In response to concerns highlighted by the financial crisis, the EU Commission is working on an ambitious programme of regulatory reform designed to ensure that financial markets are secure and reliable and that all participants in these markets operate responsibly. The reforms are intended to fill gaps in areas in which European or national regulation is considered insufficient or incomplete. One of such gaps is seen in the oversight and supervision of management activities of alternative investment funds, or funds which are presently not harmonised under the undertakings for collective investment in transferable securities (Ucits) – directive including, inter alia, private equity, mezzanine, infrastructure and real estate funds.
In Germany at least four different regulatory regimes may apply to funds set up in Germany. The following article discusses to what extent harmonised EU-fund regulation could be an opportunity for Germany in light of its widely diversified and in part inconsistent system of fund regulation, taking into consideration the historical development of fund regulation in Germany.
German regulatory fund regimes
The Investment Act governs the setting up, management, investment restrictions and distribution of Ucits funds and non-Ucits funds meeting certain formal requirements. Private equity and venture capital funds fall outside the scope of the Investment Act and, save for prospectus requirements in cases of public offerings, are unregulated unless the sponsor chooses to be subject to the special regimes of the Unternehmensbeteiligungsgesetz (UBGG) or the Wagnisbeteiligungsgesetz (WKBG), thereby benefiting from certain taxation relief.
Until recently, all other funds have not been subject to any regulation except for selling restrictions in cases of public offerings. This has now changed with the amendment to the German Banking Act, effective since March 26 2009, pursuant to which licence requirements apply to funds (that do not fall within the scope of the Investment Act) managing a portfolio of financial instruments on a collective basis for a group of individuals. Other than the special regime for investment funds under the Investment Act, the new licence requirements under the Banking Act apply in case the services are offered to German residents, irrespective of the legal arrangement or the seat of the fund.
The German Banking Act
Since March 26 2009 licence requirements apply to funds if the purpose is to purchase and sell financial instruments for a collective group of individuals with investment discretion over the selection of the financial instruments, provided that such activity is not only of ancillary nature and conducted for the purposes of allowing the investor to participate in the increase in value of the purchased financial instruments. The same applies if the individuals invest in such fund by way of a trust vehicle.
Scope
Only the purchase and sale of financial instruments is subject to licence requirements. Financial instruments are in particular shares, certificates, bonds, notes, units in investment funds (falling within the scope of the Investment Act), money-market instruments and derivatives. According to the German interpretation, interests in German partnerships and limited liability companies are not considered financial instruments due to the lack of comparability with shares. The same is true for real estate assets.
Private equity funds, although they often also invest in financial instruments, do not require a licence because of their intention to actively monitor the portfolio company's management and business decisions rather than benefit from the growth potential of the target's shares. The purpose of the new law is to protect individual investors against risky investment schemes investing in financial instruments.
The activity must be rendered on a collective basis for a group of individual investors. This requires at least two individual investors. Institutional funds would not be covered, and it remains to be seen how mixed funds will be treated. In contrast to the regulated financial portfolio management (Finanzportfolioverwaltung) included in the Banking Act, since 1998 the management thereof must be on a collective basis. Financial portfolio management only covers management of portfolios in financial instruments on a bilateral basis. It requires that a separate portfolio be managed for each client.
Moreover, the fund's management must act with investment discretion. If the investment guidelines of a collective investment scheme limit purchases and sales to certain defined financial instruments without permitting permanent active trading, no licence requirements apply due to a lack of overall discretionary authority over the investment decisions. It is not yet clear how detailed investment guidelines must be in order to fall outside of licence requirements due to absence of investment discretion. In any event, feeder funds are certain not to fall within the scope of the new provision.
Only if the purchase and sale of financial instruments is the principal feature of the offered product and not only an ancillary activity do the licence requirements apply. According to the legislative reasoning, this should be the case if marketing concentrates on the financial instruments to be purchased and sold by the fund. Hence, companies and real estate funds which keep liquidity reserves or purchase financial instruments on an ongoing but ancillary basis for hedging purposes are not subject to licence requirements.
The legislator intended to fill a gap produced by the Investment Act and therefore took an economic (as opposed to a formalistic) approach in order to include all types of collective investment schemes, irrespective of the exact legal arrangement. A structure would be covered by the licence requirements if the economic success or loss is intended to be borne by the investor. Thus it is irrelevant whether the investor participates as shareholder or limited partner in a fund vehicle or as holder of bonds, notes or certificates.
Who is subject to licence requirements?
The vehicle purchasing and selling financial instruments requires the licence or the fund. However, the German Bank Act (KWG) amendment excludes funds from the licensing requirement if such enterprise provides no financial services other than collective investment management, and its parent enterprise is licenced for collective investment management. In case the parent enterprise is located in another member state of the European Economic Area (EEA), the subsidiary can provide investment management services in Germany if the parent enterprise is licenced for an activity which is comparable to collective investment management in its home country. There is no guidance yet on what is considered a comparable activity. Financial portfolio management is likely to be considered comparable. Hence, only if the parent (the general partner or another controlling partner) is licenced is the fund exempt from a licence. If the general partner is not licenced but the manager (not a parent of the fund) provides investment management services to the general partner, the fund still requires a licence.
Foreign funds
The new licence requirements for collective investment management service are a national product and not covered by an EU directive. Hence, in principle, no EU pass-porting rules apply with respect to cross-border collective investment management services. If a closed-end fund which is not subject to investment supervision (i.e. not qualifying as foreign investment fund within the meaning of the Investment Act) offers its interests to persons resident in Germany, licence requirements should apply. However, if such non-German fund or its parent is licenced in its home-member state and covers collective investment management according to the interpretation of the home member state of the fund, then the view of such home-member state prevails and such fund can provide its services (interests in the fund) to persons resident in Germany based upon the passport.
Moreover, an exemption to the licensing requirement is also available pursuant to the so-called passive freedom of services doctrine (passive Dienstleistungsfreiheit). Under that doctrine, no licence under the KWG is required if the contact between the financial services provider and the client is initiated by the client itself and without prior solicitation.
Finally, foreign investment funds that issue so-called foreign investment units as defined under the Investment Act are specifically excluded from any licensing requirements for the described collective investment management because such funds are already subject to the regulatory scheme of the Investment Act. As a result, open-end foreign investment funds and foreign closed-end funds that are subject to regulatory supervision in their country of organisation do not require a licence under the Banking Act.
The Investment Act
Funds qualifying as foreign or domestic investment funds within the meaning of the Investment Act are not subject to licence requirements under the Banking Act because the Investment Act prevails over the Banking Act. In fact, the new licence requirements for collective investment management under the Banking Act were intended to fill a gap and hence serve as a fallback for schemes which are neither covered on a national level by the Investment Act nor on an international level by the Ucits directive.
Such a gap resulted mainly from the fact that the Investment Act covers only collective fund schemes which meet specific formal requirements: open-end Sondervermögen managed by German management companies (so-called Kapitalanlagegesellschaften) and open-end German investment stock corporations (so-called Investmentaktiengesellschaften). The marketing and distribution of non-German funds is covered by the Investment Act if such funds are open-end or closed-end funds and, in the latter case, subject to investment supervision. Open-end means that the fund rules provide redemption rights which must be granted at least every two years. In case redemption is permitted less often, the fund would be considered closed-end.
Other than the collective investment management regulation of the Banking Act, the Investment Act covers funds which are offered to institutional as well as to individual investors. Funds which are admissible for institutional investors only are the so-called Spezialfonds. They are governed by a special section in the Investment Act and benefit from regulatory exemptions, are subject to only very few investment restrictions and basically only subject to regulation as to their managers and custodians, transparency and prospectus requirements and certain rules of conduct.
All funds qualifying as investment funds under the Investment Act have in common the fact that distributions to German investors are subject to a special tax regime.
Like the rules governing collective management in the Banking Act, the Investment Act excludes private equity funds. The legislator and the German Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht) have clarified that, due to their long-term investment approach, which also includes an active monitoring of the management of portfolio companies, private equity funds are not comparable to investment funds and should not be included within the scope of the Investment Act. It was felt that such funds should be governed by special regimes, if at all. Such special regimes, UBGG and the recently introduced WKBG, have not been very successful in practice due to the substantial investment restrictions.
The Investment Act is much more than a mutual fund regime implementing the EU-harmonised Ucits funds. On the other hand, a substantial portion of funds are not covered. This leads to the question of why the Investment Act, unlike in France and Luxembourg, does not cover all types of funds. The current regulatory framework is the result of several extensions of the Investment Act over time.
When the former Investment Management Companies Act (KAGG) was implemented in 1957, the legislator intended to implement a regulatory basis for investment business that also encouraged unsophisticated investors to make investments in collective investment vehicles by providing investor protection and confidence. For these purposes, the Sondervermögen was introduced, a collective investment scheme without legal personality with variable capital managed by a management company (KAG). Any tax disadvantages that resulted from the interposition of a corporation were abolished by a special tax regime providing for certain tax privileges.
Gradually it became clear that there was also a need for corporate vehicles. As a result, the investment stock corporation with fixed capital was introduced. In fact, the original idea of introducing such a corporate investment vehicle in 1998 was to enable venture capital investments and investments in smaller unquoted companies. It turned out to be a failure because the tax privileges applicable to the Sondervermögen did not apply to the investment stock corporation to the same extent and it was subject to heavy investment restrictions. In the course of the 2004 reform, the Investment Modernisation Act, the investment stock corporation with variable capital (subject to the same tax regime as the Sondervermögen) was introduced and the investment stock corporation with fixed capital was later abolished. Unlike in 1998, such corporate vehicle was not intended for private equity or venture investments but mainly for hedge funds, which were also introduced by the law.
Until 1969 the KAGG only covered funds investing in securities. Today the Investment Modernisation Act, replaced by the Investment Act which itself has been amended several times, covers hedge funds, real estate funds, fund of funds and other funds not subject to any specific investment strategy and subject to limited restrictions. Almost any investment strategy could be reflected by the Investment Modernisation Act except for private equity and venture funds and ship funds, provided that such an investment strategy is put into a legal arrangement that meets the formalistic criteria of a German or non-German investment fund under the Investment Modernisation Act.
One of the reasons why, despite these liberalisations and the extension of scope, still relatively few funds are being set up in Germany as opposed to Luxembourg and France may be the fact that the legislator did not permit closed-end structures for German funds. Foreign funds can fall within the special regime of the Investment Act (and the corresponding tax regime), even if closed-end, but such possibility does not exist for German funds.
EU regulation
The EU commission is now trying to fill a gap and demanding a comprehensive legislative instrument establishing regulatory and supervisory standards for hedge funds, private equity and other non-Ucits funds and their managers. It is yet to be determined what exactly this will mean in practice, but the pressure is great for the implementation of some type of EU-harmonised regulation covering authorisations of managers, as well as transparency requirements, disclosure and reporting requirements and leverage control. Hopefully such regulation will not cover any limitations regarding the investment policy of the funds.
Whereas in certain EU countries like France, Italy and Luxembourg, funds can only be set up as regulated collective investment schemes governed by more or less one legislative act, other countries such as Germany still differentiate between regulated and unregulated funds. It is the latter countries that will need to substantially revise their current legislation to implement upcoming EU requirements.
In Germany the legislator also recently felt that a gap needed to be filled that was caused by the Investment Act (which, for example, does not cover German hedge funds not organised as Sondervermögen or Investment AGs or non-German closed-end funds) and responded with regulation of the fund itself, typically an empty box, or its parent (but not, for example, its manager) by defining the fund (or its parent, as the case may be) as a financial institution under the Banking Act. However, collective management schemes do not seem to fit into the Banking Act. Whereas the Banking Act puts the fund itself under the licence requirement, it does not address the issues of transparency, disclosure, leverage control and reporting to investors. Such regulatory targets should be dealt with in an act governing collective investment schemes like the Investment Act.
In practice, this could be achieved by further opening the Investment Act for all types of funds, irrespective of the legal arrangements or the target assets. In light of the extensions of the scope of the Investment Act over time, such further opening only seems to be the next logical step. Whether private equity should be covered in the Investment Act or, due to its specificities, should rather be covered in a separate act remains to be seen.
In any event, such regulation required by the EU could be an opportunity for Germany to catch up with other EU fund regimes by revising and harmonising its highly diversified regulation. Luxembourg has shown how a fund regime covering all types of funds, regulating managers, transparency requirements and – depending on the type of investor – leaving flexibility in terms of the investment policy can be successful.
With its Investment Act, Germany has the necessary framework in place which could serve as a basis. The Banking Act does not seem the right place for regulation. If regulation is implemented in a uniform fund regime, this will put an end to many uncertainties and discussions. After all, a regulation as such has never been criticised or feared by most industry players – provided, however, that such regulation is reasonable and clear.
| Author biographies |
Patricia Volhard
P+P Pöllath + Partners
Patricia is a partner with P+P Pöllath + Partners in 2005 and is based in Frankfurt. She studied law in Strasbourg, Sarrebruck, Frankfurt/Main and London. She graduated as a lawyer in Germany and France and holds an LLM in banking and finance from the London School of Economics and Political Science. Admitted as avocat à la Cour in Paris and as Rechtsanwalt in Frankfurt, she worked in Paris (1999 – 2002) and Frankfurt (2002 – 2005) with a large US law firm.
Patricia specialises in structuring private investment funds and financial products (private equity, alternative assets and real estate), with a focus on corporate, investment, banking and insurance regulatory issues. She advises fund sponsors and German investors (institutional investors as well as family offices).
P+P is an independent corporate and tax firm with 95 lawyers and tax advisers specialising in M&A, tax, private equity/venture capital, funds, asset management and real estate. The firm has 25 partners with offices in Berlin, Frankfurt and Munich and is fully independent and not affiliated with any other firm or group.
Email: patricia.volhard@pplaw.com |