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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 VII - STEPS TAKEN TO ASSESS CLIENT FUNDS PRACTICES

In October 2004, following the collapse of Access, NZX engaged Grant Thornton to review the client funds accounts of other NZX Firms to determine whether there were any issues with these accounts. The Ministry of Economic Development had also requested that NZX establish whether there were any ongoing issues with the client funds accounts of other NZX Firms.
Grant Thornton sent each NZX Firm a questionnaire designed to enable a risk assessment to be made of each Firms' client funds accounting. The Commission was consulted in relation to the questionnaire. NZX Firms completed the questionnaire and returned it to Grant Thornton for analysis. Certain follow up visits to brokers were made by Grant Thornton to test the information.
Grant Thornton released a draft report in January 2005. A copy was provided to the Commission by NZX. The final Grant Thornton report, dated 31 May 2005 was provided to the Commission by NZX on 27 June 2005, after the NZX Board had had an opportunity to consider it. Grant Thornton's key findings were that there was no evidence of misappropriation of client funds based on the information received, and the Participant Rules were being followed in all material respects in the majority of cases. Grant Thornton noted a limited number of instances where client funds accounts were overdrawn at the bank but these instances were not as a result of a true deficit and there was no increased risk of loss of client funds. In one case, firm expenses were paid from surplus market participant funds in foreign currency client funds accounts. Grant Thornton found the daily reconciliation of client obligations against assets held was often inadequate and not well documented.
Grant Thornton recommended that NZX provide guidance and education to market participants generally in relation to the identified deficiencies, and to use the inspection process to check and ensure that the deficiencies were remedied in relation to particular firms. In respect of client funds accounts being overdrawn, Grant Thornton concluded that this was an area that required greater attention by market participants and NZX.
The Commission asked Mr Weldon about the findings in the Grant Thornton report. Mr Weldon gave evidence that the NZX Board was heavily engaged in looking at the report. He noted that there was a time lag between the generation of the Grant Thornton report and the time at which the data was collected. Mr Weldon's view was that due to this time difference, conclusions cannot be drawn from the Grant Thornton report about the current state of the market. Mr Weldon gave evidence to the Commission that issues with specific firms identified in the report had been eliminated, and that he was confident there was no systemic misunderstanding or breaches of the client funds accounting rules.
Mr Allen gave evidence that the need to educate market participants was an ongoing job. Mr Allen advised the Commission that the Board had discussed the Grant Thornton report.
The Commission notes that the Grant Thornton work was a review not an audit. We note also that it describes the situation found in late 2004, shortly after the collapse of Access. The Grant Thornton report identified widespread, but lesser, issues of compliance. It did not identify evidence of a widespread problem within the broking industry regarding client funds accounting.
The Commission requested information from NZX about the ongoing compliance of participants with the client funds account requirements. Ms Campbell and Mr Smith's evidence set out that NZX had responded to the Grant Thornton findings in three ways:
1. in the course of the NZX inspection programme, inspecting a number of the participants where the Grant Thornton report identified a deficiency with compliance. The deficiencies were required to be remedied;
2. following up individually, outside of the NZX inspection programme with certain participants where an inspection was not scheduled but compliance issues were identified by Grant Thornton; and
3. producing a guidance note Guidance Note GN0008/05 - Client Assets relating to the obligations on participants under the Rules in relation to client funds and NZX's expectations.
Ms Campbell and Mr Smith gave evidence to the Commission that in addition to the Grant Thornton work, the NZX inspection programme inspects compliance with the client assets rules. Where deficiencies were identified in the course of inspections the compliance team worked with participants to remedy the deficiencies.
On 12 July 2005, NZX distributed a summary Grant Thornton report and the guidance note to market participants under cover of a letter noting the main points of the report.
The Commission also requested evidence from NZX about whether participants were co-mingling their own assets with those of their clients and paying business expenses out of client funds. In written evidence, Ms Campbell and Mr Smith advised that the Grant Thornton report had identified a single instance of a firm expense being paid directly out of a foreign currency client funds account. The payment was made from retained firm assets, not client assets. The participant was told to desist from this. Visits by the compliance team to two brokers had identified inter-mingling of client and firm monies that was unacceptable. NZX declined to accredit each of these firms as Market Participants. NZX gave evidence that it was confident participants are not making payments of business expenses from a client funds account. This was based on the inspections and the Grant Thornton work. NZX note that the Guidance Note is explicit that this is not permitted by the Rules.

Comment

The Commission is concerned that the Grant Thornton report indicated a widespread lack of familiarity with the particular requirements of the client fund rules. The Commission is also concerned that the report identified widespread (albeit lesser) deficiencies. In the Commission's opinion the Grant Thornton findings indicated that more particular attention to client funds accounting compliance issues was needed by the NZX compliance team and by market participants. However, NZX has taken steps to address the issues highlighted by the Grant Thornton review and to assess the current state of participants' compliance with the client fund requirements. These steps focus particularly on the identified deficiencies. NZX is also addressing the issues through education and guidance. This work needs to continue.

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