NZ MARKETS DISCIPLINARY TRIBUNAL FULL HEARING PROCEDURE NZMDT 004/10. the NZ Markets Disciplinary Tribunal Rules

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1 NZ MARKETS DISCIPLINARY TRIBUNAL FULL HEARING PROCEDURE NZMDT 004/10 UNDER the NZ Markets Disciplinary Tribunal Rules IN THE MATTER OF alleged breaches of the NZX Participant Rules BETWEEN NZX LIMITED AND MCDOUALL STUART SECURITIES LIMITED DETERMINATION OF NZ MARKETS DISCIPLINARY TRIBUNAL 1 DECEMBER 2010 Elaine Campbell Executive Counsel NZ Markets Disciplinary Tribunal P O BOX 15336, Miramar, Wellington 6234 Telephone Elaine.campbell@nzmdt.com

2 Introduction 1. This is a determination of a division of the NZ Markets Disciplinary Tribunal ( the Tribunal ) comprising Stephen Kos, QC (Chairman), Shane Edmond, Michael Jeffs and Peter Wilson. Background 2. The Respondent, McDouall Stuart Securities Limited (also referred to here as MCDW ), was formerly an NZX Trading & Advising Firm and an NZX Delivery & Settlement Participant. It resigned as such on 15 March For over 18 months, from 20 August 2008 to 10 March 2010, the Respondent was under what NZX has termed Intense Oversight. This originated from the Respondent self-reporting a breach of the Capital Adequacy requirements under Section 15 of the Rules on 20 August NZX states at paragraph 5 of its Statement of Case that at that time it carried out an inspection of the Respondent s records at the Respondent s offices to ensure the protection of Client Funds and assess the Respondent s financial position. 4. A waiver was granted to the Respondent, with retrospective effect from 20 August 2008, from the capital adequacy requirements of the Rules ( the Waiver ). Thereby the Respondent s initial non-compliance with the Rules was excused. This waiver was amended on 24 December 2009 ( the Amended Waiver ). 5. In both waiver determinations NZX cite as reasons for granting the waiver that in undertaking an intensive on-site review NZXR was satisfied that Client Funds were being handled appropriately (see paragraph 15(d) of the Waiver and 20(d) of the Amended Waiver). Both waiver decisions also state (see paragraph 15(g) of the Waiver and 20(g) of the Amended Waiver) that NZXR maintains a high level of continued oversight of MCDW, with detailed daily reporting to NZXR of profits, client balances and global trading activity. This information will be considered in a real time assessment of whether the continuation of this waiver is appropriate. 6. The Tribunal notes that NZX wrote to the Respondent on 13 January 2010 concerning liquid capital breaches on 8, 11 and 12 January 2010 (which breaches form part of the Breach One allegations: see below) advising the Respondent that it was considering revoking the Amended Waiver. NZX wrote to the Respondent again on 5 February 2010 concerning further liquid capital breaches on 5, 8 and 9 February 2010 (which also form part of the Breach One allegations) - again advising the Respondent that it was considering revoking the Amended Waiver. 7. On 18 February 2010 NZX wrote to the Respondent again advising it that any further breaches of the liquid capital thresholds in the Amended Waiver would result in that waiver being immediately revoked. 8. On 5 March 2010 NZX issued a ruling under Rule 17.5(c) stating that certain receivables payable by members of the MCDW Group were not on normal trade

3 3 terms and therefore could not be considered Current Assets for the purposes of Rule This Ruling was issued following NZX becoming aware of the Respondent raising intercompany invoices to other members of the MCDW Group, which invoices could be included in the Respondent s Current Assets for the purposes of its liquid capital calculation. The effect of issuing these invoices was that the Respondent complied with the Liquid Capital thresholds on certain dates. NZX was concerned that these invoices would never be paid, given NZX s view of the financial position of the MCDW Group, and that they were not on ordinary trade terms. 9. At the same time as issuing this Ruling NZX also advised the Respondent that the MCDW Group would be grouped under Rule (c) with the result that liquid capital calculations from that point forward would be prepared on a consolidated basis. NZX are of the view that these intercompany invoices aggravate the liquid capital breaches. 10. On 8 March 2010 MCDW introduced further subordinated debt in order to meet the liquid capital thresholds. The debt took the form of a loan to MCDW of 300,000 Diligent Board Member Services Limited (DIL) securities by MCDW director Duncan Priest ( the Subordinated Loan ). On 8 March 2010 NZX notified MCDW that it would not permit this Subordinated Loan to be treated as equity for the purposes of calculating liquid capital, but gave it a further 24 hours to comply with the liquid capital thresholds. On 9 March 2010 MCDW again included the Subordinated Loan in its liquid capital calculation. 11. On 10 March 2010 NZX removed MCDW s access to the Trading System and attended on site at the Respondent to supervise settlement of all outstanding trades and to supervise return of Client Funds to clients. 12. The Respondent resigned its status as an NZX Trading & Advising Firm and an NZX Delivery & Settlement Participant on 15 March Hearing procedure 13. On 24 August 2010 NZX Limited ( NZX ) served a Statement of Case on the Respondent. 14. On 2 September 2010 the Respondent filed an application for an extension of time to file its Statement of Response. 15. On 6 September 2010 the Tribunal issued a minute, timetable orders and a notice of oral hearing in respect of this matter. The Tribunal provided the Respondent with an extension until 5pm on 8 October 2010 to file its Statement of Response. Timetable orders for the hearing of this matter set out dates for receipt of NZX s rejoinder, evidence from the parties, further notices from the Tribunal and the hearing of this matter. 16. A further request for an extension of time was received from the Respondent on 6 October It was declined by the Tribunal. The Respondent s Statement of Response was then received on 8 October On 15 October 2010 NZX filed its Rejoinder to the Respondent s Statement of Response. 18. The Respondent s affidavit evidence was filed on 2 November 2010, after the Tribunal provided a one day extension of time to file this evidence. NZX did not tender affidavit evidence. 3

4 4 19. On 3 November 2010 the Tribunal ruled that NZX was to provide copies of certain Waddell Johnston McCarthy (WJM) files referred to in its Statement of Case and Rejoinder. The Tribunal notes that WJM was a market participant that amalgamated with MCDW in The Tribunal however declined the Respondent s request for further and better particulars relating to NZX s allegation that the Respondent did not return Client Funds to its clients, as allegedly required by the terms of the Amended Waiver and a direction given by NZX on 10 March The Tribunal issued a Request for Further Evidence on 4 November NZX responded to this request on 6 November 2010 and the Respondent on 8 November Both were within the requisite time provided. 21. On 9 November 2010 the Respondent advised of witnesses it proposed to call at the Oral Hearing. Four of these proposed witnesses had not already provided affidavit evidence. On the morning of 10 November 2010 the Respondent also sought to introduce a letter from a former NZX employee into evidence. NZX objected to the reception of these witnesses and the letter. The Tribunal determined to rule on these issues at the Oral Hearing. 22. The Oral Hearing of this matter took place in Wellington on 10 November Statement of Case 23. The Statement of Case alleges that the Respondent breached the following NZX Participant Rules ( Rules ), and/or the terms of the Amended Waiver, in the following respects: Breach One a. Breaches of Rule and Breaches of the Amended Waiver on 9 occasions, being failure to meet Liquid Capital thresholds as required under the Amended Waiver [see paragraphs 24 to 26 for further particulars of this alleged breach]. Breach Two b. Breaches of Rules and 8.1.1(c), being inclusion of the Subordinated Securities Loan in its capital adequacy calculation contrary to a direction from NZXMS that it did not approve the loan agreement for the Subordinated Loan and that the Rules did not contemplate such a loan [see paragraphs 27 and 28 for further particulars of this alleged breach]. Breach Three c. Breaches of Rule on 13 occasions, being failure to maintain Client Assets in excess of Client Obligations at all times [see paragraph 29 for further particulars of this alleged breach] Breach Four d. Breach of Rule 14.5, being failure to hold Client Assets on trust at all times, breach of Rule , being a failure to obtain from the Bank holding the Client Funds Account a written acknowledgement of the trust status of that account, and breach of Rule 16.9(d) being a failure to produce for inspection information requested by NZX to evidence the trust 4

5 5 Breach Five status of the account [see paragraphs 30 to 32 for further particulars of these alleged breaches] e. Breaches of Rule 8.1.1(c) and Breaches of the Amended Waiver, being failure to ensure that any excess Client Funds were paid to clients where possible [see paragraphs 33 to 35 for further particulars of this alleged breach] Breach One 24. NZX alleges that the Respondent failed to meet the Liquid Capital thresholds as required under the Amended Waiver on the dates set out in the first column of table 1, below. The thresholds required by the Amended Waiver are included in table 1 under the column headed Minimum Actual Liquid Capital required Amended Waiver and are calculated as a percentage of the Prescribed Level of Liquid Capital required by the Rules. The reported amount of actual liquid capital allegedly held by the Respondent on those dates, calculated in accordance with the terms of the Amended Waiver, is included under the heading Reported Actual Liquid Capital adjusted to include $300K Bond. Table 1 Date Reported Actual Liquid Capital adjusted to include $300k Bond Minimum Actual Liquid Capital required Amended Waiver 8 January % 80% 11 January % 80% 12 January % 80% 5 February % 110% 8 February % 110% 9 February % 110% 10 February % 110% 12 February % 110% 8 March % 140% 25. In the absence of a waiver, Rule requires a Market Participant Requiring Liquid Capital to maintain its Liquid Capital at or above the Prescribed Level at all times. Rule 15.8 defines the Prescribed Level of Liquid Capital required by a Market Participant Requiring Liquid Capital. A Market Participant Requiring Liquid Capital must notify NZX where its Liquid Capital falls below a threshold of 20% in excess of the Prescribed Levels of Liquid Capital (see Rule 15.12). (The Tribunal notes that, based on the actual reported Liquid Capital of the 5

6 6 Respondent, it would have met the requirements of the Rules with respect to Prescribed Liquid Capital on all of the dates above except 8, 11 and 12 January and 8 February 2010, noting of course the obligation to inform NZX where liquid capital falls below the 20% threshold in excess of Prescribed Levels of Liquid Capital.) 26. On 3 March 2010 NZX became aware that the Respondent had raised a number of intercompany invoices, which had the effect of increasing the Respondent s Liquid Capital. NZX was concerned that these invoices were raised on dates where, in their absence, the Respondent would have breached the waiver terms, and thus invoked the consequences of the final warning letter. On 4 March 2010 NZX attended at the Respondent to review the source documentation relating to these invoices. NZX formed a view, based on its review, that these invoices were not on normal trade terms as required by Rule 15.2(b)(iii)(2) and therefore could not be included by the Respondent in its Liquid Capital calculation. NZX formed its view based (amongst other things) on its belief that it was doubtful that the invoices would be paid, and that the invoices related to distribution of costs within the MCDW Group as opposed to a charge for services provided by the Respondent. It provided a Ruling, on 5 March 2010, that such intercompany invoices could not be included as Current Assets by the Respondent in its Liquid Capital calculation. NZX also determined as at this date to group the MCDW Group under Rule (c), with the result that the Liquid Capital calculations to be provided by the Respondent from that point forward would be carried out on a consolidated basis for the MCDW Group. Breach Two 27. NZX alleges that the breaches of Rule and Rule 8.1.1(c) arose on 9 March 2010 when MCDW included in its capital adequacy calculation the Subordinated Loan (described above at paragraph 10), after having been notified by NZX on 8 March 2010 that NZX did not approve the Subordinated Loan for the purposes of Rule Thereby, NZX alleges that MCDW failed to comply with a direction of NZX not to include the Subordinated Loan in its capital adequacy calculation, in breach of Rule 8.1.1(c) and also breached Rule because the form of the Subordinated Loan was not approved by NZX, as required by that Rule. Breach Three 29. Rule requires the Respondent to hold Client Assets in excess of its Client Obligations. NZX alleges that during the period 20 August 2008 to 15 March 2010 MCDW calculated, and reported to NZX via NZX s reporting platform, a deficit in Client Assets allegedly held by it on 13 occasions, as set out in Table 2 thereby breaching that Rule. 6

7 7 Table 2 Date of Deficit Deficit in calculation 12 September 2008 $98, January 2009 $70,501 3 March 2009 $3, May 2009 $180, November 2009 $112, November 2009 $1,812, November 2009 $1,785, November 2009 $132,195 8 December 2009 $74, December 2009 $279, January 2010 $668, January 2010 $252, February 2010 $203,186 Breach Four 30. NZX alleges that the Respondent breached Rule 14.5, which requires that a Market Participant Accepting Client Assets hold Client Assets on trust at all times for its clients. NZX alleges that an account used by the Respondent for holding Client Funds, the Charles Schwab account number ( the Charles Schwab account ), was not a Client Funds trust account and thus that the Respondent breached Rule NZX also alleges that by failing to obtain from Charles Schwab a written acknowledgement of the trust status of that account, as required by Rule , that MCDW breached that Rule. 32. Finally NZX alleges that MCDW breached Rule 16.9(d) by failing to produce for inspection, without delay, documentation to evidence the trust status of the Charles Schwab account. Breach Five 33. The Waiver, at paragraph 15(b), and the Amended Waiver, at paragraph 15(g), stipulated that the Respondent must ensure that excess Client Funds are paid to Clients where possible. NZX further alleges that on 10 March 2010 it directed the Respondent to return all excess Client Funds in Client Funds Accounts which were not required to settle outstanding positions to the appropriate clients. 34. NZX alleges that as at 10 March 2010 the Respondent held Client Funds (not including the National Bank Trust Management Accounts) of approximately $2,801,000. Of this NZX say the Respondent only required $804, for settlement purposes. NZX further alleges that MCDW resisted unwinding the Charles Schwab account and its GBP and AUD E-Trade accounts. 7

8 8 35. NZX therefore alleges that, in the absence of written instructions from clients to retain their funds, MCDW was in breach of the terms of the Amended Waiver, and failed to comply with a direction given by NZX and is thus in breach of Rule 8.1.1(c). Statement of Response Breach One 36. The Respondent admits Breach One, but advances the following in mitigation: a. In respect of the January breaches, it was confused as to the requirements of the Amended Waiver, until a clarifying letter was sent on 21 January 2010 and thus the breaches are technical only. The Respondent erroneously believed that it was only required to meet the liquid capital thresholds as at a particular date. In the Respondent s view a sustained improvement could be demonstrated by a general trend upwards, with the monthly targets as milestones for the month. Thus it argues it was trying to comply with the terms of the Amended Waiver and these breaches were entirely unintentional. b. In respect of the February breaches it admits all matters as pleaded by NZX, but notes that the breaches were self-reported and advised in detail prior to it lodging its daily returns. c. In respect of the March breach it states that it believed NZX was in error concerning the Subordinated Loan and that if MCDW s interpretation was correct it would not have breached the Rule. As at the date of this breach it states it was still endeavouring to persuade NZX to its position. It states that once NZX had not accepted its position a breach became unavoidable. It also notes that whilst it did not achieve the 140% threshold under the Amended Waiver, nevertheless it had liquid capital in excess of the requirements of 120% imposed under the Rules. (The Tribunal notes that the 120% requirement is a reporting obligation only, i.e. Participants are obliged to notify NZX where their liquid capital is within 120% of the Prescribed Level. The requirement in the Rules is to maintain Liquid Capital at or above the Prescribed Level. Therefore in the Tribunal s view, on 5 of the 9 dates the Respondent did have Liquid Capital at the level prescribed by the Rules (but not the Amended Waiver)). d. Generally in respect of all breaches, the Respondent states that the generation of intercompany invoices was proper, discussed with the Respondent s auditors and consistent with prior years practice. It notes that the invoices were consistent with GAAP and supported by documentation. Breach Two 37. The Respondent denies Breach Two. It submits: a. Subordinated loans of securities are permitted under the Rules and NZX has permitted such loans before. To this end the Respondent references another Market Participant allegedly having used securities to support a subordinated loan. 8

9 9 b. It used the form of an agreement under which NZX had accepted subordinated loans of cash from the Respondent. c. NZX initially accepted the Subordinated Loan, but subsequently changed its mind. 38. In mitigation the Respondent states that NZX is seeking a penalty for the Respondent s treatment of the Subordinated Loan under both Breach One and Breach Two and that only one penalty should be imposed in respect of the same conduct. It also states that it endeavoured to communicate with NZX throughout. Breach Three 39. The Respondent denies ten of the 13 breaches alleged within Breach Three: a. The ten breaches are denied on the basis that if the $300,000 bond held by NZX as a condition of the Waiver and Amended Waiver were included in the Respondent s Client Assets then only three of the breaches would have occurred. b. The Respondent states that all of these breaches arise due to the vicissitudes of overnight transfers of funds at various times between jurisdictions. c. Further the Respondent submits that if it had used its general ledger bank, as opposed to the physical bank balance, these breaches would not have occurred. 40. The Respondent argues in mitigation that this breach falls into Penalty Band 2, not 3, as argued by NZX it describes the breach as late filing of trades. It also refers to a complete lack of active intent and submits that actual culpability for this breach is very low with exposure to loss only nominal. Breach Four 41. The Respondent denies Breach Four in its Statement of Response. [The Tribunal notes, however, that it later admitted Breach Four at the Oral Hearing.]. In its Statement of Response it submits: a. NZX were well aware of the status of the Charles Schwab account and that it had both implicitly and explicitly accepted such a structure. The Respondent states that the account was operated by WJM prior to its amalgamation with MCDW, that NZX examined the structure of that account and approved it, and that WJM and MCDW had undergone several NZX audits [the Tribunal notes that the supervision conducted by NZX is not an audit; it is an inspection] without comment on the Charles Schwab account. b. The Respondent states that stocks were held in the name of the client. c. It further submits that it had discussion with NZX staff at the time of the amalgamation with WJM where it asked explicitly about the account structures and that NZX confirmed it was satisfied with these. Thus, the Respondent argues it was entitled to assume that the Charles Schwab account structure was approved by NZX. 9

10 In mitigation the Respondent submits that NZX has pleaded the wrong penalty band for this offence, and that it should be a Penalty Band 5 breach. It also submits that the breach is purely technical and that NZX contributed to the breach and assisted with the breach, in that NZX not only knew of, but approved of, the structure by accrediting WJM as a market participant and auditing WJM successfully for 5 years and that it had confirmed its acceptance of the Charles Schwab account as part of the WJM amalgamation with MCDW. Finally it notes that the account is protected in the United States by FDIC. Breach Five 43. The Respondent denies Breach Five: Rejoinder a. It states that unilateral payment out of funds held in foreign currency was against client instructions and that it wished to give clients the opportunity to open foreign currency accounts in their own name. b. It submits that the costs of converting foreign currency, when trading was to occur in a short period of time, meant that conversion was not sensible. c. It also submits that it was focussing its limited resources on returning NZD funds, which were the majority of the funds held by it. d. The Respondent also explains its focus on NZD accounts as being based on an alleged direction by NZX not to alert its corporate bank of NZX s requests concerning the return of Client Funds to clients, MCDW s assessment that the risk was higher to NZD clients in light of NZX s concerns about how the NZ bank would respond if it became aware of NZX s directions to it, and its view that if substantial offshore Client Funds were introduced into accounts at that bank it would be alerted to the situation, in breach of NZX s alleged direction not to so alert it. Breach One 44. In its Rejoinder to the Statement of Response, NZX submits the following with respect to Breach One: a. The intercompany invoices are only relevant to give colour to the breaches alleged by NZX, which do not relate to or depend on these invoices. b. Whether these intercompany invoices are valid for GAAP is not relevant to NZX s consideration as to whether they are valid for the purposes of the Rules. c. It rejects the Respondent s argument that the January breaches were technical. NZX submits that the Amended Waiver was both sufficiently clear as to its intent and that the Respondent understood the requirements of that waiver. NZX tendered evidence to support these arguments. d. There was ample opportunity for the Respondent to clarify any misunderstanding of the meaning of the waiver, prior to it breaching its terms. 10

11 11 e. Whilst 120% is the base liquid capital requirement under the Rules the circumstances of the Respondent were not ordinary and NZX was required to invoke its powers under Rule Breach Two 45. NZX submits: a. It accepts that a subordinated loan of securities is possible at law and under GAAP but that is not the issue in this case. What is at issue is whether such a loan should benefit from Rule b. It has contacted the other Market Participant alleged to have used scrip by way of subordinated loan and had it confirmed to it that that firm has not entered into any subordinated loan for any asset other than cash during the period , contrary to the Respondent s allegation. NZX called evidence from a representative of that Market Participant in support of that information. NZX also notes that this is consistent with its polling of Market Participants. c. NZX denies that it ever accepted the Subordinated Debt, initially or otherwise, but says it simply gave the Respondent an additional day to comply with the Rules. d. NZX also argues that it is entitled to pursue two financial penalties, especially in light of the leniency it has shown the Respondent. Breach Three 46. In respect of Breach Three, NZX submits: a. There is no merit in the Respondent s argument that if the $300,000 bond were included in the calculation the Respondent would have only breached the Rule three times, on the basis that the bond is not an asset of the Respondent and thus not available to be included in the calculation. Further, even if it was, there is no guarantee as to how the Respondent would have treated the bond. b. It also references Guidance Note GN008/2005 which states that where the Client Funds reconciliation is performed at the beginning of the following day, reconciled bank balances should be used. c. Active intent is not required for a breach of this Rule. Breach Four 47. NZX submits that: a. There is no evidence on its files that the trust status of the Charles Schwab account was reviewed by NZX staff or that the account was accepted as a Client Funds Account. [The Tribunal notes that the Respondent s argument seems to be that NZX accepted the account on the basis of the material that NZX did have and review, which revealed it was not a trust account for the purposes of the Rules, but a corporate account in the name of WJM]. b. The WJM accreditation file does not reveal that the account was reviewed by NZX in the context of WJM s accreditation. 11

12 12 c. Whilst it has no evidence of approving the Charles Schwab account as a custodial account, that even if it had, this does not equate to approval as a Client Funds Account. d. Any discussions with NZX during the acquisition are not supported by any evidence. e. Its disclaimer in inspection reports that states that just because an issue is not raised by NZX it should not be construed as confirmation by NZX of compliance. f. No evidence of the protection FDIC confers was provided by the Respondent. Breach Five 48. In respect of Breach Five NZX submits: a. The risks and difficulties in repatriating Client Funds were issues of the Respondent s own making. b. In response to the Respondent s submission concerning focussing its limited resources, issuing the instruction to Charles Schwab on 10 March 2010 to recall the funds would not have been difficult to effect; rather issuing that instruction on 10 March 2010 would have enabled reparation to occur the following day. c. It denies ever making any statement to the Respondent concerning not advising the Respondent s bank about NZX s instructions to repatriate Client Funds. It called evidence to that effect at the Oral Hearing. The Oral Hearing 49. The Oral Hearing was held in Wellington on 10 November The first matter considered at the Oral Hearing was the Respondent s 9 November 2010 notice of its intention for evidence from four witnesses (from whom no affidavits had been tendered) to be adduced at the Oral Hearing, and its desire to put in evidence a letter from a former employee of NZX received that morning. Submissions on evidence from the Respondent 51. The Respondent submitted that these witnesses, and this evidence, would assist the Tribunal. Further, that in its Statement of Response the Respondent had alluded to the evidence of these witnesses, and thus it should not be a surprise that the Respondent sought to call them. Under questioning from the Tribunal the Respondent accepted that there was no reason that the evidence of these witnesses (save for Mr Dinsdale whom the Respondent says was out of the country) could not have been filed in accordance with the Tribunal s timetable (and Mr Dinsdale s evidence could still have been supplied ahead of the Oral Hearing itself). Submissions on evidence from NZX 52. NZX argued that it was procedurally unfair to it that it be provided with such late notice of these witnesses. It submitted it was a matter of process and fairness to 12

13 13 all parties to abide by the Tribunal procedures and accordingly to maintain the integrity and protocols of the Tribunal. It argued that the Respondent had considerable notice, and the benefit of a generous extension of time, to prepare its defence. NZX maintained that it would be prejudicial to its ability to argue its case and respond effectively to evidence MCDW presents should the witnesses be allowed, on the basis that NZX did not know what evidence these witnesses were to give. Tribunal s ruling on evidence 53. The Tribunal adjourned to consider its ruling on this matter. The Oral Hearing recommenced shortly thereafter and the Tribunal ruled that the evidence of the additional four witnesses and the letter from the former NZX employee would not be permitted in evidence. The Tribunal noted that its reasons for this ruling would be provided in its written determination. The reasons for this ruling are set out below at paragraph 56. Substantive Matters 54. The Oral Hearing then proceeded on the substantive allegations. 55. During the course of the Oral Hearing submissions and witness evidence was received from both parties. Reasons for the Tribunal s determination concerning Evidence 56. The Tribunal determined that it would not permit the additional evidence of the Respondent because: a. This evidence could and should have been tendered, in compliance with the Tribunal s timetable orders i.e. by 1 November 2010 (or, in the case of Mr Dinsdale, ahead of the Oral Hearing); and b. Both the lack of pre-circulation of the evidence and the late notice provided by the Respondent that it wished to call this evidence, were unfairly prejudicial to the other party, NZX. Relevant Rules 57. NZX Participant Rule states that: To ensure that each Market Participant Requiring Liquid Capital is at all times capable of meeting its financial obligations, each Market Participant Requiring Liquid Capital must at all times maintain its Liquid Capital at, or above, the prescribed level, except as otherwise provided in Rule NZX Participant Rule 15.2 states that: Current Assets means all current assets of a Market Participant Requiring Liquid Capital, as defined by Generally Accepted Accounting Practice and: Excludes: (iii) all loans and advances to, or amounts owing by, any partners, Employees or persons associated with that Market Participant Requiring Liquid Capital, and their Immediate Family, or any Family Trust or Family Companies of those persons, any parent or Subsidiary companies, related parties or any parties having any other financial or Trading interest in that Market Participant Requiring Liquid Capital, except: 13

14 14 (1) any such loans, advances or amounts owing that are unconditionally guaranteed (which guarantee is subject only to the condition that the debtor has failed to pay the amount owing): (AA) by a person approved by NZX (which approval may be withdrawn at any time); and (BB) evidenced by a deed in the form provided from time to time by NZX; (2) where the amount in question arises through a transaction undertaken by that Market Participant Requiring Liquid Capital on behalf of the other party, and which is subject to normal trading settlement terms; 59. NZX Participant Rule states that: Subordinated loans (which may not exceed the ratio of 50/50 of the Market Participant Requiring Liquid Capital s Current Equity, subject to Rule ) must be evidenced by an agreement in writing, between the parties in a form of subordinated loan agreement approved by NZX. The subordinated loan agreement must, as a minimum, include the following: (a) (b) (c) (d) A provision that the agreement must not be amended except in writing signed by the parties and approved by NZX; The terms and conditions governing each loan; That repayment of the loan in whole or in part must not take place without the prior approval of NZX. NZX may withhold its consent if it is not satisfied that the Market Participant Requiring Liquid Capital is capable of continuing to comply with the Rules, any directions given from time to time by NZX, or Good Broking Practice, following the repayment of the loan; an acknowledgment by the lender that: (i) (ii) (iii) any right of the lender to payment in the case of bankruptcy of, or any composition or compromise with creditors by, or appointment of a trustee in bankruptcy, or in the case of liquidation, liquidator of that Market Participant Requiring Liquid Capital who has borrowed from that lender, or the partners, shareholders or directors of that Market Participant Requiring Liquid Capital, or any of them, is extinguished to such extent as will ensure payment, or provision for payment, in full of all claims of all other present and future creditors of that Market Participant Requiring Liquid Capital in priority to the claim of that lender; any right to receive interest and principal repayments are subordinated, at all times during the term of the loan, to all other creditors; and the obligation to repay the loan, and to pay interest, is suspended if the Liquid Capital of the Market Participant Requiring Liquid Capital falls below the Prescribed Level of Liquid Capital. 60. NZX Participant Rule states that: NZX, at its complete discretion, may require a Market Participant Requiring Liquid Capital to include a secondary requirement in its liquid capital calculations if NZX determines that the Market Participant is subject to any of the following risks: (a) (b) (c) Liquid assets; Risk profile; and/or Operational risks (including but not limited to inadequate management of operational risk to which the Market Participant Requiring Liquid Capital is exposed). 61. NZX Participant Rule 14.4 states that: Total Client Assets held in a FASTER Transfer Account, Nominee Account and Client Funds Account by a Market Participant Accepting Client Assets (as the case may be) 14

15 15 taken together must equal or exceed that Market Participant s total Outstanding Obligations. 62. NZX Participant Rule 14.5 states that: Each Market Participant Accepting Client Assets must hold Client Assets on trust for its clients at all times. 63. NZX Participant Rule 14.6 states that: Each Market Participant Accepting Client Assets shall open and maintain a Client Funds Account at a Bank approved by NZX. If a Market Participant Accepting Client Assets has more than one Client Funds Account, this Rule 14 shall apply to each of those Client Funds Accounts. 64. NZX Participant Rule 14.7 states that: Each Market Participant Accepting Client Assets must: (a) Obtain from the Bank holding the Client Funds Account a written acknowledgement of the trust status of the account, and must ensure that the words Client Funds Account appear in the account name of that Client Funds Account; (b) Supply to NZX current copies of the written acknowledgement of the trust status of the Client Funds Account; (c) Not deposit Client Funds into an account that is not a designated Client Funds Account; 65. NZX Participant Rule 8.1.1(c) states that: Each Market Participant and each Advisor must at all times: Comply fully with all applicable Rules, any directions given from time to time by NZX and at all times observe Good Broking Practice. Relevant Waiver Conditions 66. Paragraph 15(d) of the Amended Waiver required that: (d) MCDW must meet the following Liquid Capital targets: i. Actual Liquid Capital at 80% of the Prescribed Level as at 31 December 2009 (including $300,000 bond held by NZXR); ii. Actual Liquid Capital at 110% of the Prescribed Level as at 31 January 2010 (including $300,000 bond held by NZXR); iii. Actual Liquid Capital at 140% of the Prescribed Level as at 28 February 2010 (including $300,000 bond held by NZXR); and iv. Actual Liquid Capital at 180% of the Prescribed Level as at 31 March 2010 (including $300,000 bond held by NZXR); NZXR notes that by achieving Actual Liquid Capital of 180% of the Prescribed Level, MCDW will have a base Liquid Capital (excluding the $300,000 bond held by NZXR) of approximately 100%, and as such, will meet the requirements of the Rules. Failure to meet any of the above targets may be considered a breach of the Amended Waiver, and may result in disciplinary action being taken against MCDW; 67. Paragraph 15(g) of the Amended Waiver required that: (g) MCDW must ensure that excess Client Funds are paid to Clients where possible; 15

16 Paragraph 15(o) of the Amended Waiver required that: (o) NZXR may require that additional capital be introduced; 69. Paragraph 15(p) of the Amended Waiver required that: (p) MCDW must comply with any other condition imposed by NZXR from time to time; Determination of the Tribunal 70. The Tribunal finds Breaches One, Two, Three, Four and Five all proved. Breach One 71. The Tribunal finds that the Respondent breached Rule , and paragraphs 15(d), 15(o) and 15(p) of the Amended Waiver, on nine occasions, being 8 January 2010, 11 January 2010, 12 January 2010, 5 February 2010, 8 February 2010, 9 February 2010, 10 February, 12 February 2010 and 8 March 2010 by failing on each of these dates to have Liquid Capital at the levels prescribed in the Amended Waiver thus breaching the terms of that waiver and thus the underlying Rule from which relief was granted by the waiver. 72. It notes that the Respondent did not deny any of these nine breaches. 73. The Tribunal finds that the terms of the Amended Waiver required compliance with the thresholds stated in that waiver for the duration of the month for which that threshold applied and until the date that the next threshold commenced. The Tribunal does not accept the Respondent s argument that compliance was only required as at a particular date, with the Respondent permitted to fall under that threshold thereafter. It regards that argument as self-evidently flawed and inconsistent with the terms and spirit of the Amended Waiver. 74. The Tribunal finds the inter company invoices were not generated with the intention of inflating the Respondent s liquid capital position. The Respondent adduced evidence as to the validity of these invoices and that their generation was discussed with their auditors. The Tribunal accepts this evidence. Breach Two 75. The Tribunal finds that the Respondent breached Rule and Rule 8.1.1(c), by persisting with its inclusion of the Subordinated Loan in its Liquid Capital calculation despite a clear direction from NZX that it did not approve that Subordinated Loan for the purposes of Rule The Tribunal accepts that the Respondent genuinely believed its position concerning the Subordinated Loan was correct. However, the Tribunal finds that NZX was permitted under the Rules to reject the Subordinated Loan and, once it did, the Respondent was not able to include that loan in its Liquid Capital calculation. The Tribunal also finds that the form of agreement used by the Respondent to document the Subordinated Loan was patently unsuitable for that purpose that form of agreement was only suitable for a loan of cash. It was not appropriate for the Respondent, therefore, to proceed on the assumption that NZX would approve the use of that form for a loan of securities. 77. The Tribunal notes that it considers that the Rules as they related to subordinated loans at the time of these breaches (noting that amendments to the 16

17 17 NZX Participant Rules have been made since the date these breaches occurred) were deficiently drafted. In the Tribunal s view these rules should be clear that NZX is to approve not only the form of the agreement but the substance of the loan itself. In particular the Tribunal considers that the Rules need to be explicit as to whether loans of securities are permitted for the purposes of the subordinated loan provisions of the Rules. The Tribunal notes its view that the Rules do not, on their face, prohibit loans of securities. In this case, as noted in paragraph 76, the Tribunal, was of the view that even if the Rules permit loans of securities, the loan of DIL securities was not appropriate given the manner in which that loan was documented, i.e. in an agreement wholly unsuitable to loans of securities. Breach Three 78. The Tribunal finds that the Respondent breached Rule by not holding Client Assets in excess of its Client Obligations on 13 occasions being 12 September 2008, 20 January 2009, 3 March 2009, 22 May 2009, 10 November 2009, 19 November 2009, 20 November 2009, 30 November 2009, 8 December 2009, 28 December 2009, 15 January 2010, 18 January 2010 and 10 February The Tribunal notes that the Respondent denied ten of these 13 breaches 80. The Tribunal finds that the $300,000 bond held by NZX cannot be included in the Respondent s Client Assets for the purposes of calculating whether it s Client Assets exceed its Client Obligations. The Tribunal considers that the Respondent cannot make the argument to include the bond in this calculation in circumstances where it submitted its Client Assets to Client Obligations calculations during the entire period of Intense Oversight without including the $300,000 bond in its Client Assets calculation and without raising the issue of the inclusion of the bond in this calculation with NZX. 81. The Tribunal was concerned at the Oral Hearing that NZX had not produced any evidence to support its allegations contained in Breach Three. The Tribunal notes that NZX must produce evidence to prove each element of each alleged offence. However, on balance the Tribunal considered that it could nonetheless be inferred from Paragraph 70 of the Respondent s Statement of Response (where the Respondent argues that only three breaches would have occurred if the $300,000 bond held by NZX was included in the calculation), that, without the bond included in the calculation, all 13 breaches did occur. The Tribunal notes that without this admission from the Respondent, NZX s case on this breach would have failed for lack of proof. Breach Four 82. The Tribunal finds that the Respondent breached Rule 14.5 by failing to hold Client Assets on Trust for its Clients at all times and Rule by not obtaining from its Bank holding the Client Funds Account a written acknowledgement of the trust status of the account and Rule 16.9(d) by failing to produce evidence of the trust status of the account. All three of these breaches relate to the Charles Schwab account. 83. At the Oral Hearing the Respondent admitted these breaches (having initially denied them in its Statement of Response). 84. The Tribunal finds that Client Funds held by the Respondent in the Charles Schwab account were not held on trust, as required by the Rules. 17

18 In each Client Asset calculation received by NZX, the Charles Schwab account was listed as a Client Funds Account. The Tribunal finds that NZX had institutional knowledge of the structure of the Charles Schwab account and thus, in its view, should have been aware that this account was not a trust account and been put on notice to ask the Respondent what Client Assets were being held in that account, given its Intense Oversight and concern for preservation of Client Assets. That said, it remains the Respondent s obligation to comply with the Rules. The Respondent was well aware of the obligations under the Rules to hold Client Assets on trust and any omission by NZX to identify to the Respondent the deficiencies in its arrangements with Charles Schwab does not relieve the Respondent of its obligations to comply with the Rules. 86. The breach of Rule flows as a natural consequence of breach of Rule The Tribunal again notes that no evidence of breach of Rule 16.9(g) was produced by NZX until NZX s response to the Tribunal s Request for Further Evidence was filed. Again the Tribunal notes the onus on NZX to prove each element of each breach it is alleging. But for the evidence produced in response to the Tribunal s Request for Further Evidence, NZX would have failed in respect of this alleged Rule breach, for want of proof. Breach Five 88. The Tribunal finds that the Respondent breached Paragraph 15(g) of the Amended Waiver, by failing to ensure that excess Client Funds are paid to clients where possible. The Tribunal finds no associated breach of Rule 8.1.1(c). 89. The Tribunal has no evidence of a clear direction given to the Respondent on 10 March 2010 for the Respondent to repatriate Client Funds. The 10 March 2010 letter upon which NZX relies as evidence of this direction merely states what NZX will do; paragraph a.ii of that letter states that NZXR will attend the offices of MCDW on 10 March 2010 in order to supervise and ensure the payment of excess Client Funds to clients as soon as possible. In circumstances where NZX seeks to prosecute disciplinary proceedings for breach of a direction, the Tribunal finds that a clear and unambiguous direction is required. The Tribunal does not have any evidence of any such clear and unambiguous direction being given to the Respondent in this case. 90. Further, the Tribunal finds that even if such a direction had been provided on 10 March 2010, completing the repatriation of all Client Funds, including those in the offshore foreign currency was undertaken in a reasonable time frame from 10 March The Tribunal finds that NZX s expectation that the Respondent would instruct Charles Schwab to repatriate Client Funds on the same day, 10 March 2010, it alleges it directed the Respondent to do so, was unreasonable. The Tribunal finds that it is reasonable that the Respondent first seek instructions from its clients in respect of those funds, particularly given that the terms of the agreement entered between those clients and the Respondent anticipated that moneys would be held by Charles Schwab (see page 2 of the Custodial Terms & Conditions). Accordingly it was reasonable for the Respondent to first revert to clients to change the terms of the mandate between the Respondent and those clients with respect to the holding of those clients funds. In the Tribunal s opinion two days is not an unreasonable length of time to do this. 18

19 In the circumstances, it is not therefore necessary for the Tribunal to resolve the contested allegation by the Respondent that NZX had directed it not to alert its corporate bank of NZX s requests concerning the return of Client Funds to clients. The Tribunal is unable to resolve the conflicting evidence and makes no finding one way or the other on that allegation. 92. Notwithstanding the foregoing, however, the Tribunal is able to infer from the evidence before it that the Respondent was not complying with the terms of the Waiver and Amended Waiver concerning the Respondent returning all excess Client Funds to clients, where possible. In the Tribunal s view the quantum of excess Client Funds held by the Respondent compels the conclusion that this waiver condition was not being complied with. That is particularly so in circumstances where, following NZX s attendance on-site at the Respondent to supervise and ensure the payment of excess Client Funds to clients as soon as possible, the Respondent was able to return the excess Client Funds in a maximum period of 4 business days, and in most cases 2 business days. Thus, the Tribunal finds that the Respondent did breach the terms of the Waiver and the Amended Waiver. Penalties imposed by NZ Markets Disciplinary Tribunal 93. The Tribunal imposes the following penalties: Breach One a. In respect of the Breach One: i. An order that the Respondent pay to NZX, within 20 Business Days of this determination, a sum of $25,000 (twenty five thousand dollars) by way of penalty; and ii. a public censure of the Respondent in the form of an announcement by the Tribunal to the market that the Tribunal has found the Respondent to be in breach of Rule , and paragraphs 15(d), 15(o) and 15(p) of the Amended Waiver on 9 occasions; and Breach Two b. In respect of Breach Two a public censure of the Respondent in the form of an announcement by the Tribunal to the market that the Tribunal has found the Respondent to be in breach of Rule and Rule 8.1.1(c); and Breach Three c. In respect of Breach Three: i. An order that the Respondent pay to NZX, within 20 Business Days of this determination, a sum of $13,000 (thirteen thousand dollars) by way of penalty; and ii. a public censure of the Respondent in the form of an announcement by the Tribunal to the market that the Tribunal found the Respondent to be in breach of Rule on 13 occasions; and Breach Four d. In respect of Breach Four: 19

20 20 i. An order that the Respondent pay to NZX, within 20 Business Days of this determination, a sum of $30,000 (thirty thousand dollars) by way of penalty; and ii. a public censure of the Respondent in the form of an announcement by the Tribunal to the market that the Tribunal found the Respondent to be in breach of Rule 14.5, Rule and Rule 16.9(g); and Breach Five e. In respect of Breach Five: i. An order that the Respondent pay to NZX, within 20 Business Days of this determination, a sum of $15,000 (fifteen thousand dollars) by way of penalty; and ii. A public censure of the Respondent in the form of an announcement by the Tribunal to the market that the Tribunal found the Respondent to be in breach of paragraph 15(f) of the Waiver and 15(g) of the Amended Waiver. Publication of Tribunal s determination 94. The Tribunal recommends that this determination be published in full to the market under NZ Markets Disciplinary Tribunal Rule Reasons for the Tribunal s determination on Penalties Breach One 95. In assessing the penalties imposed for Breach One the Tribunal considered the following matters: a. Any breach of the Liquid Capital Rules, which in the Tribunal s view falls within Penalty Band 5 of Procedure 11 (Penalty Band Guidance Procedure) of the NZ Markets Disciplinary Tribunal Procedures, is a serious matter, being in the upper end of the Penalty Bands for breaches by Market Participants. The Tribunal notes that these rules are fundamental to the integrity of the markets, particularly in circumstances (as prevailed at the time of these breaches) where participants take principal risk on other participants for settlement of trade obligations. The penalty to be imposed must therefore reflect the seriousness of the breach whilst taking into account other mitigating factors. b. It is a countervailing consideration going to penalty, however, that NZX knew immediately when the Respondent fell into breach of the Amended Waiver via its Intense Oversight of the Respondent; however it permitted the Respondent to continue operating with the benefit of that waiver notwithstanding that it had an immediately available remedy of revoking the waiver relief, thus preventing future infractions. Further, prior to granting the Amended Waiver NZX had notice, via its Intense Oversight, that the Respondent s Liquid Capital position had declined in the third quarter of 2009, some 12 months after the Respondent had been operating in reliance on the Waiver. Notwithstanding this decline, NZX extended relief to the Respondent by way of granting the Amended Waiver in 20