Distribution of privately placed foreign investment funds - KII or PIB?

7 February 2012

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Introduction

Welcome to our latest Financial Services Newsflash, our alert service that details the latest information and news on areas affecting:

  • institutions/investment services firms
  • investment companies
  • insurance-regulated enterprises

and all other significant news relevant to the financial sector.

In this Newsflash we discuss the distribution of privately placed foreign investment funds.

Last year, the Investor Protection and Functionality Improvement Act (Anlegerschutz- und Funktionsverbesserungsgesetz AnsFuG) introduced the concept of a Product Information Document (Produktinformationsblatt - PIB). This Act provided that from 1 July 2011 retail clients in Germany must be provided with a PIB in a timely manner when investment advice includes a purchase recommendation for a financial instrument (section 31 sub-section 3a S. 1 and 2 of the German Securities Trading Act (Wertpapierhandelsgesetz - WpHG). However, the Act also provides that a PIB is not required where key investor information (KII) is provided for:

  • units in German investment funds pursuant to section 42 sub-section 2 of the German Investment Act (Investmentgesetz - InvG) which is required since UCITS IV has been implemented into the InvG;
  • EU investment fund units (UCITS) pursuant to section 122 sub-section 1 sentence 2 of the InvG which has been published in the German language (KII within the meaning of Commission Regulation (EU) No 583/2010);
  • foreign investment funds (i.e. units in non-UCITS compliant foreign investment funds) pursuant to section 137 sub-section 2 of the InvG (section 31 sub-section 3a sentence 3 of the WpHG).

In light of the above, it is clear that no separate PIB pursuant to section 31 sub-section 3a of the WpHG needs to be prepared for investment funds generally.

However, since the provision of section 137 sub-section 2 of the InvG relates to publicly distributed foreign investment fund units a practical issue has arisen as to whether retail clients seeking privately placed foreign investment fund units should be provided with KII - which, in principle, follows the harmonised European requirements - or with a PIB which is a German specification. In January 2012 the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht - BaFin) made it clear that the KII within the meaning of section 137 sub-section 2 of the InvG must be provided rather than the PIB.

The BaFin argued that the WpHG generally does not differentiate between public distribution and non-public distribution, i.e. private placement of financial instruments. As such, in case of private placement the KII pursuant to section 137 sub-section 2 of the InvG must be used in lieu of the PIB. This interpretation benefits from the fact that in the case of foreign investment fund units‚ retail clients are provided with KII in a standardised manner irrespective as to whether units are publicly or privately distributed. Furthermore, it achieves the legislative intent to provide any retail client with the required level of comparability of any information necessary to make an independent investment decision. BaFin stated that retail clients might be confused if they received the KII for a publicly distributed foreign investment fund unit but a PIB for a privately placed foreign investment fund unit.

Although BaFin’s clarification seems plausible at a first glance, its interpretation gives rise to a number of questions including:

  • For which products, and on what terms, does the KII need to be produced?
  • In which event does the KII need to be provided?

In this context we should point out the following issues:

  • First of all, one needs to determine whether the financial instrument qualifies as a foreign investment fund unit. This can be a very complex task and external advice may be required. Failure to make the correct categorisation at this stage might entail the use of the wrong documents vis-à-vis the investor and, ultimately, regulatory sanctions and civil liability.
  • Secondly, the question arises as to who is obliged to prepare the KII, i.e. the investment company or the German investment services firm. While the obligation to provide the KII pursuant to section 31 sub-section 3a of the WpHG is incumbent on the investment services firm, in practice investment services firms are often not able or willing to prepare such information. Hence, investment services firms try to impose this obligation on the investment company by contract. On the other hand, a foreign investment company whose product is neither intended nor authorized under the InvG for public distribution in Germany might not be aware of the fact that the KII has to be provided as part of the private placement of its product. In our view, this issue - together with the question of liability for the contents of the KII - might require clarification in the agreement made between the foreign investment company and the investment services firm. Nonetheless, the investment services firm which distributes privately placed foreign investment fund units in Germany should be aware of the duty to prepare the KII and consequently either comply with the obligation itself or delegate such obligation to the foreign investment company in order to be able to meet its duties pursuant to section 31 sub-section 3a of the WpHG.
  • A foreign investment company might not be familiar with section 137 sub-section 2 of the InvG which sets out the requirements for the different investment fund types when drafting the KII. With respect to foreign investment fund units in Germany there are different requirements for the preparation of the KII depending on the type of product. Hence, foreign investment companies or investment services firms respectively may not be able to rely on their knowledge of the European requirements as to the KII. Here, the variations in section 137 sub-section 2 of the InvG which, depending on the type of investment fund, set forth different requirements as to the content‚ form and structuring of the KII must be taken into account. That is because the German legislator refers comprehensively to the so-called KII Regulation (Commission Regulation (EU) No. 583/2010) only in the case of UCITS. Consequently, the involvement of the German investment services firm is advisable with regard to these issues as, normally, it will have a better knowledge of the applicable German law provisions and the German regulatory practice.

According to the intention of the German legislator, information about a financial instrument which is given through a PIB - or, in the case of an investment fund, through the KII - should facilitate the comparability of various financial instruments which are recommended for purchase. However, the German legislator regards such information as necessary only insofar as the purchase recommendation relating to the financial instrument is made within the course of providing investment advice‚ and where the investor does not qualify as a professional client within the meaning of section 31a of the WpHG. In other words, the KII in case of a private placement of foreign investment fund units need only be provided if the following conditions of section 31 sub-section 3a of the WpHG are met, i.e.:

  • the service is provided by an investment services firm (Wertpapierdienstleistungsunternehmen) within the meaning of the WpHG;
  • the service provided qualifies as investment advice;
  • a purchase recommendation is given; and
  • the investor obtaining investment advice qualifies as a retail client.

While private placements often form part of institutional investment business, the category of institutional investors is not always congruent with the category of professional clients within the meaning of section 31a of the WpHG (e.g. high net worth individuals or family offices, as the case may be). Consequently, a number of factors need to be considered‚ e.g. who is part of the group of non-professional clients - especially in case of so-called “opted-in” professional clients (gekorene professionelle Kunden) within the meaning of section 31a sub-section 7 of the WpHG? However, in this area several issues remain unsolved‚ e.g. with respect to municipalities or contractual trust arrangements (CTAs).

In summary, the procedure should be as follows:

Step 1: Does an investment services firm provide investment advice and is a purchase recommendation given?

Step 2: Is the investment advice provided to a retail client?

Step 3: Does the purchase recommendation relate to a (privately placed) foreign investment fund?

If these questions can be answered in the affirmative, the following matters should also be clarified:

Step 4: Who is responsible for preparing the KII (in general, the distributing investment services firm which has to provide this document; however, under certain circumstances, this obligation could be conferred upon the investment company offering the foreign investment fund) and how may liability issues be resolved?

Step 5: Are there any special requirements (i.e. requirements which deviate from the harmonised European requirements) regarding the KII for foreign investment fund units to be complied with under German law?

Any mistake which occurs when following the steps outlined above may result in regulatory consequences and especially (in the event of any disadvantageous development of the investments) civil liability.

In consequence, the assumption that it should be much easier for foreign investment companies and investment services firms to provide the KII than to provide a PIB may prove to be erroneous, in particular with respect to investment companies domiciled outside the EEA that generally do not intend to distribute their products publicly in Germany.

Finally, firms should also be aware of the possible consequences for UCITS. Although BaFin’s opinion is expressed in connection with the private placement of units in foreign investment funds, it might be possible to extend it to the private placement of UCITS. In this case, BaFin’s statements would also apply to (inter alia) private placements of UCITS units not authorized for public distribution in Germany.