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Konstantin Y. Smolentsev
SMOLENTSEV & Partners » Press Centre » Publications and Speeches »

Protecting investor's rights: International experience

Konstantin Y. Smolentsev
 Ph.D., the Academician of IIA, ÑÌÑ
Chairman of Board of directors
IC “SMOLENTSEV & Partners”
http://www.smolentsev.com/

National interests of all countries demand protection and support of priority from the point of economic safety and economic interests of certain types, spheres and directions of investment activity. As for the types, they are first of all direct investments and trade credits, because the first ensure control of objects for investing capital, and the second are a verified way of developing export of commodities and services [1]. For conciliation and arbitration of different investment arguments International center for regulating investment arguments was established.

In 1993 world society has come to the agreement of cooperation in the sphere of investment activity. In the agreement countries-participants acknowledge the value of deepening the mutual beneficial economic cooperation and take into the account mutual interests and advantages of coordinated ways in development and carry out of investment politics [2].

In USA, where currency control is absent, informational and technical support for investors is partially offered by the Overseas Private Investment Corporation (OPIC). In 1976 a new law took action: “Review of international investments” (furthermore became an article in US Civil Code), in accordance with which “the American government is authorized to collect a certain amount of information about US investments outside the country”, and avoidance of presenting information has its administrative punishment and even criminal record [3].

The more the country is economically developed the more actively it participates in the international financial exchange on a balanced ground. Foreign investors are regulated mainly by the national laws, orders and administrative procedures. General statements of these acts in majority of developed countries are identical. Main principle which such legislation bases on consists of the fact that foreign physical and legal person who perform their activity in the country have to abide by the legislation and legal norms, which apply to national companies and enterprises.

In majority of aspects of economic activities national legislation doesn’t make a distinction between the national and foreign companies, applying to them their articles of civil and commercial law and especially joint-stock rights. This is why in many western countries there are no special laws or codes for foreign investments – there are only some administrational statements and attached articles of certain laws.

Mainly legislation is directed at liberalization of the investment regime and granting foreign investors more or less comfortable conditions in comparison with domestic. National laws do carry guarantees for foreign investors in terms of transferring the profit and in the case of expropriation of their property – full compensation, order of disputes resolution among foreign investor and the accepting investments government.

In the set of national laws government is recommended to follow worked out in 1993 by MVF and MBRR concepts for foreign investments. Principles stating the same regime for foreign and national investments and acknowledgement by the host country of rights to use national judicial bodies prohibit discrimination in terms of foreign capital and are the base for national politics in the sphere of foreign investment.

It is necessary to mention the fact of expanding the sphere of activity of modern national legislation for direct foreign investments including all kinds of property actives and connected with them rights for ownership (including rights on intellectual property), which are invested in by foreign legal and physical persons. Though these kinds of laws are mostly for private investments, in the present moment they often include investments of government organizations.

Protection of investors in US and Canada – is a matter of all organizations, professionally connected with the market of securities. Special printing houses make certificates impossible to forge, banks securely store them, transfer agents operatively transfer property, registrars keep track of the turn around so no false valuable paper gets in there, stock exchanges fight over liquidity, authorities issues laws and take finger prints from workers on broker firms… As experience in USA and Canada shows, vague attitude towards an investor is not enough for him to feel protected: it should be specified and supported by special laws, accompanied by rights and means of protecting investors from concrete evil.

Under investments we understand investing in securities not in real actives. Investor is the one who thinks beforehand about risk minimization when buying securities [4]. Retail investor spends his own money, and institutional – money which were received from retail investors. Each investor has concrete goals on the market of securities, which reflect their financial possibilities, acknowledgement of risk, getting a high and stable profit, increasing capital and liquidity [5].

In US and Canada there is the most effective system of protecting investors’ rights. Probably that is one of the reasons that markets of shares of these countries are effective. Legislators were able to walk the “thin line” separating weak regulating from suffocating. Well protected investor actively invests and delicately regulated broker feels comfortable in an atmosphere of intensive competition. Not surprisingly that North American system is for many countries including Russia a perfect example for imitation. Some of its elements have been translated into the Russian system. For example after appearance of the Federal law 22.04.96 #39 FZ “On the securities market” (in the present moment 28.12.2002) and in the following instructions from FKCB Russia on how the prospect of emission should be prepared, problem about open information for a buyer on the primary market may be considered solved. We can say the same about protecting interests of shareholders in investment funds, inner accounting of operations with securities and so on.

In USA and Canada there are three lines of protecting investor: government, self regulating broker organizations and brokers themselves [6].

Government line of protection consists of special laws, and also bodies, which are responsible for carrying out those laws by participants in the industry of securities. Limitations and interdictions elaborated on the base of these laws are the most liberal. Juridical base of government regulation of securities market in USA are consisted of the following laws:

o Securities Act (1993), which demands that investors have information about emitters and their securities publicly placed and prohibits deceit and swindle when selling securities. That is why government registration of majority of released corporative valuable papers is mandatory;
o Securities Exchange Act (1934), which provides concept of publicity of corporative information on securities of the stock exchange turn over with the goal of protecting the investor. In 1964 this conception was expanded to securities of the outer stock exchange. Law prohibits certain operations with securities and dictates rules for market participants to make market fair and organized;
o Trust Indenture Act (1939), which forbids public placement of corporative obligations if the trust contract which contradicts requirements of law and holds requirements for credit organizations which carry the role of a trusty holder of obligations;
o Investment Company Act (1940), requiring that companies investing another’s means in valuable papers inform investors about their financial position and investment politics. Law regulates work of those companies.

Federal commission for securities and funds controls performance of the law.

In Canada each province has its own law on securities. In seven provinces there are commissions for securities and in three – administrators for securities. Provincial laws have a lot in common, and responsible for it persons constantly consult with each other. SEC cooperates with some Canadian commissions in the sphere of obtaining the law and order on the market of securities.

Both countries have several government organizations that in one way or another influence the market of securities. In USA among those organizations stands out Federal Reserve System (FRS) and in Canada – Bank of Canada. These central banks keep track of credit and monetary aspects of investments in securities and are the key figures on the market of government obligations.

Laws provide for regulating bodies mainly two functions, performance of which more or less protects investing public from financial losses caused by evil thought or incompetence. First of all it is supporting open information about emitters and their securities, and secondly control of the market by registering professional participants of the market – brokers first of all.

Self regulated organizations of brokers cover those spheres which are not protected or protected slightly by the first line. Directions of the self regulated organization regulate many aspects of investment business, which are left without attention by legislators or described by it in general terms. Moreover limitations and prohibition on professional work increase and become stricter. In USA those organizations are fund exchange stocks, National Association of Securities Dealers – NASD, Municipal Securities Rulemaking Board – MSRB. In Canada the status of self regulated organizations have fund exchange stocks in Montreal, Toronto, and Vancouver as well as in provinces of Alberta, Investment Dealers Association of Canada – IDA, bond traders Toronto and Montreal – firms specializing on trade of obligations.

As NASD defines it, goals of the self regulated organizations are assistance in observance of federal laws and provincial laws; standardization of principles and practice of investment business; assistance for members in cooperation with government authorities in solving problems which are problematic for the sphere and investors; acceptance of rules of fair practice and control of its performance; establishment of principles of fairness and equality in trade to protect the investor.

Third line of protection are brokers themselves. They protect themselves from investors and investors from them. Documents and procedures of this line are elaborated with regards to the government law, instructions of self regulated organizations, and specifications of the broker business. This line may be more secure than two others or maybe weaker then them. For example, official return minimum when buying shares in credit may be lower than 25% and broker may increase that minimum till 30% or even forbid clients to buy shares in credit.

Majority of brokers are members of self regulated organizations which are under the government commissions.

Laws in USA and Canada were forming under the influence of two conceptions. According to the liberal conception “pure disclosure” company may sell any securities if it has informed all its investors all material details of the project and securities. According to “blue sky laws” [7] having open information is not enough and securities are not allowed to be issued without official approval given after analysis of securities by government workers.

Liberalism has had its own victory although not complete. Each prospect of emission of securities in Canada starts with an official precaution: “Prospect represents a public offer of securities only in those jurisdictions where they may be legally sold by party which has all sanctions for sale. No other commission for securities in Canada judges the value of the securities and any opposite statement on this account is a crime”. Similar precaution is in every American prospect.

Rule “know your client” tells broker that his main problem is to connect the offer of the market with the demands of the investor. From many investment products offered by the firm broker must choose those which will bring the most benefit to his client. Good knowledge of investments is a result of professional preparation and good knowledge of the client is a result of a specialized analysis held in the period when client opens his account in a broker firm.

In North American broker firms there is a strict and all covering system of inner control. All accounts are inspected periodically (client and professional). Revision should uncover the possible unfair trade activity of certain persons whose accounts are under control from other brokers, certain securities and separate participants of the firm as for example, “crosses” between clients and employees, concentration of the capital in speculative securities, extremely large buys and sales, unsuitable transactions, constructing “pyramids” and so on. Especially cautiously go under revision accounts of trusty management. In addition to daily revision of these accounts not less than once in each quarter they undergo a revision by investment committee of the firm on the topic of coordination of the briefcase investment profile of the clients. This way on a final stage of the investment cycle (when the deal is in archive) we can see how well every broker followed the rule “know your client”.

Special laws say that trade of securities on the stock exchange and outer market is regulated by the government to protect the investor, limit the deformation of the information, fraud, manipulation of the market and other antisocial activities. Government strives to a point where all professional participants of the market fairly treated investors and among themselves had equal rights.

USA Law “Stock exchange of securities” forbids: buying and selling to clients of one security by the same price through wash sale or matched orders; closure of short positions with a loss for short sellers in the result of an agreement who has the largest block of shares (cornering); distribution of false statements; fixed prices. This law also forbids cheating actions targeted at changing prices on stock exchanges, for example: “fast sales on a minus wave (after lowering the price), as they lead to price depression; surplus trade that is additional commissions; agreements on buying again securities in the matter which can lead to manipulating prices; usage by broker client actives in personal goals without written permission of the client; confirmation of the deal on the means of a client without giving all the information about it and hiding facts which may influence on the decision of sale or purchase; pressure on the investor with the goal of making them buy the securities; secret deals on a non existing account; usage of the insiders of private information with the goals of personal profit; short trading which is agreement to sell securities not belonging to any person as an answer to the public to buy it; stabilization deals which do not follow SEC.

In USA law assigns the Council of State heads of FRS to regulate crediting of purchases of securities; in Canada this job take on self regulated broker organizations. SEC basing on the law “Securities Investor Protection Act” (1970) developed instructions on treating brokers with client values. These instructions are for a purpose that:

o Clients’ belongings intended for purchase of securities and received from usage of clients’ securities are to be stored in a secured place or be transferred on the account in a federal reserve bank;
o Fully paid securities of clients to be accounted by brokers and to be placed under their control and under their authority;
o Service of clients to be separated from company’s trade and underrating;
o Account books of brokers to be updated daily;
o Deals to be taken care of fast and without mistakes;
o Clients’ money shouldn’t be used by the broker;
o Financial responsibility of a broker to be increased;
o Client actives to be protected in case of liquidation of a company [8].

Documents and procedures necessary for the deal are developed by self regulated broker organizations, NASD and IDA (mainly for outer stock exchange market) and stock exchanges (for its members). The main danger is on the stage of working out the deal – disability to pay or receiving securities or delivery of securities in the case of a sale. The guilty (or the victim) may be an investor, dealer (if it’s a dealer deal) or contra agent (if it is a deal done through an agent).

Thus, NASD forbids its members to accept orders for purchase if there is no confidence that the client will take securities at the moment of payment. And on the opposite, it is unreasonable to sell securities by client’s order if there is no confidence that client has securities and will present them in the scheduled time. To fulfill requirement for reasonable confidence broker includes in the form of order location of the securities intended for sale.
IDA forbids registration of securities on the name of a buyer or nominal person (including securities bought on the primary market) until he has the payment for the securities. Acceptance of the registration fee by a broker from a buyer prior payment is considered an infringement.

In the case of bankruptcy of its broker American investor may go to the Securities Investor Protection Corporation. Created in 1970 with the support of the federal government it pays compensation to investors who have suffered losses from the bankruptcy of brokers. Corporation secures and guarantees client accounts with pure value up to 500 thousand dollars in the account on one client [9] (100 thousand from them should be in monetary form), and also gives its guarantees by collecting an annual fee from brokers. Having received a notice of upcoming bankruptcy of a broker corporation through court sets a trusty to manage the firm. Trusty informs the creditors and clients about the firm’s condition, liquidates its actives, distributes any revenue among creditors and clients and compensates expenses of clients depending on the size of their account. If the financial crisis in the broker society would grow into a terrible condition, then corporation would be allowed to use up to 1 million dollars from the USA exchequer to restore client accounts of the suffered firms.
In Canada the same role plays the Canadian Investor Protection Fund, which was established in 1969 by exchange stocks and IDA. Its main role is to support the trust of investors for the industry of securities, protecting clients form financial losses because of the inability to pay or bankruptcy of the broker.

In Germany there is no one law or body that regulates foreign investments. Law “On external economic connections” (1961) is the only base for regulating currency operations and movements of capital. All payments across the border may be done freely by any person in any currency; there is no restriction on volume or character of deals. According to this law government of Germany has all authority to regulate external economic relations and in certain conditions introduce restrictions on work of its certain articles including on foreign entrepreneurship (direct foreign capital investment). And it is also agreed that the applicable restrictions should not harm the mechanism of functioning of the market economy of the country.

Restrictions may be introduced only in those cases if foreign investments will have negative influence on meeting the responsibilities of Germany under the agreements, signed in the framework of participating in international economic organizations. A considerable motive for having restrictions may be the security questions in the external political interests of Germany. Foreign investors are given an opportunity to create enterprises in different forms. Among them we can highlight joint-stock company, Limited Liability Company, full trading company, Commandant Company, individual enterprise. Branches of international firms of some other legal form do not count.

In France there is also no special law regulating foreign investments. Main normative acts in this sphere are the following: Law about financial relations with foreign countries (1966); the decree concerning conditions of applying this Law (1967); decrees regulating financial relations with foreign countries (1968 and 1989); circulators of Ministry of economics, finances and budget on direct French investment in foreign countries in France (1987). Questions of regulating foreign investments are handled by the Bank of France, the Ministry of economics, finances and budget.

Created and active on the territory of France foreign company uses the same rights as a national one, that is it has to abide by the national regime of paying taxes, getting credits and other benefits. In the legislation of France there is a strict division between direct and other foreign capital investments, which is explained by applying benefit regulation in regards of the last ones. Despite the considerable simplicity of the procedure of regulating of foreign investments in the country for most operations connected with realizing direct investments on its territory there is preauthorization on intentions.
For investing capital in the economy of France companies and private persons not being members of EU have to get a special preauthorization. That system is targeted at protecting national economy from extreme influence of international capital and establishing control upon some sphere of economy. Besides that, special permission is required for foreign capital investments (as well from countries of EU) if they are: directed in branches activity of which is strictly controlled by foreign official authorities; if they can lead to a threat for national security; breaks the statements of the currency and financial legislation of the country. Here we are talking about investments in production and trade of weapons, military equipment and explosive substances, in banking and insurance, in publishing, in communications, radio and TV broadcast, transport, power and extraction of minerals.

Liquidation of capital investments of foreign investors and transfer of revenue from France is done without any limitations. However while transferring funds created in the result of liquidation of the foreign company in some cases it is necessary to perform certain formalities.

Great Britain doesn’t have any special legislation about foreign investments. Joining EU meant putting in accordance British legal rights about a company with the directives of that organization. In the result there were accepted Company Acts (1976, 1980 and 1981). Having a lot of legal acts lead to an attempt to consolidate them and in 1985 there was accepted a new Companies Act which later was changed and added. Among other normative acts we should mention Finance Act (1972 and 1975), Banking Act (1979), Arbitration Act (1979), Company Securities Insider Dealing Act (1985).

Foreign investors utilize such called national regime that is realizing their work in the same legal field as local companies.

However there are some deviations. First of all for foreigners there are restrictions in entrepreneurship in aerospace industry, air and sea transport, movie making, TV and radio broadcasting. Secondly, in accordance with the Industry Act (1975) switching of the control of large corporations under foreign control may be prohibited by the government if contradicts country’s interests.

Great Britain doesn’t have a currency control which eases export and import of the capital. The Bank of England just registers movement of the capital.
On the English market of loan capitals there are no restrictions for foreign loaners. Foreign entrepreneurs can use different investment benefits: gratuitous grants, loans on favorable terms, government guarantees for getting bank loans, tax discounts.

All in all politics of foreign governments in the investment sphere target at the following main goals: directing investments on restructuring of economy and increasing its affectivity; turning savings into investments in the real sector of economy; formation of an effective and controllable market of capitals; decreasing and insuring investment risks; improvement of the investment climate for domestic and foreign capital. Naturally, legal guarantees for investors are the most important criteria for beneficial attractive investment climate.

1 See.: Bulatov A.C.. Protecting interests of Russian investors abroad and national interests of Russia // Externally economic bulletin. 2002. ¹ 7. Ñ. 30.'
2 See.: Dmitrieva G.K., MJB. INTERNATIONAL TRADE RUGHT. — Ì., 1999. Ñ. 84.
3 Cit. : US Civil Code, § 3110.
4 In comparison with an investor, speculator is ready to take the risk, and player – any.
5 See.: AlehinB.I. Protecting investors in USA and Canada // USA. Canada. Economics. Politics. Culture. 1999. ¹ 9. Ñ. 115.
6 See.: there in the same article. p. 117.
7 In 1991 legislation of the state of Kansas decided to protect investors from unfair sellers of securities. The Supreme Court of the USA decided that state laws on securities are meant to protect investors from deals that are “pointless like several feet of blue sky”.  Here we meant extreme bureaucratic intervention in the trade of securities. For example episodic unfair deals were blocked by authorities of the state, but that intervention would annually add millions of dollars to the transactional expenses of small companies trying to mobilize capital.
8 See.: Alehin B.I. Decree. p. 130.
9 It means that the client may have several accounts in one broker firm and guarantees of the corporation will be expanded to all their accounts.

«Modern law», ¹ 1, 2004

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