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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 VI - GOVERNANCE

The preceding sections of this report have focused on particular issues in relation to the development of the NZX broker compliance programme, internal reporting processes within NZX, monitoring of client funds accounting, and the findings from the Access inspection. In the course of its inquiry the Commission also received evidence regarding the role of the NZX Board. The Commission considered it appropriate to consider the role played by the Board in the development and monitoring of NZX's broker compliance function.

Composition of NZX Board

In 2003, at the time of the Access inspection, the members of the NZX Board were:
- Mr Simon Allen (Chairman);
- Mr Lloyd Morrison;
- Mr Andrew Harmos;
- Mr Neil Paviour-Smith;
- Mr Tim Saunders;
- Mr Bill Trotter; and
- Mr Mark Weldon.

Reporting from management to the Board

As CEO, Mr Weldon has the principal responsibility to report to the Board. Other members of the NZX management team report to the NZX Board in relation to their areas of responsibility.
In his evidence, Mr Weldon explained the level of Board involvement with the regulatory function. Mr Weldon noted that substantial Board time was spent on the detail of the Rules when they were rewritten, and the changing regulatory structure. Mr Weldon also gave evidence that:

Significant Board time has been and continues to be spent on our approach to regulation and the co-regulatory model. Regulatory issues appear on the Board's agenda at nearly every full meeting, are the subject of Board papers and are addressed offline. If the Board runs out of time to address all the issues on its agenda, it is generally financial rather than regulatory issues that are relegated. Furthermore, nearly all extraordinary Board meetings have been called to deal with regulatory issues...

The Commission received evidence from Mr Weldon that the agenda for NZX Board meetings is determined by him in consultation with the Chairman. Board reports and Board papers would be requested of managers and other staff by Mr Weldon for inclusion in the Board papers. The Commission received evidence from Mr Brown that he did not prepare any reports on broker compliance for Mr Weldon during the time he was responsible for the broker compliance team.
Mr Weldon gave evidence that he was responsible on an ongoing basis for preparing a Chief Executive Officer's Report for the Board. The report contained a range of matters the Board needed to know about and matters for discussion.
Mr Weldon reported to the Board on broker compliance in July 2003. The Chief Executive Officer's Report - July 2003 ("July 2003 CEO's Report") was Mr Weldon's first formal report to the Board regarding broker compliance since the compliance function had been brought in-house. The July 2003 CEO's Report summarised the key issues highlighted by the first four NZX-conducted broker inspections. Mr Weldon gave evidence that the section on broker compliance was drafted by Mr Rodrigues. The July 2003 CEO's Report reported the risks identified in the inspections (which had been given a rating of high, medium or low), and noted (on a no names basis) the number of firms where a risk was observed. It also set out the internal processes and timeframes for conducting future inspections on the basis of the experiences of the first four inspections.
The July 2003 CEO's Report included a summary of the observations from March 2003 to end May 2003 in relation to firms that had inadequate liquid capital or inadequate client funds. This section of the report included the names of the brokerages where these issues had been identified. Access was recorded in the July 2003 CEO's Report as having actual liquid capital as a percentage of prescribed liquid capital of 109%. The report also recorded that four firms had overdrawn client funds accounts, in that they had an overdraft of the ledger, in breach of the regulations.
The Board asked that future reports regarding broker compliance be presented on a no-names basis. The Commission received evidence from Mr Weldon that:

...there was a view from the board that the information about what was happening in any particular firm should not be presented in such a way that it could be shared or used to commercial advantage or disadvantage.

However, this does not seem to have been intended where a Board report was required on a particular issue or emergency situation. Mr Weldon gave evidence that the Board would be advised of the names of brokers if it was material to making a decision.
There were no similar reports to the Board after the July 2003 CEO's Report on broker compliance. After July 2003 the only reports on broker compliance issues made to the Board were on an exception basis. Mr Weldon commented that a report like the July 2003 CEO's Report would not usually go to the Board because it was an operational report:

The Broker Compliance Update contained in the July 2003 CEO's report was an operational report on what the compliance team had done in the previous three months. As an operational report it would not ordinarily go to the Board, however I wanted to give the Board a feel for what the compliance team was doing on a day-to-day basis and the work they were producing, particularly in light of feedback from the industry about the cost of our in-house programme.

The Board did not request or receive any further reports on the operation or findings of the compliance team. There was no standing Board agenda item on broker compliance matters. There is no indication in the Board minutes that broker compliance matters were given regular attention by the Board or that the broker compliance programme was monitored by the Board in relation to the NZX broker compliance strategy.
When asked by the Commission whether any thought was given to establishing a Board committee to deal with regulatory or broker compliance issues on a named basis, Mr Weldon gave evidence that:

The Board's view of regulatory matters, and this is consistent today, is that they take priority over other things. So, while we're happy to have an audit committee dealing with finances, regulatory matters are something that the board's not willing to subdivide and take recommendations on.

The Commission understands that from time to time the Board did appoint independent directors to consider specific matters, although not a standing committee. Mr Allen gave evidence to the Commission that:

.. if an issue arose about a broker, and it didn't have to be one where an ordinary Board member is part of it, but any broker, a subcommittee was established.

Mr Weldon gave evidence that in 2002 the Board was very operational in discharging the Rules. This was due to the mutual structure where the Board had express responsibility for certain matters. When NZX changed to a corporate structure the Board discussed what it should and should not be involved with and what matters it wanted to be informed of. A separation was made between operational matters for the executive, and strategic and governance matters for the Board. Mr Weldon gave evidence that:

... the Board would rely upon, on an exception basis, the executive to bring extraordinary matters to their attention...the Board does not receive operational reports, it's not its role.

When asked about the level of information the Board received in relation to broker compliance, Mr Allen gave evidence that the Board had a general awareness:

We had a general idea. Don't forget, three of the Board members at that time...actually ran broking firms...So there was quite some knowledge of what you call the back office settlement procedures but the reality is that we had to make sure that the executive were running the processes.

Mr Allen gave evidence that the broking industry was fairly collaborative and that industry feedback would often reach the Board if an issue arose or was brought to the attention of a Board member. The Board did not receive any such feedback in relation to Access.
The Commission showed Mr Allen the July 2003 CEO's Report regarding broker compliance. Mr Allen gave evidence that he could not recall any specific Board discussions in relation to that report, only "general dialogue about the overview". When asked about the policy of not naming brokers, Mr Allen gave evidence that the Board viewed the facts of breaches separately from the identity of those who had breached. When asked by the Commission how the Board could assess the potential systemic effects of a breach without being aware of which broker was involved, Mr Allen replied that the Board's focus was on whether investor money was at risk, not the breaches attributable to particular brokers. Mr Allen noted that the no-names approach to reporting had been in place prior to demutualisation.
The Commission asked Mr Allen's opinion of this type of reporting. Mr Allen acknowledged that the Board would know the fact of a breach from the information in the July 2003 CEO's Report but would not be in a position to assess the reasons for the breach or whether any investors' money may be at risk without an explanation. Mr Allen gave evidence that it was taken as given by the Board that any issues would be inquired into by the compliance team. The Board would wish to know about any material matters. In his evidence to the Commission, Mr Allen said:

Look, just to make it clear, such a thing as an overdraft account in its own right is something that you would be concerned about but you would be expecting it to have been acted upon, that an explanation - the interesting thing would be if I got a report that said, by the way, it is in overdraft, they won't fix it or disagree with our interpretation, then you start saying, well, they're hiding something.

Mr Allen's view was that the July 2003 CEO's Report was bringing operational issues to the Board's attention. Activity was being undertaken to address the issues and Mr Allen was of the view that the Board could not have added to that process.
When asked about why there was not the same level of broker compliance reporting subsequent to the July 2003 CEO's Report, Mr Allen commented that the July 2003 report was a milestone report. Further reports were not expected until a particular issue arose, there was particular feedback or changes to the Rules. If the Board had already dealt with an issue, any further reports may only be brief.
The Commission asked about the systems in place at NZX to elevate issues internally where matters were material, but not necessarily urgent, to ensure they were addressed. Mr Allen gave evidence that timelines and prioritisation of matters were operational matters. The Board's focus was on risks. Matters where investors' funds were, or were likely to be, at risk would be escalated to the Board.
The Commission received evidence from Mr Allen that the Access final inspection report was not put to the Board and it was not expected to be. The reporting regime was by exception. If issues arose with particular brokers these were to be elevated to the Board on a named basis.

Expectations of Board in relation to NZX broker compliance programme

The July 2003 CEO's Report was the only report to the Board of this kind that contained information relating to the NZX compliance team's work on broker inspections and broker compliance.
The Commission understands that the Board did not request further information about the implementation of the broker compliance programme in relation to the strategic plan nor about the conduct of broker inspections and the compliance team's work. It does not appear that any further direction was given to management in relation to these issues. These matters were viewed as operational. The Board expected to see exceptional issues only. NZX advised that:

The Board would expect to be advised if the Strategic Plan was not being implemented as agreed; otherwise the Board relies on that plan being executed by management.

The Commission heard evidence from Mr Allen (in the context of questions about training for the compliance team) that in his view NZX operated differently to a government entity in terms of involvement in operational matters:

You set parameters and you set outcomes but if you start withdrawing someone's authority by telling them how to do it, I don't know of any successful companies that run that model. We are very careful about that. I accept that there are companies that do that. All the government owned entities do that but then that speaks for itself in some ways. So, it's not best practice

Conclusions - governance matters

Under the Securities Markets Act 1988, NZX is recognised as the front line regulator of the securities markets that it operates. It is obliged to make Conduct Rules for its markets, and to operate its markets in accordance with the approved Conduct Rules. Under this framework NZX occupies a unique position as a regulator and as a commercial entity. In the Commission's opinion this also places the Board of NZX in a unique position, and requires it to consider its role in both a commercial and a regulatory context.
The Commission's comments in this report do not concern the role of the NZX Board in relation to NZX as a commercial enterprise.
The Business Rules in force in 2003 gave particular responsibilities to the Board in relation to regulatory matters. In large part these Rules still reflected the previous status of NZSE as a mutual organisation. In 2004 NZX reviewed its Rules. The Board's specific role in relation to disciplinary matters was superceded by the creation of NZX Discipline as an independent body with the function of determining compliance matters referred to it by NZX. Other functions previously reserved for the Board are stated in the Participant Rules simply as functions of NZX (such as accreditation of Participants and appointment of inspectors).
As such, while NZX has obligations under the Securities Markets Act, and specific functions under the Participant Rules, there is no clear statement prescribing the role of the Board in respect of NZX's regulatory functions. This has not detracted from the Board's acceptance that it is ultimately responsible for the performance of these functions. It has, however, meant that there is less clarity about the degree to which the Board should involve itself in the performance by NZX of its regulatory functions. The Commission does not consider that greater clarity is necessarily required in either the law or the Conduct Rules - as a limited liability company NZX is generally subject to the disciplines and accountability mechanisms set out in the Companies Act. This means that it is up to directors to consider how they discharge their responsibility for the company's actions, and that directors are accountable to shareholders for these decisions.
However, in the Commission's opinion, NZX's role as a registered exchange means that it performs public functions as well as private ones. The importance of these functions, in the Commission's view, requires careful attention to be given to the appropriate role of the NZX Board in its governance of NZX as a regulator.
After discussions with NZX, in the Commission's view the regulatory roles of the board of a registered exchange might conveniently be considered in four areas: policy setting; discipline; crisis response; and monitoring and oversight of NZX's performance.
At the policy level, it is apparent to the Commission that the Board of NZX has been fully involved in the setting of regulatory policy, including the formulation of the Conduct Rules and the NZX Corporate Strategy. These matters set the direction for NZX as a regulator, and in the case of the Conduct Rules, provide the framework for the regulated markets operated by the exchange.
The discipline role of the Board created potential difficulties for NZX as a demutualised exchange. An increased emphasis on compliance meant that the number of cases likely to be put to the Board for disciplinary action would also increase. The Commission has heard that potential conflicts of interest prevented some Board members from considering cases of suspected breaches of the Rules. The formation of NZX Discipline as a separate body allowed matters concerning individual market participants or listed issuers to be considered at an appropriate level, and independently of the NZX executive. The Commission supports this step. The decision to separate the disciplinary function addressed the potential conflicts this role created for the Board. Accountability mechanisms for this body are included in the NZX Discipline Rules, including confirmation of appointments by the Commission, and the publication of an annual report on its activities.
The NZX Board has continued to play an active role in what might be described as crisis response. Mr Allen's evidence was that the Board will become involved in a specific situation involving a market participant where it appears that investors' money may be at risk. In the case of Access this was demonstrated by the Board's early and continuing involvement in the days following the collapse of the firm. The Commission was kept updated on developments at both Board and staff level, as were other public agencies. The Commission is of the view that the Board's policy that it should take an active role in such situations is entirely appropriate, as these are the situations where confidence in the markets is most tested.
In respect of the NZX Board's more general governance or oversight role as that relates to NZX's regulatory functions, the Commission considers that the Board has, in light of the public importance of these functions, an ongoing responsibility to monitor the performance of management against the regulatory policy or strategy set by the Board. In the Commission's view the NZX Board did not fulfil this responsibility in respect of the broker compliance programme, other than by its receipt of the July 2003 CEO's Report. It did not play any ongoing role in monitoring the strategic direction of the broker compliance function.
We record that NZX does not agree with our opinion on the appropriate role of the Board in this respect. NZX is of the view that:

The Board is entitled to assume that management are discharging their operational responsibilities in accordance with the strategic direction set down by the Board and to rely upon management to escalate exceptional issues requiring Board input. To do otherwise would be inconsistent with the proper division of responsibilities between a Board and management....

It is important in any organisation to separate operational matters from governance matters, with the latter being reserved as responsibilities of the Board. However, in the Commission's opinion what is appropriately a governance matter for the board of a registered exchange in relation to its regulatory role needs to be considered in the context of the public functions that are given to an exchange under New Zealand's co-regulatory system.
In this context we consider that the point at which NZX has decided to draw the line between strategic and operational matters in respect of its regulatory functions fails to appreciate the role that NZX has under the co-regulatory framework. The Commission would have expected the NZX Board to seek to remain informed, as a matter of governance, of the continuing performance of NZX's broker compliance programme. This requires active, not passive, monitoring of the discharge of operational responsibilities against the strategic direction set by the Board. A strong enforcement and compliance focus is needed at NZX for the market to have confidence that NZX is fulfilling its role as a registered exchange in relation to the conduct of its market participants. We have no reason to believe that this focus is currently lacking at NZX as an organisation. However, in view of the public importance of the regulatory function of a registered exchange, we consider that as a matter of good governance of its regulatory role this focus should both be set and monitored continuously by the Board.
The Board has responsibility for more than simply ensuring that NZX is successful as a commercial entity, and it recognises that this is so. It also has the responsibility to govern its regulatory functions. In the Commission's view the Board of NZX should consider the performance by NZX of its regulatory functions as a matter requiring governance input on an ongoing basis.

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