The International Capital Markets Review: Germany
i Structure of the law
The German understanding of capital markets comprises 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 that 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 in relation to market access, market behaviour and market-related behaviour of market participants, thereby safeguarding the efficiency of the markets. This law has an interdisciplinary profile, as it is 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 authorities' respective interpretations of the law, which are 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 considerable practical impact. The vast field of over-the-counter 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 and the EU Prospectus Regulation) 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) (which now only supplements the harmonised EU Prospectus Regulation), the Securities Acquisition and Takeover Act (WpÜG), the accounting provisions of the Commercial Code and the KAGB are substantially or even entirely based on (former) EU directives, implementing the (former) Investment Services Directive (now MiFID II), the AIFMD, the Financial Markets Directives, the Transparency Directive, the Settlement Finality Directive, the Investor Compensation Directive, the (former) Prospectus Directive (now the Prospectus Regulation), 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 EU Prospectus Regulation, as supplemented by 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 supplement to the EU Prospectus Regulation6 – 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 nor having received a formal waiver from the German regulator 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.8 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 relevant 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 these exemptions must notify BaFin immediately, specifying the financial instruments concerned. The short-selling ban applies extraterritorially to all shares within the scope of the rules. 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. BaFin has previously made use of these powers.
Distribution of certain grey capital market financial products only requires a licence from the competent local trade board under the Industrial Code (GewO) and currently 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). However, certain conduct rules (similar to the obligations under MiFID II) will apply to firms distributing such products. 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)9 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 made 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 currently still rather sparsely supervised, mainly 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 Regulation10 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 legislature): 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.
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, with the effect that there has been relatively little development at the purely national level. However, developments at the European level, the withdrawal of the United Kingdom from the European Union (Brexit) and the coronavirus pandemic have all had an effect on legislation and market trends in Germany.
i Developments affecting the distribution of financial instruments in general
The United Kingdom left the EU on 31 January 2020. Irrespective of the transition period until 31 December 2020, in which the United Kingdom legally is treated like an EU Member State, concerns for a 'no-deal' Brexit remain. That said, the even more pressing source of uncertainty for the capital markets now seems to be the covid-19 pandemic.
To stabilise volatility in the capital markets, BaFin declared that it would take immediate temporary measures and it released frequently-asked-questions documents (FAQs) on supervisory and regulatory measures in reaction to the coronavirus. FAQs were also released by the German Banking Supervisory Authority, with regard to ECB supervisory measures in reaction to the coronavirus for the group of significant institutions. These FAQs apply to securities trading banks and financial services institutions respectively. These FAQs are continuously updated. It should be noted that these national measures have been supplemented by regulatory activity at the European level. Furthermore, in March 2020, the European Banking Authority (EBA) released a statement with regard to the pandemic, extending time limits in ongoing proceedings and postponing target dates. As it is essentially the global money laundering and terrorist financing watchdog, FATF published its paper 'COVID-19-related Money Laundering and Terrorist Financing: Risks and Policy Responses' in May 2020.
Notwithstanding the impacts of the pandemic, which have been seen to dominate trends in the capital market, 2020 also saw developments in distinct areas. The European Securities and Markets Authority (ESMA) finalised its 'Consultation Paper on the functioning of the regime for SME Growth Markets under the Markets in Financial Instruments Directive and on the amendments to the Market Abuse Regulation for the promotion of the use of SME Growth Markets'. Also, ESMA, EBA and EIOPA together published their 'Final Report: EMIR RTS on various amendments to the bilateral margin requirements in view of the international framework'.
In the context of the covid-19 pandemic, ESMA issued a decision to temporarily require holders of net short positions in shares traded on an EU regulated market to notify the relevant national competent authority if the position reaches or exceeds 0.1 per cent of the issued share capital. The original applicability of this legislation was extended from 16 June 2020 for a period of three months.
Additionally, as already seen in previous years, increased offerings of crypto tokens and the underlying distributed ledger technology (DLT) have been points of regulatory and governmental attention. Transposing the Fifth Anti-Money-Laundering Directive,11 the German legislature, inter alia, incorporated the crypto custody business into the KWG as a new financial service, setting out an extensive definition of crypto assets. As from January 2020, when this legislation entered into force, companies seeking to provide such services require authorisation from BaFin. However, the law includes transitional provisions for those companies that conducted this type of business before these activities became subject to authorisation requirements.
The German legislature is currently evaluating a major overhaul of German securities law that introduces electronic securities and may permit the issuance of such securities on a DLT network. While limited to debt securities in the first instance, expansion of the reform is envisaged, to include fund units and shares after an evaluation period.
Finally, BaFin is keeping a close eye on practices in the marketing of financial instruments to retail investors. In response to the expiry of the product intervention measure imposed by ESMA in July 2019, BaFin released a general administrative act in which it declared that the marketing, distribution and sale of binary options to retail clients is to remain prohibited in Germany, with no time limit.
In January 2020, the Federal Court held that clauses in the issuance of bearer bonds granting creditors unlimited rights to pass resolutions over the rights and obligations of investors constitute a violation of the obligation of transparency.12
iii Role of exchanges and central counterparties
In March 2020, the German legislature introduced amendments to the Act on the Recovery and Resolution of Credit Institutions, setting out special regulations for CCPs (e.g., the requirement for default funds).
Outlook and conclusions
Developments at the European level continue to drive further European harmonisation and will have a significant impact on capital market laws and regulations and financial instruments traded on the capital markets in Europe, including Germany.
The impact of the global covid-19 pandemic on the economy has required quick regulatory action and at the same time has caused delays of initiatives in other areas. To help financial markets support Europe's recovery amendments to the Prospectus Regulation, MiFID II, MiFIR and securitisation rules have been proposed and are subject to additional consultations. Also, a new action plan to put in place a capital markets union across the EU is scheduled to be published in the early autumn of 2020.
The year 2020 also saw increasingly more developments with regard to sustainable investments, such as final recommendations for the establishment of an EU Green Bond Standard as part of the European Green Deal Investment Plan. The Taxonomy Regulation,13 the fundamental framework providing an EU-wide classification system for environmentally sustainable activities, entered into force in July 2020 and will be fully applicable as of 2022.
Furthermore the European Commission published a road map for supplementary steps to combat money laundering, and declared its intention to adopt a corresponding regulation, as the Anti-Money Laundering Directive has proved to be less effective than expected.
But developments also continue on the national level. Since August 2020, financial investment brokers and investment advisers have been required under the Financial Investment Operating Regulation to record customer discussions ('taping') and to avoid and govern, or at least disclose, conflicts of interest. The aim now is to transfer these and similar legal regulations into the WpHG and to shift corresponding supervisory responsibilities from the Chamber of Industry and Commerce and local trade authorities to BaFin (although this shift of competence has not been implemented yet).
However, it appears that coping with the aftermath of the coronavirus will inevitably remain an area of regulatory focus, together with the endeavour to further innovative approaches to the issuance or classification of financial products.
Lastly, it seems that legislative efforts to modernise German security law through the introduction of electronic securities will have a significant impact on the German capital market and may lead to a host of new market participants.
1 Stefan Henkelmann is a partner and Lennart Dahmen is a senior associate at Allen & Overy LLP. The authors thank Betül Kohlhäufl for her valuable contribution to 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 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.
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 In the context of the covid-19 pandemic (see below), the reporting thresholds have been lowered by the European Securities and Markets Authority.
9 Directive 2014/59/EU establishing a framework for the recovery and resolution of credit institutions and investment firms.
10 Regulation (EU) No. 575/2013.
11 Directive 2018/843/EU amending Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing, and amending Directives 2009/138/EC and 2013/36/EU.
12 BGH judgment dated 16/01/2020 – IX ZR 351/18.
13 Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088.