The German Federal Ministry of Finance published the draft Retail Investor Protection Act (Kleinanlegerschutzgesetz, or Act)1 on 28 July 2014. The Act is intended to strengthen the protection of German retail investors – in particular, by expanding the scope of regulatory supervision over certain financial instruments sold to such investors.
The Act is an important plank of the German government’s plan to increase investor protection (Action Plan) introduced on 22 May 2014.2 The Action Plan sets out proposals to tighten regulation of hitherto unregulated investments in the so-called “grey capital market”, including through the introduction of more stringent rules on prospectuses and restrictions on advertising. Historically, German retail investors have invested very actively in non-regulated instruments, typically in the form of subordinated loans, preference shares, profit participating loans and other non-listed financial instruments. These were often issued by corporates seeking funding from investors rather than banks.
The Action Plan is a response by the German government to the significant losses that retail investors have suffered in such unregulated or partially unregulated investments in recent years. In one example that has been the subject of significant media coverage, retail investors faced substantial losses with regard to a renewable energy developer who raised nearly €1.4bn by selling profit participation certificates offering returns of 6-8 per cent to approximately 75,000 retail investors. The issuer filed for insolvency in January 2014. Due to the type of instruments issued, the German Federal Supervisory Authority (BaFin) did not have sufficient regulatory powers based on the existing regulatory framework – this served only to draw attention to a significant hole in Germany’s investor protection regime.
The Act focuses on those financial instruments that, up to now, have neither qualified as units in a collective investment scheme nor as securities or other investment products covered by the existing regulatory framework.3 The Act seeks to eliminate loopholes in the legislation that continue to exist despite the recent tide of regulation (for example, the risk that structured financial instruments may be used to circumvent the application of the act implementing the Alternative Investment Fund Managers Directive into German law4).
Significant measures to enhance investor protection under the draft Act include:
- A requirement, in principle, for approval of sales prospectuses by BaFin. This aims to improve the transparency of investment products that are not yet subject to prospectus requirements under the existing framework. In addition, the draft Act would require BaFin to check the consistency and sustainability of the issuer's business plan that must be included in the prospectus.
- A requirement to update sales prospectuses, which have a shelf life of not more than 12 months.
- A post-issuance ad hoc information obligation of the issuer, following any significant change relating to the issuer – in particular, a change that might affect the issuer’s ability to make repayments or interest payments.
- The implementation of a “product intervention tool”. This would enable BaFin to: (i) warn investors regarding a specific financial product; (ii) prohibit the marketing and distribution of such financial product; and (iii) conduct a special audit of the issuer.
- An expanded ability to levy administrative fines on issuers that violate existing financial reporting requirements.
- Restrictions on permitted marketing activities with regard to specific investment products. Marketing activities for publicly offered investment products would be allowed only: (i) in media focusing on illustrating and analyzing economical subjects; (ii) if the recipient consents in writing to receiving advertisements; or (iii) if the recipient is a person or entity authorized under certain German regulatory acts (such as the German Banking Act). Through these restrictions, certain marketing practices widely used in the past would be prohibited – in particular, advertisements in public (such as on flyers or public transport vehicles) or internet banners on webpages without a focus on economical subjects.
- The requirement for a minimum term for certain investment products of 24 months, supplemented by a 12-month notice period for termination.
- The requirement – referred to as a product governance process – that any securities trading firms that structure and issue securities must establish an internal compliance function to regularly assess the specific risks of such financial instruments (and to update such assessments) and define the target investor base for such financial instruments.
If enacted, the Act would address several loopholes in existing legislation. It would have a significant impact on initiators, as well as the structuring and marketing of retail investment products that are distributed into the German market.
The political motivation for the draft Act is to capture financial instruments distributed to German retail investors. However, the proposed legislation has already been criticized in the German market because, based on a strict interpretation, the Act would also cover financial instruments targeting any (other) German investors, including institutional investors.
The draft Act contains certain exemptions that aim to exclude so-called internet “crowd funding” products from the tightened prospectus requirements. While these exemptions would enable this young industry to continue to finance small and medium-sized enterprises, there has been criticism that the exemptions do not go far enough.
It should be noted that some of the new regulatory features to be introduced by the draft Act would also cover securities within the MiFID legislation (as implemented into German law under theWertpapierhandelsgesetz), including, for example, exchange traded products (ETPs). The draft Act would preempt certain elements of the MiFID II/MiFIR legislative framework currently pending at the European level – such as the “product intervention tool” and the “product governance process” – and introduce them into German law for the benefit of German investor protection.
It is expected that the draft Act will be introduced into the parliamentary process after the summer recess of the German Bundestag in September 2014.