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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 Ctnd.

Issues arising from on-site Access inspection

There were issues arising from the on-site Access inspection that required resolution in order for the inspection report to be finalised. Compliance staff made some efforts to resolve these during September and October 2003. Several issues were outstanding and not resolved at the time the inspection report was settled.
Inspection issues identified by the inspectors were discussed among themselves in the first instance. Issues that the inspectors considered warranted further attention or input were communicated to Mr Brown, along with comments on the approach being taken by the inspectors in dealing with the issues.
A draft Risk Management and Compliance report was prepared for Access by the compliance team, recording the inspection findings.
A copy of the draft Access inspection report had been sent by Ms Baker to Mr Brown on 10 September 2003 under cover of an email noting the key issues in the report. The report and covering email was copied to Ms Campbell and Mr Weldon. The email set out the inspection findings recorded in the draft report. The email also stated:

Have followed same course of action ACBW as we did for [broker acronym] regard to CFA.

- Daily spreadsheet to be provided
- Three months to get system fixed (ACE does CFA but ACBW have never implemented)

Have requested clarity on principal/client etc by 17 Sept.

Copy of Report attached.

Mr Brown and Ms Campbell both expressed the view to the Commission that Ms Baker's email of 10 September 2003 did not raise any significant issues. Mr Weldon stated that he did not read this email. He gave evidence that he would very rarely read emails that were copied to him and this was understood within NZX.
In his written evidence Mr Weldon noted that since the collapse of Access he had been made aware of the email from Ms Baker to Mr Brown of 10 September 2003. Having read the email he was of the view that it does not contain anything that would lead him to think the collapse of Access was imminent or anticipated in any way.

The two issues identified at Access, an inability to reconcile its client funds account and a misclassification of one item in its capital adequacy calculations, did not give the team any concerns as to the ability of Access to meet its obligations as they fell due, and therefore no reason to think investors' funds were at risk...The issues set out in the email are not issues which I would have expected to be escalated. Nor am I aware that any of Philip, Lynda or Barbara flagged the issues set out in this email to anyone at NZX as requiring urgent or even particular attention prior to their departures.

When asked by the Commission about any steps he had taken in relation to the draft Access report Mr Brown gave evidence that:

...in the case of [name of another firm] Barbara had detailed the concerns that she had and they were I regarded as being of significant consequence and therefore became involved in that process immediately. On the report that I received from Barbara and my review of that report, there was nothing that was highlighted out of the Access report which would have led me to believe that any particular aspect of that needed to be highlighted or escalated.

Ms Baker told the Commission that at the time she did not think that Access could collapse. She did not warn Mr Weldon about Access' collapse and was not aware whether anyone else had raised particular concerns.
A copy of the draft report was then sent to Access for comment. Access advised the compliance team in mid September 2003 that it had attempted to address the issues raised in the draft report with some urgency.

Inspection findings

The Commission received evidence from Mr Rodrigues that the inspectors considered Access to be "middle rung", compared to the compliance of other firms.
The Access Final Risk Management and Compliance - October 2003 was the final inspection report for the NZX inspection of Access ("final inspection report"). It was sent to Access on 24 October 2003. This report states:

The inspection reviewed policies, controls and processes in place for the broking operation and the effectiveness of the controls and procedures to ensure compliance with NZX regulatory framework....The specific objectives of the inspection were to conduct a Risk Based review of the Rules, Regulations, Code of Practice and Good Stock broking Practice, Systems & Operations and to evaluate the financial stability of the firm...

The final inspection report identified six areas where NZX recommended that Access needed to make changes:

The following summarizes areas where changes are required:
- Introduce a process to determine the assets that have to be maintained in trust status to meet Client Funds Accounting regulatory requirements. Considered by NZX to be a material issue.
- Revise the Liquid Capital methodology to eliminate netting of outstanding balances of different items in the trial balance. Off setting may only occur where legal rights exist. Provide mapping of back office systems to Liquid Capital computation.
- Introduce a process to cease retention of Client FINs post completion of transaction [Application Forms, FI Order Slips, Storms System].
- Implement Fixed Interest unique order numbering system.
- Know your client procedures to ensure collection and recording of additional authorized person and company number information.
- Determine the Terms of Business for intermediaries providing margin lending facilities to clients dealing through the Firm."

Client funds accounting - NZX recommendations

The NZX final inspection report records that Access had breached the Regulations to the Business Rules in relation to client funds accounting. This was recorded in the final inspection report as a "materially important issue". It was assigned a risk rating in the final inspection report of "high" along with two other matters (retention of FINS and capital adequacy - points two and three of the above summary) out of a total of ten matters. Access did not have a daily process to determine the client assets that needed to be maintained in trust under the Regulations. The final inspection report recommended that the ability to determine the amount of funds to be secured in the client fund account be implemented within Access' systems. Access had advised NZX that it had initiated the process of updating its systems during the course of the inspection. The agreed implementation timetable was recorded in the report as 21 November 2003.
The final inspection report recommended that Access establish daily reporting of interim client funds account calculations until the ACE back office system was set up to calculate it. Access was to complete a worksheet and email this daily to NZX. This daily report was never provided by Access. The follow-up to the inspection is described in Part V of this report.

Use of client funds

The Access inspection did not reveal to NZX that there was any issue with misuse of client funds. The Commission received evidence that nothing was identified in the inspection of Access which made NZX suspect that client funds had been misused.
The Commission reviewed the Access inspection working papers and noted that there are limited papers on the inspection file indicating what work was done in relation to inspecting against the client funds accounting requirements of the Rules.
The comment in the final inspection report of October 2003 was:

The Firm did not have a daily process to determine the client assets that need to be maintained in the trust status as required by NZX regulations. Ensuring that NZX Firms are able to quantify the amount to be trusted daily is a material issue. During the course of the inspection, the Firm had initiated the process of updating their system to provide reports that would indicate the level of assets needed to be maintained in a trust status. The accounts for deposit of client funds were designated Client Fund Trust Accounts.

Other statements in the Access inspection report were:

Depositing of client funds in the client fund account and issuance of dues to clients.

No identified issues in this area

Segregation of funding/securities related to Own and Client obligations.

No identified issues in this area

NZX provided a large file of material to the Commission regarding the 2003 NZX inspection of Access. However there is no evidence on the inspection working paper file as to how these conclusions of "no identified issues" in relation to client funds were reached. Very limited records were kept of the work done by the inspectors in relation to client funds accounts. There is no record of whether a sample of receipts and payments was selected, what verification work was done on any sample items, or what conclusions were drawn from any verification work that may have been carried out in relation to assessing transfers from the client funds account. It seems to have been expected only that matters identified as non-compliance issues should be recorded. Except in cases where something unusual was identified, there does not seem to have been any expectation that inspectors would maintain records of the work done to identify issues or to verify that there were no issues identified in any area. As a result, NZX was unable to provide the Commission with the sample of Access bank accounts looked at for the Access inspection.
In the absence of documentary evidence on the inspection working paper file, the Commission sought evidence from members of the NZX compliance team as to the work done by them on Access' compliance with the Business Rules relating to client fund accounting.
Mr Rodrigues had been given the task of assessing compliance with the capital adequacy and client fund requirements. In relation to the sample period for assessing client funds accounts, Mr Rodrigues gave evidence that it was usual practice for the ledger and bank statements for the four weeks preceding the date of the inspection to be considered, to see what payments had been made from the client funds account. Mr Rodrigues gave evidence that it was the practice to select the month closest to the inspection date in order to obtain the most recent relevant data (although sometimes another month would be chosen). NZX told the Commission that inspectors received six months of bank statements and did sample other months on occasion. Mr Rodrigues looked for transactions that he thought would not be related to a client account. However, Mr Rodrigues gave evidence that the focus of the compliance team was on the capital adequacy of the brokerage firm and whether payments to clients were being made on time:

...we tried to pick up whether there were any problems with client dealings, any delayed payments to clients, delayed deliveries to clients, if that was happening there was a good possibility that the brokerage would be having some trouble...

and

...we knew there were two sort of criteria which should match up to the client funds being... in order. Mainly it was like liquid capital under control; if the liquid capital was not under control, then it would be an indication that the firm is having some sort of problem. Client fund accounting was more like secondary, it was just a process to identify whether there were enough assets at that point of time and whether they were lying in the proper places.

NZX told the Commission that:

...as a rule of thumb, if a business has adequate capital and is settling with its clients on time, there is unlikely to be a risk to client funds.

The Commission received written evidence from Ms Campbell and Mr Smith that all test checks conducted during an inspection must be relevant to the firm inspected. NZX's expectation is that inspectors exercise professional judgement based on assessment of factors such as the following:

The types of factors that might impact on the number of months of bank statements examined on inspection include:

Size of firm;

Number of transactions moving through the bank account;

Firm's payment cycle for creditors;

How many bank accounts are operated by the firm;

Whether in a review of the sample originally selected any factors are identified that indicate a larger sample should be reviewed;

Any other risk factors identified within that firm; e.g. review of complaints register; and

Any intelligence NZX has concerning the firm.

These factors will dictate the appropriate sample size for a given firm...

Mr Smith indicated by way of example that in the course of inspections he had considered bank statements and/or ledgers and reconciliations, taking into consideration factors such as whether the broker had an institutional or retail client base, and if there were any known issues regarding treatment of client funds.
Selection of the actual sample reviewed at Access was determined by Mr Rodrigues. Ms Campbell said that this would have been done within the inspection framework and methodology that Ms Campbell and Mr Smith had described. NZX also told the Commission in its submission that there were no formal criteria given to inspectors.
Mr Rodrigues was asked to consider the factors listed by Ms Campbell and Mr Smith. Mr Rodrigues agreed that (at the time he was an inspector) these essentially would have been the types of things to take into account, allowing for a degree of intuition in assessing them.
Ms Campbell and Mr Smith gave evidence asserting that the level of testing of the accounts would not necessarily have uncovered a client funds shortfall:

Work performed by KPMG and NZX Regulation subsequent to the Access default suggests that the level of testing of bank accounts for operational payments through client funds accounts would not necessarily have uncovered the client funds shortfall. The investigation into payments from client funds bank accounts indicated that there were a minimal amount of such transactions and that the vast majority of operational payments were made through the operational account. The key issue was that ultimately, monies transferred from the client funds bank accounts to the operational accounts were greater than that earned by Access in brokerage and other fees.

Conclusions - NZX Compliance, client funds, and the Access inspection

Since 1998 the NZSE Regulations had expressly required that brokers maintain client funds on trust, in separate accounts. In 2003 NZX executive management and the NZX compliance team were aware that many firms continued to mingle client and broker funds, and to make payments from client funds accounts for purposes other than those permitted by the NZSE Regulations. The widespread industry practice appears to have coloured NZX's approach to enforcing the Rules in that, while NZX did not approve of the practice, they did not believe they could treat it as a breach of the Rules. There was not sufficient knowledge of trust requirements within the compliance team to challenge the industry view. NZX executive management did not obtain external legal advice to assist the compliance team on the obligations created by the client funds regulations.
NZX told the Commission in its submissions that the work programme set out how an inspection should be carried out. However, the work programme did not provide this guidance in relation to client funds. There was no other manual instructing NZX inspectors in the procedures for carrying out an inspection, or how to assess compliance with the client funds accounting rules. It was left to the inspectors to decide how to conduct the inspection. Given the limited understanding of client trust money obligations within NZX there was a need for clear instructions for inspectors as to the steps they should take to assess compliance with the client funds account rules. These instructions were lacking. There was no requirement for records to be kept of inspection procedures to allow management to assess the scope and adequacy of the work done.
In the Commission's view, the requirements placed on inspectors for documentary recording of their work in relation to the client fund account rules were deficient, and meant that there could be no effective supervision of the work done or of the issues assessed as material.
NZX's view is that the role of management is to respond where issues are escalated. NZX told the Commission that:

It was not, and should not be, the role of management to review the process undertaken by the compliance team at a particular brokerage in respect of a particular issue. The people employed in the compliance team are experts employed to perform that process. The role of management is to respond appropriately to issues of compliance escalated to them.

In the opinion of the Commission, NZX management had a responsibility to satisfy itself that the inspection team was doing its job properly. It is surprising that Mr Brown, as supervisor of the compliance team, and other NZX executive management, were comfortable to have the inspection team draw conclusions as to whether any issues were identified in respect of the treatment of client funds without requiring the process and evidence underlying these conclusions to be documented and recorded. This lack of documentation would make it nearly impossible for any supervisor of the inspection team to satisfy himself or herself of the process undertaken.
The interpretation expressed by Mr Brown of what was permitted in relation to client funds held on trust under the terms of the NZSE Regulations was clearly wrong. The Regulations required the client funds account to be maintained as a trust account for the benefit of a broker's clients. They did not permit this to be used as an operating account for the broker's own funds. The NZX Rules do not require that brokers' client funds accounts be maintained in the same manner as, for instance, a solicitor's trust account. However, the Rules do require that client funds be held on trust. This requirement imports a range of common law obligations on brokers. At the heart of the requirement to hold funds on trust is the idea that trust funds do not belong to the broker. They remain, beneficially, the property of the client. The broker, as a trustee, cannot make any use of these funds for its own benefit except as specifically permitted by the client under the terms on which the funds are held. In the case of a broker's trust account at the time of the Access inspection, the permitted uses of funds in the client funds account were set out in Regulation 3. No other use of the client funds account was permitted under the Rules.
In respect of client funds, the Access inspection appears to have examined records, including a sample of bank statements, to assess the timeliness of payments made to clients. This is an important part of assessing compliance, particularly for a broking firm that operates call accounts for its clients. However, this work would not generally assist to determine whether money in the client funds accounts has been improperly applied to the operating account, or for operating purposes. At other inspections improper payments from the client funds account to the operating account had been noted as "not best practice". However the inspectors were not instructed or trained to look specifically for such improper payments as a matter of compliance with the Rules, and did not do so. The lack of documentation of the inspection procedures meant that supervisors would not know that inspectors were not examining transaction records to see whether funds had been misused.
The Chairman and CEO of NZX submitted to the Commission that the compliance programme was not designed to detect fraud. The Commission acknowledges this. However, the NZX broker compliance framework was intended to assess compliance with the NZX Rules. A key requirement of the Rules is that client funds must be segregated from a broker's other bank accounts, and held on trust. Client funds cannot be used for the brokers' own purposes except where the Rules expressly permit this. An inspection programme intended to assess compliance with the Rules must include procedures designed to give reasonable assurance that client funds are not being used for purposes not permitted by the Rules.
We also acknowledge the statement by Ms Campbell and Mr Smith that testing of bank accounts for inappropriate transactions would not necessarily have detected any misuse of funds. It is correct that no sample-based assessment can provide a guarantee that inappropriate transactions will be uncovered. Nonetheless, the NZX inspection programme needs to include formal measures to test and verify transactions involving brokers' client funds accounts. The presence of such measures may detect misuse of funds. The use of such procedures would also have a deterrent effect, and would encourage improved compliance with the Rules.
On the evidence the Commission has, the Access inspection put little weight on examining transaction records for evidence of misuse of client funds or the client funds account. It does not appear to have been expected that the inspectors should do otherwise. Apart from one question relating to misuse of client funds in the RFI, repeated in the work programme, there is no indication that the NZX compliance programme at the time sought to examine whether brokers were complying with this important aspect of the Rules. The work programme focussed on the settlement of client trades, not misuse of funds. In the Commission's opinion this situation came about because of a lack of engagement by supervisors and management in the design of the compliance programme and the inspection procedures, which was left in the hands of staff who had an incomplete knowledge of the client fund obligations under the Rules and inadequate training in the requirements for trust accounts. It was contributed to by a lack of understanding of the Rules at NZX, a consequent unwillingness to challenge industry practice, and a lack of supervision of the inspection process, including the lack of any requirement that records be kept of the inspection process.

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