On 8 November 2007 the Deutscher Bundestag, the German parliament, passed an act (the Amendment Act) amending the German Investment Act (the Investment Act). The Amendment Act came into force on 28 December 2007. It is designed to significantly modernise German investment fund laws. The key amendments relate to:
- excluding certain foreign closed-ended funds from the scope of the Investment Act;
- further harmonisation with EU law;
- creating new asset classes to facilitate product innovation; and
- improving the corporate governance of investment companies.
Whereas the majority of the changes in the Amendment Act affect exclusively the German investment industry, the following amendments also affect foreign investment funds.
Changes applying to foreign investment funds
Scope of the Investment Act
Under the Amendment Act only investment funds that provide for redemption of shares (open-ended investment funds) and only those foreign closed-ended funds that are subject to investment supervision in their home country, will fall under the regime of the Investment Act. Thus, foreign closed-ended funds that are not subject to investment supervision in their home state will no longer be governed by the Investment Act, even if they pursue an investment policy of risk diversification and invest into asset categories permitted by the Investment Act. As a result, public solicitation of certain closed-ended foreign investment funds will no longer require notification with and acceptance by the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht or BaFin) under the Investment Act. However, solicitation of shares in such closed-ended funds may still trigger (prospectus) publication and, depending on circumstances, licensing requirements under other German acts.
The shift to a more formalised definition of ‘foreign investment fund’ and the abandonment of the previous attempt to qualify almost all risk diversified investments as foreign investment funds, aims to liberalise regulatory practice and make it more transparent.
Tax impacts of the Amendment Act
As German tax law provides for a special tax regime for investment funds, the change of scope of the Investment Act also changes the scope of the tax regime for such funds. Ownership in shares of closed-ended investment funds not subject to investment supervision will no longer be subject to punitive taxation under the Investment Tax Act. Instead, taxation rules generally applicable to investments in corporations or partnerships (as appropriate) will apply. This implies that certain tax privileges for investment funds, which qualify as ‘transparent funds’, will no longer be available for unregulated closed-ended funds.
Scope of private placements
The concept of public distribution and, accordingly, the scope of private placements, will be further clarified and made more transparent by law and regulation.
The definition of the term ‘public distribution’ is clarified by a list of actions set out in the Amendment Act that are not considered to constitute public distribution. BaFin will provide further clarification by issuing guidelines that can specify quantitative thresholds or additional qualitative criteria. The list of actions not constituting public distribution clarifies some of the more persistent controversies regarding the distinction between public distribution and private placement, among others:
- marketing of shares solely to institutional investors, such as insurance companies, investment companies and pension funds;
- naming of unregistered investment funds;
- publication of issue and redemption prices of unregistered investment funds;
- publication of tax data for reasons of tax transparency in accordance with section 5 German Investment Tax Act; and
- use of sales documentation, in particular prospectuses, of umbrella funds, which also includes information on sub-funds that are not registered in Germany.
Documentation and information requirements
The Amendment Act will further simplify documentation requirements for the public distribution of both foreign and German investment funds and align them with the requirements of the UCITS Directive. It will no longer be necessary to offer investors both the full and the simplified sales prospectus before concluding a sales contract. Under the Amendment Act only the simplified prospectus must be offered, whereas the full sales prospectus only has to be made available upon request (free of charge). As a result, the additional information for German shareholders regarding, for example, the German paying and information agent, which currently appears in the full prospectus only, also needs to be reflected in the simplified prospectus. For umbrella funds, of which only some sub-funds are registered for public distribution in Germany, the sales documentation must contain a specific and clear note setting out that the fund is only partially registered.
The Amendment Act also introduces changes with a view to CESR’s guidelines to simplify the notification procedure of UCITS to provide the basis for electronic submission of documentation to BaFin.
A further element of deregulation is the recognition of English language UCITS certificates. Although the Amendment Act still requires German translations of all other documents to be provided to BaFin as part of the notification procedure, as well as to German investors, it no longer requires a German translation of the English language UCITS certificate. The translation requirements will in addition be eased in cases where umbrella funds notify only part of the sub-funds for public distribution in Germany. In addition, the Amendment Act provides that BaFin may allow the submission of English language notification letters when registering foreign funds for public distribution.
Additional duties of information are imposed in the case of the closing of investment funds. Where a foreign investment company that offers UCITS shares in Germany intends to cease public distribution of single funds, entire umbrella funds or individual sub-funds of an umbrella fund, the Amendment Act provides for additional information duties and formal procedures vis-à-vis BaFin and the Electronic Federal Gazette. These amendments aim to improve the quality of shareholder information. Further changes for the German investment industry
In addition to the changes regarding the concept of public distribution and the related documentation and notification requirements discussed above (which apply to German and foreign funds), a range of other amendments will apply to German funds and to German investment companies.
Changes at fund level
New asset classes: infrastructure funds and other funds The Amendment Act introduces two new asset classes in which German investment funds may invest: infrastructure funds and so-called ‘other funds’.
As both types of funds do not qualify as UCITS funds (and thus do not benefit from the European passport) they are not subject to the UCITS Directive prospectus regime and do not require a simplified prospectus. Instead, distributors of shares in infrastructure funds and in other funds must offer the full sales prospectus accompanied by the latest annual and semi-annual report.
The Amendment Act further states that foreign infrastructure funds and foreign other funds can be registered for public distribution as non-UCITS funds provided these funds are comparable to the respective German funds.
German investment companies will be able to establish infrastructure funds, which primarily invest in public private partnerships (PPPs) and properties that serve public purposes. This new fund category is designed to extend the range of refinancing instruments available for the growing PPP sector by giving regulated retail funds access to participations in PPPs.
Infrastructure funds will have to invest at least 60 per cent of the fund value in PPPs and eligible properties. To ensure short term and medium term liquidity, they will also be allowed to invest in securities, money market instruments and cash held with banks, as well as in money market funds. Investments in PPPs are limited to a maximum of 80 per cent of the fund value; the investment limit for participations in a single PPP is 10 per cent. The Amendment Act further provides for a cap of 30 per cent of the fund value for investments in eligible properties (including usufructuary rights relating to properties). Derivatives may be used only for hedging purposes.
Infrastructure funds will not be subject to the same strict duties as other funds regarding net asset value calculation and redemption of units. In particular, the terms and provisions may provide that the value of such funds be determined on a monthly, rather than daily, basis. In this case, only monthly issues of units will be possible. Further, units of infrastructure funds may be redeemed only on a half-yearly basis but will have to be redeemable at least once a year.
Other funds (including micro finance funds)
These are designed to allow for participation in innovative financial products. The investment policy for other funds is significantly broader than for traditional funds and will allow such funds to distinguish themselves in the areas of risk allocation, evaluation and asset liquidity. In addition to investments in traditional fund assets such as securities, money market instruments, derivatives, bank cash balances and shares in other investment funds, other funds may invest in equity participations in companies that are not listed in an official or organised market, precious metals and non-securitised receivables from cash loans. Other funds will also profit from less frequent net asset value calculation and issuance and redemption of units. The introduction of other funds is designed to close the gap between regular mixed investment funds with regulated investment strategies and single hedge funds with significantly more liberal investment policies, which may not be distributed publicly. In contrast to hedge funds, other funds may not effect short sales, may not leverage their investments and must respect certain investment limitations.
A further category of other funds are the so-called micro finance funds. Micro finance funds may invest up to 75 per cent of their net asset value in unsecuritised loans issued by micro finance institutions (Microfinanz- Institute). Micro finance institutions need to fulfil certain criteria, including maximum amounts for the loans given.
Simplifications for special funds
The rules on special funds (Spezialfonds) will become less strict (unless they are hedge funds or fund-of-hedge funds) and the current investment restrictions will be abolished. As shares in special funds may be held only by institutional investors, investment restrictions designed to protect private shareholders will no longer apply: it will be left to the contractual parties to agree on any limitations. Further, the limitation of the number of investors (previously restricted to a maximum of 30) will be abolished. Finally, the terms and conditions of special funds may restrict redemption rights. However, redemption of shares must be permitted once in a twoyear period.
Real estate funds
The original plan to establish two categories of openended real estate funds – more conservative securityoriented funds (sicherheitsorientierte Immobilienfonds) and more risk and yield-oriented funds (ertragsorientierte Immobilienfonds) – has been given up. Yet the Amendment Act does contain some substantial changes.
- Real estate funds are now granted the option to invest – under certain conditions – in real estate companies that hold participations in other real estate companies (multi level real estate companies, mehrstöckige Immobilien-Gesellschaften).
- Liquidity rules for real estate funds now include the option to invest, under certain conditions, up to 5 per cent of the value of the investment fund in REIT stock corporations.
- The fund rules of real estate funds can provide for redemptions only once a month at a specific date set out in the fund rules, whenever the aggregated value of shares due for redemption exceeds a certain amount specified in the fund rules.
- The Amendment Act no longer restricts the investment policy of real estate companies in which real estate funds intend to invest (previously a maximum of three real estate objects per real estate company was permitted).
- The initial evaluation of assets to be purchased for the real estate fund now lies with an independent and experienced expert not being a member of the expert committee responsible for the yearly evaluation of assets.
The Amendment Act also reflects the UCITS Implementing Directive, which aims to clarify definitions related to eligible assets for UCITS and to effect a oneto- one implementation of the directive. Among other provisions, the new law will extend the range of eligible assets of German UCITS funds to negotiable closed-ended funds and certain financial instruments provided the assets satisfy criteria regarding liquidity, valuation and available information. Units in closed-ended funds are eligible only if corporate governance mechanisms are adequate.
The Amendment Act provides for two significant changes regarding money market instruments. First, the residual maturity of required instruments or the period during which adjustments to the yield of such instruments must be made is extended from 12 months to 397 days. Second, any money market instruments listed on an official market or another regulated market are eligible irrespective of the type of issuer.
Acceleration of approval of fund rules
The Amendment Act requires BaFin to approve fund rules of domestic funds within a certain time frame to ensure competitiveness as against other regulators. The Amendment Act also reduces time scales for publishing changes to fund rules that alter the risk and investment structure to allow fund products to react more quickly to market trends. The Amendment Act further introduces the possibility of having pre-formulated alternative model clauses for UCITS fund rules that are pre-approved by BaFin. This will allow domestic UCITS to establish standardised fund products more quickly.
As a result of lengthy and controversial discussions among the lawmaker, the fund industry and the ministries involved, the Amendment Act now no longer requires the indication of the transaction cost ratio (ratio between the costs of the purchase and the sale of fund assets and the net asset value), but demands as a general rule for investment companies to apply adequate measures for funds to avoid discriminating investors’ interests by transaction costs, taking into account the value of the fund and the structure of investors. The recommendation’s rationale explains that such measures include, among others, avoiding a portfolio turnover rate too high to be in the best interest of the investors.
Status and governance of investment companies
One of the most drastic changes of the Amendment Act is, from a regulatory point of view, the change in the regulatory status of German investment companies (Kapitalanlagegesellschaften). Investment companies are no longer classified as credit institutions and thus will no longer be subject to the provisions of the German Banking Act (the Banking Act).
The regulatory implications of this change are fundamental: regulation, and consequently supervision, of investment companies will be reduced from the comprehensive and conclusive level set by the Banking Act to the reduced level of the Investment Act, and the dual supervision by BaFin and the Deutsche Bundesbank over investment companies will end. As the Bundesbank is competent for supervising compliance only with the Banking Act (by banks and financial institutions) but not with the Investment Act, BaFin will remain the sole regulator and supervisory authority for investment companies.
According to the authors of the Amendment Act this reduction of regulatory standards and of intensity of supervision (which also includes a reduction in minimum capital requirements) would set a milestone for creating a level playing field between German investment companies and non-German investment companies, which normally do not qualify as credit institutions and thus are subject to a simplified and more liberal regulatory regime. The German Ministry of Finance consequently expects the Amendment Act to counteract the trend of relocation of investment companies to other European countries, which, in combination with the European passport, circumvents the strict rules of the Banking Act in any case.
Apart from this fundamental and controversial change of status, the new law provides for new corporate governance rules specifically developed for investment companies. In particular, the Amendment Act stipulates that any supervisory board of an investment company must include a member who is independent from (i) the shareholders, of the Investment Company, (ii) affiliates of the shareholders, and (iii) business partners of the investment company. This requirement is designed to ensure that the investment company acts in the interest of the investors where conflicts of interest arise. This requirement does, however, not apply to investment companies solely managing special funds or special investment stock corporations. This reflects the appreciation that institutional investors invested in special funds do not need the same level of protection provided for retail clients.
Depository banks and prime brokers
To prevent conflicts of interest and strengthen the controlling function of the depository bank, earlier drafts proposed that depository banks and investment companies should not be members of the same group of companies. This concept has proven very controversial within the German investment industry and has been given up.
However, the depository bank has to ensure by means of organisation and procedures that conflicts of interest between the depository bank and the investment company are avoided.
According to the Amendment Act the control duties of the depository bank still include the control of the investment limits, but no longer the additional control of investment policies as envisaged in the earlier draft of the Amendment Act. The rationale of this change is to provide increased legal certainty: the depository bank exercises control functions, but bears no power of deciding material issues. The amendment is also designed to avoid conflicts between the investment company and the depository bank based on differing interpretations of the depth in which the depository bank shall review business policies.
The depository bank will be permitted to allow foreign custodians to keep domestic securities in safe custody and even permits safe custody through a foreign custodian that is not licensed as a credit institution provided that this custodian fulfils certain other criteria.
Although the use of a prime broker was already permissible for domestic single hedge funds under the previous Investment Act, the Amendment Act aims to resolve questions about the practical use of the prime broker by explicitly stating that the safe custody of assets can be transferred to a prime broker, as long as this prime broker (i) has its seat in the European Economic Area or a state that is a full member of the Organisation for Economic Co-operation and Development (OECD), (ii)is subject to effective public supervision in its home state, and (iii) has adequate solvency. According to the official rationale of the draft, the new rules for prime brokers are designed to allow all currently prevalent models of prime brokerage. The prime broker can be mandated either directly by the investment company or via the depositary bank.
The proposed change will ultimately strengthen the position of prime brokers and make the service of traditional depository banks redundant for hedge funds insofar as investment companies make full use of their competence to mandate prime brokers instead of traditional custodians.
According to the Amendment Act, annual and semiannual reports further on only need to be published in the Electronic Federal Gazette, but no longer additionally in a newspaper or electronic information media, as was the case previously.
The Amendment Act reduces the termination period for investment funds from 13 to 6 months. The rationale of the Financial Committee of Deutscher Bundestag explains this change with deregulation allowing for faster reactions of the investment company in cases where the management of a certain fund no longer seems profitable, and with the aim to provide for consistency with the timing set for the amendment of fund rules, in particular the change of investment strategies. Further, according to changes imposed to tax law, the so-called speculative period will be abolished making a termination period exceeding one year obsolete in the future.
Investment stock corporation
Finally, the Amendment Act will substantially change the regulatory regime for investment stock corporations (Investmentaktiengesellschaften). The investment stock corporation with fixed capital, which has not been used in practice, will be abolished. In contrast, the regulatory framework for investment stock corporations with variable capital will be modernised. Similar to Luxembourg SICAVs, they can be established as UCITS funds and therefore be passported into other European jurisdictions in accordance with the UCITS Directive. Further, an investment stock corporation may be managed by a third party, which must be a regulated investment company. Such arrangement (fremdverwaltete Investmentaktiengesellschaft) will not be regarded as outsourcing. Accordingly, not only the management activity as such but also the entire responsibility vis-à-vis regulators and investors will be transferred to that third party. Compared to previous law, the Amendment Act provides for more fund-specific rules for investment stock corporations that prevail over the general provisions of the German Stock Corporation Act (Aktiengesetz). Among other rules, there is a distinction between corporate shares (Unternehmensaktien) in an investment stock corporation and investment shares (Anlageaktien) in its funds. Investment shares do not grant a right to participate in general meetings or voting rights unless the statutes expressly provide for such rights. Furthermore, the accounting rules for investment stock corporations and funds established in the form of separate assets (Sondervermögen) are harmonised.