Compliance has become an issue of major concern to investment service providers, particularly in view of its increasing complexity and cost (see 'Making the Case for Legal Compliance Audits', International Financial Law Review April 1997, page 9). The conduct of business rules applicable to investment services firms in Germany are codified in Sections 31 and 32 of the German Securities Trading Act (Wertpapierhandelsgesetz or WpHG). Under Section 35 subsection 2 WpHG, the Securities Trading Supervisory Authority (Bundesaufsichtsamt für den Wertpapierhandel or BAWe) supervises compliance with, and can issue guidelines on, conduct of business rules.
On June 3 1997 the BAWe issued guidelines on commissions and the fixed-price and agency business (investment services business) of certain investment services firms. The Guidelines are intended to provide guidance on how the conduct of business rules set forth in Sections 31 et seq WpHG will be interpreted and enforced by the BAWe. The Guidelines do not have the status of German securities law nor even an official regulation or ordinance and therefore do not create rights of action against investment services firms. Indirectly, however, the Guidelines are likely to promote the uniform interpretation of the conduct of business rules by the BAWe and influence the grounds courts apply for liability for negligence in banking and investment business.
Position under general law
The duties and standards of conduct applicable to investment services firms have been developed by courts and commentators in a piecemeal fashion in response to developments of the investment services business, lacunae in the law and perceived dangers to customers resulting therefrom. The theoretical foundations of the duties so developed (initially in respect of banking business) have been of secondary importance. To a large extent the courts have concentrated on contractual or quasi-contractual liability to avoid the lesser protection afforded to customers under tort law.
Liability in tort
Before the introduction of Sections 31 et seq WpHG there was no statutory basis for the recovery of pecuniary damages for negligent investment advice. The courts allowed pecuniary damages to be recovered under section 826 German Civil Code (BGB) — the wording of which includes only wilful damage contrary to public policy — by expanding the scope of its application, particularly in respect of the duty to disclose and liability for negligent advice and reducing the mens rea element to conditional intent (doles eventualis or bedingter Vorsatz).
Since the introduction of Sections 31 et seq WpHG, economic loss caused by the simple negligence of an investment services firm can be recovered by investors under general tort rules. The principal disadvantages of an action in tort, however, remain:
the liability of investment services firms or agents arises only where the agent has been selected without due care;
the customer generally bears the full burden of proof; and
a limitations period of three years applies, compared with a normal limitations period for contractual claims of 30 years.
Disclosure requirementsScope of application The Guidelines specify the duties arising from Sections 31 and 32 WpHG. They apply to the investment business of:
'Customers' include private and non-private customers as well as market professionals. The inclusion of market professional within the term customer is arguably contrary to the spirit of the ISD, which was concerned to exclude market professionals from burdensome regulations aimed at consumer protection (but see 'Exception for market professionals' below). Investment services within the meaning of the Guidelines are commissions business, dealing for the own account as a service for customers, agency business and the transmission of orders from one investment services firm to another (if the service is not limited to mere transmission) in respect of securities. Securities within the meaning of Section 2 subsections 1 and 2 WpHG are publicly tradable equities, certificates representing equities, bonds, participation rights (Genußscheine), warrants, other securities comparable to equities or bonds, as well as derivatives. The Guidelines do not apply to enterprises which render investment services exclusively to their parent company or its subsidiaries or to other subsidiaries of its parent company; certain public debt administrations and funds; transactions on an exchange between two investment services firms; and own account transactions of investment services firms themselves. General information before rendering investment services On request by a customer, investment services firms must provide information regarding the nature and scope of the investment services and products offered. Before rendering investment services, investment services firms must, in a suitable manner, provide customers with information regarding the calculation, amount and the nature of any charges, collateral ('margin') or other payment obligations and explain these on request. Minimum charges must be specifically pointed out. Special rules apply to kick back agreements. Obtaining customer information and disclosure of expedient information The investment services firm must give the customer all relevant information regarding the types of business envisaged (ie the nature and risks involved) no later than before the placement of the order. The investment services firm must determine the investment profile of each customer by requesting the following information:
Furthermore, customers must be informed that:
The disclosure must be correct, comprehensive, unambiguous as well as structured in content and take a form appropriate to the customer profile. If the customer is represented by an agent, the information to be obtained regarding the knowledge or experience in the specific types of investments and the necessity of disclosure of relevant information must relate to the agent. The disclosure must be repeated if necessary, for example due to the small volume of business conducted by the customer. In general, investment services firms must, before accepting an order and taking into consideration the customer profile, inform the customer:
In respect of particular types of investments disclosure must include: Bonds: information concerning the return, the risks involved with the credit standing of the issuer, the country risk, the price and interest risks, the liquidity risk, the currency risk as well as the termination and drawing risks. Equities: information concerning the return, the price risk, the credit risk of the issuer, the liquidity risk, the risk resulting from economic cycles and currency risk. Special rules apply to equities not traded on a domestic or foreign stock exchange. Investment units: information concerning the composition of the assets of the fund, the investment strategy, the use of returns, the costs of issuance (issue premium etc), the price risk and the valuation method. Derivatives and warrants: information regarding the underlying economic circumstances and the way in which the product works (in particular the effect of the duration on the premium, the manner of exercise, the leveraging effect, the liquidity and volatility of the market and, if applicable, the option writer risk), the return, the price risk, the currency risk and the risk regarding the credit standing of the issuer. Detailed rules apply in respect of margins, including its method of calculation, the party requesting the margin and the form in which it may be furnished (eg in cash, securities), netting-out or liquidating open customer positions, and the administration and reduction of collateral. The investment services firm must document any customer's refusal to provide the requested information. Specific orders may be executed if the customer has been offered prior disclosure of the characteristics and risks involved in the types of investment. Execution-only business If a customer cannot be contacted for the purposes of disclosure and the execution of the order without undue delay is obviously in the interests of the customer, the disclosure may be communicated to the customer without undue delay after execution of the order. If an investment services firm only executes customer orders (execution-only business conducted by discount brokers and so-called direct banking providers) — ie the disclosure is not followed by investment recommendations tailored to the personal circumstances of the customer — it must advise customers of this before accepting orders. Information provided to customers must be accompanied by a disclaimer to the effect that it does not constitute investment advice. Nonetheless, investment services firms remain obliged to make enquiries as to the customer's knowledge or experience before an order is issued, to determine his/her suitability for execution-only business. If, however, the investment services firm grants credit to the customer or requires the deposit of collateral to execute the intended business, information from the customer regarding investment objectives and financial standing are also required. Exception for market professionals The collection of customer information and the disclosure described above is not required where the customer is another investment services firm or professional market participant, provided that:
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Liability in contract
Investment services business has traditionally been conducted by German banks. However, the principles developed in this context also apply generally to investment services firms.
Specialized or general banking contract
The relationship between a bank and its customer is based on what is often called the general banking contract. This is an implied framework agreement governing the long-term relationship between the customer and the bank, which itself will involve a variety of individual contracts in respect of the specific banking business conducted. It also incorporates the bank's standard business terms into the banking relationship. The legal duties incumbent on banks and investment services firms as a consequence of the general banking contract include:
a general contractual duty to act in the best interest of customers;
a duty to comply strictly with the instructions of the customer;
certain execution obligations in respect of 'neutral' banking business; and
the duty not to treat individual customers differently when conducting large volume transactions.
Furthermore, the relationship between an investment services firm and a customer will typically involve specific contractual forms within the context of the general 'banking contract', such as custody contracts, purchase contracts in respect of securities, commission agency agreements in respect of securities, and the general rules concerning mandates. Duties of care and standards of conduct have been developed for each of these contractual forms by statutes, courts and commentators. However, the general principles require refinement and tailoring in the context of investment services, not least because the contractual duties only arise on a contract being entered into.
Implied advisory contract
Rather than rely on the doctrine of pre-contractual liability, the Federal Supreme Court (BGH) held in the so-called Bond case of 1993 that an advisory contract between a bank and its customer, agreed before the damaging act, omission or transaction, was to be implied, giving investors a cause of action for breach thereof. The advisory contract was implied because the bank had included the questionable securities in its investment programme for customers. The bank breached its duties by recommending the purchase of the securities without conducting its own research in respect of the rating of the bond; it was in fact rated as speculative by the Australian Rating Agency.
More recently, the BGH has clarified that an advisory contract will not be implied if the customer does not wish or require advice from the bank. This does not, however, obviate the duty of the bank to warn the customer of specific dangers connected with the intended investment if the bank is in a position to recognize that the customer is not aware of such danger.
Legislative background
Supranationally, the Investment Services Directive (ISD) set standards of organization and laid down the central principles of conduct to be expected of investment services firms, irrespective of existing differences between the laws of the member states. Of particular significance was that the application of the principles laid down was not intended to be absolute, but rather dependent on the relative sophistication of the individual investor. Transactions involving professional and institutional investors were not to be burdened with unreasonable regulation. Articles 10 and 11 of the ISD were implemented in Germany as Sections 31 et seq WpHG under the Second Act for the Promotion of Financial Markets of July 261994.
Purpose and nature of the conduct of business rules
The twin guiding purposes of the ISD, in light of which Sections 31 et seq WpHG are to be interpreted, are to ensure the financial system is stable and functions effectively on the one hand and to ensure the protection of investors on the other.
From a remedial perspective, the qualification of the conduct of business rules as private or public law is of significance. As a result of their regulatory character, the legal effect of the conduct of business rules is, at least in part, of a public law nature, not creating causes of action for aggrieved investors. However, unlike the ISD, which pursues banking supervisory purposes, the provisions of Section 31 et seq WpHG also give rise to rights of individuals, particularly in view of their consumer protection purpose.
The precise nature and extent of individual rights so created remains unsettled. Sections 31 and 32 WpHG may be considered to define duties of care in tort and contract. On the other hand, it has been argued that the BAWe's power under Section 35 WpHG to issue guidelines defining the conduct of business rules gives the BAWe a non-justiciable monopoly over the interpretation and application of the conduct of business rules, breaches of which are punishable as administrative offences. However, notwithstanding the fact that the ISD was not intended to affect private laws of member states more beneficial to investors, it appears clear that the conduct of business rules, as supervisory rules, are connected with private law and affect the same.
Content of the Guidelines
As to the scope of application and information duties laid down by the Guidelines, see the box above.
Execution obligations
In general, investment services firms can only execute transactions for customers on the basis of a prior order or other contractual authority. Under no circumstances can investment services firms unreasonably prefer individual customers to the detriment of other customers when executing orders.
If the investment services firm categorizes customers in risk categories on the basis of the customer profile and informs the customer thereof, this categorization must be taken into account when executing orders and the criteria for the categorization must be disclosed to the customer. Orders outside the risk categorization can be executed if the customer has received appropriate prior disclosure.
In the case of futures exchange transactions, the investment services firm must request from the customer collateral in an amount at least equal to the margin rules of the respective futures exchange. Before executing transactions, and when open positions are held, the sufficiency of the margin must be marked to market daily.
Transactions by employees and management
Orders by employees or managers may not be treated preferentially over customer orders (see also the Federal Banking Supervisory Authority - Bundesaufsichtsamt für das Kreditwesen/BAKred statement Regelungen der Kreditinstitute für Mitarbeitergeschäfte of December 30 1993). Employee orders must be recorded at the time they are issued and be processed by the appropriate accounts or depository department. Orders given directly to a trader are prohibited, as are price agreements between an ordering employee and the executing trader.
Prohibited conductInvestment services firms are prohibited from making recommendations:
Investment services firms are prohibited from executing own-account transactions based on their knowledge or expectation of a customer order that may be detrimental to the ordering customer (prohibition of front-running, parallel-running or counter-running). If, for example, the publication of written customer recommendations or particular research results by the investment services firm or an enterprise affiliated with the investment services firm is imminent, own-account transactions may not be conducted in the relevant securities or derivatives before customers have had sufficient opportunity to react. Exceptions to this include where:
The prohibitions apply to proprietors of investment services firms, to persons entrusted with the conduct of their business or authorized with their representation and to such of their employees who are entrusted with the execution of transactions in securities or derivatives, with securities analysis (research) or the rendering of investment advice. |
Timely execution and customer priority
In principle all orders are, subject to express instructions to the contrary, to be executed or transmitted in the order of their receipt and in a timely manner, unless the customer's interests dictate a later execution. The execution of best interests orders (interessewahrende Aufträge or IW-Orders) must not prejudice the execution of other customer orders. The customer account is to be credited without undue delay after execution of a sell-order.
The transmission of an order to another investment services firm, and under what circumstances the latter's standard business terms apply, must be disclosed to customers who receive more than mere execution services. Exchange orders are to be issued directly to the commission agent.
Execution in the best interests of the customer
Orders must only be executed in the best interests of the customer (as recognizable to the investment services firm). Orders that are recognizably not in the interests of a customer may be executed by the investment services firm only if it has previously made the risks clear to the customer. Detailed rules apply in respect of the market price achieved, the selection of execution service providers, the division of orders, fixed-price transactions, securities allocation and aggregation of customer orders.
Execution documentation
Orders are to be documented in writing or an equivalent documentary form (eg electronically), naming the acceptee. Specific rules apply in respect of:
commission business: times of acceptance, transmission to an executing investment services firm (in particular a broker) and execution of orders are regularly to be recorded by electronic or equivalent means.
fixed-price transactions: times of acceptance and execution of orders must be recorded immediately after being effected, including all relevant execution data, and transmitted to the back office without undue delay together with all documentation.
late transactions (transactions effected after the back office has closed): to be earmarked and included in the positions of the daily total. Trader notes concerning late transactions are to be transmitted to a non-trading department without undue delay.
Transactions effected through an exchange or another settlement system can be documented in another manner. Telephone orders may, with the consent of the customer, also be documented by tape recording (see below).
Orders and customer instructions are generally to be confirmed in writing or equivalent form no later than on the day following their issue. In principle, every transaction is also to be notified to the customer in writing without undue delay after its execution (confirmation of transaction) unless it is settled without undue delay (transaction statement). Transactions effected via an exchange or other transactional system can be confirmed or settled in another manner. The transaction statement must include all information material to the transaction, be transparent in respect of the costs charged and comprehensible to the average customer.
Voice-recording
Compliance with investment services firms' documentation obligations may be significantly simplified by voice-recording telephone orders, as contemplated by the Guidelines. As a general rule, credit institutions and brokers must obtain the express consent of each individual employee, counterparty and customer before recording their telephone conversations; failure to do so constitutes a breach of the fundamental right of privacy and a criminal offence (Section 201 Strafgesetzbuch - Criminal Code). Illegal recordings are generally not admissible as evidence in court.
Market standard for interbank business
In Germany, the BAKred requests credit institutions and brokers engaged in inter-bank business to voice-record telephone calls made by their trading departments. Under a 1993 industry agreement, credit institutions intending to maintain telephone lines on which conversations are voice-recorded agreed on detailed procedures applicable between market professionals. It does not, however, cover the voice-recording of back office telephone conversations and conversations with private customers, from whom individual consent must still be obtained.
Obtaining customer consent
The most practical procedure would clearly be to obtain the customer's consent at the start of the business relationship for all future voice-recording. There is, however, no authority supporting this. Credit institutions erring on the side of caution will therefore obtain customer consent before each call, for example by automated telephone announcement that the customer has called a voice-recorded line.
Compliance audit
The BAWe will generally audit compliance by the investment services firm annually (Section 36 subsection 1 WpHG). Thus, investment services firms must satisfy the information duties in a manner allowing verification in a compliance audit. The BAWe may require information and documents from investment services firms and their associates and, for these purposes, may enter their business premises (Section 35 subsection 1 WpHG).
Conclusion
The Guidelines to the conduct of business rules provide detailed guidance to investment services firms in respect of their compliance obligations. In view of the aims of the ISD, the inclusion of market professionals within the term 'customer' has unnecessarily increased their compliance burden. Market professionals must now ensure they fall within the exceptions to the Guidelines by satisfying certain information and notification requirements vis-à-vis other market participants.