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 came to 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.
The capital markets law is a body of laws and standards that directly or indirectly regulate the capital markets regarding 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 the supranational (European) and national levels. Administrative policies (such as BaFin's Issuer Guidelines, 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, 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 with 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 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, the 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 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 replaces 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 BaFin immediately, specifying the financial instruments concerned. The short-selling ban applies extraterritorially. Further, 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 BaFin or the Bundesbank (except for the applicable prospectus regime, and 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 amended the KWG (Section 46f, Paragraphs 6, 7 and 9) to allow for two different classes of senior bonds. Since 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 since 21 July 2018 count as senior preferred issues. Only if it is explicitly stated in the terms and conditions of the securities shall the lower non-preferred ranking apply to a new issue (senior non-preferred).
Under the new regime, senior unsecured bonds issued before 20 July 2018 (inclusive) now rank pari passu with senior non-preferred bonds. They lost 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, 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 a dispute stems from a labour contract or collective labour issues). Thus, lawsuits against 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
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 BaFin only being competent for the approval of prospectuses and the banning of products and certain misleading advertising). Under an operational agreement between 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 institutions. The supervision of trading in financial instruments by 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. 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 have further tightened the grip over grey capital market financial products and tackled the distribution of financial products.
II THE YEAR IN REVIEW
Legislative and regulatory activity and activism in the area of the capital markets now mainly occur at the European Union level, to the effect that there has been relatively little development at the purely national level. However, developments at the European level and the (planned, yet delayed) withdrawal of the United Kingdom from the European Union (Brexit) have had an effect on legislation and market trends in Germany.
i Developments affecting the distribution of financial instruments in general
The delayed Brexit has been a source of uncertainty for the capital markets, including the German market. A 'no-deal' Brexit without a transition agreement between the United Kingdom and the EU could severely impact trading on, and access to, the capital markets in Europe. Similar to other markets, many financial institutions that currently operate across Europe from the UK have established a 'foot on the ground' in Germany, either by opening up subsidiaries or by transfers of their existing branches to a continental European platform. However, at the time of writing, it is still uncertain if a solution for a coordinated Brexit, now further delayed, can be agreed.
The German legislator has passed transitional laws that may ease the burden and that are tailored to ensure the orderly continuing of trading activities on the capital markets, which may also include derivative transactions with UK counterparties. However, uncertainties remain, as these laws give wide-ranging authority to BaFin to pass transitional measures. The exact scope and details of the transitional provisions remain uncertain. Market participants will be well advised to closely monitor how their portfolio of offerings may be affected by Brexit.
The regime applicable to the public offering of securities has been further amended and harmonised through the introduction of the new Prospectus Regulation.10 The Prospectus Regulation replaces the previous Prospectus Directive11 and its national transpositions. The revised regime is designed to reinforce investor protection by ensuring that all prospectuses, wherever issued in the EU, provide clear and comprehensive information while at the same time making it easier for companies to raise capital throughout the EU on the basis of approval from a single competent authority.
2019 also saw BaFin making use of its powers and authorities under the European Short Selling Regulation:12 earlier this year, BaFin imposed a short-selling ban on the shares of a German financial institution that had recently been elevated to Germany's main stock index. The decision of the regulator marked the first time that BaFin has exercised its intervention powers under the Short Selling Regulation in an individual case, and has been watched with concern and scrutinised by market participants and scholars. It may be seen as an indication of the regulator taking a more active stance but, at the same time, was specific to the unusual circumstances that were specific to the trading activity in relation to that relevant issuer.
However, BaFin and the government have indeed taken a more robust stance on the distribution of certain financial instruments. BaFin is keeping a close eye on marketing practices of financial instruments sold to retail investors, and may also utilise its intervention powers under MiFIR. In a similar vein, the government recently published a position paper under which it contemplates the prohibition of such products for the grey capital market that are regulated under the VermAnlG.
Additionally, increased offerings of crypto tokens and the underlying distributed ledger technology have been points of regulatory and governmental attention. The government is in the process of evaluating the possibility of issuing securities electronically. As it currently stands, securities under German law are usually securitised through issuing a global certificate to be kept with a central securities depositary, which itself is a specifically regulated credit institution. A government position paper published earlier this year explores whether (and to what extent) this traditional system could be fundamentally overhauled. While the paper takes care to ensure that regulation would be technology-neutral, it appears that the government has specifically considered issuances of electronic securities on blockchain and distributed ledger technology.
Moreover, the same paper builds on previous BaFin guidance to discuss and consider the regulation of public offerings of certain crypto tokens. Under the discussion paper, the government considers regulating the public offering of utility tokens and cryptocurrencies or waiting for further developments on the European level that may ensure far-reaching harmonisation of the offering of such products.13
In September 2018, the Higher Regional Court of Berlin held that bitcoin does not qualify as a financial instrument within the meaning of the KWG; therefore, trading of bitcoin does not require any financial services licence. This decision deviates from the regulatory practice of BaFin, which generally classifies bitcoin as a financial instrument (unit of account) and therefore makes trading of bitcoin subject to licence requirements. While the Higher Regional Court expressed the view that BaFin went beyond its competency when it classified bitcoin as units of account, the German regulator did not change its regulatory practice in this regard. It appears that the German legislator is backing BaFin's view by introducing draft legislation pursuant to which bitcoin shall be classified as financial instruments (see Section III).
iii Role of exchanges and central counterparties
Central counterparty (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 has published several standard form documents as annexes to the German framework agreement for derivatives that address certain EMIR requirements and facilitate clearing. Aspects regarding bilateral OTC derivatives and margining requirements also remain in focus.
III OUTLOOK AND CONCLUSIONS
Following on from the developments during 2018 that saw the coming into force of various European directives, 2019 has been a comparatively quiet year. The coming into force of the Prospectus Regulation had been long expected and did not cause great uncertainty as compared to the transposition of MiFID II and the related MiFIR just 18 months earlier. However, developments at the European level will continue to drive further European harmonisation, which will have a significant impact on capital markets laws and regulations and financial instruments traded on the capital markets in Europe, including Germany.
In addition, developments on the national level will continue. BaFin has begun the process of updating its Issuer Guidelines in which the regulator provides additional guidance on various areas of European and national law. BaFin is following a modular approach, and has recently submitted the chapter on the application of the MAR for public consideration and consultation.
It appears that the increased regulation of crypto tokens and related activities will be an area of regulatory focus. In contrast to the above-mentioned decision of the Higher Regional Court of Berlin, legislative measures indicate that the level of regulation will only increase. Most recently, the government published a draft act on the transposition of the Fifth Anti-Money-Laundering Directive15 introducing, inter alia, the custody of cryptoassets as a new licensable activity, and setting out an extensive definition of cryptoassets, generally confirming the view of the German regulator on their nature as financial instruments (see above).
One of the major outstanding legislative issues in Germany that was originally scheduled for 2018/2019 is a far-reaching reform of the regulation of brokers of highly regulated products (funds registered for public distribution and similar products) that were previously subject only to light-touch regulation by local trade authorities. Under the legislative proposal, such brokers will be subject to BaFin supervision and will need to comply with certain obligations resulting from MiFID II. However, this project has been delayed, and current plans envisage the coming into force of the relevant ordinance as of 1 January 2020.
1 Stefan Henkelmann is a partner and Lennart Dahmen is a senior associate at Allen & Overy LLP.
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) 2017/1129 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market.
11 Directive 2003/71/EC on the prospectus to be published when securities are offered to the public or admitted to trading.
12 Regulation (EU) No. 236/2012 on short selling and certain aspects of credit default swaps.
13 ESMA published advice on initial coin offerings and cryptoassets in January 2019: https://www.esma.europa.eu/sites/default/files/library/esma50-157-1391_crypto_advice.pdf.
14 CRD IV is made up of the Capital Requirements Directive (2013/36/EU) and the Capital Requirements Regulation (No. 575/2013).
15 Directive (EU) 2018/843 of the European Parliament and of the Council of 30 May 2018 amending Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing.