Has Germany opened the door for debt funds?

May 2015 Has Germany opened the door for debt funds? BaFin changes administrative practice with respect to loan originating AIFs The German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht BaFin ) made an announcement on 12 May 2015 (the Debt Fund Announcement ) 1 outlining fundamental changes to its administrative practice with respect to the origination, restructuring and prolongation of loans by alternative investment funds ( AIFs ). The BaFin announcement is made in advance of an amendment of the German Capital Investment Code (Kapitalanlagegesetzbuch KAGB ) 2, but the change in administrative practice is to have immediate effect. Status quo Table of contents Status quo... 1 BaFin s new administrative practice... 2 BaFin s recommendations for German AIFs... 3 Loan origination strategies... 3 Secondary investment strategies... 4 Impact of the Debt Fund Announcement... 4 Domestic AIFs... 4 Non-German market participants... 4 Conclusion and outlook... 5 Under the current legal framework in Germany, the origination of loans is only permissible with a banking license under the German Banking Act (Kreditwesengesetz KWG ) 3. This applies to all participants in the lending market (including domestic and foreign debt funds) subject only to few exceptions (e.g. for private and public insurance companies). In practice, this led to the implementation of structures which allow unlicensed lenders to provide loans to borrowers in Germany indirectly, e.g. by involving a regulated financial institution as a fronting bank (with the acquisition of the loan by the unlicensed market participant as a secondary acquirer) or by creating debt exposures through participations in instruments such as bearer bonds. However, market participants without a banking license that had acquired a disbursed loan in a secondary market acquisition were not able to vote on certain restructuring measures (e.g. deferral of repayment claims, adjustment of interest, prolongation initiated by the borrower) since participation in such decisions qualified as lending business and triggered the banking license requirement. 1 2 3 Please refer to BaFin s website (www.bafin.de) to see the full text of the announcement. Kapitalanlagegesetzbuch dated 4 July 2013 (BGBl. I S. 1981), last amended by Article 3 of the law of 10 December 2014 (BGBl. I S. 2085). Kreditwesengesetz as of 9 September 1998 (BGBl. I S. 2776), last amended by Article 2 paragraph 39 of the law of 1 April 2015 (BGBl. I S. 434). Alert. Has Germany opened the door for debt funds? 1

BaFin s new administrative practice According to its revised administrative practice, BaFin now considers the origination, restructuring and prolongation of loans by AIFs to be covered by their AIFM license, i.e. to be activities falling within the concept of collective management services (kollektive Vermögensverwaltung). The provisions of the KAGB regulating collective management by German alternative investment fund managers ( AIFMs ) therefore now override (as lex specialis) the more general license requirement for lending business under the KWG. The Debt Fund Announcement expressly allows these activities to be conducted by German AIFs for which the KAGB contains no (or nearly no) product level regulation, i.e. general open-ended special AIFs (sec. 282 KAGB), hedge funds (sec. 283 KAGB) and closed-ended special AIFs (sec. 285 KAGB). The relaxed administrative practice is not restricted to AIFs managed by fully regulated AIFM, but also applies to those managed by AIFMs that are merely registered under the de-minimis rules, (except for those which are pursuant to the KAGB generally not allowed to invest in loans). Based on the Debt Fund Announcement German real estate funds and UCITS funds will not benefit from the new administrative practice. The Debt Fund Announcement does not indicate how BaFin will treat non- German AIFs wanting to originate, restructure or prolong loans to German borrowers. However, BaFin s altered administrative practice is motivated by developments on the European stage: > The implementation of the AIFMD 4 has created a pan-european framework for the regulation of AIFs which (unlike the German KAGB) does not preclude the origination of loans by AIFs. > Other European states have implemented legislation specifically allowing loan originating AIFs and these can be marketed throughout the EU. > EuSEF Regulation 5, EuVECA Regulation 6 and draft ELTIF Regulation 7 (which are or will be all directly applicable law in Germany) all presume that AIFs have the ability to originate loans. > ESMA considers loan originating AIFs to be permissible and is working on a discussion paper setting out minimum standards to be applied to loan originating AIFs across Europe. Having redefined the concept of collective management to bring it in line with the broad interpretation thereof shared by other European countries and ES- MA (i.e. including the power to originate, restructure and prolong loans), the 4 5 6 7 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010. Regulation (EU) No 346/2013 of the European Parliament and of the Council of 17 April 2013 on European social entrepreneurship funds. Regulation (EU) No 345/2013 of the European Parliament and of the Council of 17 April 2013 on European venture capital funds. Draft Regulation of the European Parliament and of the Council on European Long-term Investment Funds (2013/0214 (COD); PE-CONS 97/14; EF 352; ECOFIN 1190; CODEC 2479). Alert. Has Germany opened the door for debt funds? 2

Debt Fund Announcement then goes on to limit the breadth of that interpretation for German AIFs. It does this in two ways: (i) by limiting its application to specified types of German AIFs, as set out above; and (ii) by pointing out that the German legislator will implement changes to the KAGB in the near future concerning the origination, restructuring and prolongation of loans and recommending that AIFM intending to pursue a loan origination strategy adhere to the recommendations set out in the Debt Fund Announcement. AIFM that fail to adhere to the recommendations risk having to alter their business model once the amendments to the KAGB are enacted. Until the amendments to the KAGB are enacted the broad interpretation of the concept of collective investment management appears to apply as enforceable administrative law, whereas the limitations regarding specified fund types and the limitations in the recommendations do not (since there is currently no legislative basis for these restrictions). BaFin s recommendations for German AIFs BaFin has split its recommendations for German AIFs in two parts: the first deals with origination, restructuring and prolongation of loans (loan origination strategies), whereas the second deals with the acquisition of loans (secondary investment strategies). Loan origination strategies Fund type: BaFin recommends that only closed-ended AIF should originate loans. Restrictions regarding borrowers: BaFin recommends that loans should not be granted to retail borrowers. To avoid conflicts of interests, BaFin further recommends not to grant loans to the AIFM managing the loan originating AIF, the AIF s depositary or any delegate appointed by the AIFM with respect to the services provided by the AIFM. Leverage: BaFin states that leverage for AIFs originating loans is viewed critically and, if utilised, should be very limited (no specific limit is mentioned). In order to avoid triggering the application of the Capital Requirement Regulation ( CRR ) 8 requirements, AIFs must not borrow from the public. Risk management: BaFin recommends that AIFs which originate loans should comply with certain parts of BaFin s circular 10/2012 (BA) - minimum requirements for the risk management ( MaRisk ) applicable to credit business. Liquidity management: With respect to liquidity management, BaFin recommends that AIFM ensure congruency between loans originated by them and any leverage used to refinance such loan origination, i.e. AIFM should not finance long term loans with short term borrowings. Furthermore, BaFin recommends that AIFs should hold liquid assets as a liquidity reserve to service the AIF s liabilities. 8 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012. Alert. Has Germany opened the door for debt funds? 3

Diversification: BaFin recommends AIFM set risk limits, e.g. maximum exposures to individual borrowers. No specific percentages are suggested. Secondary investment strategies Administration of loans: When administrating loans acquired on the secondary market, AIFs may now participate in the restructuring and prolongation of loans without triggering the requirement for a banking license. Risk and liquidity management: BaFin states that it considers the risks of an investment strategy involving the acquisition of loans in the secondary market to be comparable with the risks of a loan origination strategy (in particular regarding the congruency of investments and the AIF s capital base). Therefore, the risk- and liquidity management of AIFs acquiring loans in the secondary market should be appropriate to capture these risks. BaFin recommends specifically that open-ended special funds and hedge funds should not invest more than 50% of their assets in loans. This recommendation is more restrictive than currently applicable law. Impact of the Debt Fund Announcement Domestic AIFs As of the publication of the Debt Fund Announcement on 12 th May 2015, German AIFs are allowed to originate loans as set out above. The BaFin recommendations anticipate legislative amendments to the KAGB to be enacted in the near future, but appear not to be binding administrative law. Furthermore, it cannot be ruled out that the final form of the amended KAGB will include additional or other requirements for the origination of loans than those set out in the BaFin recommendations. Non-German market participants The Debt Fund Announcement does not indicate how BaFin will treat non- German market participants wanting to originate, restructure or prolong loans to German borrowers. EU AIFs: Arguably, EU AIFs should be entitled to equal treatment. The implications thereof are not clear, however, because the Debt Fund Announcement contains a mixture of binding and non-binding statements. In particular, it is currently not yet clear whether an EU AIF wanting to originate, restructure or prolong loans to German borrowers without a banking license would need to adhere to some or all of the recommendations set forth in the Debt Fund Announcement. The immediate effect of the Debt Fund Announcement could be much broader than what is stated in its text because the restrictions set out by BaFin lack a legislative basis. However, if and when the restrictions are implemented in the KAGB, they may well (in whole or in part) impact EU AIFs wanting to originate, restructure or prolong loans to German borrowers on the basis that they are entitled to equal treatment. Third country AIFs: The position for non-eu AIFs, applying e.g. the principle of free movement of capital, is less clear. Alert. Has Germany opened the door for debt funds? 4

Non-AIFs: Market participants that do not qualify as AIFs are unable to rely on the BaFin Debt Fund Announcement. Conclusion and outlook The BaFin Debt Fund Announcement represents an important development in the German debt and funds markets. Notwithstanding significant appetite amongst managers, regulatory hurdles have prevented many debt funds from becoming active in Germany. Although the legal impact of the Debt Fund Announcement on non-german debt funds needs to be clarified in more detail, the weight of economic interest in its resolution suggests it will not remain uncertain for long. The European impetus for this development also suggests that it will not remain a development that benefits German AIFs only. What is more, the BaFin recommendations concerning debt funds established in Germany are likely to be influential in the ESMA discussion around minimum standards to be applied to loan originating AIFs in Europe. Germany s active engagement in this discussion is a positive signal for debt funds targeting Germany. Alert. Has Germany opened the door for debt funds? 5

Contacts: For further information please contact: Alexander Vogt Partner +49 69 71003-414 alexander.vogt@linklaters.com Markus Wollenhaupt Partner +49 69 71003-117 markus.wollenhaupt@linklaters.com Rocco Beck Managing Associate +49 69 71003-342 rocco.beck@linklaters.com Tobias Kaufmann Associate +49 69 71003-283 tobias.kaufmann@linklaters.com Soleiman Mohsseni Associate +49 69 71003-490 soleiman.mohsseni@linklaters.com Linklaters LLP. This publication is for general information purposes only and does not claim to be comprehensive or provide legal or other advice. Articles and other publications on this site are current as of their date of publication and do not necessarily reflect the present law or regulations. Linklaters accepts no responsibility for loss which may arise from accessing or reliance on information contained in this site. Linklaters is not responsible for the content of external internet sites that link to this site or which are linked from it. Linklaters LLP. All Rights reserved 2015. Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC326345. It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on www.linklaters.com and such persons are either solicitors, registered foreign lawyers or European lawyers. Please refer to www.linklaters.com/regulation for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by emailing us at marketing.database@linklaters.com. Before 1 May 2007, Linklaters was a general partnership constituted under the laws of England and Wales. Some documents on this website were produced before 1 May 2007. Nothing in those documents is to be taken to indicate that Linklaters LLP or any of its limited liability affiliated undertakings are unlimited liability undertakings or general partnerships. Jean David Jansen Associate +49 69 71003-609 jean_david.jansen@linklaters.com Mainzer Landstraße 16 60325 Frankfurt am Main Telefon +49 69 71003-0 Telefax +49 69 71003-333 www.linklaters.com Alert. Has Germany opened the door for debt funds? 6