.

Structure of this report

  1. Part II of this report sets out a summary of events in September 2004 concerning the collapse and default of Access. The remainder of the report sets out the findings of the Commission's inquiry.
  2. This inquiry has covered a range of matters concerning the workings and management of NZX, the composition and training of its compliance team, and the involvement of management and the Board in NZX's role in regard to broker compliance. The Commission's inquiry has looked specifically at how NZX carried out its regulatory functions in the period prior to the collapse of Access in September 2004. The performance of this role during that period, and today, needs to be seen in the context of the steps taken by NZX since its demutualisation in 2002.
  3. In order to provide this context, this report considers, in Part III, the work done by NZX in 2002 and 2003 to overhaul its Participant compliance function, and the composition of the compliance team. The inquiry raised questions for the Commission about reporting lines and supervision of the compliance team at NZX. These issues are also considered in Part III. Part IV discusses issues regarding client funds and the inspection of Access carried out by NZX in August 2003, a year before the firm's collapse. Part V considers the work done following the Access inspection and the competing priorities at NZX at that time. Part VI comments on the involvement of the NZX Board in matters of broker compliance.
  4. The steps taken by NZX following the collapse of Access to ascertain whether there was a wider problem with client funds are detailed in Part VII of this report. More general observations regarding client funds accounts and the NZX Fidelity Fund make up Parts VIII and IX of the report. Part X of the report outlines changes that have occurred at NZX since the period under inquiry which address many issues identified in this report, and makes recommendations arising from the Commission's inquiry.

Procedure

  1. The Commission determined the procedures for this inquiry.
  2. In the course of the inquiry the Commission obtained evidence from the following:
  3. In addition, the Commission received documents and information from:
  4. In respect of part (a) of the Terms of Reference (steps taken to establish whether there was widespread non-compliance with client funds rules), the Commission received a report prepared for NZX by Grant Thornton, Chartered Accountants, Review of NZX Market Participants Client Funds Accounts (31 May 2005). The Commission also received evidence from NZX in relation to this part of its inquiry.
  5. As more information became available it was necessary to seek additional evidence from some of the witnesses.
  6. Confidentiality and privacy orders were in place throughout the inquiry. NZX witnesses were all represented by counsel throughout the presentation of their evidence. All other witnesses were provided with the opportunity of being represented by counsel. Oral evidence was recorded, and transcripts provided to witnesses.
  7. After receiving evidence the Commission prepared a confidential consultative report and invited comment from affected parties. These parties were given the opportunity to respond with submissions and to provide further evidence to the Commission.
  8. The Commission has carefully considered all the evidence and submissions before it before publishing this report.
  9. Mr Rodrigues, one of the witnesses in the inquiry, is a member of the Commission's staff. At the outset of its inquiry the Commission put in place internal procedures and information controls to ensure the integrity of information and proceedings in this inquiry.

PART II - DEFAULT OF ACCESS

  1. Access was registered as a company in 1986, originally under the name Discount Brokerage Limited. Access was based in Wellington and since 1986 had carried on business as a sharebroking firm and had been a member of the NZSE.
  2. On 3 September 2004, NZX was contacted by Mr Bill Garlick, the majority owner of Access, who advised that there was a deficit in the Access client trust account. A preliminary NZX inquiry showed that Access was unable to meet its obligations under the NZX Participant Rules regarding client funds and that the company was insolvent. It was estimated that Access was in deficit by approximately $3.7 million and that the Access client trust account was in deficit by approximately $4.8 million. The Commission understands that the difference was made up by securities to the value of approximately $1 million that Access held on behalf of clients.
  3. NZX's preliminary inquiry, conducted over the weekend of 4 and 5 September 2004, identified evidence to suggest that funds had been transferred from the Access client funds account into the Access operating account and that these funds were being used to meet Access' operating costs. The client funds account was required to be a trust account under the NZX Participant Rules so that client funds would be separate to Access' funds. The only authorised deductions from the client funds account (other than client trading) were reimbursing the participant for amounts paid in settling trades on behalf of clients, and the payment of brokerage fees and other permitted charges for the trades undertaken.
  4. Over the weekend of 4 and 5 September NZX advised the Ministry of Economic Development, the Securities Commission, and the Serious Fraud Office.
  5. On 5 September 2004 the Registrar of Companies appointed inspectors under the Corporations (Investigation and Management) Act 1989 to assess the situation at Access. Following discussions between the Registrar and NZX, an application was made by NZX on the morning of 6 September to place Access in interim liquidation. Michael Stiassny and Brendon Gibson of Ferrier Hodgson & Co were appointed as interim liquidators of Access by the High Court under section 246 of the Companies Act 1993.
  6. On 6 September 2004, NZX Regulation declared Access a "Defaulter" under the NZX Participant Rules and suspended Access as an NZX Firm from trading in any market provided by NZX. NZX announced that it was conducting an inquiry into all aspects of the Access matter.
  7. On the same day NZX established a helpline for Access clients and published information relating to the matter on the NZX website.
  8. On 8 September 2004, Access was placed into liquidation by a special resolution of its shareholders under section 241(2)(a) of the Companies Act 1993, at which time Mr Stiassny and Mr Gibson were appointed the Joint and Several Liquidators of Access.
  9. On 15 September 2004 the Bank of New Zealand announced that it would underwrite the $4.8 million shortfall in the Access trust account. NZX announced that it would pay out $460,000 from its Fidelity Fund.
  10. The Commission supports the steps taken by NZX in conjunction with the Registrar when the Access situation became known. This prompt and appropriate action minimised harm to the market and Access' clients.

Matters following the collapse of Access

  1. On 8 September 2004, the Commission informed the Chairman of NZX that it would undertake an inquiry into the matter and that the focus of the Commission's inquiry would be on the regulatory and market issues arising from the Access situation, rather than on specific events at Access.
  2. The Commission advised NZX of the scope of the Commission's inquiry on 1 October 2004. Consistent with New Zealand's co-regulatory arrangements, the Commission advised NZX that it considered it appropriate for NZX, as front line regulator, to continue to investigate and take action in respect of any breaches of its Conduct Rules. The Commission also considered it appropriate for NZX to review its Conduct Rules and their application as these related to participant supervision and inspection.
  3. An investigation by NZX was underway to examine the circumstances that led to the collapse of Access and whether Access or any of its personnel had breached the Participant Rules. Chartered Accountants KPMG and law firm Russell McVeagh were engaged to assist NZX with this investigation.
  4. KPMG was engaged by NZX to carry out work in relation to NZX's compliance programme to enable the NZX Board to assess whether any changes should be made to its compliance rules, procedures or practices. The Commission understands this work was put on hold once the Commission began its inquiry.
  5. NZX advised that it was also conducting a review of all NZX Firms' client funds accounting practices to determine whether there was a wider problem in relation to compliance with the NZX client fund accounting rules. Grant Thornton, Chartered Accountants, were engaged to conduct this review.
  6. NZX agreed to provide the Commission with reports on the work it was undertaking and to update the Commission on progress.
  7. The Commission advised NZX that its preference in relation to aspects of the Commission's own inquiry was to make use of evidence being gathered through the work of NZX and its external consultants where the Commission could be satisfied with the methodology and scope of the work, and with the Commission's ability to obtain unrestricted access to the results of the work. In February 2005 the Commission was given a copy of a draft report prepared for NZX by Grant Thornton, reporting on its assessment of client fund accounting practices at NZX Participant Firms. At the same time the Commission was advised that for various reasons NZX was unable to put a firm timetable on its intended assessment of its broker compliance programme. It became apparent to the Commission that the timeframe for the NZX work programme would be likely to extend beyond that which the Commission considered appropriate to complete its inquiry in a timely manner. Accordingly the Commission decided it should gather evidence itself to allow it to assess the rules, procedures, and practices relating to participant supervision and inspection by NZX, with reference to the performance of these functions in relation to Access.
  8. On 14 April 2005, NZX filed a Statement of Case with NZX Discipline relating to breaches of the Participant Rules against Access and Mr Marshall. This proceeding is ongoing.
  9. On 10 May 2005, the Serious Fraud Office announced that the Chief Executive Officer of Access, Mr Peter Marshall, had been charged with 13 counts of false accounting and two counts of making a false statement as an officer of Access. Given the Commission's functions and the scope of our inquiry, we do not comment further in this report on any matters relating to compliance by Access and its principal with the NZX Participant Rules, or on matters pertaining to the charges laid against Mr Marshall.
  10. On 12 September 2005 the BNZ and Ferrier Hodgson started legal proceedings in the High Court against NZX and Deloitte seeking recovery of money paid out by the BNZ to Access clients following Access' collapse. NZX has said it denies liability. The Commission's inquiry concerns the performance by NZX as a registered exchange in the context of the Commission's function to review and comment on activities relating to securities and securities markets, and accordingly the Commission does not comment on whether any legal liability arises or can arise from NZX's position as a registered exchange.

PART III - NZX REGULATORY STRUCTURE AND COMPLIANCE STRATEGY

Demutualisation and listing of NZX

  1. Prior to 2002 the New Zealand Stock Exchange (NZSE) was a mutual organisation owned by its members (the broking firms), established under the Sharebrokers Amendment Act 1981 as the successor of the Stock Exchange Association of New Zealand and the Auckland, Wellington, Christchurch-Invercargill, and Dunedin stock exchanges. In 2002, the members of the New Zealand Stock Exchange voted in favour of a demutualisation proposal. On 31 December 2002, NZSE became a limited liability company, NZSE Limited. Former members of NZSE were each issued with 10,000 shares in the new company.
  2. Mr Mark Weldon was appointed as Chief Executive Officer of NZSE Limited in June 2002. In May 2003 NZSE Limited changed its name to New Zealand Exchange Limited (NZX). Its markets were re-branded as the NZSX Market, the NZAX Market and the NZDX Market. NZX listed on the NZSX Market and its securities were quoted in June 2003.
  3. NZX is a registered exchange under the Securities Markets Act 1988. As a registered exchange NZX must have Conduct Rules (Listing Rules and Business Rules, the latter now called Participant Rules) approved by the Governor-General by Order in Council, on the recommendation of the Minister of Commerce. The Minister of Commerce must recommend the approval of the Rules, unless the Minister is satisfied that it is not in the public interest to do so, and must seek the advice of the Commission in determining whether or not to recommend that the Conduct Rules be approved.
  4. Section 36G of the Securities Markets Act 1988 says that NZX must operate each of its securities markets in accordance with approved conduct 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. The Securities Markets Act recognises that New Zealand's securities markets are regulated under a co-regulatory regime. This regime gives a registered exchange the task of operating its markets in accordance with its listing and business rules. In the Commission's opinion, this also requires a registered exchange to have in place measures by which it can monitor and secure compliance with those rules by market participants, in effect providing for the registered exchange to be the front line regulator of its own markets.

Changes to regulatory framework and restructuring at NZX

  1. In 2002, following demutualisation, the NZSE Business Rules came into effect under the New Zealand Stock Exchange Restructuring Act 2002. The NZSE Business Rules modernised the New Zealand Stock Exchange Rules and adapted them to reflect the changes to NZSE brought about by demutualisation.
  2. Certain amendments to the NZSE Business Rules were made in 2003, to a large extent to reflect the re-branding of NZSE as NZX. These Business Rules remained in effect until the NZX Participant Rules came into effect in May 2004.

The Business Rules

  1. At the time of the Access inspection, the compliance requirements for brokers were contained in three main documents:
    1. the NZSE Business Rules;
    2. the NZSE Regulations; and
    1. the NZSE Code of Practice.
  2. Broking firms were required to comply with "good stock broking practice". Good stock broking practice required "complying with the spirit and intent of the practices, procedures and requirements". Conduct had to be "consistent with the wider interests of fair and orderly securities markets". The Business Rules also required compliance with the matters specified in the NZSE Regulations which included the areas of client funds and liquid capital.
  3. Under the Business Rules the NZX Board was required to appoint one or more individuals as an inspector. Prior to 2002, the Business Rules required the inspector to be a chartered accountant in public practice. This was changed in 2002 so that more than one person could be appointed, and that person did not have to be a chartered accountant, but a person who the Board considered to have suitable qualifications and experience.
  4. Until 2003 the chartered accountants Deloitte Touche Tohmatsu ("Deloitte") and its predecessor firms were appointed by the NZX Board as the NZX-appointed inspector.

Deloitte involvement with inspections

  1. Until compliance work was commenced in-house in 2003, Deloitte had had a long-standing engagement as the NZSE-appointed broker inspectors. The Commission was told that this arrangement had been in place for around 40 years. Inspections were carried out by Deloitte on behalf of NZSE under the NZSE Regulations and the Business Rules.
  2. The Deloitte broker compliance monitoring comprised:
    1. a monthly summary to the NZSE Board (regarding the financial adequacy of firms);
    2. inspections of each broking firm; and
    1. spot checks, as and when requested by the NZSE Board.
  3. Deloitte was engaged to conduct inspections for NZX under Rule 23.2 of the NZSE Business Rules until March 2003.
  4. The Commission was advised by both Deloitte and NZX that, due to the long-standing nature of the engagement, no terms of engagement were available to be examined by the Commission. No terms of engagement appear to exist. Under the Business Rules the inspector had various powers to obtain information, records, and explanations from NZX firms. Each NZX firm was required under the Business Rules to satisfy the inspector that:
    1. its accounts and related subsidiary records are being maintained in a satisfactory and systematic manner and are being kept regularly up to date; and
    2. it has in place reasonable internal systems and checks, both in respect of the activities of employees able to initiate and control securities transactions and also in respect of Principals, partners, shareholders, and directors.
  5. For the purpose of ensuring that each NZX Firm was complying with this requirement to satisfy the inspector of the matters set out above, the NZSE Regulations set out certain duties and powers of an inspector, including:
    1. to inspect the separate accounting and internal control records of every NZX firm at least once each year to determine if NZX firms were carrying out their duties under the Regulations;
    2. to review each firm's procedures relating to reconciliations, internal systems and management of portfolios to become satisfied that the Regulations were in all respects being complied with; and
    1. to carry out sample verification (based on audit procedures) of clients' accounts.
  6. As no terms of engagement were able to be produced by either NZX or Deloitte, the Commission does not know precisely what Deloitte was instructed to do by NZX under its appointment as inspector.
  7. Deloitte prepared a monthly Inspector's Report summarising its inspection findings. The monthly report was sent to Mr Bill Foster, formerly managing director of NZSE, and tabled at Board meetings. The report was later sent to Mr Weldon. The Inspector's Report did not name individual brokers but identified them by region, e.g. "a metropolitan Auckland broker" or by type, e.g. "an institutional broker". Where matters were identified relating to broker compliance, these were reported on by the number of occurrences. The Commission received evidence from Mr Weldon and Mr Allen that this related to the pre-demutualisation environment where information for the Board would not name individual firms. The Deloitte monthly reports were brief and contained generalised information.
  8. The Commission understands that Deloitte inspected each NZSE firm. Deloitte would then prepare an inspection report and send it to the broking firm. The inspection report raised issues that had been identified during the inspection. The Inspection Report for each firm was also sent to Mr Foster of NZSE (and later to Mr Weldon).
  9. The Commission received the annual inspection reports for Access for the years 2000 and 2001. The 2000 report does not set out what work was undertaken, but concluded that the overall standard of control and record keeping was good. The report noted some shortcomings. The 2001 report records that Deloitte reviewed compliance with:
    1. Rules 23.3 (inspector to be satisfied of maintenance of records) and 23.4 (inspector to be satisfied of internal systems) of the NZSE Rules; and
    2. compliance with the NZSE Regulations.
  10. The 2001 report contains comments under the following headings: documentation of accounting system and internal controls, capital adequacy and monthly returns, know your client procedures, and maintenance of client funds.
  11. Under the heading Maintenance of Client Funds the 2001 Inspection Report notes that regulations 4(1)(g-i) and 17 set out the requirements for member firms in relation to the maintenance of client funds and managed portfolios. The report records that the inspector was satisfied these regulations were being met. No further information or analysis was provided in the report.
  12. The Commission received documentary evidence from Deloitte that Mr Foster had raised certain issues with Deloitte about the monthly reporting requirements for brokers, training for brokerage staff and training for Deloitte inspectors. The Commission did not receive any evidence that NZX gave Deloitte any other instruction in terms of the focus or scope of the broker inspection work. The Commission received evidence from Mr Weldon that the focus of Deloitte's inspection process was narrow in scope and inspected financial aspects only.
  13. Mr Weldon gave evidence that NZX had no reason to believe that Deloitte was under- performing. The Commission heard evidence from Mr Allen that NZX did not have any particular evidence to suggest that the adequacy of Deloitte's work was an issue. Mr Allen gave evidence that Deloitte took the work seriously. He would expect any "problem broker" identified by Deloitte to be raised at Board level by the CEO.
  14. The Commission received documentary evidence that Deloitte's inspection function covered 40 NZSE Firms. Deloitte was paid by NZX on the basis of services discharged. From the evidence it has received, the Commission understands that near the end of its engagement Deloitte's total charges for conducting the inspection work were approximately $81,000 per annum.

Inspection function brought in-house

  1. NZX has told the Commission that demutualisation led to a shift in strategic focus for NZSE Limited, and that the regulatory function was of key strategic importance in terms of building a strong reputation for New Zealand capital markets and improving the NZSE structures and rules.
  2. The Commission received written evidence from Mr Weldon regarding how the Board viewed the regulatory function:

The regulatory function is of central strategic importance to NZX. Commercial activities springboard off the core regulatory function. Damage to the reputation of NZX as a regulator is our single greatest fear, and the driving force, of the NZX Board. A strong reputation will, we believe, give New Zealand capital markets (and New Zealand companies) the best chance of becoming successful on an international scale...The regulatory function for NZX is a quality mark...

  1. Mr Allen in his evidence said:

The regulatory function is of utmost importance to NZX. From NZX's point of view, the success of the market, and therefore the success of NZX as a company, is driven by investor confidence in the market and company confidence in the market. Both of these drivers essentially depend on the existence of a well-run regulatory environment.

  1. In 2002, the NZX Board assessed whether to bring the broker inspection function in-house. A high level broker surveillance and inspection plan was presented to the Board in 2002. This included a report from NZX staff who had accompanied Deloitte inspectors in their work. The conclusion was that a more comprehensive compliance programme was required.
  2. Mr Weldon recommended to the Board that the broker compliance model be brought in-house. Mr Weldon told the Commission that in deciding whether to bring the compliance function in-house, NZX considered factors including:
    1. widening the function. The scope of the Rules was wider than the function Deloitte was performing and NZX considered compliance should align with the Rules;
    2. NZX wanted the benefit of the knowledge in-house about the brokerages and the compliance framework. The out-sourced model meant there was not readily available institutional knowledge within NZX about what was happening at the firms. NZX considered compliance a core competency of a regulator;
    1. in a crisis it was considered important in terms of risk response to have people on hand immediately to deal with the situation and deliver a better result;
    1. NZX was not aware of any other exchange that outsourced the compliance function;
    2. NZX wanted firms to be better post-inspection and to create change in the industry; and
    3. feedback from Ms Baker and Mr Rodrigues based on accompanying Deloitte inspectors on inspections.
  3. Mr Allen gave evidence that the Board had discussions around bringing the compliance function in-house:

There was a fair bit of rigour around what was going to be done when it came in-house.

  1. The Board decided to cease using Deloitte as the NZX-appointed inspector. Deloitte's engagement as external inspector was terminated by NZX in March 2003.
  2. Mr Allen gave evidence that NZX went back to first principles in developing its compliance framework. NZX felt it needed to change from a low-cost model to spending more money on education of market participants and establishing the right processes. Mr Allen gave evidence that NZX considered it important to build up knowledge within NZX to carry out compliance work. It was the Chief Executive Officer's responsibility to implement the in-house compliance function.
  3. As a result of this decision, NZX's in-house inspection programme was in a state of development throughout 2003 and 2004. The NZSE Corporate Strategy 2003-2007 details in relation to broker surveillance and compliance that:

Accurate and firm broker surveillance, backed by appropriate investigation and enforcement, is critical to the NZSE brand, market integrity and to developing investor confidence...we will institute a rigorous market surveillance and a broker dealer compliance programme...it is a more robust and comprehensive broker audit programme than that provided by Deloitte...an internal Broker Compliance Team will be established to support the execution of the programme...

PART III - NZX REGULATORY STRUCTURE AND COMPLIANCE STRATEGY Cntd.

Comment

  1. The evidence the Commission has received in this inquiry, and its own observations since 2002, indicate that NZX has, since demutualisation, increased its efforts in market compliance and as a result brokers are putting more effort into compliance. The Commission considers this to be a positive step, and a key part of NZX's function as a registered exchange.
  2. Under the Business Rules the obligation to appoint inspectors lay with the Board. Until 2003 the Board appointed Deloitte as its inspector. It is unclear to what extent NZX monitored the inspector's performance. In the absence of any terms of engagement for the Deloitte work and any evidence of specific issues being raised by NZX regarding the scope or performance of the inspection work, the Commission accepts that NZX was satisfied with the inspection work carried out by Deloitte, within the terms of what was clearly a very limited mandate. The focus of the Deloitte reporting was on liquid capital. However, the Commission doubts that a board would have derived anything but very limited benefit from the information contained in the Deloitte monthly reports. The inspection reports for a firm, provided to the Managing Director of NZX, contained little or no detail of the work that had been undertaken by the inspectors. The Commission doubts that the NZX Board would have been in a position to adequately assess the compliance of individual brokers, or the broking community more widely, from the information provided under its arrangement with Deloitte.
  3. In view of NZX's role as a front line regulator of its securities markets, the Commission supports NZX's decision to develop capability in-house to carry out its compliance role. The Commission considers the decision to do this demonstrated an increasing focus on broker compliance at NZX.

In-house broker compliance strategy

  1. The Corporate Strategy 2003-2007 detailed the requirements for the broker compliance function including the personnel requirements (in terms of number and expertise) needed to perform the function of broker compliance and the anticipated resource demands on executive management that the compliance function would involve. According to the Corporate Strategy the compliance programme would require:
    1. one full time surveillance executive;
    2. one lawyer dedicated to complaints investigation, broker dealer rules and policy;
    1. two compliance officers (one with expertise in accounting and auditing, the second with expertise in systems compliance). The compliance officers would conduct inspections and be familiar with broker dealer policies and practices;
    1. one senior person to co-ordinate and integrate compliance, surveillance, investigations and enforcement expertise and processes.
  2. Additionally, the resources of executive management would be needed. It was anticipated 5-15% of the time of the CEO (Mr Weldon), Market Development Manager (at the time Mr Brown) and General Counsel (at the time Ms Campbell) would need to be dedicated to broker compliance.
  3. Certain changes were required to the Business Rules in relation to the complaints procedures to accommodate changes to the broker compliance framework. NZX Discipline was established in 2004 as an independent body able to hear and decide on alleged breaches of both Listing Rules and Business Rules. NZX Discipline does not oversee or supervise the work of NZX staff involved in carrying out the compliance and other regulatory work of the NZX.

Composition of broker compliance team

  1. When established in 2002 the NZX compliance team had two inspectors - Ms Baker and Mr Rodrigues. A third inspector, Ms Koekemoer, joined the compliance team in April 2003. The team was supervised firstly by Mr Brown and later by Ms Campbell. In August 2003, at the time of the Access inspection, the team comprised these people, with support for the team from a surveillance executive and an in-house NZX lawyer.
  2. Mr Weldon was accountable for making the decisions about how many team members the compliance team would comprise.
  3. Compliance team personnel were recruited based on their skills and overseas exchange knowledge and experience, including experience with broker inspections (although not inspections under the NZX Rules).
  4. When asked who determined what NZX required in terms of the composition and skills of the compliance team, Mr Weldon gave evidence that NZX looked at the requirements of the Rules and mapped skills and competencies of the people to the content of the Rules. NZX also considered how many broking firms were in the New Zealand market.
  5. The supervisor of the compliance team until September 2003 was Mr Brown. Mr Weldon gave evidence that he was chosen for this task because of his broking industry experience, experience as a Managing Principal of an NZSE Firm and experience as a former Board Member of NZSE. Mr Weldon's evidence was that NZX felt that this experience would enable Mr Brown to quickly understand issues that were escalated to him and to appropriately determine how to respond to these. Mr Brown was a member of the NZX Executive Team, and was Head of Market Development at NZX during 2002 and 2003. As a former member of the NZSE Board Mr Brown had received Deloitte inspection reports. He had also had to produce liquid capital reports for NZSE Inspectors when he was Managing Principal of Fay Richwhite Equities. He did not otherwise have experience in compliance work or in supervising a compliance team.
  6. Ms Baker was considered by Mr Weldon to be the inspection team leader, reporting to Mr Brown. Ms Baker was a long-term NZX employee, having joined NZSE in 1986. The Commission was told that there was no job description available for Ms Baker prior to her involvement in the compliance team. Ms Baker's previous expertise appears to have been in technology systems. Through her NZSE and NZX roles Ms Baker had developed working relationships with many participants in the broking industry. She initially worked in the technology division of NZSE and was involved with the development of the FASTER system. She acted as liaison person between the market and NZSE. Ms Baker moved into the market relations team and broker compliance in 2002. However, Ms Baker did not have any experience in relation to broker compliance, as the NZX broker compliance function had been outsourced to Deloitte. Ms Baker did not have any relevant academic qualifications, had not previously led a team at NZX, and did not have experience in leading an inspection team.
  7. In his written evidence to the Commission Mr Weldon gave evidence that NZX had confidence in Ms Baker as the operational manager of the team:

Noone questioned Barbara's ability to spot issues which ought to be of concern to NZX, and to raise them with the appropriate staff members.

She had abilities in terms of knowledge of the market, the participants, the Business Rules and technological background. She was to be looked to by the other team members for leadership and guidance.

  1. Mr Rodrigues was responsible for the financial aspects of the NZX broker compliance role, including compliance with the liquid capital requirements and client fund accounting. Mr Rodrigues has graduate and post-graduate degrees in accounting from India. Before moving to New Zealand he had approximately four years of broker inspection and compliance experience with the National Exchange in India following his graduation from university. His work with the Indian National Exchange included conducting and leading broker inspections. He started with the title of Officer reporting to a Senior Officer. He was later promoted to the position of Senior Officer reporting to an Assistant Manager, who in turn reported to a Manager. Mr Rodrigues conducted 25-30 inspections and was later senior lead inspector on approximately ten inspections. He also trained more junior staff. Mr Rodrigues had experience with broker inspections within the Indian National Exchange's framework but did not have any exposure to the NZX broker compliance rules prior to joining the NZX broker compliance team.
  2. Ms Koekemoer was responsible for business conduct, technology and information technology systems in relation to NZX broker compliance. Her expertise was in information technology systems. Her previous work experience includes five-and-a-half years with the Johannesburg Stock Exchange in South Africa. She had sat compliance exams at that exchange but had not worked in a compliance role.

Implementation of broker compliance programme

  1. Once the Board had decided to undertake broker inspections and compliance work in-house, it was given to the broker compliance team to develop a compliance programme. Mr Weldon told the Commission that:

A
The brief was to develop, as you would expect, to develop a compliance model that delivered the best outcome for the New Zealand market.
Q.
And there was no more specification than that?
A.
...there were a lot of meetings and a lot of problem solving around the details of what we might want to accomplish and how we might go about it. Sometimes this was in a full team, sometimes I met with Philip individually for example when he was working on particular things...
Q.
...did you give any written brief, written specifications, to Barbara and the team about what...how it should be developed and what the model should be?
A.
No, it's not the way it generally works for me to write down instructions; we will have a kick-off meeting and we will iterate especially as we're developing something new.

  1. In July 2002 the NZSE Board made a decision to review the broker inspection programme conducted by Deloitte. In August 2002 Ms Baker developed a broker compliance plan at Mr Weldon's request. The draft plan was provided to Mr Weldon and Mr Brown for review. Comments on the compliance plan were provided to Ms Baker. Ms Baker gave evidence that she referred to her particular previous experience with a serious broker situation, corporate governance programmes, international accounting websites, risk management websites and a number of international standard setting bodies such as IOSCO in assessing what she thought were the compliance issues for New Zealand. She gave evidence that, drawing on these references, "I just tried to pull what I could together".
  2. The compliance plan was further formulated later in 2002 from discussions between Ms Baker, Mr Rodrigues and Mr Brown and from their market knowledge and understanding. It was also formulated from Mr Rodrigues' knowledge of broking businesses and internal auditing, visits to broking firms, and from Ms Baker's knowledge.
  3. Generally, Ms Baker and Mr Brown would reach conclusions and make recommendations to Mr Weldon about the design of the compliance programme.
  4. In February 2003 the Detailed Corporate Strategy 2003-2007 went to the Board. The compliance plan was attached to this document. NZX told the Commission that the final version of the compliance programme was submitted to the CEO and Board for approval. The compliance plan does not appear to have been referred to the Board again at any time after February 2003.
  5. The compliance plan that was submitted to the CEO and Board for approval set out (among other things) high level risk areas to be addressed through inspections, and a more detailed template Broker Inspection Report. This template contained a series of questions that it appears were to be answered in the course of an inspection, but it does not set out the procedures by which inspectors would satisfy themselves of the matters contained in the report.
  6. Mr Weldon gave evidence that he was satisfied the compliance team was implementing the programme that had been developed due to the experience and knowledge of Ms Baker and Mr Brown.
  7. Ms Baker gave evidence that the Compliance Working Group was consulted in relation to the inspection process. Ms Baker told the Commission that this Group comprised compliance, operational and financial officers from the broking industry. It was consulted in the development of the broker inspection programme, particularly in relation to identification of market risks.
  8. Ms Baker gave evidence that a broker compliance plan was developed with details about how inspections would be conducted. Ms Baker gave evidence that the Deloitte inspection programme was used as a starting point and the scope was widened. The Commission was provided with documents that were used by Deloitte and NZX as inspection work programmes. NZX informed the Commission that the NZSE's initial work programme was based on the Deloitte work programme. This NZSE initial work programme was similar to the Deloitte work programme and contained the same questions relating to client funds accounts. The Commission was also provided with a document entitled Compliance Guidelines. NZX told the Commission that this was part of the initial inspection programme prepared by Ms Baker and the compliance team. This document sets out instructions for inspectors to follow in the course of inspections. It refers to the requirements of the Regulations. Some references to the Regulations are followed by a list of tests or questions that appear to be for inspectors to conduct or to ask of brokers. Other areas of the document, including the section regarding client funds accounts, do not refer to any particular tests or questions.
  9. In August 2003 the compliance team wrote draft objectives for the first 12 months of the NZX broker compliance programme. The key objectives as stated were: for firms to have a clear understanding of the Rules so that NZX could enforce them with certainty; to inspect all NZX Firms and ensure that the compliance team had a clear understanding of brokers businesses and the risks to be assessed; and to create a compliance manual documenting the internal processes for the compliance team to use. NZX told the Commission that these were "put to Mr Weldon but never signed off as formal objectives". The Commission also heard from an NZX employee that the first two years' work enabled NZX to build up a risk profile of its Participant Firms, to enable it to better focus compliance efforts in the future. The Commission heard that the early inspections involved a tension between taking action on matters that were found and getting to all the firms to develop the risk profile.
  10. The NZX inspectors conducted four initial inspections of broking firms in 2003. All three inspectors attended these inspections. Significant issues were identified in the case of one broker. That broker had no process in place for daily reconciliation of the client funds account and the inspectors identified issues with the segregation of client funds. The inspectors also identified capital adequacy issues. Due to the combination of capital adequacy and client funds reconciliation issues the broker was put on a daily reporting regime. The broker reported daily, and the inspectors worked with the broker to remedy the identified issues.
  11. Following the first four inspections the compliance team started to produce reports on the internal processes of the four brokerages. Production of these reports involved significant time and resources. The compliance team moved to template-based reporting for future inspections.
  12. The inspectors developed a document called a Request for Information ("RFI"). This was a standard form template document setting out the information NZX required to conduct an inspection. The RFI required brokers to provide certain information to NZX for consideration and analysis prior to an on-site inspection of the broker. The RFI also specified the information that was to be made available to inspectors by the broker during the on-site inspection visit. The NZX compliance team developed the RFI in order to conduct inspections more efficiently and to reduce the time spent on-site at the broking firm by identifying issues in advance.
  13. The RFI provides guidance about what would be covered by an inspection. Neither this nor any other document that has been provided to the Commission sets out procedures for how NZX inspectors were to conduct an inspection. Ms Baker gave evidence to the Commission that no manual for inspectors was developed.

I wanted an internal compliance manual. I mean, you can go out and you can do inspections, but it's not worth a lot if you haven't in-sourced the knowledge, and in order to in-source the knowledge properly you must record it. So, the concept of involving a compliance manual with all the various processes documented, to me, was actually quite important, but that was something that we were just too busy; it continually got moved down to the bottom of the deliverables list, the whole document...everything to do with documentation did...

  1. NZX told the Commission that its focus was on doing the on-site inspections:

Development of an internal compliance manual was deemed to be of less importance than actually getting out and doing on-site inspections. NZX deemed "time to market" as the most important criterion...the programme had to start before we could understand how to make it the best possible...

  1. Informal updates on the progress of each on-site inspection were given to Mr Brown.
  2. Following each inspection the inspectors' prepared a draft report and sent a copy of this to the broker for comment before the document was finalised. The compliance team entered their inspection findings into the Risk Management and Compliance template document. The document comprised five parts:
    1. inspection purpose;
    2. executive summary;
    1. scope and objectives of inspection;
    1. recommendations; and
    2. inspection observations and risk assessments.
  3. Once comments had been received from the broker the report would be settled and delivered to the broker, including recommendations for action where breaches of the Rules had been found and where firm procedures did not meet "best practice" standards.
  4. The regular reporting work that brokerages were required to do, such as monthly reporting of liquid capital and reporting on internal controls, used templates created by Deloitte. Each compliance team member would analyse the information that was in their area of expertise. The compliance team also created templates in relation to their findings from the firms' reporting.

PART III - NZX REGULATORY STRUCTURE AND COMPLIANCE STRATEGY Cntd.

NZX internal reporting lines

  1. Supervision of the compliance team was initially assigned to Mr Brown due to his broking experience and his experience on the NZSE Board. At the time Mr Brown was also Head of Market Development. Ms Baker was viewed by Mr Weldon as the operational manager of the team. Mr Weldon viewed her seniority as important in terms of her capability to escalate necessary issues. Ms Baker was not a member of the NZX executive management team. The Commission received evidence from Mr Weldon that the effective functioning of the team lay with Ms Baker:

She was unequivocally and without doubt the operational leader of that team...it was very very clear, both in operation, both from Philip and Lynda's perspective and from instruction to Barbara that she was responsible for the management of that team on an operational basis.

  1. Mr Brown gave evidence that:

Barbara was clearly the manager of that unit and that was a unit that I saw very much as her responsibility.

  1. In her evidence to the Commission, Ms Baker said that she did not consider herself a manager of the compliance team. Ms Baker also told the Commission that she was offered the position of Team Leader, but did not accept the terms, and was not formally appointed to that position. Ms Baker told the Commission that she was a contractor, not an employee, and so did not consider herself to be a manager of the team. NZX said on this point that it did not wish to have a contractor in such a senior role. Ms Baker said she considered herself a peer of the other compliance team members, reporting to Mr Brown on Mr Weldon's instruction.
  2. To some extent Ms Baker appears to have been uncertain of her status within the team. However it is apparent from the evidence the Commission received that the other members of the inspection team and management staff regarded Ms Baker as the operational team leader of the inspection team, under the supervision of Mr Brown. Matters tended to be reported first to Ms Baker who would inform Mr Brown.
  3. The Commission was told that there was no formal line reporting responsibility to Ms Baker. The job descriptions for Ms Baker, Mr Rodrigues and Ms Koekemoer show that they all formally reported to Mr Brown.
  4. Ms Campbell assumed supervision of the compliance team from Mr Brown at the end of September 2003. Closer association with the NZX legal team was considered desirable as the compliance team members were not legally trained. In addition, the rewrite of the Business Rules was to involve both the compliance team members and the lawyers in the regulatory team. The NZX participant compliance team continues to report to Ms Campbell.
  5. Mr Brown and Ms Campbell each reported directly to Mr Weldon in relation to broker compliance. Mr Weldon reported to the Board.

Reporting to management and reporting expectations

  1. When asked by the Commission about how he saw his role and whether this had been formally communicated to him, Mr Brown said:

A
...I saw my role very much as somebody who was going to be involved in escalations of issues above and beyond what the compliance team would have done on their day-to-day activities.
Q
... That's what you saw as your role?
A
Yes.
Q
Did somebody actually articulate that to you?
A
I'm sure in the establishment of that as a group, and it would only be by way of conversations rather than anything formal, that would be outlined to me, yes.

  1. Mr Brown told the Commission that to the extent that he was involved in issues it was in managing relationships with brokers rather than technical aspects.
  2. Mr Brown received draft inspection reports and gave comments back to the compliance team. Mr Brown confirmed that he was to act as "a filter" for issues that needed to be brought to the attention of Mr Weldon. The Commission heard from Mr Brown that there were no specific requirements around the types of issues that needed elevation to Mr Weldon. He would raise issues to Mr Weldon if he considered an issue sufficiently serious.
  3. Despite his role as a filter for issues, it appears that Mr Brown relied heavily on Ms Baker.

    He told the Commission:

Where I would raise issues with Mark is where I felt there was something of significant importance and I would rely on Barbara to identify those for me....

...I very much regarded Barbara as the person who made those decisions for which I signed off, you know rather than me having any major influence in determining - you know, I wasn't part of the inspection process, so I didn't know what they'd seen. All I was really looking at was identifying those as issues, agreeing with the priorities she had attached to them, and then looking at the timeframe in which they would be resolved.

  1. This also seems to have been the experience of members of the inspection team. Mr Rodrigues told the Commission:

...I think the reporting was to Barbara, because...one or two times I did try to take matters to Geoff [Brown] where he said that you can probably discuss it with Barbara first.

  1. Mr Weldon had established a management team of eight people when he joined NZX. The NZX management team met weekly to discuss issues. The Commission received evidence from Ms Campbell that where issues were raised with him, Mr Weldon would usually comment on the resolution of those issues, although he would generally follow her lead on NZX Regulation. Mr Weldon confirmed in his evidence that he would always provide input but would generally defer to Ms Campbell's judgement on operational matters within her expertise and that of her team.
  2. The Commission received evidence that each manager holds weekly meetings with their direct reports. The Commission received evidence that weekly compliance team meetings were held. The meetings were attended by the compliance team members and Mr Brown. Later Ms Campbell attended the meetings. At that time Ms Baker stopped attending. Inspection issues would be discussed at these meetings, and work scheduling and priorities established.
  3. Mr Rodrigues gave evidence that he regularly attempted to bring issues to the attention of Mr Brown and to keep the other compliance team members informed of developments with issues that he saw arising out of inspections. Issues tended to be communicated to Mr Brown by way of email correspondence. Many emails were copied to Ms Campbell. Some were copied to Mr Weldon. Emails were also copied to the general compliance email distribution list to which the compliance team members had access. The Commission has seen little evidence of responses to issues raised in emails, but was informed that issues were discussed at the weekly compliance team meetings. The Commission received evidence that deliverables lists were prepared and updated to track progress on inspections and record the actions to be taken.
  4. Draft inspection reports were sent to NZX managers with responsibilities in respect of the compliance team. These were commented on prior to being sent out to the broking firms. However the compliance team received limited feedback from management on certain other information that they produced. The Commission was told by Mr Rodrigues that the compliance team reported to managers of the compliance team on the liquid capital information they had received from brokers to see if management had a view on how the compliance team should address issues. Mr Rodrigues said that while the liquid capital information was received by management, there was little feedback.
  5. Given this situation, the compliance team continued preparing and sending the liquid capital information and tried to work on their own to deal with matters. When asked if the level of feedback caused him any concerns, Mr Rodrigues said:

...what concerned me is that...I'm preparing all these figures all the time...I'm giving all these figures to everyone all the time and... if I have missed something, someone else will pick it up. But..., it did not happen that way.

  1. NZX told the Commission that escalating an issue to NZX management is done by voicemail, telephone call, or face-to-face conversation:

It is understandable that the Commission has not seen evidence of responses to issues raised in emails. This is because raising an issue by email at NZX is not a request for a response.

  1. Issues arising from on-site inspections that the compliance team considered required further attention were raised with Mr Brown by exception based reports. Mr Brown gave evidence that he would discuss with the compliance team what had happened and explain what was required to be done in those instances. Mr Brown gave evidence that he monitored issues by receiving further reports. Ms Baker gave evidence that, when away from Wellington, her practice was to call Mr Brown from broking firms' offices if particular issues arose in the course of an on-site inspection or if she found deficiencies or had particular concerns that she thought needed his consideration or input at that time. When Ms Baker attended on-site inspections in Wellington she reported to Mr Brown on her return from the brokers' offices.
  2. Mr Weldon's evidence was that NZX has clear internal procedures for escalation and that these are well understood. He gave evidence that the process for engaging executives on issues is also well understood. When asked about the level of discretion that the compliance team had in dealing with matters, Mr Weldon gave evidence that it was known throughout NZX that there were three main levels of reporting - matters that require escalation, matters that need to be reported and communicated, and matters that are communicated for information only.
  3. The Commission received evidence from Ms Baker that an "escalation" template report was developed by the compliance team in July 2003 at the request of Mr Weldon. The purpose of the escalation template was for the compliance team to escalate urgent issues to Mr Weldon, Ms Campbell and Mr Brown. It was to be used by staff individually where an event occurred in their area. The Commission received evidence that no escalation report was prepared in relation to Access.
  4. In his initial written evidence to the Commission Mr Weldon did not appear to be aware of any escalation template. Ms Campbell was also unaware of the escalation template. Mr Weldon wrote:

We do not use any particular template for the escalation of regulatory issues, and I do not recall ever seeing, or approving, such a template.

  1. The Commission later received evidence from Mr Weldon that he had subsequently become aware of the existence of an escalation report template, although it was not something that he ever saw. The Commission received evidence from NZX that the escalation report had been used once in July 2003, by Ms Baker. It was used to elevate an issue regarding unqualified advisors at another brokerage to Mr Weldon and Mr Brown.
  2. The inspection team produced summary spreadsheets of the liquid capital returns and internal control returns submitted monthly to NZX by brokers. The monthly summaries were provided to Ms Baker and Mr Brown. When asked by the Commission if the production of this information was part of a process that had been established, Mr Rodrigues said:

Basically it was on my own initiative because there was no sort of reporting being done...I thought there should be something that keeps a track of how people are keeping their capital so that, in case there's any problems with them we can see from the trends...since we are regulating the business we definitely need to keep track of how all the firms are doing.

  1. The summaries highlighted where actual liquid capital was inadequate or was less than 120% of prescribed liquid capital. The evidence received by the Commission showed that ten broking firms were listed as having actual liquid capital as a percentage of prescribed liquid capital of less than 120% in several of these monthly summaries. Access was listed in two of these. Under the Rules, firms were required to notify NZX immediately if the liquid capital level fell below 120%.
  2. The Commission received evidence from Mr Brown that information regarding liquid capital summaries had been provided to him and kept. The Commission received evidence from Mr Brown that he relied on the compliance team to ensure that brokers were meeting their obligations and expected the compliance team to investigate any issues that arose. He did not provide feedback on the monthly liquid capital reports that he was given. The compliance team was to exercise judgement as to whether explanations provided by broking firms were satisfactory or not satisfactory.
  3. In his evidence, Mr Brown said:

A
I would be guided by what the recommendations were here from the compliance team and from Barbara. Barbara at no stage suggested to me in relation to Access that there was anything in relation to their liquid capital that I needed to be concerned about.
Q
But you as a professional would have looked at these numbers yourself?
A
Yeah.
Q
You were actually supervising Barbara?
A
That's right.
Q
And you did have the opportunity, I presume, to say to her this is a very serious matter?
A
Yes, and I didn't take that opportunity.

  1. The Commission received evidence that Access had, for a number of years, used a methodology for calculating liquid capital that was not consistent with the methodology adopted as a part of the Regulations and as a result had overstated the Liquid Capital. The issue was identified by the compliance team in August 2003, prior to the Access inspection. In August 2003, under the corrected methodology, Access' actual liquid capital was recorded as 38% of prescribed liquid capital. Mr Rodrigues revised the liquid capital information for Access for March to July 2003 under the corrected methodology and provided the realigned figures to Mr Brown.
  2. In his evidence to the Commission Mr Brown was asked whether the liquid capital figure of 38% for Access under the revised methodology raised any questions with him about the ability of the firm to continue in business and take public money.

A
It should have and wasn't incorporated in anything that I got back outside of the stuff from Philip. It's certainly not incorporated in the report that Barbara presented to me for review.
Q
I understand that, but...as a professional...did it not occur to you that one of the most critical aspects of your role was to ask yourself, is this firm capable of still taking in public money and not putting that money at risk?
A
Yep.
Q
And you had information before you which, with a small amount of analysis, would have shown you that this company was at risk and yet somehow you were not alerted or you didn't alert yourself to that; is that correct?
A
Yes, yes.

  1. The Commission received evidence that the issue was followed up by compliance team staff and corrected by Access. Access recorded increased liquidity by also recording its NZX shares as part of its liquid capital calculation (as it was entitled to do under the Rules). Previously this had not been included in the calculation.
  2. The Commission received evidence that Mr Weldon had significant input into reviewing the draft reports for the first four inspections conducted by the in-house compliance team. This level of involvement ceased after the first four inspections. Mr Weldon did not provide any comments to the compliance team on the Access inspection report.
  3. The Commission received evidence from Mr Weldon that he did not read inspection reports as a matter of course but that he did read the report for one broker (not Access) after Ms Baker escalated issues. Mr Weldon gave evidence that he would read written material that personnel provided to him directly for his attention or directed him to read. The Commission received evidence from Mr Weldon that staff and managers at NZX are expected to draw matters to his attention if the materiality of the matter warrants it. Mr Weldon said that everyone at NZX was aware he would not necessarily read internal emails, emails that were copied to him, or attachments to copied emails. Copied emails to him meant "for your information" only. Voicemail was the preferred method of communication for alerting Mr Weldon to issues. Mr Weldon gave evidence that staff had been informed about these communication matters on many occasions.
  4. When asked who was the executive accountable for ensuring that the findings in the inspection report were followed up, Mr Weldon gave evidence that in the first instance this was Ms Baker. Accountability also lay with Mr Brown who was overseeing the compliance team. Ultimate accountability lay with Mr Weldon as CEO. Mr Weldon gave evidence that he would consider it inappropriate if noone on the team had taken any action and followed up the issues at any point of time.

Comment

  1. NZX's new in-house compliance function was still under development at the time of the Access inspection in August 2003. The compliance plan was put to the Board for approval. Development of inspection procedures was largely left to the compliance team, based on what they had seen when accompanying Deloitte, their previous experience, and what information they could acquire from research. None of the team members had experience in leading compliance teams or in designing inspection or audit programmes in the New Zealand context. The Compliance Working Group was consulted on the inspection programme but inspection procedures appear to have largely been developed as inspections were undertaken. These procedures were not documented, and there was no ability for supervisors to assess the methodology designed by the team.
  2. The Commission does not suggest that NZX required a rigid inspection procedure. Such a framework is unlikely to be appropriate, and flexibility in processes will be needed to address specific situations. The conduct of inspections will also be reliant to a degree on the professional judgement of the inspectors. However the Commission is of the view that the NZX inspectors should have had the benefit of clearer procedures, sufficient to provide adequate guidance to the inspectors and a greater level of assurance for supervisors.
  3. Broker compliance was a new task for NZX. There were no staff who had experience in conducting inspections under the NZX Rules. While members of the compliance team had experience with inspections, this appears to have been either indirect (Mr Brown and Ms Baker) or junior to mid-level at overseas exchanges (Ms Koekemoer and Mr Rodrigues). The Commission considers that executive management failed in their management responsibilities in leaving the design of the stock exchange's inspection procedures to these staff members.
  4. Internal reporting procedures for the compliance team were not well established in 2003. The supervisor of the compliance team, Mr Brown, was responsible for identifying and assessing issues that required further elevation. In practice he appears to have relied to a great extent on issues being identified for him. He did not pay sufficient attention to the information that was reported by the inspectors. There was a lack of direction to the team as to how they should keep senior team members apprised of information from brokers. This is seen in Mr Rodrigues' decision to initiate a monthly liquid capital report for Mr Brown. There was a marked lack of attention paid by Mr Brown to information that was reported to him. This is apparent from the lack of reaction to a number of reports that showed Access' liquid capital to be below 120% and a lack of reaction to the information that Access had been using an incorrect methodology and appeared to have liquid capital of only 38%.
  5. In the Commission's view a report identifying that a broker had liquid capital of only 38% should have, on the face of it, raised concerns with NZX management even if the methodology was later corrected and the issue remedied.
  6. NZX told the Commission that:

It is not the role of a manager to review all information gathered by their team. It is the role of a manager to respond to issues which are escalated for their input. There was a clearly understood procedure for escalating issues to management at NZX. Where this procedure was followed, Mr Brown's involvement was forthcoming...

  1. The Commission agrees that it is not the task of management necessarily to review all information gathered by a team. However, it is the role of management to supervise the work of a team. NZX appears to take the view that management's role is essentially passive: to respond to matters put to them using a specific escalation method. The Commission does not agree that this is the role of a supervisor, in particular the supervisor of a team carrying out a function that was new to the exchange at the time. NZX has, in its submissions to the Commission, placed weight on the fact that some important issues were identified in written reports, not by voicemail, NZX's preferred method of identifying material matters. In the Commission's view NZX management should be receptive and responsive to significant information communicated to them by the compliance team, regardless of the method by which this information was communicated.

PART IV - CLIENT FUNDS AND THE ACCESS INSPECTION

  1. This section focuses on client funds because the NZX investigation of Access after the firm's collapse indicated that there was a significant shortfall in the funds that should have been held in the firm's client funds account.

Requirements of the Rules regarding application of client funds

  1. Under the Business Rules and the NZSE Regulations, certain funds had to be held by brokers in a client funds account. The Regulations placed restrictions on the uses to which these funds could be put. The relevant provisions are set out in Appendix B of this report.
  2. The Business Rules defined "client funds account" to mean "a trust account held by an NZSE Firm at a Bank for the benefit of the NZSE Firm's clients for its Outstanding Broker Obligations". Firms were required to hold client funds on trust, and for this purpose to open and maintain a client funds account.
  3. The Rules stated that NZSE Firms:
    1. Must obtain from the Bank holding the Client Funds Account a written acknowledgement of the trust status of the account, and must ensure that the words "Client Funds Account" appear in the title of the Client Funds Account;
    2. Must ensure that Client Funds Accounts are not overdrawn; and
    1. May not use funds in their Client Funds Accounts as security for any obligation of the NZSE Firm, or of any other person.
  4. Firms were required to hold client assets on trust for their clients at all times. Total client assets held by a firm were required to match or exceed the firm's total outstanding broker obligations at all times.
  5. Regulation 3 of the NZSE Regulations 2002 stated the permitted uses of client funds held in brokers' client funds accounts:

3.8
Application of funds: All amounts required to be paid into a Client Funds Account under Regulation 3.6 shall be held upon trust and applied:


(a)
in reimbursing the NZSE Firm for any amount paid by it in settling the purchase of Securities for clients, including the transfer to an intraday same day funds settlement account operated by the NZSE in FASTER for true DVP settlement where it is to be applied to the payment against the transfer of such Securities to the NZSE Firm's Transfer Account;


(b)
in payment to selling clients of the sale price for Securities transferred into the NZSE Firm's Transfer Account by the client;


(c)
in payment to any other person for whom funds have been held in the Client Funds Account; and


(d)
in payment of brokerage and other charges properly payable to the NZSE Firm by its clients for transactions under Regulations 3.8(a) and (b).

Rules versus practice - compliance culture

  1. When NZX decided to establish an in-house compliance function it recognised that there was a need for more resources to be put into the education of market participants in regard to their compliance obligations under the NZX Business Rules. Mr Allen gave evidence that in establishing the compliance function, NZX took the approach that it would not necessarily equate established market practice with good practice:

When we demutualised and we had the regulatory changes and the new regime coming through, that was all part of us saying we're going to treat virtually all the things that are currently done in the New Zealand capital markets as something that we're not going to assume is right just because it's been done that way in the past.

  1. The Commission received evidence that there was discontent among brokers about the NZX inspection programme due to time and cost considerations, and that there was widespread dislike of the NZX compliance programme. Mr Weldon gave evidence that he had been contacted by some managing principals about this:

...the first time that the [Request for Information documents] went out into the market it was like...a whip being cracked...and there was a response of shock and I think there was a response of resistance to change, and clearly this was going to involve cost in terms of time...

  1. The NZX response was to educate the brokers about what it was trying to achieve from the compliance framework in terms of meeting international standards and improving firm regulatory status. Mr Weldon told the Commission that broker resistance did not influence the NZX approach to broker compliance or the implementation of its programme.
  2. Mr Allen said that he received feedback that the compliance function had become "over zealous" in terms of time, costs and resource. Mr Allen gave evidence that he told the compliance team to carry on with the job, and that NZX had given consideration to broker reaction when the compliance regime was introduced.
  3. The Commission received evidence that there was quite widespread non-compliance among brokers with the Rules concerning client funds accounts at the time the compliance programme was established. Mr Brown told the Commission:

...there were a number of areas where market practice differed from the requirements of the regulations and there were a number of areas where - and I give by way of example the firms who regarded it as being acceptable to pay for business expenses out of the client funds account, and I think there were a number of areas where the rules as they currently were stated did not give us sufficient comfort about our ability to inspect organisations...

  1. After the NZX broker compliance programme had been in operation for five months, NZX sent a newsletter to brokers summarising the areas where compliance issues had been identified. In relation to client funds accounting, the newsletter stated:

... lack of procedures to determine the amount of funds needed to be secured in the Client Fund Trust Account", "payment for non-securities related transactions paid from Client Fund Account" and "CFA in overdraft - human errors."

  1. The Commission also asked Mr Rodrigues about market practices:

Q
...I just want to check with you that what's here is your view or if you want to put colour to it, say. "Under the rules it is our understanding that the rules do not prevent...did not prevent a broker from using client fund accounts for any other purpose provided there was enough in the account to satisfy client fund obligations."
A
...That's right, that we picked up from the market practice.
Q
...There is nothing specifically in the rules that says the broker cannot pay his or her phone bill for example for the client funds account?
A
...Yeah, I think so that was our understanding

  1. Mr Brown gave evidence that:

...there were a number of brokers who argued that they could pay business expenses out of the client funds account which is something that I didn't regard as being acceptable practice. So there were things that were occurring within the industry which were not, you know, acceptable to us and not that we regarded as being acceptable...

Training and understanding at NZX in relation to client funds

  1. In the Commission's opinion members of the compliance team did not receive adequate training about the requirements for client trust accounts, or about trust obligations more generally.
  2. The Commission received evidence that the inspectors would discuss their understanding of the Rules with each other. If there was an issue where a broker interpreted the Rules differently, then they would initially look to Ms Baker and Mr Brown and would refer it to an NZX lawyer who was providing support to the compliance team.
  3. The Commission received evidence from Mr Weldon that the design of the inspection framework in relation to client funds was driven by the design of the Rules. The Rules determined what had to be inspected. Mr Weldon was asked:

Q
...Who made the decision as to how to inspect against those rules?
A
...There was not a decision of how to inspect, it was just, there were the rules and there's what you would inspect.
Q
...Okay, so who decided what you would inspect?
A
...I think the rules decided what we would inspect

  1. The Commission asked Mr Weldon how NZX ensured that compliance team members understood the obligations under the Rules and the significance of the client fund accounting requirements. Mr Weldon gave evidence that reliance was placed on the involvement of Mr Brown and Ms Baker, the knowledge within the team and the language of the Rules.

Well, the rules, the English, is pretty simple and those are not difficult accounting concepts. So the way that you ensure is...Geoffrey's been involved in the stuff for a while, Barbara, so it's a matter of what the knowledge is of the team.

  1. Mr Weldon gave evidence that there had been discussions around the nature of the trust aspect, but that in his opinion there was no ambiguity about the need to maintain separation of client funds from firm funds and so no external legal advice was obtained by NZX.
  2. The NZSE Regulations in force in 2003 defined a Client Funds Account as a trust account held by an NZSE Firm at a bank for the benefit of the NZSE Firm's clients. Despite this, it was apparent both that client funds accounts were used for payments of broker expenses beyond what was permitted by the Rules, and that despite Mr Weldon's view that there was no ambiguity, other NZX staff did not appreciate that the use of client funds accounts for the payment of firm expenses was contrary to the Rules. The use of client funds accounts for brokers' own purposes appears to have been seen as a matter of poor practice rather than as a breach of the Rules. Mr Allen, in a submission to the Commission, said he was confident that Mr Rodrigues understood that the payment of firm expenses from the client funds account was not "best practice". Mr Brown gave evidence to the Commission that:

A
...The other issue of paying business expenses out of client funds accounts was not something that we would have expected and yet it seemed to be something that did occur within the broking community.


Q
...you're suggesting, if you like, that there were practices within the broking community?


A
Yes.


Q
Which were clearly contrary to the rules?


A
There was no statement in the rules that said you couldn't pay expenses out of a client funds account.

  1. Mr Rodrigues gave evidence that when he first arrived at NZX he had been surprised to find that brokers were not always keeping client funds separate:

Initially I thought that this shouldn't be happening, but that is the way the market has evolved and we have to probably work over a period of time to get things right...

  1. The Commission asked Mr Rodrigues about his understanding of the obligation to hold client funds on trust under the NZX Rules:

Q
...Was it your understanding at the time that you were doing these inspections that a trust account was required to be maintained by the brokers?


A
Yeah.


Q
Did you have any guidance or understanding within your team at that time about what a trust account actually is?


A
I did try to find out what a trust account is for the securities...as for the securities market was, and I couldn't find. So, we just went by what was being done.


Q
Okay. Did you have any idea at all that a trust account is...means something legally...


A
No. I tried to find out whether it was similar to a solicitors trust account, but I guess after that came to realise that it wasn't, it was different from a solicitors trust account.


Q
And that was based on?


A
Based on my discussions within the compliance team, I think.

  1. Training for the new broker compliance team was on-the-job in nature. Inspection experience in relation to NZSE firms was gained by the compliance team accompanying Deloitte inspectors. Ms Baker and Mr Rodrigues accompanied the Deloitte inspectors as observers on six inspections in 2002 and early 2003 before NZX took over broker inspections on 1 April 2003.
  2. NZX relied on the backgrounds and experience of compliance team members. It did not obtain or provide specific training for these team members. At the time it did not have any existing staff members who were experienced in broker inspections in New Zealand, as this work had always been outsourced by NZX. NZX has noted that there are no formal training opportunities in New Zealand for broker compliance.
  3. Mr Weldon gave evidence that there was an eight month period during which the in-house compliance framework was planned and established. The Commission notes that Ms Koekemoer and Mr Rodrigues conducted six inspections under Ms Baker's supervision. Then an assurance was sought by NZX from Ms Baker and a senior compliance officer at a broking firm that these two members of the inspection team were able to conduct inspections appropriately. Ms Baker told the Commission that she passed on comments from this senior compliance officer that Ms Koekemoer and Mr Rodrigues were robust in their processes and had tested evidence, but denied that she gave any assurance. Ms Baker said that she objected to inspections being carried out by these two inspectors on their own, given they had only undertaken four inspections. On the evidence the Commission has, it appears that Mr Weldon believed that he had this assurance from both Ms Baker and the compliance officer.
  4. The NZX Corporate Strategy set out the personnel requirements for the broker compliance teams. When asked whether the Board had any involvement in setting the size of the team and the required competencies, and whether the Board considered if any training may be necessary, Mr Allen gave evidence that:

..we would have talked about getting it right and having the right competencies but we would not be about setting the job descriptions or the competency descriptions of a team like that...

  1. The Commission asked Mr Weldon if NZX had considered giving the compliance team an opportunity to see the operation of a compliance team in an overseas stock exchange. Mr Weldon indicated that this was not done at the time the compliance team was established.

...it's certainly something we will consider and won't exclude, but we didn't obviously make a decision [to] do it at that point in time.

The Access inspection

  1. The inspection of Access was the seventh broker inspection conducted by the NZX inspectors.
  2. Prior to the on-site inspection, Access was asked to complete an RFI. Access was sent a standard form RFI on 14 July 2003 under cover of a form letter noting:

The objectives of this initial inspection, is to ensure as much as possible, that NZX has all the information to enable and assist all firms to become compliant. To this end, this first visit is as much an information gathering exercise as it is an inspection.

  1. The inspectors assessed the information received from Access in response to the RFI and identified issues for follow up. Certain omissions from the RFI were noted by the inspectors regarding the processes for determining the funds to be maintained in trust and relevant records in relation to client funds accounting. Access did not provide some of the requested information, stating in response that "documentation will be provided at time of visit".
  2. The RFI contained a question asking whether any payments had been made from the Client Funds Account for transactions other than related to securities. Access answered "No".
  3. Financial information was also sought by the inspectors in advance of the inspection. Financial statements for Access for the year ended 31 March 2003 were provided to the compliance team by Mr Marshall.
  4. The Access on-site inspection was carried out over a three day period on 19, 20 and 27 August 2003. The NZX compliance staff who conducted the on-site inspection were Ms Baker, Mr Rodrigues and Ms Koekemoer. Ms Baker was not present for the whole of the inspection. From the evidence the Commission has received, the Access inspection was conducted in the usual manner, following the same process the inspectors had used in previous inspections. The inspectors considered it a routine inspection.

PART IV - CLIENT FUNDS AND THE ACCESS INSPECTION Ctnd.

Issues arising from on-site Access inspection

  1. There were issues arising from the on-site Access inspection that required resolution in order for the inspection report to be finalised. Compliance staff made some efforts to resolve these during September and October 2003. Several issues were outstanding and not resolved at the time the inspection report was settled.
  2. Inspection issues identified by the inspectors were discussed among themselves in the first instance. Issues that the inspectors considered warranted further attention or input were communicated to Mr Brown, along with comments on the approach being taken by the inspectors in dealing with the issues.
  3. A draft Risk Management and Compliance report was prepared for Access by the compliance team, recording the inspection findings.
  4. A copy of the draft Access inspection report had been sent by Ms Baker to Mr Brown on 10 September 2003 under cover of an email noting the key issues in the report. The report and covering email was copied to Ms Campbell and Mr Weldon. The email set out the inspection findings recorded in the draft report. The email also stated:

Have followed same course of action ACBW as we did for [broker acronym] regard to CFA.

- Daily spreadsheet to be provided
- Three months to get system fixed (ACE does CFA but ACBW have never implemented)

Have requested clarity on principal/client etc by 17 Sept.

Copy of Report attached.

  1. Mr Brown and Ms Campbell both expressed the view to the Commission that Ms Baker's email of 10 September 2003 did not raise any significant issues. Mr Weldon stated that he did not read this email. He gave evidence that he would very rarely read emails that were copied to him and this was understood within NZX.
  2. In his written evidence Mr Weldon noted that since the collapse of Access he had been made aware of the email from Ms Baker to Mr Brown of 10 September 2003. Having read the email he was of the view that it does not contain anything that would lead him to think the collapse of Access was imminent or anticipated in any way.

The two issues identified at Access, an inability to reconcile its client funds account and a misclassification of one item in its capital adequacy calculations, did not give the team any concerns as to the ability of Access to meet its obligations as they fell due, and therefore no reason to think investors' funds were at risk...The issues set out in the email are not issues which I would have expected to be escalated. Nor am I aware that any of Philip, Lynda or Barbara flagged the issues set out in this email to anyone at NZX as requiring urgent or even particular attention prior to their departures.

  1. When asked by the Commission about any steps he had taken in relation to the draft Access report Mr Brown gave evidence that:

...in the case of [name of another firm] Barbara had detailed the concerns that she had and they were I regarded as being of significant consequence and therefore became involved in that process immediately. On the report that I received from Barbara and my review of that report, there was nothing that was highlighted out of the Access report which would have led me to believe that any particular aspect of that needed to be highlighted or escalated.

  1. Ms Baker told the Commission that at the time she did not think that Access could collapse. She did not warn Mr Weldon about Access' collapse and was not aware whether anyone else had raised particular concerns.
  2. A copy of the draft report was then sent to Access for comment. Access advised the compliance team in mid September 2003 that it had attempted to address the issues raised in the draft report with some urgency.

Inspection findings

  1. The Commission received evidence from Mr Rodrigues that the inspectors considered Access to be "middle rung", compared to the compliance of other firms.
  2. The Access Final Risk Management and Compliance - October 2003 was the final inspection report for the NZX inspection of Access ("final inspection report"). It was sent to Access on 24 October 2003. This report states:

The inspection reviewed policies, controls and processes in place for the broking operation and the effectiveness of the controls and procedures to ensure compliance with NZX regulatory framework....The specific objectives of the inspection were to conduct a Risk Based review of the Rules, Regulations, Code of Practice and Good Stock broking Practice, Systems & Operations and to evaluate the financial stability of the firm...

  1. The final inspection report identified six areas where NZX recommended that Access needed to make changes:

    The following summarizes areas where changes are required:

Client funds accounting - NZX recommendations

  1. The NZX final inspection report records that Access had breached the Regulations to the Business Rules in relation to client funds accounting. This was recorded in the final inspection report as a "materially important issue". It was assigned a risk rating in the final inspection report of "high" along with two other matters (retention of FINS and capital adequacy - points two and three of the above summary) out of a total of ten matters. Access did not have a daily process to determine the client assets that needed to be maintained in trust under the Regulations. The final inspection report recommended that the ability to determine the amount of funds to be secured in the client fund account be implemented within Access' systems. Access had advised NZX that it had initiated the process of updating its systems during the course of the inspection. The agreed implementation timetable was recorded in the report as 21 November 2003.
  2. The final inspection report recommended that Access establish daily reporting of interim client funds account calculations until the ACE back office system was set up to calculate it. Access was to complete a worksheet and email this daily to NZX. This daily report was never provided by Access. The follow-up to the inspection is described in Part V of this report.

Use of client funds

  1. The Access inspection did not reveal to NZX that there was any issue with misuse of client funds. The Commission received evidence that nothing was identified in the inspection of Access which made NZX suspect that client funds had been misused.
  2. The Commission reviewed the Access inspection working papers and noted that there are limited papers on the inspection file indicating what work was done in relation to inspecting against the client funds accounting requirements of the Rules.
  3. The comment in the final inspection report of October 2003 was:

The Firm did not have a daily process to determine the client assets that need to be maintained in the trust status as required by NZX regulations. Ensuring that NZX Firms are able to quantify the amount to be trusted daily is a material issue. During the course of the inspection, the Firm had initiated the process of updating their system to provide reports that would indicate the level of assets needed to be maintained in a trust status. The accounts for deposit of client funds were designated Client Fund Trust Accounts.

  1. Other statements in the Access inspection report were:

Depositing of client funds in the client fund account and issuance of dues to clients.

Segregation of funding/securities related to Own and Client obligations.

  1. NZX provided a large file of material to the Commission regarding the 2003 NZX inspection of Access. However there is no evidence on the inspection working paper file as to how these conclusions of "no identified issues" in relation to client funds were reached. Very limited records were kept of the work done by the inspectors in relation to client funds accounts. There is no record of whether a sample of receipts and payments was selected, what verification work was done on any sample items, or what conclusions were drawn from any verification work that may have been carried out in relation to assessing transfers from the client funds account. It seems to have been expected only that matters identified as non-compliance issues should be recorded. Except in cases where something unusual was identified, there does not seem to have been any expectation that inspectors would maintain records of the work done to identify issues or to verify that there were no issues identified in any area. As a result, NZX was unable to provide the Commission with the sample of Access bank accounts looked at for the Access inspection.
  2. In the absence of documentary evidence on the inspection working paper file, the Commission sought evidence from members of the NZX compliance team as to the work done by them on Access' compliance with the Business Rules relating to client fund accounting.
  3. Mr Rodrigues had been given the task of assessing compliance with the capital adequacy and client fund requirements. In relation to the sample period for assessing client funds accounts, Mr Rodrigues gave evidence that it was usual practice for the ledger and bank statements for the four weeks preceding the date of the inspection to be considered, to see what payments had been made from the client funds account. Mr Rodrigues gave evidence that it was the practice to select the month closest to the inspection date in order to obtain the most recent relevant data (although sometimes another month would be chosen). NZX told the Commission that inspectors received six months of bank statements and did sample other months on occasion. Mr Rodrigues looked for transactions that he thought would not be related to a client account. However, Mr Rodrigues gave evidence that the focus of the compliance team was on the capital adequacy of the brokerage firm and whether payments to clients were being made on time:

...we tried to pick up whether there were any problems with client dealings, any delayed payments to clients, delayed deliveries to clients, if that was happening there was a good possibility that the brokerage would be having some trouble...

and

...we knew there were two sort of criteria which should match up to the client funds being... in order. Mainly it was like liquid capital under control; if the liquid capital was not under control, then it would be an indication that the firm is having some sort of problem. Client fund accounting was more like secondary, it was just a process to identify whether there were enough assets at that point of time and whether they were lying in the proper places.

  1. NZX told the Commission that:

...as a rule of thumb, if a business has adequate capital and is settling with its clients on time, there is unlikely to be a risk to client funds.

  1. The Commission received written evidence from Ms Campbell and Mr Smith that all test checks conducted during an inspection must be relevant to the firm inspected. NZX's expectation is that inspectors exercise professional judgement based on assessment of factors such as the following:

The types of factors that might impact on the number of months of bank statements examined on inspection include:

  1. Size of firm;
  2. Number of transactions moving through the bank account;
  1. Firm's payment cycle for creditors;
  1. How many bank accounts are operated by the firm;
  2. Whether in a review of the sample originally selected any factors are identified that indicate a larger sample should be reviewed;
  3. Any other risk factors identified within that firm; e.g. review of complaints register; and
  4. Any intelligence NZX has concerning the firm.

These factors will dictate the appropriate sample size for a given firm...

  1. Mr Smith indicated by way of example that in the course of inspections he had considered bank statements and/or ledgers and reconciliations, taking into consideration factors such as whether the broker had an institutional or retail client base, and if there were any known issues regarding treatment of client funds.
  2. Selection of the actual sample reviewed at Access was determined by Mr Rodrigues. Ms Campbell said that this would have been done within the inspection framework and methodology that Ms Campbell and Mr Smith had described. NZX also told the Commission in its submission that there were no formal criteria given to inspectors.
  3. Mr Rodrigues was asked to consider the factors listed by Ms Campbell and Mr Smith. Mr Rodrigues agreed that (at the time he was an inspector) these essentially would have been the types of things to take into account, allowing for a degree of intuition in assessing them.
  4. Ms Campbell and Mr Smith gave evidence asserting that the level of testing of the accounts would not necessarily have uncovered a client funds shortfall:

Work performed by KPMG and NZX Regulation subsequent to the Access default suggests that the level of testing of bank accounts for operational payments through client funds accounts would not necessarily have uncovered the client funds shortfall. The investigation into payments from client funds bank accounts indicated that there were a minimal amount of such transactions and that the vast majority of operational payments were made through the operational account. The key issue was that ultimately, monies transferred from the client funds bank accounts to the operational accounts were greater than that earned by Access in brokerage and other fees.

Conclusions - NZX Compliance, client funds, and the Access inspection

  1. Since 1998 the NZSE Regulations had expressly required that brokers maintain client funds on trust, in separate accounts. In 2003 NZX executive management and the NZX compliance team were aware that many firms continued to mingle client and broker funds, and to make payments from client funds accounts for purposes other than those permitted by the NZSE Regulations. The widespread industry practice appears to have coloured NZX's approach to enforcing the Rules in that, while NZX did not approve of the practice, they did not believe they could treat it as a breach of the Rules. There was not sufficient knowledge of trust requirements within the compliance team to challenge the industry view. NZX executive management did not obtain external legal advice to assist the compliance team on the obligations created by the client funds regulations.
  2. NZX told the Commission in its submissions that the work programme set out how an inspection should be carried out. However, the work programme did not provide this guidance in relation to client funds. There was no other manual instructing NZX inspectors in the procedures for carrying out an inspection, or how to assess compliance with the client funds accounting rules. It was left to the inspectors to decide how to conduct the inspection. Given the limited understanding of client trust money obligations within NZX there was a need for clear instructions for inspectors as to the steps they should take to assess compliance with the client funds account rules. These instructions were lacking. There was no requirement for records to be kept of inspection procedures to allow management to assess the scope and adequacy of the work done.
  3. In the Commission's view, the requirements placed on inspectors for documentary recording of their work in relation to the client fund account rules were deficient, and meant that there could be no effective supervision of the work done or of the issues assessed as material.
  4. NZX's view is that the role of management is to respond where issues are escalated. NZX told the Commission that:

It was not, and should not be, the role of management to review the process undertaken by the compliance team at a particular brokerage in respect of a particular issue. The people employed in the compliance team are experts employed to perform that process. The role of management is to respond appropriately to issues of compliance escalated to them.

  1. In the opinion of the Commission, NZX management had a responsibility to satisfy itself that the inspection team was doing its job properly. It is surprising that Mr Brown, as supervisor of the compliance team, and other NZX executive management, were comfortable to have the inspection team draw conclusions as to whether any issues were identified in respect of the treatment of client funds without requiring the process and evidence underlying these conclusions to be documented and recorded. This lack of documentation would make it nearly impossible for any supervisor of the inspection team to satisfy himself or herself of the process undertaken.
  2. The interpretation expressed by Mr Brown of what was permitted in relation to client funds held on trust under the terms of the NZSE Regulations was clearly wrong. The Regulations required the client funds account to be maintained as a trust account for the benefit of a broker's clients. They did not permit this to be used as an operating account for the broker's own funds. The NZX Rules do not require that brokers' client funds accounts be maintained in the same manner as, for instance, a solicitor's trust account. However, the Rules do require that client funds be held on trust. This requirement imports a range of common law obligations on brokers. At the heart of the requirement to hold funds on trust is the idea that trust funds do not belong to the broker. They remain, beneficially, the property of the client. The broker, as a trustee, cannot make any use of these funds for its own benefit except as specifically permitted by the client under the terms on which the funds are held. In the case of a broker's trust account at the time of the Access inspection, the permitted uses of funds in the client funds account were set out in Regulation 3. No other use of the client funds account was permitted under the Rules.
  3. In respect of client funds, the Access inspection appears to have examined records, including a sample of bank statements, to assess the timeliness of payments made to clients. This is an important part of assessing compliance, particularly for a broking firm that operates call accounts for its clients. However, this work would not generally assist to determine whether money in the client funds accounts has been improperly applied to the operating account, or for operating purposes. At other inspections improper payments from the client funds account to the operating account had been noted as "not best practice". However the inspectors were not instructed or trained to look specifically for such improper payments as a matter of compliance with the Rules, and did not do so. The lack of documentation of the inspection procedures meant that supervisors would not know that inspectors were not examining transaction records to see whether funds had been misused.
  4. The Chairman and CEO of NZX submitted to the Commission that the compliance programme was not designed to detect fraud. The Commission acknowledges this. However, the NZX broker compliance framework was intended to assess compliance with the NZX Rules. A key requirement of the Rules is that client funds must be segregated from a broker's other bank accounts, and held on trust. Client funds cannot be used for the brokers' own purposes except where the Rules expressly permit this. An inspection programme intended to assess compliance with the Rules must include procedures designed to give reasonable assurance that client funds are not being used for purposes not permitted by the Rules.
  5. We also acknowledge the statement by Ms Campbell and Mr Smith that testing of bank accounts for inappropriate transactions would not necessarily have detected any misuse of funds. It is correct that no sample-based assessment can provide a guarantee that inappropriate transactions will be uncovered. Nonetheless, the NZX inspection programme needs to include formal measures to test and verify transactions involving brokers' client funds accounts. The presence of such measures may detect misuse of funds. The use of such procedures would also have a deterrent effect, and would encourage improved compliance with the Rules.
  6. On the evidence the Commission has, the Access inspection put little weight on examining transaction records for evidence of misuse of client funds or the client funds account. It does not appear to have been expected that the inspectors should do otherwise. Apart from one question relating to misuse of client funds in the RFI, repeated in the work programme, there is no indication that the NZX compliance programme at the time sought to examine whether brokers were complying with this important aspect of the Rules. The work programme focussed on the settlement of client trades, not misuse of funds. In the Commission's opinion this situation came about because of a lack of engagement by supervisors and management in the design of the compliance programme and the inspection procedures, which was left in the hands of staff who had an incomplete knowledge of the client fund obligations under the Rules and inadequate training in the requirements for trust accounts. It was contributed to by a lack of understanding of the Rules at NZX, a consequent unwillingness to challenge industry practice, and a lack of supervision of the inspection process, including the lack of any requirement that records be kept of the inspection process.

PART V - FOLLOW UP TO THE ACCESS INSPECTION AND COMPETING PRIORITIES AT NZX

Ongoing issues with Access

  1. There were two main issues that arose from the Access inspection where the NZX compliance team had ongoing dealings with Access.
  2. Firstly, Access was to establish daily reporting of interim client funds account calculations until the ACE system was set up to calculate this. A daily spreadsheet was to be completed by Access and sent to the NZX compliance team. The ability to determine the amount of funds that needed to be secured in the client funds account was recorded by NZX as a "materially important" issue in the inspection report.
  3. The required daily client funds calculation was never provided to NZX. The compliance team was told by Access that Access was unable to provide the required information.
  4. The Commission received evidence that the compliance team did continue to receive monthly liquid capital reports from Access. These reports gave the compliance team comfort that Access was complying with the liquid capital requirements.
  5. Secondly, the NZX compliance team was concerned about the "mapping" of Access' accounts to the liquid capital computation. In his evidence to the Commission, Mr Rodrigues explained that "mapping" is where an NZX Firm sends NZX their trial balance and provides details of where the items in the trial balance are coming from. The compliance team were of the view that insufficient information had been provided by Access. The compliance team made efforts to also follow up this information.
  6. In November 2003 the compliance team was advised that Access would be changing its back office system from ACE to SSS. Access had advised that this systems change would address the issues that had arisen with the inspection report. Based on this, the compliance team decided not to follow up on the daily client funds computations or mapping issues until the new SSS system was established. NZX management was then briefed on this. The compliance team requested that reconciliation of items in the back office system to the capital adequacy reports be taken up once the new system was in place.
  7. Access advised the compliance team in early 2004 that there would be a delay with the implementation of the new SSS system. It would be implemented in March or April 2004. The compliance team did not consider this raised any concerns because Access continued to comply with the liquid capital requirements. The Commission was advised NZX was also aware this delay was contributed to by competing demands on the SSS vendor. In March/April 2004 Access advised that the SSS system was operational. Access was not required to submit any daily reports or mapping information after the SSS system was implemented. As that system was capable of reconciling the accounts, the operation of the new SSS system was to be tested by the inspectors in the re-inspection of Access later in 2004.

Delays with re-inspection of Access

  1. The re-inspection of Access was initially scheduled for December 2003. In November 2003, Access asked for this to be postponed as it was about to change its back office system. The re-inspection was rescheduled for February 2004. The re-inspection of Access was not carried out in February 2004. It was further postponed at Access' request because the changes to Access' back office system had not been implemented. No firm re-inspection date was set at this time.
  2. NZX compliance staff corresponded with Access during 2004 in regard to rescheduling the re-inspection. The re-visit was scheduled for late June, then rescheduled to July 2004 due to Mr Marshall's lack of availability. It was further rescheduled to August 2004 to accommodate NZX workloads. It was rescheduled again on Access' request, due to Mr Marshall's health problems, until September 2004. The compliance team raised the issue of postponement with Access, noting that the reconciliation of items in the back office system to the capital adequacy reports was supposed to be taken up on implementation of the SSS system. Given the postponement of the re-inspection, the compliance team requested Access to send in a mapping of the items in the capital adequacy report to the balances run from the new back office system. There were further delays with provision of the requested information. Mr Rodrigues continued to ask Access for the information until the time Mr Rodrigues left NZX in July 2004.
  3. Mr Weldon gave evidence that he did not receive any written advice from the compliance team regarding the delays with the re-inspection and whether this was of concern to the team. He was aware that a re-inspection was to occur. He was aware of the new SSS system implementation and that this was delayed. Mr Weldon did not know that there was a client funds accounting capability on Access's ACE system. He would have expected this capability to be implemented, although NZX was pleased that Access was changing to the SSS system. Mr Weldon noted that NZX was implementing the Participant Rules and that the decision was to delay all inspections and re-inspections until after that. He was also aware of delays due to Mr Marshall's surgery. Mr Weldon noted that NZX decided to invest resources in re-writing the Business Rules.
  4. A consequence of this decision to invest resources in rewriting the Rules was that the inspection programme was halted between February and May 2004.
  5. Mr Moore joined the NZX compliance team in May 2004. He gave evidence to the Commission that he was not aware the re-inspection of Access had been delayed a number of times when he joined the team.
  6. The Commission received evidence from Mr Moore that the compliance team did not consider the delays with the re-inspection and postponements in mid 2004 to be of particular concern. The reasons provided by Mr Marshall for rescheduling the re-inspection included the absence of key staff, or the absence of Mr Marshall due to holiday or illness. These were viewed by the compliance team as reasonable matters for which extensions of time should be allowed. In his evidence to the Commission, Mr Moore said:

...someone continually seeking to re-arrange an inspection is something that would give me concern, but at this point this didn't raise a flag that it was a chronic situation...one postponement due to holiday and a second postponement due to surgery, that didn't raise a red flag with me.

  1. No re-inspection of Access had been carried out by NZX at the time Access went into default in September 2004.

Competing priorities at NZX

  1. In 2003, following the Access inspection, NZX compliance staff were told to focus on other NZX priorities. Compliance team members were pulled away from broker inspections in October 2003 to work on other activities, including developing an inspection module for futures dealers and development of the Participant Rules. Ms Campbell gave evidence to the Commission that between September 2003 and the collapse of Access the compliance team were very busy with:
    1. inspections (15 in this period);
    2. re-inspections (10 in this period);
    1. writing the NZX Participant Rules;
    1. amending documentation to reflect the new Rules;
    2. developing an inspection programme for Futures & Options participants; and
    3. assisting with drafting the Rules governing Futures & Options Participants.
  2. The development of the new Participant Rules was a matter of priority for NZX. Evidence received from Ms Campbell was that the purpose of the Business Rules re-write was threefold:
    1. To resolve issues with the Rules identified in the course of inspections undertaken by the Participant Compliance team;
    2. To reflect current business structures within NZX Firms (for example the delineation between Advisory and Trading and settlement participants); and
    1. A desire to allow market participants to use modern trading methods (for example DMA).
  3. The Commission received evidence that Mr Weldon determined that the Rules needed to be re-written, taking into consideration the changes at NZX, outcomes from the initial inspections, changing technology and the appropriateness of the Rules given the changes to the regulatory structures.
  4. The Commission received evidence from compliance team members that work on the Participant Rules and other projects required considerable amounts of compliance team members' time, reducing the capacity for inspections.
  5. Due to the focus on other NZX activities, the compliance team available for inspections was effectively two people from September 2003 until December 2003, and thereafter one person until new inspectors were recruited in 2004. The Commission received evidence that one inspection at the end of 2003 and one in early 2004 were conducted by one member of the compliance team due to reduced numbers of personnel. Inspection activity was halted between February and May 2004 while the new Participant Rules were being written, and pending their introduction.
  6. It was anticipated that the Participant Rules would be approved by 1 March 2004. This was deferred to 1 May 2004 due to submissions made by brokers. Ms Baker gave evidence that the re-write of the Rules was originally to take six weeks. It turned into an intensive six month process. Ms Baker gave evidence that she was told by Mr Weldon to focus 100% of her time on the re-write of the Business Rules from October 2003.
  7. In his written evidence to the Commission Mr Weldon discussed the decision that Ms Baker was to work on the Participant Rules:

I made a decision in September 2003, in consultation with Elaine, that the highest value use of Barbara at that time was to work full-time on drafting the new NZX Participant Rules...she had an unparalleled knowledge of the broking industry and, in particular, of the regulatory issues associated with it....therefore, upon receiving assurances from both Barbara and [compliance officer of a broking firm] (as an industry leader) that both Philip and Lynda were well up to scratch as inspectors, we withdrew Barbara from the on-site inspection function. This did not mean to say that Barbara Baker was not involved in the Compliance team nor that her role in supervising the team disappeared. She still reviewed each inspection report before it was sent out and was still responsible for ensuring appropriate escalation and follow up on inspection issues.

  1. Mr Weldon gave evidence that the intention was for Ms Baker to continue to be engaged with broker compliance and that he would be surprised if she had ever been told to focus solely on the Rules. Working full-time on the Rules was never intended to mean that other obligations would cease. Mr Weldon was not aware if anything was written down to set out for Ms Baker what the expectation of her was in terms of working hours or her responsibilities. Mr Weldon did not agree that the re-write of the Rules placed a heavy burden on the compliance team.
  2. Ms Campbell informed the Commission that no inspections or re-inspections were undertaken between February and May 2004 due to the pending introduction of the new Participant Rules. NZX compliance resources were fully committed on other activities. Ms Campbell noted that other firms also needed re-inspections scheduled, and in comparison to these, did not consider that there was particular priority to the Access re-inspection, and did not question the delay the other activities caused to the re-inspection.
  3. The Commission received evidence from Ms Baker that there was resistance from brokers to further inspections given the imminent re-write of the Rules. Brokers considered resources should be put into compliance with the new Rules.
  4. When asked whether the competing priorities within NZX may have compromised the inspection work, Mr Weldon gave evidence that NZX was willing to redeploy staff given the regulatory changes that the company was going through. NZX was satisfied that the prioritisation was appropriate.
  5. The Commission asked whether NZX had considered outsourcing the writing of the new Participant Rules. Mr Weldon gave evidence that the previous Rules had been drafted by a law firm. He was of the view that there was a lack of knowledge within NZX about the Rules as a result of that. He considered it important that NZX go through the process internally, with review by external legal advisers.
  6. All three members of the compliance team who conducted the Access inspection had left NZX by July 2004.

Comment

  1. The inspection of Access highlighted that there were problems with reconciling the client funds account, and problems with liquid capital calculations. The liquid capital irregularities were remedied following discussions between NZX personnel and Access staff. NZX was told that Access would need to upgrade its systems in order to be able to make daily reconciliations of the client funds account. In the meantime the firm was put on a daily reporting schedule to give NZX some assurance about client funds. This was the same procedure that had been put in place for another broker with deficiencies in its client fund accounting. However, while that other broker did produce the required daily reports, in the case of Access the inspectors identified the issue along with an appropriate plan to resolve it but there does not appear to have been sufficient follow-up to require Access to adhere to this reporting schedule and management appear to have been comfortable that Access not adhere to the reporting schedule.
  2. In the months following the Access inspection there were several staff changes in the NZX compliance team. The incoming staff appear not to have been entirely aware of the history of Access' inability to comply with its daily reporting obligation and the delays with the scheduled re-inspection. The Commission acknowledges that Access' compliance was not regarded by inspectors as exceptionally poor. The inspectors did not think that client funds were at risk. However, it is undesirable that identified breaches were left unresolved. A higher priority should have been given to ensuring that Access complied with the interim measures that were put in place by NZX pending the installation of Access' new back office system.
  3. It was sensible to involve members of the compliance team in the review of the NZX Rules, in order to make use of their experience. However, the manner in which this was done impacted heavily on the team's ability to continue with its inspection programme. The Commission does not criticise the decision to review the Rules, but considers the decision to devote compliance team members to the review to this extent at a time when the compliance programme was still at an early stage, and while the compliance team was still building its knowledge of the broking industry, was misguided. The effect of the decision was that for the duration of the review NZX's ability to perform its function to enforce the Conduct Rules was limited.
  4. At the time, there were outstanding re-inspections of firms where non-compliance had already been identified, including Access. This work should not have been suspended. Work on the Rules review appears, however, to have been given priority over continuation of the inspection programme, including completion of the work needed to resolve identified compliance issues at several firms, Access being among them.

PART VI - GOVERNANCE

  1. The preceding sections of this report have focused on particular issues in relation to the development of the NZX broker compliance programme, internal reporting processes within NZX, monitoring of client funds accounting, and the findings from the Access inspection. In the course of its inquiry the Commission also received evidence regarding the role of the NZX Board. The Commission considered it appropriate to consider the role played by the Board in the development and monitoring of NZX's broker compliance function.

Composition of NZX Board

  1. In 2003, at the time of the Access inspection, the members of the NZX Board were:

Reporting from management to the Board

  1. As CEO, Mr Weldon has the principal responsibility to report to the Board. Other members of the NZX management team report to the NZX Board in relation to their areas of responsibility.
  2. In his evidence, Mr Weldon explained the level of Board involvement with the regulatory function. Mr Weldon noted that substantial Board time was spent on the detail of the Rules when they were rewritten, and the changing regulatory structure. Mr Weldon also gave evidence that:

Significant Board time has been and continues to be spent on our approach to regulation and the co-regulatory model. Regulatory issues appear on the Board's agenda at nearly every full meeting, are the subject of Board papers and are addressed offline. If the Board runs out of time to address all the issues on its agenda, it is generally financial rather than regulatory issues that are relegated. Furthermore, nearly all extraordinary Board meetings have been called to deal with regulatory issues...

  1. The Commission received evidence from Mr Weldon that the agenda for NZX Board meetings is determined by him in consultation with the Chairman. Board reports and Board papers would be requested of managers and other staff by Mr Weldon for inclusion in the Board papers. The Commission received evidence from Mr Brown that he did not prepare any reports on broker compliance for Mr Weldon during the time he was responsible for the broker compliance team.
  2. Mr Weldon gave evidence that he was responsible on an ongoing basis for preparing a Chief Executive Officer's Report for the Board. The report contained a range of matters the Board needed to know about and matters for discussion.
  3. Mr Weldon reported to the Board on broker compliance in July 2003. The Chief Executive Officer's Report - July 2003 ("July 2003 CEO's Report") was Mr Weldon's first formal report to the Board regarding broker compliance since the compliance function had been brought in-house. The July 2003 CEO's Report summarised the key issues highlighted by the first four NZX-conducted broker inspections. Mr Weldon gave evidence that the section on broker compliance was drafted by Mr Rodrigues. The July 2003 CEO's Report reported the risks identified in the inspections (which had been given a rating of high, medium or low), and noted (on a no names basis) the number of firms where a risk was observed. It also set out the internal processes and timeframes for conducting future inspections on the basis of the experiences of the first four inspections.
  4. The July 2003 CEO's Report included a summary of the observations from March 2003 to end May 2003 in relation to firms that had inadequate liquid capital or inadequate client funds. This section of the report included the names of the brokerages where these issues had been identified. Access was recorded in the July 2003 CEO's Report as having actual liquid capital as a percentage of prescribed liquid capital of 109%. The report also recorded that four firms had overdrawn client funds accounts, in that they had an overdraft of the ledger, in breach of the regulations.
  5. The Board asked that future reports regarding broker compliance be presented on a no-names basis. The Commission received evidence from Mr Weldon that:

...there was a view from the board that the information about what was happening in any particular firm should not be presented in such a way that it could be shared or used to commercial advantage or disadvantage.

  1. However, this does not seem to have been intended where a Board report was required on a particular issue or emergency situation. Mr Weldon gave evidence that the Board would be advised of the names of brokers if it was material to making a decision.
  2. There were no similar reports to the Board after the July 2003 CEO's Report on broker compliance. After July 2003 the only reports on broker compliance issues made to the Board were on an exception basis. Mr Weldon commented that a report like the July 2003 CEO's Report would not usually go to the Board because it was an operational report:

The Broker Compliance Update contained in the July 2003 CEO's report was an operational report on what the compliance team had done in the previous three months. As an operational report it would not ordinarily go to the Board, however I wanted to give the Board a feel for what the compliance team was doing on a day-to-day basis and the work they were producing, particularly in light of feedback from the industry about the cost of our in-house programme.

  1. The Board did not request or receive any further reports on the operation or findings of the compliance team. There was no standing Board agenda item on broker compliance matters. There is no indication in the Board minutes that broker compliance matters were given regular attention by the Board or that the broker compliance programme was monitored by the Board in relation to the NZX broker compliance strategy.
  2. When asked by the Commission whether any thought was given to establishing a Board committee to deal with regulatory or broker compliance issues on a named basis, Mr Weldon gave evidence that:

The Board's view of regulatory matters, and this is consistent today, is that they take priority over other things. So, while we're happy to have an audit committee dealing with finances, regulatory matters are something that the board's not willing to subdivide and take recommendations on.

  1. The Commission understands that from time to time the Board did appoint independent directors to consider specific matters, although not a standing committee. Mr Allen gave evidence to the Commission that:

.. if an issue arose about a broker, and it didn't have to be one where an ordinary Board member is part of it, but any broker, a subcommittee was established.

  1. Mr Weldon gave evidence that in 2002 the Board was very operational in discharging the Rules. This was due to the mutual structure where the Board had express responsibility for certain matters. When NZX changed to a corporate structure the Board discussed what it should and should not be involved with and what matters it wanted to be informed of. A separation was made between operational matters for the executive, and strategic and governance matters for the Board. Mr Weldon gave evidence that:

... the Board would rely upon, on an exception basis, the executive to bring extraordinary matters to their attention...the Board does not receive operational reports, it's not its role.

  1. When asked about the level of information the Board received in relation to broker compliance, Mr Allen gave evidence that the Board had a general awareness:

We had a general idea. Don't forget, three of the Board members at that time...actually ran broking firms...So there was quite some knowledge of what you call the back office settlement procedures but the reality is that we had to make sure that the executive were running the processes.

  1. Mr Allen gave evidence that the broking industry was fairly collaborative and that industry feedback would often reach the Board if an issue arose or was brought to the attention of a Board member. The Board did not receive any such feedback in relation to Access.
  2. The Commission showed Mr Allen the July 2003 CEO's Report regarding broker compliance. Mr Allen gave evidence that he could not recall any specific Board discussions in relation to that report, only "general dialogue about the overview". When asked about the policy of not naming brokers, Mr Allen gave evidence that the Board viewed the facts of breaches separately from the identity of those who had breached. When asked by the Commission how the Board could assess the potential systemic effects of a breach without being aware of which broker was involved, Mr Allen replied that the Board's focus was on whether investor money was at risk, not the breaches attributable to particular brokers. Mr Allen noted that the no-names approach to reporting had been in place prior to demutualisation.
  3. The Commission asked Mr Allen's opinion of this type of reporting. Mr Allen acknowledged that the Board would know the fact of a breach from the information in the July 2003 CEO's Report but would not be in a position to assess the reasons for the breach or whether any investors' money may be at risk without an explanation. Mr Allen gave evidence that it was taken as given by the Board that any issues would be inquired into by the compliance team. The Board would wish to know about any material matters. In his evidence to the Commission, Mr Allen said:

Look, just to make it clear, such a thing as an overdraft account in its own right is something that you would be concerned about but you would be expecting it to have been acted upon, that an explanation - the interesting thing would be if I got a report that said, by the way, it is in overdraft, they won't fix it or disagree with our interpretation, then you start saying, well, they're hiding something.

  1. Mr Allen's view was that the July 2003 CEO's Report was bringing operational issues to the Board's attention. Activity was being undertaken to address the issues and Mr Allen was of the view that the Board could not have added to that process.
  2. When asked about why there was not the same level of broker compliance reporting subsequent to the July 2003 CEO's Report, Mr Allen commented that the July 2003 report was a milestone report. Further reports were not expected until a particular issue arose, there was particular feedback or changes to the Rules. If the Board had already dealt with an issue, any further reports may only be brief.
  3. The Commission asked about the systems in place at NZX to elevate issues internally where matters were material, but not necessarily urgent, to ensure they were addressed. Mr Allen gave evidence that timelines and prioritisation of matters were operational matters. The Board's focus was on risks. Matters where investors' funds were, or were likely to be, at risk would be escalated to the Board.
  4. The Commission received evidence from Mr Allen that the Access final inspection report was not put to the Board and it was not expected to be. The reporting regime was by exception. If issues arose with particular brokers these were to be elevated to the Board on a named basis.

Expectations of Board in relation to NZX broker compliance programme

  1. The July 2003 CEO's Report was the only report to the Board of this kind that contained information relating to the NZX compliance team's work on broker inspections and broker compliance.
  2. The Commission understands that the Board did not request further information about the implementation of the broker compliance programme in relation to the strategic plan nor about the conduct of broker inspections and the compliance team's work. It does not appear that any further direction was given to management in relation to these issues. These matters were viewed as operational. The Board expected to see exceptional issues only. NZX advised that:

The Board would expect to be advised if the Strategic Plan was not being implemented as agreed; otherwise the Board relies on that plan being executed by management.

  1. The Commission heard evidence from Mr Allen (in the context of questions about training for the compliance team) that in his view NZX operated differently to a government entity in terms of involvement in operational matters:

You set parameters and you set outcomes but if you start withdrawing someone's authority by telling them how to do it, I don't know of any successful companies that run that model. We are very careful about that. I accept that there are companies that do that. All the government owned entities do that but then that speaks for itself in some ways. So, it's not best practice

Conclusions - governance matters

  1. Under the Securities Markets Act 1988, NZX is recognised as the front line regulator of the securities markets that it operates. It is obliged to make Conduct Rules for its markets, and to operate its markets in accordance with the approved Conduct Rules. Under this framework NZX occupies a unique position as a regulator and as a commercial entity. In the Commission's opinion this also places the Board of NZX in a unique position, and requires it to consider its role in both a commercial and a regulatory context.
  2. The Commission's comments in this report do not concern the role of the NZX Board in relation to NZX as a commercial enterprise.
  3. The Business Rules in force in 2003 gave particular responsibilities to the Board in relation to regulatory matters. In large part these Rules still reflected the previous status of NZSE as a mutual organisation. In 2004 NZX reviewed its Rules. The Board's specific role in relation to disciplinary matters was superceded by the creation of NZX Discipline as an independent body with the function of determining compliance matters referred to it by NZX. Other functions previously reserved for the Board are stated in the Participant Rules simply as functions of NZX (such as accreditation of Participants and appointment of inspectors).
  4. As such, while NZX has obligations under the Securities Markets Act, and specific functions under the Participant Rules, there is no clear statement prescribing the role of the Board in respect of NZX's regulatory functions. This has not detracted from the Board's acceptance that it is ultimately responsible for the performance of these functions. It has, however, meant that there is less clarity about the degree to which the Board should involve itself in the performance by NZX of its regulatory functions. The Commission does not consider that greater clarity is necessarily required in either the law or the Conduct Rules - as a limited liability company NZX is generally subject to the disciplines and accountability mechanisms set out in the Companies Act. This means that it is up to directors to consider how they discharge their responsibility for the company's actions, and that directors are accountable to shareholders for these decisions.
  5. However, in the Commission's opinion, NZX's role as a registered exchange means that it performs public functions as well as private ones. The importance of these functions, in the Commission's view, requires careful attention to be given to the appropriate role of the NZX Board in its governance of NZX as a regulator.
  6. After discussions with NZX, in the Commission's view the regulatory roles of the board of a registered exchange might conveniently be considered in four areas: policy setting; discipline; crisis response; and monitoring and oversight of NZX's performance.
  7. At the policy level, it is apparent to the Commission that the Board of NZX has been fully involved in the setting of regulatory policy, including the formulation of the Conduct Rules and the NZX Corporate Strategy. These matters set the direction for NZX as a regulator, and in the case of the Conduct Rules, provide the framework for the regulated markets operated by the exchange.
  8. The discipline role of the Board created potential difficulties for NZX as a demutualised exchange. An increased emphasis on compliance meant that the number of cases likely to be put to the Board for disciplinary action would also increase. The Commission has heard that potential conflicts of interest prevented some Board members from considering cases of suspected breaches of the Rules. The formation of NZX Discipline as a separate body allowed matters concerning individual market participants or listed issuers to be considered at an appropriate level, and independently of the NZX executive. The Commission supports this step. The decision to separate the disciplinary function addressed the potential conflicts this role created for the Board. Accountability mechanisms for this body are included in the NZX Discipline Rules, including confirmation of appointments by the Commission, and the publication of an annual report on its activities.
  9. The NZX Board has continued to play an active role in what might be described as crisis response. Mr Allen's evidence was that the Board will become involved in a specific situation involving a market participant where it appears that investors' money may be at risk. In the case of Access this was demonstrated by the Board's early and continuing involvement in the days following the collapse of the firm. The Commission was kept updated on developments at both Board and staff level, as were other public agencies. The Commission is of the view that the Board's policy that it should take an active role in such situations is entirely appropriate, as these are the situations where confidence in the markets is most tested.
  10. In respect of the NZX Board's more general governance or oversight role as that relates to NZX's regulatory functions, the Commission considers that the Board has, in light of the public importance of these functions, an ongoing responsibility to monitor the performance of management against the regulatory policy or strategy set by the Board. In the Commission's view the NZX Board did not fulfil this responsibility in respect of the broker compliance programme, other than by its receipt of the July 2003 CEO's Report. It did not play any ongoing role in monitoring the strategic direction of the broker compliance function.
  11. We record that NZX does not agree with our opinion on the appropriate role of the Board in this respect. NZX is of the view that:

The Board is entitled to assume that management are discharging their operational responsibilities in accordance with the strategic direction set down by the Board and to rely upon management to escalate exceptional issues requiring Board input. To do otherwise would be inconsistent with the proper division of responsibilities between a Board and management....

  1. It is important in any organisation to separate operational matters from governance matters, with the latter being reserved as responsibilities of the Board. However, in the Commission's opinion what is appropriately a governance matter for the board of a registered exchange in relation to its regulatory role needs to be considered in the context of the public functions that are given to an exchange under New Zealand's co-regulatory system.
  2. In this context we consider that the point at which NZX has decided to draw the line between strategic and operational matters in respect of its regulatory functions fails to appreciate the role that NZX has under the co-regulatory framework. The Commission would have expected the NZX Board to seek to remain informed, as a matter of governance, of the continuing performance of NZX's broker compliance programme. This requires active, not passive, monitoring of the discharge of operational responsibilities against the strategic direction set by the Board. A strong enforcement and compliance focus is needed at NZX for the market to have confidence that NZX is fulfilling its role as a registered exchange in relation to the conduct of its market participants. We have no reason to believe that this focus is currently lacking at NZX as an organisation. However, in view of the public importance of the regulatory function of a registered exchange, we consider that as a matter of good governance of its regulatory role this focus should both be set and monitored continuously by the Board.
  3. The Board has responsibility for more than simply ensuring that NZX is successful as a commercial entity, and it recognises that this is so. It also has the responsibility to govern its regulatory functions. In the Commission's view the Board of NZX should consider the performance by NZX of its regulatory functions as a matter requiring governance input on an ongoing basis.

\

PART VII - STEPS TAKEN TO ASSESS CLIENT FUNDS PRACTICES

  1. In October 2004, following the collapse of Access, NZX engaged Grant Thornton to review the client funds accounts of other NZX Firms to determine whether there were any issues with these accounts. The Ministry of Economic Development had also requested that NZX establish whether there were any ongoing issues with the client funds accounts of other NZX Firms.
  2. Grant Thornton sent each NZX Firm a questionnaire designed to enable a risk assessment to be made of each Firms' client funds accounting. The Commission was consulted in relation to the questionnaire. NZX Firms completed the questionnaire and returned it to Grant Thornton for analysis. Certain follow up visits to brokers were made by Grant Thornton to test the information.
  3. Grant Thornton released a draft report in January 2005. A copy was provided to the Commission by NZX. The final Grant Thornton report, dated 31 May 2005 was provided to the Commission by NZX on 27 June 2005, after the NZX Board had had an opportunity to consider it. Grant Thornton's key findings were that there was no evidence of misappropriation of client funds based on the information received, and the Participant Rules were being followed in all material respects in the majority of cases. Grant Thornton noted a limited number of instances where client funds accounts were overdrawn at the bank but these instances were not as a result of a true deficit and there was no increased risk of loss of client funds. In one case, firm expenses were paid from surplus market participant funds in foreign currency client funds accounts. Grant Thornton found the daily reconciliation of client obligations against assets held was often inadequate and not well documented.
  4. Grant Thornton recommended that NZX provide guidance and education to market participants generally in relation to the identified deficiencies, and to use the inspection process to check and ensure that the deficiencies were remedied in relation to particular firms. In respect of client funds accounts being overdrawn, Grant Thornton concluded that this was an area that required greater attention by market participants and NZX.
  5. The Commission asked Mr Weldon about the findings in the Grant Thornton report. Mr Weldon gave evidence that the NZX Board was heavily engaged in looking at the report. He noted that there was a time lag between the generation of the Grant Thornton report and the time at which the data was collected. Mr Weldon's view was that due to this time difference, conclusions cannot be drawn from the Grant Thornton report about the current state of the market. Mr Weldon gave evidence to the Commission that issues with specific firms identified in the report had been eliminated, and that he was confident there was no systemic misunderstanding or breaches of the client funds accounting rules.
  6. Mr Allen gave evidence that the need to educate market participants was an ongoing job. Mr Allen advised the Commission that the Board had discussed the Grant Thornton report.
  7. The Commission notes that the Grant Thornton work was a review not an audit. We note also that it describes the situation found in late 2004, shortly after the collapse of Access. The Grant Thornton report identified widespread, but lesser, issues of compliance. It did not identify evidence of a widespread problem within the broking industry regarding client funds accounting.
  8. The Commission requested information from NZX about the ongoing compliance of participants with the client funds account requirements. Ms Campbell and Mr Smith's evidence set out that NZX had responded to the Grant Thornton findings in three ways:
    1. in the course of the NZX inspection programme, inspecting a number of the participants where the Grant Thornton report identified a deficiency with compliance. The deficiencies were required to be remedied;
    2. following up individually, outside of the NZX inspection programme with certain participants where an inspection was not scheduled but compliance issues were identified by Grant Thornton; and
    1. producing a guidance note Guidance Note GN0008/05 - Client Assets relating to the obligations on participants under the Rules in relation to client funds and NZX's expectations.
  9. Ms Campbell and Mr Smith gave evidence to the Commission that in addition to the Grant Thornton work, the NZX inspection programme inspects compliance with the client assets rules. Where deficiencies were identified in the course of inspections the compliance team worked with participants to remedy the deficiencies.
  10. On 12 July 2005, NZX distributed a summary Grant Thornton report and the guidance note to market participants under cover of a letter noting the main points of the report.
  11. The Commission also requested evidence from NZX about whether participants were co-mingling their own assets with those of their clients and paying business expenses out of client funds. In written evidence, Ms Campbell and Mr Smith advised that the Grant Thornton report had identified a single instance of a firm expense being paid directly out of a foreign currency client funds account. The payment was made from retained firm assets, not client assets. The participant was told to desist from this. Visits by the compliance team to two brokers had identified inter-mingling of client and firm monies that was unacceptable. NZX declined to accredit each of these firms as Market Participants. NZX gave evidence that it was confident participants are not making payments of business expenses from a client funds account. This was based on the inspections and the Grant Thornton work. NZX note that the Guidance Note is explicit that this is not permitted by the Rules.

Comment

  1. The Commission is concerned that the Grant Thornton report indicated a widespread lack of familiarity with the particular requirements of the client fund rules. The Commission is also concerned that the report identified widespread (albeit lesser) deficiencies. In the Commission's opinion the Grant Thornton findings indicated that more particular attention to client funds accounting compliance issues was needed by the NZX compliance team and by market participants. However, NZX has taken steps to address the issues highlighted by the Grant Thornton review and to assess the current state of participants' compliance with the client fund requirements. These steps focus particularly on the identified deficiencies. NZX is also addressing the issues through education and guidance. This work needs to continue.

PART VIII - TREATMENT OF CLIENT FUNDS ACCOUNTS HELD AT FINANCIAL INSTITUTIONS

  1. Media reports following the collapse of Access indicated that some clients of Access had been confused as to the status of funds deposited with Access because they received annual statements printed on Bank of New Zealand ("BNZ") letterhead and had client deposit cards that carried the BNZ logo.
  2. This confusion may have been contributed to by the double branding of call accounts as BNZ accounts and Access accounts. After Access collapsed it became apparent that some clients of Access believed that they had funds held in their own name in trust accounts with the BNZ. The BNZ provided a trust account for Access clients to transact with Access. This was a pooled trust account, rather than many individual trust accounts.
  3. In the course of its inquiry the Commission received evidence from Mr Rodrigues that Access had call account arrangements with the BNZ. In evidence Mr Rodrigues said that the cash management accounts were trust accounts. In the case of Access the inspection team did look at the processes and controls to administer these accounts. In evidence, Mr Rodrigues said:

Access said that these call accounts and cash management accounts were being audited by BNZ, so that was a great sort of comfort factor...

and later in evidence:

There was this client fund call account and then there are call accounts for each of the clients. So there was one common BNZ account, within which they had sub-client accounts...

  1. The Regulations to the Business Rules required that firms:

Must obtain from the Bank holding the Client Funds Account a written acknowledgement of the trust status of the account, and must ensure that the words "Client Funds Account" appear in the title of the Clients Funds Account.

  1. Mr Weldon noted that with a disclosure based regime, NZX is reliant on managing principals signing off on the correctness of information that they submit. Mr Weldon noted that a material fact of reliance is the declaration by the bank that the account for client funds is a trust account. Mr Weldon suggested that the bank has a monitoring role in relation to trust accounts and this is one aspect on which the compliance framework relies.

One of the other material facts of reliance is the fact that...the account at the BNZ, the declaration by the BNZ is actually that....the client trust account, the one account, is for client purposes and won't be used; both of those accounts are at the BNZ. Those guys sit on top of that data, see the electronic transfers on a daily basis, that's why they charge more for it, you know, managing a trust account than they do an established cheque account because there's supposed to be some other things that they do to monitor that. So you know there are a series of things upon which this structure relies.

Comment

  1. Fundamentally, the responsibility lies with every investment broker to ensure that clients are clearly informed about money handling procedures, including whether client money will be held on trust, and the status of the funds. This is a requirement under the Investment Advisers (Disclosure) Act 1996. It is the responsibility of a broker to make sure that this information is not misleading. Certain money handling requirements are also set out under Rule 14.13 of the Participant Rules.
  2. The NZX Business Rules required that client funds must be held on trust. Client assets are funds received and held on account. Client assets must be held by the firm on trust for its clients at all times. The responsibility of broker as trustee in relation to client funds should be real and apparent to clients. While in law a bank may in certain situations have responsibility as a constructive trustee if it is on notice of misdealing in trust account money, this does not detract from the primary responsibility of a broker, as trustee.
  3. NZX has a statutory obligation to ensure that its markets are operated in accordance with its approved Conduct Rules. NZX may place reliance on factors such as acknowledgement that an account has the status of a trust account. It may place some reliance on monitoring carried out by a third party, including a bank that maintains a trust account. If it does rely on this, we consider the NZX should first receive some formal assurance from the third party that it is in fact conducting such a role.

PART IX - FIDELITY GUARANTEE FUND

  1. The Commission received evidence in relation to the role, sufficiency, and use of the NZX Fidelity Guarantee Fund from Mr Allen.
  2. The Fidelity Fund is established under the Participant Rules. It can be called upon, in NZX's discretion, where a client suffers loss as a result of a participant's failure to meet financial obligations. The NZX Participant Rules state that in the event of a shortfall in a client funds account, clients will be paid out pro rata from the available funds. This means that in the event of any misuse of client funds every client is likely to suffer a loss, and is likely to seek to call upon the Fidelity Fund.
  3. The Fidelity Fund originated in the mutual structure of the NZSE where NZSE members (the brokers) had unlimited liability. The Fidelity Fund was retained under the corporate structure and is provided for in the Participant Rules. It is to be managed and controlled by NZX. Participant Rule 8.11 provides:

NZX shall make arrangements for a fidelity guarantee fund (the Fidelity Guarantee Fund) for the purpose of meeting just claims from persons who have suffered pecuniary loss from a broking transaction as a result of any Market Participant involved in Client Funds...being unable to meet its financial obligations, provided that nothing in this Rule, or in establishing and maintaining the Fidelity Guarantee Fund, shall constitute a legal obligation to any such person.

  1. The Commission asked Mr Allen whether the Board of NZX had given any consideration to the adequacy of the Fidelity Fund. He gave evidence that the Board had discussed the issue. The Rules provide a maximum claim of $20,000 per client and $500,000 per event. Mr Allen gave evidence that NZX does not take financial responsibility for regulatory activities. If another Access situation were to happen, NZX has no legal responsibility to pay out the Fidelity Fund, although Mr Allen noted that NZX would be viewed negatively if an investor were to lose money.
  2. Mr Allen gave evidence that NZX paid out the whole Fidelity Fund after the Access collapse and that currently the Fidelity Fund is at zero. The Commission understands that $460,000 was paid out. Mr Allen stressed, however, that recapitalisation could occur before or after any event leading to a call upon the fund.
  3. When asked about recapitalisation possibilities, Mr Allen noted the possibilities included government funding, on the basis that it is a public good fund, a levy on participants or a percentage of each trade. Mr Allen noted that NZX had the right to levy market participants but that there was no requirement for it to do so. He said that the NZX Board has not yet considered how the fund should be replenished. Mr Allen gave evidence to the Commission that he would regard the Fidelity Fund issue as urgent if another Access was on the horizon, but acknowledged that NZX would not know when any such event may occur.

Comment

  1. In the Commission's view the maintenance of a fidelity guarantee fund for stock exchange transactions raises law reform issues that are beyond the scope of this inquiry. These issues will, we understand, be considered by the Government in its current review of securities law. The Commission notes that other countries operate variously fidelity funds, compensation schemes or do not make any such provision. In the Commission's view there may be reasons to re-examine the purpose of and expectations for a fidelity fund, including how this or any similar investor compensation mechanism should be funded.
  2. Any review of the law in this area will take time. In the meantime, the Participant Rules provide for the maintenance of a Fidelity Fund. The Commission considers that the likely public perception created by the provision for this Fund raises a number of issues that require review by NZX. In submissions made to the Commission, NZX noted that the Fidelity Fund is intended to be used as a credit settlement fund between brokers. This is not apparent on the face of the Participant Rules. The Fund currently has a nil balance. NZX has noted that it has a number of options for recapitalising the Fund, including by contribution or insurance, or by levying Participants after a default event has taken place. There are also issues concerning the practical extent of compensation available under the Fund, and its availability to broker transactions other than NZX market transactions.
  3. While NZX does not have a legal obligation to use the Fund in any particular case, we consider that any difference between the public perception of this Fund and its likely application in the event of any default could raise issues of public confidence. We recommend that the NZX Board, as a matter of priority, consider its policy concerning the Fidelity Fund and the manner in which that is communicated to the investing public, addressing the issues described here.

PART X - DEVELOPMENT OF NZX COMPLIANCE FUNCTION SINCE 2003 AND RESPONSE TO ISSUES

  1. The Commission's inquiry arose from the failure of Access, and has focussed on events as they were in the period prior to that firm's collapse. The Commission informed NZX at the commencement of its inquiry that it would seek to make recommendations, if warranted, for improvements to the rules, procedures, and practices for broker supervision and inspections.
  2. As outlined in this report, the inspection of Access occurred during the development by NZX of its in-house broker compliance role. The Commission has concluded that there were shortcomings in the design and early implementation of this role. However, any assessment of the findings of this report, and any recommendations that might follow, need to be undertaken in the context of changes that have occurred at NZX since the time under review.
  3. The Commission has not at this time undertaken an extensive review of NZX's current broker compliance or other regulatory functions. Evidence relevant to this was received in the course of the inquiry, from NZX and from other witnesses. It is apparent that the broker compliance programme, in its formative stages at the time of the Access insp

ection in 2003, has developed significantly since. This can also be said of NZX's regulatory function more generally.

  1. Since 2003, NZX has:
    1. set up NZX Discipline as an independent body to hear and determine cases of alleged breaches of the NZX Conduct Rules, and introduced the NZX Discipline Rules;
    2. appointed a dedicated Head of Regulatory and Public Policy, responsible for NZX Regulation, a unit within NZX responsible for carrying out its regulatory functions;
    1. increased numbers and expertise of personnel in its participant compliance team, including members with extensive regulatory and internal audit experience;
    1. completed inspections for all Market Participants, allowing the development of risk profiles for the team's ongoing work;
    2. introduced spot inspections of Market Participants, in addition to scheduled inspections;
    3. tightened re-inspection schedules where breaches are found;
    4. introduced the new Participant Rules with higher compliance standards, including daily liquid capital reporting for Market Participants and a requirement for each Market Participant to have a nominated Compliance Manager who must not undertake operational activities;
    5. required all Market Participants to undergo accreditation under the new Participant Rules (in the course of which accreditation was denied to two firms); and
    6. referred several instances of suspected non-compliance with the Participant Rules to NZX Discipline.
  2. As detailed above, in response to the Grant Thornton report NZX has followed up the individual cases where breaches of the client funds rules were identified, and has published a guidance note to clarify Market Participants' understanding of these rules. NZX also informs the Commission that it intends to prepare a discussion document seeking suggestions for improvements to the client funds rules.
  3. The Commission received evidence from Mr Weldon that the compliance programme had evolved to NZX's satisfaction and that NZX considers the compliance function to be well constructed. Mr Weldon noted that the market was seeing value in compliance. The broking community was now seeing compliance as a source of competitive advantage and was becoming more compliance focussed. Mr Weldon considered that the NZX compliance team in place today had the requisite experience, backgrounds and compliance attitude.
  4. The Commission also received statements from senior market figures to the effect that the introduction of the Participant Rules and NZX's increased focus on compliance through its reporting and inspection programmes have resulted in a more rigorous compliance regime with market participants taking their obligations more seriously, and have enhanced the standing of the securities industry in New Zealand. One Managing Principal wrote:

The benefits from the consistency and accountability of the current processes cannot be underestimated...in summary I believe the introduction of the new participant rules, changes to the inspection and reporting processes and the consistent enforcement of the rules has had a major positive impact on the working and image of the NZX markets.

  1. These comments accord with the Commission's own observations in practice. Since demutualisation NZX has clearly increased its focus on regulatory matters. We have confidence that NZX is committed to maintaining high standards in its markets. At the time of its inspection of Access NZX had not yet completed the development and implementation of its broker compliance programme. The Commission is of the view that the steps NZX has taken since that time address in large part the issues raised in this report.

RECOMMENDATIONS

  1. It is a matter for NZX, as front line regulator of its markets, to take responsibility for the design and implementation of its compliance programmes. We recommend that NZX review its procedures in light of the comments in this report. We recognise that a number of changes have already been made.
  2. To the extent these do not address the issues identified in this report, the Commission recommends that NZX review the following areas of its operations:

Documentation and Guidance on Inspection Procedures Relating to Client Funds Accounts

Procedures should not be so rigid as to remove the necessary element of professional judgement, but should be sufficiently clear to enable a consistent and thorough assessment of market participants' compliance.

Record-keeping and Recording of Inspection Procedures

NZX indicated in its submissions that it would only expect records to be kept where breaches are found. The Commission recommends that NZX review this. We are of the view that inspectors should make a sufficient record of inspection procedures to allow for meaningful peer or supervisory review of the actual work undertaken in the course of an inspection.

Role of Supervisors

To the extent that NZX maintains that a supervisor's role is only to respond to issues raised by team members, the Commission recommends NZX review its requirements for supervision of its regulatory functions, to ensure that supervisors take an active role in quality assessment of their team's work, and also to ensure that supervisors are receptive and responsive to issues that are raised, whether or not this is done in the context of formal escalation procedures.

Role of the NZX Board

The Commission has expressed the view that the NZX Board should take an active role in monitoring the performance of NZX's regulatory functions, requiring more than exception reporting from executives.

Client Funds

The Commission recommends that NZX initiate a review of its client funds rules by preparation of its intended discussion document to allow input from market participants, and to see whether any improvements are required. The Commission also encourages NZX to continue to give heightened attention to client funds issues in inspections, and to continue its education efforts to ensure that all market participants are aware of their obligations.

Fidelity Fund

The Commission recommends the NZX Board consider its policy relating to the Fidelity Fund, including the likely application and scope of this fund in the future, and the communication of this policy to the investing public.

REFERRAL AND CONCLUSION

  1. The Commission's inquiry has reviewed procedures in place at NZX in 2003 and 2004, and has identified issues arising from this. Since the period under review there have been changes at NZX that address many of these issues. The Commission refers this report to the NZX Board for consideration of the Commission's recommendations, and appropriate action.
  2. The Commission's inquiry, and this report, arose from the collapse of Access. The focus of the inquiry has been on compliance processes and procedures associated with client funds accounts held by NZX Participants. Under New Zealand law investment brokers other than NZX Participants are not required to hold client funds on trust. Non-NZX investment brokers must simply advise potential clients whether or not their funds will be held on trust. Only NZX Participants must hold client funds in trust accounts. This is a significant legal protection.
  3. NZX is a registered exchange, the only one in New Zealand. This means that NZX Market Participants are, in many areas, subject to higher standards than are most in the advisory industry. The benefit of this is that investors can take confidence that there are intermediaries who are subject to such standards for the protection of investors, and whose compliance is monitored by a registered exchange. This is important not only for investors in New Zealand, but also for the reputation overseas of New Zealand's capital markets. The Commission welcomes the increased focus by NZX on its regulatory functions, since its demutualisation in 2002 and since the events detailed in this report. Performance of these functions is a significant contributor to confidence in our country's capital markets.

APPENDIX A

TERMS OF REFERENCE

The Securities Commission ("the Commission") is conducting an inquiry, under sections 10(b), 10(c), and 10(caa) of the Securities Act 1978, into regulatory and market issues arising from the default of Access Brokerage Limited (in liquidation) ("Access Brokerage") under the New Zealand Exchange Limited ("NZX") Conduct Rules in September 2004. The Commission is inquiring into the performance by NZX of its regulatory responsibilities as a registered exchange under the Securities Markets Act 1988. In particular the Commission will consider:

  1. steps taken by NZX to ascertain whether there are poor practices among NZX Participants in respect of Participant client fund accounting and reporting;
  2. client fund accounting rules and practices under the NZX Conduct Rules, including the treatment of client fund accounts maintained at financial institutions and the presentation of these to clients;
  1. the rules, procedures, and practices relating to participant supervision and inspection by NZX as these applied in the case of Access Brokerage;
  1. the role, sufficiency, and use of the NZX Fidelity Guarantee Fund; and
  2. any other matters relevant to the inquiry;

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.

February 2005

APPENDIX B

PROVISIONS OF NZSE REGULATIONS 2002 REGULATION 3 - CLIENT ASSETS AND CLIENT FUNDS ACCCOUNT
3.1
Definitions: For the purposes of this Regulation 3:

  1. Client Assets means
    1. Securities held by NZSE Firms in their Transfer Accounts and in their Client Funds Accounts;
    2. Securities purchased or sold by an NZSE Firm for or on behalf of a client;
    3. Funds received and held by NZSE Firms for undelivered buy contracts; and
    4. Funds received and held on account.
  2. Outstanding Broker Obligations means an agreement or arrangement between an NZSE Firm and its client where:
    1. Securities of the client have been transferred by the NZSE Firm to settle a sale or proposed sale of the Securities, and the NZSE Form has not paid the amount owing or that will be owing by it to the client on that sale or proposed sale; or
    2. The client has paid money to the NZSE Firm for the purchase of Securities and the Securities have not been transferred to the client (or as directed by the client); or
    3. The client has paid money to the NZSE Firm for any other purpose and the amount paid is required by Regulation 3.6 to be held by the NZSE Firm in its Client Funds Account and the NZSE Firm has not applied the amount paid (less permitted fees or commissions) for that other purpose; and
  1. Client Funds Account means a trust account held by an NZSE Firm at a Bank for the benefit of the NZSE Firm's clients for its Outstanding Broker Obligations.



3.2
3.2 Client Assets to exceed Outstanding Broker Obligations: Total Client Assets held by an NZSE Firm must at all times match or exceed the NZSE Firm's total Outstanding Broker Obligations.


3.3
Client Assets held on trust:

  1. Each NZSE Firm shall hold its Client Assets on trust for its clients at all times.
  2. All Securities recorded as being held in an NZSE Firm's Transfer Account shall be held by the NZSE Firm on trust for its clients with uncompleted contracts.



3.4
NZSE Firms to have Client Funds Accounts: An NZSE Firm shall open and maintain a Client Funds Account. If an NZSE Firm has more than one Client Funds Account, this Regulation 3 shall apply as if the Client Funds Accounts were a single Client Funds Account.


3.5
Requirements for Client Funds Accounts: NZSE Firms:

  1. Must obtain from the Bank holding the Client Funds Account a written acknowledgement of the trust status of the account, and must ensure that the words "Client Funds Account" appear in the title of the Client Funds Account;
  2. Must ensure that Client Funds Accounts are not overdrawn; and
  1. May not use funds in their Client Funds Accounts as security for any obligation of the NZSE Firm, or of any other person.



3.8
Application of funds: All amounts required to be paid into a Client Funds Account under Regulation 3.6 shall be held upon trust and applied:

  1. in reimbursing the NZSE Firm for any amount paid by it in settling the purchase of Securities for clients, including the transfer to an intraday same day funds settlement account operated by the NZSE in FASTER for true DVP settlement where it is to be applied to the payment against the transfer of such Securities to the NZSE Firm's Transfer Account;
  2. in payment to selling clients of the sale price for Securities transferred into the NZSE Firm's Transfer Account by the client;
  1. in payment to any other person for whom funds have been held in the Client Funds Account; and
  1. in payment of brokerage and other charges properly payable to the NZSE Firm by its clients for transactions under Regulations 3.8(a) and (b).

NZLII: Copyright Policy | Disclaimers | Privacy Policy | Feedback
URL: http://www.nzlii.org/nz/other/NZSecCom/2005/9.html