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«February 2014 About this Guidance Note Section 1: Overview Section 2: Upcoming changes to the law Section 3: Guidance Section 4: Operational ...»

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Financial Markets Authority

Website: www.fma.govt.nz

Auckland Office

Level 5, Ernst & Young Building

2 Takutai Square, Britomart

PO Box 106 672


Wellington Office

Level 2

1 Grey Street

PO Box 1179


February 2014

About this Guidance Note

Section 1: Overview

Section 2: Upcoming changes to the law

Section 3: Guidance

Section 4: Operational considerations

Section 5: Looking to the future

Issuing guidance is one of the ways FMA strives to be transparent and share our approach with the market.

Guidance helps market participants to be confident that they understand how we interpret and intend to apply the law relating to broker obligations.

This guidance note is based on the law as at January 2014, and is for brokers (as defined in the Financial Advisers Act 2008 (Act)). This guidance does not change or add to existing legal requirements for brokers. It is aimed at improving compliance with broker conduct obligations and trust accounting obligations in Part 3A of the Act, by setting out how FMA interprets and applies certain parts of Part 3A. The focus of this guidance is on custody of client money and client property, and the key obligation of brokers to hold client money and client property on trust.

Significant changes to broker obligations are likely to come into force during 2014, through changes to the Act and the introduction of regulations governing custodians. These changes will clarify existing law and will impose new and extended obligations on brokers. The new law includes the introduction of an explicit prohibition on adding broker’s own funds to client money trust accounts. It also mandates that custodians obtain annual assurance of the design and effectiveness of their controls relating to client money and property. Further details are provided in this guidance note.

This guidance is additional to guidance provided in relation to broking and custodial services in Guidance Note:

Discretionary Investment Management Services published by FMA in October 2013.

Who is a broker?

1. This guidance note is intended for “brokers”, as that term is used in the Act. Broadly speaking a “broker” under the Act is a financial services provider who holds or deals with client money or property on behalf of clients.1 This can include stock brokers, providers of portfolio administration services and financial advisers who receive property or money from clients (such as DIMS providers). Some financial services providers are known as brokers but do not hold client money or property, such as some insurance brokers and mortgage brokers. This guidance does not apply to those people.

2. Certain persons are not classed as brokers under the Act, including law firms, accountants and real estate agents acting in the ordinary course of their businesses, and authorised futures dealers (who are subject to separate obligations)2.

3. As at 2 January 2014, there were 1,271 companies and individuals registered on the Financial Service Providers Register (FSPR) as providing broking services.

Legal obligations of a broker

4. Broker obligations are set out in Part 3A of the Act.

5. The general conduct obligations (in sections 77J to 77O) include obligations to:

 exercise care, diligence and skill  not engage in misleading or deceptive conduct.

6. The trust accounting obligations for services to retail clients (sections 77P to 77T) include obligations to:

 hold client money and property on trust in a separate trust account  properly account to the client for money and property held  maintain adequate records of the client money and property  not use or apply client money or property, except as expressly directed by the client.

7. These obligations have now been in force for more than two years and all brokers should be fully

compliant with them. FMA’s expectation is that senior management of brokers will be actively:

 promoting a culture of compliance For a detailed definition of “broker” and “broking services” see sections 77B, 77C and 77U of the Act (and the relevant definitions) and FMA’s website: www.fma.govt.nz/help-me-comply/Brokers/who-needs-to-comply/. Note that amendments to these definitions are likely to come into force during 2014. See Section 2 of this Guidance Note for more information.

See the Futures Industry (Client Funds) Regulations 1990.

 ensuring that robust risk management and compliance monitoring processes are in place.

Contracting-out (outsourcing) of broking services to third parties

8. Where a broker contracts out (outsources) broking services to another business providing broking services, for example to a custodian, the broker remains responsible to the client for broking services (see section 77U of the Act). The person providing the outsourced broking services is required to register on the FSPR as providing broking services, but it will not have any broker obligations under the Act if it is acting on behalf of the other broker’s business.

9. Where a broker outsources provision of broking services to a third party for which the broker is responsible under the Act, the broker should carry out (and record) a reasonable level of due diligence on that third party and the proposed arrangements under the agreement between the broker and the

third party. This should include consideration of:

 whether the third party has adequate processes and controls to ensure compliance with the Act and other requirements  whether the third party has internal audit or external review processes to verify compliance with this expected practice for brokers  whether the third party will be allowed to appoint any sub-agents  the third party’s standing and reputation with other brokers and publicly available information on the third party’s compliance history, owners and directors  the third party's capability to perform core administrative activities, including IT, accounting and risk management systems, proven capability of managing risk events and the third party’s arrangements for how various types of assets are held  whether the third party has adequate professional indemnity insurance in place (and any requirements as to their capital adequacy)  whether the third party’s fees are reasonable  the manner in which the third party must hold and deal with client money and property. This is particularly important if overseas custodians are used.

Key areas of focus

10. FMA has identified several key themes as part of our monitoring of brokers:

 client consent not being obtained by brokers before taking a margin on interest earned on client money  poor protection of client faster identification numbers, common shareholder numbers and security reference numbers  incorrect naming of client money trust accounts as a ‘working account’ or ‘business account’  brokers not reporting to clients on money and property holdings with required frequency, or in some cases, accuracy  little or no documentation supporting the classification of wholesale clients  bank and custody reconciliations not being performed in a timely manner  client money trust accounts overdrawn or with balances that are less than the amounts owed to clients.

We provide guidance on these matters in Section 3 below and expect that brokers will consider and use it to examine their existing compliance arrangements. We provide guidance on these matters in Section 3 below. We were concerned during our monitoring that some brokers were not meeting all the minimum legislative requirements. Improvements are needed to better comply with or demonstrate compliance with the obligations in the Act. Our expectation is that brokers will consider this guidance and use it to examine their existing compliance arrangements.

11. Custodian regulations and changes to the Act are likely to come into force during 2014. These changes to law and regulation will affect many brokers. The changes will include new obligations in relation to brokers who provide ‘custodial services’. There will be additional requirements and limitations in relation to the provision of broking services. Some of the key changes are incorporated into the Act through the Financial Markets (Repeals and Amendments) Act 2013 (FMRAA).

12. FMA expects that brokers will already be considering the effect of these changes and making any changes to systems and controls necessary to comply. You can refer to the FMRAA and the Ministry of Business, Innovation and Employment’s (MBIE) website www.mbie.govt.nz, as well as our own website www.fma.govt.nz for more detailed information on the new requirements and timetable for delivery3.

All brokers will need to be fully compliant from the date the amendments to the Act and regulations come into force.

Key changes 13. ‘Custodial services’ as a subservice of ‘broking services’, will be defined in the amended Act in section 77B (1)(b). This will remove any ambiguity about whether brokers who provide custodial services only, such as nominee companies, are required to register on the FSPR.

14. The proposed custodian regulations will require brokers to comply with a number of extended or

additional obligations in relation to the provision of custodial services:

 Audit and Assurance: obtain an annual audit of client money and client property against client reports and an annual audit of controls. Many brokers have already adopted audits and assurance checks as good practice.

 Reporting: comply with specified minimum obligations with respect to reporting.

 Reconciliations: comply with specified minimum obligations with respect to reconciliations, including in relation to frequency, escalation and resolution.

15. We consider that the proposed requirements in relation to reporting and reconciliations clarify and extend existing obligations in those areas.

16. The amended Act at section 77P(1A) will explicitly prohibit brokers from placing their own money in client money trust accounts, i.e. it clarifies that the practice of holding ‘buffers’ of broker funds in client money trust accounts is not permitted. We will conduct targeted consultation with industry participants to consider the effect of section 77P(1A) on current practice.

See: www.med.govt.nz/business/business-law/current-business-law-work/dims-and-custody and www.fma.govt.nz/help-me-comply/brokers/your-obligations/upcoming-changes-to-law/.

Protection of client CSNs, SRNs and FINs

17. New Zealand share registries of listed equity securities use a Common Shareholder Number (CSN) to identify a shareholder and Faster Identification Numbers (FIN), which are the equivalent of a bank account PIN code to identify the shareholder as the unique holder of their securities. The Australian equivalent of a CSN is a Security Reference Number (SRN).

18. Brokers’ obligations relating to the use and management of FINs are governed by section 77K of the Act.

This requires brokers to exercise the care, skill and diligence that a reasonable broker would exercise when providing broking services. FMA considers that a reasonable broker would, where it is necessary to hold a FIN on file, encrypt it electronically. We do not consider it is appropriate to forward clients’ CSNs, SRNs and FINs by email. Where FINs are not required to be held on file, they should be destroyed immediately after each transaction.

Cross-use of client money

19. Sections 77P and 77S of the Act set out clear obligations and restrictions on how brokers hold and apply money and property of retail clients. Brokers cannot use client money held on trust for one client to temporarily fund shortfalls in client money for other clients. Such ‘cross-use’ can arise in a number of circumstances, none of which we consider are permitted under the Act. Uses that are not permitted


 transferring balances between client ledgers to fund shortfalls in client money for particular clients  permitting a client to incur obligations to be settled from the client trust account without holding sufficient client money from that client to meet those obligations (which gives rise to effective transfer between clients)  transferring ‘buffers’ of brokers’ own funds to retail client money trust accounts to make up shortfalls in funds held for particular clients, except where such buffers are ‘client money’ at the time of transfer to the account.

20. We do not consider use of ‘buffers’ in trust accounts to be permitted, except where such buffers are allocated to specific clients to the extent of their outstanding obligations and are ‘client money’ of those clients. Nor do we consider that timing issues excuse or permit cross-use; if client obligations are to be settled from a client trust account that holds client money for more than one client sufficient client money (including by way of credit facilities) should be available to ensure that each client meets their own obligations.

Deducting margins from client money

21. Some brokers deduct a ‘margin’ from client money. For example, they deduct margins from interest earned by retail clients on their money and when client money is subject to foreign currency conversions. We understand that those margins are taken as fees for services provided. We consider before a margin can be deducted that the deduction must be expressly, clearly and unambiguously disclosed in the relevant agreement between broker and client, in order to obtain informed consent from the client. We are not suggesting that brokers cannot deduct fees from client money, but the law requires that brokers obtain the necessary informed consent from the client before making such deductions.

22. FMA considers that express, clear and unambiguous disclosure requires the value of the margin (e.g. as a dollar amount or percentage of interest earned), and the purpose for which the margin is taken, be disclosed. We also consider that the purpose for which the margin is taken must be associated with the

services provided to the client. It is not sufficient in the agreement to:

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