German regulator threatens crack-down on “excessive influence” of special fund investors – Non-German asset managers cooperating with Master-KVGs directly affected

Introduction

The German special investment fund (Special Fund) is a widely used investment vehicle that is very popular amongst German institutional investors. Special Funds are AIF-managed typically by German AIFM known as “KVG” or Kapitalverwaltungsgesellschaften. Compared to directly investing into assets such as shares and bonds as well as alternative assets such as real estate, an investment into a Special Fund, besides professional management by an asset manager, may also have accounting and tax benefits for the investor. 

Many investors have appointed so-called Master-KVGs, which are AIFM that focus on fund administration and risk control, but which delegate portfolio and risk management functions to third-party asset managers (TPAM) chosen by their investors. From the investors’ perspective, this gives them a large degree of flexibility, as they can maintain their fund investments with the administrating AIFM, but can relatively easily replace the entity that is supposed to take and implement the investment decision.

So far, another advantage, from the perspective of the investor, is their de facto ability to influence investment decisions being taken either by the KVG or – in the case of Master-KVGs – the TPAM. As the Special Fund units are typically held only by one investor (or several affiliated investors), such investors may have strong opinions not just about the overall investment strategy, but also about specific investments, the purchase or sale of specific shares or bonds. 

Typically, investors of Special Funds are members in a so-called investment committee, in which in addition to representatives of the AIFM, the TPAM and the depositary are supposed to exercise an advisory function. 

As regards the role and competencies of such investment committees, already in 1997, the predecessor of the Federal Financial Services Supervisory Authority (BaFin) stated the following in a letter to the German Investment and Asset Management Association (BVI):

“The KAG's [=KVG’s] management obligation includes its sole management right and thus any right of third parties to issue instructions, including that of the unit holder...is excluded.

With regard to the customary activities of investment committees, particularly in the case of special funds, it should be noted in this context that the investment committee is not a body of the KAG provided for under investment law, but a body of experts developed from the practice of fund management with an exclusively advisory function for the fund management. The recommendations of the investment committee regarding the selection of individual securities can only be based on the current economic circumstances of the issuer, but cannot introduce new essential criteria for the selection. The responsibility for selecting the securities to be acquired within the framework of the investment principles and investment limits lies without restriction with the management of the KAG.”

This is in line with the views expressed by ESMA¹, whereby investors in an AIF must not have any day-to-day control over the activities of such AIF. 

I. BaFin considers need to curb excessive influence of Special Fund investors

In March this year, BaFin published a draft circular which on the one hand reiterated the guidance given already in 1997, but which at the same time imposes new and very strict documentation rules on AIFM and their TPAM regarding communications with Special Fund investors. 

The circular explains whether and to what extent Special Fund investors, which may also include banks and insurers supervised by BaFin, may influence the investment decisions of the AIFM. It contains provisions on the question of whether and up to what limit such influence is permitted under the Capital Investment Code (KAGB). According to BaFin, the boundary between permissible and impermissible influence by investors under supervisory law is fluid, which is why it is to be further specified by way of a circular.

It is not an exaggeration to say that this consultation is a real bombshell that has caused considerable concern among (Master-)KVGs and their investors. If the draft circular were officially adopted by BaFin, this would have a tremendous impact also on TPAM and it would potentially negatively affect their relationship with the Special Fund investors. This is why we shall, in the following, provide a detailed summary of the draft circular.

• Investors must not have “too significant an influence” on investment decisions
  • The starting point of BaFin’s analysis is Section 17 KAGB. Pursuant to Section 17 (1) KAGB, an AIFM is a company whose business is aimed at managing investment funds. Only one AIFM can be responsible for each AIF and it is responsible for compliance with the requirements of the KAGB. According to Section 17 KAGB, it is therefore not the investors who manage the investment fund (no self-administration), but the AIFM, which is responsible for compliance with the provisions of the KAGB (third-party management). This is not compatible with investors having too significant an influence on the investment and divestment decisions of the AIFM for the account of investment funds.
    
    The AIFM alone is hence responsible for portfolio and risk management. It can either fulfil this core task itself through its own employed portfolio managers or commission a TPAM with this task. However, it cannot have this task performed by the investors. Such far-reaching influence by the investors would be incompatible with the management and responsibility of the AIFM in accordance with Section 17 KAGB.
    
    Specifically, this means that the final decision on which assets are acquired or sold for an investment fund must be made by the AIFM or its TPAM and not by the investors. If this limit is exceeded, this constitutes unauthorized influence by investors under supervisory law.

• Specific do’s and don’ts
  • Instructions from investors in relation to individual securities
    • Instructions from investors to the portfolio manager to buy or sell individual securities are not compatible with Section 17 KAGB and are therefore inadmissible, as the final decision on the purchase and sale of assets lies with the portfolio manager.
  • Veto rights and reservations of consent by investors
    • Furthermore, veto rights or reservations of consent by investors in relation to individual transactions in securities are not permitted. In this case, it is not the portfolio manager who would make the final decision in relation to the asset, but the investor, by vetoing the portfolio manager's decision or withholding consent, thereby blocking the portfolio manager's decision to acquire or dispose of an asset.
      
      By contrast, veto rights or reservations of consent by investors in investment committees are unproblematic if they relate to the abstract determination of the investment strategy within the scope of the contractually agreed investment guidelines, for example, in connection with the question of whether or not a special fund should be able to invest in certain types of securities, regions or sectors, or not. In these cases, the investor can influence the basic strategic orientation of the investment fund. However, the final decision on the acquisition or disposal of a specific asset remains entirely with the portfolio manager.
  • ‘Investment ideas’ or ‘recommendations’ from investors
    • Non-binding ‘investment ideas’ or ‘recommendations’ from investors are also unproblematic, as the ultimate decision-making authority of the portfolio manager is not called into question here either.
      
      However, this does not apply if an idea or recommendation actually constitutes an indirect instruction. Whether an indirect instruction exists must be assessed on the basis of the circumstances of the specific case. Indications of an indirect instruction would be if the portfolio manager executes all of the investor's recommendations on a one-to-one basis without carrying out his own research or material assessment of the opportunities and risks of the investment or divestment and formally limits his review to acquisition criteria or an investment limit check. The same applies if the initiative for the acquisition or disposal of assets rarely or never comes from the AIFM, but essentially and continuously from the investors.

• Interim assessment
  • One could take the view that the specific do’s and don’ts follow already from the statement made by the regulator in 1997, which has never been revoked or modified. In practice, however, at least some of the previous statements seem to have been honored more in the breach than the observance.
    
    From a tax perspective, very few investors actually dare to give what could be considered “binding instructions,” as this could in the past have led to a situation where the tax authorities disregarded the AIF as such and treated the investor as if it had made all investments directly, potentially leading to quite significant tax penalties.
    
    BaFin points out that the question of whether and to what extent an excessive influence of investors may lead to the conclusion that an entity does not qualify as an investment fund within Section 1 (1) KAGB is not within the scope of the circular. Even if BaFin’s statement suggests that influence taken by the investors does not necessarily mean that the fund falls outside the scope of regulation under the KAGB, the tax authorities may take a different view. Due to the amendment to the German Investment Tax Act (“InvStG”) by the Annual Tax Act 2020 (Jahressteuergesetz 2020), tax authorities are not bound by the decision of BaFin whether a vehicle qualifies as an investment fund within the meaning of Section 1 (1) KAGB, which sets the course of whether an investment vehicle (other than partnerships) falls into the scope of the InvStG with the consequence that the fund and its unitholders are subject to a different tax regime as compared to corporates. The explanatory notes of the Annual Tax Act 2020 point out that in contrast to BaFin's objective, which is based on the task of investor protection, the tax authorities are concerned with safeguarding the tax base and preventing tax-saving models. Due to the different tasks, the tax authorities may come to a different conclusion than BaFin.
    
    Going forward, de facto influence pursuant to the circular should no longer be exercised. It remains to be observed what conclusions the tax authorities will draw from the ongoing disregard of such regulatory obligations. This uncertainty explains why, for instance, the German Insurance Companies’ Association quite vocally opposed the draft circular and lobbies for major amendments (see below II).
    
    For the avoidance of doubt: While BaFin’s examples of do’s and don’ts refer to securities transactions, other asset classes are just as much affected. In particular in the case of large investments in illiquid assets, such as real estate or infrastructure, it seems to be the rule rather than the exception that no investment is made without the investor’s consent, effectively giving the investor a – non-permissible – veto right.

• Documentation obligations
  • According to BaFin, “whether an indirect instruction exists must be assessed on the basis of the circumstances of the specific case.” Thus, BaFin now introduces new, far-reaching and onerous documentation obligations:
    
    Section 28 (1) KAGB requires a proper business organization of the AIFM. This “obviously” includes the documentation of business processes, not least as proof to BaFin and the auditor that the business organization ensures compliance with the legal requirements – for example, in accordance with Section 17 KAGB.
    
    In order to enable BaFin and the auditor to understand and verify that no investor influence incompatible with Section 17 KAGB has taken place, the portfolio manager must document any form of investor influence on investment decisions for the account of investment funds, effective as per the publication of the final circular.
    
    If a Master-KVG outsources portfolio management functions, the TPAM must be contractually obliged to provide corresponding documentation, as the outsourcing must not impair the effectiveness of BaFin's supervision of the Master-KVG.
    
    In the draft circular, BaFin somewhat disingenuously states that “due to the existing documentation obligation pursuant to § 28 KAGB which also relates to business processes and investment decisions, the present concretization of this documentation obligation is not expected to result in any significant documentation obligation.” This is obviously wrong, as the “recommendations” or “investment ideas” are in practice rarely documented in a form that would be fit for an audit.

II. Reaction by the fund management industry and investors

While AIFM and their TPAM will find the documentation obligations quite strenuous, they also oppose quite vigorously the view of the BaFin that the investors’ influence is too significant. 

Four principal arguments are being put forward against the draft circular:

• Regulated investors must exercise significant influence

Insurance companies and other investors that are bound by the Investment Ordinance (AnlageVO) claim that they have to be able to give specific instructions, also to enable them to comply with the Asset-Liability Management (ALM) obligations: 

Insurance companies may only invest in assets and instruments whose risks they can adequately identify, assess, monitor, manage, control and include in their reporting, as well as adequately take into account when assessing their solvency requirements. With regard to investments in investment funds, institutional investors are only able to adequately identify, assess, monitor, manage and control the associated risks if they have knowledge of the risks involved and the investments contained therein and have dealt with them intensively. The exchange between the regulated investor and the portfolio manager should therefore also be seen against this background.

Following discussions with the concerned parties, it appears that the BaFin might be amenable to take this argument into account.

• In the case of funds in limited partnership form, giving investors control over investment decisions is legally required

It is argued that, in the context of (closed-end) investment funds that are organized as investment limited partnerships, investors can decide on the approval of investment decisions through the partners' meeting, among other things. It remains unclear, the argument goes, how such shareholder resolutions could be reconciled with the inadmissibility of veto rights, reservations of consent and instructions by investors provided for in the draft information sheet. In order to avoid possible conflicts in the event of conflicting investment decisions by the AIFM as portfolio manager, an exception is required here that takes into account the special circumstances of the investment limited partnership.

This argument does not withstand closer scrutiny, as German partnership law does not require limited partners to have veto rights with respect to investments made by an AIFM.

• By observing an investor’s recommendations, the AIFM merely complies with the requirement to act in the investor’s interest

The purely quantitative view taken by the draft circular – how many investment ideas were brought up by the investor, and how many by the manager? – obscures the KVG's fiduciary duty to act exclusively in the interests of the investor in accordance with Section 26 KAGB, as communication with the investor may be required under both supervisory law and civil law, but would always be considered an indirect instruction. 

It is asked how else the KVG is supposed to ascertain the best interests of the special fund investor and, in case of doubt, be able to prove that its decisions were in the best interests of the investor? In order to be able to act in the best interests of the investor (Section 26 KAGB), it must, according to the BVI, be permissible for the KVG to take into account considerations relevant to the investor and put forward by the investor when making the (final) decision, which should be clarified in the information sheet.

• The documentation requirements are excessive, unnecessary and hurtful for Germany as a fund management jurisdiction

Germany is already playing second fiddle compared to Luxemburg when it comes to public mutual funds. However, the German Special Fund has been a success model and is – at least when it comes to liquid investments – going from strength to strength. 

Imposing the new documentation requirements can ultimately only lead to a situation where those investors that either consider themselves obliged to exercise significant influence or that just wish to do so will transfer their holdings to a Luxembourg AIFM. Already real estate funds and private debt funds are very often established in Luxembourg as this jurisdiction – while having finally brought its house in order with strict substance requirements for AIFM – is known for the flexibility and business acumen of its regulator.

III. What lies ahead?

The investment management industry in Germany is up in arms against an initiative by BaFin that is widely considered as completely unnecessary.

In fairness, one could say that BaFin merely reiterated a position it has taken already almost 30 years ago and that, in addition, is in line with the AIFMD as interpreted by ESMA. 
However, while nobody will deny that there is always room for improvement when it comes to investor protection, who does the BaFin think it protects when it limits an institutional investor’s right to determine how its assets shall be invested? At a time when the investment industry still suffers from PTSD after implementing chaotic ESG requirements and now prepares to implement equally unpractical liquidity management tools under AIFMD II, is it sensible to impose requirements that neither AIFMs nor their investors want? 

It is too soon to guess what will be the ultimate outcome of the consultation, but it is certainly worthwhile to watch this space.