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

13 December 2005

EXECUTIVE SUMMARY

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

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