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Credit linked notes: BaFin intervenes to protect investors

In 2015 the German legislator passed the Retail Investors Protection Act (“Kleinanlegerschutzgesetz”). This has been done to remedy shortcomings on the so called “Grey Capital Market”, which ended up in the failure of Prokon GmbH, a huge issuer of profit-sharing rights. Among other things the act added section 4b to the German Securities Trading Act (WpHG). This provision introduced the so called product intervention.

BaFin finds sale of credit linked notes to retail investors to violate investor protection

The Federal Financial Supervisory Authority (BaFin) can use such a product intervention to prohibit or restrict the distribution, sale and marketing of specific financial instruments. There are several reasons for BaFin to act, one of them being serious concerns for investor protection. In a recently published note BaFin finds that credit linked notes raise such concerns. Therefore, it intends to stop their sale to retail investors. Affected parties and experts are given time until 2 September 2017 to voice their opinion. WINHELLER already offered an opinion about several legal and factual aspects of the proposed decree. Our opinion can be found here in German.

BaFin expresses particular concern about the fact that credit linked notes are marketed as bonds instead of certificates or derivatives. The issuer of the note offers the investor regular payments as long as there is no credit event by an underlying company. But the term credit event encompasses many more situations than the bankruptcy of a company. If such a credit event is found to be occurred is also not determined by an agency of the state but by the private International Swaps and Derivatives Association. The perceived likelihood of a credit event is expressed by the current market price of Credit Default Swaps (CDS). But retail investors have no realistic possibility to participate in the CDS market and figure out the current quotation of these instruments. Therefore, they cannot evaluate the risk embedded within a specific credit linked note and cannot appraise if the possible return is worth it.

BaFin already has CoCo Bonds in its sight

In the past it was not unusual for BaFin to warn retail investors about certain investments. One of the more recent warnings has been issued in regard to so called Contingent Convertible Bonds (CoCos). The importance of CoCos has risen since the financial crisis of 2008. They are used by banks to refinance themselves while also providing equity. In normal times CoCos are similar to traditional bonds. An investor lends his money in exchange for regular interest payments. But in the event that the bank needs capital to fulfil its regulatory minimum capital requirements the bank has the unilateral right to stop these payments and simply convert the investment of the investor to own capital. What happens to the investor depends on the design of the individual CoCo Bond. He may get equity in the company equal to the invested amount. Or he may have to write his money off. In Germany CoCos have been issued mostly by Deutsche Bank and Aareal Bank.

Eliminating the risk of product intervention

CoCos are struggling with similar problems that have led to BaFin’s proposed product intervention in regard to a sale restriction for credit linked notes. Since the original warning was issued in 2014, it is clear that BaFin is aware of these financial instruments. It seems reasonable to expect that BaFin is going to use its new intervention competence more frequently in the future. According to section 4b WpHG BaFin can act even before the marketing and sale of a specific instrument has started. For issuers planning to bring a new financial instrument to the market it is therefore highly recommended to evaluate beforehand if it will come under scrutiny of the financial supervision authority. Our specialized banking and capital market law attorneys advise on these risks.

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Stefan Winheller

Attorney Stefan Winheller has specialized in tax law for about 20 years, especially in the areas of cryptocurrencies, foundations/nonprofits and international tax law.

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