CZECH REPUBLIC
Assessment of Governance of the Collective Investment Fund Sector
September 2004
Private and Financial Sector Development Department
Europe and Central Asia Region
The World Bank
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ACRONYMS
AMCAsset Management Company
CIUCollective Investment Undertaking
CSCCzech Securities Commission
CZKCzech Koruna (crown)
EUEuropean Union
FEFSIFédération Européenne des Fonds et Sociétés
d'Investissement
FSAPFinancial Sector Assessment Program
GDPGross Domestic Product
ICIInvestment Company Institute
IOSCOInternational Organization of Securities
Commisions
MOFMinistry of Finance
NAVNet Asset Value
OECDOrganization for Economic Cooperation and
Development
OTCOver the Counter
ROSCReport on Observance of Standards and Codes
SECSecurities and Exchange Commission
UCITSUndertakings for the Collective Investment of Transferable Securities
UNISUnion of Czech Investment Companies
USUnited States
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Table of Contents
Context and Acknowledgements
Introduction
The Czech Collective Investment Fund Sector
Sector Composition
Legal Structures
Summary of Key Issues and Recommendations
Key Issues
Key Recommendations
Conflicts of Interest between Investment Companies, Depositaries and Unit-Holders
Investment Companies (AMCs)
Depositaries
Segregation of Assets
Supervisory Boards
Risk Management, Internal Controls & Financial Reporting
Regulations to Prohibit Abusive Practices
Regulations for Special Funds
Tables
Table 1: Number of Funds and Assets under Management
Table 2: Comparison of Legal Forms of Collective Investment Undertakings
Table 3: Czech Investment Companies - Summary Information
Table 4: Related Party Transactions
Box
Governance of US versus European Funds...... 7
Annex
Detailed Assessment...... 25
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Context and Acknowledgements
In well-developed capital markets, collective investment funds provide a potentially attractive investment option for investors. They provide individual investors with access to a diversified investment portfolio, potentially benefiting from efficient sales and purchases of large blocks of securities. However, collective investment funds also entail some risks. Individual investors lack direct information regarding the investment assets and are therefore obliged to trust the fund managers—and the sector’s governance framework—to ensure that their interests are protected. It is the role of the Government to ensure that such trust is warranted and that investors can feel confident that their interests will be placed ahead of those of the investment managers. These issues are particularly sensitive in the Czech Republic where the 1990’s saw the establishment of collective investment funds in an environment of insufficient regulation, providing fertile ground for widespread governance abuses by fund managers.
This assessment of corporate governance of the Czech investment fund sector is the first assessment in a pilot program to analyze the governance of collective investment funds in transition and emerging markets. The assessment has four objectives: (1) identify possible governance weaknesses in the Czech governance framework, (2) consider what provisions should be in place to ensure that governance of investment funds adequately protects investors and other stakeholders, (3) develop a set of benchmarks for assessment of governance of collective investment fund sectors, and (4) conduct a trial assessment of the Czech governance framework against the proposed benchmarks. The assessment thus both highlights the key weaknesses in the Czech collective investment fund sector and also provides a systematic assessment of the Czech framework compared to the benchmarks. The benchmarks and the assessment of the Czech framework against the benchmarks are found in the Annex. However, because this is a pilot assessment, even the final report will likely be no more than “work-in-progress.” Nevertheless, it is expected that the report will play a useful role in contributing to the international public debate on guidelines for strong corporate governance of the collective investment fund sectors in both developed and emerging markets.
The collective investment fund governance assessment is one of a series of pilot financial sector governance assessments prepared by the World Bank at the request of the Czech Government. The other financial sector governance assessments include the banking sector and may in the future also cover the insurance and private pension fund sectors. The report draws on other financial sector assessments prepared by the World Bank for the Czech Republic, including a Capital Markets Review in 1999, a Financial Sector Assessment Program (FSAP) Review in 2001, a Corporate Governance Report on Observance of Standards and Codes (ROSC) in 2002 and an Accounting and Auditing ROSC in July 2003.[1]
The assessment of Czech collective investment fund governance was prepared based on a mission to Prague from January 26, 2004 to February 5, 2004. The mission was led by Ms. Marie-Renée Bakker, Lead Financial Sector Specialist and Finance and Private Sector Program Coordinator for the New EU Member States. The other mission members were Ms. Susan Rutledge, Regional Corporate Governance Coordinator for the Europe and Central Asia Region and Mr. Richard Symonds, Senior Legal Counsel at the World Bank. Advising the mission was Mr. Steffen Matthias, Secretary-General of the Fédération Européenne des Fonds et Sociétés d'Investissement (FEFSI), the industry association for the European investment fund sector. In addition, E-Merit Consulting Services of Prague completed a preparatory template-questionnaire regarding the investment fund governance framework in the CzechRepublic. The mission met with officials from the Ministry of Finance MOF), the Czech Securities Commission (CSC), the Czech National Bank (CNB), the Prague Stock Exchange (PSE) and its clearing subsidiary, Univyc, the Prague Securities Center, the Union of Investment Companies of the Czech Republic (UNIS) and numerous asset management companies, depositaries, broker-dealers, and members of the financial and legal community. The World Bank would like to express its gratitude for the efforts undertaken by all parties involved to facilitate its work.
Introduction
All financial institutions have important fiduciary duties to the individuals and corporations who have entrusted their funds to them. However, collective investment funds have particularly strong fiduciary obligations. Fund investors need to be able to focus on the issues of maximizing the return on their capital, not return of their capital. Furthermore investors are entitled to honest and industrious fiduciaries, who abide by fair and ethical principles. The collective investment sector is characterized by complex agency relationships, where the fund operator might misrepresent the quality or value of an asset portfolio--or the nature of the risks involved--or the operator might manage the assets in his own interests rather than in the best interests of the investors. The asymmetry of market power and information available to a fund operator enables such abuses if the corporate governance framework for the collective investment fund sector does not preclude such behavior.
A framework for corporate governance comprises of the following three areas: (1) the financial and company laws that constitute the legal framework, (2) the supervisory and enforcement institutions that constitute the regulatory framework and (3) the common business practices that determine the willingness of the financial and corporate sectors to comply with the legal and regulatory framework. The market-place practices also influence the sector’s interest in adopting high standards of corporate social responsibility, which cannot be legislated but are important for the corporate and financial community. More specifically, corporate governance relates to the set of relationships between company management and the company’s supervisory board, shareholders and other stakeholders—and the ways in which conflicts of interest are managed and addressed.
With regard to the collective investment fund sector, the report takes as its starting point the objective that the sector should provide all investors with a level playing field when investing in collective investments. Good corporate governance should complement state regulation of the collective investment fund sector and should ensure both transparency and accountability in the sector. Transparency of fund operations is needed to enable investors to make informed and timely decisions. Accountability may lie with the supervisory boards of the asset-management companies or it may lie with the bank depositaries that control the activities of the asset-management companies or self-managed investment companies. In either scheme, investors need to rest assured that a reliable and trust-worthy body is accountable and looking out for the investors’ interests.
One of the difficulties in assessing collective investment fund governance is that there are no internationally accepted benchmarks for governance of the collective investment fund sector. The Guidelines for Private Pension Fund Governance prepared by the OECD in 2002 provide a useful starting point.[2] Also of relevance are the IOSCO Objectives and Principles of Securities Regulation, specifically Principles 17 to 20 (which touch on governance issues for mutual funds, even though they are more regulatory principles than governance principles)—as well as the methodology developed by IOSCO for assessing compliance with the Principles.[3] The European Union (EU) has issued the “UCITS” Directive (initially as 85/611/EEC) which lays out the requirements for undertakings in collective investments in transferable securities.[4] The EU is currently reviewing a number of areas related to collective investments, such as the use and function of depositaries,[5] which were taken into account in preparing this assessment. In addition, the European collective investment fund industry association, FEFSI, has issued a number of specific principles on issues such as investment policies, business transactions (including affiliated transactions), and investor information, including a model simplified prospectus and a methodology for calculation of the performance and total expense ratio of a collective investment fund.[6] The US Securities and Exchange Commission (SEC) has proposed (and already partially adopted) new requirements for governance of investment companies.[7] Also, the US investment fund industry association, the Investment Company Institute (ICI), has released recommendations for the directors of investment companies.[8] However, none of these recommendations or guidelines provide a comprehensive set of benchmarks for reviewing the governance of a country’s collective investment fund sector.
Indeed recent years have witnessed rapidly changing—and improving—standards for regulation. In April 2004 the US SEC proposed regulations to: (1) enhance and modernize the national market system for investment companies , (2) expand the categories of events that trigger prompt disclosure and (3) increase disclosure of investment companies’ policies and practices on market timing and selective disclosure of portfolio holdings.[9]The agency has already revised significant disclosure rules and forced the investment companies to adopt new ethics codes and to appoint compliance officers. In June 2004, the SEC adopted new rules requiring that the at least 75 percent (rather than 50 percent) of the boards of directors of investment companies should be “independent” members and that the chairman of the board should also be independent.[10]In part the impetus for change has come from the rapid growth of the mutual fund sector and the widespread conflicts of interest highlighted by US prosecutors. However, the issues related to governance of collective investment funds are present in all major capital markets. The common occurrence of such issues provide encouragement for systematic review of collective investment fund governance, particularly in those markets (such as the Czech Republic) where corporate governance abuses existed in the past.
Although the developments in the US represent positive news for fund investors, the rapidly changing approaches and the absence of internationally agreed principles that could be used as benchmarks have complicated the task of reviewing the Czech collective investment fund sector. The mission therefore kept in mind the historical experience of the Czech Republic in corporate governance development while relying on best practices used in well-regulated and governed capital markets.
It should be noted that in the Spring and early Summer of 2004, the Government passed legislation to bring the Czech laws and regulations in compliance with all Directives and regulations of the European Union. In particular, two major pieces of legislation were completed: (1) the Law on Collective Investments, which replaces the old Law Investment Companies and Investment Funds, to comply with the UCITS Directive and (2) the Law on Capital Market Undertakings, which replaces the old Law on Securities for the same purpose. As of June 2004, revisions to the Commercial Code were under way. In addition, the Czech Securities Commission (CSC) had drafted six new regulations related to collective investment funds as well as over 15 regulations concerning other parts of the capital markets. The report focuses on the new legislation that was passed in April 2004 and relevant translated decrees and compares it to the prior laws and regulations. The comparison will provide useful insight into the governance strengths and weaknesses of the Czech collective investment sector.
Box 1: Governance of US versus European Funds
The proposed changes in US legislation regarding investment companies highlight the differences between the governance structures of collective investment funds in the US compared to those in Europe. In the US, mutual funds are corporations or business trusts, overseen by boards of directors or trustees, that are required by the Investment Company Act of 1940 to be organized and operated in the best interests of shareholders. Funds typically have no direct employees and hire management firms and other service providers. For such funds, the key governance issues relate to conflicts of interest, particularly where officials of the asset-management company are also the fund’s directors and can set the management fees paid by the funds. Hence the focus of American regulatory reform is on having a large number of “independent” or unaffiliated directors or trustees.In Europe, funds are also organized using legal structures for corporations and trusts, but, in addition, can be structured based on the contract approach. In the contract approach, a fund is viewed as a product of the management company and the fees and other terms are spelled out in a governing agreement between the fund manager and investors. The fund has no legal status but is essentially a pool of assets with investors owning a specified number of units of the trust. For all types of collective investment funds, there is an outside entity such as a depositary that helps to ensure that the fund is indeed run by the fund’s manager in accordance with governing documents, rules and regulations and fund investment guidelines. These independent oversight organizations, called “depositaries”, are typically units of big banks and are responsible for safeguarding the assets of collective investment funds and for monitoring fund managers' actions. However, unlike the board of an investment company in the US, a depositary for a UCITS collective investment fund has no discretion to set investment policies for the fund.
The Czech Collective Investment Fund Sector
Sector Composition
The creation of the CSC in 1998 and the amendments to the securities legislation provided for substantial improvements in corporate governance practices in the Czech securities markets, particularly those related to collective investments. However, despite the improvements in the legal and regulatory framework for collective investment funds—and despite the potentially attractive opportunities for investors—the collective investment sector remains small.
As can be seen from Table 1, the number of domestic collective investment funds has declined steadily during the last few years, while the market share of foreign funds has increased. Total assets under management remain very low at CZK 159.3 billion (approximately US$5.6 billion equivalent), or less than 7 percent of GDP (2003 data). By comparison, the investment fund sector of the old EU member countries represents approximately 40 percent of the old EU’s GDP.
Table 1: Number of Collective Investment Funds and Assets under Management
Legal Structures
For the purposes of this paper, the Czech terminology in the area of collective investment funds should be explained. Czech law recognizes two different types of fund structures: (1) an “investment fund,” which has a corporate legal form as a joint stock company and (2) a “unit trust” which does not have a legal personality and is based on contract. The term “unit trust” is used in the new Law on Collective Investments and will be used to describe contractually based funds (under the old Czech law, they were referred to as “mutual trusts”).
Unit trusts are managed by asset management companies (called “investment companies” under Czech law.) Investment funds can be self-managed or managed by an asset management company. Table 2 provides a summary of different legal forms for collective investment undertakings. The new legislation on collective investments in the CzechRepublic that came into force on May 1, 2004, converts all existing management companies into UCITS-type asset managers. Existing investment funds and mutual trusts are automatically considered “special funds,” and will be required to request authorization from the CSC for transformation into a UCITS-type collective investment undertaking.
Since the primary audience for this assessment is the Czech collective investment fund sector, the Czech terminology will be used in the text sections referring to institutions created under Czech law, with several minor changes for the benefit of clarity for non-Czech readers.
As a result:
- “Collective Investment Fund” will refer generically to all types of collective investment funds under Czech law, no matter what their legal form is.
- “Investment (management) company” will refer to asset management companies.
- “Corporate investment fund” will refer to collective investment funds organized as a corporation.
- “Unit trust” will refer to a collective investment fund organized on a contractual basis with a legal personality.
- “Depositary” will refer to the entity which controls the activity of the collective investment fund under Czech law.
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