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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 V - FOLLOW UP TO THE ACCESS INSPECTION AND COMPETING PRIORITIES AT NZX

Ongoing issues with Access

There were two main issues that arose from the Access inspection where the NZX compliance team had ongoing dealings with Access.
Firstly, Access was to establish daily reporting of interim client funds account calculations until the ACE system was set up to calculate this. A daily spreadsheet was to be completed by Access and sent to the NZX compliance team. The ability to determine the amount of funds that needed to be secured in the client funds account was recorded by NZX as a "materially important" issue in the inspection report.
The required daily client funds calculation was never provided to NZX. The compliance team was told by Access that Access was unable to provide the required information.
The Commission received evidence that the compliance team did continue to receive monthly liquid capital reports from Access. These reports gave the compliance team comfort that Access was complying with the liquid capital requirements.
Secondly, the NZX compliance team was concerned about the "mapping" of Access' accounts to the liquid capital computation. In his evidence to the Commission, Mr Rodrigues explained that "mapping" is where an NZX Firm sends NZX their trial balance and provides details of where the items in the trial balance are coming from. The compliance team were of the view that insufficient information had been provided by Access. The compliance team made efforts to also follow up this information.
In November 2003 the compliance team was advised that Access would be changing its back office system from ACE to SSS. Access had advised that this systems change would address the issues that had arisen with the inspection report. Based on this, the compliance team decided not to follow up on the daily client funds computations or mapping issues until the new SSS system was established. NZX management was then briefed on this. The compliance team requested that reconciliation of items in the back office system to the capital adequacy reports be taken up once the new system was in place.
Access advised the compliance team in early 2004 that there would be a delay with the implementation of the new SSS system. It would be implemented in March or April 2004. The compliance team did not consider this raised any concerns because Access continued to comply with the liquid capital requirements. The Commission was advised NZX was also aware this delay was contributed to by competing demands on the SSS vendor. In March/April 2004 Access advised that the SSS system was operational. Access was not required to submit any daily reports or mapping information after the SSS system was implemented. As that system was capable of reconciling the accounts, the operation of the new SSS system was to be tested by the inspectors in the re-inspection of Access later in 2004.

Delays with re-inspection of Access

The re-inspection of Access was initially scheduled for December 2003. In November 2003, Access asked for this to be postponed as it was about to change its back office system. The re-inspection was rescheduled for February 2004. The re-inspection of Access was not carried out in February 2004. It was further postponed at Access' request because the changes to Access' back office system had not been implemented. No firm re-inspection date was set at this time.
NZX compliance staff corresponded with Access during 2004 in regard to rescheduling the re-inspection. The re-visit was scheduled for late June, then rescheduled to July 2004 due to Mr Marshall's lack of availability. It was further rescheduled to August 2004 to accommodate NZX workloads. It was rescheduled again on Access' request, due to Mr Marshall's health problems, until September 2004. The compliance team raised the issue of postponement with Access, noting that the reconciliation of items in the back office system to the capital adequacy reports was supposed to be taken up on implementation of the SSS system. Given the postponement of the re-inspection, the compliance team requested Access to send in a mapping of the items in the capital adequacy report to the balances run from the new back office system. There were further delays with provision of the requested information. Mr Rodrigues continued to ask Access for the information until the time Mr Rodrigues left NZX in July 2004.
Mr Weldon gave evidence that he did not receive any written advice from the compliance team regarding the delays with the re-inspection and whether this was of concern to the team. He was aware that a re-inspection was to occur. He was aware of the new SSS system implementation and that this was delayed. Mr Weldon did not know that there was a client funds accounting capability on Access's ACE system. He would have expected this capability to be implemented, although NZX was pleased that Access was changing to the SSS system. Mr Weldon noted that NZX was implementing the Participant Rules and that the decision was to delay all inspections and re-inspections until after that. He was also aware of delays due to Mr Marshall's surgery. Mr Weldon noted that NZX decided to invest resources in re-writing the Business Rules.
A consequence of this decision to invest resources in rewriting the Rules was that the inspection programme was halted between February and May 2004.
Mr Moore joined the NZX compliance team in May 2004. He gave evidence to the Commission that he was not aware the re-inspection of Access had been delayed a number of times when he joined the team.
The Commission received evidence from Mr Moore that the compliance team did not consider the delays with the re-inspection and postponements in mid 2004 to be of particular concern. The reasons provided by Mr Marshall for rescheduling the re-inspection included the absence of key staff, or the absence of Mr Marshall due to holiday or illness. These were viewed by the compliance team as reasonable matters for which extensions of time should be allowed. In his evidence to the Commission, Mr Moore said:

...someone continually seeking to re-arrange an inspection is something that would give me concern, but at this point this didn't raise a flag that it was a chronic situation...one postponement due to holiday and a second postponement due to surgery, that didn't raise a red flag with me.

No re-inspection of Access had been carried out by NZX at the time Access went into default in September 2004.

Competing priorities at NZX

In 2003, following the Access inspection, NZX compliance staff were told to focus on other NZX priorities. Compliance team members were pulled away from broker inspections in October 2003 to work on other activities, including developing an inspection module for futures dealers and development of the Participant Rules. Ms Campbell gave evidence to the Commission that between September 2003 and the collapse of Access the compliance team were very busy with:
1. inspections (15 in this period);
2. re-inspections (10 in this period);
3. writing the NZX Participant Rules;
4. amending documentation to reflect the new Rules;
5. developing an inspection programme for Futures & Options participants; and
6. assisting with drafting the Rules governing Futures & Options Participants.
The development of the new Participant Rules was a matter of priority for NZX. Evidence received from Ms Campbell was that the purpose of the Business Rules re-write was threefold:
1. To resolve issues with the Rules identified in the course of inspections undertaken by the Participant Compliance team;
2. To reflect current business structures within NZX Firms (for example the delineation between Advisory and Trading and settlement participants); and
3. A desire to allow market participants to use modern trading methods (for example DMA).
The Commission received evidence that Mr Weldon determined that the Rules needed to be re-written, taking into consideration the changes at NZX, outcomes from the initial inspections, changing technology and the appropriateness of the Rules given the changes to the regulatory structures.
The Commission received evidence from compliance team members that work on the Participant Rules and other projects required considerable amounts of compliance team members' time, reducing the capacity for inspections.
Due to the focus on other NZX activities, the compliance team available for inspections was effectively two people from September 2003 until December 2003, and thereafter one person until new inspectors were recruited in 2004. The Commission received evidence that one inspection at the end of 2003 and one in early 2004 were conducted by one member of the compliance team due to reduced numbers of personnel. Inspection activity was halted between February and May 2004 while the new Participant Rules were being written, and pending their introduction.
It was anticipated that the Participant Rules would be approved by 1 March 2004. This was deferred to 1 May 2004 due to submissions made by brokers. Ms Baker gave evidence that the re-write of the Rules was originally to take six weeks. It turned into an intensive six month process. Ms Baker gave evidence that she was told by Mr Weldon to focus 100% of her time on the re-write of the Business Rules from October 2003.
In his written evidence to the Commission Mr Weldon discussed the decision that Ms Baker was to work on the Participant Rules:

I made a decision in September 2003, in consultation with Elaine, that the highest value use of Barbara at that time was to work full-time on drafting the new NZX Participant Rules...she had an unparalleled knowledge of the broking industry and, in particular, of the regulatory issues associated with it....therefore, upon receiving assurances from both Barbara and [compliance officer of a broking firm] (as an industry leader) that both Philip and Lynda were well up to scratch as inspectors, we withdrew Barbara from the on-site inspection function. This did not mean to say that Barbara Baker was not involved in the Compliance team nor that her role in supervising the team disappeared. She still reviewed each inspection report before it was sent out and was still responsible for ensuring appropriate escalation and follow up on inspection issues.

Mr Weldon gave evidence that the intention was for Ms Baker to continue to be engaged with broker compliance and that he would be surprised if she had ever been told to focus solely on the Rules. Working full-time on the Rules was never intended to mean that other obligations would cease. Mr Weldon was not aware if anything was written down to set out for Ms Baker what the expectation of her was in terms of working hours or her responsibilities. Mr Weldon did not agree that the re-write of the Rules placed a heavy burden on the compliance team.
Ms Campbell informed the Commission that no inspections or re-inspections were undertaken between February and May 2004 due to the pending introduction of the new Participant Rules. NZX compliance resources were fully committed on other activities. Ms Campbell noted that other firms also needed re-inspections scheduled, and in comparison to these, did not consider that there was particular priority to the Access re-inspection, and did not question the delay the other activities caused to the re-inspection.
The Commission received evidence from Ms Baker that there was resistance from brokers to further inspections given the imminent re-write of the Rules. Brokers considered resources should be put into compliance with the new Rules.
When asked whether the competing priorities within NZX may have compromised the inspection work, Mr Weldon gave evidence that NZX was willing to redeploy staff given the regulatory changes that the company was going through. NZX was satisfied that the prioritisation was appropriate.
The Commission asked whether NZX had considered outsourcing the writing of the new Participant Rules. Mr Weldon gave evidence that the previous Rules had been drafted by a law firm. He was of the view that there was a lack of knowledge within NZX about the Rules as a result of that. He considered it important that NZX go through the process internally, with review by external legal advisers.
All three members of the compliance team who conducted the Access inspection had left NZX by July 2004.

Comment

The inspection of Access highlighted that there were problems with reconciling the client funds account, and problems with liquid capital calculations. The liquid capital irregularities were remedied following discussions between NZX personnel and Access staff. NZX was told that Access would need to upgrade its systems in order to be able to make daily reconciliations of the client funds account. In the meantime the firm was put on a daily reporting schedule to give NZX some assurance about client funds. This was the same procedure that had been put in place for another broker with deficiencies in its client fund accounting. However, while that other broker did produce the required daily reports, in the case of Access the inspectors identified the issue along with an appropriate plan to resolve it but there does not appear to have been sufficient follow-up to require Access to adhere to this reporting schedule and management appear to have been comfortable that Access not adhere to the reporting schedule.
In the months following the Access inspection there were several staff changes in the NZX compliance team. The incoming staff appear not to have been entirely aware of the history of Access' inability to comply with its daily reporting obligation and the delays with the scheduled re-inspection. The Commission acknowledges that Access' compliance was not regarded by inspectors as exceptionally poor. The inspectors did not think that client funds were at risk. However, it is undesirable that identified breaches were left unresolved. A higher priority should have been given to ensuring that Access complied with the interim measures that were put in place by NZX pending the installation of Access' new back office system.
It was sensible to involve members of the compliance team in the review of the NZX Rules, in order to make use of their experience. However, the manner in which this was done impacted heavily on the team's ability to continue with its inspection programme. The Commission does not criticise the decision to review the Rules, but considers the decision to devote compliance team members to the review to this extent at a time when the compliance programme was still at an early stage, and while the compliance team was still building its knowledge of the broking industry, was misguided. The effect of the decision was that for the duration of the review NZX's ability to perform its function to enforce the Conduct Rules was limited.
At the time, there were outstanding re-inspections of firms where non-compliance had already been identified, including Access. This work should not have been suspended. Work on the Rules review appears, however, to have been given priority over continuation of the inspection programme, including completion of the work needed to resolve identified compliance issues at several firms, Access being among them.

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