Presentation-3 - The Institute of Chartered Accountants of

Role and Functions of Compliance & Inspection Wing
Surveillance, Supervision and Enforcement
Department (SSED)
Securities Market Division (SMD)
August 10, 2016
2
Objectives of Today’s meeting


1.
2.
3.
4.
5.
6.
To Share SECP Inspection team experiences of onsite
inspections/investigations of brokers
To ensure uniform approach by the auditors w.r.t. assignments
particularly in following areas;
NCB
System Audits
Segregation of clients' Assets
Assets Under custody
Internet Based Trading/Penetration Testing and Vulnerability
Assessment.
Recent Regulatory Developments

To have insight from Auditors about challenges of different activities
performed for the Broker

To encourage and increase liaison with auditors to better achieve the
objectives of audits.
3
FOREWORD

Compliance monitoring function was being performed by
respective departments to a limited extent at SECP.

A need to put in place a mechanism to check compliance status
of the regulatees to fetch early signals regarding emerging risk
areas and take enforcement actions/corrective measures.

Independent and dedicated Compliance Wing (‘C&IW’) was
established in SMD in 2011 to ensure compliance of Rules and
Regulations in all respect and at all levels.
Compliance and Inspection Wing, Securities Market Division
4
Governing Legislation
Securities and
Act, Exchange
2015
commission of Pakistan Act, 1997
Securities Act, 2015
Securities and Exchange Ordinance, 1969
Securities and Exchange Rules, 1971
Stock Exchange Members (Inspection of Books and Record) Rules, 2001
Securities Brokers (Licensing and Operations) Regulations, 2016
Brokers and Agents Registration Rules, 2001
CDC Act, 1997 and CDC Regulations
NCCPL Rules and Regulations
PSX Rule Book
Directives /Circulars/Guidlines of the Commission
5
Over view of activities
Compliance Assurance Activities Initiatives On Site Inspections Updation in Regulatory Framework Offsite Review Clarifications of regulatory framework.
Enquiries and Investigations Thematic Reviews to check compliance of PSX/NCCPL/CDC and PMEX Regulations
6
Inspections Types
Routine Inspections
For Cause Inspections
Follow‐Up Inspections
Compliance and Inspection Wing, Securities Market Division
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Subjects of Inspections
8
ON SITE INSPECTION - BROKERS

In addition to other inspections, Compliance and
Inspection Wing of SSED, has so far initiated on
site Inspections a total 106 brokers of PSX (with
representation of all regions).
9
Core issue to be discussed

Net Capital Balance (NCB)
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Importance of NCB

NCB is basis of allowing exposure to the broker.

Any miscalculation may put system at risk

System at risk may lead to default of broker and
ultimately damage to overall system.

NCB is an indication of financial health of Broker.

Allowing financially weak broker to take exposure
may result mis-use of clients assets.
11
Issues in NCB
As per study conducted by the Inspection wing
NCB of 76% Brokers was NOT calculated as per
SEC Rule, 1971/SECP guidelines issued from time
to time.

12
Regulatory Framework: SE Rules, 1971


2(d) of SE Rules defines NCB as;
“Net Capital” means excess of current assets over
the liabilities determined in accordance with the
Third Schedule to these rules;
Third Schedule of SE Rules, 1971
13
14
NCCPL Regulations

Clause 12.3.1 of NCCPL Regulations prescribe that; The Net Capital Balance
(‘NCB’) shall be calculated in accordance with the Third Schedule to the
Securities & Exchange Rules, 1971. Maximum Exposure in each and/or all
Markets of a Broker shall not exceed the number of times of his NCB
attributed to the NCCPL for the purpose.

(a) The Broker shall submit bi-annually a certificate from its last statutory
auditor confirming their NCB on the format prescribed by the Company on
the dates and within such time as may be notified by the NCCPL for this
purpose.

(b) The certificate submitted by the Broker Clearing Members in accordance
with the regulation 12.3.1.(a) above shall specify that the auditor has
verified/audited the NCB; and

(c) NCB certificate shall be submitted by the Broker within the time as may
be prescribed by the NCCPL, failing which a penalty shall be imposed as
provided in the Schedule-V attached to this chapter.
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PENALTY SCHEDULE OF NON-COMPLIANCE OF
NET CAPITAL BALANCE SUBMISSION
NO. OF CALENDAR PENALTY
REDUCTION
IN
DAYS UNDER NON- IMPOSED (RS. NET
CAPITAL
COMPLIANCE
PER
DAY) BALANCE
From Day 1 to Day 15
2,000
10%
From Day 16 to Day 30
3,000
20%
From Day 31 to Day 45
4,000
40%
From Day 46 to Day 50
5,000
80%
From Day 51 onward
5,000
100%
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Securities Brokers (Licensing and Operations)
Regulations, 2016
Category of
Paid up Capital
Net worth
Minimum NCB
-PKR million-
-PKR million-
--PKR million
Broker can only execute its
proprietary trades and trades on
behalf of its customers but cannot
settle executed trades or keep
custody of securities
Can execute as well as settle its
proprietary trades and trades
executed on behalf of its
customers and can keep custody
of securities owned by it and its
customers
15
15
2.5
35
35
5
Trades-Self and Others
100
100
10
Description
securities
broker
Trading Only
Trading and
Self Clearing
Trading and
Clearing
Settlement- Self and others,
Custody- Self and others
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Securities Brokers (Licensing and Operations)
Regulations, 2016
6(4) A securities broker shall submit an audited
statement of net capital balance on half yearly
basis till notification of audited Liquid Capital by the Commission.
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Net Capital Balance (NCB)
NCB is calculated as per Rule 2 of Securities & Exchange Rules, 1971 “SE
Rules” read with NCCPL Regulations and guidelines issued by the
Commission from time to time.
Risks in NCB?
Overstatement of C. Assets and understatement of C. Liabilities.
Issues Observed in NCB.
Cash and Cash Equivalents:
 Cash deposited with PSX/NCCPL as fixed deposit is included in Cash and
Cash Equivalents.
 Heavy Cash included in NCB as compare to Bank Balance(s).
 Prize Bonds have been included in the Cash and equivalent without any
verification.
 Cash /Gold lying in the Bank Lockers is included in NCB.

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NCB- Observations Cont.…
A.
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
Receivables
The incorrect aging of trade receivables
Inclusion of ineligible accounts in trade receivables.
Trade receivables aging is maneuvered through J.V’ s.
Late Payment charges are treated as receivables.
Netting of Receivables with Income heads
Advances/Loans included in trade receivables
Trade receivables relating to money market and forex market has been
included which is not allowed as per guidelines.
Proprietary accounts accounted for in NCB calculation as Receivables.
20
R/A Cont.…



Netting of trade receivables with trade payables
whereas both accounts were having different
nature.
Loan to a client has been treated as trade
receivable.
Receivables of Corporate Finance Consultancy,
Money Market and Foreign Exchange brokerage
were included in NCB.
21
Aging Methodology
For the purpose of NCB, trade debts more than
fourteen days should be excluded. For the
determination of “over dues”, the principal of
FIFO (‘First In First Out”) should be used.
22
Aging Methodology
Date
June 17, or December 18
Dr.
Particulars
Purchase
Any date between above
dates and June 30 or
Sale
December 31
Purchase
Sale
Total
Debit
Cr.
Amount in Rs.
Credit
1,000
10,000
Opening Balance
100,000
Total of Credits
85,000
Portion of Opening Balance remained unpaid thus overdue
15,000
(Dr.) 100,000
101,000
5,000
11,000
Balance
80,000
85,000
96,000
106,000
26,000
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Aging Methodology

In above example:

Closing balance
= 26,000
Less Over due 14 days
=15,000
Receivable within 14 days =11,000


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Securities Purchased for clients



Improper Rates used for valuation of shares
Basis of allowing securities against overdue 14
Days
Securities allowed are not tradable (freeze)
25
Securities in the name of Broker







Improper Rates used for valuation
Securities allowed are not tradable (freeze)
Securities were not listed at relevant time.
Investment is Book Building for which securities
are not received.
Securities appearing in House Account don’t
pertain to the Broker are included in NCB.
15% haircut has not been applied on the
investment.
Difference of Investment(s) as per B/S and NCB.
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Listed
TFC’s
Corporate
Bonds
(at 10% discount)

Included Bonds in the calculation of NCB which
are not allowed and not included by PSX into its
list of margin eligible securities.

Investment in ineligible mutual funds have been
included in the calculation of NCB which is not
allowed as per guidelines stipulated.
27
Current /Other Liabilities



Improper aging methodology applied.
Improper categorization of creditors thus understating
the liability. E.g. Advance against shares.
Adjustment of Trade payables with Receivables above
14 day.

Incomplete trade payable like interest payables,
current portion of long term liabilities etc.

Payables falling in other liabilities have been shown as
long term loan from directors and excluded from
other liabilities. (Understatement of other liabilities).
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Understatement of C. Liabilities

Certain payables (current liabilities) converted
in to “Advance against Share Capital” (noncurrent liabilities) in spite of insufficient unpaid
amount out of its existing authorized capital of
Broker.

Basis of reclassification of payables into advance
against share capital was not available
including;
◦ Minutes of BoD highlighting relevant approvals
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C. Liabilities Cont.….
◦ Issuance of notices under 86(3) of the Companies
Ordinance, 1984 & copy of notice filed with the
Commission, if any.
◦ Copy of permission sought from SECP for increase of
Authorized capital.
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Auditors Certificate not on the prescribed
format

Clause 19.3.2(b & c) of Pakistan Stock Exchange Ltd.(PSX) Rule Book
states that,

(i). The Brokers shall submit bi-annually a certificate from its last Statutory
Auditor confirming their NCB on the format prescribed by the Exchange on
the dates and within such time as may be notified by the Exchange for this
purpose.

(ii) “The certificate submitted by the Brokers in accordance with the regulation
19.3.2.(a) above shall specify that the Auditor has verified/audited the NCB.”

Further, Notice No. KSE/N-4163 of PSX dated August 29, 2002 has
specified the format of NCB, required to be signed by the Chartered
Accountants, specifically states that, “We further confirm that the above
net capital balance of M/s______________ is calculated/arrived at on the basis
of the numbers/figures duly audited.”
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NCB Format Cont.….

With regard to above, reference may be made to Para 2.4 of Selected
Opinion No. XVI issued by ICAP on the subject. Extract from selected
opinion is stated below for ready reference:

2.4 CERTIFICATE OF NET CAPITAL OF MEMBERS OF KARACHI
STOCK EXCHANGE (KSE)

Enquiry: With reference to above subject matter, we are enclosing herewith
form of certificate issued by the ---- for reporting on net capital of members of
the KSE. The format uses the words 'audited' whereas auditors only arrives at
figure by examining ledgers and no other audit procedures are performed. We
understand that this engagement may be undertaken as per ISRS No. 4400
'Engagement to perform Agreed upon Procedures Regarding Financial
Information'.
Considering this, we request you to provide us appropriate advice to
understand and appropriately discharge our reporting responsibilities.
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NCB Format Cont..

Opinion: The Committee considered your enquiry and is of
the view that the certification of Net Capital Balance does
not fall under the scope of ISRS No. 4400 'Engagement to
perform Agreed upon Procedures Regarding Financial
Information' rather it is an Assurance Engagement and
appropriate assurance procedures would
need to be
performed to enable the auditor to issue the required
certificate.

Further, as this certification is a regulatory requirement on
the basis of audit/ review therefore the form of certificate
provided by KSE may be followed for the purpose.
(April 15, 2011)

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Difference of Calculations
NCB calculate by Broker, audited and inspected by
the Inspection Team showed following differences;
Heads of NCB As per Broker
(as per SE Rule, 1971
Assets
3.6 million
As per Inspection
Team
Difference
Over/(Under)
3.0 million
0.6 million
Liabilities
2.2 million
4.0 million
(1.8 million)
NCB
1.4 million
(1.0 million)
2.4 million
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Reporting
to
the
Commission
by
Auditors
under Securities Act, 2015.
 85. Auditor to report to the Commission in certain cases.—If,
during the performance of his duties as auditor for a regulated
person, an auditor—

(a)
becomes aware of any matter which in his opinion
adversely affects the financial or regulatory position of the
regulated person to a material extent; or

(b)
discovers evidence of a contravention of any
financial resources regulations or of section 78 (customer assets)
or with section 79 (accounts and records to be kept),
he shall promptly report it in writing to the Commission
and to the regulated person.
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Reporting Mechanism

The above observations by the Auditors may be
reported to
Mr. Yaser Manzoor
Director,
Surveillance,
Enforcement Department
[email protected]
Supervision
and
Some New Developments;
36
Law
Requirement
Securities Brokers
(Licensing and
Operations)
Regulations, 2016
Maintenance of Liquid Capital and L.C be
submission of audited L.C. Statement on audited by
half yearly basis after notification by Auditors.
Commission. (6(4)).
Segregation of customer money
Customer money shall not form part of the
assets of the securities broker for any
purpose and shall not be available in any
circumstances for payment of any debt or
liability of the securities broker (Section 23)
Action by
Auditors
Auditor to
ensure
while
audit/segre
gation
statements.
Appointment and Role of Compliance Professional
Officer;
Accountant
Immediately report non-compliance to s
Broker and in case of non- resolution report
to Commission/PSX. (u/s 29)
37
Some New Developments Cont..
Law
Requirement
Action by
Auditors
Securities
Brokers
(Licensing
and
Operations)
Regulations,
2016
A securities broker licensed under the Trading and
Self-Clearing category or Trading and Clearing
category shall ensure that an internal audit
function, headed by a dedicated or designated
head of internal audit possessing relevant
qualification and experience, is put in place. (u/s
12(16)(i).
Role as
professional
Accountant
s
Section 35. In preparing an audit report, the Auditor
auditor shall carry out such investigations as will
enable him to form an opinion as to the matters
required by sub-regulation 5 to be stated in the
auditor’s report like;
1-appropriate systems is in place to distinguish
clients and brokers assets, 2- Section 78 of Sec. Act,
3- Compliance officer role as per size nature of
services offered by Broker.
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Some New Developments Cont..
Law
Requirement
Action
by
Auditors
Securities
Brokers
(Licensing
and Opera.)
Reg., 2016
The Annual Report shall contain the following: A Auditor
statement by the CEO that there are no transactions
entered into by the broker during the year, which are
fraudulent, illegal or in violation of any securities
market laws. (u/s 9)
Disclosure in its financial statements (in addition to Auditors
existing);
1-customer assets held , 2- total value of pledged
securities with financial institutions indicating
separately securities belonging to customers
3-pattern of shareholding, giving names of persons
holding more than 5% shares
4-aging analysis of amount due from customers (u/s
34(2)).
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Some New Developments Cont..
Law
Requirement
Action by
Auditors
Securities Brokers
(Licensing and
Operations)
Regulations, 2016
All securities brokers, except listed Auditor
securities brokers, shall publish a statement
of compliance with this Code (as given in
these regulations) in their Annual Reports
1-Accounting for and use of customer Auditor
money by broker (u/s 24)
2- A complete audit trail of the transactions
pertaining to customer’s assets is to be
maintained by the securities broker (u/s.
25(4)).
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Thank you.