On July 27, 2010, the Act on the Prevention of Improper Securities and Derivatives Transactions (Gesetz zur Vorbeugung gegen missbräuchliche Wertpapier- und Derivategeschäfte or the Act) became effective. The Act stipulates several regulatory restrictions on certain securities and derivatives transactions that the German legislator believes may have exacerbated the global financial market crisis. The Act partially includes restrictions contained in the General Decrees (the Decrees) enacted by the German Financial Services Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht or BaFin) as of May 18, 2010 which prohibited the following financial transactions:
- Short sales of certain company’s shares
- Naked short sales of debt securities issued by EU Member States whose legal currency is the euro
- Naked credit default swaps, to a limited extent
In addition to these prohibitions, the Act provides for further restraints on other types of securities and derivatives transactions, as well as increased disclosure requirements on such transactions (the latter of which, however, will enter into force at a later date). Also, BaFin is granted extended regulatory authority over certain securities and derivatives transactions.
In the course of the implementation of the Act, BaFin, per General Decree as of July 26, 2010 has revoked the Decrees with effect as of July 27, 2010.
This Client Alert briefly summarizes the legal purpose of the Act as well as the scope of application of its major provisions.
I. Legal Purpose and Overview
The German legislator intended the Act to focus on securities and derivatives trading activities that could undermine the stability of the financial markets.
The principal amendments to the German Securities Trading Act (Wertpapierhandelsgesetz, WpHG) implemented by the Act relate to:
- Extension of BaFin’s authority for purposes of securing the financial system (under II.);
- Prohibition of naked short sales in shares and certain debt securities issued by EU Member States (under III.);
- Prohibition of certain credit derivative transactions based on the debt obligations of EU Member States where no hedging effect is achieved (including authorization for the German Federal Ministry of Finance and BaFin to enact further bans on transactions under certain circumstances) (under IV.);
- Introduction of a two-stage disclosure regime for net short positions that will become effective on March 26, 2012 (under V.); and
- Reporting obligations in relation to violations of the new shortselling rules and related disclosure obligations (under VI.).
II. Extension of BaFin’s Authority to Secure the Financial System
According to Sec. 4 para 1 WpHG, BaFin may take several regulatory measures it deems necessary and appropriate to counteract undesirable developments which may adversely affect the orderly trading of financial instruments, the provision of investment or ancillary services, or which may result in serious disadvantages for the financial markets.
Under the new Sec. 4a WpHG, BaFin may also take a variety of actions to secure the financial system. The duration of any regulatory action taken by BaFin under this new authority (as described in more detail below) is generally limited to 12 months, but may be extended for an additional period of up to 12 months (in which case the German Federal Ministry of Finance must submit a report to the German Parliament within one month following the extension).
In general, BaFin, in consultation with the German Federal Central Bank (Deutsche Bundesbank), may issue certain orders deemed adequate and necessary to eliminate or prevent undesirable developments which may lead to disadvantages for the stability of the financial markets or damage to the trust in the efficiency of the financial markets. In particular, BaFin may enact the following measures:
1. Ban on Trade in Certain Financial Instruments
BaFin may temporarily prohibit trade in a single or multiple financial instruments, in particular, regarding the following:
- Transactions with derivatives whose value directly or indirectly derives from the price of shares or debt instruments issued by central governments, regional governments and local area municipalities of EU Member States whose legal currency is the euro, provided that (i) such securities are admitted to trading on a regulated market of a stock exchange in Germany, (ii) the transactions, from an economic perspective, have a structure and effect equivalent to selling the respective shares or debt instruments short and (iii) the transactions do not lead to a reduction of a market risk (whether existing or having assumed in direct temporal connection with the derivative transaction)
- Transactions in currency derivatives whose value directly or indirectly derives from the value of the euro, provided that it is expected that the market value will increase in case of a decline of the price of the euro and such transactions do not hedge existing or expected currency exposures
2. Suspension of Trading
BaFin may also suspend trading in a single or multiple financial instruments in all markets where trading of financial instruments occurs.
3. Disclosure Requirements and Other Regulatory Measures
BaFin may request any market participant to publish its positions in one or more specified financial instruments and to simultaneously notify BaFin thereof. BaFin may also take further regulatory measures (e.g., request additional information, enter business premises, etc.) in connection with its securities supervision mandate.
4. Regulation of Transactions Abroad
Section 1 para 2 WpHG also refers to Sec. 30h and 30i WpHG. As a result, the new rules in Sec. 30h (see III. below) and 30i (see V. below) WpHG also apply extraterritorially to acts and omissions if the financial instruments are admitted for trading in Germany.
III. Ban on Naked Short Sales of Shares and Certain Debt Securities
The new Sec. 30h WpHG introduced by the Act further provides for a ban on naked short sales of shares and certain debt securities. According to such provision, naked short sales are prohibited for:
- Debt instruments issued by central governments, regional governments and local area municipalities of EU Member States whose legal currency is the euro
In each case, the prohibition only applies if the relevant securities are admitted to trading on a regulated market of a stock exchange in Germany. This prohibition does not apply to the shares of companies that are seated outside of Germany if such shares are not admitted to trading exclusively on a regulated market of a German stock exchange.
Within the meaning of the regulation, a naked short sale occurs when the seller of the shares or debt instruments (i) is not the owner of such securities or (ii) 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.
This ban does not apply retroactively to transactions that occurred prior to July 27, 2010 (unless the short sale was prohibited by another regulation). The Act also provides an exemption for short sales by an investment service company or similar organization located abroad, if and to the extent such company or (i) trades the respective shares or debt instruments for its own account (Eigenhandel) and offers on a regular and continuous basis to purchase or sell these at prices defined by such company, or (ii) fulfils customer orders and hedges the resulting positions on a regular and continuous basis, and, provided that the corresponding underlying transaction must be necessary for the performance of such activity. Any market participant intending to utilize such exemptions must notify BaFin immediately, specifying the respective financial instruments concerned.
In addition, market participants are also exempt from this ban for any transaction with a customer to settle an outstanding transaction in financial instruments at a fixed or definable price (fixed price transactions). It is important to note that the exemption “trading for one’s own account” does not refer to the market maker definition in Sec. 23 para 4 WpHG and, as a result, the market maker exemption is broader as the restrictions contained in such definition do not apply.
IV. Ban on Certain Credit Derivatives
According to the new Sec. 30j WpHG, market participants are prohibited from establishing or entering into credit derivative positions under certain circumstances. The prohibition applies if:
- Upon the occurrence of a specified credit event, the seller is obligated to make a payment to the buyer (a credit default swap), regardless of the settlement method (i.e., fixed payment, net cash payment or physical settlement); this regulation also covers credit default swaps imbedded in credit-linked notes or total return swaps and
- The reference asset is the obligation of at least one central government, regional government or local area municipalities of an EU Member State whose legal currency is the euro.
However, this prohibition does not apply to credit derivatives that, from an economic perspective, significantly reduce the buyer’s underlying credit exposure with respect to:
- A position in the reference asset (whether existing or acquired in direct temporal connection with the transaction), or
- Another position (whether existing or acquired in direct temporal connection with the transaction) in a different financial instrument or in another existing liability whosevalue may fall if the creditworthiness of the debtor of a reference asset deteriorates
Further, transactions of an investment service company or similar organization located outside of Germany are exempt from this prohibition, if and to the extent such company:
- Trades the credit derivatives for its own account (Eigenhandel) and offers on a regular and continuous basis to purchase or sell these at prices defined by such company and
- The respective underlying transaction is necessary for the performance of such activity
Any market participant intending to utilize the above mentioned exemption must notify BaFin immediately, specifying the respective financial instruments concerned.
V. Notification and Publication Obligations of Short Sellers Effective on March 26, 2012
To increase the transparency of existing short positions, the Act imposed new disclosure requirements set forth in Sec. 30i WpHG. However, these requirements will not become effective until March 26, 2012. Once the new disclosure regulations become effective, market participants must notify BaFin of any net short positions which reach, fall below or exceed 0.2 percent (rounded to the nearest hundredth of a percent) of the outstanding shares of a company whose shares are admitted to trading on a regulated market of a stock exchange in Germany by the end of the next trading day. In addition, market participants with net short positions that reach, fall below or exceed the 0.5 percent must publish a report of such positions in the German Electronic Federal Gazette. The market participant will also be required to submit further notifications or publish further reports in the German Electronic Federal Gazette, as the case may be, when the net short position reaches, falls below or exceeds the 0.2 percent threshold in 0.1 percent increments.
For purposes of the disclosure requirement, a market participant has a net short position with respect to a company’s shares if, after netting all financial instruments (e.g. including options, futures and swaps) held by the market participant, the market participant has an aggregate economic interest in the company’s shares which corresponds to a short sale of the shares. From the wording of the new law, it appears that the calculation must be made on an individual entity but not on a group level.
Net short positions held by an investment services company or similar company are exempt from these disclosure requirements, if and to the extent such company is located abroad and:
- Trades the respective shares for its own account (Eigenhandel) and offers on a regular and continuous basis to purchase or sell these at prices defined by such company or
- Fulfills customer orders and hedges the resulting positions, on a regular and continuous basis
In each case, the respective underlying transaction must be necessary for the performance of such activity.
The commencement of any activities exempt from the above notification and publication obligations has to be notified to BaFin immediately specifying the respective financial instruments concerned.
VI. Reporting Obligations for Violations of the New Short-Selling Regulations and Related Disclosure Obligations
According to Sec. 10 WpHG, financial institutions and certain other entities are obliged to notify BaFin, without undue delay, of any facts that give rise to suspicion that a transaction with financial instruments violates a prohibition or requirement pursuant to Sec. 14 or 20a WpHG. Sec. 10 WpHG has been amended to include references to the new Sec. 30h and 30j WpHG, so that a reporting obligation will exist with respect to these sections in the future as well.
VII. Sanctions for Violations of the New Short- Selling Regulations and Disclosure Obligations
Breaches of the newly introduced provisions do generally constitute an administrative offense that may be sanctioned with an administrative fine ranging, depending on the kind of offence, between €200,000 and €500,000 for each violation.
The Act remains subject to various questions with respect to the interpretation of certain terms and rules newly introduced in the WpHG. It seems unclear how BaFin will interpret and implement the new law. BaFin has announced that it will issue answers to frequently asked questions which hopefully will help to clarify the application of these new regulations.