GLOSSARY OF KEY TERMS AND ABBREVIATIONS
Annual Regulatory Report
An annual report required of NZX Discipline under the NZX Discipline Rules.

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

Austraclear
A system for securities trades and cash transfers, operated in New Zealand by the Reserve Bank.

Business Leaders
Staff in the NZX Regulation and Participant Compliance teams of the Market Supervision Group.

Compliance Inspectors
NZX staff in the Participant Compliance team.

Conduct rules
The Participant Rules and Listing Rules of NZX.

DMA
Direct Market Access - system enabling accredited DMA firms to trade directly into the New Zealand market.

FASTER
Fully Automatic Screen Trading and Electronic Registration securities transfer system.

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

FSS
FASTER Settlement Solution - transfer system for the real-time settlement of trades.

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

IOSCO
International Organization of Securities Commissions

IOSCO Assessment Methodology
The methods and interpretations approved by IOSCO in 2003 for assessing implementation of the IOSCO Principles.

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

LCR
Listed Company Relations - a team which is part of the NZX Market Supervision Group.

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

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

MAP
Market Announcements Platform

Market Operations Group
Group within NZX that focuses on NZX's trading and systems infrastructure and technology arrangements.

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

Market Supervision Group
A group within NZX led by the Head of Regulation comprising three teams - NZX Regulation, Participant Compliance and Listed Company Relations.

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

NZSX
New Zealand Stock Market

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

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

NZXR
NZX Regulation- a team within NZX's Market Supervision Group which focuses on regulation of Listed Issuers.

NZX
New Zealand Exchange Limited

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

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

Review period
2005 calendar year

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

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

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

X-Stream
Brand name of NZX's securities trading system.

OVERSIGHT REVIEW OF NZX 2005

EXECUTIVE SUMMARY

The Securities Commission has reviewed NZX's performance of its regulatory functions as a registered exchange under the Securities Market Act 1988. This review, the first oversight review of NZX conducted by the Commission, focussed on NZX's arrangements in the 2005 calendar year for discharging its obligations.
We report on NZX's performance in relation to the following themes:
- conflict management;
- arrangements for supervision of Market Participants;
- arrangements for supervision of Listed Issuers;
- arrangements for release of market information;
- market operations and infrastructure;
- disciplinary arrangements and NZX Discipline;
- supervision of NZX as a Listed Issuer by the Special Division; and
- governance.
The Commission's overall conclusion is that NZX is satisfying its obligation to operate its markets in accordance with its conduct rules.
NZX's performance as a registered exchange is good. However, the Commission has made recommendations for improvements in relation to a number of areas. These recommendations are set out below.
The Commission has communicated its concerns and recommendations to NZX, NZX Discipline and the Special Division. Responses from the parties in regard to the recommendations and the Commission's views on those responses are also set out below.
NZX has already agreed to take specific action in response to certain recommendations and has committed to do so by the end of the 2006 calendar year. If NZX takes these actions within the stated timeframe, the Commission believes this will properly address those recommendations.
In respect of the remaining recommendations made to NZX, NZX has committed to reconsider its position and has undertaken to report back to the Commission by the end of the 2006 calendar year.

Recommendations

Market Supervision Group (general)

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

NZX says that it currently has a policy regarding conflicts of interest and agrees to set this out in writing.

NZX has committed to do this by the end of this calendar year.

Supervision of Market Participants

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

While NZX indicated in the course of our review that it is likely to do this in future, NZX noted that disciplinary action may not be the appropriate regulatory tool for dealing with breaches. NZX Discipline has indicated that it does not consider it appropriate for all breaches to be referred to it, in particular less material breaches.

The Commission considers that repeat breaches of the Rules can demonstrate particular attitudes towards compliance. NZX needs to use a mechanism to penalise repeat breaches by Market Participants. Currently, taking a case to NZX Discipline is the only avenue for doing this. If NZX is of the view that current NZX Discipline proceedings may not be appropriate in all cases, we think that NZX should consider the sufficiency of the regulatory tools available to it under the Discipline Rules. The Commission plans to keep this under review.

NZX will consider this matter again and has undertaken to report back to the Commission by the end of this calendar year.

Supervision of Listed Issuers

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

NZX agrees with this recommendation.

NZX has committed to do this by the end of this calendar year.

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

NZX considers that it currently has in place measures to determine compliance with its timing obligations. However, NZX will consider this matter again and has undertaken to report back to the Commission by the end of this calendar year.

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

NZX believes that it currently has adequate measures in place.

The Commission considers that these measures need to be more clearly communicated to NZX staff.

NZX will consider the matter again and has undertaken to report back to the Commission by the end of this calendar year.

NZX Discipline

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

NZX has advised that administrative and resource arrangements are being discussed with NZX Discipline and are close to being settled. NZX advises that it proposes to review these arrangements annually.

NZX has committed to do this by the end of this calendar year.

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

NZX is willing to entrench the fees so that they may not be reduced. NZX is willing to review the fees at regular intervals.

NZX has committed to do this by the end of this calendar year.

NZX Discipline should publish its Annual Regulatory Report annually.

NZX agrees with and supports this recommendation.

Special Division

The Special Division, as a body, should determine whether the Special Division has jurisdiction to deal with matters referred to it. Any delegations from the Special Division to its Chairman should be formally recorded.
Given the important role of the Special Division in respect of NZX's compliance as a Listed Issuer, the Special Division should take steps to ensure that it is fully aware of the powers available to NZX Regulation under the Listing Rules in respect of other Listed Issuers, and should exercise those powers as appropriate in relation to NZX as a Listed Issuer.
Given NZX's position as both a Listed Issuer and regulator of all other Listed Issuers listed on its markets, NZX should set an example of full compliance with all lawful directions or requests from the Special Division.

NZX considers that it is entitled, as is any other issuer, to decline to provide information sought where NZX does not consider it relevant or appropriate to provide such information. NZX considers that NZX should only comply with those requests or directions necessary for the Special Division to undertake its enforcement role (as opposed to the role of considering a waiver or ruling application) and within its powers and jurisdiction. NZX is of the view that it cannot compel production of information by issuers in relation to waiver applications.

The Commission considers that in practice NZX does have the power to compel production of information by otherwise refusing to grant waivers if relevant requested information is not provided. We remain of the view that NZX should set an example of full compliance with all lawful directions or requests of the Special Division.

NZX will consider this matter again and has undertaken to report back to the Commission by the end of this calendar year.

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

NZX has advised that it will request a meeting between NZX and the Special Division to discuss resource requirements and the guarantee of funding.

NZX has committed to do this by the end of this calendar year.

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

NZX has agreed to implement a communication strategy about the role of the Special Division. NZX considers that the Special Division should have considerable involvement with this. The Commission agrees.

NZX has committed to do this by the end of this calendar year.

The Special Division should formalise its delegation to the appointed solicitor and should receive regular reports on work dealt with by the appointed solicitor under delegation.
The Special Division should have and use the same procedures manuals in respect of NZX's compliance as a Listed Issuer that are used by NZX Regulation in respect of all other Listed Issuers. The Special Division should satisfy itself that the appointed solicitor uses the NZX Regulation procedures, including where matters are delegated to that solicitor.
The Special Division should settle internal procedures that it would use, including procedures for communicating with the market, in dealing with a serious compliance matter regarding NZX.
The Special Division should formalise its expectation about the referral of data generated by the SMARTS market surveillance system concerning NZX's listed securities. Where alerts from SMARTS are below the threshold set by the Special Division for referral to it, the appointed solicitor should regularly advise the Special Division of the number of such alerts received in the period and a summary of any alerts that were not referred.
To avoid a situation of conflict for the appointed solicitor, the appointed solicitor should have no role in matters that raise contentious issues, including complaints handling (beyond an initial transmittal of a matter to the Special Division). The Special Division should engage external advisers to assist it in dealing with such matters and be funded to do so. The external advisers should have access to NZX's facilities and regulatory precedents and be able to consult with NZX Regulation.

The Special Division agrees that it would be appropriate for it to handle such matters without the involvement of the appointed solicitor or for the Special Division to engage external counsel if necessary. In respect of waiver and ruling applications the Special Division is of the view that the appointed solicitor should, at the Special Division's request, be able to provide analysis and comment to the Special Division on precedent applications under the Listing Rules.

The Commission considers that in respect of waiver and ruling applications involving contentious matters the Special Division should use its external advisers, and that these advisers should be given access to precedents and other relevant information.

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

NZX and the Special Division consider that it would be suitable if the appointed solicitor was not involved in any commercial work that had Listing Rule content but could carry out other commercial work.

The Commission does not agree. The appointed solicitor should be free to carry out other work for NZXR, but we consider that this person should not undertake corporate advisory work for NZX.

NZX will consider this matter again and has undertaken to report back to the Commission by the end of this calendar year.

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

NZX notes that the Special Division's decisions are published in the same way as NZXR decisions and that this recommendation is unnecessary.

The Commission notes NZX's response but considers that benefit will be derived by both NZX Discipline and the market if the Special Division's activities are included in NZX Discipline's Annual Regulatory Report.

Governance

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

NZX is of the view that these responsibilities are sufficiently clear at present, but has agreed to consider whether any further clarification is desirable, and to report back to the Commission by the end of this calendar year.

The Commission comments, but does not make specific recommendations, in relation to NZX's commercial and regulatory conflict management arrangements, arrangements for release of market information or market operations and infrastructure.

OVERSIGHT REVIEW OF NZX 2005

INTRODUCTION

The Securities Commission has reviewed NZX's performance of its regulatory functions as a registered exchange under the Securities Market Act 1988. This review, the first oversight review of NZX conducted by the Commission, focussed on NZX's arrangements in the 2005 calendar year for discharging its obligations.
NZX has obligations under section 36G of the Securities Markets Act 1988 to secure compliance with its listing and business rules, and to perform any obligations that lie on NZX under those rules.
The Commission has statutory functions to review practices relating to securities and activities on securities markets, and to comment on these. In relation to NZX, performance of these functions requires the Commission to keep under review and comment on NZX's performance of its obligations as a registered exchange.
The Commission carried out the review under Terms of Reference. The Terms of Reference, along with the scope of and background to the review and the process that we followed, are set out in the Appendix to this report.
This review incorporates NZX's progress on the recommendations made to NZX in 2005, in the Commission's report into Performance by NZX of its Regulatory Functions as a Registered Exchange During 2003 and 2004 Prior to the Collapse of Access Brokerage. NZX has taken steps to address those recommendations, which concerned documentation of procedures, record keeping, the roles of supervisors and the Board, client funds, and the NZX Fidelity Fund. The Commission notes that further work is intended by NZX in relation to policy issues concerning client funds and the fidelity fund.
We report on NZX's performance under the following themes:
- conflict management;
- arrangements for supervision of Market Participants;
- arrangements for supervision of Listed Issuers;
- arrangements for release of market information;
- market operations and infrastructure;
- disciplinary arrangements and NZX Discipline;
- supervision of NZX as a Listed Issuer by the Special Division; and
- governance.

OVERSIGHT REVIEW OF NZX 2005

CONFLICT MANAGEMENT

NZX's position as a registered exchange and public issuer

NZX is a limited liability company. It is a Listed Issuer: its shares are traded on the NZSX market. In this respect NZX is both the frontline regulator of a securities market and a commercial entity that participates as a regulated entity on that market. In 2001 the Parliamentary select committee considering the NZSE demutualisation legislation noted the public interest issues raised by the demutualisation of the exchange. The assessment methodology for the IOSCO Principles notes that while all exchanges should have procedures in place to address conflicts of interest, there may be more concern for conflicts of interest, or the appropriate use of self-regulatory resources, in the case of for-profit, demutualised markets. One concern is that such an exchange would seek to cut its regulatory activities or standards in order to boost returns for its shareholders. Such an inherent conflict within a demutualised exchange has been noted in various overseas jurisdictions, and differing approaches have been taken overseas to manage this conflict.
We record that NZX has consistently stated that it does not see its commercial and regulatory functions as inherently conflicting. NZX maintains that its success as a registered exchange, and correspondingly as a commercial entity, largely depends on its ability to engender confidence in the regulated markets that it operates, and that this in turn gives NZX every incentive to maintain high standards in its regulatory operations. The Commission agrees that these incentives exist, but does not consider that this means there is no conflict of interest. The Commission notes that it is largely the perception of conflicts of interest that can damage confidence.
There is no doubt that commentators in New Zealand and overseas, and many overseas exchanges, recognise that a listed exchange company's dual roles create the potential for conflicts of interest. The Commission is concerned that the unwillingness of the NZX Board to acknowledge that there is an inherent conflict within any demutualised exchange between commercial and regulatory functions may preclude the NZX Board from giving sufficient and necessary consideration to potential organisational developments within NZX regarding the regulatory function.
The Board of NZX has told the Commission that whilst it does not consider that such a conflict in fact exists, NZX and the NZX Board are aware that the perception of such a conflict can exist and is held in some quarters. The NZX Board considers that addressing this perception is important and it is engaged to ensure that the perception of such a conflict is addressed, including by keeping under review its regulatory structures and their position within the organisation.
The Commission in its review has considered the steps that have been taken by NZX to manage these conflicts. In the Commission's opinion market confidence is best served where it can be demonstrated that a registered exchange conducts its regulatory operations independently of conflicting commercial objectives.
The Commission considers that there is currently in practice effective separation between NZX's supervisory functions and its corporate activities, and that the conflicts of interest between these functions are managed satisfactorily.

OVERSIGHT REVIEW OF NZX 2005

MARKET SUPERVISION FUNCTION

Arrangements for Market Supervision

The Market Supervision Group comprises three teams - NZX Regulation ("NZXR"), Listed Company Relations ("LCR") and Participant Compliance. The Group Leader of the Market Supervision Group is the Head of Regulation. In 2005, the Head of Regulation and the four other NZX Group Leaders reported to the CEO.

The Market Supervision Group comprises three teams - NZX Regulation ('NZXR'), Listed Company Relations ('LCR') and Participant Compliance.

The focus of the NZXR team is on NZX's Listed Issuers. NZXR supervises the activities of Listed Issuers in relation to their compliance with the Listing Rules.
During the review period the NZXR team comprised two Business Leaders and four NZX Solicitors. The NZXR Business Leaders have responsibilities for managing the NZX Solicitors in the NZXR team. Matters tend to be raised with the Business Leaders in the first instance. Matters are referred to the Head of Regulation as necessary. The NZXR team formally reports to the Head of Regulation.
LCR is responsible for the accurate and timely release of market information, such as information submitted by issuers via the Market Announcement Platform, and compliance checks of certain information provided by Listed Issuers in relation to market announcements.
The LCR team comprised two Client Relationship Managers and a LCR Team Leader. Any compliance issues identified by members of the LCR team are escalated to the LCR Team Leader in the first instance, and are referred to a NZXR Business Leader as necessary. Matters may also be raised with the Head of Regulation by members of LCR or by the designated Business Leader. The team formally reports to the Head of Regulation.
The Participant Compliance team supervises the activities of NZX accredited intermediaries and brokers (Market Participants) in relation to their compliance with the NZX Participant Rules, and Futures and Options Participants in relation to the NZX Futures and Options Rules.
During the review period the Participant Compliance team comprised two Business Leaders and three Compliance Inspectors. The Business Leaders have responsibilities for managing the Compliance Inspectors. Compliance Inspectors raise matters with the Business Leaders in the first instance. Matters are referred to the Head of Regulation as necessary. The Participant Compliance team formally reports to the Head of Regulation.

Resources for Market Supervision Group

There is no separate budget or separate financing for NZX's regulatory functions. NZX Board members expressed the view that any separation would be unnecessary, and could be seen as constraining the resources available to this Group. In practice, we were told, the regulatory function will be given such resources as it requires. We were told the Board would expect the Head of Regulation to raise any resource constraints with Board members.
The Board's impression is shared by executive management. The Head of Regulation considers that Market Supervision has unlimited access to financial resources to discharge its function. The Head of Finance and Strategy prepares high level projections and budgets for businesses within NZX, including Market Supervision. These are discussed with the Head of Regulation. The Head of Regulation has been able to talk directly with the CEO about any resource needs. Resources have been forthcoming.
Any resource issues concern human resources. NZX has used secondees or external legal providers to cover any shortfall in this regard. The Head of Regulation is free to make decisions at her discretion regarding external services. There is no limitation on the budget for these services. The Head of Regulation was satisfied that all requests for resources had been met in the review period.
Operationally there is crossover of the personnel that carry out commercial and regulatory work, in particular the NZX Solicitors in the NZXR team. There is an expectation that these solicitors will undertake a certain amount of commercial work for NZX in addition to their regulatory activities. NZX's view is that this does not of itself create a conflict for any solicitor, except in a situation where a solicitor might undertake work for the Special Division, as regulator of NZX. During the review period the NZX Solicitor appointed to act as the liaison between NZX and the Special Division did not undertake any commercial work for NZX.
The fact that NZX Solicitors are available to undertake corporate work for NZX has the potential to cause resource conflicts between NZX's corporate and regulatory work. However, in practice it appears to have been clearly communicated to all NZX Group Leaders that the first demand on NZX Solicitors' time is their regulatory work. Sharing of legal resources that have regulatory and commercial functions is discussed between the Head of Regulation and the Corporate Counsel (or the Group Leaders). It was evident that NZX's corporate groups are expected to contract out legal work if the level of regulatory work would create competing priorities for NZX Solicitors. We did not see evidence of material resource difficulties in the review period caused by the in-house legal resource being shared between the regulatory and corporate groups.
The Commission has previously recorded in its report arising from the collapse of Access Brokerage that NZX has, since demutualisation, increased its focus on market compliance. Our more detailed review has reinforced this observation. It is our impression that adequate resources were applied to regulatory functions in 2005.

Interaction between Market Supervision and the other NZX groups

NZX Solicitors noted interaction with Group Leaders (other than the Head of Regulation) and the Corporate Counsel in relation to the commercial aspects of their work. Some NZX Solicitors were also involved in bringing a regulatory perspective to the Listings Group, run by the Head of Market Products, in relation to potential new listings.
The Participant Compliance team's main interactions with other NZX business units concern IT and systems matters if any systems issues arise.
The LCR team has some interaction with other Group Leaders, particularly in relation to IT and systems issues, database management, and NZX's publications for which LCR generates data. LCR is responsible for running a helpdesk and matters may be referred from the helpdesk to other parts of the business for a response. The LCR Team Leader participates in the Listings Group which focuses on promoting and attracting listings.
Of the personnel in the Market Supervision Group, only the Head of Regulation reports to and appears before the Board.

Responsibility for Market Supervision

NZX has powers under its Listing Rules and Participant Rules in relation to administration and enforcement of the Rules. Some of the enforcement powers have been delegated by the Board to NZX Discipline. All relevant powers, as they relate to NZX as a Listed Issuer, have been delegated to the Special Division.
Identical delegations for administration and enforcement of the Rules have been granted to the CEO and to the Head of Regulation. We consider that this detracts from the separation that has been established between corporate and regulatory activities.
The directors of NZX were strongly of the view that Board delegations for the exercise of regulatory powers should lie with the CEO as well as the Head of Regulation because the Board needs to be able to hold the CEO ultimately accountable for all aspects of NZX's performance.
In practice it was clear that the Head of Regulation exercises supervisory authority over regulatory matters. The CEO is consulted on regulatory matters from time to time, but the Head of Regulation has no belief that this detracts from her authority to exercise the delegated powers. The Head of Regulation noted that there had been no instances during the review period where the CEO and Head of Regulation had disagreed on the approach to be taken on a regulatory matter. We understand that should this occur on an important matter, it would be escalated to the Board. It appears that in practice the CEO is kept informed of regulatory work, to allow him to ensure that as CEO he is involved in any material matters affecting policy or risk.

Separation of the Market Supervision Group

Our review found that NZX has in place physical and procedural information controls designed to isolate the regulatory work undertaken by the Market Supervision Group, in particular NZXR which is responsible for Listing Rule compliance.
All NZX personnel work in the same building. While the working environment is open plan, work areas are divided so that the Market Supervision Group is separated from the commercial groups. This area can be locked off from the rest of the floor. Information in the regulatory area is understood by commercial personnel to be confidential.
We were advised that there are information controls on the NZX computer system. The server has a dedicated drive for NZXR personnel, which is only accessible by them. Access to electronic files and regulatory databases is also restricted to NZXR personnel. The Participant Compliance team has similar controls, and information about Market Participants can only be accessed by members of that team and the Head of Regulation.
All staff we spoke to appeared to be aware of the need to maintain separation between corporate and regulatory work.
The treatment of listing applications has highlighted conflicts of interest in overseas jurisdictions. This has occurred where pressure has been applied, for the sake of increasing revenue, to accept lower quality listings. The regulatory requirements for a listing on NZX are, consistent with other activities, dealt with by the NZXR team, quite separately from the corporate side of NZX's business. Separation at this stage is assisted by the continuing use of the Listing Subcommittee, which comprises two persons who are otherwise independent of NZX, to review listing documents for compliance with the Listing Rules. We were told there were occasions on which Listed Issuers, and in particular companies that are in the process of listing, have contacted members of the Market Operations Group for assistance or support on a regulatory matter. It seemed to be clearly understood that any such inquiry would be immediately forwarded to the appropriate regulatory personnel.

Personnel

As an entity exercising regulatory authority it is important that NZX's processes for dealing with potential conflicts of interest on the part of individuals are clear and consistently applied.
At a staff level, management of conflicts of interest is important, in particular for NZX Solicitors who have authority to take decisions (in divisions of 3 solicitors) on various applications made by Listed Issuers. NZX Solicitors were aware that they should declare conflicts of interest. However, NZX does not have any formal written policy about identification and disclosure of personal conflicts by its Market Supervision staff. We were told that it is the responsibility of the Lead Solicitor on any matter to ensure that no member of a division has an interest in the matter. NZX Solicitors were of the view that interests should be declared to the Head of Regulation or to the relevant Business Leader, who can determine whether or not an interest is such as to preclude participation in any matter. Participant Compliance team members appear to have a similar understanding but it was not clear that a specific expectation had been communicated to them regarding disclosure of conflicts of interest. We recommend that NZX introduce and communicate to all Market Supervision staff a formal policy about disclosure of conflicts of interest so that all Market Supervision staff have a consistent understanding of NZX's expectations about conflicts disclosure. NZX has a policy regarding trading by its officers and employees in the securities of any NZX Listed Issuer.

Recommendation

We recommend that:

NZX introduce and communicate a formal policy for all Market Supervision staff concerning identifying and declaring personal conflicts of interest.

NZX says that it currently has a policy regarding conflicts of interest and agrees to set this out in writing.

NZX has committed to do this by the end of this calendar year.

OVERSIGHT REVIEW OF NZX 2005

ARRANGEMENTS FOR SUPERVISION OF MARKET PARTICIPANTS

Role of Participant Compliance

Participant Compliance performs the following functions in relation to supervision of Market Participants and Futures and Options Participants:
1. Review of daily, monthly and annual financial returns submitted by Market Participants, Futures and Options Firms, and Futures and Options Introducing Brokers;
2. Review of Internal Control Checklists, which contain confirmation from Market Participants of their compliance with various Participant Rules;
1. Onsite reviews of Market Participants' compliance with the Participant Rules and Futures and Options Participants' compliance with the Futures and Options Rules;
1. Review and investigation of complaints received from investors relating to the activities of Market Participants that may be referred to NZX Discipline;
2. Review of trading in the shares of Listed Issuers to identify possible breaches of NZX Rules and securities laws; and
3. Reviewing applications from entities and individuals seeking accreditation by NZX.

Conduct of market surveillance regarding trading activity

The Participant Compliance team has the primary responsibility for reviewing the alerts received from SMARTS, the real-time market surveillance system. Members of NZXR also have access to SMARTS.
The SMARTS system maintains an audit trail of the alert and the person who has reviewed the alert. A review of a sample of alerts indicated that alerts were regularly reviewed by members of the Participant Compliance team.

Complaints handling regarding Market Participants

NZX has a complaints manual detailing processes for handling complaints. Participant Compliance team members advised that they use the processes set out in the manual to deal with complaints. The files evidenced that the complaints procedure was followed. All members of the Participant Compliance team handle complaints. Complaints handling is overseen by a Business Leader and the Head of Regulation.
Where complaints raise substantive issues and lead on to referral to NZX Discipline, the Participant Compliance team prepares the Statement of Case which commences the discipline process.

Onsite inspections and periodic reporting

The findings of the inspection and working papers relating to inspections of Market Participants were well documented. Findings of inspections were generally observed to be communicated to Market Participants within the timeframes determined by internal NZX policies. Copies of inspection reports were sent to the Commission at the time.
There was regular communication with Market Participants for correcting the breaches and shortcomings observed in the course of inspection. The inspection files contained well-documented records of regular follow-up correspondence with respective Market Participants.
Some delays in relation to internally determined timeframes were observed in the submission of monthly reports to the Head of Regulation.
Some repeat breaches of Participant Rules, observed in inspection reports selected for sample review, did not result in these breaches being referred for disciplinary action. We understand from discussions with members of the Participant Compliance team that the approach is to provide guidance and advice to the Market Participants and to try to change their behaviour rather than initiate immediate disciplinary action.
The Head of Regulation noted in terms of NZX's approach to participant compliance that it may be a matter of selecting the right regulatory tool to deploy in any given situation. In the course of its inspection programme, NZX focuses on education rather than discipline but depending on the circumstances would bring disciplinary actions as well. The Head of Regulation indicated that the focus on education may change now that NZX has inspected every Market Participant. Material received from NZX Discipline shows that several broker compliance matters have been referred to it. We recommend that NZX take disciplinary action against Market Participants who commit repeat breaches of the Participant Rules.

Accreditation of Market Participants

Market Participants are required to be accredited by NZX under the Participant Rules. The Participant Compliance team processes accreditation applications. NZX seeks to ensure that only fit and proper entities are designated as NZX Participants. In the course of the NZX Sponsor application process, the application is put to a panel of senior NZX staff (comprising the Head of Regulation, the Group Leader - Market Products and the CEO) for review. The files showed that the panel makes comments on the applicant's appropriateness for accreditation. This panel approval process was used for each of the files that we reviewed. The panel's decision was then confirmed to the applicant. Other Market Participant applications are approved by the Head of Regulation following review and recommendation by Participant Compliance staff.

Escalation of issues

The Participant Compliance Business Leaders report to the Head of Regulation from on-site inspections if there are significant issues. The Head of Regulation has been involved in reviewing five inspection reports during 2005. Her focus is on the findings and recommendations, and the timeframes for issues to be remedied. The Head of Regulation also takes into consideration whether the report is raising issues that she needs to bring to the attention of the CEO or Board. A similar approach is taken for escalating significant issues observed in other areas of participant compliance work.
Where repeat breaches occur within a firm there may be increased intervention by NZX. The Head of Regulation always expects to be made aware of situations where a client funds account is in overdraft, liquid capital thresholds have been breached, or "cultural" issues noted at a firm. This expectation has been communicated to the Participant Compliance Business Leaders.

Recommendation

NZX has adequate processes in place for supervision of Market Participants and Futures and Options Participants under the Participant Rules and the Futures and Options Rules and uses its processes consistently. We make the following recommendation:

NZX ensures that, now the "education process" with Market Participants is complete (through the inspection process), NZX takes disciplinary action against Market Participants who commit repeat breaches of the Participant Rules.

While NZX indicated in the course of our review that it is likely to do this in future, NZX noted that disciplinary action may not be the appropriate regulatory tool for dealing with breaches. NZX Discipline has indicated that it does not consider it appropriate for all breaches to be referred to it, in particular less material breaches.

The Commission considers that repeat breaches of the Rules can demonstrate particular attitudes towards compliance. NZX needs to use a mechanism to penalise repeat breaches by Market Participants. Currently, taking a case to NZX Discipline is the only avenue for doing this. If NZX is of the view that current NZX Discipline proceedings may not be appropriate in all cases we think that NZX should consider the sufficiency of the regulatory tools available to it under the Discipline Rules. We plan to keep this under review.

NZX will consider this matter again and has undertaken to report back to the Commission by the end of this calendar year.

OVERSIGHT REVIEW OF NZX 2005

ARRANGEMENTS FOR SUPERVISION OF LISTED ISSUERS

NZXR's focus

NZXR focuses on applications made under the Listing Rules received from Listed Issuers. NZXR also supports the LCR team, prepares matters for NZX Discipline, provides support to the Special Division (as required) and monitors the regulatory environment and effectiveness of the Listing Rules. Members of the NZXR team also undertake corporate legal work for NZX, including preparing applications to the Special Division on behalf of NZX as a Listed Issuer.
NZXR works in divisions of three solicitors for considering most matters. Generally this process seems to work well, and ensures that decisions are well-canvassed and that a mix of experience and viewpoints are taken into account. We noted that the division process appeared to create certain timing difficulties in some instances. We comment further on the division process below.
NZXR does not initiate investigations regarding compliance with the Listing Rules, absent complaints, and observed or suspected non-compliance. While the Participant Compliance team actively monitors the market, through a programme of inspections and the SMARTS technology, the NZXR work is reactive. Solicitors are approached by issuers or third parties in respect of matters which require their attention, such as document approvals required by the Listing Rules or applications for waivers from the requirements of the Listing Rules. This is consistent with the approach taken by other exchanges.

Approval of listings and delistings

NZX Solicitors have access to a comprehensive listing manual which is intended to provide guidance to the solicitors on the listing process. It was evident from file reviews that the NZX Solicitors were following the processes and checklists contained in the manual. The Market Products Group has a role in promoting and attracting listings, but once a listing application is received by NZXR, the Market Products Group has no involvement in the processing of that application.
As with all NZXR work, an application for listing is assigned to a Lead Solicitor. The Lead Solicitor then works in tandem with the Listing Subcommittee to assess the application and make a decision. Divisions are not used to consider listing applications. NZX's process of using the Listing Subcommittee to consider listing applications is derived from the previous NZSE mutual structure. It is not a requirement of the Listing Rules. The Lead Solicitor and the Subcommittee correspond at length about the issues raised in any particular matter. The Subcommittee's focus is on the financial information disclosed in offer documents.
The Subcommittee has two members. In the event of a conflict, the conflicted member stands down and the Subcommittee is reduced to one member. We recommend that NZX consider enlarging the membership of the Listing Subcommittee to address conflicts.
On one occasion we found the Listing Subcommittee recommended that a draft offer document submitted with a listing application should include information that would have been in breach of the securities laws. Although the Listing Subcommittee's focus is on the financial information included in offer documents we would expect the Listing Subcommittee to be aware of the securities law requirements. We note that the Companies Office also reviews offer documents from a statutory perspective, although NZX and the Companies Office do not have any formal liaison. In interviews, NZX told us that where it discovered an offer document was in breach of Securities Act requirements, it would communicate its concerns to the issuer in the first instance, and would likely also refer the breach to the Companies Office. In its comments on the report NZX said that it would communicate its concerns to the issuer and may refer the matter to the Companies Office or to the Securities Commission. The Commission expects all unresolved breaches to be referred.
Delisting applications were considerably less complicated. It appears that delisting applications are dealt with by a Lead Solicitor working alone. For issuers who had a listing in another jurisdiction the primary concern was that any outstanding obligations were settled by the issuer so that delisting could proceed. NZX was also concerned that communications were undertaken with security holders so that they were informed of their position. NZX advised in submissions that it would be likely to require shareholders' resolutions where a company that did not have a secondary listing with another exchange wanted to delist.

Other approvals under the Listing Rules

NZXR reviews and approves a range of other documents under the Listing Rules, including:
1. Waiver and ruling applications;
2. Approvals of persons to prepare Appraisal Reports;
1. Notices of Meetings; and
1. Approval of the independent solicitor to prepare an opinion on an issuer's constitution.
NZX has a Solicitor's Handbook which contains checklists and guidelines for these matters. It appears from the files reviewed that during the review period NZXR staff followed these checklists and guidelines consistently.

Waiver and ruling applications

Processing of waiver and ruling applications for Listed Issuers followed a consistent process. The Solicitor's Handbook contains a guide to waivers and rulings which sets out the steps of an application for the solicitors. The decisions appeared consistent with those made on similar facts.
Waiver and ruling applications are dealt with by the division process. NZXR solicitors reviewed the applications and identified issues for follow-up with other members of the division, with Business Leaders, and with the applicant. Once a draft decision had been prepared, there was input from the division in terms of proof-reading and content.
Where waiver and ruling applications were made in respect of several Listing Rules, the NZXR solicitors considered the application in respect of each Rule. There was good use of precedents. Many of the published decisions did not refer to the precedents searched. NZX Solicitors advised that NZXR always considers the position of shareholders in considering applications more generally. Statements about the effect on shareholders were in fairly standard form across the decisions we examined. Decisions and conditions appeared consistent across applications.
File reviews indicated that NZXR would consider past compliance issues when determining applications, although each application is determined on a case by case basis.
Applications for waivers and rulings that involve Listing Rule 10.1.1 (continuous disclosure of material information) were dealt with differently to other waiver and ruling applications due to different statutory requirements. A Business Leader dealt with these applications in consultation with the Head of Regulation. This process reflects the experience of the Business Leaders in dealing with this type of application. In some particularly complex applications, external advisers were consulted. In these cases, the Business Leader would consult with the external adviser and Head of Regulation. In the case of one waiver application dealing with Listing Rule 10.1.1, there was active involvement from the CEO. This application was made in the context of an IPO.
It appeared that there were several Listing Rules where a significant number of issuers sought waivers. NZX noted that it had identified that the market had missed the fact of the new obligation for the nomination period for directors, and this had led to widespread non-compliance. To remedy the situation, NZX took positive steps to educate the market, including making announcements and writing to issuers to remind them of the new obligation. NZX has advised that it monitors waivers and rulings and incorporates these into the rule review process.

Timing requirements for approvals

An area of concern was timing in processing applications. Under the Listing Rules, certain documents requiring approval by NZX, and waiver and ruling applications, are to be submitted to NZX at least 10 days before the document is to take effect or a determination is sought. Waivers and rulings can also be sought on an urgent basis. When this occurs, the matter must be dealt with within 10 working days and urgency rates apply. The Commission acknowledges that the quality of applications and information provided by applicants can have an effect on timing. File reviews indicated some delays in addressing applications, with some issuers expressing concerns about this, although in most cases the 10 day timeframe was met. This appears partly to be a side-effect of the division process, as the Lead Solicitor must wait for feedback from other division members. At times this slows down the process. We recommend that more attention be paid to this. File reviews also indicated issues about applications made under urgency which were not dealt with in the expected timeframe. In some cases this caused problems for the issuers, and in one instance led to NZX making representations to the issuer that it would not find an issuer in breach on the basis that NZX had not fully considered the application.

Surveillance: trading halts and price enquiries

There are two types of trading halts: issuer-requested and NZX-initiated. File reviews evidenced that these did not require much action by NZX. Where trading halts were requested, the LCR team actioned them promptly.
Price enquiries arise when SMARTS generates an alert that there has been unusual trading activity, either in the price of the securities being traded, or in the volume. Unusual trading activity may suggest insider trading and may raise questions as to whether the issuer is complying with its continuous disclosure obligations. Where alerts generated by SMARTS warrant further enquiry, a Business Leader will action a price enquiry in conjunction with a member of the Participant Compliance team. A form letter is sent to the issuer, setting out the concern and asking for confirmation that the issuer is complying with Rule 10.1.1. NZX normally releases its letter and the response to the market. NZX also provides information to the Commission under the Securities Markets Act.

Inspections and investigations

NZX has powers to obtain information by exercising its powers of inspection. The Solicitor's Handbook refers to the inspection power in a short note on investigation processes.
File reviews indicated that in some cases, issuers were not forthcoming with documents. NZXR has a range of enforcement tools which it is willing to consider and has indicated it is willing to use its powers of inspection to obtain required documents.
NZXR is able to contract resources, and in the case of suspected breaches, this may be an option in order to determine whether a breach has occurred. This external adviser is managed by the Lead Solicitor on a matter. In some cases the NZX would also refer matters to the Commission. NZXR did note that the extent to which it investigated a matter would need to be determined in terms of the outcomes that would likely be achieved.
On occasion, when NZXR referred breaches to NZX Discipline, some issuers involved expressed their unhappiness with the referral directly to NZXR. We note that NZXR did not make any changes to their approach, despite potential risks to listings, but followed the procedures that NZXR had identified as appropriate.

Disciplinary actions

The Solicitor's Handbook contains a brief note about the NZX Discipline process. It does not contain further specific guidance in relation to disciplinary processes. The matters giving rise to disciplinary actions varied throughout the review period. NZXR followed the same general process in respect of each matter.
The Statement of Case and Notice of Referral to NZX Discipline were drafted by the Lead Solicitor in consultation with the Business Leaders and the Head of Regulation. An external adviser was also used during the review period. The Statements of Case and Notices of Referral followed a standard format and attached relevant documentation.
There was evidence that NZXR was under considerable pressure at times, both from complainants and issuers. NZXR corresponded in a measured way and did not yield to demands from these parties. NZXR was clearly following a process and attempting to ensure that disciplinary matters were dealt with in a considered fashion. The Lead Solicitor sought input from external advisers when drafting responses on these types of matters.
There was some variance between the views of NZXR and NZX Discipline regarding the penalties handed down by NZX Discipline for breaches of the Listing Rules versus the penalties recommended by NZXR. Executive management noted disagreement with some decisions handed down by NZX Discipline but considered this indicated that the process of having NZX Discipline act as the disciplinary body was effective and showed that NZX Discipline was acting independently. Both NZXR and NZX Discipline have regard to the published NZX Discipline Penalty Bands Guidance Note in recommending and setting penalties. The Commission has no comments about consistency in relation to the penalties imposed by NZX Discipline, although we note there have not been a sufficient number of NZX Discipline decisions to identify any clear trend.

Records: practices and procedures

File reviews indicated that NZXR's files appear to be comprehensive, well maintained and clearly identified. It was clear from the files reviewed what process NZXR had undertaken in respect of each application. The NZXR team makes use of a file closing form, which indicates the names of the members of the division, the Rule which the file related to, and the time spent on the matter, as well as other information such as whether an external adviser was engaged.
NZX also has a Legal Reference System, which is essentially a database of all NZXR decisions and includes key items of correspondence and application documents. NZX Solicitors use this information to assess the precedent value of decisions. We understand that every decision is summarised for the Legal Reference System, although the summary may be brief for straightforward matters.

Complaints handling

NZXR maintains a complaints log. This contains a copy of all complaints received and a summary of the responses to those complaints. NZXR uses the complaints manual to process complaints. In the complaints process, NZXR essentially acts as a go-between for the parties. NZX indicated that it would assess whether complaints were frivolous or without substance before entering into the extended complaints process.
Where complaints are made in respect of NZX's compliance as a Listed Issuer, the complaints procedures manual makes it clear the complaint should be referred to the Special Division. The Special Division did not receive any complaints about NZX's, or its related parties, own compliance with the Listing Rules during the review period.
If a complaint concerns NZX as a regulator and market operator, NZXR will respond directly to the complainant.

Education initiatives regarding the Listing Rules

The Business Leaders have involvement in seminar presentations about the Listing Rules. They also provide assistance to issuers on an individual basis regarding clarification of the Rules as requested. One NZX Solicitor who focussed more on the AX Market work undertook a similar role in terms of working with the AX issuers to provide information and clarification as necessary.

Supervisory structure within the NZXR team

The NZX Solicitors report to two Business Leaders, who in turn report to the Head of Regulation. The NZXR team has a clear reporting and supervisory structure, and in the review period staff undertook their roles within that structure. Business Leaders have responsibilities for work allocation to the NZX Solicitors with the assistance of the Head of Regulation. Members of the NZXR team were clear that they would raise any workload issues with the Business Leaders or the Head of Regulation.

Decision-making structure: divisions

Work is allocated to a Lead Solicitor who conducts the initial review of an application matter and records their initial comments. The Lead Solicitor asks for volunteers from the NZXR team to form a division. A division is usually made up of three NZX Solicitors, and may contain a Business Leader or the Head of Regulation, depending on the complexity of the issue. Division members give feedback to the Lead Solicitor through circulation of marked-up draft documents. Meetings are convened if the matter is more complex. Generally the NZXR division process appeared to have worked well in the review period.
Although no deadlocked divisions were experienced during the review period, all NZXR staff stated that the proper procedure would be to escalate the matter and seek the opinion of a Business Leader or the Head of Regulation.
The Lead Solicitor is responsible for timing and procedural matters relating to an application. However, it appears unclear to NZXR staff where accountability lies for the decision made by a division, that is, whether accountability lies with the Lead Solicitor, the division as a whole or the Head of Regulation. We think that this should be clarified. It is also unclear whether the delegation to divisions to decide matters has been formally recorded. We recommend that NZX clarify these matters for the NZXR staff.

Escalation

All NZX Solicitors were clear that if they were unsure how to deal with a matter or needed assistance that the appropriate person to escalate it to was their Business Leader in the first instance, and following that, the Head of Regulation. Business Leaders were clear that they should escalate matters to the Head of Regulation when they needed further assistance or if they considered the Head of Regulation should be made aware of a situation. NZX Solicitors have discretion to deal with issuers or other parties themselves, up until the point they consider escalation is appropriate.

Staff management

All NZX Solicitors and one Business Leader were required to undertake both regulatory and commercial work during the review period. Job descriptions for the relevant staff indicate that the targeted division between regulatory functions and commercial activities was between 20% to 50% allocation to commercial work. This was broadly in line with the amount reported by the NZX Solicitors and Business Leaders. The NZXR team was clear that regulatory work took precedence at all times, and in the event of a time conflict, commercial work would be de-prioritised or dealt with externally. If such a conflict arose it would be escalated to the Head of Regulation to discuss with the Corporate Counsel in terms of managing the shared legal resource.
NZXR staff received mainly on-the-job training during the review period. All NZXR staff reported that they had received induction training and NZX also conducted regular internal seminars for its staff, involving external advisers and experts. NZXR staff are also encouraged at their annual and interim performance reviews to actively seek external training. Staff take up these opportunities as appropriate.

Recommendations

NZXR has adequate processes in place for supervision of Listed Issuers under the Listing Rules and uses its processes consistently. We make the following recommendations.
1. NZX should consider enlarging the membership of the Listing Subcommittee to address potential issues arising from any conflicts of interest.

NZX agrees with this recommendation.

NZX has committed to do this by the end of this calendar year.

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

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

NZX believes that it currently has adequate measures in place.

The Commission considers that these measures need to be more clearly communicated to NZX staff.

NZX will consider this matter again and has undertaken to report back to the Commission by the end of this calendar year.

ARRANGEMENTS FOR RELEASE OF MARKET INFORMATION - LISTED COMPANY RELATIONS

The LCR team members have a systems-based role. A core focus is the accurate and timely release of market information, the administration of the Market Announcement Platform (MAP), and associated administrative activities and systems checks. LCR staff use an extensive procedures manual to assist them in their work. LCR staff work closely as a team.
It appears from the review that the LCR team has a clear and comprehensive understanding of its role and that its activities are carried out to a satisfactory standard.

Recommendation

We make no recommendation in relation to LCR.

OVERSIGHT REVIEW OF NZX 2005

MARKET OPERATIONS AND INFRASTRUCTURE

Introduction

To be an effective market operator, NZX needs appropriate infrastructure arrangements to operate that market. The market, through the technology that NZX uses, must operate effectively and have integrity. There must be procedures to ensure that the market operates smoothly and to manage any outages and disasters that may arise.
The Commission has not reviewed the particular systems technology that NZX has chosen to implement. This is a matter for NZX to decide. However, the Commission has reviewed the market infrastructure, development and maintenance, backups and disaster planning to assess whether the market is functioning effectively. While there were a number of outages in the review period, we have concluded that the market operated effectively.

Structure and focus of the Market Operations Group

The Market Operations Group's activities include the following:
1. IT Strategy - looking at the future state of NZX's core market systems;
2. Operations and Trading - maintaining the operability of the FASTER trading and FASTER clearing and settlement environment, network infrastructure and connectivity;
1. Development - enhancements and development for the FASTER Settlement Solution; and
1. Conformance and Sales - connecting new Participants, accreditation of systems, training and support for FASTER.
There are four Business Leaders within the Market Operations Group. Each meets with his or her team weekly. The Business Leaders meet with the Head of Operations individually each week. Interaction is otherwise on an as-needed basis. The Head of Market Operations (also referred to as the Chief Operating Officer) meets weekly with the CEO or otherwise as-needed.

Core systems

NZX has individual core systems for trading and settlement: the FASTER trading system, based on the X-Stream trading system, and the FASTER Settlement Solution (FSS). FASTER is the Fully Automatic Screen Trading and Electronic Registration securities transfer system.
Together, the combined system (the NZX system) facilitates execution and settlement of NZX market transactions and manages Participants' unsettled obligations.

Back-ups for core systems - continuity and disaster planning

The trading platform system and the clearing and settlement system both exist in Auckland and Wellington and are mirrored. There is a fail-safe in place to switch between the nodes if needed. The systems are redundant from a disaster recovery perspective. The two data centres operate in 'lock-step' mode. If one site fails the other will take over and no transaction is lost.
NZX runs two external disaster recovery exercises on a six-monthly basis. The fail-safe is tested in the six-monthly disaster recovery test. The disaster recovery test also involves Market Participants to check that they can switch from Auckland to Wellington or vice versa. Within approximately one hour trading can be migrated from Auckland to Wellington.
The last disaster recovery exercise was carried out in March 2006 and prior to that October 2005. The disaster recovery exercise raised small issues that were incorporated into operational checks. NZX sent the results of the disaster recovery exercise to all Market Participants.
NZX has a Hewlett Packard package that monitors the core market infrastructure platforms. The systems are housed in Telecom's "trader support high availability centres" in Auckland and Wellington. There are environmental controls in place.
Network connections always face some risk of failure. There is no full network provider other than Telecom.

Market outages and disruptions in 2005

NZX closed the market on three occasions during 2005 due to Telecom network faults or firewall faults for a total of 460 minutes. Of that time, 370 minutes' closure was due to two general Telecom network faults and 90 minutes was due to a firewall failure at NZX. All Telecom customers were affected by the Telecom network faults.
There were two instances where a trading system fault closed the market. The whole market was closed for 35 minutes. The debt market only was closed for 110 minutes for trading in debt securities.
NZX also experienced some FASTER settlement incidents during the review period, mainly loss of connectivity to registries. Some of these connectivity faults were intermittent but recurring during 2005. The market was closed for trading in one registry's securities for 105 minutes.
The whole market operated without fault for 99.67% of total market operating hours. This figure excludes outages caused by the general Telecom network faults.
The share market operated without fault for 99.78% of total market operating hours. This figure excludes outages cause by the general Telecom network faults.
During 2005, the London Stock Exchange (LSE) did not experience any outages of its SETS and SETSmm trading platforms. The New York Stock Exchange (NYSE) experienced market outages totalling 4 minutes of trading time. The Australian Stock Exchange (ASX) has a benchmark of 99.8% systems availability. In 2004/2005 all of ASX's critical systems exceeded this benchmark.

Incident management and communication with the market

NZX has a formal incident management procedure for system disruptions. Systems are categorised in terms of their criticality to market function. The response to incidents is managed against procedures established for each system category. Incident management reports are stored in a register.
The communication and reporting procedures for an incident are outlined in the procedure. The procedure outlines to stakeholders the communication processes that NZX will use to notify Market Participants and Data Distributors of issues that may lead to the suspension of trading or impact on key systems.
The procedure includes the processes NZX will use to communicate about failures. This relies in part on text messaging. NZX has identified that the text message service had not worked very well for technical reasons. NZX is working with its user groups to identify the most effective avenues for communication.
The first real trial of the incident management procedure was in December 2005 when a software bug caused the debt market to cease operating. NZX received positive comments about how it communicated the explanation of the outage. It also appears that NZX followed its published procedures.

Capacity of core systems

NZX considers the NZX system to be mature and stable. It has been operational for a number of years and progressively developed to meet market and user requirements and demand. The trading system is currently running at less than 20% of capacity. The system can be reconfigured to allow more trades if near-capacity is reached.

Monitoring and supervision of systems

Staff expertise and training

The Market Operations Group comprises experienced individuals who are knowledgeable about the operation of New Zealand's securities markets as well as specific software and technologies. NZX considers that little training is required in terms of technical knowledge for the people in this Group. There is a focus on the development of individuals, given evolving technologies and technical trends that NZX needs to stay abreast of. The Information Technology team has attended international courses on such matters.

Monitoring of systems and change management

A series of procedures is carried out at the start of each day to make sure that everyone is connecting to the trading platform and that the registries are connecting. These "start of day" procedures are run by the Information Technology Operations team. The NZX network has diagnostic equipment to provide notification if a link is down and SMS texting that is automatically generated if there is a network failure.
NZX considers that it has a network design now that works very well and the design that it wants. NZX focuses on ongoing monitoring of the infrastructure environment. We queried how NZX benchmarks the performance of its IT systems. Each system has a classification according to its contribution to the IT framework. Standards are set against these around availability, reliability and access, and achievement of the standards is monitored by the Operations Group.
NZX has change-control guidelines to analyse any systems changes that may be required. Changes are tested in a test environment and there is a further test process before any change goes live. Changes are also managed through the communication channels.
The network is provided by Telecom. The Head of Market Operations advised us that NZX retains a critical level of involvement but it is Telecom's infrastructure and Telecom's design engineers who work on it. NZX has a package that maps the Telecom network, showing all Participants and where they are connected. There is ongoing monitoring of this and work has been carried out to ensure that each Market Participant has a separate connection and that there is no sharing of lines, so that if a connection goes down multiple Participants would not be affected.

Market Participant connection and accreditation

The Participant Rules do not mandate the way in which a Market Participant connects to the NZX network. NZX has given recommendations as to how it believes Market Participants should connect and that they should provide for an alternative connection if one is lost.
There are formal accreditation procedures and tests to be met before there is sign-off and recognition that a Participant is accredited. The system needs to be tested to ensure that it can interface with the NZX system. NZX requires the Participant to have fully developed and tested its system within the NZX test environment before applying to NZX for conformance. NZX produces information setting out the standard requirements for conformance.
Following initial accreditation and conformance testing, the Participant Compliance team looks at the way the Participant firm's back office systems are connecting during the inspection process.

Training for Participant users of the NZX systems

Training requirements for the Participants that use the trading system are set out in a practice note and information document. Determinations regarding the competence of the candidate in operating the system are made by the Operations and Development section of the Market Operations Group. Determinations on competence regarding the Participant Rules are made by Participant Compliance.
All FASTER dealers using the trading system undertake training with an NZX Trainer. Training is undertaken in a test environment. The feedback on the "train the trainer" system, introduced in December 2005, is that it is effective. Where the applicant fails the test, the competence of the NZX Trainer may be questioned. We understand this has not been an issue.
A trading participant is responsible and liable for all trading messages sent to the trading system. Each FASTER dealer has its own user ID and password to access the system. Access to systems is reviewed on inspection. Each firm that uses Direct Market Access ("DMA") facilities must have filters in place to ensure that any order entered via DMA does not cause the firm to breach any Participant Rules.
The inspection process reviews client order/trade records to review error records. Participants and their employees who frequently commit dealing errors are liable for suspension from operating the trading system. No Participants or any Participants' employees were suspended from operating the trading system in the review period.

Market infrastructure strategy and planning

External user groups provide feedback

NZX communicates with a number of external user groups in the areas of clearing and settlement, technology, and the securities industry more generally. User groups have given feedback that there is overall satisfaction with the trading, clearing and settlement platform. Where issues were raised by the user groups, NZX has taken steps to address those concerns.

Internal groups assess needs

NZX has a number of committees and groups comprised of NZX staff which focus on IT-related issues. In particular we note the IT Governance Committee. The responsibilities of the Committee are to have input into the technology strategy, to approve the resulting technology 12 month plan, prioritisation, and investment decisions. Essentially it provides oversight for NZX information technology, infrastructure and applications. The Head of Market Operations chairs the Committee.

Enterprise Risk Management Group

The Head of Market Operations heads the Enterprise Risk Management Group (also called the Internal Risk Committee). The Committee considers risks to both NZX as a listed entity and NZX as the market operator.
The Enterprise Risk Management Group is charged with monitoring NZX's risk profile. We are advised that it uses international standards to categorise risks - operational, financial, strategic, environmental and external. These are fed through to the Audit and Risk Committee of the NZX Board and to the full Board if considered necessary. In terms of Market Operations, the Group looks at operational risks arising from the core trading platform and infrastructure.

Resources

The IT Leadership Team identifies major maintenance requirements 12 months in advance for approval. Any new development expenditure requires a business case.
The Market Operations Group did not request or require any urgent investment in 2005. There were no major projects or investments that were deferred due to lack of resources. No major requests for resources had been declined. The majority of large investments were made in 2004 and early 2005.
The Market Operations Group considers that it is sufficiently resourced to carry out its functions. There is longevity in terms of the experience of the Group and specialist knowledge. A business case would be made if there were larger capital expenditure requirements.
The only area in 2005 where the Market Operations Group identified that it needed further resourcing regards the future clearing and settlement structure. This was identified in the corporate strategy and has been discussed by NZX. NZX does not consider the dual functioning of FSS and Austraclear (a transfer system for the real-time settlement of trades) to be efficient. NZX has recruited a resource from overseas who will be leading work to specifically investigate and recommend an approach to the clearing and settlement structure. This is an area where the Market Operations Group would have faced constraints without additional expertise.

Reporting to the Board

Relevant updates on market operations are presented to the Board in a report by the CEO. The Head of Market Operations does not present reports to the Board in the normal course. He may attend Board meetings if there is a paper that he has prepared or to support a paper prepared by the Market Operations Group.

Recommendation

NZX has adequate service levels and adequate systems and processes for back-ups and continuity planning. We make no recommendation in respect of the Market Operations Group.

OVERSIGHT REVIEW OF NZX 2005

DISCIPLINARY ARRANGEMENTS - NZX DISCIPLINE

Role and functions

While maintaining governance authority in a single Board, NZX has created a separate entity, NZX Discipline, to adjudicate on alleged breaches of the NZX Listing Rules and Participant Rules. This was done in 2004. The decision to separate this function was a positive step in terms of managing potential conflicts of interest (both corporate and personal) for Board members.
NZX Discipline is constituted by the NZX Discipline Rules, which form part of the conduct rules of the NZX under the Securities Markets Act. These Rules also set out the procedures of NZX Discipline. NZX Discipline is dependent on NZX for resources. Both NZX Discipline and the Special Division carry out functions under delegation from NZX. Their functions form part of NZX's obligations. While NZX Discipline and the Special Division operate separately from NZX and set their own policies and processes, NZX remains responsible for these bodies because they perform functions for which NZX is responsible under the Securities Markets Act.
NZX Discipline has procedures set out in the Discipline Rules for dealing with conflicts of interest on the part of any of its members. No member of NZX Discipline who has a conflict of interest in respect of a case can consider that matter.
In brief, NZX Discipline acts as a tribunal, hearing cases that are referred to it by NZXR. There are separate procedures for summary and full hearings. NZX Discipline has powers to impose penalties including private reprimands, public censures, suspension or cancellation of listing, suspension or revocation of a Market Participant's designation, monetary penalties, and restitution. NZX Discipline can also consider and determine a referral of any waiver or ruling decision of NZX under the Listing or Participant Rules where the decision is referred to it by the applicant. A determination of NZX Discipline on any matter is binding on NZX in its exercise of its powers to grant waivers or rulings.
NZX Discipline has both independent members and representatives of NZX. Board Members, the CEO, Corporate Counsel, and NZXR personnel are ineligible for appointment. The NZX Board has resolved to remove NZX appointees from NZX Discipline. This will be effected in upcoming changes to the NZX Discipline Rules.

Matters considered

The Commission received copies of all decisions taken by NZX Discipline in the review period, and a copy of the report of NZX Discipline for the two years from its inception in May 2004.
In the review period, NZX Discipline considered 12 matters. These comprised four matters under the Listing Rules, seven under the Participant Rules, and one referral of a waiver decision.
The Chairman of NZX Discipline noted that from May 2005 there was a marked increase in its activities. This had increased the demands on the members and Chairman of NZX Discipline.
The Chairman of NZX Discipline spoke very highly of the members of the disciplinary body, describing their contribution in the review period as "outstanding". He reported that members of NZXR have conducted their activities in a professional manner, and have been supportive of the role undertaken by NZX Discipline. The Chairman of NZX Discipline reported that the concept of NZX Discipline is working well.

Process and decisions

The procedures for NZX Discipline are set out in the Discipline Rules. The Chairman of NZX Discipline reports that during its early stages it worked to "bed-in" its processes. The Chairman has sought to be involved in most hearings to provide consistency and continuity.
The majority of NZX Discipline decisions have been published, consistent with the presumption in favour of publication set out in the Discipline Rules. The Chairman remarked that some decisions were not published where the breaches concerned were relatively minor, because of a concern that this would harm confidence in NZX Participants generally. In these cases, notice of the NZX Discipline decision was given to all Market Participants, without naming the firm concerned.
There is evidence in the cases heard to date of differences of views between NZX in its submissions and NZX Discipline decisions. It seems clear that NZX Discipline takes care to maintain operational independence from NZX.
No cases taken to NZX Discipline were settled in the review period. However the Chairman of NZX Discipline noted that the requirement for NZX Discipline approval of a settlement was an important element of the settlement process. The Commission agrees.
There were instances in the review period of uncertainty about procedure, affecting a review of a waiver application and the preliminary steps for a disciplinary hearing. The latter case also showed some uncertainty as to the extent to which the Chairman of NZX Discipline can give binding procedural directions preliminary to hearings. The Commission thinks this should be clarified. However, such issues are not surprising given the relatively short period for which the Discipline Rules have been in force. We note that NZX has recently announced a review of the Discipline Rules, which should provide a useful opportunity to make improvements based on experience to date.

Resources

NZX Discipline comprises part-time members. It has no secretariat or premises provided by NZX. Hearings to date have been held, at NZX Discipline's election, in premises supplied by NZX Discipline members. The Chairman's personal computer and recording equipment has been used. NZX has supplied teleconference equipment. NZX has advised that premises would be made available to NZX Discipline should it wish to use them.
The Chairman of NZX Discipline noted that he had not asked for further resources during the period. He was confident that these would be supplied if sought. We were told that it would be helpful if some further administrative support could be supplied by NZX. The Chairman has carried out the administrative work himself to date, and has not billed NZX for this time. NZX advised that it was not aware of this and has discussed this with the Chairman.
It became clear to us that the current success of NZX Discipline's operations is largely due to the goodwill and dedication of the Chairman and other members. NZX Discipline has to date coped with its workload, although this has placed significant demands on the time of the Chairman, who acknowledged that this might not have been possible had he been in private practice at the time. File reviews showed that NZXR had expressed concern about the timeliness of the publication of one decision which had been delivered to NZX and the respondent but where publication was delayed.
We are of the view that NZX and NZX Discipline should together review administrative support and other resourcing arrangements, and these matters should be reviewed on a regular basis. We stress that NZX Discipline has operated very well in the review period, but we record also that this appears to be largely dependent on the willingness of the individuals involved to go to significant lengths to ensure the success of the organisation.
Members' fees are set by NZX. NZX and NZX Discipline consulted on this. The fees have not been reviewed since NZX Discipline was established. There is no provision in the Discipline Rules for review of these fees. Given the dependence of NZX Discipline on NZX for its resources, and the importance of continuing to attract high quality members, we think it would be appropriate for NZX to establish a periodic review of NZX Discipline members' fees and to consult with NZX Discipline members on this. NZX has said that it is willing to review the fees regularly. It may also be appropriate, as is the case for judicial officers, to entrench in the Discipline Rules that NZX may not reduce the level of NZX Discipline fees.

Reporting

Most NZX Discipline decisions are published. Where they are not, it is clear that NZX Discipline members have recorded their decision, including the reasons for not publishing.
Under the Discipline Rules, NZX Discipline is required to provide an annual report to NZX on its operations. This report is required to state, among other things, whether NZX Discipline received sufficient resources in the year to date.
We note that no annual report was provided by NZX Discipline to NZX in the review period. The report made in April 2006 covered the first two years of operations. The Chairman of NZX Discipline commented to us that although assistance was offered by NZX during 2005, this was not taken up by NZX Discipline. NZX Discipline intends to make use of available assistance in future. The Commission recommends NZX and NZX Discipline discuss this further, with a view to ensuring that NZX Discipline receives all the resources it requires to enable it to continue to carry out its functions effectively. The Commission recommends that NZX Discipline publish its report annually.

Appeal Panel

Under the NZX Discipline Rules, decisions of NZX Discipline can be appealed to an Appeal Panel. Other than as set out in the NZX Discipline Rules, the Appeal Panel determines its own processes for hearing and determining appeals. This Panel has been established and has met, but has not yet had to consider an appeal. Accordingly we do not comment on it further, other than to note our view that we expect NZX to publish information about the Appeal Panel, including contact details required for lodging an appeal.

Recommendations

NZX Discipline as an organisation has effectively carried out its function in the review period but there are certain gaps in resources and administration. The Commission makes the following recommendations:
1. NZX and NZX Discipline should together review the administrative support and resource arrangements in place for NZX Discipline. These resource arrangements should be reviewed regularly to ensure that NZX Discipline receives all the resources it requires to enable it to continue to carry out its functions effectively.

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

NZX is willing to entrench the fees so that they may not be reduced. NZX is willing to review the fees regularly.

NZX has committed to do this by the end of this calendar year.

NZX Discipline should publish its Annual Regulatory Report annually.

NZX agrees with and supports this recommendation.

OVERSIGHT REVIEW OF NZX 2005

SPECIAL DIVISION - SUPERVISION OF NZX AS A LISTED ISSUER

Conflict management

As a Listed Issuer, NZX must comply with the Listing Rules. This requires it, like other issuers, to make certain applications and potentially be subject to disciplinary proceedings before NZX Discipline. To deal with the obvious conflict that arises for NZX in these situations, it has formed a Special Division of NZX Discipline. The Special Division is an independent body. It deals with regulatory matters concerning NZX as a Listed Issuer and its related entities.
The Special Division plays a vital role given NZX's dual functions as a market regulator and commercial listed entity. The Special Division is integral to conflict management and the integrity of the NZX structure. The oversight review showed that the system of using the Special Division was working effectively and seemed to achieve separation between NZX's commercial and regulatory functions. We are satisfied that the Special Division adequately carried out its function in the 2005 review period.

Jurisdiction and powers

The Special Division is established under the NZX Discipline Rules. The Special Division is empowered under the NZX Discipline Rules to "stand in the shoes" and exercise the powers and functions of NZXR in respect of NZX as a Listed Issuer that NZXR exercises in respect of other issuers listed on NZX's markets. The Chairman of the Special Division confirmed its understanding of the role. Given the key role that the Special Division plays in NZX's conflict management, we expect it to assert its jurisdiction clearly and actively.
The objective of the Special Division under the NZX Discipline Rules is to foster market confidence that the Listing Rules, NZX Participant Rules and NZX Discipline Rules are applied in respect of NZX, or a related entity, in an impartial and independent manner.
The Special Division operates independently of NZX. It comprises four independent members approved by the Securities Commission. Special Division members must have no conflicts of interest as regards NZX. The role of Chairman of the Special Division is separate from the Chairman of NZX Discipline. In the 2005 review period the Special Division dealt with a total of nine matters. These included document approvals, a waiver application and a continuous disclosure matter. The Special Division did not deal with any complaints about NZX as a Listed Issuer.
The Special Division's jurisdiction to deal with a matter is in the first instance seen as a matter for the Chairman to determine. In the review period there were no formal written delegations by the Special Division to the Chairman of the Special Division in relation to jurisdictional matters. If the Chairman is to have authority to determine whether matters are referred to the Special Division we think that the delegation from the Special Division should be formally recorded. However, given the importance of the Special Division's role, we consider it preferable that determination of the Special Division's jurisdiction to deal with matters be assessed by the Special Division, rather than any one member.
In 2005 NZXR sought information from NZX on behalf of the Special Division regarding the CEO's remuneration. The information related to an application for a waiver. NZX declined to provide the Special Division with the requested documentation. The Chairman of NZX was clear that NZXR would simply demand any information it sought from issuers. NZX advised in its submissions that it considers it does not have powers to compel disclosure of information. In the context of a waiver application, NZX advises that it may instead consider whether, in the absence of the information sought, it has sufficient information to make a decision. If not, NZX advised that it will decline to grant a waiver. We consider that in practice NZX does have the power to compel production of information by otherwise refusing to grant waivers where relevant and requested information is not provided.
The Special Division believes it pursued the matter and obtained sufficient information by other means. The Special Division was satisfied that it had managed to obtain an assurance from NZX in relation to the information that it sought and granted the waiver. The Special Division exercises the powers of NZXR in respect of NZX as a Listed Issuer. The Special Division should be aware of these powers and exercise them as appropriate. NZX should comply fully with all lawful requests and directions from the Special Division. We do not consider it was appropriate for NZX to refuse access to the requested documentation.
The Special Division's view is that NZX is not bound to a higher standard under the Listing Rules than any other Listed Issuer. Nor is there a lesser standard for NZX. However, the Special Division encourages NZX to set a higher standard of disclosure and compliance as a matter of practice and has provided comment to NZX about this.

Resources

The Special Division is dependent on NZX for resources. The Special Division considered that it was adequately resourced in 2005 to carry out its function. The level of resource is established on an as-needed basis. The Special Division has access to independent counsel and experts. The Special Division invoices NZX and is paid. The Special Division did not request additional resources in 2005. While resource needs have not yet been tested, we think the Special Division should give critical thought to its likely and contingent resource needs. We expect the Special Division to discuss its resource requirements with the Board of NZX.
The Special Division has not considered with particularity what would happen in terms of process and resources if the Special Division were to take a case against NZX to NZX Discipline. Security of funding in advance of initiating such an action has not been discussed between the Special Division and NZX. The NZX Board informed the Commission that it would guarantee funding for the Special Division should such a situation arise. The Commission considers it appropriate that a guarantee of advance funding for such an action be formalised between the Special Division and the Board of NZX.

Communication

The first point of contact for external correspondence with the Special Division is NZX. This includes confidential complaints about NZX as an issuer that are sent to the attention of the Special Division. No separate contact details for the Special Division are made publicly available. The Special Division sees benefit in separate contact details being published. We recommend this be done. The Board of NZX agrees that communication about the existence and role of the Special Division needs to improve. Market feedback received by NZX suggests that the role of the Special Division is not well understood. NZX intends to develop a communication strategy in this area. We support the development and timely implementation of a communications strategy concerning the Special Division, including capacity for complaints to be addressed directly to the Special Division rather than through NZX staff.

Appointed solicitor

An NZX Solicitor is appointed to act as the liaison between NZX as a Listed Issuer and the Special Division. Most matters are referred to the Special Division by NZX via the appointed solicitor. The Special Division advised that the appointed solicitor is not to make recommendations to the Special Division. On occasion in 2005 the appointed solicitor did make recommendations. NZX advised that it had not been told that the appointed solicitor was not to make recommendations and no concerns were expressed by the Special Division about the solicitor's performance during the year. The appointed solicitor provides the Special Division with relevant information and documents and is the main "pivot point" between NZX and the Special Division. This process appeared to function efficiently during the review period, although it seems there were differing views about the role of the appointed solicitor.
Special Division members may at times initiate matters based on market knowledge. The Special Division itself does not monitor the trading activity of NZX. The Special Division relies on the appointed solicitor to report unusual trading information generated by the SMARTS surveillance system.
In the 2005 review period the appointed solicitor, as nominated by the Head of Regulation, did not perform any commercial work for NZX. The Special Division considers it of key importance that the appointed solicitor be independent of the commercial activities of NZX. The Chairman of the Special Division advised that he had sought and received an assurance from the Head of Regulation that the currently appointed solicitor would not perform any NZX commercial work that would require the Special Division's involvement. In submissions, NZX and the Special Division were of the view that it would be suitable if the solicitor was not involved in commercial work that had Listing Rule content but could carry out other commercial work.
In the Commission's view, any corporate advisory work undertaken by an employee of NZX in relation to NZX's own business as a Listed Issuer has the potential to raise a conflict of interest for the employee concerned where that person also provides advisory services to the Special Division. The appointed solicitor should be free to carry out other work for NZXR, but we consider that this person should not undertake corporate advisory work for NZX. In the Commission's view, either an assurance to this effect should be settled between NZX and the Special Division, or NZX should revisit the use of an NZX Solicitor for the appointed solicitor role.
Even with an assurance that the appointed solicitor will not carry out corporate work for NZX, we think that the conflict for the appointed solicitor as an employee of NZX is potentially acute. In dealing with more contentious issues such as complaints handling, or matters where there is disagreement between the Special Division and NZX, or any potential Listing Rule breaches or disciplinary matters, we think that there is a serious risk that an appointed solicitor would be placed in an unreasonable position of conflict as the "pivot point" between the Special Division and his or her employer, NZX.
We consider that the appointed solicitor should have no role in such matters (beyond any initial transmittal of a matter to the Special Division). The Special Division should engage external advisers to assist it in dealing with these matters, including accessing NZX's facilities and regulatory precedents and consulting as needed with NZXR. We consider that in respect of any waiver and ruling applications that raise contentious matters, the Special Division should also use external advisers rather than the appointed solicitor.
We acknowledge that the appointed solicitor is likely to continue to have a role in relation to SMARTS surveillance and the referral of alerts as the Special Division does not have access to this system. We think that the Special Division should formalise its expectation about the referral of data generated by the SMARTS market surveillance system concerning NZX's listed securities. Where alerts from SMARTS are below the threshold set by the Special Division for referral to it, the appointed solicitor should regularly advise the Special Division of the number of alerts received in the period and a summary of any alerts that were not referred.
The Special Division has delegated administration of compliance checks of advertisements and amendments to trust deeds to the appointed solicitor. Under the NZX Discipline Rules the Special Division is not permitted to delegate certain key functions, such as the cancellation or suspension of the quotation of NZX securities, and the power to make rulings and give waivers. The Special Division advised that it had retained all substantive listing rule compliance. File reviews evidenced this. The Special Division expects to be advised by the appointed solicitor if there are particular issues with matters dealt with under delegation. The Special Division does not otherwise expect to receive reports from the appointed solicitor on matters dealt with under delegation. There needs to be a complete record of the Special Division's business and appropriate periodic review of the delegation. We recommend that all matters dealt with by the appointed solicitor under delegation be recorded and reported on to the Special Division regularly.

Process

The NZX Corporate Counsel, or an NZX Solicitor acting in a commercial capacity, prepares applications for referral to the Special Division. As noted above, the Chairman of the Special Division determines whether the particular matter can be dealt with by the Chairman of the Special Division or should be referred to a division of Special Division members. If a division of members is required the Chairman determines the composition of the division. There is no written conflicts disclosure policy for Special Division members, however the Special Division has received external advice in relation to independence and avoidance of conflicts of interest. Conflicted members are expected to disclose the conflict and remove themselves from consideration of the matter.
The appointed solicitor provides NZX's applications and supporting material to the Special Division, accompanied by the appointed solicitor's comments and views on the application. The appointed solicitor also refers the Special Division to precedents. The Special Division's practice is that NZX is bound by the precedents and policy that NZXR sets for other issuers.
File reviews evidenced that Special Division members were actively engaged in matters referred to them. The Special Division made it clear that it required receipt from the appointed solicitor of all relevant documentation associated with applications. Comments were exchanged between Special Division members. Responses and decisions were conveyed to NZX through the appointed solicitor.
The Chairman of the Special Division has a copy of a procedures handbook used by NZXR, however the Special Division does not make use of procedural material such as handbooks and checklists that NZX uses in respect of other issuers. The Chairman of the Special Division advised that the Special Division relies on the appointed solicitor to use the correct procedures. If NZXR operates in a certain way then the Special Division considers its procedures should be the same. We expect the Special Division to formally communicate its expectations to the appointed solicitor. The Special Division should have and use the same procedures manuals in respect of NZX's compliance as a Listed Issuer that are used by NZXR in respect of other Listed Issuers. The Special Division should not rely on the appointed solicitor to use the NZXR procedures. We also suggest that the Special Division consider the internal procedures that it would use (including procedures for communicating with the market) if it were in the situation where it needed to pursue a serious compliance matter regarding NZX.

Reporting

The Special Division reported on its work to the Annual Meeting of NZX Discipline in 2005. We think that the Special Division should report to NZX Discipline all material findings that it makes. We think that NZX Discipline should incorporate that information into its Annual Regulatory Report. There is no particular reporting process for the Special Division to comment to NZX on the Special Division's view of NZX's compliance as a Listed Issuer. However, the Special Division may note concerns or issues in its communications with NZX.

Recommendations

The Special Division operated adequately during the review period, however the Special Division has not yet been tested in a significant matter. In light of the substantive and procedural issues identified, including NZX's refusal to provide requested information, we have reservations as to how the Special Division would deal with a contentious situation with NZX. We make the following recommendations:
1. The Special Division, as a body, should determine whether the Special Division has jurisdiction to deal with matters referred to it. Any delegations from the Special Division to its Chairman should be formally recorded.
2. Given the important role of the Special Division in respect of NZX's compliance as a Listed Issuer, the Special Division should take steps to ensure that it is fully aware of the powers available to NZXR under the Listing Rules in respect of other Listed Issuers, and should exercise those powers as appropriate in relation to NZX as a Listed Issuer.
1. Given NZX's position as both a Listed Issuer and regulator of all other Listed Issuers listed on its markets, NZX should set an example by full compliance with all lawful directions or requests from the Special Division.
  
  NZX considers that it is entitled, as is any other issuer, to decline to provide information sought where NZX does not consider it relevant or appropriate to provide such information. NZX considers that NZX should only comply with those requests or directions necessary for the Special Division to undertake its enforcement role (as opposed to the role of considering a waiver or ruling application) and within its powers and jurisdiction. NZX is of the view that it cannot compel production of information by issuers in relation to waiver applications.
  
  The Commission considers that in practice NZX does have the power to compel production of information by otherwise refusing to grant waivers if relevant requested information is not provided. We remain of the view that NZX should set an example of full compliance with all lawful directions or requests of the Special Division.
  
  NZX will consider the matter again and has undertaken to report back to the Commission by the end of this calendar year.
1. The Special Division should discuss its resource requirements with the Board of NZX. The NZX Board should have a formal guarantee of funding for the Special Division should the Special Division need to take NZX to NZX Discipline.
  
  NZX has advised that it will request a meeting between NZX and the Special Division to discuss resource requirements and the guarantee of funding.
  
  NZX has committed to do this by the end of this calendar year.
2. NZX and the Special Division should develop and implement a communication strategy about the role of the Special Division. Communication should include publication of separate contact details for the Special Division.
  
  NZX has agreed to implement a communication strategy about the role of the Special Division. NZX considers that the Special Division should have considerable involvement with this. The Commission agrees.
  
  NZX has committed to do this by the end of this calendar year.
3. The Special Division should formalise its delegation to the appointed solicitor and should receive regular reports on work dealt with by the appointed solicitor under delegation.
4. The Special Division should have and use the same procedures manuals in respect of NZX's compliance as a Listed Issuer that are used by NZXR in respect of all other Listed Issuers. The Special Division should satisfy itself that the appointed solicitor uses the NZXR procedures, including where matters are delegated to that solicitor.
5. The Special Division should settle internal procedures that it would use, including procedures for communicating with the market in dealing with a serious compliance matter regarding NZX.
6. The Special Division should formalise its expectation about the referral of data generated by the SMARTS market surveillance system concerning NZX's listed securities. Where alerts from SMARTS are below the threshold set by the Special Division for referral to it, the appointed solicitor should regularly advise the Special Division of the number of such alerts received in the period and a summary of any alerts that were not referred.
7. To avoid a situation of conflict for the appointed solicitor, the appointed solicitor should have no role in matters that raise contentious issues, including complaints handling (beyond an initial transmittal of a matter to the Special Division). The Special Division should engage external advisers to assist it in dealing with such matters and be funded to do so. The external advisers should have access to NZX's facilities and regulatory precedents and be able to consult with NZXR.
  
  The Special Division agrees that it would be appropriate for it to handle such matters without the involvement of the appointed solicitor or for the Special Division to engage external counsel if necessary. In respect of waiver and ruling applications the Special Division is of the view that the appointed solicitor should, at the Special Division's request, be able to provide analysis and comment to the Special Division on precedent applications under the Listing Rules.
  
  The Commission considers that in respect of waiver and ruling applications involving contentious matters the Special Division should use its external advisers, and that these advisers should be given access to precedents and other relevant information.
8. NZX should either formally assure the Special Division that the appointed solicitor will not perform any corporate advisory work for NZX or should revisit the use of an NZX Solicitor for the appointed solicitor role.
  
  NZX and the Special Division consider that it would be suitable if the appointed solicitor was not involved in any commercial work that had Listing Rule content but could carry out other commercial work.
  
  The Commission does not agree. The appointed solicitor should be free to carry out other work for NZXR, but we consider that this person should not undertake corporate advisory work for NZX.
  
  NZX will consider this matter again and has undertaken to report back to the Commission by the end of this calendar year.
1. The Special Division should report to NZX Discipline all material findings that it makes. NZX Discipline should incorporate that information into its published Annual Regulatory Report.
  
  NZX notes that the Special Division's decisions are published in the same way as NZXR decisions and that this recommendation is unnecessary.
  
  The Commission notes NZX's response but considers that benefit will be derived by both NZX Discipline and the market if the Special Division's activities are included in NZX Discipline's Annual Regulatory Report.

OVERSIGHT REVIEW OF NZX 2005

GOVERNANCE

Monitoring and oversight of regulatory functions

NZX Board oversight of the NZX regulatory function has improved since the collapse of Access Brokerage in 2004.
A template for periodic separate regulatory reporting at each NZX Board meeting was developed as of November 2005, with significant involvement by the NZX Board in directing the development of this reporting template. Prior to this, the NZX Board received a report on regulatory matters via the CEO Report.
Each NZX Board meeting allows time for direct reporting to the Board by the Head of Regulation. NZX Board members and the Head of Regulation confirm that the working relationship is particularly productive, including open interaction between the Head of Regulation and individual Board members outside of scheduled Board meetings.
NZX Board members believe that with a reasonably small Board (six members including the CEO) the full Board, rather than a committee, should deal with regulatory matters. The Commission agrees that this strategic approach works well for the current NZX Board structure, and that NZX Board members are well-informed and involved regarding regulatory matters.
The NZX Board has set a "risk" threshold (i.e., risk to market integrity of a material nature) for escalation and reporting on regulatory issues to the Board. Functionally this is an appropriate standard and NZX Board members are sensitive to maintaining rigorous standards in this regard.
All NZX Board members are of the view that there are no financial resource constraints on the regulatory function (a view shared by the Head of Regulation), and that from a resource perspective their principal concern would be ensuring that appropriate professionals are available and responsible for regulatory activities. The Head of Regulation was satisfied that all requests for resources had been met in the review period.

Board composition

NZX Board members do consider it beneficial to have a blend of skills and competencies represented on the Board. This desired blend includes awareness of the need for experience regarding regulatory responsibilities.
The Commission believes that, with a small Board requiring members with securities industry experience, the NZX Board should continue to pay particular attention to achieving a Board with a balance of perspectives.

Identical delegations for regulatory responsibilities to the Head of Regulation and the CEO

The NZX Board believes, consistent with the current placement of the Market Supervision function within the NZX organisation, that it is appropriate for both the Head of Regulation and the CEO to have identical delegations for regulatory responsibilities. The Commission notes that these identical delegations organisationally and functionally reflect the NZX Board's belief that there is no inherent conflict between the commercial and regulatory functions of an exchange.
In practice it was clear that the Head of Regulation exercises supervisory authority over regulatory matters. However, we believe that the existence of the identical delegations to the CEO and Head of Regulation potentially blurs who is responsible for exercising the delegations and the circumstances in which the delegation is intended to apply, particularly in crisis situations. We recommend that the Board of NZX reconsider the issue to ensure that the responsibilities are clarified.

Regulatory crisis response and risk management

NZX Board members, except as noted herein, do reflect a focussed awareness of how NZX at all levels would respond to a regulatory crisis. The Commission notes that having two people with the same delegated authority for regulatory responsibilities creates potential for confusion. This may pose a risk to responding most efficiently to a regulatory crisis.

Market Operations policy setting

The NZX Board believes that overall operational performance improved during the review period. The Commission agrees and believes that the NZX Board appropriately communicates to executive management its rigorous performance expectations regarding market infrastructure and holds executive management responsible for meeting these expectations.

Board interaction with the Special Division

The NZX Board believes that NZX should not be treated any differently by the Special Division from any other issuer before NZXR. As to what would happen if NZX had to be taken to NZX Discipline by the Special Division, although there is currently no explicit understanding, the NZX Board would have no difficulty in giving an undertaking as to resources if this was sought by the Special Division and had no difficulty with a guarantee of resources. The NZX Board should give a formal guarantee of funding for the Special Division should the Special Division need to take NZX to NZX Discipline.

Placement of the Market Supervision function within the NZX organisational structure

NZX is the frontline regulator of the securities markets but can organise itself in the way it believes best enables it to fulfil its statutory obligations as a market regulator.
Currently the Head of Regulation reports to the Chief Executive Officer.
NZX Board members are of the view that this present organisational structure meets the needs of the New Zealand securities markets. NZX Board members informed us that the matter is given periodic consideration in light of differing structures in other jurisdictions.
The Commission notes that it is an increasing concern in overseas jurisdictions that an exchange's regulatory function is perceived to be as independent as possible from an exchange's commercial activities. In addition, the increasing evolution to autonomous structures for regulatory functions enables such functions to handle more efficiently the conflicts between the commercial and supervisory interests of an exchange. The Commission acknowledges that at present, in practice, NZX maintains an effective separation between its commercial and regulatory functions.
Nevertheless, the Commission is concerned that the unwillingness of the CEO and other NZX Board members to acknowledge that there is an inherent conflict within any exchange between commercial and regulatory functions may preclude the NZX Board from giving sufficient and necessary consideration to potential organisational developments within NZX regarding the Market Supervision function.

Recommendation

The NZX Board takes an active and appropriate governance role in regard to NZX's performance of its regulatory responsibilities. We make the following recommendation:

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

NZX is of the view that these responsibilities are sufficiently clear at present, but has agreed to consider whether any further clarification is desirable, and to report back to the Commission by the end of this calendar year.

OVERSIGHT REVIEW OF NZX 2005

CONCLUSION

Our overall conclusion is that NZX is satisfying its obligation to operate its markets in accordance with its conduct rules.
The conduct of an oversight review of NZX by the Commission will be an annual process. This first oversight review has focussed on NZX's performance of its obligations during the 2005 calendar year from an overall perspective. It is expected that future oversight reviews may address particular areas in greater depth. The concerns and recommendations that we have recorded as a result of this review, NZX's actions and response to these recommendations, and relevant intervening matters, will be reviewed next year.

APPENDIX

Scope of review

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

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

In particular, the Commission will review the following aspects of NZX's activities:
1. supervision of market participants and enforcement of the Participant Rules;
2. supervision of listed issuers and enforcement of the Listing Rules;
1. allocation of human, technological and financial resources as it affects performance of the regulatory functions of NZX;
1. internal practices and procedures associated with investigations, price enquiries, complaints-handling and referrals;
2. discipline practices, procedures and resources;
3. arrangements for market infrastructure development and maintenance;
4. Special Division practices, procedures and resources; and
5. corporate governance arrangements, including board composition, policy setting, crisis response and oversight of executive management, with reference to regulatory standards relating to governance of demutualised exchanges under IOSCO and other international principles.

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.

March 2006

Background to review

In 2002 the Securities Markets and Institutions Bill created a co-regulatory regime for registered exchanges. NZX is the only registered exchange in New Zealand. Under the co-regulatory regime it is intended that the Commission monitors the performance of NZX's statutory responsibilities.
In 2003 the International Monetary Fund conducted a Financial Sector Assessment Programme (FSAP) review of New Zealand. The FSAP measured New Zealand's framework of securities regulation and its operation against the Objectives and Principles of Securities Regulation published by the International Organization of Securities Commissions. The IOSCO Principles include principles for self-regulatory organisations.
One of the recommendations in the FSAP report was that the Commission develop a formalised oversight plan for regulated exchanges, providing for risk assessment criteria and periodic inspections that take into account best practices for self regulatory organisations and exchanges. It recommended that there should be public disclosure summarising the objectives of the oversight plan and of the key findings of such reviews. The Government response noted that the Commission had decided to develop a formal oversight plan for regulated exchanges and had informed NZX.
Demutualisation and listing of stock exchanges has been an emerging phenomenon overseas in the past decade. In all cases we have seen, regulatory structures have been put in place accompanying such moves, reflecting the core importance of stock exchanges to countries' capital markets and broader economies. In New Zealand these regulatory structures include an ownership cap, regulatory review of exchange rules, and oversight by the Commission. Different approaches have been taken in various jurisdictions overseas. The approach taken in New Zealand was settled after consideration of international models existing at the time, and the particular circumstances of the New Zealand markets. It has not been a part of this review to reconsider these arrangements.
However, as encouraged by the FSAP review, we have looked to the emerging high-level standards in overseas jurisdictions to gain an insight into best practices for exchanges. We have taken into account the report of the FSAP inspectors, the IOSCO Objectives and Principles of Securities Regulation, and the methodology used for assessing compliance with these standards, in particular the principles applying to self-regulatory organisations.
We have also looked to the legal obligations of exchanges in similar jurisdictions to gain an understanding of the expectations that overseas investors in particular are likely to have for the conduct of a registered exchange. While there are differences in the approaches taken by each jurisdiction, there are a number of standards that can be taken from an overall assessment of the IOSCO Principles and overseas law and practice. These suggest that a stock exchange should:
1. meet and maintain adequate standards of integrity and fitness to operate a market;
2. develop rules for the conduct of listed issuers and market participants;
1. develop and operate fair procedures for the enforcement of its rules;
1. conduct a fair, orderly, informed, and efficient market;
2. maintain effective trading, clearing, and settlement systems;
3. have adequate capacity to carry out its regulatory functions and enforce its rules; and
4. have procedures in place to manage conflicts of interest.
Development of rules is addressed in New Zealand under the statutory approval and disallowance process for conduct rules. The IOSCO Principles also address competition issues, which are outside the remit of the Securities Commission. The remaining matters have been addressed in this review.
The oversight review conducted this year is the first oversight review of NZX conducted by the Commission. The review focussed on the 2005 calendar year.

Process

The Commission requested information from NZX under section 36ZK of the Securities Markets Act. Section 36ZK says that a registered exchange must give the Commission (or any person authorised by the Commission) information, assistance, and access to the exchange's facilities if the Commission reasonably requests it to carry out its functions.
The Commission sent questionnaires to NZX, NZX Discipline, the Special Division and the Appeal Panel seeking information the Commission considered necessary to effectively evaluate NZX's performance of its regulatory functions. The questionnaires covered the eight areas identified in the Terms of Reference.
We requested copies of any procedures manuals and process documents that evidenced NZX's policies and procedures for each of the areas covered by the questionnaires. Where written procedures and policies were not available, we requested written explanations and information from NZX in response to each specific information request.
A significant amount of information was provided by NZX in response to the questionnaires. NZX also provided a number of procedures manuals and process documents to us. Questions relating to NZX Discipline, the Special Division and the Appeal Panel were answered by the Chairs of those bodies.
The information provided in response to the questionnaires enabled us to gain a fuller understanding of the business of NZX, and the procedures and processes that NZX uses to discharge its regulatory functions.
Commission staff selected and reviewed a sample of NZX's files across a range of regulatory activities.
Commission staff conducted interviews with NZX personnel and Board members. Commission staff also interviewed the Chairman of NZX Discipline and the Chairman of the Special Division. A total of 29 interviews were conducted.
Confidentiality and privacy orders were in place throughout the review. NZX personnel and Board members were represented by counsel during the interviews and the interviews were recorded.

NZLII: Copyright Policy | Disclaimers | Privacy Policy | Feedback
URL: http://www.nzlii.org/nz/other/NZSecCom/2006/5.html