Richard Inder: Sceptics remain as NZX cleared

The Securities Commission largely gave the NZX a clean bill of health this week as it declared shortcomings highlighted by the collapse of discount broker Access had been largely corrected.

But investors should regard the conclusion with a fair dose of scepticism.

The commission's report - an analysis of NZX's conduct of its regulatory role before the September 2004 collapse - paints a disturbing picture of New Zealand securities markets.

The regime giving NZX the ability to perform its core regulatory function - ensuring broker compliance with its own rules - was established by a team largely without reference to the NZX board.

Inspection procedures were developed ad hoc, were not documented and supervisors - read NZX chief executive Mark Weldon - could not assess the methodology designed by the team.

No one in the team had experience in leading compliance teams or in designing inspection or audit programmes in New Zealand.

When asked whether NZX thought of sending one of the team overseas to observe the operation of a compliance team in another jurisdiction Weldon replied: " ... it was certainly something we will consider and will not exclude, but we did not obviously do it at that point in time."

NZX management did not monitor the performance of the team and instead took what the commission described as a "passive" stance, responding only to matters escalated by the ill-qualified team managers.

The effects of these and other shortcomings highlighted in the report were profound.

NZX rules, for example, state explicitly that client funds should be held in a trust account and used only to settle client trading obligations. (These rules are at the centre of a Serious Fraud Office case against Access and its chief executive Peter Marshall. Such client funds were allegedly used to keep the business running.)

Before the collapse of Access, there were widespread breaches of these rules. Geoff Brown, NZX head of markets, for instance, told the commission there were a number of brokers at the time that believed it was acceptable to pay for business expenses out of client accounts.

Yet one of the key members of the compliance team said at the time that there was nothing in the NZX rules that prevented a broker from paying his or her phone bill out of client accounts.

"That was our understanding," the officer told the commission.

In August 2003 the NZX team also highlighted shortcomings with Access' back office systems that prevented the broker from properly monitoring its client trust fund account and its capital adequacy calculations.

However, reviews of Access to ensure compliance with NZX's requirements were delayed several times. Excuses for the failure to review the broker included chief executive Peter Marshall's poor health, his holiday plans and the absence of key staff. In fact NZX did not revisit Access until it collapsed in September 2004.

This is only the start of the many failures included in the report.

More to the point, all this occurred despite Weldon asserting that the regulatory function of NZX was a "quality mark".

He told the commission: "Damage to the reputation of NZX as a regulator is our single greatest fear."

The commission's report concludes that since the collapse NZX had done much to repair the regulatory function. Measures included the creation of NZX Discipline to hear alleged breaches of NZX rules; taking on new staff and beefed up compliance standards among other things.

Weldon and other "senior market figures" had assured the commission NZX had adopted a more rigorous approach to compliance; a report by accountant Grant Thornton into broker management of client funds in the wake of the collapse has sparked a broker education programme and a review of procedures.

However, it is an inescapable fact the commission's confidence relies on the assurances of Weldon and the NZX board - the very people who must bear responsibility for the creation of what was a flawed compliance regime.

Secondly it relies on assurances from an industry that has shown itself reluctant to accept even the previously flawed regime. Weldon told the commission the first time a note was sent out asking a broker to supply certain information ahead of an inspection, NZX encountered resistance.

"It was like ... a whip being cracked ... and there was a response of shock and there was a response of resistance to change," Weldon said.

My own soundings of brokers suggests resistance continues to this day. And this is despite an assurance to the commission from a "managing principal" that "the benefits from the consistency and accountability of the current processes cannot be underestimated".

The Access collapse should not be dismissed as the result of shortcomings confined to one bad apple in the industry. The Securities Commission report shows such a failure was waiting to happen.

A more robust review of the legislation is warranted.