Reports on Observance of Standards and Codes Czech Republic and the IMF Czech Republic ROSC I.  Update II.  Overview III.  Data Dissemination IV.  Fiscal Transparency V.  Transparency of Monetary and Financial Policies VI.  Banking Supervision VII.  Securities Market SURVEY What do you think of Reports on the Observance of Standards and Codes?

REPORT ON THE OBSERVANCE OF STANDARDS AND CODES (ROSC) Czech Republic   Queries/Comments      should be directed to:    Director    European I Department    700 19th Street, NW    Washington, DC 20431    202-623-7000    http://www.imf.org    scu-comment@imf.org VII.  Securities Market   Prepared by staff from the International Monetary Fund on the basis of information provided by the Czech authorities Prepared in August 1999 and reissued in July 2000 Transparency and the Securities Market1 1. This chapter discusses the institutional framework and practices in the Czech securities market, focussing on the equity market and the investment funds.

2. The origins of the Czech securities market are closely linked to the mass voucher privatization scheme, which formed the center piece of the government’s economic reform program in the early and mid–1990s. 2,3 The voucher privatization led rapidly to a very large number of publicly tradable companies and the capital market was lightly regulated in order to encourage secondary trading and ownership transfer. In 1997, the Czech Republic had over 2,100 listed joint stock companies, with a market capitalization of around 30 percent of GDP, suggesting a capital market much larger than in other transition economies and of comparable size to some well-established Western European markets. 3. However, these figures are somewhat misleading. First, the bulk of the listed companies are in fact not traded. Second, government holdings of enterprise shares through the NPF (which are not traded) account for about 40 percent of market capitalization. Adjusting for double counting resulting from the role of investment funds as major shareholders in some large enterprises,4 the World Bank estimated that in 1997 the "true" size of the Czech capital market was around 14 percent of GDP—much closer to that of other transition economies and countries with the same level of per capita income. A. Description of Practice5 Regulatory Framework 4. The Czech securities market is regulated by a number of laws and decrees introduced gradually since 1991, and amended on several occasions since then, including: the Bonds Act (1990); the Commercial Code (1991); the Securities Act (1992); the Stock Exchange Act (1992); the Investment Fund Code (1992); and the Securities Commission Act (1998). 5. Primary supervision over the securities market was exercised by the MOF until 1998 when an independent SC was established. The SC has enforcement powers in specific areas related to securities issuance and trading, although the enforcement of provisions contained in the Commercial Code (e.g., those governing buy-outs and the obligations of publicly-traded companies) remains with the commercial courts. 6. The SC is guided in its work by the Czech Republic’s objective to join the European Union (EU). Hence EU standards and regulations, rather than IOSCO principles, have constituted the SC’s primary frame of reference in its first year of operation.6 The SC also actively participates in international fora addressing financial crime. The SC does not have the authority to issue new regulations, which must be adopted as government decrees and remains within the purview of the MOF. However, it has the responsibility to initiate regulations by preparing drafts of government decrees for the MOF in its areas of competence. 7. The regulatory powers of the SC as well the penalties for non-compliance are publicly known. The appeals process against decisions of the SC comprises, in the first instance, an appeal to the SC Board, which has established independent appeals committees to handle such cases. Further appeals then go to regional courts and, in the final instance, to the Constitutional Court. 8. The regulatory framework and the practices of the SC, including its objectives, role and responsibilities, modalities of accountability, and internal rules and regulations are posted on its public web site. The SC issues monthly reports on its activities and decisions, as well as quarterly budget and activities reports, which are also available on its web site. Before finalizing any proposal for new market regulations, the SC solicits input from a variety of affected groups through widespread public consultation, and its recommendations and drafts of new regulations are also posted on its web site. Functioning of the Czech Securities Market 9. The Czech equity market is characterized by a multiplicity of dealing channels. An investor has three options: (i) go through a broker to the Prague Stock Exchange (PSE); (ii) deal directly on the "RM" system (one of the two organized equity markets, the other being the PSE); or (iii) deal privately off-market with another investor. A broker, in turn, can either operate as a member of the PSE, deal on the RM system, or deal bilaterally with another member of the PSE off-market. 10. As noted in the World Bank report, this structure of the equities market has contributed to fragmentation and price distortion.7 In 1998, the PSE introduced a market maker-based trading system (SPAD–The Czech acronym for System Supporting the Market for Shares and Bonds), which increased sharply the proportion of trading on the PSE taking place at market-determined prices. However, the RM-System (which in 1998 accounted for about 16 percent of trading) continues to be dominated by direct trades. Trading completely outside the two organized markets accounted for a further 20 percent of the trading volume in 1998. 11. At least since the 1996 amendments of the Commercial Code and the Securities Act, joint stock companies have been subject to extensive disclosure requirements.8 Initial compliance was patchy, however, and in February 1999 the SC issued fines to over 800 publicly-traded companies for failure to comply with disclosure requirements. Since then, compliance has improved dramatically. 12. Investment funds were introduced in 1992, during the first wave of the voucher privatization program. They were expected to play a number of important roles, including collecting vouchers from individuals, bidding for shares in primary auctions, conducting secondary trading, and exercising active corporate governance. However, liberal licensing criteria, lax supervision, limited disclosure rules, and weak performance incentives contributed to poor performance of these funds, and the perception that several investment funds were vehicles for fraudulent transactions. In addition, the closed-end structure of the funds, which exempted them from the obligation to redeem shares at their net asset value on demand, acted as a disincentive for fund managers to maximize the value of their portfolio. 13. Beginning in 1998, the government started to reform the regulatory framework of the securities market, including the investment funds. The 1998 amendment to the Investment Fund Act mandated the gradual conversion of closed-end to open-end funds, and the SC was established in that year. The conversion of closed-end funds is proceeding well, with half of the funds having already opened voluntarily and ahead of schedule. The SC’s first task, the relicensing of all securities brokers, investment companies, and public market organizers, is almost completed and is likely to lead to a sharp reduction in the number of licenses. B. IMF Staff Commentary The segmentation and (initial) loose regulation of the securities market contributed to a lack of transparency in pricing of securities, evidenced by the frequent multiple prices for the same security. Technical factors, such as the absence of a harmonized dealing and settlement system, have partly accounted for the price divergence. Another reason would appear to be the willingness of large investors to pay a premium for corporate control. However, there has also been evidence of fraudulent transactions, including the use of shell companies for asset stripping, which may help explain the significant price differences between markets. This has been compounded by weak corporate governance on the part of many of the investment funds. At the level of individual enterprises, insufficient corporate disclosure, largely because of the lack of enforcement of existing requirements rather than inadequate requirements per se, also weakened outside monitoring and control. Recent improvements in compliance with disclosure requirements are a welcome sign of increased transparency, but the lack of enforcement responsibility of the SC in some critical areas such as the regulations governing shareholders’ rights has continued to cast a pall over the Czech capital markets and prevented the confidence of investors from being fully restored. In addition, the lack of direct regulatory powers remains an impediment for the effective functioning of the Commission. While the establishment of the SC was an important step forward and the Commission is characterized by far-reaching transparency in its structure and operation, issues need to be addressed, despite the 1998, reforms in both the areas of regulation and enforcement, as well as market fragmentation, if capital markets are to be strengthened on a durable basis. The focus of further reform—currently under consideration—should be two-fold: First, further strengthen the regulatory framework. A comprehensive package of legislation (amendment of the Commercial Code, the Accounting Act, the Securities Act, the Securities Commission Act, and the Bonds Act) is being prepared with the aim to introduce it on January 1, 2000. This package should, inter alia, strengthen minority shareholders’ rights, clarify the responsibilities of boards of directors, improve disclosure, and facilitate takeovers of inefficient companies by strategic investors. The package should also strengthen the enforcement powers of the Commission, enabling the agency to enforce key regulations of the Commercial Code (e.g., minority shareholder rights). The authorities expect that several companies will be unable to comply with these stricter rules, resulting in a reduction in the number of publicly tradable companies to those that really fit the profile. Such a package would greatly improve transparency in securities market activities and strengthen corporate governance. In this regard, it would also be desirable to invest the SC with direct regulatory powers and reduce its dependence on the MOF. Second, address the continued fragmentation of the securities market. The authorities are also making efforts in this direction, by strengthening the role of SPAD (the dealer system introduced in early 1998) and introducing an order routing system, ensuring the execution of best orders. Enhancing the transparency of off-market trading by imposing stringent disclosure requirements equivalent to those prevailing in the formal markets would also contribute to reducing price divergence. It will be important that efforts on both fronts are carried to fruition if much-needed transparency and confidence in the Czech capital market are to be restored. 1 Prepared by Mr. Nord (European I Department) and Mr. Rocha (World Bank), in consultation with the Czech authorities. 2 The development of the capital market is discussed at length in, for example, the World Bank's recent report: Czech Republic -Capital Markets Review, A World Bank Country Study, May 1999. 3 For a summary of the voucher privatization scheme, see, for example, The Enterprise Sector and Corporate Governance in the Czech Republic-An Assessment, in Czech Republic-Selected Issues, IMF 1999 (SM/99/157, Sup. 1, 7/7/99). 4 The double counting results from the role of investment funds as intermediaries: total market capitalization includes both the value of these intermediaries' shares as well as that of the securities in which they invest. 5 This is a summary prepared by the IMF and the World Bank staff. It was reviewed by the authorities and based on information provided by them. 6 It appears that the Czech securities regulations comply with the majority of IOSCO principles, the main exception being the role of self-regulatory organizations, which are currently not covered by the Czech regulatory system. 7 The World Bank (1999) estimated, based on an analysis of data on stock price behavior between January 1996 and March 1998, that formal market mechanisms handled only 5 percent of trading volume, with most transactions negotiated off-market at prices that differed significantly from those determined in the formal market. It was not uncommon to observe significantly different prices for the same security in the various markets. 8 Companies are required to prepare annual audited balance sheets and income statements, an extensive and detailed annual report, and six-monthly financial statements, unaudited but following a standard format. Companies listed on the PSE must submit quarterly financial statements as well.