Compliance: Theory and Practice in the Financial Services Industry

November 2002 Exam Paper

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This examination is an open book examination. You may bring into the examination room and refer to any written materials that you think may be helpful in answering the questions below.

The examination is divided into 2 sections and is worth 60% of your assessment. You must answer:

(a)    15 of the questions in Part A (each question correctly answered is worth 2 marks, for a total of 30 marks); and
(b)    the question in Part B (30 marks).

You will have 20 minutes reading time and 2 hours to complete the examination. Good luck!


Part A

Short Answers:

Answer 15 out of the following 20 questions. Your answers should be brief (no more than 2 sentences). Please identify clearly the number of the question you are answering.

1.    A "financial product" is defined under the Corporations Act as a facility through which, or through the acquisition of which, a person does one or more of 3 things. What are those 3 things?
2.    How is "financial product advice" defined for the purposes of the Corporations Act?
3.    Australian Standard AS 3806-1998 says that there are 3 essential elements to an effective compliance program. What are they?
4.    Section 1043A of the Corporations Act prohibits a person from trading in relevant Division 3 financial products if they are in possession of inside information. How is "inside information" defined for these purposes?
5.    There are 3 requirements that have to be satisfied for a body corporate to take advantage of the Chinese Walls defence in the Corporations Act so that it can enter into a transaction involving a particular security at a time when an officer of the body corporate is in possession of inside information about that security? What are they?
6.    A stockbroker wishes to short sell securities for a client relying on a securities lending arrangement under which the broker is able to borrow those securities to complete the sale. What 3 conditions must the broker satisfy under the Corporations Act to effect the short sale without breaching section 1020B(2)?
7.    An ASX trading participant has a number of client orders, a house order and an order from one of its directors to buy a particular stock. Under the ASX Business Rules, how is it required to deal with those orders?
8.    Under the ASX Business Rules, when can an ASX trading participant charge commission on a principal trade?
9.    What is the basic rule for determining whether a person has a relevant interest in a security (for the avoidance of doubt, this is the rule you would apply assuming that the tracing and acceleration provisions in the Corporations Act are not applicable)?
10.   An investor acquires a 5%+ shareholding in XYZ Limited, a company listed on the ASX. Who must the investor notify about the acquisition and by when must they give the notification?
11.   A building society is proposing to impose a requirement, as part of its lending conditions, that a borrower must insure any property over which the building society will take security for a housing loan with an insurance company nominated by the building society. What is wrong with that proposal?
12.   Under section 1041H of the Corporations Act, saying something that is literally true can still be misleading. One example is where what is said is only a half-truth. Describe 3 other examples.
13.   There are 4 categories of illegal activities that, if a cash dealer has reasonable grounds to suspect may be involved in a transaction to which it is a party, will trigger an obligation on the part of the cash dealer to file a suspect transaction report under the Financial Transactions Reports Act (Cth). One is where the transaction is preparatory to, or otherwise involves, a financing of terrorism offence. What are the other 3?
14.   A financial services licensee is approached by a new retail client to advise the client on how to hedge an exposure the client has to a particular security. Having analysed the clientís personal circumstances, the licensee recommends that the client buy a particular derivative product. What 3 disclosure obligations must the licensee satisfy in this fact scenario?
15.   There are 3 "situations" in which a regulated person must give a Product Disclosure Statement to a retail client. What are they?
16.   The Privacy Act is designed to help to protect the personal information of individuals. What is "personal information" for these purposes?
17.   A financial services licensee becomes aware that one of its employees has in the course of his duties as employee breached a financial services law. Who must be notified and by when?
18.   There are 3 circumstances in which a managed investment scheme must be registered under the Corporations Act (assuming, for these purposes, that section 601ED(2) does not apply to the scheme). What are they?
19.   You work for an ASX stockbroker and a client sends you a cheque for $100,000 on account to cover a number of buy orders the client plans to make over the coming days. What must you do with the money?
20.   A new employee whose duties will include advising clients and soliciting client orders starts working for an SFE Full Participant. What must the Participant ensure before the employee can do that?


Part B

Compulsory Problem Question:

Analyse the following fact situation. What legal or regulatory breaches may have occurred? What other compliance issues are involved? What additional matters would you consider looking into over and above those enquiries referred to below?

You are a compliance officer working for McWorry Stockbroking Limited ("MS"). MS is a trading and clearing participant on the ASX and a wholly owned subsidiary of McWorry Bank Limited ("MB"), a conglomerate financial services group.

You receive a phone call from the Surveillance Unit of the ASX asking you to provide details of trading that MS carried out during the 5 trading days from 18 - 22 November 2002 in EZ Feez Limited ("EZF"), a recently listed company that has a low market capitalisation and is very thinly traded on the ASX.

You immediately set about investigating MSís trading in EZF during the week in question in order to gather the information requested by the ASX.

From your enquiries you learn that EZF was admitted to trading on the ASX on 1 September 2002. MS underwrote the float of EZF at $1.00 per share and, while it was able to get away most of the stock, it was left with a small principal position of 50,000 EZF shares as a result of an underwriting shortfall. The shares in EZF have not traded well since the float and quickly dropped to trade fairly consistently in a narrow band between 70 and 75 cents.

Consistent with their post-float trading, the shares in EZF opened on the ASX on the morning of 18 November at 75 cents. By the close of trading on 22 November 2002, however, they had traded up to close at 90 cents.

Coincidentally, on the evening of 22 November, after the close of trading, EZF announced an off-market takeover bid for ABC Limited ("ABC") offering 1 EZF share for every 2 ABC shares. ABC shares closed on 22 November at 36 cents, although they had recently traded as high as 40 cents. EZFís announcement described its takeover bid as attractively priced, saying that based on their comparative closing prices on the date of announcement, the bid valued each ABC share at 45 cents, a 25% premium over ABCís then market price of 36 cents. MBís corporate advisory division is EZFís financial adviser for the takeover.

It transpires that 2 MS employees dealt in EZF shares during the week in question Ė one a client adviser called Peter Piper and the other a house trader called Richie Rich. Rich played a leading role in the float of EZF and knows the directors and senior management of EZF quite well. He regularly plays golf with the managing director of EZF.

Piper and Rich are "good mates" and are often seen having a cigarette together at the front of MSís offices during work breaks or sharing a beer after work in the bar next door to MSís offices.

MSís computer trading records show that Piper processed the following orders over the course of the week in question:

Date Client Bought Sold Price (Ę)
18/11/02 123 Pty Limited (*) 1,000   77.5
18/11/02 123 Pty Limited (2) 5,000   78.0
18/11/02 123 Pty Limited (*) 1,000   79.5
18/11/02 123 Pty Limited (3) 5,000   80.0
19/11/02 123 Pty Limited (*) 1,000   82.5
19/11/02 123 Pty Limited (4) 10,000   83.0
20/11/02 123 Pty Limited (*) 1,000   84.5
20/11/02 123 Pty Limited (5) 5,000   85.0
21/11/02 123 Pty Limited (*) 1,000   87.5
21/11/02 123 Pty Limited (6) 5,000   88.0
22/11/02 123 Pty Limited (*) 1,000   89.5
22/11/02 123 Pty Limited (*) 1,000   90.0
22/11/02 123 Pty Limited (7) 10,000   90.0
22/11/02 123 Pty Limited (8) 10,000   90.0

The broker on the other side of the trades marked an asterisk in brackets (*) was Hardly Pointless, a third party broker unrelated to MS. The broker on the other side of the trades marked with a number in brackets (1) - (8) was MS.

MSís computer trading records show that Rich processed the following orders over the course of the week in question:

Date Client Bought Sold Price (Ę)
18/11/02 Josie Rich (1) 10,000   75.0
18/11/02 MS House A/C (1)   10,000 75.0
18/11/02 MS House A/C (2)   5,000 78.0
18/11/02 MS House A/C (3)   5,000 80.0
19/11/02 MS House A/C (4)   10,000 83.0
20/11/02 MS House A/C (5)   5,000 85.0
21/11/02 MS House A/C (6)   5,000 88.0
22/11/02 MS House A/C (7)   10,000 90.0
22/11/02 Josie Rich (8)   10,000 90.0

[The numbers in brackets indicate that the orders in question crossed Ė ie that Richís 10,000 sell order for Josie Rich on 22/11/02 marked (8) crossed with Piperís 10,000 buy order for 123 Pty Limited on 22/11/02 marked (8).]

You interview Piper and he tells you that 123 Pty Limited ("123") is a new client who was introduced to him by Rich. He describes it as a professional share trader but he knows nothing about its portfolio apart from the holding it has in EZF resulting from the purchases he made on its behalf. He tells you that his instructions to buy EZF shares came from Bill Bloggs, a director of 123. He knows nothing about Bill Bloggs other than that Rich assured him that he was a reputable and financially reliable professional share trader. He says that Bloggs instructed him to buy up to 60,000 EZF shares and to take any offers that came to market at less than 90 cents and to put in intermittent bids for purchases of 1,000 shares at progressively higher prices up to 90 cents "to shake out any volume that might be available".

Piper also shows you his trading diary for 18 November 2002 which has an entry indicating that he had a phone conversation with Bloggs early that morning and had been instructed to buy up to 60,000 EZF shares on a careful discretion basis up to 90 cents per share.

Piper says that he noticed that Rich had appeared in the market selling parcels of shares and that, in accordance with his instructions from Bloggs, he purchased those shares as they became available. He said that he had not spoken to Rich about the transactions and simply assumed that Rich was taking advantage of the improving market price to exit his long position in EZF shares in the MS House Account. He also noticed that Hardly Pointless had consistently hit his buy orders for 1,000 shares but says that he knows nothing about their trading.

You check the client file for 123 and find that there is nothing on the file apart from an account opening form that has been completed by Bill Bloggs, as a director of 123, which gives 123ís name, ACN, mailing address and bank account settlement details and no other information. When you quiz Piper about the paucity of documentation on the file, he simply responds that 123 is an institutional client and that standard practice at MS, as with most brokers in the market, is only to obtain name, address and settlement details for institutional clients.

You conduct a company search of 123. You find that 123 has an issued capital of $2.00 and that Bill Bloggs and Mary Bloggs (who appears to be Bill Bloggsí wife) are directors of, and each holds one $1.00 share in, 123.

You also conduct a company search of EZF. You find that Bill Bloggs is the company secretary of EZF.

You interview Rich and he tells you that "MS House A/C" is an MS principal trading account over which he has trading responsibility. The shares Rich has sold over the period from 18 to 22 November effectively comprise the 50,000 shortfall MS acquired in the underwriting shortfall. He says that he had been holding these shares since the float waiting for an opportunity to sell them when the market price of EZF improved. When he saw Piperís consistent buying, he figured that this was as good an opportunity as any to realise his principal position.

Rich tells you that Josie Rich is his wealthy grand aunt who lives in Melbourne and that she gave him the instructions to buy 10,000 EZF shares for her account as an investment but then changed her mind when she saw the price increase and instructed him to sell the shares to realise her profit.

You check the client file for the Josie Rich account and find again that there is nothing on the file apart from an undated account opening form that purports to have been completed by Josie Rich, which gives her mailing address as a PO Box in Maroubra, Sydney and nominates an account at the Maroubra branch of the Commonwealth Bank as her account for settlement purposes. The account opening form has an illegible signature and does not attach any of the usual identification documents (standard practice at MS for retail clients is to obtain identification documents equivalent to Austracís 100 point check). When you quiz Rich about why none of the usual identifying documents are on file, he says that his grand aunt is a relative, that it is not necessary for him to verify her identity because he knows her and that she is a very wealthy lady and there was never any doubt that she would settle her obligations to the firm.

When you ask Rich why he, as a house trader, is executing client orders he says that it is not uncommon for the house traders at MS to execute small client orders for friends and colleagues.

You make a few discrete enquiries with the HR department and find out that Rich lives in Maroubra and that his commission is paid by electronic funds transfer to an account at the Maroubra branch of the Commonwealth Bank.

The MB group has an employee trading policy that requires all share trading by employees, their immediate family members, relatives who live with them or accounts they control to be conducted through MS and to be pre-cleared by Compliance. Rich maintains that the Josie Rich account is not subject to the employee trading policy because she is not part of his immediate family, she does not live with him and he does not control the trading on her account. Accordingly, he was not required to seek Compliance pre-clearance to the trading in EZF shares on her account.

You check the MS order records for the trades and see that they are consistent with the trading records (ie an electronic order form was correctly completed for each trade that Piper and Rich effected and sent electronically to an MS SEATS trader for processing).

You check the duplicate MS contract notes for the trades. Again, they are consistent with the trading records (ie a contract note was correctly issued for each trade that Piper and Rich effected).

The contract notes include a pro forma disclaimer that "some or all of this order may have been crossed as principal or as agent for another client". Nowhere on the contract notes does it mention, however, that the shares purchased by 123 from MS as principal included shares that MS held because of an underwriting shortfall. You also notice that Rich has not charged commission on the trades he effected for Josie Rich but that Piper has charged standard commission for all of the purchases he effected for 123.

MS does not tape the phone lines of either its house traders or client advisers because its senior management considers that the costs involved outweigh the putative benefits.

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