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Erscheinung:16.03.2015 Dr. Jean-Pierre Bußalb, BaFin

Subordinated loans and loans with profit participation: BaFin urges caution in connection with capital raising

Not all companies looking to raise large sums from investors on the financial market are supervised by the Federal Financial Supervisory Authority (Bundesanstalt für FinanzdienstleistungsaufsichtBaFin) as closely as banks, for example.

Persons and entities offering stakes in the business and other investments such as subordinated loans (Nachrangdarlehen) and profit participation loans (partiarisches Darlehen) will in the future usually be required to draw up a prospectus in accordance with the Capital Investment Act (Vermögensanlagengesetz) and have that prospectus approved by BaFin. This will be a requirement of the Retail Investors Protection Act (Kleinanlegerschutzgesetz), which is expected to be enacted in spring. However, this does not guarantee the suitability of the product or the integrity of the persons offering it.

During periods of low interest rates, many investors are on the hunt for attractive investment opportunities with high returns. Time and time again they are confronted with promotional offers relating to subordinated loans and loans with profit participation. These loans are typically marketed as offering high interest rates or returns over and above market rates.

Profit participation loans and subordinated loans
Under a profit participation loan (partiarisches Darlehen), investors transfer capital to the offeror (borrowing entity) for a specific purpose and receive an interest in profits in return. This is the profit-based component of the loan, which depends on the amount of profits generated. Many of these loan agreements also offer interest on the loan amount.
Under a subordinated loan (Nachrangdarlehen), if the company becomes insolvent, the investor's claim is not honoured until the claims of all of the company's creditors are satisfied. The investor's claim ranks prior to or pari passu with shareholders' claims for the repayment of their capital. This condition is described asloan subordination or an agreement to subordinate claims and forms part of the loan agreement. In the case of qualified subordination (qualifizierter Nachrang), the parties agree that the investor's claims will not be satisfied if repayment would create grounds for insolvency.

There is a diverse range of products on offer. Persons and entities offering these products are constantly finding and inventing new investment opportunities and areas for investment. For this reason it is not possible to provide an exhaustive list of these products. The market segments in which subordinated loans and profit participation loans are used to investors, particularly online, include the following: commodities, renewable energies, real estate, forestry, agriculture, pharmaceutical research and development, kitchen cabinets, pet food, breadcrumbs, the marketing of events and happenings, recreational technology and catering/food services.

Over the past few years there have been numerous cases in which the borrowing entity has been unable to repay investors' capital and has had to file for insolvency. Investors were left empty-handed or recouped substantially less than they had invested. It is crucial, particularly for these types of loans, that investors weigh up all of the risks and rewards before deciding to invest.

A high-risk investment

An investor who extends a loan to a company does not have the same interest as a shareholder. For example, the investor is unable to influence business operations and does not gain adequate insight into the company's performance either. This lack of transparency presents a huge risk to the investor. He or she has to speculate on whether the company will survive commercially, without benefiting from the rights to information and monitoring rights enjoyed by shareholders. Investors should therefore avoid being blinded by promises of high returns and should proceed with caution. Only those who are able to cope with losing all of their capital should even consider such investments.

There is yet another risk factor that investors should not underestimate: the terms of the loan agreements include an "agreement to subordinate claims", which is often hidden in the fine print. Investors thereby assume a business risk that is largely the same as the risk assumed by a shareholder, and higher than general corporate risk. This is because investors who agree to qualified subordination have to leave their capital in the company (like a shareholder) if the company runs into financial difficulties. This can happen quickly if the company's financial approach is unsound or, worse still, dubious. In such a situation (and thanks to the subordination arrangement), the company is able to use the investor's capital to pay other creditors, without having to file for insolvency. Even if the investor recognises early that the company could run into difficulties, it is often too late: many loan agreements cannot be terminated for several years after they are concluded.

Investors should therefore take it very seriously if prospectuses, fact sheets and advertising brochures relating to a certain investment refer to the risk of losing the entire amount invested. It is not merely a formal requirement or standard phrase, no matter what offerors and brokers may claim. Generally speaking, anyone who lends money risks losing the entire amount. However, under qualified subordinated loans and profit participation loans there is an additional risk of losing the entire amount invested, because the provisions of the Insolvency Code (Insolvenzordnung) designed to protect creditors may not apply to investors. The claim becomes legally and financially worthless, or is so right from the start. (The expert article The unregulated capital market in Germany contains the legal structure of qualified subordination arrangements.)

Requirement to publish a prospectus

As mentioned above, the Retail Investors Protection Act will introduce a prospectus requirement for persons and entities seeking to market profit participation loans and subordinated loans. This will establish a minimum level of transparency. Before publishing their offer, offerors and issuers will have to file a prospectus with BaFin in future, and they will only be able to publish the prospectus once it has been approved by BaFin. Prospectuses are very detailed, but are often instructive. Even though it may seem tedious, investors should carefully read and understand the investment terms and conditions, the financial figures and, above all, the information provided in relation to the risks, the investment strategy and the use of funds. Statements regarding the risk of losing the entire amount invested are particularly important.

BaFin reviews each prospectus to assess whether it is complete, consistent and coherent. It does not, however, review the product. Similarly, it does not assess the economic feasibility of the business model or the integrity or creditworthiness of offerors, initiators or senior managers. The issuers are not subject to ongoing supervision and control either, unlike banks for example. Moreover, BaFin does not check whether the information contained in the prospectus is substantively correct.

If BaFin approves a prospectus, it means that the prospectus contains the minimum level of information about the offeror and the product required under the Capital Investment Act. However, it does not mean that BaFin has endorsed or authorised the company or its business model. BaFin’s prospectus review is not a seal of approval or authorisation of the company's business, even though people like to tell their clients otherwise. BaFin's review of the prospectus cannot completely prevent individual persons or entities from engaging in criminal conduct.

The requirement to publish a prospectus for subordinated loans and profit participation loans does, however, help investors to better appraise the legitimacy of the aforementioned types of investment and the likelihood of yielding a financial gain. This makes it easier for investors to make a well-informed decision with knowledge of the risks. That said, each investor is responsible for his or her own investment decisions: if a risk materialises, the investor has to deal with the negative consequences.

Where there is no prospectus

Investors should exercise particular caution in the case of offers for which no approved prospectus exists. In cases such as these, investors receive only a small amount of information about the company and the investment, usually in the form of promotional material. It is sensible in these cases to seek information from other sources such as the Internet. However, investors should be mindful of where that information comes from and whether the sources of that information are well-known, legitimate and objective. The more limited the amount of meaningful information available about an investment, the greater the cause for investor scepticism. If you harbour any doubts, do not go ahead with the investment.

The requirement to publish a prospectus will not apply to subordinated loans and profit participation loans that qualify as crowdinvesting under a crowdfunding campaign, provided the company concerned raises no more than EUR 1 million, the campaign is run online, and investors are not permitted to invest more than EUR 1,000 without receiving further information. Crowdfunding is particularly attractive to new companies and start-ups. Investors are provided with information and often also business plans, but they are often non-binding. Start-ups first have to find a foothold in the market for their business concept. Investors should therefore generally assume that they will lose their entire investment. Crowdinvesting is therefore not a suitable form of investment for investors seeking to secure retirement income; it should really be seen as gambling money.

Healthy scepticism

Investors should generally be sceptical of blatant promotions, promises of above-average returns, dubious business models or uncertainty surrounding the individuals behind an investment. If in doubt, refrain from investing. As with all investments, investors should carefully scrutinise the contract documentation and prospectus in the case of subordinated loans and profit participation loans. No matter how the investment is described, use extreme caution if there is a subordination clause in the contract or supplementary documentation.

Further information

Investors can obtain further information on investing at Verbraucherzentrale Bundesverband e.V. (Federal Association of Consumer Protection Agencies) and regional consumer protection agencies. These agencies also have a list of dubious offerors. You can also check BaFin's company database to see whether any of your companies are subject to supervision. You will also find links there to summaries of prospectuses for securities and other investment products.

Additional information

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