• About
• Publications
• Exemptions
• Notices
• What's new?
• International
• Speeches
• Information for investors
• Contact us
• Site map
• Home

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 Cntd.

Comment

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

In-house broker compliance strategy

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

Composition of broker compliance team

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

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

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

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

Implementation of broker compliance programme

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

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

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

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

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

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