Legal Aspects of Finance Slide Set 15 Matti

Legal Aspects of Finance Slide Set 15 Matti Rudanko

Case 2: Norms on investment services Act on Investment Firms: provisions on establishing and control SMA ch. 4: trade and brokerage in securities • proper practice requirements • relationship between intermediary and client • declaration duties concerning transfers of securities FSA norms applicable (now mainly obsolete, see before) • guideline 203. 1 for securities intermediaries on the application of SMA • guideline 201. 9 on agreements for safekeeping and administration of securities (including safe custody), book-entry accounts and portfolio management 1997 • regulation 103. 4 (credit institutions) on the activities of trustee departments 1998 Legal Aspects of Finance 15 2

Case 2: Norms on investment services 2 SMA • ban on procedure contrary to good practice • ban on brokerage contract terms contrary to good practice or unconscionable for the client • an intermediary shall execute his orders with due diligence (carefully) and in the best interests of the client without undue delay - guideline 203. 1: the best interests of the client must always be the primary principle in executing the order Legal Aspects of Finance 15 3

Case 2: Norms on investment services 3 FSA regulation 103. 4 • securities commissions are based on a literary contract showing clearly the bank’s rights and duties FSA guideline 201. 9 4 Basic content of a portfolio management agreement • 4. 3. 1 Investment strategies • 4. 3. 2 Investments and limits • 4. 6 Reporting • 4. 9 Portfolio manager responsibilities • 4. 10 Customer responsibilities Legal Aspects of Finance 15 4

Case 2: Norms on investment services 4 FSA guideline 201. 9 4. 3. 1 Investment strategies The portfolio management agreement should define the investment objectives and how these objectives are to be met (e. g. preserving value, maximizing profit, securing a minimum rate of return, or achieving a specific tax benefit). Mutual appraisal of the projected rate of return on investment also involves mutual appraisal of the level of risk accompanying the investment. 4. 3. 2 The agreement must indicate where funds may be invested. The portfolio manager must give the customer sufficient information on various investments and their attributes - Legal Aspects of Finance 15 5

Case 2: Norms on investment services 5 4. 9 Responsibilities of the portfolio manager The agreement must indicate the responsibilities of the portfolio manager and any liability for damages. In the event of disputes, it is important that the obligations andresponsibilities of the parties are precisely defined. The portfolio manager may not always entirely eliminate his responsibility for the outcome of investment activities on the strength of the terms of the agreement. The portfolio manager is in any case responsible for pursuing the agreed investment objectives in a prudent, professional manner. Nevertheless, the responsibility of the portfolio manager is restricted solely to actions taken and does not extend to the consequences of those actions. Responsibility for profits or losses arising out of investment activities lies with the customer. Legal Aspects of Finance 15 6

Case 2: Norms on investment services 6 4. 10 Responsibilities of the customer The customer is responsible for ensuring that the portfolio manager has sufficient funds at his disposal for carrying out the measures specified in the agreement. If the customer has delegated all decision-making authority to the portfolio manager, responsibility for maintaining sufficient funds on the account rests with the portfolio manager. The agreement must indicate the actions to be taken in the case of insufficient funds. The agreement should also indicate whether the customer has the right to use the account while the agreement is still in force, and under what conditions. If a portfolio manager manages the portfolio independently, it is recommended that a separate account be opened for this purpose which the customer is not entitled to use. Legal Aspects of Finance 15 7

Case 2: Norms on investment services 7 The agreement should state, for the sake of clarity, that the customer is solely responsible for his investment choices and their financial performance. Legal Aspects of Finance 15 8

The Significance of FSA Norms (on contract form and contents) Securing sufficient information to the client on • rights and duties of the parties • objects of the contract • risks related to the contract Securing possibilities of evidence of the contract The party in breach of the norms bears the burden of proof concerning • the significance of the breach • the facts that should have been informed about in a literary form Legal Aspects of Finance 15 9

FSA Norms in Litigation A party in breach may not make use of the breach (cf. this case) rules on the burden of proof (damages in a breach of contract case) • damage, causal relationship: plaintiff • negligence (if needed): defendant; cf tort law (no contract): plaintiff • provisions of the contract (e. g. guarantee): plaintiff / defendant (if in breach of norms on contract form / contents) Legal Aspects of Finance 15 10

FSA Norms in Litigation (cont. ) Lack of literary form and not obeying norms on contents of contract rendered the assessment of the contract impossible the party in breach is to carry risks so caused • the significance of the breach: whether it matters or not is to be proven by that party • guarantee liability: the bank referred to FSA norms prohibiting banks from assuming such a liability but lack of written contract may indicate just that kind of a commitment (marketed to the client but denied in lack of evidence) Legal Aspects of Finance 15 11

FSA Norms in Litigation (cont. ) if guarantee liability is assumed, it has to be carried in relation to the client despite the FSA ban cf also the general reversion of burden of proof rule in contractual relations (the exculpation rule) • the final result of the portfolio management was the worst possible from the point of view of the client • in such a situation, the portfolio manager should exculpate itself, i. e. prove that it has acted with due diligence (bear the burden of proof of evidence) Legal Aspects of Finance 15 12

Due Diligence of a Portfolio Manager The average value of the portfolio being FIM 5, 25 M and velocity of circulation 2, 5, the annual return should exceed 22, 4 % to bring net profit to the client (with respect to fees and other costs) a portfolio manager should avoid precipitate decisions under market turbulence • the bank took care mainly of its short range interests when realizing the portfolio to get payment • it had the opportunity to grasp the debtor’s (whole) pledged property as realized securities for the loans (at a very fair price) Legal Aspects of Finance 15 13

Due Diligence of a Portfolio Manager (cont. ) cf the present hypothetical outcome of the portfolio manager should have attended primarily to the customer’s interests however, the duration and depth of the economic depression was not foreseeable the blocked account: the exclusive access of the bank should have stressed its responsibility of the sufficiency of funds deposited (cf FSA norms) Legal Aspects of Finance 15 14

The loan arrangement An investment program based on borrowed funds was unrealistic in the prevailing market situation the bank instructed, however, the client to take the loan (the initiative was the bank’s) the bank began hastily to collect not mature debts due to failures to cover interests with the results of investment activity cf the demands of good faith (loyalty) of the portfolio manager: the interests of the client Legal Aspects of Finance 15 15

The loan arrangement (cont. ) Cf the lender liability discussion • the lender has to take care of the solvency of the customer when granting credit • the loan was a part of the portfolio management arrangement suggested by the bank; this accentuates the good faith demand pertaining to the lender liability of the bank Legal Aspects of Finance 15 16