As in the US, Germany’s dotcom boom in the 1990s saw many investors indiscriminately follow the recommendations of investment analysts. In several cases, this led to a rude awakening. Analysts and investment banks attracted strong criticism. There was widespread and sometimes justified suspicion that investment analysts often lacked the required degree of independence and assessed shares in a manner that did not fully correspond to their actual views and convictions due to conflicting interests (cf Schlößer, BKR 2003, 404). The collapse of the New Economy (Neue Markt) naturally led to an outcry for stricter rules and regulations on a number of issues, including the activities of investment analysts and the disclosure of any third-party interests that might affect their work. Statutory rules of conduct and requirements of internal organisation for investment services enterprises (Wertpapierdienstleistungsunternehmen) were enacted in accordance with the appropriate EU directives. These statutory rules were repeatedly revised to keep up with new developments. There is no end in sight to this reform process made necessary by a sustained process of change of the capital market.
Sources of law and practice
The provisions on the handling of conflicting interests by investment services enterprises are for the most part laid down in the Securities Trading Act (Wertpapierhandelsgesetz), in regulations issued by the Federal Ministry of Finance, and in administrative instructions of the supervisory authority.
The Securities Trading Act was enacted as late as 1994 following initiatives taken at EU level. Until then, the proper handling of conflicting interests by investment services enterprises was primarily determined by case law, which was abundantly available (Bliesener, Aufsichtsrechtliche Verhaltenspflichten beim Wertpapierhandel, 1998, p 157).
With regard to the securities research activities, reference should be made to the Code of Conduct published in 2003 by the German Society of Investment Analysis and Asset Management (Deutsche Vereinigung für Finanzanalyse und Asset Management, DVFA). This Code of Conduct is a voluntary undertaking by the members of the Society and does not have force of law (Pfüller/Wagner, WM 2004, 253, 255).
The Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht) is in charge of monitoring and enforcing compliance with the Securities Trading Act. It may inspect the books and records of investment services enterprises at any time and for no particular reason. It also has the power to request information and the submission of documents. The Federal Financial Supervisory Authority may also set up general guidelines for assessing whether the conduct of an investment services enterprise is in line with the statutory requirements (s 35, para 4 of the Securities Trading Act). That authority may take such actions in connection with any infringements of rules of conduct or organisational requirements that may be committed in connection with the drafting of financial analyses.
In addition, investment services enterprises have to instruct an auditor each year to inspect their books and records and to determine, among other things, whether they have taken appropriate action to avoid any conflicts of interest or, if required, have handled any such conflicts appropriately. The report to be drawn up by this auditor is to be filed with the Federal Financial Supervisory Authority which, prior to such filing, may give instructions regarding the matters to be examined by the auditor or, if warranted under the circumstances of the individual case, even carry out such examinations itself (s 36 of the Securities Trading Act). On application, investment services enterprises may be released from the obligation to carry out such examinations. Non-compliance with these examination requirements constitutes a regulatory offence and is subject to an administrative fine.
Conflicts of interest: definition and culture
An enterprise which renders investment services to investors and issuers of securities, and which is possibly even itself a player on the capital market, may be confronted with a variety of conflicting interests. The individual interests of one customer of an investment services enterprise may be in conflict with interests of other customers or with own interests of that enterprise (Bliesener, Aufsichtsrechtliche Verhaltenspflichten beim Wertpapierhandel, 1998, p 168). In both cases, such conflicting interests should be avoided under German law. Investment services enterprises are required to use their best efforts to avoid any conflict of interests arising in connection with any advisory activities or transactions they may engage in.
However, if a conflict of interests is unavoidable, ie cannot be prevented by reasonable means, the instructions issued by the relevant customer must be complied with in an appropriate manner and in accordance with the interests of such customer (Eisele in: Bankrechts-Handbuch, s 109, no 20). The German banking industry is dominated by universal banks and financial service providers offering a multitude of different financial services, which makes it inevitable that conflicts of interest occasionally occur. Such conflicts are intrinsic to the securities and investment business. Consequently, unavoidable conflicts of interests must be appropriately dealt with, whereby the interests of customers should be considered with priority (Eisele, above, s 109, no 20).
In Germany, the rules of conduct to be followed by providers of financial services involved in securities trading are now a separate area of capital markets law which has gradually developed over a number of decades from a mixture of statutory regulations, case law and legal writings. Following the fantastic boom in stock prices in the 1990s and the loss of trust of investors in German capital markets law after the bubble burst, this field of law has been completely reorganised over the last few years. New EU legislation has played an important role in this reform process (Bliesener, Aufsichtsrechtliche Verhaltenspflichten beim Wertpapierhandel, 1998, 1).
The EC Securities Services Directive (EG-Wertpapierdienstleistungsrichtlinie, Directive 93/22/EEC of 10 May 1993) contained certain rules of conduct to be followed in connection with conflicting interests. This Directive was transposed into German law in 1994 in the form of the Securities Trading Act, which has been repeatedly amended since to adjust to the varying requirements of the capital market. Part 6 of the Act provides for rules of conduct for investment services enterprises when preparing and implementing capital market transactions. These rules are complemented by provisions concerning the internal organisation of investment services enterprises and the prohibition of insider trading.
Several further amendments to the Securities Trading Act followed, notably a new s 34b in 2002, which was then amended in 2004. It provided for certain standards to be met by investment services enterprises and their affiliates in connection with financial analysis, especially in terms of experience and know-how, diligence and conscientiousness, as well as with regard to the disclosure of conflicting interests.
Moreover, several important rules on insider law were changed by the new Act to Improve Investor Protection (Anlegerschutzverbesserungsgesetz), which took effect in late 2004.
The supervision of investment services enterprises by the Federal Financial Supervisory Authority is far from ineffective. This is shown by the figures published by that Authority in its 2004 report (http://www.bafin.de). With regard to the rules of conduct relating to securities research activities, the supervisory activities of the Federal Financial Supervisory Authority in 2004 extended to 360 banking institutions and providers of financial services. The attention of the Federal Financial Supervisory Authority focused on the compliance structures (Annual Report 2004, p 125).
The annual audit reports to be prepared under s 36 of the Securities Trading Act are used by the Federal Financial Supervisory Authority for determining whether disclosure duties are being met and whether appropriate organisational measures to avoid conflicts of interests are being taken. According to the Authority’s 2004 report, disclosure obligations relating to conflicts of interests are mostly being met. However, there were criticisms to be made in occasional cases where affiliates had to be involved in the process of identifying and disclosing conflicting interests, which requires somewhat more complicated organisational measures involving all companies forming a group (Annual Report 2004, p 125ff.).
In 2004, there were 57 cases where the Federal Financial Supervisory Authority instituted insider trading investigations. Twenty-three of the cases investigated by the Federal Financial Supervisory Authority were transferred to the relevant criminal prosecution authorities, with criminal charges having been brought against 71 individuals (Annual Report 2004, p 188ff).
The possibility of a surprise audit being carried out by the Federal Financial Supervisory Authority has preventive effects (Assmann/Schneider/Koller, Wertpapierhandelsgesetz, s 35, no 2). Any measures taken by that authority will damage the reputation and thereby the business of the enterprises concerned. To avoid this, and to avoid claims for damages being asserted by third parties, it is in the own best interest of investment services enterprises to ensure full compliance with all statutory rules of conduct and organisational requirements.
Organisational requirements and rules of conduct
Section 31, para 1, no 2 of the Securities Trading Act, which is worded in rather general terms, contains the rules of conduct to be followed by investment services enterprises with regard to conflicts of interests:
“Investment services enterprises shall be required … 2. to endeavour to avoid conflicts of interest and to ensure that in the event of unavoidable conflicts of interest customers’ orders are executed with due regard to customers’ interests.”
All banks and providers of financial services are “investment services enterprises” in the meaning of that provision. Moreover, rules on how conflicts of interest should be avoided also apply to foreign enterprises rendering securities-related services to customers in Germany (s 31, para 3 of the Securities Trading Act). Ancillary securities-related services such as investment counselling or the depositing business also fall under s 31 of the Securities Trading Act.
First and foremost, investment services enterprises are required to avoid any conflict of interests. However, s 31 of the Securities Trading Act is silent on how this should be done, while it is merely stipulated in s 33, para 1, no 2 of that Act that investment services enterprises:
“must be organised in such a way that in providing the investment service and non-core investment service conflicts of interest between the investment services enterprise and its customers or between different customers of the investment services enterprise are kept to the unavoidable minimum.”
The measures to be taken by the enterprises are contained in administrative instructions of the supervisory authority (cf Administrative Instructions of the Bundesaufsichtsamt für den Wertpapierhandel of 25.10.1999, BAnz Nr 210 and of 23.08.2001, BAnz Nr 165). The following are examples of measures that may be taken to avoid conflicting interests (Eisele in: Bankrechts-Handbuch, s 109, no 22; Assmann/Schneider/Koller, Wertpapierhandelsgesetz, s 31, no 35ff):
1 organisational and functional separation of business domains having interests or duties which are potentially in conflict with each other (separation/segmentation, so-called “Chinese walls”);
2 handling of instructions and orders received from customers in the order of their receipt (principle of priority); 3 full disclosure to customers of potential or existing conflicts of interest, including disclosure of any further information relating thereto; and 4 avoidance of conflicts of interest by not accepting assignments that might give rise to such conflicts.
The following applies in cases where conflicts of interest cannot be avoided using reasonable means and precautions.
If a conflict between interests of an investment services enterprise and interests of one of its customer is inevitable, the investment services enterprise shall ensure that the instruction given by the relevant customer will be properly complied with, as is in the best interest of the customer. If there is an indissoluble conflict between the interests of two customers, the investment services enterprise shall adopt an absolutely neutral position. The investment services enterprise shall treat each of these customers in the same way as it would if it had absolutely no knowledge of any intentions of the other customer concerned (Assmann/Schneider/Koller, Wertpapierhandelsgesetz, s 31, no 53).
Special rules of conduct designed to cope with potential conflicts of interest between an investment services enterprise and one of its customers are laid down in s 32 of the Securities Trading Act, whereby the interests of the customer are to be considered with priority:
“(1) Investment services enterprises or related enterprises may not,
The special importance of s 32 of the Securities Trading Act lies in the fact that the rules of conduct therein also apply to affiliates of investment services enterprises and indirectly also extend to employees and officers as well as the proprietors of such enterprises (Assmann/Schneider/Koller, Wertpapierhandelsgesetz, s 32, no 1). Violations of the rules are punishable with a fine of up to €200,000.
Securities analysis
The provision of s 34b of the Securities Trading Act has been in force since 2002 and relates specifically to securities analysis. It requires that, when preparing a financial analysis, all investment services enterprises which are subject to the corresponding supervisory provisions shall disclose any conflicts of interest which may arise.
Section 34b of the Securities Trading Act applies to all financial instrument analyses or analyses of the respective issuers which are prepared or distributed on a professional basis. This means that freelance analysts preparing or distributing financial analyses professionally are also subject to supervision by the Federal Financial Supervisory Authority. Separate provisions apply to journalists who prepare or distribute such analyses (cf s 34b, para 4 of the Securities Trading Act).
The Federal Ministry of Finance (Bundesministerium der Finanzen) issued a regulation concerning s 34b of the Securities Trading Act on 17 December 2004 (BGBl I 3522) which specified the obligations incumbent on financial analysts. Section 4, para 2 of the regulation states that details must be given as to whether the financial analyses were made available to the issuer prior to being distributed or published and whether they were amended thereafter.
Section 5 of the regulation requires that financial analyses indicate any circumstances or relationships which may result in conflicts of interest. If a person or company having more than a 5% stake in an issuer’s share capital is involved in compiling an analysis relating to said issuer, this must be indicated in the analysis itself.
Any services provided with regard to the financial instrument being analysed, eg the handling of purchase or sale transactions, or any agreement entered into with an issuer of financial instruments concerning the preparation of the analysis must also be disclosed.
If, at any point during the preceding 12 months, any financial analyst preparing an analysis has acted as lead manager in issuing the financial instruments which form the subject of the analysis concerned, this must also be disclosed. The same goes for any agreements entered into with the issuer concerning investment banking services, unless this would involve the disclosure of any confidential business information. Any remuneration paid by the issuer for investment banking transactions must always be disclosed.
In the event that any of the above facts and circumstances have to be indicated in a financial analysis, the information must be presented clearly and unambiguously and must be highlighted typographically. Simply because a conflict of interest exists does not mean it will affect the impartiality of the financial analysis, but the information to be provided at least enables the investor to consider this risk when making his investment decision.
The only cases beyond those covered by the statutory legislation and the aforementioned regulation in which parties are not obliged to disclose potential conflicts of interest is where specific organisational measures have been taken to ensure that such conflicts do not occur.
Insider trading
Insider trading is a classic example of a conflict of interest.
It is forbidden under s 14 of the Securities Trading Act:
1 to take advantage of knowledge of inside information to acquire or
dispose of securities for one’s own account or for the account or on
behalf of a third party;
2 to disclose or make available inside information to a third party without
being authorised to do so; and
3 to recommend or otherwise entice a third party, on the basis of their
knowledge of inside information, to acquire or dispose of insider
securities.
Insider information is defined as any specific information concerning facts not available to the general public which relate to one or more issuers of securities, or to the securities themselves, and which may have a significant effect on the stock exchange or market price of such securities if it became public. Any information which a prudent investor might take into account when making an investment decision is deemed to have the potential to have such an effect. Under the Securities Trading Act, the aforementioned facts also include those which can reasonably be expected to occur at some point in the future.
The scope of the term “insider security” includes all financial instruments admitted for trading on a domestic stock exchange, including the open market, or which are traded on a regulated market in a member state of the EU or another contracting state to the Agreement on the European Economic Area, or the price of which is directly or indirectly dependant on the aforementioned financial instruments.
The revised version of the provision on ad hoc publications will have a major impact. It originally stated that any insider information concerning the issuer directly must be published immediately. This requirement has now been extended to cover events occurring beyond the issuer’s own sphere of activity, such as those taking place at the issuer’s parent company or the sale of a block of shares by a major shareholder (Baur, Die Bank 10/2004, 14, 15). From now on the issuer will have to decide for itself whether – by way of an exception – it is initially necessary to keep any such information secret in order to protect its legitimate interests. Nevertheless, issuers will be required to publish information in this regard as soon as insider information reaches any party not required to keep it confidential. On 13 December 2004, the Federal Ministry of Finance issued regulations on the requirements under which ad hoc publications can be suspended as well as the requirements for informing the general public soon (BGBl I 3376).
Banks are required to notify the Federal Financial Supervisory Office immediately if they become aware of any facts suggesting that any trading they are undertaking on their own behalf or on behalf of a client is breaching the ban on insider trading or price manipulation (s 10 of the Securities Trading Act).
Since the Act to Improve Investor Protection came into force on 31 October 2004, all issuers of financial instruments admitted for trading on a domestic regulated market are required to keep a record of all persons acting on their behalf and having authorised access to insider information. This includes lawyers and auditors working on assignments for issuers of financial instruments. The requirement is devised to help the Federal Financial Supervisory Authority or the Public Prosecutor’s Office investigating suspected insider dealing to identify all potential insiders and take any necessary action.
Any party infringing or attempting to infringe the provisions against insider trading may receive a fine or a prison sentence of up to five years. Any infringement of the relevant duties of disclosure is deemed a regulatory offence (Ordnungswidrigkeit) and may incur an administrative fine.
It may be possible for third parties to claim damages under civil law if an issuer fails to publish insider information or publishes insider information which is false or misleading (ss 37b, 37c of the Securities Trading Act).
In December 2004, the Financial Supervisory Authority published a draft of a guideline for issuers, in which it gave details on the provisions against insider trading and on the requirements of ad hoc publications.
As described above, the principle of avoiding conflicts of interest is only defined very generally in ss 31, 33 and 34b of the Securities Trading Act but detailed in administrative instructions. Investment services enterprises’ organisational and procedural structures must be designed to keep conflicts of interest between enterprise and customers and between customers themselves to an absolute minimum. The following organisational measures have proved effective in practice.
“Chinese walls” are a precautionary measure intended to prevent sensitive information from one department or team reaching colleagues in another department or team.
Companies tend to summarise their internal privacy and non-disclosure regulations in a compliance manual for employees. This manual requires all employees concerned not to disclose any sensitive information relating to the company’s or clients’ interests and only to pass such information on to colleagues in other departments/areas if this is necessary for the performance of their professional duties (“need-to-know” principle).
Therefore, the taking of organisational measures to restrict the flow of confidential information (to a need-to-know basis) and to make individual departments and business areas independent in operational terms (the “independence principle”) are key requirements. Apart from Chinese walls, such organisational measures include the keeping of watch lists and restricted lists with regard to certain securities transactions.
Internal company information flows will be monitored by a neutral compliance department as provided for under s 33, para 1, no 3 of the Securities Trading Act. This department should keep a close check on whether relevant legal provisions and other regulations are being observed. The external monitoring carried out by the Federal Financial Supervisory Authority also includes ensuring that the compliance department is performing its role properly.
German capital market law has undergone fundamental changes over the last few years, mainly as a result of losses incurred by investors in the Neuer Markt. One of the most notable aspects of the recent amendments is the use of precautionary measures to prevent conflicts of interest arising in the first place. Where such conflicts are unavoidable, the more stringent disclosure requirements placed on issuers and investment services enterprises should allow investors to recognise potential conflicts early enough to be able to adjust their investment decision accordingly.
The guidelines on how to deal with conflicts of interest among financial analysts issued in September 2003 by the International Organization of Securities Commissions (IOSCO) are likely to have further effects on the legal framework in Germany. These guidelines are due to be adopted by the various securities supervisory authorities and are to be implemented by all IOSCO members. They state, for example, that salary agreements with financial analysts should be structured to avoid current and potential conflicts of interest. The guidelines also aim to prevent issuers, institutional investors and any other third parties having undue influence over analysts. Analysts and the companies employing them should also be banned from trading in securities or related derivatives prior to publication of financial analysis relating to such instruments, while companies should not be allowed to issue favourable analysis reports in return for payment. Finally, analysts should be prevented from reporting to the investment banking departments within their own companies.
Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) Bonn office: Graurheindorfer Str 108 53117 Bonn
Frankfurt office: Lurgiallee 12 60439 Frankfurt Tel: +49 0228 4108 0 Fax: +49 0228 4108 1550 E-mail: poststelle@bafin.de Website: http://www.bafin.de
German Society of Investment Analysis and Asset Management (Deutsche Vereinigung für Finanzanalyse und Asset Management, DVFA) DVFA GmbH DVFA eV Einsteinstrasse 5 D-63303 Dreieich Tel: +49 6103 5833 0 Fax: +49 6103 5833 33 E-Mail: info@dvfa.com Website: http://www.dvfa.com
As in several other countries, a number of spectacular bankruptcies have filled the newspapers in Germany over the last few years. The cases of Balsam/Procedo, Phillip Hozmann, Flowtex, and Comroad are fresh in the memory.
Apart from the managers concerned, some of whom proved to be outright criminals, it was the auditors who found themselves in the focus of public attention. People asked why auditors failed to become aware of the catastrophic financial situation of certain companies. How can it be that a company has to file for bankruptcy just a short time after an auditor had certified that the company’s financial situation was sound and that its accounts were in order? The consequence was harsh criticism, not only of the quality of audits, but also of some auditors’ suspected lack of independence.
Following the wave of financial scandals, it became necessary to regain the confidence of investors in the capital markets. That meant reviewing the regime under which auditors operate.
After several years of discussion, tighter rules securing the independence of auditors took effect in late 2004, introducing stiffer requirements, especially regarding the auditing of accounts of listed companies.
Sources of law and practice
The obligation of auditors to be independent and unbiased is laid down in a number of rules regulating the professional conduct of auditors. The relevant provisions of the Commercial Code (Handelsgesetzbuch) are primarily intended to secure the independence of annual auditors and are of great practical importance.
Leading court decisions on the handling of conflicting interests by auditors are rare and their practical significance is limited. However, that may change, because the newly introduced statutory provisions require the interpretation by the courts in several aspects.
Responsibility for surveillance, interpretation and enforcement
The Association of Auditors (Wirtschaftsprüferkammer) has jurisdiction for the prosecution of minor infringements of professional ethics by an auditor.
However, if a violation of professional ethics involves more than a “minor degree of guilt”, it will fall within the jurisdiction of the Office of the Public Prosecutor General (Generalstaatsanwaltschaft) in Berlin, which will act as investigating authority and institute court proceedings if this is warranted by the outcome of the investigations. The professional tribunals may pronounce formal warnings, reprimands, impose fines of up to €100,000 or even expel an auditor from the auditing profession. Hearings of the professional tribunals are usually open to the public when cases concerning charges of neglect of duty in connection with the auditing of accounts are being heard.
Conflicts of interests: definition and culture
Under German law, an auditor may not accept assignments if there is any reason to suspect that he may not be completely unbiased or that his independence may be at risk in any way. An auditor is deemed to be “independent in mind” if he exercises his functions without being subject to any external influences that might affect his judgment; an auditor is considered to be “independent in appearance” if he is also fully independent in the eyes of the public, with there being no reason to suspect that he may not be completely unbiased (Baetge/Brötzmann, Der Konzern 2004, 724, 725).
Based on the recommendations made on 16 May 2002 by the EU Commission on the independence of auditors in the EU, it is acknowledged that any one of the following three factual scenarios may be regarded as adversely affecting the independence of auditors:
1 an auditor has a personal interest in the company the accounts of
which are to be audited, or the management of that company is in a
position to exert financial pressure on the auditor;
2 the risk of an auditor examining his own work, ie where an auditor
would be forced to assess the results of advisory services he himself has rendered to the company the accounts of which are to be audited (ban
on auditing own work products, Selbstprüfungsverbot); and
3 an unusually close relationship between an auditor and the
management. In practice, conflicts between the interests of different clients of an auditor are rarely a matter of concern. The reason for this is that a conflict of interests in the legal sense of the term can only arise if a professional represents two clients in one and the same matter, while conflicting interests of a purely commercial nature are irrelevant from a legal perspective.
Over the last few years there has been some dramatic change in the regulatory environment in which auditors exercise their profession. One of the principal objectives of the new legislation was to modernise the legal provisions intended to secure the independence of auditors and to adjust these provisions to international developments.
In May 2002, the EU Commission published recommendations on the “independence of auditors in the EU – general principles” (L 191/22 of 19 July 2002, 2002/590/EC). The aim of these recommendations was the EU-wide harmonisation of legal standards on the independence of auditors in the exercise of their profession.
The German Corporate Governance Code (cf http://www.corporate-governance-code.de), which has been in force since 2002, contains guidelines for companies seeking advice on how to select and supervise their auditor.
On 16 March 2004 the EU Commission submitted a draft for a new directive regarding the work of auditors (KOM(2004) 177 endg). This draft also provides for general principles regarding the independence of auditors. Official deliberations regarding this draft are still in progress. Nevertheless, the Act Reforming Balance Sheet Law (Bilanzrechtsreformgesetz), which took effect as of 10 December 2004, is to a great extent already in line with the draft directive drawn up by the Commission.
The manner in which auditors are supervised in the exercise of their profession was often criticised in the past. The principal criticisms were that most cases of misconduct went undiscovered, that the sanctions imposed were too mild and that rebukes and verdicts of the professional tribunals were not published (Sommerschuh, Berufshaftung und Berufsaufsicht: Wirtschaftsprüfer, Rechtsanwälte und Notare im Vergleich, 2003).
Such criticism was one of the factors that led to the adoption of a two-phase “enforcement procedure”, which was introduced in Germany on 1 July 2005 to monitor the accuracy of statements of accounts.
Phase one of this procedure will be an intervention by a Financial Reporting Enforcement Panel (Deutsche Prüfstelle für Rechnungslegung) organised under private law. The panel will inspect corporate accounts in cases where there is reason to suspect that these may not be entirely correct, whereby such a suspicion may be based on information provided by shareholders, creditors or contained in press reports. Companies submitted to spot checks will also be chosen at random.
Should a listed company fail to co-operate with the Enforcement Panel or if the inspection proceedings on that level cannot be brought to a satisfactory conclusion for any other reason, the matter will be transferred to the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht). This is a government agency having all means at its disposal that may be required for inspecting accounts even against the will of the company.
If the Federal Financial Supervisory Authority finds that any accounts are inaccurate, it will have the right to require the company concerned to issue a public statement disclosing such inaccuracy together with a summary of the reasons which led to the inaccuracy. However, such a publication may be dispensed with ex officio by way of an exception in certain cases.
The obligations of auditors to be independent and unbiased are two essential requirements of professional conduct laid down in general terms in the Auditors’ Code of Conduct (Wirtschaftsprüferordnung). These obligations are described in more detail in the Occupational Regulations for Auditors (Berufssatzung) issued by the Association of Auditors (Wirtschaftsprüferkammer).
The auditing provisions of the Commercial Code, which are of great practical significance, strongly emphasise the requirement of auditors of financial statements being independent.
Canons of professional etiquette
Auditors must be independent (s 43, para 1 of the Auditors’ Code). Independence is understood to mean that a professional should be free of any personal or financial links that might influence his professional judgment (s 2, para 1 of the Occupational Regulations for Auditors).
The requirement of auditors being independent is closely linked to that of auditors being unbiased (cf Hagemeister, DB 2002, 333). An auditor may not accept an assignment if there is any reason to suspect that he may not be completely unbiased (s 49 of the Auditors’ Code). Auditors should avoid anything that might cast any doubt on their independence or neutrality.
Whether a personal or financial link of an auditor actually involves a risk of him being biased is to be determined in the light of the facts and circumstances of the individual case. In this respect, auditors have considerable discretion when deciding whether to accept an assignment (cf Hagemeister, DB 2002, 333, 334).
A suspicion that an auditor may not be completely unbiased may also arise if he has clients whose interests are in conflict with each other. Consequently, auditors are prohibited from acting on behalf of parties having conflicting interests in one and the same matter, as is stipulated in s 3 of the Occupational Regulations for Auditors. They are prohibited from representing conflicting interests, be it simultaneously or successively, if the facts and circumstances of the relevant matters are identical or partly identical. An auditor may advise and represent several parties in connection with one matter if the interests of these
parties are not conflicting, provided that all these parties retained the auditor acting jointly, or individually but with the approval of all other parties.
Commercial law provisions
Section 319ff of the German Commercial Code (Handelsgesetzbuch, HGB) contains specific provisions intended to ensure that audits of financial statement are carried out fairly by auditors acting in an entirely neutral capacity.
The general clause laid down in s 319, para 2 of the Commercial Code basically states that an auditor may not audit the financial statements of a company if there is reason to doubt his impartiality. The decisive criterion is whether, in the eyes of a prudent and cautious third party, there are sufficient objective reasons to doubt the auditor’s impartiality. Such reasons may exist if the auditor:
1 himself has a significant interest, economic or otherwise, in the
outcome of the audit;
2 is required during the audit to render an assessment of any facts,
figures or statements given in the financial statement which he helped
to prepare;
3 has close relations with the management of the company to be audited,
thereby giving grounds for undue dependence/potential bias; or
4 is being influenced by the company in such a way that this could
adversely affect his objectivity (cf Written Justification for Government Draft
of Act Reforming Balance Sheet Law, p 81). There are therefore reasons to suspect a lack of impartiality if, for example, the auditor and the company to be audited effect transactions which third parties would effect differently or if transactions are effected under preferential conditions (eg favourable pricing or terms of delivery).
Also of relevance here is the situation whereby an auditing company employee takes up a senior accounting position at one of the companies whose financial statements he previously audited. German law makes no provision for a “cooling-off period”, ie a period between the employee auditing a company’s financial statements on behalf of an auditing company and taking up a position with his former client. This means that it is always necessary to determine on a case-by-case basis whether the general clause set out in s 319, para 2 of the Commercial Code applies in such cases given either the total lack of a cooling-off period or the existence of only a very short one.
However, concerns that the auditor may not act in an independent and neutral manner may sometimes be refuted under the aforementioned general clause. The written justification for the Act Reforming Balance Sheet Law refers on p 81 to “measures to reduce the identified risks and to ensure objectivity” undertaken by the audited company or the auditor without giving further details.
Overall then, it can be said that the general clause contained in s 319, para 2 of the Commercial Code only disqualifies auditors from auditing financial statements if:
1 circumstances exist which may, in principle, provide grounds to suggest
that the auditor might not act in an independent and neutral manner;
and
2 no measures have been taken which might negate any concerns along
these lines (cf Baetge/Brötzmann, Der Konzern 2004, 724, 727). Section 319, para 3 of the Commercial Code sets out specific circumstances in which an auditor may not act as such:
“An auditor or chartered accountant may not act as such if, inter alia,heor
one of his professional associates
This means that auditors are disqualified from auditing financial statements if they have “significant financial interests” in the company to be audited, even if they do not hold any shares in such company. The relatively vague phrase “significant financial interests” gives the parties involved a certain amount of scope when assessing whether an auditor or chartered should be disqualified, although this freedom of interpretation should only be used very sparingly in practice.
Since the prohibition to act as laid down in s 319, para 3, no 3 of the Commercial Code does not apply in cases where the other activities of the auditor that may give rise to a conflict of interest were only insignificant in nature, this also allows a certain degree of scope when interpreting the provisions. The exact limits of this scope will be gradually determined as case law accumulates in this area (cf Arbeitskreis Bilanzrecht der Hochschullehrer Rechtswissenschaft, BB 2004, 546, 548).
According to s 319, para 4 of the Commercial Code, the grounds for disqualification set out in paras 2 and 3 are also applicable if the financial statements are to be audited by an auditing company and if this firm itself or one of its legal representatives, shareholders, supervisory board members or affiliates is not allowed to audit the financial statements due to the reasons described above.
Section 319a of the Commercial Code sets out additional, more stringent grounds for disqualification, which apply in the event that the independence and impartiality of corporate auditors is deemed of public interest. Parties auditing the financial statements of listed companies, banks or insurers have to meet more stringent requirements to prove that they do not solely depend on the business with the firm to be audited, which might affect their ability to act independently. Auditors are therefore disqualified from auditing the financial statements of listed companies if they have received more than 15% of their total professional income from the company to be audited or one of its affiliates in the past five years.
The Act Reforming Balance Sheet Law has also supplemented s 285 of the Commercial Code (cf s 285, no 17), according to which listed companies are required to disclose the amount of the fees paid to their auditor. They are also required to give details of the amount of any additional fees paid to the auditor for services other than the audit itself (cf Peemöller/Oehler, BB 2004, 539, 548).
Further, s 319a, para 1, no 2 of the Commercial Code states that an auditor is prohibited from auditing annual financial statements if, in addition to auditing services, he has provided legal or tax advice to a company during the business year to be audited. The only exception is if such advice does not go beyond identifying potential legal approaches and tax structures and does not have a significant effect on the company’s results and financial position. This places additional restrictions on the “full service” concept offered by auditing companies in the past since advisory and auditing services are no longer compatible in all cases.
The provisions concerning the “internal rotation” of auditors, ie where an auditing firm changes the auditors working on specific accounts, have also been amended (s 319a, para 1, sent 1, no 4 of the Commercial Code). An auditor is prohibited from auditing a company’s financial statement if he has already certified the audit for said company’s financial statements on seven or more previous occasions. This prohibition ends, however, after a three-year “cooling-off” period.
Any infringement of the provisions set out in ss 319 and 319a of the Commercial Code does not result in the audit certificate losing its validity. It does, however, constitute a regulatory offence on the part of the auditor, which can incur an administrative fine (s 334 of the Commercial Code) and lead to disciplinary measures of the professional tribunal.
Reflection of the requirements in practice
Active measures to ensure that auditors remain independent and neutral may be taken within the framework of the general clause set out in s 319, para 2 of the Commercial Code. However, if an auditor is disqualified to act as such under s 319, para 3 of the Commercial Code the assumption of his impartiality not being guaranteed is absolute, which means that any attempt to establish his impartiality is futile from the outset.
In practice, auditing companies tend to take measures to prevent suspicion of partiality before even accepting a particular assignment. One such measure is to set up an internal information system containing details of the nature of relationships existing between an auditing company’s employees and the company to be audited. Any potential risks should then be identified and appropriate measures taken to ensure that no relationships exist which might raise suspicions over the auditor’s ability to act impartially and independently (cf Baetge/Brötzmann, Der Konzern 2004, 724, 727f.).
The EU Commission issued a set of guidelines entitled Statutory Auditors’ Independence in the EU – A Set of Fundamental Principles (OJ L 191/22 of 19 July 2002, 2002/590/EC, s B 7.1 (2a)), which states that “firewalls” should be set up to avoid conflicts of interest in the event that an auditor provides both advisory and auditing services to the same company. In this sense, a firm of auditors would create a firewall to separate its auditing and advisory departments/teams to ensure that the two could not share information. This approach can only be used for audits of annual financial statements, however, if the auditing company has not rendered an advisory service which, under s 319a, para 1, sent 1, no 2 of the Commercial Code, would disqualify it from auditing a company’s financial statements. In cases where such grounds for disqualification do not exist, firewalls can be a very effective way of eliminating any concerns that the auditors may not act in an independent and neutral manner. It is now commonplace for the major auditing companies to divide teams strictly using firewalls.
The German Corporate Governance Code (the Code) also provides for measures that are intended to secure the independence of auditors.
According to s 5.3.2 of the Code, the supervisory board shall set up an audit committee to handle issues such as accounting and risk management, the necessary independence required of the auditor, issuing the audit mandate to the auditor, determining the focus of an audit and arranging the fee agreement.
The members of the audit committee do not have to be independent board members. The Code only states that the chairman of the audit committee should not be a former member of the management board of the company. With respect to the audit committee’s control of the auditor’s independence, s 7.2.1 of the Code requires the committee to obtain a statement from the proposed auditor stating whether any professional, financial or other relationship (eg consulting services provided) exists between auditor and company. However, pre-approval from the supervisory board is not required before mandating an auditor, unless such approval is required in the articles of the association.
A somewhat less controversial issue is the ban on auditors representing conflicting interests. This is probably due to the fact that it is relatively rare for a firm of auditors to represent several companies in the same matter. Conflicts of interest which are purely commercial in nature and occur in various matters do not constitute conflicts of interest in the legal sense under German law. If, in such cases, the auditor’s duty to maintain confidentiality needs to be taken into account, any infringement of which is a criminal offence under s 203, para 1, no 3 of the German Penal Code (Strafgesetzbuch, StGB), this can be done by taking suitable precautionary measures (eg “firewalls”).
The ruling concerning the unconstitutional nature of s 3, para 2 of the Occupational Regulations for Lawyers (cf NJW 2003, 2520ff) handed down by the Federal Constitutional Court (Bundesverfassungsgericht, BVerfG) on 3 July 2003 is also of interest in this context. The aforementioned provision extended the prohibition of accepting an assignment due to conflicting interests to all professionals of a law firm. The Federal Constitutional Court, however, decided that s 3, para 2 interfered disproportionately with a lawyer’s freedom to practice his profession and therefore revoked it.
The court’s decision primarily rested on the assertion that a lawyer should be free to move to a new firm if sufficient precautions have been taken to ensure that he does not pass on sensitive information on a particular client to his new colleagues where these are acting on behalf of the opposing party. It is possible to ensure this by using organisational measures to prevent such knowledge transfer. The court made particular reference to the use of firewalls in such cases.
Due to the aforementioned ruling, which is to be applied analogously to auditors, s 3, paras 2 and 3 of the Occupational Regulations for Auditors, which extended the prohibition to act due to conflicting interests to all professionals of the auditing company, were revoked with effect as of 2 March 2005. From now on all circumstances of the individual case should be taken into account to determine whether an auditing company is barred from working on a particular matter after it is joined by a professional who previously represented the opposing party or after it merges with a firm representing the opposing party. According to the principles of the Federal Constitutional Court, the views of the clients concerned (which should have been given complete information in advance to reach an informed assessment) should be taken into account, as should the availability of technical equipment suitable to prevent improper transfers of information within an auditing firm. In section C below, the practical implications of the Federal Constitutional Court’s ruling of 3 July 2003 are investigated in detail.
5. Outlook
The Act Reforming Balance Sheet Law, which took effect at the end of 2004, has significantly modernised, inter alia, the legal provisions relating to conflict of interests in auditing services.
The new provisions seem to represent an important step in the right direction. It is too early to make a definitive assessment as most of the provisions only took effect at the end of 2004 and it remains to be seen whether they will work effectively under the scrutiny of an interested public. The main criticism of the revised versions of ss 319 and 319a of the Commercial Code is that vague phrases such as “not insignificant in nature” or “have a significant effect” seem to leave too much scope for interpretation. More specific guidelines need to be issued as soon as specific cases have actually been ruled on (cf Hülsmann, DStR 2005, 166, 172). However, it is likely that auditors will generally interpret the new provisions fairly and objectively. The larger auditing firms at least can already lay claim to having high-tech methods, which can be implemented to remove concerns over independence or impartiality. Their full-service concept, however, is very much a thing of the past.
The key indicator of any assessment of the new provisions will be whether allegedly “true and fair views” will continue to prove spectacularly false and misleading despite having been audited and whether this will lead to regular corporate scandals along the lines of Enron, Flowtex and Parmalat. Even if the new provisions only manage to reduce the frequency of this kind of event, they will have been well worth it.
6. Useful references
Federal Bar Association of Auditors (Wirtschaftsprüferkammer) Rauchstr 26 D-10787 Berlin Tel: +49 3072 6161 0 Fax: +49 3072 6161 212 E-mail: admin@wpk.de Website: http://www.wpk.de
Financial Reporting Enforcement Panel (Deutsche Prüfstelle für Rechnungslegung DPR eV) Zimmerstr 30 D-10969 Berlin Tel: +49 3025 7947 0 Website: http://www.frep.info
Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) Bonn office: Graurheindorfer Str 108 53117 Bonn
Frankfurt office: Lurgiallee 12 60439 Frankfurt Tel: +49 0228 4108 0 Fax: +49 0228 4108 1550 E-mail: poststelle@bafin.de Website: http://www.bafin.de
SECTION C: LAWYERS
1. General introduction
Following decades of stasis, the rules of professional conduct for German lawyers have changed significantly in recent years. Competition, globalisation and profitability pressures have led to fundamental changes in the regulatory Germany environment in which German lawyers operated. The old canons of professional etiquette have become largely obsolete.
Occupational ethics, developed for lawyers working on their own and not actively trying to solicit new clients, had long ceased to be in line with current requirements, especially with regard to the new forms of co-operation between lawyers that had developed.
Interestingly, it was not primarily the lawyers themselves or their professional organisations that modernised and liberalised their professional rules of conduct. The driving force of reform was the courts, especially the Federal Constitutional Court (Bundesverfassungsgericht). It held in its Bastille decisions of 1987 (BVerfGE 76, 171; 76, 196) that the principles of professional conduct then in force, which restricted the professional freedom of lawyers in many respects, were incompatible with constitutional requirements. The Federal Constitutional Court specified that any rule restricting the professional freedom of lawyers would have to be well founded, giving due consideration to the principle of free vocational practice.
Later, it was again the judicature which decided that law firms should be allowed to have offices in more than one place. The prohibition against lawyers engaging in secondary professional activities was eased, the rule that lawyers could not be simultaneously admitted to the bar at Regional Courts (Landgerichte) and Higher Regional Courts (Oberlandesgerichte) was abolished and restrictions on advertising were eased. The liberalisation process has proved lengthy and difficult; for German lawyers are considered to be not just private service providers, but an integral part of the system for the administration of justice, working side by side with the courts and the prosecution authorities.
The prohibition against representing clients with conflicting interests, a core ethical principle, was not overlooked in the reform process. Inevitably, the surge of mergers of law firms and the increased mobility of lawyers led to new controversies. Given that the statutory provisions on the handling of conflicting interests had not undergone any essential change for decades and, moreover, were quite succinct, it is hardly surprising that there were, and in some areas still are, certain issues left open to interpretation. An example is the question of whether different teams within a single law firm may represent different takeover bidders in a merger or acquisition.
In this area too, the Federal Constitutional Court has largely set the pace of reform. Notwithstanding strong opposition from the Federal Lawyers’ Association (Bundesrechtsanwaltskammer), the Federal Constitutional Court held in 2003 that certain of the Occupational Regulations restricting the freedom of individual lawyers to change from one law firm to another constitute an unacceptable interference with the principle of occupational liberty and are therefore to be regarded as legally void (BVerfGE NJW 2003, 2520). The significance of this decision extended well beyond cases of lawyers changing from one law firm to another, because the court also stated general guidelines for the handling of conflicts of interests, which are still regarded as authoritative. Local and federal lawyers’ associations, which sometimes took a rigid stance against potential conflicts of interests, have lost influence, whereas the scope of self-responsibility of lawyers and their clients has increased.
However, the potential for conflict is somewhat reduced by the fact that under German law purely commercial differences between the interests of two parties do not necessarily prevent the lawyer from representing both parties. A conflict of interests in the legal sense exists only if the facts and legal implications of one matter handled by a lawyer overlap with those of another assignment that may be proposed to him by another client. In other words, the decisive point is whether the facts of two different assignments are (partly) identical.
Sources of law and practice
The prohibition against representing conflicting interests is laid down in statutory rules of professional conduct. It is a peculiarity of German law that non-compliance with these provisions may be a criminal offence.
Due to the succinctness of the relevant statutory texts it is necessary to refer to court decisions, especially to precedents of the Federal Constitutional Court, for their interpretation and application.
Surveillance, interpretation and enforcement
The prosecution of violations of the prohibition against representing conflicting interests falls within the jurisdiction of the local associations of lawyers (Rechtsanwaltskammern) and professional tribunals.
It is up to the board of local associations of lawyers to ensure that its members abide by their professional duties. These bodies deal with any violations, including violations of the prohibition against representing conflicting interests, so long as the lawyer’s degree of guilt is only minor. A rebuke (Rüge) by the local association of lawyers is the mildest form of disapproval of the conduct of a lawyer and does not involve the imposition of any further sanctions. Local associations of lawyers may not issue a cease-and-desist order, so their powers are rather limited.
As a rule, however, representing clients with conflicting interests will not be regarded as a breach of regulations involving only a minor degree of guilt, which means that such matters usually fall within the jurisdiction of professional tribunals. These tribunals, consisting of professional judges as well as lawyers, have considerable powers and may pronounce formal warnings (Warnungen) or reprimands (Verweise) or impose fines of up to €25,000. They may prohibit lawyers from representing particular clients or even disbar lawyers.
Such proceedings remain subordinate to criminal proceedings, which may be instituted when a lawyer has betrayed a client by advising or representing the adverse party (Parteiverrat). No disciplinary action may be taken while such criminal proceedings are pending.
Definitions and culture of “conflicts of interest”
According to the relevant statutory texts, the prohibition against representing conflicting interests applies only to “the same legal matter”. In strictly legal terms, this means that a lawyer may act for the opponent of a former client against the client in another matter, even though the lawyer may have been given highly sensitive information by the former client. Such conduct is not necessarily incompatible with the confidentiality obligations of lawyers. A lawyer may not disclose or pass on client information. However, this does not mean that a lawyer may not otherwise use or benefit from such knowledge in connection with work he may do on behalf of another client. In practice, it may often be difficult to draw the line between “being aware of” and “disclosing” sensitive information. Therefore, appropriate organisational measures should be taken by law firms to rule out an unauthorised transfer of such information.
Conflicts of purely commercial interests, which may well make it incongruous for a lawyer to accept an assignment, are not regarded as conflicting interests in legal terms. According to German law, the mere possibility of a lawyer not complying with confidentiality obligations does not mean per se that the lawyer may not accept an assignment for that reason. Such a prohibition is considered unnecessary because a lawyer who breaches his confidentiality obligations is guilty of a criminal offence. It is believed that this should suffice to stop lawyers from accepting assignments which involve a risk of a breach of their professional confidentiality obligations (Steuber, RIW 2002, 590, 593).
It follows that a lawyer who decides to turn down an assignment because it might involve him in a conflict with the commercial interests of another client does so voluntarily. However, attorneys often consider it to be ill-advised to take on new assignments from competitors of existing clients because this might jeopardise existing client relationships. Clients increasingly tend to be rather sensitive in this regard and value transparency above all. International clients, especially, expect their legal advisers to consult them before taking on assignments from competitors. Clients may also ask their lawyers to enter into an exclusivity agreement in which the lawyer undertakes not to represent certain competitors of the client. Not surprisingly, law firms are very reluctant to enter into such undertakings. Conflicts of commercial interests are an important factor considered by law firms when deciding whether or not to accept an assignment, but this is due to strategic and business considerations and not due to legal reasons (Steuber, RIW 2002, 590, 591ff).
2. Background/environment
The prohibition against lawyers representing conflicting interests was introduced into German law in 1871 in the form of the criminal offence known as “betrayal of a client” (Parteiverrat, s 356 of the Criminal Code). In essence, the statutory definition of this criminal offence has remained unchanged since that time.
According to the 1963 version of the guidelines for professional ethics for lawyers it was even regarded as professional misconduct if a lawyer behaved in a way giving rise to a mere suspicion that he was representing conflicting interests.
The Federal Constitutional Court ruling in 1987 that the canons of professional conduct for lawyers were not compatible with constitutional requirements prompted a fundamental reform of professional ethics. This long-overdue exercise led to the adoption of the Federal Code of Conduct for Lawyers (Bundesrechtsanwaltsordnung) in 1994. The prohibition to represent conflicting interests was worded as follows (s 43a, para 4):
“A lawyer may not represent conflicting interests.”
In 1997, the Statutory Assembly of Lawyers (Satzungsversammlung), the “parliament” of German lawyers, introduced a rather restrictive provision in the Occupational Regulations for Lawyers (Berufsordnung). According to s 3, para 2, a prohibition against acting in the face of conflicting interests applied to all partners, associates and other professionals of a law firm. This meant that when a lawyer moved to a new firm, that firm would have to terminate any professional services concerning matters in which the lawyer’s former firm was acting for the adverse party, irrespective of whether the relevant lawyer had been personally concerned with these matters. Initially, in 2000 the Federal Supreme Court handed down a decision confirming this rule (“If one lawyer is out, the firm is out”) (BGH (Federal Supreme Court) NJW 2001, 1571). The decision was criticised, especially by large law firms, as constituting a severe impediment to mobility and free competition among lawyers, while at the same time violating the principle of occupational liberty (cf Kilian, WuB VIII B sec 43 a BRAO 1.01).
In the end, this decision of the Federal Supreme Court did not withstand legal review by the Federal Constitutional Court: in 2003, Germany’s highest court decided (contrary to the views of the Federal Bar of Lawyers) that s 3, para 2 of the Occupational Regulations for Lawyers was void (BVerfG, NJW 2003, 2520).
The decision of the Federal Constitutional Court was a great contribution to understanding and interpreting the prohibition against representing conflicting interests. Nevertheless, there are still no clear statutory guidelines on how conflicts of interests should be dealt with, and in this area there is a degree of uncertainty as to what the law actually is. Currently, German law firms seeking guidance on how to assess and handle conflicting interests refer to the principles laid down by the Federal Constitutional Court with regard to individual lawyers changing from one law firm to another. In line with this, the German Lawyers’ Association (Deutscher Anwaltsverein) emphasises that the handling of conflicting interests is an issue to be responsibly dealt with by lawyers in the light of the facts and circumstances of each individual case (cf 2003–04 Activity Report of the Board of the German Lawyers’ Association, p 3). It is to be assumed that the local bar of lawyers (Rechtsanwaltskammern) will adopt a more moderate stand regarding the prosecution of possible infringements of the prohibition to represent conflicting interests and that in the future they will take action in obvious cases only.
Any new attempt by the Statutory Assembly of Lawyers to extend further the prohibition against acting due to conflicting interests to all members of a law firm would be unlikely to succeed (cf Kleine-Cosack, AnwBl 2005, 95, 100). Rules severely interfering with the occupational freedom of lawyers have repeatedly been overruled by the Federal Constitutional Court as being unreasonable and incompatible with constitutional provisions (cf Kleine-Cosack, Bundesrechtsanwaltsordnung, 4th edn, 2003, s 43 a, no 124).
3. Applicable law, regulation, codes and case law
The prohibition on representing conflicting interests is laid down by law and non-compliance with this statutory prohibition is subject to prosecution under criminal law. Betrayal of a client (Parteiverrat) is a criminal offence under s 356 of the Criminal Code. Thus, compliance with this prohibition constitutes a cardinal obligation of lawyers.
However, due to the rudimentary nature of the relevant statutory texts, there are still several controversial questions regarding their interpretation, even though case law exists which is very helpful for the interpretation of these provisions in several respects. The statutory texts themselves leave many questions unanswered because they do not provide for a clear definition of the relevant facts. Therefore, the court decisions are of great importance with regard to the interpretation of the statutory provisions.
4. The requirements
Laws and regulations
The prohibition against representing conflicting interests is laid down in a number of laws and regulations. The criminal offence of betraying the interests of a client is defined as follows in s 356 of the German Criminal Code:
“(1) A lawyer or other person rendering legal assistance, who, in relation to matters confided to him in this capacity, serves both parties with counsel and assistance in the same legal matter and in breach of duty, shall be punished with imprisonment from three months to five years.
(2) If the same person acts in collusion with one party to the detriment of the other party, then imprisonment from one year to five years shall be imposed.”
The wording of s 43a, para 4 of the Federal Code of Conduct for Lawyers (Bundesrechtsanwaltsordung) is much shorter:
“A lawyer may not represent conflicting interests.”
However, according to s 3, para 1 of the Occupational Regulations for Lawyers this prohibition refers only to “the same legal matter” (this restriction is in line with s 356 of the Criminal Code):
“(1) A lawyer may not undertake to render any legal services if acting in his capacity as lawyer or any other capacity he has previously advised or represented another party involved in the same matter and having conflicting interests …”
This fundamental occupational obligation of lawyers not to represent conflicting interests is, in practical terms, covered by the prohibition to betray interests of a client, as laid down in s 356 of the Criminal Code. However, the occupational regulations go beyond the prohibition existing under the Criminal Code. A lawyer may be held liable under the former even if he committed a breach thereof merely through negligence, ie without having done so intentionally. Irrespective thereof, all lawyers are expected to be familiar with their occupational regulations, which means that unawareness of the prohibition against representing conflicting interests is not accepted as a defence under either occupational or criminal law.
Purpose of the statutory regulations
The official statement of grounds published with the 1994 Government draft of a revised Federal Code of Conduct for Lawyers (BT-Drucksache 12/4993, p 27) mentions three reasons for the provision made in s 43a, para 4:
| 1 | protection of the relationship of mutual trust that should exist between |
| lawyers and their clients; | |
| 2 | protection of the independence of lawyers; and |
| 3 | the uprightness of the services of a lawyer, which is essential for the |
| proper administration of justice. |
Therefore, the object of legal protection extends beyond the interests of a client of a lawyer and covers the interest of the general public in being able to rely on the integrity and trustworthiness of lawyers.
“Sameness” of matters
Any prohibition to act under occupational or criminal law exists only with regard to the “same” matter. For the purposes of these provisions a conflict of interests may only arise if a lawyer assesses or attends to one and the same set of facts and circumstances (the “same matter”) on behalf of different clients (BGH NJW 1991, 1176). However, this is deemed to be the case even if the facts submitted to a lawyer by one client (and the legal consequences resulting therefrom) only partly coincide with or touch on those of a matter of a different client (Kleine-Cosack, Bundesrechtsanwaltsordnung, 4th edn, 2003, s 43a, no 84).
Under German law it is not sufficient to assume a conflict of interests if a lawyer acts against an existing client in a different matter. There is not deemed to be a conflict of interests unless a lawyer represents two clients with conflicting interests in the “same matter”. This restriction distinguishes German law from the provisions of other countries, where a conflict of interests is already assumed if a lawyer acts against an existing client, even though in a thoroughly different matter (Henssler, NJW 2001, 1521, 1523).
Conflicting nature of interests
Different interests represented by a lawyer in the same matter may not be “conflicting”. Most legal authorities agree that the term “interests” should be understood in a subjective sense in this respect, which means that the “interests” of the parties should be determined in the light of their aims and intentions (BVerfG, NJW 2003, 2520; Kleine-Cosack, Bundesrechtsanwaltsordnung, 4th edn, 2003, s 43a, no 97; Henssler/Prütting/Eylmann, Bundesrechtsanwaltsordnung, 2nd edn, 2004, s 43a, no 145). Therefore, the question of whether interests to be represented by a lawyer are “conflicting” should be answered on the basis of what the relevant clients wish to achieve.
Representation of interests
The term “representation” covers any activities a lawyer may engage in, ie any form of providing advice or support, without being limited to actual representation in court or out of court (Kilian, WM 2000, 1366, 1368).
Representation of conflicting interests with the approval of the clients concerned
In principle, the general rule under German law is that even if the relevant clients were to give their permission, an individual lawyer may not represent conflicting interests in the same matter. Even the client concerned may not give permission to a lawyer to commit the criminal offence of “betrayal of a client”. Moreover, enabling the general public to trust in the reliability and integrity of lawyers is a key aim of the statutory provisions prohibiting the representation of conflicting interests.
However, the laws and regulations prohibiting the representation of conflicting interests undoubtedly also serve to protect clients. Therefore, it is questioned why a client may release his lawyer from his professional duty to maintain confidentiality, but may not release him from the prohibition of representing conflicting interests. Some believe that clients should be given more freedom of decision in this respect – at least in some areas, such as in civil law (Henssler, NJW 2001, 1521, 1529; Schlosser, NJW 2002, 1376, 1378ff; Kilian, WM 2000, 1366, 1368).
Legal consequences of non-compliance with the above
Before accepting any new assignment, a lawyer must investigate and determine whether the instructions to be given to him may, in legal terms, have the effect that he would be representing:
1 a party he may not represent in view of an adverse assignment which he
has already accepted (given that he would otherwise become guilty of
betrayal of clients); or
2 conflicting interests of different clients in the same matter. The legal consequences to be anticipated in the event of non-compliance with the prohibition of representing conflicting interests are as follows. The board of the local association of lawyers will reprehend such conduct or bring the matter before a professional tribunal. In addition, the service agreement between the lawyer and the client will be void with the effect that the lawyer will not be able to claim any fees for services rendered, while the client will have the right to demand to be refunded any fees he may already have paid. In terms of procedural law, however, non-compliance with the statutory prohibition of representing conflicting interests does not trigger any consequences. In particular, a judge may not disallow a lawyer to represent a client for that reason (special rules apply in criminal proceedings) and any pleadings or other procedural action taken in a lawsuit will not lose its validity.
Criminal proceedings will have to be instituted against lawyers charged with intentionally having “betrayed” a client by representing the adverse conflicting interests of other parties as well.
Practical considerations
In practice, conflicts of interests of a legal or commercial nature are most likely to arise in the following instances.
(i) Lawyers changing from one law firm to another It is generally agreed that an irresolvable conflict of interests will exist if a lawyer changing law firms is to act on behalf of different parties to a particular matter before and after such change. However, if a lawyer changes from one law firm to another law firm where both are involved in a matter on different sides, while the relevant lawyer was not concerned with that matter at all, this will not necessarily lead to an irresolvable conflict of interests within the new law firm. The Federal Constitutional Court has ruled that s 3, para 2 of the Occupational Regulations for Lawyers, where it was stipulated that a prohibition to act due to conflicting interests applied to all partners, associates and other professionals of a law firm, is void because it would amount to an unreasonable interference with the occupational freedom of lawyers (BVerfG NJW 2003, 2520, 2521ff).
What this decision of the Federal Constitutional Court boils down to is that a lawyer may not be hindered from changing from one law firm to another as long as reasonable precautions have been taken to ensure that such change will not lead to a violation of professional duties. In such cases, an illicit transfer of information can be ruled out by means of appropriate organisational measures within the new law firm, ensuring that sensitive information the joining lawyer may have will not be disclosed to his new colleagues. The Federal Constitutional Court has made, inter alia, the following observations in this regard (NJW 2003, 2520, 2521ff):
“Whenever it cannot be ruled out from the outset that a change of law firms by a lawyer may involve a risk in terms of confidentiality or the upright representation of the interests of a client, it is first and foremost up to the clients of both law firms involved to determine whether their interests may be adversely affected in the specific case. It is therefore essential that the clients are truthfully and comprehensively informed of all relevant details by both law firms. Apart from that, it is up to the lawyers concerned to assess in a responsible manner and in accordance with the standards set by the law whether any assignments should be terminated due to a conflict of interests or perhaps simply to avoid any perturbations on the level of existing client/lawyer relationships … If the clients whose interests may potentially be affected by a lawyer having changed from one law firm to another do not believe that a conflict of interests may arise from this, and trust in the discreetness of the lawyers concerned as well as in the efficiency of any measures taken to prevent any improper disclosure of information (all of which naturally implies that the clients concerned are comprehensively informed of all relevant details), there should be no reason for any ex officio intervention in the interest of the proper administration of justice, unless of course there are any facts or circumstances that were not disclosed to or accurately appreciated by the clients. In this regard, the local associations of lawyers are entitled and obligated to consider and investigate any hints or information they may receive, but they may not take any action merely because they may vaguely suspect or gather from any general circumstances that a breach of duty cannot be entirely ruled out.”
The decision of the Federal Constitutional Court should not be misunderstood to mean that a conflict of interests is necessarily ruled out just because the clients concerned accept the arrangements that have been made. For example, even after having changed to a new law firm a lawyer may not change sides and participate in activities directed against his former clients. What this decision of the Federal Constitutional Court does mean is that a lawyer changing from one law firm to another does not necessarily “infect” all other members of his new law firm making it improper for them to continue their work on matters, in which the “old” firm of their new colleague is acting for adverse parties. In its decision, the Federal Constitutional Court considered the modern forms of co-operation between lawyers, including the technological environment in which such co-operation takes place. The court did not believe that the rules on how one-man law firms should handle possible conflicts of interests should also be strictly applied to big, modern law firms. Following the Constitutional Court decision, it appears that all parties involved are best advised to proceed as follows (described in detail by Westerwelle in NJW 2003, 2958).
A law firm that is being joined by a lawyer who previously worked for another law firm should, as a first step, go through all matters handled by it to point out those matters that may involve a conflict between interests of its own clients and clients of the relevant lawyer’s previous law firm.
If it becomes apparent that there are matters with regard to which such conflicts of interests cannot be ruled out, the second step should then be submit each of these matters to closer scrutiny. It is quite possible that the lawyer changing law firms does not have any confidential information regarding matters that could otherwise involve or lead to a conflict of interests.
Even if the research work to be undertaken reveals that the lawyer changing the law firm is indeed aware of confidential information, this does not necessarily mean that the new law firm will have to terminate the relevant assignments. In such cases, however, it is essential that the relevant clients of both law firms involved agree that they shall be “truthfully and comprehensively” informed about the given conflict of interests. If after the receipt of this information these clients also agree to both law firms continuing their work on the relevant matter, there will be no reason for the new law firm of the lawyer changing firms not to do so, provided only that adequate internal measures are taken to prevent any improper disclosure of confidential information.
Law firms accommodating a lawyer who previously worked for another law firm should take appropriate time to reassure their clients that their interests will not be jeopardised by any sensitive information that may be known to the lawyer who is to join their professional staff. This can be done by forming a team that is separated from the rest of the staff by a Chinese wall. It should be borne in mind that any waiver of a client of any rights relating to a possible conflict of interests is void unless such client is fully informed of all relevant facts and circumstances. Therefore, the law firm is well advised fully to inform all parties that may be affected by a possible clash of interests of any risk of an improper transfer of sensitive information and of all precautions taken on the level of internal organisation and procedures to reduce such risks to a minimum. According to the Federal Constitutional Court, not only a lack of information of clients, but also an inaccurate assessment of the situation by clients may lead to an intervention of the local bar of lawyers. However, the probability of such risks being incorrectly assessed by experienced international corporations seems to be rather small.
(ii) Mergers of law firms The said decision of the Federal Constitutional Court is not only of great significance with regard to cases where a lawyer changes from one law firm to another. The principal issue, ie the risk of sensitive information being disclosed, exists also in connection with mergers of major law firms maintaining offices at several locations. It may happen that prior to such a merger the firms to be merged represented clients who are opponents in litigious or other matters. How should such conflicts of interests be handled by law firms wishing to merge?
There appears to be no case law on this question. Of course, here too one can argue that appropriate measures may be taken in connection with such mergers to assure that sensitive information will be kept confidential and not be disclosed to anybody not belonging to the team or the office handling the relevant case. Within international law firms the risk of sensitive information being transferred is rather small due to language and cultural barriers and because all lawyers working in such firms are likely to be highly specialised in very particular fields of the law. Further, these law firms have established organisational measures (eg Chinese walls) in order to prevent improper transfers of sensitive information within their firm. Even the Federal Constitutional Court referred to Chinese walls as suitable organisational measures for preventing the flow of confidential information. Provided that both clients agree, there is no compelling reason why a new law firm formed by a merger of two firms representing opposing parties in a particular matter would have to discontinue its work for both of these clients (cf Henssler, NJW 2001, 1521, 1527: at least for a transition period). What would not be allowed, of course, is that the same individual lawyers work for both sides, given that no individual lawyer is allowed to represent conflicting interests in one and the same legal matter.
(iii) Participation in pitches So far, no court decision exists on whether participating in a competitive procedure for the allocation of an assignment (referred to as “pitch”) gives rise to a prohibition of representing the other side. The question is whether a lawyer who took part in a pitch without being awarded the assignment may then represent a bank, public authority or competitor against the pitching company.
Strictly speaking, a lawyer who took part in a pitch has thereby dealt with the matter in the sense of s 3, para 1 of the Occupational Regulations for Lawyers. However, judging by the purposes of that statutory provision, client protection cannot be said to be adversely affected if the company organising a pitch agrees from the outset that all lawyers who may unsuccessfully participate in the pitch shall be released from their professional confidentiality duties in this respect and may accept instructions from third parties concerning the matter in question (cf Henssler/Prütting/Eylmann, Bundesrechtsanwaltsordnung, 2nd edn, 2004, s 43a, no 137).
(iv) Representation of several bidders Another controversial issue is the question of whether one law firm may represent more than one party participating in an auction.
In Germany, there have been several cases in recent years where law firms represented several bidders participating in one particular tender, it being understood that all parties concerned agreed to the relevant law firms representing more than one bidder (cf Juve Rechtsmarkt 11–12-2000, p 9). It is a matter of controversy whether bidders participating in a tender have conflicting interests, or whether they merely have different commercial interests.
To date, there are no reports of such arrangements having led to any sanctions being imposed for unethical professional conduct or under criminal law (Kleine-Cosack, Bundesrechtsanwaltsordnung, 4th edn, 2003, s 43a, no 100). Contrarily, on 26 June 2005 the local bar of lawyers in Frankfurt rendered a decision, in which it explicitly approved the practice of major law firms of representing more than one bidder by referring to the decision of the Federal Constitutional Court. The decision of the local bar has not yet been published.
In the light of the decision of the Federal Constitutional Court all of the following conditions must be met if one law firm is to represent more than one party participating in a given tender:
1 All parties concerned must agree that they are being represented non-exclusively. The name(s) of the other bidder(s) do not have to be disclosed; it is sufficient for each client concerned to know that it is not the only bidder represented by its law firm (Steuber, RIW 2002, 590, 594).
2 Moreover, it needs to be appropriately evidenced to any outsiders that the individual lawyers concerned are fully able to represent exclusively the interests of the clients they are required to look after, irrespective of other lawyers of the same law firm being instructed to attend to the interests of another bidder (Henssler, NJW 2001, 1521, 1523). Most important is the erection of a Chinese wall, which ensures that any sensitive information that may be provided to any one of the relevant teams remains confidential and that any illicit flow of information within the law firm is prevented.
5. Outlook
The decision handed down by the Federal Constitutional Court in 2003 sharply changed the approach to handling different assignments involving conflicting interests by one and the same law firm. The highest German court introduced general guidelines which will have considerable impact on the prevention and handling of conflicting interests by law firms. The fundamental principles laid down by the Federal Constitutional Court, especially with regard to the right of clients to authorise the continuation of assignments despite conflicting interests, should apply not only to cases where a lawyer changes from one law firm to another. They should also apply to cases of merger of law firms and even in cases where different professionals of a law firm work for adverse parties (eg representation of more than one bidder participating in a tender) (Westerwelle, NJW 2003, 2958, 2960). The Federal Constitutional Court also stated how to avoid all lawyers within a firm being deemed to be concerned with all cases handled by that firm which may involve conflicting interests. This can be achieved by members of a law firm being kept away from confidential information entrusted to other member of that firm, by means of a Chinese wall or through “geographical separation”. The essential point to avoid is that any individual lawyer is aware of sensitive information relating to two (or more) matters involving interests that are in conflict with each other. By its decision the Federal Constitutional Court supported the practice of international law firms.
To date, no rules exist on how Chinese walls within a law firm should be set up and what organisational and other measures should be taken to ensure their efficiency. It should also be quite difficult to formulate such rules because the relevant internal procedures and other circumstances differ considerably from one law firm to another. Nevertheless, the Federal Constitutional Court has expressly acknowledged the significance and efficiency of Chinese walls as a means of avoiding sensitive information being spread within a law firm.
In practice, it has become increasingly difficult to identify conflicts of commercial or legal interest. As a consequence of ongoing globalisation corporate groups are more and more interwoven. Therefore, major law firms have introduced standard procedures to identify possible conflicts of interest between their existing assignments and new assignments proposed to them. Using constantly updated databases and applying certain mandatory checks and reviews, major law firms are now able to answer such inquiries very promptly.
The requirements to be met to ensure the confidentiality of sensitive information should not be underestimated as regards the infrastructure they necessitate. It has become indispensable for major law firms to maintain a central management unit which is in charge of thoroughly examining any proposed new assignments in order to identify possible conflicts of interest. All files and other documents concerning conflicting assignments must be kept separately and any electronic data relating to such assignments must be accessible to authorised users only. These technological precautions must be coupled with regular further training on appropriate issues of professional etiquette and the handling of mechanisms designed to prevent illicit transfers of information (Kilian, BB 2003, 2189, 2194). The requirements to be met with regard to such protective mechanisms have to be considered to be very high. Comparatively small law firms will often not have the resources necessary to meet these requirements and will thus de facto be forced to turn down conflicting assignments proposed to them. Having the resources necessary to identify conflicting interests and to establish and maintain the required organisational measures will more and more become a competitive advantage of major law firms.
Since the above-discussed decision of the Federal Constitutional Court, it is now beyond doubt that reform is under way regarding the law of conflicts of interest, which was for a long time regulated by rules of professional conduct which did not keep up with the changes of modern economy. The process of modernisation and liberalisation is not complete. For the moment, one can expect the associations of lawyers and the professional tribunals to follow the guidelines set by the Federal Constitutional Court to construe the prohibition to represent conflicting interests more restrictively than they often did in the past.
Germany
6. Useful references
Federal Bar of Lawyers (Bundesrechtsanwaltskammer, BRAK) Littenstraße 9 D-10179 Berlin Tel: +49 3028 4939 0 Fax: +49 3028 493911 E-mail: zentrale@brak.de Website: http://www.brak.de
