But at the same time this market segment is also teeming with providers trying, for various reasons, to circumvent the authorisation requirement for certain types of business with the aid of newer and newer constructions. Small and medium-sized providers often want merely to avoid the costs associated with supervision. But there are also abusive business models, where the providers select specific structures and marketing methods in order to lay their hands on the capital of inexperienced small investors and re invest them in high-risk assets to their own advantage without having to meet the requirement to hold an authorisation or publish a prospectus. Such products are frequently aimed at capital tied up in traditional assets, such as life insurance policies, which clients have therefore entrusted to companies that are subject to solvency supervision by BaFin (see expert article Purchasers of second-hand life insurance policies).

Providers of investment offers frequently give the models they have designed the name of “products”. From a marketing perspective this may be an accurate and desirable description for a plan to attract capital. On the other hand, it should always be clear to the investor that by signing up for an investment that is not securitised he is not acquiring an existing product that already has its own value but is – on the contrary – only undertaking in the first instance to allow part of his assets to be passed on to a third party or managed by a third party. In return, he receives the promise of a return from the provider which the latter has to keep at a later date. For that reason trust is a key pillar of the unregulated capital market segment in particular as well.

Risk capital market

For all the great variety of products on offer on the unregulated capital market, one thing that they have in common with each other is that they involve risk capital investments that are not securitised. The assignment of an investment product to the unregulated or regulated capital market does not allow the investor to draw any conclusion about the risk that an investment carries.

Rather, he must continually bear in mind the principle that the expectation of a return higher than that obtainable from the typical investments offered by banks also involves a higher risk for the investor. However dazzling, emotive or drawing on recent trends a presentation may be, this should not influence the necessary rational assessment of the balance between risk and return. In the case of investment products in which investors participate as stockholders, the risk of their losing their capital contribution is obvious. Many investment products on the unregulated capital market are, however, based on nothing but transfer of capital contracts under the law of obligations. Because of their great variety their risk profile is harder to assess. One prominent example of these are participations via jouissance rights, which have been offered for decades now.

Jouissance rights

The Federal Supreme Court describes jouissance rights (Genussrechte) as “permanent debt obligations sui generis which establish no membership rights under company law and extend no further than creating a certain monetary claim (on the part of the jouissance right owner)”.²⁾ These claims may also be represented by marketable securities, or jouissance certificates (Genussscheine). Since under the law of obligations jouissance rights do not confer upon the holders the status of stockholder, they do not automatically acquire the right to obtain information or the oversight right of stockholders under section 233 of the Commercial Code (Handelsgesetzbuch) either. The contracting parties usually agree, however, individual participation elements that are similar to those of stockholders, such as sharing in current losses, subordination clauses in the event of the insolvency or liquidation of the jouissance right issuer and other rights and obligations that typically accrue to stockholders (see expert article Capital Investments).

These properties also make jouissance rights risk investments. Unlike the acceptance of funds on the basis of typical bank loans, the repayment of jouissance right capital, if any such has been agreed, is subject to certain conditions, for otherwise this would represent deposit-taking business within the meaning of section 1 (1) sentence 2 no. 1 of the Banking Act (Kreditwesengesetz), which requires authorisation. In the case of jouissance rights, the investor bears a risk vis-à-vis the company which in practically all forms comfortably exceeds the normal default risk inherent in any transfer of capital. For instance, if the jouissance right conditions provide for sharing in any current losses, this would reduce the capital that the investor would, if appropriate, have to be repaid, even before the jouissance rights issuer fails. Since the calculation base of the interest claim is reduced as a result of this, the return for the investor is also smaller, even when agreements provide for a fixed interest rate.

Subordination clauses

Investors must pay special attention to so-called subordination clauses (Nachrangklauseln). These may be found not only in jouissance right conditions but also in loan agreements. In order to avoid the need for authorisation required by the Banking Act for deposit-taking business, providers on the unregulated capital market frequently use qualified subordination clauses, especially when there is no provision for sharing in any losses of the capital accepted apart from this.

By virtue of the subordination clause, this capital acquires a liability function for other liabilities of the acceptor. The investor ultimately makes the satisfaction of his claims dependent on the economic survival of the company to which he has made the funds available. This naturally increases his risk.

Supervision of the unregulated capital market

Abusive constructions, designed to circumvent the authorisation requirement, are forever appearing on the unregulated capital market. Such business models can cause considerable losses for investors and also shake the confidence in the financial market of investors not directly concerned. For that reason, collective investor protection is part of BaFin’s statutory mandate to ensure the proper functioning, stability and integrity of the Germany financial market. Even though BaFin does not supervise providers on the unregulated capital market on an ongoing basis, it acts in various ways to establish an appropriate level of protection for investors.

In order to identify emerging dangers in good time and to avert them if possible, BaFin monitors and appraises this highly innovative market segment on an ongoing basis. The principle of forward-looking and risk-based supervision, BaFin’s guiding principle, also applies, therefore, to the unregulated capital market insofar as BaFin has competences here.

The wealth of ideas on the unregulated capital market gives birth to increasingly new constructions which BaFin continuously investigates to see whether they are after all unregulated capital market products that require no authorisation or are in reality abusive circumvention constructions that satisfy the conditions for requiring authorisation. The conducting of such business and the provision of such services without taking into account the reservation of authorisation must then actually be assigned to the illegal (“black”) capital market. The assignment of individual products to the unregulated or illegal capital market, which from a legal perspective is often a very tricky and time-consuming business, is more often than not disputed between the providers of the products concerned and BaFin, as a result of which BaFin has to engage in many opposition proceedings and administrative court proceedings at all court levels. In the vast majority of cases the courts confirm BaFin’s interpretation of the law.

If BaFin takes measures against those carrying on unauthorised business, it uses its statutory powers³⁾ to inform the public of its measures. In this way it is made clear to the investor whether his investment decision concerns an unregulated capital market product that requires no authorisation at all.

Regulation

The scope of the statutory elements that are associated with a reservation of authorisation does, however, have its limits. For that reason, the lawmakers have repeatedly placed selected additional constructions and business models under supervision and so gradually restricted the unregulated capital market. BaFin’s knowledge and expertise play an important role in such regulations. For instance, as far back as the 6th Banking Act Amendment 15 years ago extensive measures were introduced that were also intended to combat undesirable practices on the unregulated capital market. Worthy of special mention here were the extension of the core element of deposit-taking to include the alternative “acceptance of other repayable funds”⁴⁾, which was geared to investor protection, and the power given to the then Federal Banking Supervisory Office – and later to BaFin – to also identify and combat unauthorised providers operating on the unregulated market. To that end, new investigative and intervention powers were added to the Banking Act – powers that remain unique in Europe to this day. (The Insurance Supervision Act (Versicherungsaufsichtsgesetz), the Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz) and the Investment Code (Kapitalanlagegesetzbuch) contain similar powers.)

In 2002 the Fourth Financial Market Promotion Act (Viertes Finanzmarktförderungsgesetz) introduced further measures, based on BaFin’s experience in the practical application of its powers under the Banking Act. Since then its powers also extend to businesses that are involved in the initiation, conclusion or settlement of unauthorised business. In 2009 the lawmakers added certain forms of asset management (Anlageverwaltung) to the Banking Act as another financial service requiring authorisation (Act on the Further Development of Pfandbrief Law (Gesetz zur Fortentwicklung des Pfandbriefrechts)). In so doing, they were reacting to gaps in protection that had arisen from the restrictive case law of administrative courts on principal broking services.

A further milestone in the regulation of the unregulated capital market was the Investment Code, which came into effect on 22 July 2013, replacing the Investment Act (Investmentgesetz) of 2004. On the basis of this, by no later than the end of the transitional periods on 21 July 2014 a significant segment of the unregulated capital market – closed-end funds – will be subject to supervision. But forms of participation falling under the law of obligations, such as jouissance rights and registered bonds, will also be covered by the Investment Code if the investment vehicle is an investment undertaking within the meaning of section 1 (1) of the Investment Code⁵⁾ (see BaFin Interpretation Letter on the scope of the Investment Code; only available in German).

If, in a particular case, the way a product that is not securitised is structured means that it is not an investment undertaking, and if it does not fall under the other supervisory acts, especially the Banking Act, either, it still continues, on the other hand, to be an unregulated capital market product. It is therefore not subject to a reservation of authorisation and ongoing supervision by BaFin. So jouissance rights in particular are often used to raise finance for businesses that operate in the real economy – which does not automatically mean, however, that the funds raised have to be used for operational purposes.

Investments

But that does not mean that investment products without a reservation of authorisation escape regulation in every case. Although BaFin does not supervise businesses that accept funds on an ongoing basis, the requirement to issue a prospectus means that it plays an important role in the public marketing of offers by ensuring transparency and disclosure. The basis of its activity here is the Capital Investment Act (Vermögensanlagengesetz), which replaced the Prospectus Act (Verkaufsprospektgesetz) of 2004 on 1 June 2012.

The Capital Investment Act covers assets held in trust, jouissance rights, registered bonds and other interests that grant participation in the earnings of a company and are not units in an investment undertaking within the meaning of the Investment Code. For such offers companies have to publish a prospectus which BaFin examines beforehand to see whether it contains all the minimum information prescribed by law and is understandable and consistent. The prospectus may not be published until BaFin has approved it. BaFin may not, however, examine the investment product itself, nor may it offer any opinion on whether the issuer or provider is reputable and financially sound (see expert article Capital Investments). Nor would it be able to do this with any reliability at all without regular solvency supervision.

Employee and Complaints Register

On the unregulated capital market it is important not only that the investor trusts the provider itself but also that he has confidence in the services provided in the marketing of the product. BaFin therefore seeks to ensure that the investment services enterprises under its supervision observe the conduct of business and organisational requirements of the Securities Trading Act (Wertpapierhandelsgesetz) when providing investment advice on and investment broking for financial instruments. Since the Investor Protection and Capital Markets Improvement Act (Anlegerschutz- und Funktionsverbesserungsgesetz) came into force on 1 December 2012, the same also applies when the financial instruments marketed by investment services enterprises are capital investments – i.e. unregulated capital market products.

In addition, this Act also introduced the Employee and Complaints Register (Mitarbeiter- und Beschwerderegister), on which investment services enterprises must register their investment advisers, marketing and compliance officers and complaints from clients. This enables BaFin to better identify shortcomings in the provision of investment advice and to take appropriate measures (see expert article Investment advice minutes). If investment services enterprises are concerned with regard to capital investments, the Employee and Complaints Register also contributes to the protection of investors on the unregulated capital market. The same will apply in equal measure for the fee-based investment adviser register which BaFin will maintain from 1 August 2014, when the Fee-Based Investment Advice Act (Honoraranlageberatungsgesetz) comes into force.

Responsibility of the investor

The existence of a legal unregulated capital market is not in itself a regulatory deficiency but an expression of the principles of freedom of trade and personal autonomy. An unregulated capital market is the norm in our economic system – unlike the regulated capital market, the distinguishing character of which is preventive prohibition qualified by a reservation of authorisation.

Anyone who decides to invest capital on the unregulated capital market benefits from the efforts of BaFin to create the conditions for informed and risk-aware investment decision-making in the interests of collective investor protection. The creation and maintenance of an appropriate level of protection for investors on the unregulated capital market is an ongoing process. Capital is generally invested for a number of years, and the effectiveness and inter-action of the statutory regulation measures can also only be assessed over a period of time. Aberrations or gaps in the protection offered therefore often reveal themselves only with the passage of time or when unforeseen developments occur. BaFin supports the Federal Government on an ongoing basis in ensuring that private investors enjoy appropriate protection. For instance, a number of options for adapting the statutory provisions on transparency, marketing channels and the scope of supervisory powers are currently being examined.

Irrespective of how the further regulation of the unregulated capital market that the Federal Government is currently honing turns out: state regulation and an investor’s personal responsibility must continue to remain in a balanced relationship. In the future, as well, the investor must not lose sight of the fact that he is entering a market segment in which he enjoys freedom but also has a responsibility to make investment decisions that match his own personal risk-readiness and investment objectives.

Notes and definitions at a glance

Regulated (“white”), illegal (“black”) and unregulated (“grey”) capital markets

The capital market is just as multifarious as its participants with their different interests. To differentiate between them, the individual market segments are often (in Germany, at least) named after the monochrome colours white, black and grey. The regulated (or “white”) capital market comprises those institutions, service providers and insurance undertakings that are authorised to carry on their business under the relevant supervisory acts in each case: the Banking Act (Kreditwesengesetz), the Investment Code (Kapitalanlagegesetzbuch), the Insurance Supervision Act (Versicherungsaufsichtsgesetz) and the Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz). They are subject to ongoing supervision. White’s complementary colour is used to denote the illegal (“black”) capital market; its main distinguishing feature is that those who operate on it conduct business that requires authorisation without having the necessary authorisation from BaFin or who carry on business that is prohibited altogether. The unregulated (“grey”) capital market, on the other hand, is the sum of all market participants and products that do not need an authorisation from BaFin and are also therefore not subject to its supervision. A certain interplay can be observed between it and the regulated financial market: the more tightly the latter is regulated, the more frequently providers switch to investment products which in their opinion do not require authorisation. The “grey” capital market is often perceived by the public as a totally unregulated market segment. But in fact BaFin performs diverse functions here, too.

Protection of investors

It is a core duty of BaFin to ensure the proper functioning, stability and integrity of the German financial system. It is bound by law to serve the public interest of collective consumer protection. It champions transparent and understandable market conditions. In so doing, it takes into account information received from consumers and consumer protection organisations. The Consumer Advisory Council (Verbraucherbeirat) that has been set up at BaFin supports it in identifying and addressing matters relating to collective consumer protection at an early stage. In this way BaFin also contributes to maintaining and strengthening an elementary condition for a properly functioning financial market – the confidence of private and professional investors – on the unregulated capital market as well.

Subordination clauses

Subordination clauses govern the order in which creditors are satisfied in insolvency proceedings. In an insolvency, in cases of doubt, claims that are subject to subordination under a contract are repaid after all other claims, i.e. also after claims that are already subject to statutory subordination (section 39 (1) and (2) of the Insolvency Code (Insolvenzordnung)). So even proprietors’ loans are taken into account beforehand, even though proprietors are normally for the most part better informed about the state of the company than outside investors. In insolvencies the claims of subordinated creditors are therefore considered only then and only to the extent that funds are still available after all other creditors have been satisfied. In the case of qualifying subordination agreements it is agreed that investors cannot assert their claims to repayment before insolvency proceedings are initiated, either, if and when this would give the company a reason for initiating insolvency proceedings (see BaFin Guidance Notice on deposit business; only available in German). In these circumstances companies may refuse to repay investors the funds they have invested and the interest promised without this giving rise to insolvency proceedings.

Recommendations for investors

In her address to the New Year press reception BaFin President Dr Elke König gave investors four recommendations to follow that are intended to help them to make rational investment decisions:

1. There is a connection between the return promised and the risk.
2. Providers on the financial markets – whether supervised or not – are not philanthropic organisations, nor do they need be.
3. People should only invest in products that they understand and display a healthy scepticism.
4. People should invest at least as much time on investment decisions as they do when buying a smartphone.

Footnotes

1) Since the German expression actually has a broader scope than “grey capital market” in the UK/USA, where it generally refers just to trading in securities that are not yet traded on an exchange, and in order to avoid any ambiguity, it will generally be referred to here as the “unregulated capital market (segment)”.

2) Civil Law Ruling II 109/02 of 21 July 2003, BGHZ (FSC Civil Law Decisions) 156, 38;
fundamental to jouissance rights: Civil Law Ruling II 172/91 of 5 October 1992, BGHZ 119, 305.

3) Section 15 (2) sentence 2 of the Investment Code, section 37 (1) sentence 3 of the Banking Act, section 81f (1) sentence 3 of the Insurance Supervision Act, section 4 (1) sentence 3 of the Payment Services Supervision Act (marketing: section 314 (3) and section 315 (2) sentence 3 of the Investment Code).

4) Later expanded to include the qualifier “unconditionally”.

5) A UCITS (undertaking for collective investment in transferable securities) or an AIF (alternative investment fund)