The beginnings of the GFOCP
The “Garanční fond obchodníků s cennými papíry” (Securities Traders Guarantee Fund - GFOCP) has been created by the Czech law in line with the Directive 97/9EU (ICD) 1st January 2001. The Statutes and candidates for the 5 member Board are approved by the Minister of Finance. The GFOCP has solved 9 cases of securities traders' insolvency, compensated almost 21 thousand of clients, solving more than 11 thousand lawsuits of the clients against the GFOCP. With regard to the compulsory separation of the trader's property from client accounts, criminal proceedings have been initiated in most cases but most of them have not finished yet.
The Securities Traders Guarantee Fund (the “Fund”) is defined by the law as a non-state, non-insurance institution. Its positive definition in the law is very brief, has been amended many times and even the current law is not perfect. Thus, a part of lawsuits conducted by the Fund aims at obtaining a binding interpretation of the Securities Act or of the Capital Market Business Act. The laws have been amended many times and in some of these cases, the Fund's situation has become even more complicated. More than 90 percent of compensations for clients which have been paid by the Fund have originated from the state budget. The assumption (which is not expressly stated by the law) that the Fund's income are designated solely for bankruptcies of small and medium-sized traders indicates that the state is obliged to help with funding large traders' bankruptcies. The law stipulates that if the Fund's own money is not sufficient to pay compensations, the missing funds may be provided by the state in the form of subsidy or refundable financial assistance and the Fund shall take a loan from a bank to cover the balance. In fact, the financial situation of the Fund in the first years of its existence was such that the state had to finance over 90% of paid compensations.
In the first year after its establishment (2001), the Fund was technically overburdened with debt, i.e. the contributions from securities traders were by far insufficient to fulfil its obligations. Before the due date of the first annual contributions paid by securities traders, two traders - Forte Invest and Private Investors – were declared bankrupt, whereby the Fund became obliged to pay compensations over 360 million CZK, while the first contributions from securities traders amounted to approximately 5.2 million CZK. At the same time, it was proved that, given its income, the Fund is unable in any case to obtain a bank loan for missing funds, as stipulated by the law. However, the legal prohibition to declare the Fund bankrupt does not avert the risk of execution against the Fund. The Fund's technical overburdening with debt (without a possibility to declare the Fund bankrupt) lasted seven years until 2008.
KTP Quantum's caseis the largest and most complicated case resolved by GFOCP and highlights all problems with applicable laws: KTP Quantum's insolvency notice was received by the Fund on 21 May 2002. This was the fourth case of insolvency of a securities trader. In accordance with the law, the Fund called upon KTP Quantum's clients to register their claims for compensation with the Fund; however, the claims continued to be sent to the Fund until the end of the five years' limitation period in 2008. Almost twenty thousand claims were registered. Claims were accompanied by statements of the clients' accounts with KTP Quantum, which had been sent to clients in bulk by the bankruptcy trustee. According to these data, the total compensation paid by the Fund to KTP Quantum's clients was to amount to approx. 1,850 million CZK. Based on these data, the Fund applied in 2003 for refundable state subsidy equal to 50 percent of this amount.
According to the law, the Fund is to provide compensation for client assets – see Section 8lb(1) of Act No. 591/1992 Coll. which was then in force. The client assets were comprised of money and securities. For the purpose of calculation of the compensation amount, the securities were to be appraised by the market price – see Section 8lc(8) of the above Act. In his statements, the bankruptcy trustee noted that the client assets of the vast majority of assets of KTP Quantum's clients consisted of shares of Media Bohemia, which were appraised at 1000 CZK per one share. This appraisal was doubtful from the very outset, because Media's assets had become subject to bankruptcy before the date as of which these shares were to be appraised. Therefore, these shares had to be deemed worthless. This was the first reason to challenge the relevance of the data submitted by the bankruptcy trustee.
Before this issue could be reviewed, the first bankruptcy trustee was recalled from his office and a new bankruptcy trustee was appointed. In his correspondence with the Fund, the new bankruptcy trustee essentially challenged the data presented by the first trustee, stating that they cannot be used in any case. In this respect, the trustee noted that the client assets which would be surrendered to the clients and would not be thus paid out of the Fund's sources would include shares of Soliter a. s. and Chemopharma a. s. with the value of ca 400 million CZK and cash on clients' bank accounts in the amount of 50 million CZK. The new trustee further expressed his doubt whether to pay out of the Fund's sources also “contractual fines” (an accounting term used by the bankrupt trader, which is not known by the law) which were credited to accounts of KTP Quantum's clients in cases where KTP Quantum failed to achieve the contracted 14 or 9 percent yield. The list of contractual fines presented by the new trustee indicated that the difference in compensations resulting from contractual fines may reach up to 350 million CZK. Since the new trustee was unable to deliver to us documents enabling us to make payments from the Fund, the Fund filed against him a lawsuit with the Regional Court in Hradec Králové to enforce this duty.
Subsequently, the removal of the first bankruptcy trustee from his office was abolished by decisions of the Constitutional Court of the Czech Republic and the High Court in Prague and the first bankruptcy trustee resumed his office in 2004. The trustee presented to the Fund reference documents where he quantified components of client assets described by the second trustee; among others, he allocated cash balances on client accounts to each client. However, these documents included totally non-reviewable item names contravening the Accounting Act, such as “undistinguishable cash”, making it impossible to determine the compensation amount. Moreover, the trustee also included Media Bohemia's shares in the bankruptcy estate, which indicates that, contrary to the previous trustee's allegations, these shares should not be included in client assets. In such confusing situation, the Fund commissioned an opinion from the auditor firm Deloitte, which concluded that the trustee had failed to fulfil legal requirements relating to such documents and the Fund had not received full and sufficiently specific information about the amounts claimed by each of KTP Quantum's clients. Therefore, even three years after KTP's bankruptcy, it was impossible to validate the applications and to calculate and to pay compensations.
In the meantime, the Municipal Court in Prague dealt with the lawsuit filed against the Fund by KTP Quantum's client J.K., who submitted to the court, beside a summary statement elaborated by the trustee, an itemized statement of all movements posted by KTP Quantum to his account. This was the first lawsuit held before the Municipal Court in Prague. In its judgment promulgated on 31 December 2004, the court ruled that the Fund is not obliged to provide the compensation for the contractual fines and that Media Bohemia's shares are not a part of client assets and the Fund is to provide compensation for their acquisition cost in lieu of their market price. This judgment was appealed by the Fund on 3 March 2005 and was upheld by the High Court in Prague on 4 October 2005. This upheld judgment indicated that the lawsuit was justified only up to 71 percent of the claimed amount. This means that if Fund had paid the compensations quickly in accordance with the original documents elaborated by the bankruptcy trustee, it would have caused to itself and the state damage amounting to hundreds of millions CZK.
In JK's case, the Fund filed recourse with the Supreme Court of the Czech Republic. Nevertheless, it prepared in 2005 payment of partial compensations to KTP Quantum's clients, calculating the amount of these compensations by deducting all doubtful items from the relevant bankruptcy claim and paying compensation for the indisputable part of client assets. With regard to differences in portfolios on accounts of KTP Quantum's clients, the percentage of the partial compensation which was paid to clients was not the same but ranged from zero (in case of clients with a debit balance) to one hundred percent (in case of clients whose assets exceeded significantly the compensation amount stipulated by the law). The Fund's recourse in JK's case was dismissed by the judgment of the Supreme Court dated 30 August 2006.
Since that date, the Fund has been asking the bankruptcy trustee to provide to it the information necessary for the calculation of compensation in accordance with the principle specified by the courts in JK's case, but to no avail. The amount of the contractual fines was known to the Fund; however, none of the documents presented until now has specified the acquisition cost of Media Bohemia's shares, which was to be taken as the basis for calculation of the compensation in accordance with the judgments of the above-mentioned courts. Based on documents presented by some of KTP Quantum's clients, the Fund ascertained that these shares had been credited for at least three different prices. At the same time, more than 1,100,000 of these shares were credited to client accounts; therefore, the difference arising from different prices may be in the range of tens of millions CZK. Since the Fund did not obtain such documents from the bankruptcy trustee, it petitioned the Municipal Court in Prague to request such data from the bankruptcy trustee as evidence. Judges of the Municipal Court acknowledged that, without such documents, the Fund is unable to calculate the compensation amount.
Only after the court notified the trustee that he would be fined if he failed to deliver such documents, the trustee filed with the Municipal Court a complete database of account statements of all KTP Quantum's clients. Only in May 2007, the Fund had an opportunity to calculate the final compensation amount for individual KTP Quantum's clients. The Fund prepared immediately another partial payment, using for it its entire available financial means, except for reserve for pending lawsuits, operation of its offices, etc. The payments were made in the period between 29 June 2007 and 31 August 2007.
If the Fund paid all funds provided within the refundable financial subsidy in a single payment, without validating the relevant claims, such step would result not only in a risk of overpayment in the range of tens of millions CZK, but also in a risk of total collapse of the Fund, which would mean the impossibility to pay the amounts under accruing final and effective judgments and incurring further fees for execution proceedings, which are comparable with court fees. The only way to avert lawsuits would be to pay to each client the entire compensation plus late interest; however, the Fund lacked until April 2008 ca 0.8 billion to take such step. Until the issue of the ruling of the Supreme Court of the Czech Republic in JK's case in autumn 2006, it was not clear when the Fund's compensations were due. The due date was not stipulated in the Securities Act applicable at that time or in any other legal regulations. The Securities Act only stipulated the time limit within which the Fund is obliged to start making payments. Pursuant to this Act, payments should have begun within three months after validation of registered claims but not later than 10 months after publication of the notice of KTP Quantum's insolvency issued by the Securities Commission. The Fund assumed that the registered claims could have been validated only in May 2007, after the Fund obtained the necessary data from the trustee. According to the interpretation of this provision used by the courts, the Fund is also obliged to complete the payment within the time limit stipulated for their beginning, notwithstanding whether it had the data necessary for payment and a possibility to validate the claims. Such absurd interpretation of the law could not have been foreseen by the Fund.
The Fund could not prevent in any way class actions filed by KTP Quantum's clients, this is a consequence of the Act, which established an institution that is not and cannot be able from the very outset the duties imposed upon it by the law. Even the immediate payment of the entire refundable financial assistance provided by the state, which is equal to 50 percent of the expected claims, could not stop the wave of lawsuits, because the clients were not satisfied with partial payment, which is document by the continuation of the influx of lawsuits after the first partial payment in 2005 and even after the second partial payment in summer 2007.
The provision of the remaining 50 percent of the necessary amount by means of a loan, as presumed by the law, has been and still is an illusion. Despite the foregoing, the Fund attempted several times to obtain the loan. It addressed all major banks in the country but was notified that the loan cannot be provided to it due to its financial situation.
Expected compensation amount according to KTP's bankruptcy trustee 1,908 million CZK
After the trustee's replacement, a new category of assets – contractual fines – has been identified in the total amount 551 million CZK
April 2004: the second trustee proposed to the Fund the following adjustment of the amount of contractual fines 346 million CZK
October 2005 - JK's judgment: the contractual fines are not client assets – a precedent for reduction of compensations in the total amount of 369 million CZK
April 2007 – the number of lawsuits against the Fund exceeded 11,000, the total amount sued 1,127 million CZK
May 2007 - the Fund obtained “client cards” from the court, reconstruction of KTPQ's accounting history, identification of fictitious transactions, purchases without funds on the account, different acquisition costs of client assets- compensations reduced by ca 13 million CZK
Almost 2000 judgments were issued until full payment of KTP compensations, based on which the Fund paid 148 million CZK (of which 97M CZK principal, 21 million CZK late interest and 30 million CZK legal costs). The total savings of the Fund resulting from conducting lawsuits amounted to 27 million CZK.
After receipt of the state subsidy, the Fund paid in 2008 compensations to most former KTP's clients:
Principal paid to former clients 1,367 million CZK Interest paid to former clients 164 million CZK Total compensation incl. interest paid to date 1,531 million CZK
Due to intensive negotiations with legal representatives of KTP's clients, the Fund managed to agree in 2008 on a three-year payment schedule of out-of-court settlement of the legal costs in the total amount of 138 million CZK, which prevented the Fund's insolvency and executions against it. The sum of principal, interest and legal costs covered by these agreements amounts to 734 million CZK. Out-of-court settlement agreements resolved 8,167 lawsuits with total legal costs amounting to 139 million CZK.
The above-mentioned GFOCP's experience indicates that, given the Czech legislation and case law, EU's initiative focusing on significant acceleration of payment and increase of the compensation amount would significantly worsen the functioning of the compensation system.
Indemnity plan could cost €28bn
By Steve Johnson
Published: October 3 2010 10:15 | Last updated: October 3 2010 10:15
Europe’s asset management industry faces a bill of as much as €28bn ($38bn) to fund a continent-wide investor compensation scheme demanded by Brussels. The “whacking great” figure is more than four times the operating profits of €6.4bn racked up by the western European fund industry in 2009, according to McKinsey, the consultancy. The European Commission is pressing ahead with plans to create a pan-European investor compensation scheme to augment the patchwork of national schemes in operation. Crucially, unlike many existing schemes, the new vehicle would be pre-funded, with a target funding level of “at least” 0.5 per cent of the value of assets covered by the scheme.
More than €5,600bn was invested in Ucits funds, which the scheme is designed to cover, as of the end of March, according to the European Fund and Asset Management Association, although some of this will be on behalf of institutional investors and may not be subject to the levy. The compensation fund is designed to cover losses resulting from fraud or administrative malpractice, or where there is a loss of assets due to the failure of a depositary or sub-custodian, as happened to a small number of Ucits funds caught up in the Madoff scandal.
The Europe-wide scheme would also raise the maximum pay-out to an investor to €50,000, up from the €20,000 limit enshrined in many national schemes. It forms a strand of Brussels’ plan to harmonise compensation schemes for the banking, insurance and investment industries across the 27-member bloc. However, while broadly agreeing with the concept of the scheme, industry figures argue that its sheer size will cause problems. The UK Investment Management Association has warned the cost could “give rise to a massive and unpredictable increase in levies for firms, which could have a destabilising effect on the markets”.
Susan Wright, adviser, regulation at the IMA said: “The idea behind it is great but our concern is it has this 50 basis points [levy] across all funds. We feel that is an arbitrary figure. It’s a whacking piece of money.”
Peter de Proft, director general of Efama, said: “There are additional costs, very likely to be ultimately borne by Ucits unitholders, which would be entirely disproportionate to the benefits of the protection and therefore a threat to Ucits versus other investment products, for products that don’t have a problem. “The crisis did not come from funds, people were not losing money in them, it was the banks.” Peter Tyler, policy director, retail at the British Bankers’ Association said a pre-funded system would be “prohibitively expensive”, with 0.5 per cent of assets “totally disproportionate” to the likely liabilities. He argued the concept of pre-funding, which is designed to speed up the payment of compensation, was less important for long-term investments than for bank deposits.
Seán Páircéir, chairman of the Irish Funds Industry Association, feared the levy would lead to “a significant” change to the cost of operations, and that the industry was being punished “because of the failure of a small number of participants to exercise full control”.
The proposals, about to start their passage through the European Parliament, will also need to be agreed by the Council of Ministers.