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

PART III - NZX REGULATORY STRUCTURE AND COMPLIANCE STRATEGY

Demutualisation and listing of NZX

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

Changes to regulatory framework and restructuring at NZX

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

The Business Rules

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

Deloitte involvement with inspections

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

Inspection function brought in-house

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

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

83. Mr Allen in his evidence said:

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

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

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

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

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