Investment Company by wuxiangyu

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									                           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
        ACRONYMS


AMC     Asset Management Company
CIU     Collective Investment Undertaking
CSC     Czech Securities Commission
CZK     Czech Koruna (crown)
EU      European Union
FEFSI   Fédération Européenne des Fonds et Sociétés
        d'Investissement
FSAP    Financial Sector Assessment Program
GDP     Gross Domestic Product
ICI     Investment Company Institute
IOSCO   International Organization of Securities
        Commisions
MOF     Ministry of Finance
NAV     Net Asset Value
OECD    Organization for Economic Cooperation and
        Development
OTC     Over the Counter
ROSC    Report on Observance of Standards and Codes
SEC     Securities and Exchange Commission
UCITS   Undertakings for the Collective Investment of
        Transferable Securities
UNIS    Union of Czech Investment Companies
US      United States
Table of Contents
Context and Acknowledgements ........................................................................................ 4
Introduction ......................................................................................................................... 5
The Czech Collective Investment Fund Sector ................................................................... 8
   Sector Composition......................................................................................................... 8
   Legal Structures .............................................................................................................. 9
Summary of Key Issues and Recommendations ............................................................... 12
   Key Issues ..................................................................................................................... 12
   Key Recommendations ................................................................................................. 14
Conflicts of Interest between Investment Companies, Depositaries and Unit-Holders.... 15
   Investment Companies (AMCs) ................................................................................... 15
   Depositaries................................................................................................................... 16
   Segregation of Assets .................................................................................................... 18
Supervisory Boards ........................................................................................................... 19
Risk Management, Internal Controls & Financial Reporting ........................................... 21
Regulations to Prohibit Abusive Practices ........................................................................ 23
Regulations for Special Funds .......................................................................................... 26

Tables

Table 1: Number of Funds and Assets under Management ................................................ 9
Table 2: Comparison of Legal Forms of Collective Investment Undertakings ................ 11
Table 3: Czech Investment Companies - Summary Information...................................... 17
Table 4: Related Party Transactions ................................................................................. 23

Box

Governance of US versus European Funds .........................................................................7

Annex

Detailed Assessment ..........................................................................................................25
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

1
       The completed ROSC reports can be obtained from http://www.worldbank.org/ifa/rosc_cg.html.
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 Czech Republic. 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


                                              5
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.

2
          Guidelines for Pension Fund Governance. OECD Secretariat. July 2002. A copy can be found at
http://www.oecd.org/dataoecd/22/2/2767694.pdf
3
          See the February 2002 report of the International Organization of Securities Commissions. Copies
can be found at http://www.iosco.org/pubdocs/pdf/IOSCOPD125.pdf
4
          See European Union Directive of 20 December 1985 on the coordination of laws, regulations and
administrative provisions relating to undertakings for collective investments in transferable securities
(85/611/EEC) as modified by Directives 88/220, 95/26 and 00/64 including the Common Positions adopted
on 5 June 2001 (EC23/2001 & 24/2001.) Copies can be downloaded from
http://europa.eu.int/scadplus/leg/en/lvb/l24036a.htm.
5
          European Commission Communication to the Council and Parliament, Regulation of UCITS
Depositaries in the Member States, COM (2004) 207 (30.03.2004)
6
          Copies can be found on the FEFSI website www.fefsi.org under ―FEFSI standards‖.
7
          The SEC proposed requirements are summarized at http://www.sec.gov/news/press/2004-5.htm.
8
          Corporatecollective investment funds are called ―investment companies‖ in the United States
under the Investment Company Act of 1940. A copy of the 1999 ICI’s Best Practices for Fund Directors
can be found at http://www.ici.org/statements/ppr/rpt_best_practices.pdf.


                                                    6
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.



9
         See the April 2004 speech of US Securities and Exchange Commission Chairman William
Donaldson, which can found at http://www.sec.gov/news/speech/spch042204whd.htm
10
         Other details are also important. The outside directors will have to hold quarterly meetings without
fund executives being present, and each board will be required to justify the fund managers it retains. The
SEC is also planning in 2004 to complete rules limiting after-hours trading, requiring greater disclosure of
some fees and regulating more closely the payments and other compensation paid by funds to the brokerage
firms that execute their sales and purchases of securities.


                                                     7
                         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.




                                                      8
        Table 1: Number of Collective Investment Funds and Assets under Management
                                                        Assets (bln.  Assets (bln.           Assets as
                                        No. of entities   CZK)           US$)      Share (%) % of GDP
 1999 Open-ended mutual trusts                                   54.2         1.57               0.28%
                      1)
 2000 Investment funds                              33           20.4         0.53    19.83%
       Investment companies2)                         36             78.9          2.04     76.68%
       Open-ended mutual trusts                       87
       Closed-end mutual trusts                        7             3.6           0.09      3.50%
       Total (Czech entities only)                                 102.9           2.67       100%     0.52%
 2001 Investment funds1)                              20              12           0.32     14.94%
                                2)
       Investment companies                           21             66.5          1.75     82.81%
       Open-ended mutual trusts                       88
       Closed-end mutual trusts3)                      4             1.8           0.05      2.24%
       Foreign entities                              n.a.            n.a.                       n.a.
       Foreign funds4)                               209
       Total (Czech entities)                                        80.3          2.11       100%     3.69%
                        1)
 2002 Investment funds                                 8             5.2           0.16      3.49%
                                2)
       Investment companies                           17           107.9           3.30     72.42%
       Open-ended mutual trusts                       92
       Foreign entities                               44             35.9          1.10     24.09%
       Foreign funds                                 651
       Total (Czech entities)                                      113.1           3.45     75.91%
       Total (including foreign entities)                            149           4.55       100%     6.55%
 2003 Investment funds1)                               4             2.3           0.08      1.44%
       Investment companies2)                            15        106.7           3.78     66.98%
       Open-ended mutual trusts                          66
       Foreign entities                                  49             50.3         1.78     31.58%
       Foreign funds                                    723
       Total (Czech entities)                                           109          3.86     68.42%
       Total (including foreign entities)                             159.3          5.64       100%   6.29%
       Source: Czech Securities Commission, Czech National Bank.
       1) Includes only active investment funds, not investment funds in liquidation
       2) Includes only active investment companies, not investment companies in liquidation
       3) There are no more closed-end funds as of 2002
       4) The foreign funds were only allowed in the Czech Republic since the beginning of 2001.
          The data for 2001 are not available

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‖).




                                                 9
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
Czech Republic 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:

   1. ―Collective Investment Fund‖ will refer generically to all types of collective
      investment funds under Czech law, no matter what their legal form is.
   2. ―Investment (management) company‖ will refer to asset management companies.
   3. ―Corporate investment fund‖ will refer to collective investment funds organized
      as a corporation.
   4. ―Unit trust‖ will refer to a collective investment fund organized on a contractual
      basis with a legal personality.
   5. ―Depositary‖ will refer to the entity which controls the activity of the collective
      investment fund under Czech law.




                                           10
                                              Table 2: Comparison of Legal Forms of Collective Investment Undertakings 11


Type of Fund                        Legal Form               Type           Manager                    Depositary                   Title to Assets            Investor Interest

Czech Republic
Investment Fund                     Corporation              Closed         Investment Company         Assets must be               Investment company         Shares
                                                                            (the term for asset        “controlled” (or             holds title or
                                                                            management company         supervised) by a             investment fund if it
                                                                            in the Czech law) or is    depositary                   is self-managed
                                                                            self-managed
Unit trust                          Fund created by          Open or        Investment Company         Assets must be               Investment company         Units of Participation
or Mutual Fund                      Contract                 Closed                                    “controlled” (or             holds title
                                                                                                       supervised) by a
                                                                                                       depositary

UCITS Recognized
Investment Company                  Corporation              Open or        Asset Management           Assets must be entrusted      Determined by               Shares
(such as SICAV)                                              Closed 12      Company (AMC) or is        to a depositary for           national law
                                                                            self-managed               safekeeping
Fund Based on Contract              Fund created by          Open           Managed by AMC             Assets must be entrusted      Determined by               Units of Participation
                                    Contract                                                           to a depositary for           national law
                                                                                                       safekeeping
United Kingdom
Unit Trust                          Trust under Anglo-       Open           Managed by a Trust         UK - Assets held by           Trust Company as            Beneficial Units in
                                    Saxon law                               Company acting as the      trustee                       trustee has legal title     Trust
                                                                            Trustee

United States
Investment Company                  Corporation              Open or        Investment Advisor         Not obligatory, although     Title held by              Shares
                                                             Closed         (registered with SEC) or   assets can be held by a      investment company
                                                                            is self-managed            custodian




11
             For additional information on the governance of collective investment fund sectors in various OECD countries, see John K. Thompson and Sang-Mok Choi, Governance
Systems for Collective Investment Schemes in OECD Countries. OECD, Financial Affairs Division. April 2001. A copy can be found at
http://www.worldbank.org/wbi/banking/insurance/contractual/pdf/thompson_choi.pdf
12
           Although UCITS funds refer to open-ended funds, there appears to be an exception for exchange-traded funds which can be closed, if the asset manager intervenes to keep
the price of the fund within 5% of the NAV. This intervention is considered by the UCITS directive to be the functional equivalent of open-ended redemption, however the exchange
listed funds are still closed-end from a legal standpoint.



                                                                                         11
Summary of Key Issues and Recommendations
Key Issues

The report highlights six key issues concerning governance of the Czech collective
investment fund sector. They relate to:
   1) Conflicts of Interest between asset-management companies, depositaries and unit-
       holders,
   2) Supervisory boards of asset-management companies,
   3) Risk management, internal controls and financial reporting,
   4) Regulation of abusive practices,
   5) Authority of the Czech Securities Commission, and
   6) Regulations for special funds.

These issues are summarized below. A more detailed description can be found in the
Annex to this paper (Detailed Assessment of the Corporate Governance Framework for
Collective Investment Undertakings in the Czech Republic: A Comparison of Rules and
Practices Against Proposed Best Practice Benchmarks).

Conflicts of Interest between Investment (Management) Companies , Depositaries and
Unit-Holders - Over 95 percent of all assets in collective investments are managed by just
four investment (management companies). While these companies are separately
incorporated as joint stock companies, each one of them is also owned by the same bank
(or banking group) that acts as both broker-dealer and depositary for the funds they
manage. Although these arrangements provide some efficiencies for their activities, the
common ownership structure could create conflicts of interests and highlights the need
for strong supervisory boards and systems of risk management and internal controls.

Supervisory Boards – The Czech Commercial Code is due for revision and provides for
only weak internal governance of joint stock companies. In particular, the Code fails to
establish adequate fiduciary duties for members of supervisory and management boards.
As asset-managers, Czech investment (management) companies and corporate
investment funds should have stronger governance provisions than those that apply to
non-financial joint stock companies. Their supervisory boards should also be responsible
for ensuring that adequate systems of risk management and internal controls are in place.

Risk Management, Internal Controls and Financial Reporting – Major improvements in
the internal systems of investment (management) companies and corporate investment
funds are mandated by the introduction of the CSC’s regulation on business operations
and internal controls of May 2004 – which will be effective as of July 1, 2005. However,
while the regulation assigns responsibility to the internal auditors to verify compliance
with existing internal risk limits, it does not specifically require investment
(management) companies and corporate investment funds to have adequate risk
management systems in place. The industry claims to be ahead of the regulator in this
area. They argue that the entry of strategic foreign bank owners into the Czech parent
banks that own the major investment (management) companies has resulted in the


                                           12
introduction of mature market risk management and internal control systems from
abroad. Even if this is the case, however, it is evident that the CSC will still need to build
up its own in-house capacity to monitor and review risk management and internal
controls of investment (management) companies and corporate investment funds—and
develop a credible enforcement track record.

Regulation of Abusive Practices – Related-party transactions provide the most fertile
ground for abusive practices related to collective investment funds. Both the legal
structure governing collective investment funds and the internal rules of such funds must
address this issue directly to adequately protect investor interests. The law should provide
different regulatory approaches for different types of related party transactions in order to
protect investors while maximizing their opportunities for returns. Since most abusive
practices are conducted by individuals for their personal benefit, the new Law on
Collective Investments should provide appropriate regulatory provisions and sanctions
for abusive practices by individuals. Unfortunately, there are large gaps in the new Law
regarding the individuals that come within the regulatory structure for abusive practices
by related-parties. The result is that many individuals can engage in abusive practices
without a real threat of sanction. The attempt to solve this problem through decree does
not create a sufficiently strong sanction to deter abusive practices by such individuals.

Authority and Capacity of the Czech Securities Commission - While the Czech Securities
Commission (CSC) has dramatically improved its institutional capabilities and legal
authority in recent years, the CSC still has limited authority to promulgate its own
secondary legislation. Instead of receiving a general authority to issue such decrees, the
Law on Collective Investments limits the areas regarding which the CSC can issue
decrees. As a result, the CSC lacks the authority to issue decrees related to the important
area of sales practices of investment (management) companies and corporate investment
funds.

Emphasis should also be placed on strengthening the capacity of the CSC to ensure that
collective investment funds provide financial reporting to investors in compliance with
International Financial Reporting Standards, as far a meaningfully applicable, and the
Law on Collective Investments.

Regulations for Special Funds - The Law on Collective Investments will allow the
creation of both ―standard‖ funds, which not only meet the requirements of the UCITS
Directive, but are even stricter in terms of permissible investments and structures, as well
as ―special‖ funds, many of which would not meet the provisions of UCITS-type funds.
Special funds will likely include non-transferable (and illiquid) securities, real estate,
derivatives, funds of funds and special asset classes, in addition to transferable securities.
It is expected that most investment managers will look to special funds as a means of
obtaining higher returns, albeit at higher risks, than would be possible with the UCITS-
type funds. However, the detailed regulations necessary to provide guidance to market
participants have only recently been prepared and are just in the process of
implementation. Given the past history in the Czech Republic of the voucher
privatization funds and the possible rapid appearance of hedge fund type structures in the



                                              13
Czech Republic (coming either from other EU member states or domestic initiatives) in
the post EU accession phase, it is imperative that the CSC and the industry undertake
maximum effort to educate investors about the risks associated with investing in such less
regulated funds, and to explain the differences in the level of regulation and oversight
applicable to both types of funds.

Key Recommendations

The following recommendations are made based on the evaluation of the Czech
collective investment fund sector contained in this assessment:

    Strengthen the CSC’s authority to extend ―fit and proper‖ requirements to the
   appointment of members of the supervisory board of both investment (management)
   companies and corporate investment funds.

    For supervisory board members of investment (management) companies and
   corporate investment funds, extend the statutory fiduciary obligations to include
   appropriate regulation of related-party transactions, conflicts of interest, fraudulent
   activity, holding of incompatible offices, and violation of loyalty duties.

    Amend the legislation to clarify that the assets of unit trusts should be legally
   segregated from those of the investment (management) company, in addition to book
   entry segregation.

    Provide the CSC with adequate powers to enforce the use of applicable
   accounting standards for collective investment funds (preferably International
   Financial Reporting Standards, as far as meaningfully applicable) and build the
   requisite enforcement capacity.

    Complete the development of a corporate governance code for investment
   (management) companies and corporate investment funds and put in place
   appropriate mechanisms to monitor and enforce compliance (either at the CSC or
   through the Union of Investment Companies of the Czech Republic, UNIS.)

    Implement the regulations recently promulgated to prohibit abusive market
   practices (such as front-running and preferential sales of fund units.) Establish
   sanctions for individuals who engage in improper or fraudulent sales activities.
   Amend the Law on Collective Investments to include a regulatory framework that
   brings all related party individuals within its reach and that has appropriate sanctions
   for conduct which violates the law.

    Adequately enforce the detailed regulation recently promulgated on requirements
   for systems of internal controls. Amend the regulation to require that investment
   (management) companies as well as corporate investment funds put in place the
   missing elements of integral risk management systems (i.e., in addition to internal




                                            14
     controls, an appropriate supervisory structure and an established process for
     approving new investments strategies and instruments.)

      Finish preparation of all regulations needed for implementation of the new
     legislation on collective investment funds.

      Delay the introduction of special funds until the CSC is able to prepare and make
     effective the necessary regulations affecting special funds.

      Provide for the creation of an Office of Risk Assessment in the CSC to evaluate
     potential regulatory problems in all of the areas it regulates, including collective
     investments.

The Annex to this paper (Detailed Assessment of the Corporate Governance Framework
for Collective Investment Undertakings in the Czech Republic: A Comparison of Rules
and Practices Against Proposed Best Practice Benchmarks) includes additional
recommendations with reference to the specific benchmarks.

Conflicts of Interest between Investment (Management) Companies,
Depositaries and Unit-Holders
Investment (Management) Companies

There is an inherent conflict between the obligation of an investment (management)
company to maximize profits for its own shareholders and, at the same time, give priority
to the economic interests of the investors in the funds it is managing. A fundamental
element of investor protection in collective investments is the need for independent
―control‖ (i.e. supervision) of an investment manager’s activities in regards to the
investment funds under its care. In order to provide this supervision, the institution of the
depositary was created to provide an independent review of the activities of the
investment (management) companies.

The new Czech legislation contains provisions to ensure that there is independent
supervision of the management of the collective investment funds. Heavy emphasis is
placed on the role of the depositary in monitoring and supervising the investment
decisions of the investment (management) companies. Furthermore the Law on
Collective Investment Funds sets a test of ―professional care‖ establishing a high level of
fiduciary duty on the part of the depositary for a collective investment fund. The liability
has been tested in court. In 2003, Plzenska Banka was ordered to pay CZK 1.3 billion
(approximately US$52 million equivalent) in damages for its role as depositary in
permitting C.S. Fondy to purchase 70 percent of a bankrupt poultry company. 13



13
         See Prague Post on April 2, 1997, ―1.3 billion Kc disappearing act wins little applause‖
http://www.praguepost.cz/archive/busi42b.html


                                                    15
In unit trusts, inherent conflicts of interest are rife particularly over the level of
management fees paid by the trust. The investment (management) company wants to
receive high management fees while investors wish to pay lower fees. To further protect
investors’ interests, the CSC should follow the provisions in the EU Recommendation on
Some Contents of the Simplified Prospectus14 and require that a fund disclose the Total
Expense Ratio, as calculated in the Recommendation, in the fund’s prospectus, periodic
reports, annual reports and marketing materials. The CSC will also need to create a
mechanism to monitor the calculation of the Total Expense Ratio to ensure its accuracy.
The CSC should also have the authority to request investment (management) companies
to correct excessively high fees. At a minimum, investment (management) companies
should be required to explain why the fees are so high and how the fee levels compare
with customary levels in other financial systems.

Depositaries

There is a similar conflict of interest between the duty of the depositary both to maximize
profits for its own shareholders and to put the interests of the unit-holders first. This has
frequently been resolved by creating a fiduciary-type duty in the law for the depositary
vis-à-vis the unit-holders; by requiring the depositary to be independent of the investment
(management) company; and by requiring the depositary to be a regulated financial
institution, most commonly a bank.15

The Czech legislation has adopted a number of these safeguards to reduce the dangers of
a conflict of interest, such as the requirement that a collective investment fund use a
depositary; that the depositaries have legal duties to the unit-holders; and that only banks
are permitted to be depositaries.
However, there are serious concerns as to the independence of the depositaries from the
asset management companies. As found in many small financial sectors worldwide, the
Czech investment fund sector is tightly interconnected. As seen in Table 3 below, four
major investment (management) companies are responsible for over 95 percent of all
assets under management through collective investment funds (excluding the private
pension funds.) The four investment (management) companies are subsidiaries of four
major banks, with Ceska Sporitelny alone accounting for over 40 percent of total assets
under management in the Czech collective investment fund sector. The mission was
advised that each investment (management) company directs the vast majority of its
trading to the broker-dealer of its parent bank and each company uses the parent bank as
its depositary.

It should be noted that having an asset-management company and a depositary in the
same banking group is a common feature of universal banking systems and is seen widely
in western Europe. This has not been considered to be a serious problem by the legal and
financial community. Throughout Europe, the depositary and asset-management
company are subject to regulation by the securities regulator, as they are in the Czech

14
        EU Commission Recommendation of 27 April 2004 on Some Contents of the Simplified
Prospectus as Provided for in Schedule C of Annex I to Council Directive 85/611/EEC (2004/384/EC)
15
        The governance of banks in the Czech Republic will be covered in a separate study.


                                                 16
Republic by the CSC. In addition, if the depositaries are banks, they are also regulated by
the banking regulator, as they are by the Czech National Bank. Moreover, ―Chinese
walls‖ between the various entities and departments within the entities are also thought to
ensure that potential conflict within such structures are properly regulated without major
problems. Indeed the UCITS Directive has been interpreted in practice to require that
depositaries be separate from the asset-management companies but not necessarily that
they be ―independent‖ from the asset-management company. Nonetheless, concern has
developed at the EU that different countries in the European Union address the issue of
depositaries and asset-management companies in different ways,16 and the EU is moving
to harmonize depositary regulation and operations among its member states.

             Table 3: Czech Investment (Management) Companies - Summary Information
Investment (Management)                Major Shareholders             Depositary         Assets under
Company                                                                                  Management
                                                                                         (CZK millions)
Inv. spol. České spořitelny, a.s.      Česká spořitelna (100%)        Česká spořitelna   49,227
Investiční kapitálová společnost KB,   Komerční banka (100%)          Komerční banka     29,562
a.s.
ČSOB inv. spol., a.s.                  100% control by ČSOB           ČSOB               26,459
                                       group
ŽB - Trust, inv. spol., a.s.           Živnostenská banka (100%)      Živnostenská       6,632
                                                                      banka
ČP Invest inv. spol., a.s.             ČP Finanční holding            Deutsche Bank      3,261
                                       (100%)
Prosperita inv. spol., a.s.            M. Kurka (50%)                 ČSOB               752
                                       M. Kurka (50%)
AKRO inv. spol., a.s.                  n.a.                           Commerzbank        270
InvestAGe, inv. spol., a.s.            J&T Banka, a.s. (100%)         Komerční banka     146
MAPIS, inv. spol., a.s.                Proxy Finance, a.s. (100%)     Komerční banka     142
Pioneer česká inv. spol., a.s.         Pioneer International Corp     ČSOB               57
                                       (100%)
Citicorp, inv. spol., a.s.             Citibank Overseas              Citibank, a.s.     n.a.
                                       Investment Corp (100%)
Credit Suisse Asset Management         CS Asset Management            HVB Bank           n.a.
inv. spol., a.s.                       Holding Europe (100%)
Inv. spol. Jupiter Invest, a.s.        Epic Securities, a.s. (100%)   Citibank, a.s.     n.a.
J&T Asset Management, inv. spol.,      J&T Banka, a.s. (100%)         Komerční banka     n.a.
a.s.
Total                                                                                    116,508


16
          See for example, the March 2004 EC Communication regarding Regulation of UCITS depositaries
in the Member States: review and possible developments. A copy can be found at
http://europa.eu.int/comm/internal_market/en/finances/mobil/ucits/docs/com-2004-207/com-2004-
207_en.pdf


                                                    17
Source: Czech Securities Commission (www.sec.cz); Union of Czech Investment Companies of the Czech Republic
(www.uniscr.cz.)‖Inv. Spol‖. refers to investiční společnost. All data are for 2002.

Nevertheless, as the IOSCO principles concerning collective investment funds also
recognize, the independence of depositaries from their client asset- management
companies is an important factor in determining the level of investor protection, in
particular in emerging markets. For example, in the private pension fund sector,
independent depositaries are commonly used and the requirement for a depositary is
included in the OECD principles on private pension fund governance. The role of the
depositary is critical in ensuring good corporate governance of pension funds. It is the
depositary that provides an independent check on the net asset value (NAV) calculation
of the asset management company. Indeed, in the Czech private pension funds, which
provide a ―Third Pillar‖ for the pension system, asset-management companies are obliged
to use independent bank depositaries.

Segregation of Assets

One of the primary concerns in the area of conflicts of interest between an asset-
management company, a depositary and the unit-holders is the segregation of the assets
of the fund from those of the management company and the depositary. Fund assets
should be physically or legally separated from the assets of the asset management
company or the depositary. However, under Czech law, legal title to the securities in a
unit trust is held by the investment (management) company. Dematerialized securities are
held at the Securities Center17 where separate accounts are set up for each unit trust to
hold all dematerialized securities in the portfolio of the trust. A list of investors in each
unit trust is also maintained by the Securities Center. Nonetheless, title is held by and the
accounts are held in the name of each investment (management) company with only a
notational reference to the applicable unit trust.

This system creates some risk for depositaries. Under the old law, the securities of a unit
trust held by the Securities Center could be pledged or used as collateral for a bank loan
by the investment (management) company managing the trust without the knowledge of
the depositary. In such a case, the depositary would be legally responsible for such
conduct regarding the securities in the unit trust, even though the depositary lacked the
authority to implement the necessary ―control‖. The new Law on Collective Investments
attempts in part to address this issue of insufficient authority of depositaries to ―control‖
the assets under their care. The new legislation requires the depositary to approve all
transactions before final settlement and delivery of the securities (referred to as ex ante
approval).

As to physical assets, under the old law, the bank depositary could have acted as
custodian for the physical assets held by a unit trust . If it did, the assets were required to

17
         Clearing and settlement services are provided by Univyc, a subsidiary of the Prague Stock
Exchange, and share registration is maintained by the Prague Securities Center, which is a ―contributory
organization‖ of the Ministry of Finance. The MOF has the authority to appoint the Director of the
Securities Center. While the Securities Center is administratively part of the MOF, the supervision of the
Center is carried out by the Czech Securities Commission.


                                                            18
be kept in a segregated account. Under the new Law, the investment (management)
company must turn over to the depositary all assets for custody or other safekeeping.
These assets must be kept in accounts separate from the depositary’s own accounts.

The fact that the investment (management) company has title to the assets appears to give
it the power to direct the Securities Center to transfer assets from the accounts of the unit
trusts into the management company’s own accounts, or otherwise dispose of them, prior
to notification to the depositary. However, the mission found that the legal and financial
community was unanimous in its view that the assets were safe from misuse by the
investment (management) company; that the notification and approval procedures to the
depositary under the new law were adequate; and that, under the new law, the assets were
clearly the property of the investors. The local community also confirmed that the assets
are not part of the property of the investment (management) company or the depositary;
nor would they be part of the bankruptcy estate of the investment (management)
company or depositary.

Moreover, the new Law on Collective Investments holds the depositary responsible for
the custody or safekeeping of the assets of unit trusts and corporate investment funds and
if that safekeeping were breached, the depositary would be liable. Further, the new Law
on Capital Market Undertakings provides for the creation of a Central Depository of
Securities to take the place of the Securities Center. The Central Depository is not yet
operational and thus it is not clear what its procedures will be. Nonetheless, it may
provide for more extensive notification and authority to the depositary of an corporate
investment fund and unit trust. It would also be helpful if the legislation could clarify that
assets of unit trusts should be legally segregated from those of the fund manager, in
addition to their physical segregation or book-entry segregation at the Securities Center.

Supervisory Boards
The potential for conflicts of interest between an investment management company or
corporate investment fund and a depositary in the same banking group also highlights the
need for well-functioning supervisory boards of investment (management) companies
and corporate investment funds. The Czech Republic relies on a dual-board structure
commonly found in corporate legislation based on the German law. The dual-board
structure places primary responsibilities with the company’s management board.
However, even in Germany, shareholders associations such as DSW (Deutsche
Schutzvereinigung fur Wertpapierbesitz) have emphasized the need for a strong strategic
and supervisory role to be played by the company’s supervisory board.18

The issue is important. Modern corporations, both in America and Europe, are
accountable to a myriad of stakeholders, covering not only shareholders but diverse
groups such an environmental and human rights non-government organizations (NGOs.)
A modern corporation must find the most appropriate balance between short-term profit
objectives and its medium-term obligations for corporate social responsibility.
18
        Information on other European Shareholders’ Associations can be found on the website of
Euroshareholders at http://www.wfic.org/esh/.


                                                  19
Determination of the appropriate balance falls to the supervisory board, which should set
the tone for the company’s business culture and corporate ethics and thus leave the day-
to-day running of the company to the management board. At its core, corporate
governance concerns two issues: transparency and accountability. While the management
board plays an important role in achieving transparency and accountability, ultimately it
is the responsibility of a company’s supervisory board to ensure that both are achieved.

The Czech Commercial Code provides some guidance for corporate supervisory boards.
However the fiduciary duties of board members—both of supervisory and management
boards—is generally defined as the requirements that they conduct their duties with due
care, due diligence and in the best interests of the company. The Czech Commercial Code
includes the requirements for due care and due diligence but fails to adequately specify
the duty of loyalty—that the board members should conduct their activities in the
company’s interests.

Similarly in the old Czech legislation, the fiduciary duties of ―senior officers‖ (who are
by definition members of the management board) sets a higher standard than for other
corporations. Senior officers must meet the test of ―professional care‖ suitable for
financial intermediaries and other institutions active in the financial sector. However,
under the new Law on Collective Investments, members of supervisory boards are not
defined as ―senior officers‖ and thus are not covered by the regulatory system that applies
to members of the management board or other ―senior officers.‖ Therefore, although they
should be responsible for ensuring that the investment (management) companies or
corporate investment funds maintain systems of risk management and internal controls
that fully protect investors’ interests,19 there is no specific obligation to do so.

The new legislation requires that investment (management) companies and corporate
investment funds place the interests of investors in priority ahead of its own interests.
However, it may be helpful to require that investment (management) companies and
corporate investment funds act ―honestly and fairly‖ (as specified in the most recent
UCITS Directive)20 in the interests of both the collective investment funds they manages
and the integrity of the market. Investment (management) companies and corporate
investment funds should also be obliged to actively take measures to avoid conflicts of
interest. When such conflicts cannot be avoided, the investment managers should ensure
that the collective investment funds are treated fairly.

In addition to the rules of conduct provisions for investment (management) companies
and corporate investment funds, it is important that the supervisory authorities be
satisfied with the business reputation and professional experience of the directors of the
investment management company, corporate investment fund and depositary (as well as
those of significant shareholders in any of these entities.) The new legislation provides
for substantive discussion of such ―fit and proper‖ rules, but they only apply to senior

19
          To ensure that the compliance officer (or compliance unit) is fully effective, it is recommended
that the officer (or the unit) report to both the management and the supervisory boards of the AMC.
20
          See Article 5h of EU Directive 2001/107/EC for further detail on rules of conduct for management
companies of UCITS funds.


                                                   20
officers and individuals holding over 10 percent of the stock of the corporate investment
fund or investment (management) company (or an interest that is deemed controlling.)
They do not apply to members of the supervisory board. Such ―fit and proper‖ rules are
important in ensuring that the Czech collective investment fund sector includes reputable
officials not only as key officers and management directors, but also as members of the
supervisory board.21

To supplement the legislative provisions, it would be helpful if a corporate governance
code could be developed for collective investment fund managers and other institutional
investors, such as private pension funds. The general corporate governance code for listed
companies in the Czech Republic was developed in 2001, with the assistance of an
advisor from the U.K. Know-How Fund. The code is currently in the process of being
updated but has not been adopted as part of the listing standards of the Prague Stock
Exchange. However, even if a general corporate governance code were adopted in the
near future, it would still be helpful if a special code could be prepared for the collective
investment funds sector with possible application to private pension funds. The mission
was informed that discussions and preparation for such a special code are already
underway.

With or without a corporate governance code, serious consideration should also be given
to including other provisions that would strengthen the role of supervisory boards of
investment (management) companies and corporate investment funds in protecting
minority shareholders’ interests. One key way would to establish a minimum number of
non-executive and independent directors on their supervisory boards.

Risk Management, Internal Controls & Financial Reporting
As noted above, the close ownership ties between investment (management) companiesor
corporate investment funds and depositaries highlight the importance of robust systems
of risk management, including internal controls. A risk management system should
include three key elements:

     1) An appropriate supervisory structure,
     2) A strong set of internal controls, and
     3) An established process for approving new investment strategies and instruments.

In collective investment funds, it is clear that internal controls must be established and
maintained for accounting, NAV calculation, customer records, segregation of assets and
regulatory compliance. A compliance officer has been found to be one of the best
institutions for achieving this. In addition, the risk management system should include
detailed provisions on internal controls to protect investors’ interests and ensure that
investment policies set forth in the prospectus are followed and that trading and

21
         This is less of an issue for depositaries as only licensed banks can be depositaries, and there are
adequate fit and proper tests for bank managers in place (even though there are weaknesses in the
supervisory board oversight exercised over bank management, as documented in the forthcoming separate
assessment of corporate governance of banks.)


                                                     21
investment strategies do not entail risks beyond those disclosed in the prospectus. While
asset segregation is in practice ensured through the mandatory use of the central
securities registry, until very recently there were no regulatory requirements for
investment (management) companies and corporate investment funds to maintain
adequate internal controls.

The supervisory structure might include a designated senior officer in the investment
(management) company or corporate investment fund who maintains a significant level
of independence from the officers who make the investment decisions. The senior officer
should regularly report to the supervisory board of the investment (management)
company or the corporate investment fund on the fund investments and exposures and
ensure that the information is provided to the board in a complete and readily
understandable way so that the board can make informed decisions.

The system of internal controls used by each investment (management) company and
corporate investment fund will depend on the degree of complexity and sophistication of
the investment strategies to be implemented. However, one key issue is the need for
functional segregation between the individuals responsible for entering into the
investment transactions and those responsible for the ―back-office‖ operations, that is,
processing the transactions, calculating exposure, monitoring risk, performing
reconciliations (and correcting errors) and reporting the transactions. In particular, the
system of internal controls should include rules to track personal investment transactions
by employees and officers of investment (management) companies and corporate
investment funds to ensure that all such transactions can be monitored and reconstructed,
if necessary. Focus should also be placed on the depositary banks’ information
technology systems to eliminate the operational risk of losing data due to poorly planned
computer systems. The framework for internal controls should also ensure that the prices
for transactions are verified independently of those who are responsible for trade
execution. Alternatively, the calculations should be regularly verified by the internal
audit department of the investment (management) company or corporate investment fund.
Where investments are made in complex or sophisticated derivative instruments, the
investment manager should also conduct stress testing and scenario analysis so that the
consequences of extreme market shocks can be measured against the current market, thus
providing a benchmark for measurement of unusual risks.

The system of risk management should furthermore provide for a process by which new
investment instruments or strategies are evaluated and approved. The approval process
should establish appropriate parameters, controls and limits to ensure that the risks are
well-understood and fall within the fund’s accepted level of risk tolerance.22

The new Law on Collective Investments requires a corporate investment fund and
investment (management) company to adopt a system of internal controls pursuant to the
decrees issued by the CSC. The CSC issued a regulation on business execution and
internal controls for investment (management) companies and corporate investment funds

22
         See also Risk Management Process:Guidelines for UCITS Managers, which can be found at
http://www.foa.co.uk/publications/riskmanpro.pdf


                                                22
in May 2004 (Regulation No. 347 ―On the manner of complying with the rules for careful
execution of business and the rules for the organization of the internal operations of
investment companies and investment funds‖.) Moreover, some provisions have already
been put in place to ensure external review of the internal control systems of investment
(management) companies. For example, the legislation requires that each unit trust
maintain its own financial statements (even though the funds are not ―legal entities‖ but
only tax-paying units.) Furthermore, the financial statements must be audited by an
independent auditor and Czech practice is for the auditor to complete a review of the
internal controls and financial statements of each of the unit trusts. In addition, both the
Czech National Bank, as supervisor for the banking sector, and the CSC, as regulator for
the capital markets, conduct onsite and offsite inspections of the bank depositaries and
their inspections include reviews of the depositaries’ internal control procedures. The
CSC also conducts its own onsite and offsite inspections of the collective investment
funds.

Nevertheless, the UCITS Directive requires the CSC to introduce an explicit requirement
for investment (management) companies to establish and maintain adequate risk
management systems. However, the Decree of May 5th, 2004, on the Method for
Fulfilling the Rules of Cautious Business Practice only deals with this issue indirectly. It
should set out the requirement in a separate section in detail, including an explanation of
how to calculate the risk. The EU Recommendation on the Use of Financial Derivative
Instruments for UCITS23 would provide a good basis for preparing a methodology to
measure risk and establishing the obligation to disclose risk measurements. This will
become all the more important when the volume of assets under management grows and
the use of more complex fund of funds structures intensifies, especially for smaller
locally owned investment managers. Explicitly requiring the use of a modern risk
management system will also serve to set a standard for the pension fund management
companies, which hitherto are under a much weaker regulatory structure.

Regulation of Abusive Practices

Legislation for collective investments should provide detailed guidance to prohibit certain
common practices through which an investment (management) company or corporate
investment fund can conduct its activities in the interest of its management —or its board
members—rather than in the interest of the investors. Related-party transactions
constitute the single most abused area with respect to conflicts of interest and investors in
collective investment funds are concerned about potential conflicts of interest between
those individuals and entities managing the collective investment fund and the companies
in which the fund makes equity investments. Each type of related party transaction, can
be regulated in a different manner so as to balance the protection of investors against the
benefits to investors that can come from some related-party transactions. As shown in
Table 4, different types of related-party transactions can be regulated in different ways.

                               Table 4: Related Party Transactions

23
        EU Commission Recommendation of 27 April 2004 on the Use of Financial Derivative
Instruments for UCITS (2004/383/EC)


                                                23
Type of Related Party Transaction                        Method of Regulation
Fraud                                                    Absolute prohibition
      Front-running.
      Preferential sale of fund units to insiders or
          favored customers.
      Sale or purchase of fund assets to insiders
          or affiliated entities as non-market based
          prices.
Sales to and Purchases from Insiders and affiliated               Full Disclosure and approval by Board of
entities.                                                Directors.
                                                                  Requirement of arms-length transaction
                                                         and independent appraisal.
                                                                  Approval by shareholders or units holders
                                                         for transactions over 10% of assets.
Market Timing.                                                    Strict pricing measures.
                                                                  Exit fees for short-term holders.
Dealings with Affiliated Entities such as Brokers.                Full Disclosure of Fees and approval by
                                                         Board of Directors.
                                                                  Disclosure of non-monetary compensation
                                                         such as ―soft-dollar‖ commissions.
Source: World Bank


The investor should have the opportunity to review all related-party transactions to see if,
in her or his view, the transactions constitute an important risk for the investment
portfolio. Still more importantly, investors should be informed of the safeguards which
the fund manager has taken to avoid such conflicts. Investors should be advised of the
investment manager’s policies and practices concerning how the manager’s ―Chinese
walls‖ effectively protect the interests of the investor.

In addition, the law should provide for sanctions against individuals who engage in
fraudulent activity in relation to a collective investment fund. Common practices that
could damage the investor’s interest include ―front-running,‖ where an asset-management
company or insiders buy or sell securities in advance of purchases or sales by the
collective investment fund, thus profiting from the price movements caused by the fund’s
transactions. The investor should be able to be confident that his asset-management
company has internal controls in place to prevent the use the information to the advantage
of the management company or its officers, directors or employees. Also the law (or
other regulations) should provide specific guidance to asset-management companies on
the need to avoid preferential allocation of shares to investors, depending on their
relationship with the asset-management company.

In the prohibition against related-party transactions, the new Law on Collective
Investments is unfortunately weaker than the previous legislation. The new Law on
Collective Investments prohibits abuses only by the investment (management) company,
the corporate investment fund and the senior officers of each. However, it is often the
supervisory board members or others with indirect control over these entities that commit
governance abuses. In addition, employees also engage in abusive practices, such as
front-running. The legislation should cast a wide net to prohibit all types of abusive
related-party transactions. The CSC has attempted to correct this with the provisions of
Decree of May 5th, 2004, On the method of fulfilling the rules of cautious business


                                                        24
practices. An investment (management) company or corporate investment fund is
required to establish provisions regulating related-party transactions in its internal
regulations. Nonetheless, there does not appear to be any sanction against an individual
for violating the internal regulations, other than dismissal by the investment
(management) company or corporate investment fund. The regulations in the Decree of
May 5th will have no serious effect unless they are backed up by the possible of severe
sanctions for their breach.

Authority of the Czech Securities Commission (CSC)
In many ways, the CSC has substantial authority. The CSC has the power to levy sizeable
fines of up to CZK 100 million (approximately US$4 million.) The fines can be imposed
directly by the CSC without requiring that the court imposes the fines. Similarly, the CSC
can ban investment (management) company board members and controlling shareholders,
if the CSC views the proposed board member ―is prevented from proper discharge of the
office by some other activity‖ or an investor as not being suitable for the ―sound and
prudent management‖ of the corporate investment fund or investment (management)
company’s transparent and credible activity, or if the ―interconnection of the applicant
with the investment (management) company or corporate investment fund would impede
effective performance of supervision.‖

However, on one key issue, the CSC is lacking in authority. The CSC does not have full
authority to directly issue its own regulations providing the necessary guidance for the
capital markets. As a result, much of the secondary legislation needed to ensure good
corporate governance in the capital markets—and the collective investment fund sector—
is missing, such as the ability to regulate sales practices and fee determination practices
and disclosures. In addition, the CSC should be able to issue regulations providing
guidance on the methods by which investment (management) companies and corporate
investment funds should vote at the shareholders’ meetings of companies they are
invested in. The new Laws on Capital Market Undertakings and Collective Investments
give the CSC some of the requisite authority, however, they do not go far enough.
Another important area in which the CSC needs additional authority is in ensuring
accurate and reliable financial reporting of the collective investment funds. While the
Ministry of Finance (or eventually a new Accounting Standards Board to be created) sets
the accounting rules for collective investment funds, at the moment neither the Ministry
nor the CSC has explicit legal authority to ensure adequate enforcement of such rules.
Legal changes to the Accounting Law and the Law on Collective Investments are needed
to give the CSC the requisite authority in this respect (e.g., covering issues such as access
to external auditors’ working papers, ability to impose meaningful penalties for
infractions and authority to request correction of erroneous financial statements and/or
audit reports.) Additionally, sufficient resources should be set aside to ensure that the
CSC quickly builds up the capacity to effectively undertake the enforcement function.
This will be particularly important once the use of International Financial Reporting
Standards, as appropriate, are required for collective investment funds.
In addition, membership of the European Union has brought the Czech Republic under
the EU’s ―single passport‖ rules under which the home country supervisor of a UCITS


                                             25
fund selling units in the Czech Republic will be responsible for supervision and
regulation of the fund, rather than the host country supervisor (e.g., the CSC).
Nonetheless, the CSC will be responsible for the regulation of the offer and sale of these
foreign funds to investors in the Czech Republic. The CSC will need to develop a set of
rules for the regulation of the marketing of these funds. Also, it will be important for the
CSC to maintain close co-operation with foreign supervisory authorities in order to
properly oversee non-domestic funds and fund operators.

Learning from the experience of the US mutual funds industry which has recently been
plagued by a wave of scandals and abuses, it may also be helpful for the CSC to establish
a special department to monitor risks in the areas that it regulates, including fund
practices, such as the Office of Risk Assessment and Strategic Planning of the US SEC.
The Office is specifically responsible for assessment of developments in the market in
general and anticipating potential problems in the US mutual fund sector, among other
areas.

Regulations for Special Funds
The new Law on Collective Investments has created two types of funds: (1) UCITS-type
funds where moneys are invested in transferable securities in accordance with the UCITS
Directive applicable in the European Union and (2) ―special funds‖ that would be outside
the remit of the UCITS-based regulations. In light of the limited liquidity of the Czech
capital markets, where most trading is concentrated in as few as three companies and
trading margins are thin, the strong interest of investment managerslies with creating
special funds. The mission found that both Czech and foreign investment managers were
planning to offer special funds, once the requisite legislation has been approved. Since
the funds would be outside the UCITS-based restrictions, the special funds would allow
investment managers to offer pooled investments in illiquid and sometimes speculative
securities and assets, such as real estate and exchange-traded and OTC derivatives that
are not purchased for hedging purposes. The special funds would allow high levels of risk
with commensurate levels of reward. In other countries, notably Australia, property funds
have been the subject of corporate governance abuses (where the fund manager was able
to ―dump‖ investments in illiquid properties into the fund.) Special care needs to be taken
before allowing the public the opportunity to invest in any collective investment funds
invested in real estate. Although a decree has been issued on the valuation of assets,
including those of a special fund, it is not detailed enough, particularly in the areas of
valuation of financial and commodity derivatives, especially if they are OTC in character.
Moreover, the marketing regulations for such funds are critical to ensuring investor
protection, but, as previously stated, the CSC does not have the authority to issue such
regulations.

At the same time, not all issues have been resolved regarding the old legislation. The old
Law on Investment Companies and Investment Funds required that all existing funds,
including the former voucher privatization funds, converted their structure from joint
stock companies (as was permitted under the former legislation) to open-ended mutual
trusts, which are regulated by contracts between unit holders and the investment


                                             26
(management )companies and have no status as legal entity. The mission was advised that
at least one, and perhaps two, of the former voucher privatization funds have not been
converted into the requisite fund structure due to ongoing litigation in which minority
shareholders of the privatization fund joint stock company have argued that their interests
will be damaged by the transformation of the fund’s legal structure. The lack of
resolution of such legal issues from the past privatization program will likely create some
investor uncertainty over the new funds, particularly special funds for which the detailed
regulations are still being developed.




                                            27
                                                                                                    ANNEX

Detailed Assessment of the Corporate Governance Framework for Collective
Investment Undertakings in the Czech Republic: A Comparison of Rules and
Practices Against Proposed Best Practice Benchmarks.24

GOVERNANCE OF COLLECTIVE INVESTMENT UNDERTAKINGS (CIUs)
BOARD OF DIRECTORS
The legal and regulatory regime should designate an entity that is accountable to the investor and to the
supervisory authority. The entity should be responsible for assuring that investor rights are respected and
act as the entity against whom redress for violation of investors’ rights may be sought.

Within a corporate structure, the management board should be responsible for the policy formulation,
implementation and performance of the corporate CIU and asset management companies. In its general
activities, the management board should oversee the preparation of the prospectus, annual reports and
implementation of investment policy. It should also oversee the risk management system, internal controls
and compliance functions of the corporate CIU and asset-management company. In addition the
management board should be responsible for the formulation and implementation of a code of ethics for
its officers, management, employees, and external advisors.

The supervising board–be it a ―supervisory board‖ under a dual board structure or a ―board of directors‖
under a unitary board structure—should operate independently of the management board. Depending on
the structure of governance of the collective investment schemes concerned, this may be achieved through
appointment of independent directors and/or audit committees.
Description         In its provisions relating to corporations, the Commercial Code provides for the
                    creation of a board of directors (management board) to act as the primary managerial
                    unit of the corporation and a supervisory board to act as a control entity for the benefit
                    of the corporation as a whole.

                    Under the Commercial Code, these entities are charged with conducting their affairs
                    with prudent care. The Law on Investment Companies and Investment Funds, No.
                    248/1992 has additional qualifications for members of the two boards. In order to
                    obtain a license as a corporate investment fund or investment (management) company,
                    a corporation must obtain approval from the CSC. The CSC as part of that review
                    approves the members of the board of directors (management board) and supervisory
                    board pursuant to a methodology that it has issued.

24
          Following international practice, the benchmarks use the EU terminology, rather than the Czech
terminology. As a result, they refer to ―collective investment undertakings‖ (CIUs) which are the entities
participating in the collective investment fund sector. Under international practice, a CIU generally has one
of the following legal forms: (1) a ―contract-based fund‖ which does not have a legal personality and is
organized and managed by a―management company‖, (2) an ―investment company‖ which is a fund in
corporate form, which may be self-managed or managed by amanagement company, or (3) a ―unit trust‖
organized under the common law in which the asset management role is carried out by the trustee of the
trust.

However, when the discussion deals with Czech organizations, it will use Czech terminology without
modification. Under the Czech terminology, a CIU may be: (1) an ―investment fund‖, which is a CIU in
corporate form, or (2) a ―unit trust‖ (its name under the new Law on Investment Funds. An ―investment
company,‖ is an asset management company that manages a contractual fund or an investment fund as
defined above. A ―depositary‖ is the entity responsible for the safe keeping of the assets if the investment
fund or unit trust.


                                                      28
             In order to reinforce the independence of the board members, Section 29 provides for
             specific incompatibilities which would render an individual unqualified to be a
             member of the board of directors (management board) or supervisory board, such as
             government service, or a position on the board of another corporate investment fund or
             investment (management) company, broker-dealer or the depositary of the investment
             (management) company or corporate investment fund.

             Section 73 of the new Law on Collective Investments carries over the
             incompatibilities for membership on the management boards which are in the Law on
             Investment Companies and Investment Funds, No. 248/1992, but does not extend the
             incompatibilities to the Board of Supervisors. In addition, the CSC will continue to
             use its methodology for determining the qualifications of members of the management
             board. Under the new Law on Collective Investments, this will be extended to all
             ―senior officers‖ of the investment (management) company or corporate investment
             fund.

             In the new Law on Collective Investments, the duty of professional care in Section 75
             extends the duty to the senior officers of the corporate investment fund or investment
             (management) company and thus to the management board of both. The duty of
             professional care is not well defined in the new Law on Collective Investments, nor
             are the specific provisions related to the duty of loyalty which set forth what is and is
             not permitted for the members of the management board and other senior officers
             when dealing with the corporate investment fund, investment (management) company
             or unit trust.
Comments     The Commercial Code and the Law on Investment Companies and Investment Funds,
             No. 248/1992 give ultimate responsibility for the management of a corporate
             investment fund and investment (management) company to the board of directors
             (management board), however the duties of professional care and loyalty are not well
             defined in the old or new Law on Collective Investments. The law needs to develop
             these concepts so that they can be properly enforced.

             Similarly, there are only weak sanctions in the new Law on Collective Investments for
             violations of the duty of professional care by members of the management board.
             There is possible civil liability, but the only regulatory sanction would be a fine of up
             to CZK 5,000,000 (approximately US$200,000 equivalent.) The sanctions should be
             increased in scope, including a warning, suspension from office and removal from
             office in order to give more weight and authority to the regulatory structure.

             The members of the Supervisory Board should be approved by the CSC before taking
             office. The members of the Supervisory Board should also be independent of the
             corporate investment fund, the investment (management) company and the depositary.
             This should be explicitly set out in the new Law on Collective Investments.
CONFLICTS OF INTEREST




                                              29
The asset-management company and its owners, directors, officers and managers should manage a
corporate CIU or contract based investment fund exclusively for the benefit of the investors in the
corporate CIU or contract-based investment fund. The corporate CIU and contract-based investment fund
should not be used to generate business for related financial firms, provide funding for non-financial
companies or otherwise generate benefits for the asset management companies or affiliated parties unless
such action is in the interest of investors. The asset-management company should be legally obliged to: (i)
act in the sole interest of investors in the corporate CIU or contract based investment fund and (ii) treat all
investors equally. In the asset-management company, both the legal entity and the individual members of
the management board and supervisory board should be held accountable for acting against the best
interests of the corporate CIU and the investors in contract-based investment funds.
Description         Under Section 5a(3) of the Law on Investment Companies and Investment Funds, No.
                    248/1992, the investment (management) company and corporate investment fund have
                    a general duty to prefer the interests of the investors over rheir own interests and the
                    interests of their employees, executive management, board of directors and
                    supervisory board.

                    Section 24a(3) of Law on Investment Companies and Investment Funds, No. 248/1992
                    provides for a prohibition against transactions, both buying and selling between a
                    corporate investment fund and unit trust and parties that are related to them (such as
                    management and supervisory boards, managers and employees of the corporate
                    investment fund or investment (management) company.)

                    In addition, the old law requires a corporate investment fund and investment
                    (management) company and the persons carrying out its activity to act honestly and
                    not manipulate the market, misuse confidential information or disseminate false
                    rumors.

                    To further insure the lack of conflicts of interest, the Law on Investment Companies
                    and Investment Funds, No. 248/1992 provides in Section 14 that the entity conducting
                    transactions for a corporate investment fund and unit trust must be independent from
                    them, with the exception of the depositary which can carry out transactions for the
                    fund.

                    However, notwithstanding the provisions against the abuse of trust from conflicts of
                    interest, there are no sanctions against individual persons acting on behalf of the
                    corporate investment fund or investment (management) company. Under the old Law,
                    the corporate investment fund, investment (management) company or depositary can
                    be directed to correct its activity, lose its license, or be fined up to CZK 100 million
                    (approximately US$4 million equivalent.)

                    Under the new Law on Collective Investments, the ethical duties in Article 75 include
                    the same general duties of putting the client first and prohibition against engaging in
                    market manipulation, misusing confidential information and making
                    misrepresentations. However, the new law does not explicitly prohibit some of the
                    most common conflict issues in CIUs such as front-running the trades or market
                    timing of an investment company or unit trust. Nor does the new law provide for a
                    general requirement to avoid conflicts of interest. Nor are there provisions to require
                    special approval (by for example, the supervisory board of the corporate investment
                    fund or investment (management) company) for related-party transactions. Finally,
                    only the members of the board of directors, and not other senior officers, employees or
                    members of the supervisory board, are obligated to act with professional care,
                    including the obligation to act in the best interests of the investors.
                    Moreover, Section 75(1)(b) of the new Law on Collective Investments deals with the



                                                      30
                    obligation of the investment company to prefer the interests of the investors over the
                    interests of the investment manager and third parties. However, the supervisory board,
                    management board, other senior officers and employees of the investment manager are
                    not covered by this requirement. Consequently, the prohibition in the new Law on
                    Collective Investments does not clearly require the persons who carry out the activities
                    of the legal entities to put the interests of the investors ahead of their own, while the
                    old law did contain such prohibitions.

                    The new Law on Collective Investments in Article 75(4) carries over the prohibition
                    against brokerage activities on behalf of a corporate investment company or unit trust
                    by parties related to them. In the old law, the sanctions and remedies in the legislation
                    are only applicable against the legal entities of the corporate investment fund,
                    investment (management) company and depositary. In the new Law on Collective
                    Investments, there are only sanctions against the senior officers, and even then the
                    sanction is only a fine.
Comments            The old law was weak in the area of prohibiting and enforcing rules against conflicts
                    of interest and fraud. It provided no real deterrent to individuals for conducting such
                    activity. The new Law on Collective Investments seriously weakens these protections
                    even further, particularly by not prohibiting several critical types of related-party
                    transactions. The new legislation should provide a general requirement that corporate
                    investment funds and investment (management) companies take measures to avoid
                    conflicts of interest. The new decree on business operations and internal controls
                    specifies that fund managers should have rules in place to avoid related-party
                    transactions. However without explicit reference to related-party transactions in the
                    new law, it is not clear that the CSC will have the legal basis to take corrective action
                    in case of violations. Also, the new decree does not come into force until July 1, 2005
                    leaving investors exposed to potential abuses in the mean time.

                    The anti-fraud provisions are too general and not comprehensive enough in light of the
                    types of violations that have come to light over the last several years, such as market
                    timing by outside clients, market timing by officers, directors and employees, and
                    front running by investment managers or their directors, officers and employees.

                    Moreover, the exemption in the new Law on Collective Investments that the
                    investment (management) company can use the depositary to broker transactions of a
                    unit trust or corporate investment fund would appear to be in violation, at the least, of
                    the spirit of the prohibition against related party brokerage transactions. It is difficult
                    to see how the depositary can fairly evaluate the fees and commissions charged to
                    these entities, if it receives the benefit of those fees and commissions directly or
                    indirectly. At the least, the CSC should have a strict rule that a broker must always
                    obtain the best execution of a transaction for a client collective investment
                    undertaking.
INVESTORS’ PARTICIPATION IN GOVERNANCE
Investors should be able to assert their interests by either participating in the governance of a corporate
CIU or relying on vigilant efforts of the supervisory authority and the depositary for collective
investments organized as funds based on contracts or common law of trusts.
Description         Section 7(6) of the old law provides that corporate investment funds can only issue
                    shares with one nominal value and are prohibited from issuing preferential or
                    employee shares. The articles of association of the fund cannot restrict the
                    transferability of the shares. Investors in corporate investment funds are traditional
                    shareholders and have the rights and powers granted to shareholders of joint stock
                    companies under the Commercial Code. As such, they can change management at the
                    annual general meeting. They can call special meetings to consider changes in



                                                      31
           investment policy or of the depositary or investment (management) company which
           manages the assets of the corporate investment fund (if any.) Such changes would
           require the approval of the CSC.

           Investors in a unit trust, the contractual type of CIU which has no legal personality, do
           not have any rights over governance of the trust. All management authority is vested
           in the investment (management) company which manages the assets of the trust. Unit
           holders also do not have authority to force a change in the investment (management)
           company or depositary if they are unsatisfied with the activities of either. Only the
           investment (management) company or the CSC can make or require such changes.
           Consequently, unit holders in unit trusts rely almost entirely on external governance
           structures to protect their interests. One unit trust in the Czech Republic does have an
           investors committee; however, it has no authority to influence the decisions of the
           trust. The committee merely monitors the activity in the trust, advises unit holders on
           the status of the trust and communicates unit holder attitudes and concerns regarding
           the operation of the unit trust to the investment (management) company.

           The new Law on Collective Investments retains the basic characteristics of the
           corporate investment fund and the unit trust structures for CIUs in the Czech Republic.
           Shareholders/investors in collective investment funds have the same rights as under
           the old legislation.
           Holders of units of participation in unit trusts do not have any authority over the
           operation of the unit trust. Under Section 7, a unit holder cannot request a distribution
           or the winding up of a unit trust. Moreover, an investment (management) company
           can transfer a unit trust to another investment (management) company without
           approval and permission of unit holders; only CSC permission is needed for such a
           transfer.

           In addition, the depositary has the responsibility to monitor and control the activity of
           the investment (management) company and its unit trusts for the benefit of the
           investors. In the event of misconduct (and a failure to take corrective action) by the
           investment (management) company or in the event of egregious violations, the
           depositary shall notify the CSC, which may suspend redemption of units and
           transactions in the unit trust’s portfolio.

           Notwithstanding the above, Section 84 of the new Law on Collective Investments
           permits a meeting of the unit holders for the purpose of changing the prospectus
           (―statute‖) of the unit trust, although the creation of such a unit holder meeting is not
           mandatory. This is an odd anomaly in the new law, but does not seem to give unit
           holders any significant rights unless the statute of the unit trust provides for the
           creation of the meeting.
Comments   In corporate investment funds, the shareholders/investors have parity with
           shareholders in other corporations in terms of their right to assert their interests as
           shareholders. To a certain extent their rights are better protected, since the corporate
           investment funds cannot issue different classes of shares which would dilute the
           interests of the shareholders.

           On the other hand, investors in units of a unit trust do not have such rights to assert
           their interests. They rely on the CSC to approve the shareholders and management of
           the investment (management) company that manages the unit trust. The CSC also
           approves the initial ―statute‖ (prospectus) of the unit trust. Under the new Law on
           Collective Investments, even though the articles of the unit trust can permit the
           creation of a committee of unit holders to review changes in the statute, the review is



                                             32
                    not mandatory and it is unclear how many unit trusts will have such a committee.
CIU MANAGMENT & ADMINISTRATION
PORTFOLIO MANAGEMENT
The asset-management company (AMC) of a CIU should manage the CIU with a high level of
professional competence. The AMC should establish an investment policy and describe the characteristics
of the policy and its execution strategy. It should also develop procedures for portfolio management
covering at least three areas: (i) risk management, including prudent investor rules, (ii) net asset valuation
and procedures for correction of errors, and (iii) best trade execution to achieve efficient portfolio
operations. In addition, the management company should maintain a minimum capability to conduct
research or evaluate outside research.
Description          Section 17a of the old Law on Investment Companies and Investment Funds, No.
                     248/1992 requires that a corporate investment fund and investment (management)
                     company and the persons conducting its activity exercise expert care in the conduct of
                     the corporate investment fund and unit trust’s activity. This includes expertly
                     analyzing the advantages of investments and trading, obtaining best execution for
                     transactions for the collective investment funds and keeping adequate records of such
                     activity. Expert care also includes the avoidance of some conflicts of interest
                     discussed in more detail above. There are no rules requiring the establishment of
                     investment committees. However, discussions with members of the industry have
                     indicated that, in the Czech Republic, this is common practice as it is in Western
                     Europe and the United States.

                    Section 17 of the old law also establishes permitted types of instruments which a
                    corporate investment fund and unit trust can invest in, while Section 24 sets portfolio
                    distribution limits for them.

                    Section 75(1) (a) of the new Law on Collective Investments requires that the
                    investment manager act with ―professional care‖ which carries over the provision in
                    the old law regarding professional competence of asset management companies.

                    Sections 26-35 of the new Law on Collective Investments provide for portfolio
                    distribution limits for standard funds which brings them into conformity with the EU
                    UCITS Directive. Sections 49-57 provide for portfolio limits for special funds,
                    although these are not as rigid as those for standard funds. Under Section 139, the
                    CSC will issue a decree setting forth the prudent use of investments and risk reducing
                    strategies pursuant to Section 27(8.)
Comments            The legislation puts the duty of professional care on the corporate investment fund and
                    investment (management) company and requires them to prefer the interests of
                    investors over their own. The portfolio limits are in line with EU standards and the
                    competence of the management directors are evaluated in advance by the CSC prior to
                    their employment by the corporate investment fund or investment (management)
                    company.

                    However, there appears to be a conscious effort in the proposed legislation to remove
                    liability of individuals who manage or supervise the activities of corporate investment
                    funds and investment (management) companies by reducing their obligations in the
                    law. Moreover, there are no penalties for individuals in the old legislation or the new
                    Law on Collective Investments for violations of the duty to put investors first.

                    Since breaches of duty are most commonly done by individuals for their own benefit,
                    rather than the benefit of the corporate investment fund or investment (management)
                    company, the old legislation was weak and the new legislation is weaker in prohibiting
                    activity by the investment manager against the interests of investors. The recently
                    issued decree on business procedures and internal controls brings in elements of good


                                                      33
                    operational policies and procedures but falls short of introducing a comprehensive risk
                    management system (with the three requisite elements of an appropriate supervisory
                    structure, a robust set of internal controls and an established process for approving
                    new investment strategies and instruments.) The decree allows the internal audit
                    function to be outsourced to the depositary, which would remove a layer of protection
                    for the unit holder in a unit fund structure.
INTERNAL CONTROLS FOR COMPLIANCE WITH LAWS AND REGULATIONS
Each asset-management company (AMC) and self-managed corporate CIU should have written rules and
procedures to conduct its business and monitor compliance with its rules and procedures and regulatory
requirements. They should institute internal policies to assure that actions of their organizations and of
external parties acting as their agents are consistent with relevant laws and regulations, accepted industry
practices and company policies. AMCs and self-managed corporate CIUs should establish an internal
code of ethics for employees, officers, management and directors. As part of the code, they should
establish internal compliance procedures to ensure that the activity of the entities they manage meet with
internal policies and regulatory requirements. An AMC and self-managed corporate CIU should have an
employee designated as the compliance officer to administer the compliance procedures and communicate
with the supervisory authority regarding their compliance activity. This would include preparation of all
regulatory reports and oversight of any outsourced operational activity. The AMC and self-managed
corporate CIU should fully disclose all compliance policies and procedures in their prospectuses.
Description         Section 29a of the Law on Investment Companies and Investment Funds, No.
                    248/1992 requires that a corporate investment fund and an investment (management)
                    company issue compliance procedures to reduce conflicts of interest and the misuse of
                    funds belonging to investors for the benefit of the investment manager and against the
                    interests of investors.

                    Investment managers currently have written internal procedures, but these are not
                    drawn up pursuant to a uniform regulation and vary from company to company. In
                    addition, there is no designated individual with the full responsibilities of Compliance
                    Officer. The various functions of the officer are carried out by a wide range of people.

                    Section 74(3) and 76(4) of the new Law on Collective Investments carries over the
                    obligation of the corporate investment fund and investment (management) company to
                    establish internal compliance procedures. Pursuant to those sections and Section
                    139(h), the CSC shall issue a decree setting forth in detail the requirements for such
                    internal rules and compliance procedures and practices. The CSC issued an elaborate
                    decree on business execution and internal controls for collective investment funds in
                    May 2004, which calls for the creation of a designated compliance officer function.
                    The compliance officer reports to the management board, but also has a limited
                    reporting duty (i.e., related only to the use of non-public information and insider
                    trading activity) under the decree to brief the supervisory board at least once every six
                    months.
Comments            The designation of a compliance officer by collective investment funds has proven to
                    be an extremely effective compliance mechanism and it is commendable that the
                    creation of this position is part of the new decree on internal procedures and
                    compliance matters. However, the decree does not require any disclosure to the public
                    on the role and responsibilities of the compliance officer, neither in the initial offering
                    prospectus nor in interim quarterly or bi-annual disclosures. Also, it is applicable only
                    as of July 1, 2005 – thus its impact will not be felt immediately. It is recommended
                    that the decree be amended to require that the compliance officer reports to both the
                    management and supervisory boards of the corporate investment fund or investment
                    (management) company on the full range of compliance issues and that collective
                    investment funds disclose at least bi-annually to investors the activities and findings of
                    the compliance officer. The applicable legal/regulatory rules on the content of the
                    prospectus should be amended to require inclusion of a description of the fund


                                                      34
                    manager’s compliance policies and procedures.
INTERNAL OPERATIONS CONTROLS
CIUs should have adequate internal control systems to ensure that the CIU can accurately and promptly
determine its financial condition and adherence to its investment policies and internal rules. The role of
the ―back office‖ of a corporate CIU or asset-management company should be to: (i) maintain the internal
control and accounting systems for the corporate CIU and unit trusts, (ii) prepare interim reports, account
for transactions and calculate the internal NAV calculation, and (iii) handle relations with external service
providers and entities to whom the corporate CIU and asset-management company has delegated
operational functions.
Description         Section 29a of the Law on Investment Companies and Investment Funds, No.
                    248/1992 requires a corporate investment fund and an investment (management)
                    company to draft an internal organizational and work directive setting out rules of
                    internal operation, data processing, investor relations and compliance procedures.
                    These operational rules are reviewed by the CSC prior to the approval of the corporate
                    investment fund or investment (management) company to commence operations as
                    part of its review that the entities have the prerequisite equipment and personnel to
                    perform the function of a licensed entity. Failure to create or follow such internal
                    procedures could lead to an order from the CSC to remedy such action or to suspend
                    or withdraw the license for activity. However, the CSC currently has no methodology
                    or benchmarks for approving or evaluating the adequacy of the control structures put
                    in place. Representatives of the collective investment industry in Czech indicated to
                    the mission that all investment managers have such internal procedures and rules of
                    operation in order to carry out their business.

                    Section 74 of the new Law on Collective Investments carries over the obligation of the
                    corporate investment fund and investment (management) company to establish
                    internal rules of operation and audit. Pursuant to Sections 74(3) and 76(4) and Section
                    139(h), the CSC shall issue a decree setting forth in detail the requirements for such
                    internal rules, procedures and practices. The CSC has just issued this decree (May
                    2004).

            The supervisory board of the corporate investment fund or investment (management)
            company has the general responsibility under the Czech Commercial Code of
            controlling the activities of the entities and ensuring that they behave in compliance
            with the law. However, the supervisory board should have even more authority to
            establish and maintain the internal controls of the corporate investment fund or
            investment (management) company in the areas of compliance with the articles of
            incorporation, internal auditing, and risk management of the entities. The current
            structure and future structure provide for internal control mechanisms, but there is no
            governance entity that is responsible for their implementation and operation. The
            supervisory would be the appropriate entity in the Czech legal structure to do this.
            However, the board, as currently composed in many investment managers, is primarily
            staffed with employees and officers of the bank that is the controlling interest in the
            financial group. Their responsibility is not so much to the investors as to the
            controlling financial interests in the group. The supervisory board of the investment
            (management) company or corporate investment fund should be independent of
            management and the owners of the two entities.
Comments    The creation of internal operating rules is standard operating procedure for CIUs in the
            EU and the US and is necessary for the orderly conduct of business for a CIU.
            The members of the supervisory board should be required to be independent of
            management and the controlling financial interest in an investment (management)
            company or corporate investment fund.
RISK MANAGEMENT




                                                     35
CIUs should have dedicated risk management department to evaluate the risks inherent in the investment
policy and portfolio of a CIU. This risk management system must include an ability to evaluate the risks
in OTC and non-exchange traded instruments and assets and provide for strategies to mitigate the risks.
Description         The Decree of May 5th, 2004, the decree indirectly refers to risk management
                    responsibilities but does not directly obligate a CIU to set up a risk management
                    department which has specified risk evaluation processes and which is obligated to
                    report the CIUs situation to the CSC.
Comments            The Decree should be amended to specifically set out the responsibilities and duties of
                    a CIU regarding risk management.
SALES AND DISTRIBUTION
Sales practices should meet the highest standards of integrity. The responsibilities of any parties making
investment recommendations should be explicitly stated. Sales literature and practices and other
advertising materials for a CIU should fairly and accurately describe the activity and financial results of
the CIU, the levels of applicable management fees and how they are calculated. False statements,
incomplete performance records, inadequate risk warnings and other misleading sales practices should be
prohibited.
Description         Section 23 of the Law on Investment Companies and Investment Funds, No. 248/1992
                    prohibits untrue and misleading statements or the concealment of material facts
                    regarding a CIU. In addition, the CSC has issued a methodology setting forth in more
                    detail the obligations for truthful advertising regarding collective investment funds .
                    Also UNIS has issued a set of guidelines for the proper promotion and advertising by
                    investment managers that are members of the UNIS. There is no provision for the
                    regulation of distributors of the units or shares of a corporate investment fund or unit
                    trust that are not registered as a broker dealer.

                    Section 79 of the new Law on Collective Investments provides that all material
                    information must be disclosed to potential investors and all investors must have equal
                    access to such information. Section 80 requires that adequate risk warnings be made in
                    promotional literature and that representations as to performance shall fully and
                    completely describe the performance of the investment manager, standard fund and
                    special fund. Section 81 requires a disclosure of the types of investments made by the
                    CIU and the possibilities of fluctuation in the value of the assets.

                    There is still no provision for the regulation of distributors of the units or shares of a
                    collective investment fundthat is not registered as a broker dealer. Moreover, the CSC
                    is not given the authority in the new law to issue a decree on sales practices.
Comments            The old legislation is deficient in that it does not give authority to the CSC to
                    promulgate a decree establishing a detailed set of rules for the advertising of CIUs in
                    the Czech Republic. Although the CSC has addressed this question, it was only able to
                    do this in the form of a methodology or guideline rather than as a set of regulations
                    that have a set of penalties attached to them for their violation. The provisions in the
                    old law are not specific enough, nor are there penalties for violations of the provisions
                    by individual sales-people.

                    The new Law on Collective Investments also does not give the CSC the authority to
                    issue a decree on sales practices. In addition, it does not have provisions for regulation
                    of sales by entities other than broker dealers or the depositary. Experience in other
                    countries has shown that this is an area where violations can easily occur and such
                    entities should be effectively regulated.

                    In addition, the new Law on Collective Investments does not allow for any sanctions
                    against individuals for improper or fraudulent sales activities, except for requiring
                    their dismissal from the entity they work for. This is not sufficient to ensure honest



                                                      36
                     sales practices. The only sanction that is in the new law is an administrative tort for
                     failure to meet the disclosure requirements in Sections 79 and 81 for the public
                     offering of securities with a penalty of a fine of up to CZK 10,000,000 (approximately
                     US$400,000 equivalent). The CSC should also develop capacity to monitor fee levels
                     and explain to the public how fee levels in the Czech Republic compare to fee levels
                     in other countries.
DISCLOSURE AND TRANSPARENCY
PROSPECTUS
Prospectuses for CIUs should provide all material and relevant information necessary for the investor to
make informed decisions. In particular, the prospectuses should include detailed discussions of: (i) fund
performance standards; (ii) investment policies, (iii) fees, charges and expenses of the AMC, advisor,
broker, and depositary; (iii) risk disclosures, including those related to volatility and foreign exchange;
(iv) information on the custodian and depositary; (v) description of the AMC and its key officers; (iv)
methodology for calculation of asset valuations; (vii) procedures for fund purchases and redemptions;
(viii) relevant financial information; and (ix) description of the rights of investors. In addition to the full
prospectus, a simplified prospectus should be prepared that describes briefly--and in an easily
understandable language--the key features of the CIU.
Description          Section 16 of the Law on Investment Companies and Investment Funds, No. 248/1992
                     sets forth the contents of the prospectus for a corporate investment fund or a unit trust.
                     The objectives, investment policy and management principles must be disclosed. In
                     addition, information on the investment (management) company and depositary must
                     also be provided. The Minister of Finance has issued a decree setting forth the
                     minimum contents of the prospectus.

                     Section 27 of the Law on Investment Companies and Investment Funds, No. 248/1992
                     sets forth the fees that the investment (management company) may charge a corporate
                     investment fund and unit trust. It also states the charges for expenses that the
                     investment (management) company can charge them, such as consulting, promotion
                     and advertising and the research and analysis of the financial market.

                     Section 84 of the new Law on Collective Investments sets forth the requirement for a
                     prospectus (―statute‖ in Czech terminology) and simplified prospectus. Section
                     139(1)(b) requires the CSC to issue a decree on the contents of the statute and
                     simplified statute. The decree has been issued but has not been translated into English
                     as of the date of this report.
Comments             The provisions provide for a general framework for the disclosures in the prospectus
                     of a a corporate investment fund and unit trust.
PERIODIC REPORTS
Annual and interim financial reports should provide investors with a full and fair description of the
financial condition of the investment fund and its performance. A CIU should publish an annual report
regarding its activities that contains an audited financial statement. Semi-annual or quarterly statements
should be published for the benefit of unit and shareholders to keep them up to date on the developments
in the CIU. Annual financial reports should be available within six months after the fiscal year-end25.
Semi-annual and quarterly reports should be available within three months after the end of the period.
Description          Section 25 of the Law on Investment Companies and Investment Funds, No. 248/1992
                     requires a corporate investment fund and investment (management) company to file an
                     annual audited financial statement and a report on its performance during the year. In
                     addition, it must file a semi-annual report on its activities which does not need to be

25
         The EU’s new Transparency Directive requires issuance of the Annual Report for all securities
issuers within four months of the year end. This could be adopted by the CSC as a best practice benchmark
for mutual funds.


                                                        37
                    audited. Article II(c) and (g) of the Law on Investment Companies and Investment
                    Funds, No. 248/1992 provides that the MOF shall set forth the contents of the
                    financial statements in the annual report and the contents of the annual and semi-
                    annual reports.

                    An investment (management) company managing one or more unit trusts must have
                    an annual certified report prepared for each unit trust which it manages.

                    Section 85 of the new Law on Collective Investments provides that the investment
                    (management) company and corporate investment fund prepare and distribute their
                    annual reports to shareholders and the CSC. Section 86 requires the two entities to file
                    a semi-annual report. Section 139(1)(f) provides that the CSC issue a decree setting
                    out the non-accounting contents of the annual and semi-annual reports as required by
                    Section 89 of the new Law on Collective Investments.
Comments            In this area, the new Law on Collective Investments is a marked improvement over the
                    old law, by giving the CSC the authority to issue a decree for the contents of the
                    annual and semi-annual reports. This decree has just been issued but has not been
                    translated into English at the time of this report. The CSC should consider adopting
                    internationally recognized performance presentation standards, such as those
                    developed by the CFA Institute (formerly the Association for Investment Management
                    and Research) of the US
NAV CALCULATIONS
The legislation governing CIUs should establish a stable framework for purchases and redemptions of
units of participation or shares in a CIU. The purchase and redemption prices of open-ended CIUs are
based on the net asset value (NAV) of the units of participation or shares of the CIU. The calculation
should be done on a regular basis, as specified in the prospectus of the CIU. The assets in the portfolio of
the CIU should be valued using market quotes or fair market valuation. Pricing errors should be promptly
identified and corrected.
Description         Section 17(4) of the Law on Investment Companies and Investment Funds, No.
                    248/1992 and Article II(2)(i) of Act No. 151/1996 provide that the Minister of Finance
                    shall determine by decree the method of calculating the value of a unit or share of a
                    corporate investment fund or unit trust. Section 26 provides that the investment
                    manager managing them shall publish at least once a week the NAV of a unit of an
                    open-end mutual trust.

                    There are no specific procedures for recalculation of the NAV to correct for errors.
                    However, discussions with depositaries indicate internal procedures for such
                    correction exist in the depositaries.

                    Section 18 of the old law provides that valuation of real estate that are part of the
                    assets of a corporate investment fund or unit trust shall be done by an expert.

                    The new Law on Collective Investments, Section 82 provides that the methodology of
                    the valuation of the NAV shall be set by decree. To implement this, Section 139(1)(a)
                    provides that the CSC shall determine the methodology for calculating the NAV of a
                    collective investment fund (both standard and special)while, at the same time, the
                    assets and liabilities are valued pursuant to the Act regulating accounting. The NAV
                    must be calculated at least every two weeks. The CSC has completed this decree but it
                    has not been translated into English as of the date of this report.

                    Both the old and new Law on Collective Investments provide that the depositary shall
                    control, monitor and verify the NAV calculation.



                                                      38
Comments            As the expert agency, the CSC has properly been given the authority to issue the NAV
                    decree. Both the old and new Law on Collective Investments allow for the control and
                    monitoring of the NAV by the depositary which is extremely important for investor
                    protection. However, there does not seem to be a formal, uniform procedure for
                    subsequent corrections for errors in the NAV calculation. This should also be included
                    in the new NAV decree.

                    Although some funds so not require a daily calculation, the new Law on Collective
                    Investments only requires that the calculation of the NAV of standard funds should be
                    performed at least once every two weeks. The NAV of the standard funds should be
                    calculated daily and the decree should reflect this. Moreover, the calculation of the
                    NAV of the special funds should provided for frequent and accurate evaluations of the
                    special funds’ assets (under International Financial Reporting Standards, all assets
                    would need to be valued at fair value).
FUNDS HOLDING NON-EXCHANGE TRADED, DERIVATIVE OR ILLIQUID ASSETS
Funds with non-exchange-traded, derivative or illiquid assets should prominently disclose the risks
inherent in holding such assets in the fund’s portfolio. The method of calculation of such assets should be
clearly set out in the prospectus of the fund.
Description         The new Law on Collective Investments allows for the establishment of ―special
                    funds‖ which can hold real estate, non-exchange traded securities and derivative
                    instruments. These funds do not fall under the UCITS rules for the organization and
                    operation of collective investment funds.
Comments            The CSC is in the process of finalizing all regulations needed to regulate such funds.
                    In the opinion of the CSC, it has already promulgated most regulations needed for
                    these funds and is about to complete any remaining regulations.


EXTERNAL GOVERNANCE STRUCTURES
LEGAL FRAMEWORK
All collective investment undertakings (CIUs) that solicit or obtain funds from the investing public should
be required to operate through a recognized legal framework. The legislation in a jurisdiction should
prescribe the manner and set out the requirements for establishing a CIU. The legislation should also
establish the regulation of the CIU once it is in operation.
Description         Czech CIUs operate within an extensive legal environment. The Law on Investment
                    Companies and Investment Funds, No. 248/1992 provided for the basic system of
                    regulation of CIUs. In addition, the Commercial Code, No. 513/1991, which provides
                    for the legal structure for joint stock companies, governs many of the corporate
                    governance issues for investment (management) companies and corporate investment
                    funds due to the fact that these entities must be created in the form of a joint stock
                    company pursuant to the provisions in the Commercial Code. The new Law on
                    Collective Investments, April 14, 2004, currently regulates CIUs. In addition, the Law
                    on Securities , No. 591/1992 directly affects the assets held by CIUs. The new Law on
                    Capital Market Undertakings, April 14, 2004, governs the operation of the securities
                    exchanges, including CIUs which are themselves listed on the Prague Stock Exchange
                    and the RM OTC market. Finally, the Law on the Securities Commission, No.
                    15/1998, creates the governmental authority for regulating the CIU industry.

                    The Czech Securities Commission (CSC) has issued six new regulations (called
                    decrees in Czech terminology) to effectuate the new Law on Collective Investments.
                    Except for the decree on business operations and internal controls for collective
                    investment funds, these have not been translated into English as of the date of this
                    report.



                                                     39
Comments            The Czech legislative structure meets the minimum requirements for a legal
                    framework for the operation of CIUs.
SUPERVISORY AUTHORITY
Legislation governing CIUs should designate a supervisory authority (or authorities) responsible for the
regulation and supervision of CIUs. The authority should set minimum requirements for the establishment
and management of a CIU within its jurisdiction. The supervisory authority should have the ability to
review the financial and operational qualifications of an entity which wishes act as a CIU. In addition, the
authority should have the ability to evaluate the qualifications of management (and significant
shareholders) of the AMC and evaluate whether their character is ―fit and proper‖ for the responsibility of
managing the savings of the public.
Description         The Law on the Securities Commission, No. 15/1998, creates the governmental
                    authority for regulating the CIU industry. In addition, the Law on Investment
                    Companies and Investment Funds, No. 248/1992 gave the CSC extensive authority
                    and powers in the establishment and regulation of investment companies and
                    investments funds. The Law on Investment Companies gives the CSC the
                    responsibility of licensing investment (management) companies and corporate
                    investment funds. The CSC has authority to review the background of owners and
                    directors of investment (management) companies and corporate investment funds and
                    to refuse to register them if they are ―undesirable‖ due to their associations and
                    interests. The CSC has promulgated a methodology to evaluate the fitness of
                    managerial applicants and has established a board to assist it in reviewing applicants
                    and thoroughly vets their qualifications. It has the authority to request background
                    information such as criminal records, but has not had a need to exercise the authority.
                    In addition, the CSC has the authority to establish capital requirements for firms.

                    After a corporate investment fund, investment (management) company and unit trust
                    are approved for operation, the CSC has the authority to examine and conduct controls
                    of the investment (management) companies and corporate investment funds to
                    determine their compliance with the law and uses this authority on a regular basis.
                    Finally, the CSC has the authority to sanction an investment (management) company
                    or corporate investment fund by withdrawing its license or placing it into liquidation
                    proceedings.

                    Other institutions also have an impact on the legal environment for CIUs. The Czech
                    National Bank licenses banks as depositaries of CIUs with the concurrence of the
                    CSC. The MOF issues all regulations in consultation with the CSC and sets the
                    accounting standards for mutual funds. The CSC has issued guidelines and
                    methodologies for certain activities in the collective investment area, but has not
                    issued an extensive set of detailed regulations until recently in order to meet the
                    requirements of the new Law on Collective Investments.

                    Sections 60-68 of the new Law on Collective Investments carries over the CSC’s
                    authority to create requirements for licensing the different forms of CIUs in the Czech
                    Republic: corporate investment funds and investment management companies which
                    organize and manage unit trusts. Article 72 would give the CSC the authority to
                    evaluate and approve the management of a corporate investment fund and investment
                    (management) company (―senior officers‖), in addition to the board of directors
                    (management board), in order to close a loophole in the old law. In addition, Article
                    71 would give the CSC the authority to approve share ownership and control in an
                    investment (management) company and in a corporate investment fund to insure that
                    the owners are also fit and proper for their position.
Comments            The CSC is given extensive authority to approve the operations of corporate
                    investment funds, investment (management) companies, unit trusts and depositaries in



                                                     40
                    the Czech Republic and to terminate the operations if it is in the interests of the public.
                    The authority is used on a regular basis. Nonetheless the authority of the CSC should
                    be strengthened in its ability to approve members of the Board of Supervisors and to
                    issue regulations (decrees) in all areas, particularly marketing. Also, the CSC should
                    be given adequate powers to enforce the use of applicable accounting standards
                    (preferably International Financial Reporting Standards, given the public interest
                    nature of collective investment funds’ activities). Finally, the CSC should set up a
                    department of risk assessment which will evaluate regulatory risks in all of the areas
                    within the CSC’s responsibility, including collective investments.
DEPOSITARY
The legislation governing CIUs should provide for the establishment of a depositary that is responsible for
the safekeeping of the assets of the CIU and controlling and monitoring the activity of the AMC to verify
that all actions taken are for the benefit of investors. To ensure the independence of the depositary, it
should be functionally independent of the AMC (or in the case of self-managed investment funds, of the
investment fund or persons managing the funds).

The assets of each CIU should be segregated from all other assets of the depositary and the AMC and held
for the exclusive benefit of investors in the CIU. The depositary should hold the assets itself or delegate
the responsibility to a sub-custodian as required by law (such as dematerialized securities held at a Central
Registry) or by contract (such as foreign securities held by a foreign sub-custodian).

The depositary should ensure that investor rights are respected, relevant laws and standards are observed,
the conduct of the AMC in regards to the assets of the CIU is in conformity with the investment goals of
the CIU and conflicts of interest are resolved without prejudice to investors.

The organization of the depositary and its relation to the AMC should be fully disclosed to investors. The
extent of liability of the depositary should also be fully disclosed to investors, as well as the liability of
any sub-custodians used by the depositary in carrying out their functions.
Description         The Law on Investment Companies and Investment Funds, No. 248/1992 gave the
                    responsibility to the depositary to ―control‖ and monitor the activities of corporate
                    investment funds and investment (management) companies. Only banks are allowed to
                    obtain a license to act as a depositary. The depositary for unit trusts is usually the bank
                    that established the investment (management) company which manages the trusts.
                    Although this follows general practice in Western Europe, the depositary nonetheless
                    has a direct relation with the investment (management) company through the bank
                    which is the center of the financial conglomerate. The industry feels that the legal
                    separation between the depositary and the management of the investment
                    (management) company functions acts as a sufficient ―Chinese wall‖ to maintain the
                    independence of the depositary.

                    The depositary maintains custody of physical assets of corporate investment funds and
                    unit trusts and monitors their activities to make sure that they conform to the policies
                    set forth in their prospectuses and to the requirements set forth in the Law on
                    Investment Companies. This includes verifying the NAV calculation and determining
                    whether investments are within the scope of the stated investment policy of the
                    corporate investment fund or unit trust and within the parameters for investments
                    established by the Law.

                    Under the old law, dematerialized securities in the portfolio of a corporate investment
                    company and unit trust were registered with a statutorily created entity called the
                    Securities Center which is under the supervision of the CSC. All dematerialized issues
                    are registered at the Center, which includes all units of participation in unit trusts.
                    Since legal title to securities is given to the name holder of the securities at the



                                                      41
           Securities Center, the name holder for unit trusts is the investment (management)
           company which manages them. Consequently, legal title for securities in the portfolio
           of a unit trust is held in the name of the investment (management) company which
           manages the unit trust.

           However, there is no nominee ownership in the Czech Republic. Consequently there is
           some concern whether the assets of the unit trusts are adequately separated from the
           assets of the investment (management) company. Various provisions in the old law
           provided for the separation. The Law on Investment Companies and Investment
           Funds, No. 248/1992 in Section 5(2) stated that assets of a unit trust are the joint
           property of the holders of the units of participation and that the holders of the units are
           co-owners of the assets. Moreover, Article 35d (8) provided that the assets of a unit
           trust are not part of the assets of the investment (management) company for the
           purposes of insolvency or satisfaction of creditors of the investment company. On the
           other hand, leaving title with the investment (management) company meant that it
           could direct the disposition of the assets at the Securities Center, since it has legal title
           to the assets.

           One solution to this is Sections 21 and 23 of the new Law on Collective Investments,
           as well as the new decree issued by the CSC on the operations of depositaries. (This
           has not yet been translated into English and was therefore not reviewed by the
           mission.) Under the provisions in the new law, it appears that the depositary would be
           obligated to review the transactions prior to execution. Under the old law, since the
           depositary was not the custodian of the transactions, this review has been after (ex
           post) the trade takes place. Under the new law, it appears that this has been changed to
           a new rule that the review is done ex post (after) the trade, but ex ante (prior to)
           settlement. (There is considerable debate in the investment industry over this, since the
           depositaries have argued that it should be ex post the settlement. If widely used in an
           active market, the review of the transaction between trade and settlement could create
           a great deal of uncertainty as to the finality of transactions.) The new rule provides
           some protection for improper transactions by the investment (management) company,
           but it is not as efficient as nominee ownership.

           The new Law on Capital Market undertakings is expected to create a new Central
           Depositary which will be a privately owned entity in place of the old Securities
           Center, which is owned by the government. However, the time frame for the
           implementation of the Central Depository (which will take considerable time to
           establish) is unclear.

           Nonetheless, the creation of the Central Depository may not completely resolve the
           issue of the segregation of assets. Industry participants noted that the new Law on
           Collective Investments would also not allow nominee ownership, but under Section 21
           would allow the Central Depository to note which depositary was the custodian
           overseeing the account of each unit trust at the Central Depository. In this way it
           would be notified before any transactions were effected in a security in the portfolio.
           How efficiently this will work in practice is yet to be seen.
Comments   The current system seems to work well for segregation of assets. All industry
           commentators have felt that the system does not have serious flaws. However, the lack
           of nominee ownership is a matter that needs to be addressed to bring the Czech
           markets in line with general practice in Europe.




                                              42
INDEPENDENT AUDITOR
Financial reports of operations and activities of CIUs should be prepared, as far as meaningfully
applicable and in the interest of investors, in accordance with International Financial Reporting Standards
(IFRS), or other internationally accepted sets of accounting standards, or national standards for CIUs until
IFRS or other internationally accepted sets of accounting standards are adopted in the jurisdiction. In
addition, annual reports of CIUs should be audited by an external independent auditor pursuant to
International Standards of Auditing to determine that the financial statements of each CIU meet applicable
standards of financial reporting.
Description         The Law on Investment Companies and Investment Funds, No. 248/1992 required in
                    Article 25 that corporate investment funds and investment (management) companies,
                    for each unit trust under management, prepare an annual full length audit report.
                    Article 20 required that records are to be maintained in accordance with the provisions
                    of the Accounting Act. Article 14 also provided that the accounting of unit trusts shall
                    be done pursuant to regulations issued by the MOF.

                    The new Law on Collective Investments in Article 85 requires that annual reports
                    should be certified by an auditor. Article 86 requires the preparation of a semi-annual
                    report which does not need to be certified.
Comments            The Czech Republic has not fully implemented IFRS and the financial statements of
                    CIUs are prepared pursuant to national accounting standards. However, IFRS is
                    mandated for publicly traded companies.

                    The auditing of corporate investment funds, investment (management) companies and
                    unit trusts are performed pursuant to International Standards of Auditing (ISA.)
                    However, the Chamber of Auditors in the Czech Republic (CACR) has not adopted
                    IFAC’s Code of Ethics. Nor have recommendations by the EU regarding auditor
                    independence (or the provisions of the proposed Eighth EU Directive) been endorsed
                    in the Czech Republic. (The issue of weak auditor independence was also discussed at
                    length in the Accounting and Auditing ROSC of July 17, 2001.) The auditing practices
                    are improving at a substantial pace, but more improvements are needed to bring the
                    auditing of investment funds and unit trusts up to international standards. The CSC
                    needs to develop its own capacity to evaluate the financial statements of corporate
                    investment funds, unit trusts, investment (management) companies and depositaries,
                    as well as the auditing practices of auditors that are engaged to prepare the financial
                    statements, and also should have adequate enforcement capacity to correct any
                    mistakes or misrepresentations in the financial statements or audit reports of collective
                    investment funds (as further elaborated on page 19.)
CODES OF ETHICS AND GOVERNANCE PRINCIPLES
A code of ethics and principles of governance for CIUs should be issued by the supervisory authority or
industry associations and self-regulatory organizations. In order for codes and principles issued by self-
regulatory organizations to be effective, there should be meaningful sanctions in place for the violations of
these principles. Internationally accepted standards and principles, such as the OECD Principles of
Corporate Governance, should be used in formulating domestic standards and practices.
Description         Industry practice for investment companies is determined by the Union of Investment
                    Funds of the Czech Republic (UNIS.) Membership is not mandatory and suspension
                    or expulsion from UNIS has no legal effect. However, the reputational consequences
                    of expulsion from UNIS are considered to be serious.

                    The CSC issued a Corporate Governance Code based on the OECD Principles of
                    Corporate Governance in 2001. However, the Code is not part of the Prague Stock
                    Exchange listing rules as yet, and is generally not complied with. The mission has
                    been informed by the CSC that it is working to develop a special code of governance



                                                     43
                   for CIUs.
Comments           The current efforts by UNIS are laudatory. UNIS was one of the entities responsible
                   for the rehabilitation of the CIU industry in the Czech Republic by adopting a Code of
                   Ethics and a disciplinary proceeding for members who violated it. The CSC should
                   move as quickly as possible to go further and amend the Code of Corporate
                   Governance to include issues specific to the CIU industry or finalize a Special Code of
                   Governance for Collective Investments. Adequate monitoring and enforcement
                   mechanisms should be put in place to ensure industry compliance (either at the CSC or
                   at UNIS.) Membership in UNIS should be made mandatory for all CIUs incorporated
                   in the Czech Republic.
ROLE OF FUNDS AS SHAREHOLDERS
VOTING POLICIES
AMCs should establish and disclose clear voting policies, including proxy voting. AMCs should consider
the costs and benefits of voting.
Description        Section 24a of the Law on Investment Companies and Investment Funds, No.
                   248/1992 provided that the investment managers are prohibited from voting shares
                   held by a unit trust or corporate investment fund. Consequently, the fund cannot act as
                   an entity for corporate governance in the entities in which it has an investment.
                   The new Law on Collective Investments does not contain a prohibition against the
                   exercise of voting rights of shares in the CIUs portfolio by the management of the
                   investment (management) company or corporate investment fund.
Comments           The new Law on Collective Investments eliminates the restriction on voting shares in
                   the portfolio of a corporate investment fund and unit trust, but does not provide any
                   guidance as to the modalities of how such voting decisions should be made. Should
                   the general assembly of a corporate investment fund make the decision? Should the
                   voting be predetermined in the prospectus as with socially conscious funds? Should
                   the voting decisions be made public? These issues are not resolved and there is no
                   authority in the new Law on Collective Investments for the CSC to resolve them by
                   decree. This authority should be given to the CSC in an amendments to the new Law
                   on Collective Investments.
CONDUCT IN SUPPORT OF MARKET INTEGRITY
AMCs should conduct their operations in ways to achieve and sustain market integrity. The purpose of a
CIU is to invest the assets of the investors in a productive manner, not to manipulate or otherwise take
advantage of market anomalies. The AMC should not use the assets of the CIU to unfairly and
fraudulently manipulate the market.
Description        Section 17a(2)(a) of the Law on Investment Companies and Investment Funds, No.
                   248/1992 prohibited an investment (management) company and a corporate
                   investment fund from manipulating the markets in any way.

                   Section 75(2)(f) of the new Law on Collective Investments carries over the provision
                   from the old law and also provides that actions of the fund shall not manipulate the
                   market or disrupt the integrity of the market.
Comments           The old law and new Law on Collective Investments prohibit the manipulation of the
                   market by the trading of assets of a corporate investment fund and unit trust, and
                   provide a sanction of a fine of CZK 10,000,000 (approximately US$400,000) and the
                   withdrawal of a license.




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