Compliance: Theory and Practice in the Financial Services Industry

November 2005 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.    There are 3 prongs to the definition of “financial product” in the Corporations Act. What are they?
2.    When does a person deal in financial products for the purposes of the Corporations Act (please ignore the various exclusions from the definition of “dealing’ in sections 766C(3)-(7) in your answer)?
3.    Under section 12.3(2)(d) of the Commonwealth Criminal Code, a fault element of a Federal offence can be established by proving that a body corporate failed to create and maintain a corporate culture that required compliance with the law. What does “corporate culture” mean for these purposes?
4.    What is the jurisdictional reach of Australia’s insider trading laws?
5.    The requirement for ASX participants to have Chinese walls in place emanates from the prohibition in Market Rule 7.18.2. What does that rule provide?
6.    Section 1043B(2)(b) of the Corporations Act deems a person to have created a false or misleading appearance of active trading in financial products if they place “matched orders”. What are “matched orders” for these purposes?
7.    Under the ASX Market Rules, when must a record of a client order or decision to effect a proprietary trade be brought into existence? How does the ASX interpret this requirement?
8.    An employee of a licensed SFE futures broker wants to buy a futures contract that is traded on the SFE for her own account. What Corporations Act constraint must she comply with?
9.    A broker receives an order from a client to sell securities on the ASX in the ordinary course of trading. What requirements must be met for the sale to fall outside of the prohibition on short selling in section 1020B(2) of the Corporations Act?
10.   Under the so-called “tracing rules” in Chapter 6 of the Corporations Act, a person is deemed to have a relevant interest in securities held by a body corporate in two situations. What are they?
11.   Who (ie what categories of persons) have to file notices under section 26 of the Foreign Acquisitions and Takeovers Act if they enter into an agreement under which they acquire a substantial shareholding in an Australian corporation
12.   The Australian Securities and Investments Commission Act implies certain warranties into contracts for the supply of financial services to consumers. Who is a “consumer” for these purposes?
13.   A bank has opened a money market account with a substantial credit balance in the name of a non-resident. Interest is accumulated in the account, after deducting 10% withholding tax. The bank receives information that the beneficial owner of the funds is an Australian resident and suspects that the account may be a vehicle to evade tax. What must the bank do and by when?
14.   In what situations does a financial services licensee have to give a Financial Services Guide to a retail client? In normal (ie non-time critical) circumstances, at what time must it be given?
15.   A licensed financial adviser recommends that a retail client subscribe for units in a hedge fund to protect the value of their portfolio in the event of a general market decline. In normal (ie non-time critical) circumstances, when does the adviser have to give the client a PDS for the hedge fund? Who is responsible for preparing the PDS?
16.   The responsible entity of a managed investment scheme receives money for issuing units to a new investor and deposits the money into an account maintained under section 1017E of the Corporations Act. When can it withdraw that money?
17.   When must the responsible entity of a managed investment scheme have a compliance committee? How must the membership of the compliance committee be made up?
18.   Under ASX Market Rule 3.6.3, a market participant must have appropriate supervisory policies and procedures, and meet any standards set out or referred to in the ASX Procedures, to ensure compliance by it and each person involved in its business as a market participant with the ASX Market Rules and the Corporations Act. What are the prescribed standards for these purposes?
19.   Under section 761D(1) of the Corporations Act, a derivative is an arrangement under which a party must, or may be required to, provide at some future time consideration of a particular kind or kinds to someone. That future time must be not less than the number of days prescribed by regulations after the day on which the arrangement is entered into. What is the prescribed period for these purposes? How is this affected by Corporations Regulation 7.1.04(2)?
20.   To be a regulated superannuation fund under the Superannuation Industry (Supervision) Act, what requirements must you satisfy?


Part B

Compulsory Problem Question:

Analyse the following fact situation. What legal or regulatory breaches may have occurred? What other compliance issues may be involved? What further investigations would you consider making in light of what has been uncovered thus far?

You are an independent compliance consultant engaged by the new chairman of Notional Australian Bank (“NAB”). NAB has recently announced that it has lost $100 million as a result of fraudulent foreign exchange trading by a senior employee, Red Handed. NAB’s auditors have thoroughly reviewed and reported on the foreign exchange losses but the chairman is concerned to investigate whether Handed may have been involved in other compliance breaches in the organisation.

You start your review by asking for Handed’s employee trading records. There is nothing particularly noteworthy about the trading on his employee account. However, you notice that his account is handled by one Ben Delore, an equities dealer who works on the sales desk in NAB’s stockbroking subsidiary Notional Securities Limited (“NSL”). You decide to interview Delore.

You ask Delore about his connection with Handed. He tells you that he, Handed and the head of NSL’s warrants desk, Peter Out, used to work together at another broking organisation and they all came across to NAB at around the same time. As a consequence, they are all “good mates” and spend a fair bit of time together outside of work. He is quite distressed at how the organisation has dealt with Handed and is resentful of your questioning.

You get a general feeling of unease about Delore and decide to look further into his trading activities. When you do so, two particular transactions catch your eye.

1.   Trading in NAB shares

On 26 September 2005, Delore opened a new trading account for the Swiss branch of Bank Leumi Le-Israel and executed a trade for that client to sell 500,000 NAB shares at $35.00. The following day, Delore executed a trade for the same client to buy 500,000 NAB shares at $31.50.

You recall that NAB announced the $100 million loss on the fraudulent foreign exchange trading on 27 September 2005 and that NAB shares lost 10% of their market value on that day following the announcement (that happened to be your birthday and your parents had given you 100 NAB shares as a present, which is why you remember it so clearly).

You review the client file and note that there are no records apart from a faxed instruction sheet on the letterhead of the Swiss branch of Bank Leumi Le-Israel, giving the name of a bank executive (Will Tellnuthing) authorised to operate the account and Swiss bank account details for the payment of settlement funds.

You examine NSL’s settlement records and you see that NSL defaulted on delivering to the Australian Clearing House the 500,000 NAB shares sold on 26 September 2005, as it was required to do on day T+3 (ie 3 business days after the trade was effected). However, that default was effectively rectified the following business day by the off-setting settlement for the 500,000 NAB shares purchased on 27 September 2005.

When you quiz Delore about the trading, he says that he opened the account on the telephone instructions of Tellnuthing. When you ask him how, out of all the advisers at NSL, Tellnuthing had come to speak to him, Delore tells you that he had been recommended to Tellnuthing by Red Handed and that Tellnuthing and Handed knew each other from foreign exchange dealings they had done together.

You ask Delore what enquiries he made about the client and the transaction before agreeing to do such a large trade for a hitherto unknown client. Delore says that he asked Tellnuthing whether the sale was on principal account or for a Bank Leumi Le-Israel client. Tellnuthing had told him that the sale was for one of their wealthy private clients but that Swiss law prohibited him from giving any further details about that client. Delore says that he did not need to make any further enquiries because Bank Leumi Le-Israel was a well known international bank with a significant private client banking business.

When you ask Delore about the failure to deliver the 500,000 shares originally sold he said that there had been a hitch with Bank Leumi obtaining a release of the securities in time for settlement but that no-one was particularly concerned because of the off-setting purchase on the following day, which meant that the default would only last for one day. He notes that not only did NSL receive a very healthy commission for the sale and subsequent purchase but that Bank Leumi had also paid the fee that NSL was charged by the Australian Clearing House for defaulting on the delivery for the original sale. He says he can’t understand why you are making such a big deal about the transaction in light of that.

2.   Trading in Telstra warrants

NAB was the warrant issuer for a new ASX-traded warrant over Telstra shares. Trading in the warrant opened on the ASX on Tuesday morning 4 October 2005 at $1.50, slowly traded up to $1.60 and then eased back down again to close the day at $1.52.

You notice that during the course of that morning, Delore placed 30 separate buy orders for between 1,000 and 10,000 warrants at prices varying between $1.50 and $1.60 in the name of one of his regular clients, Phil Myorda. By noon that day, Delore had accumulated a parcel of 100,000 warrants in the name of Myorda at an average purchase price of $1.55.

As the trading day wore on, Delore began liquidating the position with small sales. Most of the sales resulted in small profits sufficient to cover the commission charged on both the initial purchases and the subsequent sales and leave a modest return for Myorda. There was one trade, however, at the end of the trading day where the last 20,000 warrants bought for Myorda were sold at the closing price of $1.52. This trade was booked to an NSL error account and instead Myorda was credited with $1.55 on the sale and NSL’s commission on the sale was waived.

You quiz Delore about the trading and he tells you that Myorda had contacted him on the morning of 4 October 2005 looking for some hot stock tips. Delore had told him that NAB was issuing a new ASX-traded warrant over Telstra shares which had an attractive tax-effective yield that he expected would be well received by the market and that it should trade very well. He tells you that Myorda then instructed him to buy up to 100,000 warrants at market on the morning they listed and see what he could sell them for over the day.

When you ask Delore why the last trade on the day was booked as an error, he says that because the warrant was one issued by NAB and he had advised the client to buy the warrant, he did not think it fair or appropriate for the client to bear the loss on the trade. Accordingly, he had booked it to an error account and waived NSL’s commission so that the client did not come out of the trade behind. He says that the loss was only $600 (20,000 x $0.03) and it was money well spent to keep an important trading client on-side. In fact, he says, Peter Out, the head of the warrants desk, was so concerned about the market reaction to the listing of the new warrant and so appreciative of the support that Myorda had shown for the new warrant on its first day of issue, that he had said the warrants desk would wear the loss on the error trade.

Delore noted that the Telstra warrant had been one of the more successful warrant issues by NAB and the $600 was a “mere bagatelle” compared to the hundreds of thousands of dollars the warrants desk had made on that issue.

When you review Myorda’s client file, you see that he is shown in NSL’s trading records as a wholesale client and there is a current accountant’s certificate on the file confirming that Myorda has earnt more than $250,000 per annum over the past 2 years and has more than $2.5 million in net assets. Myorda is a heavy trader of securities and often engages in short term speculative trading and so the trading in question is not inconsistent with earlier trading on his account.

You review Delore’s trading diary for the day in question. There is an entry recording a phone call with Myorda at 9.30 am with a scribbled note next to it saying “Buy/sell 100,000 Telstra warrants @ market”.

You check to see if NSL has issued any research reports on the new warrant and find that none were issued. However, you notice that on Monday 3 October 2005, NSL’s telco analyst had issued a very bullish forecast about Telstra’s profits for the coming year and put a strong buy recommendation on Telstra shares. Most other analysts have been fairly neutral about Telstra’s prospects.

You casually mention to the Head of NSL that you are looking at Delore’s trading in Telstra warrants. He blows up and tells you to “pull your head in”. He says that NSL has been short-listed by the Australian Government to act as the selling agent and underwriter for the sale of the remaining shares the Government owns in Telstra, a deal worth tens of millions of dollars to the company, and the last thing they need at this time is any sort of adverse publicity involving Telstra.

NSL does not tape the phones of the brokers who work in Delore’s section of the business.

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