i Structure of the law
The German understanding of 'capital markets' is the market for financial instruments (within the ambit of Annex I, Section C of the Markets in Financial Instruments Directive2 (MiFID II))3 and the 'grey capital market' that conceptually includes any financial products that are not technically financial instruments in the narrow sense (mostly for lack of tradability in a legal sense, such as stakes in closed-ended fund structures outside the Alternative Investment Fund Managers Directive (AIFMD),4 which are legally partnership interests, and shares in limited liability companies). Although this dichotomy is becoming ever more blurred since numerous grey capital market financial products are deemed to be financial instruments within the ambit of the Banking Act (KWG) for certain (quite limited) regulatory purposes, and some now fall within the ambit of the German transposition of the AIFMD (in the Capital Investment Code (KAGB), which provides a unified framework for all kinds of undertakings for collective investment in transferable securities and alternative investment funds), it still continues to be useful for analytical purposes.
While the market for financial instruments in the narrow sense is very densely regulated in respect of market access and market behaviour, the grey capital market is more sparsely regulated, except for the accounting directives (which indiscriminately apply to both issuers of financial instruments and originators of other financial products), the AIFMD, and the PRIIPs Regulation,5 harmonised EU capital markets law almost exclusively aims to regulate markets for financial instruments, and German law basically follows this approach, except for a special prospectus requirement for financial products of the grey capital market, a special licensing requirement (hardly more than mere registration) for distributors of such products, certain structural requirements for such products, and the power of the Federal Financial Supervisory Authority (BaFin) to ban certain products (as an ultima ratio measure) and certain misleading sales promotion. The former 'light touch regulation' of the grey capital market had already been somewhat fundamentally changed in the context of the transposition into German law of the AIFMD by the KAGB, which made all kinds of collective investment schemes subject to fund regulatory law (albeit with limited effect unless the AIFMD thresholds for assets under management are met) basically finally found an end as a result of the Small Investor Protection Act, which partly anticipated the German transposition of MiFID II and partly further tightened the grip over grey capital market financial products.
Capital markets law is the body of laws and standards that directly or indirectly regulate the capital markets – market access, market behaviour and market-related behaviour of market participants – and thereby safeguard their efficiency. It has an interdisciplinary profile, being implemented through a vast and somewhat unsystematic body of administrative, civil and criminal law provisions at both supranational (European) and national levels. Administrative policies (such as the BaFin's Issuer Guideline, circulars and other publications, and certain publications of the European Securities and Markets Authority and the former Committee of European Securities Regulators) play a highly important role in practice; they provide a minimum level of comfort to market participants although they merely reflect the respective authority's interpretation of the law – which is not necessarily correct – and are not binding on the courts. Standards set by private standard setters (such as the International Accounting Standards Board, the German Accountancy Standards Committee and the German Institute of Auditors) have high practical impact. The vast field of over-the-counter (OTC) derivatives is almost exclusively dominated by standard forms of agreements proposed by private institutions such as the International Capital Market Association, the International Swaps and Derivatives Association and the Federal Association of German Banks (BdB), but market infrastructure law and regulations (the European Market Infrastructure Regulation (EMIR) and MiFID II) have certain repercussions on documentation and trading.
German capital markets law is, to a large extent, harmonised EU capital markets law: more than 85 per cent of the relevant provisions are either directly applicable EU law (e.g., the Market Abuse Regulation (MAR)) or are based on EU law. The Securities Trading Act (WpHG) – sometimes called 'the constitution of the German capital market' – the Deposit Protection Act and the Investor Compensation Act, the Stock Exchange Act (BörsG) and the Stock Exchange Admission Regulation (BörsZulV), the Securities Prospectus Act (WpPG), the Securities Acquisition and Takeover Act (WpÜG), the accounting provisions of the Commercial Code, and the KAGB are substantially or even entirely based on EU Directives, implementing the Investment Services Directive, the AIFMD, the Financial Markets Directives, the Transparency Directive, the Settlement Finality Directive, the Investor Compensation Directive, the Prospectus Directive, the Directive on the Admission of Securities to Official Stock Exchange Listing, the Accounting Directives and the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive. While, in the past, EU Directives almost exclusively provided for 'minimum harmonisation' and left ample leeway for national legislators to provide for stricter rules at the national level – which the German legislator sometimes did – they now mostly provide for 'maximum harmonisation', meaning that Member States must follow the levels prescribed by the European Union and have no discretion to introduce stricter rules.
The core parts of German capital markets law are codified in the WpHG and the WpÜG, which basically deal with market comportment issues relating to the market for financial instruments; and in the KWG, the BörsG and BörsZulV, and the WpPG, which basically deal with market access issues relating to the market for financial instruments and to distributors active in this market. The market comportment regulation in the WpHG is basically a transposition of the MiFID II regime. The regulatory framework for the sale of structured products is provided by the PRIIPs Regulation – in force since the beginning of 2018 – which is directly applicable in Germany. The WpPG – the German transposition of the Prospectus Directive6 – is supplemented by the Capital Investment Act (VermAnlG), which replaced the former Sales Prospectus Act and provides for a prospectus requirement for investments that are not technically securities in a narrow sense, such as stakes in certain commercial undertakings, profit participation interests, subordinated loans and structured deposits, and thereby covers virtually all the grey capital market. In addition to the prospectus requirement, the VermAnlG also provides that the relevant (retail) products must have a minimum maturity and a minimum notice period – so as to avoid liquidity issues and outright runs, which occurred when very short-maturity subordinated profit participations rights were used to refinance long-term renewable energy investments – and prohibits the distribution of retail products that require subsequent additional capital contributions.
The direct or indirect distribution of non-self-issued financial instruments to (retail, wholesale and institutional) customers is a regulated financial service that requires a licence under the KWG or a passported European licence, and involves regulatory supervision by the BaFin and the German Federal Bank (Bundesbank).7 Except for the licensing requirement for providers of collective securities management (which is aimed at certain financial products related to collective investment schemes – such as stakes in closed-end securities trading funds and self-issued bonds linked to the performance of managed securities portfolios – that would otherwise fall into an unregulated gap between financial portfolio management within the ambit of the KWG and investment fund administration within the ambit of the KAGB), these licensing requirements are transpositions of Article 5(1) of MiFID II (requirement for authorisation); however, investment advice, investment brokering and best-efforts underwriting may be provided by tied agents (i.e., persons not holding a financial services licence themselves, but acting under the umbrella of the licence held by a deposit-taking credit institution or a securities trading firm) if the conditions set out in Article 29 of MiFID II are met. A tied agent acting in Germany under the umbrella of a deposit-taking credit institution or a securities trading firm from another European Economic Area country would not be deemed a German branch of that foreign firm, to the effect that the foreign firm would only have to hold a European passport for cross-border services into Germany.
Cross-border financial services that are provided in Germany from other countries are deemed regulated financial services in Germany if the German market is actively targeted, meaning that financial promotion (solicitation) is directed into Germany. Whether this is the case depends on a complex bundle of criteria, mainly driven by customer protection concerns. As a consequence, foreign firms not holding a European passport are basically banned from actively providing cross-border financial services into Germany unless they use a German fronting bank or a client initiates a reverse solicitation. There are some exceptions with respect to certain activities of Swiss banks under a German–Swiss memorandum of understanding of 16 August 2013.
Naked short sales of shares and eurozone public debt instruments admitted to trading on a regulated market in Germany, and cash-settled credit derivatives the reference asset for which is eurozone public debt, are banned under Regulation (EU) No. 236/2012 on short selling and certain aspects of credit default swaps, which substituted the former German framework. Further, there are notification and publication obligations for net-short positions in shares admitted to trading on a regulated market in Germany exceeding certain thresholds. A naked short sale within the ambit of the law occurs when the seller of the shares or debt instruments is not the owner of the securities or does not have an unconditionally enforceable claim for delivery of a corresponding number of securities by the end of the day on which the respective transaction occurs. The short-selling ban provides an exemption for short sales by an investment services company or similar organisation domiciled abroad if and to the extent the company acts as a market maker or hedges positions resulting from certain trades with customers. The ban on public debt credit derivatives provides an exemption for short sales by an investment services company or similar organisation domiciled abroad, if and to the extent that the company acts as a market maker. Any market participant intending to make use of such exemptions must notify the BaFin immediately, specifying the financial instruments concerned. The short-selling ban applies extraterritorially. Further, the BaFin is empowered to temporarily prohibit or suspend trade in certain financial instruments, in particular with regard to derivatives whose value directly or indirectly derives from the price of shares or eurozone public debt instruments admitted to trading on a regulated market in Germany, if their structure and effect are, from an economic perspective, equivalent to short-selling and do not lead to the reduction of a market risk.
Distribution of certain grey capital market financial products only requires a licence (basically little more than a mere registration) from the competent local trade board under the Industrial Code (GewO), and does not involve regulatory supervision by the BaFin or the Bundesbank (except for the applicable prospectus regime, and the BaFin's power to ban certain products and certain misleading advertising). As with financial services, the licensing requirement is triggered if the German market is actively targeted in the context of cross-border distribution from abroad.
The provision of regulated financial services without a proper licence (or European passport) is a criminal offence under the KWG and a tort under the Civil Code.
Investors in German bank debt should be aware of the effects of the bank resolution and bail-in regime under the German Restructuring and Resolution Act, which transposes the Bank Recovery and Resolution Directive (BRRD)8 into German law. In 2015, the German legislator subordinated senior unsecured bonds of banks to help German banks to meet the minimum requirement for own funds and eligible liabilities and the total loss absorbing capacity. In other European countries, banks could continue to issue preferred senior bonds that were priced differently from the lower-ranking German subordinated senior bonds. To achieve a level playing field for German bank issuers and to implement an amendment of the BRRD effective as of 28 December 2017 with the aim of improving consistency between creditor hierarchies across the European Union, the German legislator has amended the KWG (Section 46f, Paragraphs 6, 7 and 9) to allow for two different classes of senior bonds. From 21 July 2018, German banks can choose to issue senior-preferred and senior non-preferred bonds. If the terms and conditions of the securities to be issued do not provide otherwise, issues from 21 July 2018 count as senior preferred issues. Only if it is explicitly stated in the terms and conditions of the securities, the lower non-preferred ranking shall apply to a new issue (senior non-preferred).
Under the new regime, senior unsecured bonds issued until 20 July 2018 (inclusive) now rank pari passu with senior non-preferred bonds. They will lose European Central Bank (ECB) eligibility as of 31 December 2018. However, this grandfathering is only available for issues prior to 16 April 2018.
It is expected that numerous German banks will make use of the new asset class of senior preferred bonds, because those issues will benefit from a higher issue rating and will be less expensive. In addition, the new senior preferred bonds are eligible as ECB collateral.
ii Structure of the courts
The German court system consists of five distinct structures, each of which is basically three-tiered with its own supreme court (i.e., each consists of a trial court, a court of appeal and a supreme court). In addition to the hierarchy of the ordinary (civil and criminal) courts, there are separate systems of labour, administrative, tax and social security courts. The legality of administrative actions can be challenged before the administrative courts (tax courts and social security courts being specialised administrative courts), whereas disputes between private persons (and between private persons and the state and its subdivisions, if these are not acting in an administrative capacity) are dealt with by the ordinary courts (and the labour courts if the dispute stems from a labour contract or collective labour issues). Thus, lawsuits against the BaFin for the purpose of challenging a regulatory measure would have to be brought before the administrative courts, whereas disputes between market participants are to be litigated before the ordinary (civil) courts. In the ordinary (civil) courts, there are special chambers for commercial affairs at the trial court level, where a professional judge sits with two commercial experts chosen for their specific expertise.
iii Supervisory agencies
The BaFin is the supervisor for any and all issues related to financial instruments, whereas the grey capital market is (extremely sparsely) supervised by the local trade boards under the GewO (with the BaFin only being competent for the approval of prospectuses and the banning of products and certain misleading advertising). Under an operational agreement between the BaFin and the Bundesbank, the latter is assigned most of the operational tasks of day-to-day supervision of banks and financial services providers. The Bundesbank's responsibilities notably include evaluating the documents, reports, annual accounts and auditors' reports submitted by the institutions, and carrying out regular audits of their operations. The Bundesbank holds both routine and ad hoc prudential discussions with the institutions. The supervision of trading in financial instruments by the BaFin serves the objectives of market transparency, market fairness and investor protection. The stock exchange supervisory authorities of the federal states are responsible for the supervision of compliance with stock exchange regulations. The BaFin's competences with regard to credit institutions within the ambit of the Capital Requirements Regulation9 are now partly superseded by the ECB under the single supervisory mechanism.
iv Trends reflected in decisions from the courts and other relevant authorities
It is fair to say that banks and financial intermediaries currently have a somewhat difficult standing with the courts and the regulator (and the legislator); there is a broad consensus (which is to a large extent the consequence of severe hindsight bias) that applicable standards should be tightened to the detriment of the former. As in the aftermath of any financial crisis, investors are inclined to forget about the true reasons for their investment decisions, plaintiffs' lawyers search for 'put options by law' to allow for ill-fated investments to be unwound, and, by (retroactively) tightening standards of disclosure and advice, the courts seem quite willing to 'help' investors who seem to have been milked or bilked. The focus is mostly on mis-selling, but another big issue is the validity of the terms and conditions underlying certain financial products under the law on unfair contract terms. The Small Investor Protection Act and the German transposition of MiFID II further tighten the grip over grey capital market financial products and tackle the distribution of financial products.
II THE YEAR IN REVIEW
Legislative and regulatory activity and activism in the area of capital markets now mainly occurs at the EU level, to the effect that there has been relatively little development at the purely national level.
i Developments affecting the distribution of financial instruments in general
The biggest innovation in the area of capital markets law in 2018 was the entry into force of MiFID II and MiFIR.10 Whereas MiFIR was directly applicable in Germany as in all other EU Member States, MiFID II had to be transposed into German law. The German legislator did that with the Second Financial Market Amendment Act (2nd FiMaNoG). In addition to transposing MiFID II, the 2nd FiMaNoG modified some other laws according to MiFIR, in particular the KWG and the BörsG.
With the First Financial Market Amendment Act (1st FiMaNoG), the MAR, Market Abuse Directive II (MAD II), Central Securities Depositories Regulation (CSDR) and the PRIIPs Regulation had been transposed into German law as from 2016. The implementation of MiFID II was deliberately excluded at that time. The changes caused by the MAR/MAD II came into force on 2 July 2016, all others on 31 December 2016.
Most of the changes brought by the now effective 2nd FiMaNoG concern the WpHG which has been completely restructured and renumbered as a result of the implementation of the new European requirements. The changes in the WpHG are an example of the increasing importance of European law and the decreasing importance of national regulation; many provisions in the WpHG are only of a fundamental nature dealing with principle features and concepts. The vast majority of the regulatory volume is now made up of European implementing regulations that are directly applicable and to which the WpHG refers. The focus here is on the life cycle of products and the associated organisational and conduct of business obligations. Many of the obligations newly regulated in the course of MiFID II implementation relate in particular to the distribution and sale of financial products, and advice in relation to financial products, and have a direct influence on the relationship between service provider and customer. The innovations therefore also mean a strengthening of collective consumer protection in a harmonised European legal framework. In addition, the 2nd FiMaNoG contains implementing provisions for two other European legal acts that are directly applicable: the Regulation on Securities Financing Transactions11 and the Benchmarks Regulation.12 The 2nd FiMaNoG regulates, among other things, the responsibilities for the monitoring of the relevant regulations and their sanctioning by fine regulations.
Furthermore, the Act on the Exercise of Options under the EU Prospectus Regulation and on the Amendment of Other Financial Market Acts has been passed by the German legislator. The enactment of this law became necessary because of amendments to the Prospectus Regulation.13 This regulation gave EU Member States a margin of manoeuvre: below the threshold of €1 million, other proportionate disclosure requirements may be imposed nationally, but no prospectus may be required. In addition, the Prospectus Regulation allows public offers without a European passport of up to an aggregate amount of €8 million to be exempted nationally from the obligation to publish a prospectus. By making use of these options, German law adapts, among other things, the WpPG in such a way that investors are protected by transparency requirements in the form of a securities information sheet for offers of between €100,000 and €8 million; a prospectus is only required nationally from €8 million.
There are three regulations that have been amended: the Financial and Risk-bearing Capacity Information Regulation (FinaRisikoV), the Regulation on the Examination of Investment Services Enterprises (WpDPV) and the Investment Rules of Conduct and Organisation Regulation (WpDVerOV). The amendment of the FinaRisikoV grants some reporting simplifications to reporting agents in the context of financial information while the WpDPV and the WpDVerOV had to be amended because of the implementation of MiFID II. An essential innovation of the WpDPV concerns the insertion of Section 2(4) WpDPV, which defines the term 'other findings'. Other findings are therefore deemed to exist if the auditor determines that the interpretation of EU law requirements undertaken and published by the European Securities and Markets Authority has not, or has not fully, been taken into account. This is important for the auditor in that the questionnaire to be attached to the audit report must now include a brief description of the other findings (Section 18(2) WpDPV).
Last but not least, BaFin has published several circulars, two of which are worth mentioning here: Circular 08/2018 (BA) on the reporting of serious payment security incidents and the updated Circular 10/2017 (BA) on the Banking Supervisory IT Requirements (BAIT). Circular 08/2018 (BA) refers to Section 54(1) of the Payment Services Supervision Act, according to which a payment service provider must immediately inform BaFin of a serious operational or security incident. This Circular contains criteria on when an operational or security incident is serious and therefore subject to reporting, and rules on the format and procedures for reporting.
The BAIT Circular provides, on the basis of Section 25a(1) KWG, a flexible and practical framework for the technical and organisational equipment of institutions – in particular for the management of IT resources and for IT risk management. It also specifies the requirements of Section 25b KWG (Outsourcing of Activities and Processes).
In May 2018, the Federal Constitutional Court (BVerfG), which is the highest judicial authority in Germany and monitors conformity with the German constitution, decided that there is no impunity for offences under the WpHG that were committed before the MAR became applicable on 3 July 2016 and have not yet been finally adjudicated. The court followed thereby the Federal Court of Justice (BGH), Germany's supreme civil court, and decided the controversial question in the literature whether there had been a 'punishment gap' for criminal offences under the WpHG. The background was that the relevant criminal provision in Section 38(3) No. 1 WpHG had already entered into force on 2 July 2016, while Article 14 MAR, to which reference is made in this provision, had already entered into force in June 2014 but was only applicable from 3 July 2016. It was argued that this was an empty referral that led to impunity because a regulation that was not yet applicable could not be infringed. However, the BVerfG did not follow this reasoning. The reference in Section 38(3) No. 1 WpHG to Article 14 MAR is to be regarded as a mere waiver of reproducing its wording.
The BGH ruled, also in May, on price clauses of a bank for 'interest cap premium' or interest rate hedge fee. In an injunction action, the plaintiff challenged a contractual clause by which the defendant bank collected an interest cap premium, or interest hedging fee from its customers in loan agreements with a variable interest rate. The BGH ruled in favour of the plaintiff and found that the deviation from the legal model of Section 488(1), Sentence 2 of the German Civil Code indicated inappropriate discrimination against the contractual partner.
iii Role of exchanges and central counterparties
Central counterpart (CCP) clearing for OTC derivatives is still a focus with regard to the implementation of EMIR, CRD IV14 and MiFID II. The German Banking Association published several standard form documents as annexes to the German framework agreement for derivatives that address certain EMIR requirements and facilitate the clearing. Also, aspects regarding bilateral OTC derivatives and margining requirements remain in focus.
III OUTLOOK AND CONCLUSIONS
In view of the flow of regulatory reform initiatives from the European Union, there are still many draft laws and regulations at national level in the pipeline. For instance, the German government published draft laws that aim to adjust financial market laws to (the Securitisation Regulation15 and the Capital Requirements Regulation, as amended by Regulation (EU) 2017/2401 (CRR Amendment Regulation), providing for a new European framework for the regulation of securitisations. The two EU regulations will apply from 1 January 2019. The national legal acts to be adapted are the KWG, the Insurance Supervision Act, the KAGB, the WpHG, the German Solvency Regulation, the German Audit Report Regulation and the Regulation on the Rules of Conduct and Organisational Rules Pursuant to the Capital Investment Code.
In addition to this legislative development, there are several other projects concerning the capital market that BaFin is pushing ahead with. First are the 'minimum requirements for the orderly conduct of depositary business and the protection of client financial instruments for investment service providers' (known as MaDepot), which BaFin put to consultation in April 2018. The Circular is intended to provide the practice with an overview and compilation of the relevant supervisory requirements on behavioural and organisational duties in the area of depositary business. In addition, it is intended to reflect the administrative practice of BaFin on selected issues to the extent that it can be generalised. It is essentially based on the requirements of MiFID II for the protection of client assets.
Furthermore, BaFin put the Interpretation and Application Notes of the Money Laundering Act under consultation. With these notes, BaFin sets out its administrative practice on issues in connection with the new Anti-Money Laundering Act (GwG) in its version of 23 June 2017. These apply to all obligated persons under the GwG who are under the supervision of the BaFin. It is intended that all earlier statements of the BaFin on the interpretation of the GwG will be declared null and void with the publication of these Interpretation and Application Notes.
1 Stefan Henkelmann is a partner at Allen & Overy LLP, Frankfurt. Stefan would like to thank Dennis Kunschke for his contribution as author in the previous edition on which the current chapter is based, as well as Georg Luetkenhaus for his help in updating this chapter.
2 Directive 2014/65/EU on markets in financial instruments.
3 Transferable securities, money market instruments, units in collective investment undertakings, multiple classes of derivatives, contracts for difference and emissions allowances.
4 Directive 2011/61/EU.
5 Regulation (EU) No. 1286/2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs).
6 Directive 2003/71/EC on the prospectus to be published when securities are offered to the public or admitted to trading.
7 Investment advice, investment brokering, contract brokering, underwriting, financial portfolio management, proprietary trading or collective securities management, depending on the nature of the service.
8 Directive 2014/59/EU establishing a framework for the recovery and resolution of credit institutions and investment firms.
9 Regulation (EU) No. 575/2013.
10 Regulation (EU) No. 600/2014 on markets in financial instruments.
11 Regulation (EU) 2015/2365 on transparency of securities financing transactions and of reuse.
12 Regulation (EU) 2016/1011 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds.
13 Regulation (EU) 2017/1129 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market.
14 CRD IV is made up of the Capital Requirements Directive (2013/36/EU) and the Capital Requirements Regulation (No. 575/2013).
15 Regulation (EU) 2017/2402 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation.