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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

PART IV - CLIENT FUNDS AND THE ACCESS INSPECTION

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

Requirements of the Rules regarding application of client funds

  1. Under the Business Rules and the NZSE Regulations, certain funds had to be held by brokers in a client funds account. The Regulations placed restrictions on the uses to which these funds could be put. The relevant provisions are set out in Appendix B of this report.
  2. The Business Rules defined "client funds account" to mean "a trust account held by an NZSE Firm at a Bank for the benefit of the NZSE Firm's clients for its Outstanding Broker Obligations". Firms were required to hold client funds on trust, and for this purpose to open and maintain a client funds account.
  3. The Rules stated that NZSE Firms:
    1. Must obtain from the Bank holding the Client Funds Account a written acknowledgement of the trust status of the account, and must ensure that the words "Client Funds Account" appear in the title of the Client Funds Account;
    2. Must ensure that Client Funds Accounts are not overdrawn; and
    3. May not use funds in their Client Funds Accounts as security for any obligation of the NZSE Firm, or of any other person.
  4. Firms were required to hold client assets on trust for their clients at all times. Total client assets held by a firm were required to match or exceed the firm's total outstanding broker obligations at all times.
  5. Regulation 3 of the NZSE Regulations 2002 stated the permitted uses of client funds held in brokers' client funds accounts:
3.8
Application of funds: All amounts required to be paid into a Client Funds Account under Regulation 3.6 shall be held upon trust and applied:

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

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

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

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

Rules versus practice - compliance culture

  1. When NZX decided to establish an in-house compliance function it recognised that there was a need for more resources to be put into the education of market participants in regard to their compliance obligations under the NZX Business Rules. Mr Allen gave evidence that in establishing the compliance function, NZX took the approach that it would not necessarily equate established market practice with good practice:
When we demutualised and we had the regulatory changes and the new regime coming through, that was all part of us saying we're going to treat virtually all the things that are currently done in the New Zealand capital markets as something that we're not going to assume is right just because it's been done that way in the past.
  1. The Commission received evidence that there was discontent among brokers about the NZX inspection programme due to time and cost considerations, and that there was widespread dislike of the NZX compliance programme. Mr Weldon gave evidence that he had been contacted by some managing principals about this:
...the first time that the [Request for Information documents] went out into the market it was like...a whip being cracked...and there was a response of shock and I think there was a response of resistance to change, and clearly this was going to involve cost in terms of time...
  1. The NZX response was to educate the brokers about what it was trying to achieve from the compliance framework in terms of meeting international standards and improving firm regulatory status. Mr Weldon told the Commission that broker resistance did not influence the NZX approach to broker compliance or the implementation of its programme.
  2. Mr Allen said that he received feedback that the compliance function had become "over zealous" in terms of time, costs and resource. Mr Allen gave evidence that he told the compliance team to carry on with the job, and that NZX had given consideration to broker reaction when the compliance regime was introduced.
  3. The Commission received evidence that there was quite widespread non-compliance among brokers with the Rules concerning client funds accounts at the time the compliance programme was established. Mr Brown told the Commission:
...there were a number of areas where market practice differed from the requirements of the regulations and there were a number of areas where - and I give by way of example the firms who regarded it as being acceptable to pay for business expenses out of the client funds account, and I think there were a number of areas where the rules as they currently were stated did not give us sufficient comfort about our ability to inspect organisations...
  1. After the NZX broker compliance programme had been in operation for five months, NZX sent a newsletter to brokers summarising the areas where compliance issues had been identified. In relation to client funds accounting, the newsletter stated:
... lack of procedures to determine the amount of funds needed to be secured in the Client Fund Trust Account", "payment for non-securities related transactions paid from Client Fund Account" and "CFA in overdraft - human errors."
  1. The Commission also asked Mr Rodrigues about market practices:
Q
...I just want to check with you that what's here is your view or if you want to put colour to it, say. "Under the rules it is our understanding that the rules do not prevent...did not prevent a broker from using client fund accounts for any other purpose provided there was enough in the account to satisfy client fund obligations."
A
...That's right, that we picked up from the market practice.
Q
...There is nothing specifically in the rules that says the broker cannot pay his or her phone bill for example for the client funds account?
A
...Yeah, I think so that was our understanding

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

Training and understanding at NZX in relation to client funds

  1. In the Commission's opinion members of the compliance team did not receive adequate training about the requirements for client trust accounts, or about trust obligations more generally.
  2. The Commission received evidence that the inspectors would discuss their understanding of the Rules with each other. If there was an issue where a broker interpreted the Rules differently, then they would initially look to Ms Baker and Mr Brown and would refer it to an NZX lawyer who was providing support to the compliance team.
  3. The Commission received evidence from Mr Weldon that the design of the inspection framework in relation to client funds was driven by the design of the Rules. The Rules determined what had to be inspected. Mr Weldon was asked:
Q
...Who made the decision as to how to inspect against those rules?
A
...There was not a decision of how to inspect, it was just, there were the rules and there's what you would inspect.
Q
...Okay, so who decided what you would inspect?
A
...I think the rules decided what we would inspect

  1. The Commission asked Mr Weldon how NZX ensured that compliance team members understood the obligations under the Rules and the significance of the client fund accounting requirements. Mr Weldon gave evidence that reliance was placed on the involvement of Mr Brown and Ms Baker, the knowledge within the team and the language of the Rules.
Well, the rules, the English, is pretty simple and those are not difficult accounting concepts. So the way that you ensure is...Geoffrey's been involved in the stuff for a while, Barbara, so it's a matter of what the knowledge is of the team.
  1. Mr Weldon gave evidence that there had been discussions around the nature of the trust aspect, but that in his opinion there was no ambiguity about the need to maintain separation of client funds from firm funds and so no external legal advice was obtained by NZX.
  2. The NZSE Regulations in force in 2003 defined a Client Funds Account as a trust account held by an NZSE Firm at a bank for the benefit of the NZSE Firm's clients. Despite this, it was apparent both that client funds accounts were used for payments of broker expenses beyond what was permitted by the Rules, and that despite Mr Weldon's view that there was no ambiguity, other NZX staff did not appreciate that the use of client funds accounts for the payment of firm expenses was contrary to the Rules. The use of client funds accounts for brokers' own purposes appears to have been seen as a matter of poor practice rather than as a breach of the Rules. Mr Allen, in a submission to the Commission, said he was confident that Mr Rodrigues understood that the payment of firm expenses from the client funds account was not "best practice". Mr Brown gave evidence to the Commission that:
A
...The other issue of paying business expenses out of client funds accounts was not something that we would have expected and yet it seemed to be something that did occur within the broking community.

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

A
Yes.

Q
Which were clearly contrary to the rules?

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

  1. Mr Rodrigues gave evidence that when he first arrived at NZX he had been surprised to find that brokers were not always keeping client funds separate:
Initially I thought that this shouldn't be happening, but that is the way the market has evolved and we have to probably work over a period of time to get things right...
  1. The Commission asked Mr Rodrigues about his understanding of the obligation to hold client funds on trust under the NZX Rules:
Q
...Was it your understanding at the time that you were doing these inspections that a trust account was required to be maintained by the brokers?

A
Yeah.

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

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

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

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

Q
And that was based on?

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

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

The Access inspection

  1. The inspection of Access was the seventh broker inspection conducted by the NZX inspectors.
  2. Prior to the on-site inspection, Access was asked to complete an RFI. Access was sent a standard form RFI on 14 July 2003 under cover of a form letter noting:
The objectives of this initial inspection, is to ensure as much as possible, that NZX has all the information to enable and assist all firms to become compliant. To this end, this first visit is as much an information gathering exercise as it is an inspection.
  1. The inspectors assessed the information received from Access in response to the RFI and identified issues for follow up. Certain omissions from the RFI were noted by the inspectors regarding the processes for determining the funds to be maintained in trust and relevant records in relation to client funds accounting. Access did not provide some of the requested information, stating in response that "documentation will be provided at time of visit".
  2. The RFI contained a question asking whether any payments had been made from the Client Funds Account for transactions other than related to securities. Access answered "No".
  3. Financial information was also sought by the inspectors in advance of the inspection. Financial statements for Access for the year ended 31 March 2003 were provided to the compliance team by Mr Marshall.
  4. The Access on-site inspection was carried out over a three day period on 19, 20 and 27 August 2003. The NZX compliance staff who conducted the on-site inspection were Ms Baker, Mr Rodrigues and Ms Koekemoer. Ms Baker was not present for the whole of the inspection. From the evidence the Commission has received, the Access inspection was conducted in the usual manner, following the same process the inspectors had used in previous inspections. The inspectors considered it a routine inspection.


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