CNB Guidelines on Due Care (ODBP)

CONTENT

1. Purpose and Nature of the Material..................................................................................................... 3
2. Scope ........................................................................................................................... 6 2.1. Personal Scope ....................................................................................................... 6 2.2. Subject-Matter Scope ........................................................................................................ 7
3. Due Care as an Indefinite Legal Concept ......................................................................... 8
4. Principles of Assessing Due Care..................................................................................... 9
5. Conditions for Exercising Due Care .............................................................................. 11
6. Topics Related to the Issue of Assessing Due Care ....................................... 12 6.1. Investors and Customers – Recipients of Due Care.......................................................... 12 6.1.1. Protection of Investors and Customers ........................................................................ 12 6.1.2. Who is a Customer – Towards Whom is Due Care Directed? ................................ 13 6.1.3. Relationships with Customers......................................................................................... 14 6.1.4. Informing the Customer..................................................................................... 14 6.1.5. Conflicts of Interest........................................................................................................ 15 6.1.6. Customer-Entrusted Assets .............................................................................. 16 6.2. Principles of Due Care - Competence, Honesty, Integrity, and Responsibility............ 16 6.3. Practice on the Capital Market........................................................................................ 17

Appendix: Due Care for Specific Entities

1. Securities Dealers and Investment Intermediaries.......................................... 18
2. Investment Companies, Investment Funds, and Custodians........................................................ 26

ODBP ● October 2004 ● Version 1.1. 1

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ODBP: Change Log

Change No.	Effective Date	Description of Changed Section	Version Number After Change	Made By
1.	13.10.2004	• Technical amendments following the entry into force of new legal regulations<br>• Change in the personal scope of the material<br>• New definition of the term "customer"
• Individual elements of due care are supplemented with links to legal regulations and Commission materials
• Addition of methodology for some new cases from practice
• Renumbering of chapters	1.1.	MAO

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ODBP 1: Purpose and Nature of the Material

1. Purpose and Nature of the Material

The Securities Commission (hereinafter referred to as the "Commission") is legally obliged to exercise state supervision over the compliance with obligations established by legal regulations in the field of the capital market. Within this authority, the Commission interprets and applies legal regulations governing the capital market area. One of the statutory objectives of the Commission is to contribute to the protection of investors and the development of the capital market.

The purpose of this document is to bring to the attention of capital market participants the interpretation of the concept of "due care," which the Commission applies and will continue to apply in the exercise of state supervision over the activities of service providers on the capital market. The material should contribute in particular to increasing the level of legal certainty for capital market participants and to making the Commission's activities as a regulator more transparent in the interpretation and application of the law.

The term "due care" is a frequently used indefinite legal concept, the interpretation and subsequent application of which gives rise to a number of problems and disputes at all levels, from market participants themselves, through the Commission, to the courts. The Commission's aim was to create a more general document outlining this concept in broad terms and describing how the Commission interprets and applies it in its activities.

The Commission is aware that the definition of the concept of due care is relatively complex and depends on the specific circumstances of the case. The interpretation of the concept of due care is also largely determined by practice on capital markets, which is currently constantly evolving in a period of rapid changes (trading and settlement technologies, new forms of communication and remote service provision regardless of national borders). Therefore, it is impossible to provide a comprehensive definition of this concept in advance, but certain principles can be established according to which due care (or the exercise of due care) will be assessed. On the other hand, it must be said that the concept is not new, but is a traditional concept, previously used mainly in the field of private law.

In preparing the material, the Commission was guided primarily by its previous experience in the exercise of state supervision, as well as by established judicial and doctrinal interpretive practice of the concept in question.

The structure of the material is based on the Commission's approach to assessing actions involving due care. The material first broadly defines the principles of action with due care and its assessment, which should serve as a guide when deciding on the exercise of due care, and then contains in the appendix a summary of the Commission's previous decision-making practice in this field. However, it must be taken into account that the domestic capital market has been undergoing relatively rapid development since its inception, moving towards the standardization of structure and business practices typical of developed markets. Some of the Commission's decisions cited, especially those older (before the year 2000), are based on the factual and legal situation where the domestic capital market suffered to a greater extent from a number of deficiencies and non-standard phenomena. Although the actions described in some of the cited decisions are characteristic of the past and are now very rare phenomena, the Commission considers it appropriate to include them in this material as illustrations of its approach to assessing due care.

Under no circumstances should one expect the Commission to create in advance a detailed catalog of permissible or impermissible actions, according to which market participants could simply follow and from which it would be completely clear in advance which specific actions the Commission considers to be the exercise of due care and which are not. The Commission intends to proceed "bottom-up" in the future, i.e., to gradually supplement the material in the form of appendices with individual specific cases and any generalized solutions, but always based on practical experience.

In the appendix to the main document, the concept of "due care" is specified for individual types of service providers on the capital market. It lists the Commission's decisions published so far relating to due care, as well as examples from practice that the Commission has recorded in its activities. The appendix is divided according to the individual types of service providers on the capital market. The appendices illustrate the Commission's approach to this issue in individual specific cases and should serve to specify and illustrate the principles mentioned. The Commission intends to continue to supplement the material in the future with specific cases and any generalized solutions in the form of appendices based on practical experience.

One way to expand and deepen the issue of assessing due care is to consult specific problems with the Commission through so-called "qualified questions" (see document "Commission's Approach to Providing Comments to Capital Market Participants," available at www.sec.cz), or to participate in public discussions on draft legal opinions and methodologies.

A comprehensive and current overview of the Commission's activities (methodologies, opinions, decisions) relating to the assessment of due care can be found at www.sec.cz in the section Capital Market by Topic. In this way, the Commission makes its interpretation of the concept of due care available to capital market participants and the public, and makes its procedure in applying this indefinite legal concept more transparent. In its practice (especially in the exercise of supervision), the Commission also proceeds from the assumption that the affected entities are aware of the Commission's procedure and opinions.

This material is not a legal regulation. The Commission is always obliged to decide based on the specific circumstances of the given case and according to the evidence collected in the individual administrative proceedings. The Commission will always respect the principle of individualization of administrative proceedings and material truth as a central postulate.

The Presidium of the Commission approved this material (version 1.0) on 10.11.2003.

Version 1.1 of this material was approved by the Presidium of the Commission on 13.10.2004.

The Commission's contact person is Mgr. Luděk Pestr, Methodological-Analytical Department, tel. 221 096 442, fax. 221 096 110, e-mail ludek.pestr@sec.cz.

Questions regarding the assessment of specific situations and actions should be raised in the form of so-called qualified questions (see above).

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ODBP 2: Scope

2. Scope

2.1. Personal Scope

The obligation to act with due care is not centrally established for individual service providers on the capital market, unlike the previous legal regulation, but is always regulated by the relevant provisions of legal regulations that apply exclusively to that particular person. This fact contributes to the legal certainty of capital market participants, as it allows them to clearly assess whether the obligation to act or provide their services with due care applies to them or not.

This material concerns:

a) Service providers on the capital market:

• Securities dealers (§ 15 para. 1 letter a) of the Act on Capital Market Business);
• Investment intermediaries (Decree No. 429/2004 Coll., which establishes the rules of conduct of an investment intermediary with customers, administrative procedures, and the internal control mechanism necessary for the proper performance of the activity of an investment intermediary);
• Investment companies (§ 75 para. 1 letter a) of the Act on Collective Investment);
• Investment funds (§ 75 para. 1 letter a) of the Act on Collective Investment);
• Pension funds (§ 33 para. 1 of Act No. 42/1994 Coll., on Pension Savings with State Contribution and on Amendments to Certain Laws Related to Its Introduction);
• Custodians (§ 23 para. 11 of the Act on Collective Investment),
• Organizer of a regulated market
  • Securities exchange (§ 58 para. 6 of the Act on Capital Market Business)
  • Organizer of an OTC market (§ 80 para. 1 of the Act on Capital Market Business),
• Operator of a settlement system (§ 83 para. 13 of the Act on Capital Market Business),
• Central securities depository (§ 103 para. 8 of the Act on Capital Market Business),
• Person who maintains a register linked to the central register of securities maintained by the central securities depository (this conclusion implicitly follows from the above provision),
• Person who maintains a separate register of investment instruments, or a person who maintains a register linked to the separate register of investment instruments (this fact can be derived from § 93 para. 2 and 3 of the Act on Capital Market Business),

b) A member of the board of directors or a proxy of an investment company or investment fund who does not have a management contract (§ 75 para. 3 of the Act on Collective Investment).

All the above persons have a statutory obligation to act with due care, which is the reason for their inclusion in the scope of this material. However, the presented material is primarily focused on the due care of securities dealers and persons involved in collective investment, where the Commission deals with this issue most frequently.

2.2. Subject-Matter Scope

This material concerns only those activities that are directly related to the provision of services on the capital market to customers. It therefore does not apply to other activities of service providers on the capital market that they may carry out in connection with their business.

For example, the Commission will not assess whether a securities dealer acted with due care when selecting a provider of cleaning services in the premises where the dealer conducts its business, etc.

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ODBP 3: Due Care as an Indefinite Legal Concept

3. Due Care as an Indefinite Legal Concept

The law, with some exceptions, does not explicitly define what is considered the exercise of due care. According to Article 2 para. 2 and Article 4 para. 1 of the Charter of Fundamental Rights and Freedoms, obligations can only be imposed on the basis of the law and within its limits. The obligation to act with due care, as already mentioned above, is directly regulated by individual provisions of the Act on Collective Investment and the Act on Capital Market Business. The content of this indefinite concept, which represents one way of establishing an obligation based on the law while allowing flexible response to changing reality, is further specified by implementing decrees to these laws.

The term "due care" should be understood as specific actions, which due to their diversity cannot be objectively and explicitly captured in advance in the law. By using this concept, the legislator intentionally gives the administrative authority (and the court) room to assess itself whether a specific case falls within the scope of this concept, always in relation to the purpose of the legal regulation.

An important principle in fulfilling the content of indefinite legal concepts is equality and uniformity of their assessment under equal conditions. Although the administrative authority has a certain margin of discretion in interpreting indefinite legal concepts, it is always limited by the scope of this concept. Indefinite legal concepts cannot be interpreted arbitrarily and ad-hoc, which does not mean, however, that their content cannot change depending on specific conditions. The principle of predictability of law and the legality of public administration must always be kept in mind.

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ODBP 4: Principles of Assessing Due Care

4. Principles of Assessing Due Care

The law assumes for every entrepreneur that they are a professional who knows their field of activity well and who acts in their business with the care and diligence generally expected of every proper trader (so-called care of a diligent manager). This principle was already established in the General Commercial Code (Act No. 1/1863 R.z.), which spoke of the care of a proper merchant.

The concept of "due care" or "care of a proper trader" is a standard term of private and public law since the days of Austria-Hungary and was also used in the law of interwar Czechoslovakia, as evidenced by a number of court decisions dealing with the concept of due care.

Action with the care of a diligent manager is a criterion whose importance lies both in the prevention of undesirable action and in the subsequent possible enforcement of responsibility against the person who should have acted with such care but did not.

This applies all the more to service providers on the capital market, as they are obliged to a higher degree of care, due care, compared to "ordinary" entrepreneurs.

The obligation of due care also applies to other entities, not only on the capital market.

The requirement to act with due care must always be seen in connection with the performance of some specific activity. Due care does not stand alone as a separate obligation, but is always linked to the specific activity performed by the obligated party. Therefore, one cannot define "what is due care," but one must always consider "what is due care in... (performance of a specific activity)." The obligation to act with due care is thus a corrective to the actions of service providers in the performance of any of their activities in providing services.

Due care must be exercised especially in:

• Preparation of conditions for providing services (analytical activities, personnel and technical support, etc.);
• Offering and promotion of services;
• The process of accepting customers (concluding contracts, etc.);
• Advice and actual sale of offered products;
• Handling of entrusted assets (management, administration, execution of transactions, etc.);
• Informing customers.

Due care includes expertise (knowledge) and diligence (activity).

The content of the concept of due care is expertise (i.e., professionalism in the sense of knowing and being able to) and diligence (i.e., in the sense of active action and conscientiousness).

Due care must be assessed according to objective criteria.

The concept of due care must always be interpreted from the perspective of objectivity, in relation to objective professional knowledge and abilities. Due care thus expresses the obligation to exert, in addition to one's subjective abilities and knowledge, professional abilities in handling affairs. If a person acted diligently but not professionally, they would violate their legal obligation. On the other hand, the requirement for quality performance of activities with due care is not exhausted only by the requirement for qualified action. The aspect of diligence must be assessed with equal emphasis. Diligence in performing a certain activity means avoiding unnecessary and irresponsible risk-taking, but also excessive anxiety.

The requirements for the exercise of due care cannot be exhaustively defined in advance; they are always examined case by case.

The concept of due care must be assessed individually in each case, because the manner of acting with due care always depends on the specific activity and its unique conditions. The requirement to act with due care must always be seen in connection with the performance of some specific activity of the person.

The exercise of due care cannot be assessed retrospectively, but always from an ex ante perspective.

When assessing action with due care, one cannot proceed from how a certain action appears retrospectively from the current perspective (which is usually "simple"), but it must always be assessed in relation to the conditions existing at the time of the action in question.

When assessing due care, it is therefore appropriate to conduct a kind of test, in which it is necessary to place the action as much as possible in the context and conditions existing at the time of the action, and only then infer the exercise of due care.

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ODBP 5: Conditions for Exercising Due Care

5. Conditions for Exercising Due Care

Service providers on the capital market should organize and manage their internal affairs effectively and responsibly. The system of internal organization and management is always a condition for performing activities with due care. The prerequisite for exercising due care is therefore that the service provider on the capital market especially:

• Has the necessary material and personnel equipment and its employees are suitable and professionally qualified persons for the activity they perform;
• Applies effective internal control measures (compliance procedures), including compliance with standards and requirements set by the market regulator and procedures eliminating participation in unfair practices such as market manipulation, money laundering, or other types of financial crime;
• Delegates the fulfillment of obligations among management members and key personnel so that their obligations are clear and the company's business and the activities of all its employees can be appropriately monitored and directed;
• Keeps proper records of its activities and internal organization.

The mere fulfillment of these conditions does not exhaust the obligation to act with due care, as sometimes stated. Their fulfillment is only a prerequisite for acting with due care. It always depends on whether and how the service provider acts in a specific case, i.e., whether they utilize the aforementioned potential or not.

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ODBP 6: Related Topics

6. Topics Related to the Issue of Assessing Due Care

In the following text, the Commission describes some topics closely related to the issue of assessing due care. Due to the diversity of business forms and persons with the obligation of due care, the text below must always be viewed from the perspective of the specific activity and the person performing it. This applies especially to the difference between the activity of a securities dealer or investment intermediary (provision of investment services) and an investment company or pension fund (collective investment and pension savings). Although their activities may seem very different, they share many common characteristics, and therefore the same principles and rules of due care apply to this activity.

6.1. Investors and Customers – Recipients of Due Care

6.1.1. Protection of Investors and Customers

Regulation of the capital market is based on the fact that persons meet on this market who are in a very unequal position regarding their professional knowledge and professional equipment (information asymmetry). One cannot expect that this difference will be leveled over time, for example, by all market participants gradually professionalizing.

If only comparably strong, well-founded, informed, and technically equipped entities were to appear on the market, it would be entirely appropriate to leave all regulation of their relationships to the means of private law. However, this is not the case in practice at all. With increasing specialization and demands for the proper performance of professional activities, the difference between professionals and non-professionals in all fields of human activity increases. Every loss of professional abilities of certain entities on one side is compensated by law by increased requirements for the protection of these entities on the other side.

A significant corrective to business on the capital market and business in general is thus the legal regulation protecting the party that occupies a weaker position in the contractual relationship, contractual negotiation, and reality. The statutory term "customer" or "client" should therefore be perceived primarily as the opposite pole to the mentioned professionalism of service providers on the capital market, i.e., in the sense of "layperson," "non-professional," "unqualified investor," or even more precisely "consumer."

The domestic legal regulation distinguishes, with regard to the approach to customers and investors, essentially two categories: professional investors (see § 2 letter a) of the Act on Capital Market Business) and ordinary customers. Furthermore, it must be noted that the Act on Capital Market Business also operates with the concept of institutional investors.

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13 See, for example, the Commission's opinion of 10.5.2000 "Interpretation of the concept of 'customer', 'client' of a securities dealer" (available at www.sec.cz). Strong emphasis is placed on the protection of consumers and unqualified investors in EU member states as well.

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