Q&A: BaFin takes a hard line

Special report: Focus on Germany

The Markets in Financial Instruments Directive (Mifid) comes into force in November and will likely affect the sales of complex instruments, especially if they are bought without advice. Will this affect the existing regulation of investment advice in Germany?

According to the Investment Services Directive (ISD) investment advice is an ancillary service, which is only supervised by BaFin if it is provided by licensed investment firms. Persons who are not licensed as investment firms because they do not provide an investment service are allowed to provide ancillary services, including investment advice, without authorisation or supervision. Regulated investment firms providing investment advice must observe the general conduct of business rules and must provide investment services as well as ancillary services with the requisite degree of expertise, care and diligence in the interests of their customers, and must try to avoid conflicts of interest. If investment firms cannot avoid conflicts of interest, customers' orders have to be executed with due regard to customers' interests. Regulated investment firms have to demand from their customers details concerning their financial situation, experience and knowledge, as well as the aims pursued with the transactions. They also have to furnish their customers with all pertinent information.

Applying these rules to investment advice, the firm has to take into account the complexity of the financial instruments intended to be recommended. However, there are no special provisions concerning investment advice or complex instruments in the Securities Trading Act.

With the arrival of Mifid, investment advice will become the core business. Therefore even firms that solely provide investment advice will have to apply for authorisation and be supervised by BaFin.

However, firms giving advice that relates only to investment funds and no other financial instruments will not need a license. The conduct of business rules will be more detailed and severe than the current regime. Before providing investment advice or portfolio management the firm will have to obtain all necessary information to choose or recommend investment services or financial instruments suitable for the client. The company therefore has to verify whether the client's investment objectives are met, whether the client is able to bear the related investment risks and whether the client has the necessary experience and knowledge in order to understand the risks involved.

In contrast to the current BaFin guidelines, Mifid doesn't set specific standards for what information on financial instruments is to be provided to clients. However, Mifid does require that the information must be tailored more closely to a client's individual knowledge and experience, and if the firm cannot obtain details about this it is not allowed to provide investment advice or portfolio management. The rules are less severe in the case of professional clients and eligible counterparties.

If a client wants to buy complex instruments without advice, the firm has to ask them to provide information regarding their experience and knowledge of investments so it can assess whether the product or service is appropriate. If the firm doesn't receive the necessary information, or on the basis of the information received considers that the product or service is inappropriate, it must warn the client of this. If the client still insists on the transaction it may be carried out. However, execution-only services, which do not apply to complex instruments, are excluded from these requirements.

Apart from copying out implementing the respective rules of Mifid and the Level 2 directive, Germany will abstain from additional regulation for services regarding complex instruments. Whether there will be supplementary BaFin guidelines on these topics has not been decided yet.

BaFin has extended its interpretation of the scope of licensable 'principal broking services' under the Banking Act to crack down on unlicensed issuers of structured products. However, the interpretation was subsequently overturned by two German courts in 2005 and 2006. Is BaFin trying to solve this problem?

BaFin considers enterprises that collect funds from the public by issuing certificates (such as bearer bonds or registered bonds) in order to invest them in financial instruments to be undertakings providing principal broking services within the meaning of the German Banking Act. Since the Administrative Court of Frankfurt am Main and the Higher Administrative Court of Hesse have ceased to support the legal opinion of BaFin in this matter (contrary to their earlier decisions), BaFin has recently lodged an appeal with the Federal Administrative Court so that a final decision can be reached on this issue in due course.

Another effect of Mifid will be the reclassification of clients. This will impact on private banks and the types of product they offer to investors. Banks will have to demonstrate that the products are suitable and appropriate for their clients. Is this going to be an issue for banks in Germany that offer complex certificates?

The current conduct-of-business rules in the Securities Trading Act do not differentiate between types of client. BaFin has published guidelines regarding the above-mentioned obligation to demand details from customers concerning their experience or knowledge of transactions, of the aims pursued with those transactions and about their financial situation.

The guidelines aim to furnish customers with all pertinent information, insofar as this is necessary to protect their interests and with regard to the type and scope of the intended transactions. If the client is an investment firm or a person who professionally and regularly deals in financial instruments, investment firms could abstain from demanding customer information and from providing pertinent information, provided that the client would have received written information on his classification.

To the extent that banks have already classified their customers according to this BaFin interpretation they will probably be allowed to continue this categorisation after November 1, 2007.

The new classification rules implemented with Mifid decree that customers can be treated as professionals only for certain types of transactions or products they are familiar with, and this also requires the customers' consent. Banks therefore might have to fulfill different conduct-of-business rules when providing services to the same client, depending on whether the financial instrument involved is regarded as complex or not.

Since the implementation of the Prospectus Directive in July 2005, some EU member states, particularly Portugal, have seen an increase in retail structured notes issuance. Is BaFin responsible for looking at the passported note products? If so, have there been many passported offerings?

The Prospectus Directive has established the European passport system for issuers of prospectuses. This system does not require vetting of the financial products in the case of a notification of the prospectus. The issuer only has to request the competent authority of its home member state to notify another member state of the approved prospectus.

Once the foreign regulator has been notified of the prospectus, the issuer can start a public offering of the securities or ask for their admission to trading in the respective host member state. In our German practice, we have seen a significant rise in both incoming and outgoing notifications in 2006. BaFin last year issued notifications for 791 prospectuses compared with 104 in 2005, and received notifications regarding 726 prospectuses compared with 187 in 2005.

The hedge funds industry in Germany hasn't taken off since authorised retail distribution of hedge funds and funds of hedge funds was introduced in 2004. Some market participants say this is because of the high disclosure requirements that have been imposed. Are these requirements likely to remain?

The disclosure requirements under discussion stem mainly from the Investment Tax Act. Tax regulation is enforced by the revenue authorities, and further information can be found at the website of the Federal Ministry of Finance (www.bundesfinanzministerium.de) or the Federal Central Tax Authority (www.bzst.bund.de).

Public distribution of single-name hedge funds is not permitted in Germany, but some certificates linked to such funds have been sold to private investors. Is BaFin doing anything to address this?

Investment funds and certificates are different types of product. As opposed to hedge funds, certificates are debentures. Each product is governed by a different legal framework, and certificates may be publicly distributed in Germany whereas single hedge funds may not. BaFin checks whether companies offering investment funds or certificates comply with the respective legal requirements.

As far as certificates are concerned, BaFin is only allowed to check if the prospectuses meet the formal requirements of the Securities Prospectus Act. BaFin cannot check the financial investment itself.

Many mutual funds in Germany now have risk profiles and payouts similar to those of certificates. Is BaFin looking at the possibility of closing the gap between funds and certificates? For example, a new taxation regime, which is due to come into force in 2009, will introduce a flat rate on capital gains on various different types of investment products, including certificates.

Although mutual funds and certificates may feature similar risk and payout profiles, they are completely different products. The Investment Act governs the scope of German mutual funds whereas certificates are treated as bonds.

BaFin supports the approach of the 3L3 committees to analyse both products. BaFin watches out for potential impacts on both the funds and certificates markets. But changes to taxation law are subject to the legislator. In addition, this issue may be considered from a trans-national perspective: The European Commission has raised the issue in its White Paper on enhancing the single market framework for investment funds, and doesn't believe that the answer lies in extending Ucits-type regulation to all long-term savings vehicles.

The Ucits III directive has allowed more open-ended funds to use derivatives and to use different underlyings. Will this affect the way that local mutual funds are regulated?

The Ucits III directive has already affected the way that local investment funds are regulated. According to the changes by Ucits III and the recent Commission Directive on eligible assets, Ucits are allowed to invest in a wider range of assets, which are also partly more complex.

A more risk-based approach to Ucits regulation that relies on sound risk management processes employed by fund managers is therefore increasingly important. Such an approach also helps to ensure that the regulation of Ucits remains effective in the face of changing market dynamics and investor requirements. In addition, notwithstanding this development, Ucits funds remain a highly regulated product for retail investors. In view of this aim, the Ucits III directive lays down requirements for organisation, management and oversight of the fund and imposes rules relating to fund diversification, liquidity and use of leverage.

Some regulators in EU, such as the Autoriteit Financiele Markten (AFM) of the Netherlands, are proactively assessing the impact of retail structured products due to their substantial growth. Is BaFin conducting any research on the German structured products market?

As BaFin monitors market trends and the potential impact of product innovations, it notices the increased role of structured products. But in general, BaFin focuses its monitoring on product transparency and acting in compliance with corresponding codes of conduct.

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