How to get your licence cancelled (the hard way)

A recently released High Court judgment saw the first detailed consideration of the FMA's licence cancellation powers, including the scope of appeal rights in respect of cancellation decisions.

In this Financial Law Insight, we unpack the Rockfort Markets Limited v Financial Markets Authority [2023] NZHC 3210 case and look at where Rockfort went wrong, what the FMA got right, and what it means for market service licensees more generally.

What happened?

In a High Court judgment publicly released on 30 August 2024, but dated 14 November 2023, Edwards J dismissed an appeal by Rockfort Markets Limited (Rockfort) against the decision by the Financial Markets Authority (FMA) to cancel its derivatives issuer licence.

The Register of Financial Service Providers now shows Rockfort's derivatives issuer licence was cancelled on 19 July 2024. (Rockfort is still registered to provide wholesale services relating to derivatives.)

How did Rockfort end up here?

The FMA first notified Rockfort that it intended to cancel its licence on 16 March 2023. However, that was not the beginning of this story.

Based on the judgment, it appears that from the time Rockfort was licensed in February 2018, it fairly quickly ran into trouble with the regulator. In fact, the licence conditions imposed by the FMA suggest there were concerns that Rockfort was already behind the eight ball at the time of licensing.

Immediate improvements required

Rockfort's specific licence conditions featured a short-dated condition that required it to engage a third party to conduct an independent and comprehensive review of the design and effectiveness of its risk and compliance framework, conflict of interests' policy, and other policies relating to its proprietary trading operations. Rockfort wasn't alone in having such a condition; a number of market service licensees have had similar conditions imposed.

Standard condition failures

Rockfort subsequently received a visit from the FMA in June 2019. Following this supervisory monitoring review, the FMA raised a number of concerns, including that Rockfort did not undertake proper suitability assessments of retail clients and did not ensure introducing brokers were properly authorised in foreign jurisdictions. These failures would breach the standard conditions of Rockfort's licence. Rockfort created an informal 'action plan' intended to address these concerns.

Advertising issues

Despite already being (or, potentially, because it was) under the FMA's watch, Rockfort had another misstep. In August 2019, the FMA asked Rockfort to remove certain statements from its website that appeared to be false and/or misleading. Rockfort said it would, but the FMA had to follow up to get the statements taken down. They were eventually removed in December 2019.

Maintenance failures

In May 2020, the FMA censured Rockfort in relation to some of the compliance failures identified during the June 2019 review, including a general failure to maintain required governance standards (either in respect of standard condition 6 for derivatives issuer licences or specific condition 1 of Rockfort's licence - the conditions are essentially the same).

But wait, there's more

The FMA remained concerned about Rockfort's advertising, both on its website and via social media. This time the FMA took issue with various statements including suggestions that trading in derivatives was 'safe' and that Rockfort 'exceeds' regulatory requirements.

Following a back and forth, on 3 March 2021 the FMA issued an order directing Rockfort to remove the offending material and take steps to ensure its marketing materials complied with the Financial Markets Conduct Act 2013 (FMC Act).

Did Rockfort step up its compliance?

Apparently not. Despite repeated (and essentially ongoing) engagement with the FMA, Rockfort still failed to comply with its licensee obligations. This time, in July 2021 during a further monitoring visit by the FMA, it was found that Rockfort only had one director and that there were various gaps in the board's capabilities, including a lack of understanding of legislation and legislative process.

The final straw

Matters identified during the July 2021 visit proved to be the final straw for the FMA. In August 2022, the FMA issued a notice to Rockfort that the FMA intended to cancel its licence. That initial notification of intention to cancel asserted ten material contraventions of licensee obligations by Rockfort, and set out the FMA's view that Rockfort was no longer capable of effectively performing the services of a derivatives issuer and that it had reason to believe that Rockfort would likely contravene a market services licensee obligation in the future.

Rockfort provided another informal 'action plan', which outlined steps to be taken in response to each of the alleged contraventions. Rockfort also took other steps intended to address the concerns raised, including stopping all advertising and the onboarding of new clients pending the review of its policies and procedures. The FMA was unmoved and issued Rockfort with its final decision on 16 March 2023 - the FMA was cancelling Rockfort's licence, effective 18 September 2023.

The lag between the decision to cancel and the 'effective date' was to allow time for existing investors to close out their open positions (and is reflected in several specific conditions added to Rockfort's licence at the time).

On to the appeal

Rockfort appealed the FMA's decision to cancel its licence via section 531 of the FMC Act. This provides a broad right of appeal against FMA decisions, including where the FMA declines to issue a licence, imposes conditions on a licence, or cancels a licence.

Importantly, Edwards J held that appeals under section 531 are standard appeals with the Court able to come to its own view on the merits. This meant the Court could essentially rehear the matter, 'and make any decision it thinks should have been made'.

This is useful confirmation, as decisions by the FMA regarding licensing - to grant, restrict, or revoke - are fundamental to market participants' ability to undertake retail business. By providing a general right of appeal, section 531 functions as a necessary check on FMA power and decisions relating to licences - not only about processes and procedures, but also the actual decision made. We think this is the right result given the significance of decisions about licensing and cancellation of licences for participant businesses.

Weight given to FMA's expertise

Despite there being a general appeal right, matters are still weighted in the FMA's favour. Edwards J, referring to the Innovative Securities Ltd v FMA decision from 2017, held that the appellant bears the onus of showing the original decision was wrong, stating:

"Given the FMA's particular advantage in terms of technical expertise, this appeal Court may hesitate to conclude that its findings of fact are wrong."

So, in practice, there is a presumption the FMA was right, and any appellant will need to work extra hard to counter that view.

Materiality threshold

A key element in considering whether to cancel a licence (or take some other action such as censure) is that any contravention must be 'material'.

As Edwards J notes, 'material' is used in different contexts throughout the FMC Act but is not defined. Usefully, although without going into much detail, Edwards J confirms that a material contravention involves something that is more than trivial or inconsequential (so 'must be a matter of moment or some significance') and depends on the particular facts and circumstances of each case.

Relevant factors in assessing whether a particular contravention is material include:

• the purposes of the FMC Act
• the nature of the contravention
• the circumstances in which the contravention arises, and
• the nature of the risk posed by the contravention.

Considerations

Under sections 414 and 415 of the FMC Act, in order to cancel Rockfort's licence, the FMA first had to be satisfied (i.e. make up its mind) that Rockfort had materially contravened a market service licensee obligation and that it was therefore no longer capable of effectively performing the licensed service.

The FMA also had to consider whether a censure, action plan, or direction would be more appropriate. This is because section 414 is structured in such a way as to ensure the FMA gives due consideration to lesser actions before escalating to cancellation (noting cancellation essentially functions as a 'death penalty' for an entity's New Zealand retail business).

Contraventions

The FMA's final decision to cancel was based on eight material contraventions by Rockfort. These were for breaches of market services licensee obligations under the FMA's standard licence conditions, the FMC Act, and the Financial Markets Conduct Regulations 2014.

Rockfort admitted four contraventions: failures in respect of introducing brokers; not maintaining adequate records of suitability assessments; not complying with a direction order; and failing to notify the FMA of key personnel changes.

The other four contraventions asserted by the FMA were challenged by Rockfort.

Suitability assessments

In respect of standard condition 12, Rockfort contended that what is required is an assessment of the client's ability to understand derivatives (and the risks) rather than an assessment of the client's actual knowledge and experience.

Unfortunately for Rockfort, it had onboarded 40 New Zealand-based retail clients who had no experience with derivatives and who had 'evidenced' as much in answering Rockfort's onboarding questionnaire - by selecting 'never' or 'no' in response to all seven questions. What this illustrated was that Rockfort failed to take appropriate action, such as asking for further information, where responses from investors indicated they did not have the requisite experience.

Edwards J states that standard condition 12 places a positive onus on the licensee to seek information regarding knowledge, experience, and level of understanding to allow the ability of an investor to understand, and therefore the suitability of the product, to be determined. Rockfort failed in this respect, by asking investors to confirm their understanding of derivatives rather than seeking information as to the investors' actual knowledge and experience - and seeking further information if necessary. Following that conclusion, Edwards J agreed with the FMA and found that Rockfort had materially contravened the requirements of standard condition 12.

Edwards J noted in passing that the explanatory note to the condition could be expressed more clearly. The FMA is currently working on amendments to standard condition 12, and we expect the explanatory note will also be updated in light of this case.

Maintaining capability

Specific condition 1 of Rockfort's licence, which confusingly is a standard condition of all licences, required it to 'maintain the same or better standard of capability, governance and compliance as was the case when the FMA assessed its application'.

At the time of licensing, Rockfort had three directors and indicated it would have a dedicated compliance officer. However, for a period of seven months Rockfort was down to one director and had combined the compliance officer role with that of general counsel.

Given Rockfort's ongoing issues, particularly those identified by the FMA during that seven month period, Edwards J held that the FMA was correct in finding Rockfort had materially contravened specific condition 1. Clearly, the standard of capability, governance and compliance had materially dropped. Further, these compliance concerns were never self-identified by Rockfort but rather identified by the FMA.

Disclosure deficiencies

Rockfort failed to include mandatory information regarding hedging counterparties in its product disclosure statement (PDS). Not including this information meant Rockfort was in breach of the PDS content requirements. On that basis, section 82 of the FMC Act was potentially applicable. If the PDS omitted required information and that omission was 'materially adverse from the point of view of an investor' then Rockfort would not be able to offer, or continue to offer, derivatives.

Edwards J found that to be the case, stating that by not identifying hedging counterparties, investors could not understand the creditworthiness of the counterparty - and therefore could not make an informed assessment about the risks underlying a derivative. Edwards J reached this conclusion after considering Australian case law, as the meaning of 'materially adverse from the point of view of an investor' had not previously been addressed by the courts in New Zealand. Reference was also made to the principles discussed above regarding materiality in the context of a material contravention of a licence obligation.

Referring to the New South Wales case of Roadships Logistics Ltd v Tree from 2007, Edwards J noted that the test is an objective one and is fact driven and involves something that would turn a prudent but non-expert investor away rather than making that investor more willing to invest.

On that basis the Court ultimately held that the FMA did not err in concluding there was a breach of section 82 of the FMC Act - that there was a materially adverse omission of information regarding hedging counterparties.

Catch-all contravention

Standard condition 5 requires derivative licensees to have in place adequate and effective systems, policies, processes and controls to ensure all market services licensee obligations are met in an effective manner. The condition effectively operates as a catch-all - other contraventions and breaches of obligations can amount to a contravention of this 'compliance condition'.

This was the case for Rockfort. Shortcomings identified in respect of introducing brokers, suitability assessments, and general failures regarding advertising essentially substantiated the fact Rockfort did not have adequate systems and controls in place. Again, Edwards J held that the FMA did not err in concluding Rockfort had materially contravened standard condition 5.

No longer capable

Given the various contraventions, the FMA concluded that Rockfort was no longer capable of effectively performing the licensed service (section 396(c) of the FMC Act) and that there was reason to believe Rockfort was likely to contravene its licensee obligations (section 396(d) of the FMC Act).

In coming to this conclusion, the FMA made reference to its licensing guide for derivative issuers. That guide sets out what the FMA terms minimum standards for licensing. Although the various 'minimum standards' are not market services licensee obligations - and cannot be 'breached' - they set out base line requirements to obtain a licence.

Given persistent issues that arose with Rockfort's performance, or lack thereof, regarding record keeping, governance, advertising, and disclosure, Edwards J held that the FMA was correct in concluding that Rockfort could no longer effectively perform the licensed service.

Edwards J also held that there was substantiation for the FMA's concerns that there was reason to believe Rockfort would likely contravene again. Rockfort's history of non-compliance and deficient governance arrangements meant there could be no confidence future contraventions would not occur.

Cancellation

Finally, Edwards J held that the FMA's decision to cancel Rockfort's licence was appropriate. Importantly, a lesser regulatory power - censure, action plan, or direction - was not more appropriate than cancellation given the extent and nature of Rockfort's various contraventions and past history of non-compliance.

Further, Edwards J held that there was no additional requirement for the FMA to 'consult' Rockfort before cancelling the licence. This is because the cancellation process has a built-in notice and submission process along with a right of appeal to court. To infer an additional consultation requirement could 'paralyse' the FMA's decision making process.

What to make of all this?

This is really a case of what not to do and provides lessons that all market services licensees should take on board. The FMA gave Rockfort plenty of chances, but that wasn't enough. If you tell the regulator you are going to do something, then you need to do it.

Ultimately, cancellation did not occur because of one particular issue but because of a raft of concerns. Here the cumulative effect of the various contraventions and breaches meant the FMA simply had no confidence that Rockfort could meet its licensee obligations.

Questions might be asked about why Rockfort was licensed in the first place - however, this may be able to be explained by the fact that the FMA is directed by statute not to unnecessarily restrict the licensing of persons. This makes sense. The FMA should be inclined to grant a licence where an applicant meets the large majority of assessment criteria. Residual concerns can be addressed via specific conditions, i.e., the licensee will be able to effectively perform the service in light of those conditions.

In practice, having robust systems, policies, processes and controls, along with maintaining governance standards - and actually following through with what you agree with the FMA when confronted with a compliance concern - should ensure licensees avoid the fate of Rockfort.

Start a conversation

If you would like to discuss the Rockfort case, or licensing and regulatory actions more generally, please contact David Ireland on +64 4 498 0840, Catriona Grover on +64 4 498 0816, Tom McLaughlin on +64 9 892 5215, or Mark Schroder on +64 9 375 1120 or email the team at [email protected]

Public link

Please use the above public link if you want to share this noodl on another website.