New Opportunities for Loan Funds

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1 28 May 2015 New Opportunities for Loan Funds BaFin changes its administrative practice relating to the granting, restructuring, and prolongation of loans by investment funds Executive Summary > When certain conditions are met, BaFin accepts prolongations and restructurings of existing loans by certain AIFs > When certain conditions are met, BaFin also accepts loan origination (direct lending) with respect to loans for the account of closed-ended specialized AIFs (Loan Originating Funds) > Simplifications apply to fund managers fully subject to the obligation to obtain authorization as well as to registered fund managers, to the extent to which such fund managers are acting for the account of the AIF > But: recommendation of enhanced requirements as to risk management and product design, e.g. - requirements under MaRisk - no granting of any consumer loans - no granting of loans in the event of any conflicts of interest - a liquidity reserve has to be maintained - adequate diversification of risk - leverage has to be restricted > Enhanced requirements are also recommended when acquiring unsecuritized loans I. Introduction With its letter dated May 12, 2015, the BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht, German Federal Financial Supervisory Authority) has changed its administrative practice such that the restructuring and prolongation, but also the granting of loans are now generally permissible as part of collective investment management under the KAGB [Kapitalanlagegesetzbuch, German Capital Investment Code], subject to compatibility with the statutory product regulations set out for the respective type of fund pursuant to the KAGB. Meanwhile, however, BaFin also points out that, foreseeably, enhanced statutory requirements will come into effect in this connection, and recommends to start complying already now with certain minimum requirements relating to the granting of loans, the acquisition and restructuring/prolongation of unsecuritized loans, and the granting of shareholder loans for the account of an Alternative Investment Fund (AIF). The possibilities regarding the acquisition of unsecuritized loans remain unaffected by the new administrative practice, even though the BaFin does recommend ensuring compliance with certain enhanced requirements with respect to this as well. II. Previous legal position in Germany and the BaFin s administrative practice The KAGB itself does not contain any general provisions regarding the question whether the granting, prolongation, or restructuring of loans for the account of an investment fund is permissible. According to the BaFin s previous opinion, the granting of loans for the account of an investment fund was inadmissible on principle, with the exception of the granting of shareholder loans for the account of such AIFs for which the KAGB does not provide any product requirements at all or for such AIFs for which it provides virtually no requirements i.e., in particular, general open-ended specialized AIFs, hedge funds, and closed-ended specialized AIFs. 1

The admissibility of the restructuring or prolongation of loans was generally assessed based on whether the elements of Section 1 Subsection 1 Sentence 2 No.

2 The admissibility of the restructuring or prolongation of loans was generally assessed based on whether the elements of Section 1 Subsection 1 Sentence 2 No. 2 Alternative 1 KWG (Kreditwesengesetz, German Banking Act) regarding a credit business were present and whether a corresponding obligation to obtain authorization had been established (please cf. the BaFin s guidance notice Merkblatt der BaFin - Hinweise zum Tatbestand des Kreditgeschäfts, version as of April 2014, German language version only). An obligation to obtain authorization under the KWG as was regularly the case in the event of genuine phase financing or the provision of new credit funds used to exclude the admissibility pursuant to the KAGB. The result of the BaFin s restrictive administrative practice was that foreign debt funds which are admissible in other European countries were either dependent on a bank acting as an intermediary (what is called a fronting bank) with respect to the financing of projects or companies in Germany, or could merely act under the passive freedom to provide services granted by European law. III. Fundamental change in the BaFin s administrative practice 1. based on European requirements In the meantime, there exist several European regulations 1 for various special types of AIFs where the granting of loans explicitly forms part of the permissible activities of the AIF; most recently - in the ELTIF Regulation - the European legislator has explicitly provided the possibility for an ELTIF to provide loans directly to qualifying portfolio undertakings. As the European AIFM Directive does not contain any product regulations as opposed to the UCITS Directive and thus does not impede the admissibility of such granting of loans for the account of an AIF, the ESMA endorses the admissibility of loan origination by means of direct lending for the account of an AIF (what is called a Loan Originating Fund) and is currently preparing a corresponding discussion paper. In other jurisdictions like Ireland, Italy, or Malta, the Loan Originating 1 E.g., Regulation (EU) No 345/2013on European venture capital funds (EuVECA Regulation), Regulation (EU) No 346/2013 on European social entrepreneurship funds (EuSEF regulation) and the draft of the regulation on European long-term investment funds (ELTIF Regulation). Fund is already specifically regulated by legislation or by supervisory authority provisions. In the context of these developments, the BaFin has now changed its previous administrative practice and now classifies the granting, restructuring, and prolongation of loans for the account of an AIF as part of collective investment management. Therefore, it is exclusively the KAGB as the lex specialis which governs a more specific subject matter and thus overrides the more general KWG (please confer the scope exceptions pursuant to Section 2 Subsection 1 No. 3b and Subsection 6 No. 5a KWG) which has to be consulted when deciding the question whether this type of investment activity is permissible. Note: In practice, the question whether a fund manager may grant uncommitted funds for its own account to third parties is a question that has to be distinguished from the activity for the account of the AIF; here, pursuant to the BaFin practice, the KAGB principle that the more specific regulation prevails over the more general regulation still applies and opposes this, even if the granting of the loan is effected in the context of what is called the group privilege, i.e., intra-group, within the relevant group of companies. 2. for registered fund managers and fund managers fully subject to the obligation to obtain authorization Both fund managers that are fully authorized pursuant to Section 20 KAGB (fund managers) as well as fund managers that, due to the threshold rules, are merely registered pursuant to Section 44 KAGB may subject to the admissibility according to the KAGB grant and/or restructure and prolongate loans for the account of certain AIFs, 2

3 without triggering an obligation to obtain authorization pursuant to the KWG. Even though the BaFin does not distinguish between domestic and foreign fund managers in its statement and merely quotes the KWG s scope exceptions regarding domestic fund managers, the changed administrative practice as we understand it does also apply directly to European fund managers and foreign management companies, because the KWG, in turn, contains a conform exemption clause for such non-domestic fund managers (please cf. Section 2 Subsection 1 No. 3c and Subsection 6 No. 5b KWG), and a discriminating treatment at any rate with respect to European fund managers would hardly be compatible with the principle of non-discrimination under European law. At this point, however, it is necessary to point out that according to the BaFin s recommendation the provisions under Sections 26, 28, and 29 KAGB (which are otherwise not applicable; they are provisions relating to the prevention of conflicts of interest, proper business organization, and risk management) have to be complied with when taking advantage of the enhanced investment opportunities. 3. but only for certain types of funds With respect to the types of funds for whose account the enhanced investment opportunities shall apply, the BaFin restricts this to AIFs for which the KAGB provides (virtually) no product regulations. According to the BaFin s opinion, this includes the following: general open-ended specialized AIFs (Section 282 KAGB); hedge funds (Section 283 KAGB); all closed-ended specialized AIFs (Section 285 KAGB); specialized AIFs below the threshold (EUR 100 or 500 million) pursuant to Section 2 Subsection 4 KAGB; internally managed AIFs under Section 2 Subsection 4a KAGB (less than EUR 5 million AUM and not more than 5 natural persons as investors); and internally managed retail AIFs in the legal form of a cooperative under Section 2 Subsection 4b KAGB (not more than EUR 100 million AUM and a statutorily secured minimum return, e.g., energy cooperatives under the Erneuerbare Energien Gesetz [German Renewable Energies Act]). Consequently, the BaFin s changed administrative practice does not in principle affect UCITS, specialized real estate funds [Immobilien- Sondervermögen], open-ended specialized AIF with fixed investment conditions (previously: specialized funds pursuant to the InvG [German Investment Act], old version), or any retail AIFs managed by a fully authorized fund manager or a fund manager registered according to Section 2 Subsection 5 KAGB. However, the BaFin furthermore grants permission to the abovementioned AIFs to restructure and prolongate such loans which said AIFs were permitted to acquire under the KAGB s product regulations as unsecuritized loans. In brief: An AIF as, for example, an open-ended specialized AIF with fixed investment conditions that is permitted to acquire unsecuritized loans shall henceforth also be entitled to prolongate or restructure such unsecuritized loans. 4. and with enhanced requirements However, the BaFin does point out in its statement that it is intended by German legislation to include concrete provisions as to the granting, restructuring, and prolongation of loans by AIFs in the KAGB (e.g. by means of the upcoming shadow banking regulation) and recommends the compliance with enhanced requirements. In detail: (a) as to the granting of loans (i) granting of loans only by closed-ended specialized AIFs Because of the opposing requirements set forth in the UCITS Directive (please cf. Article 88 Subsection 1), the granting of loans by UCITS is excluded by law. However, even with respect to AIFs, the BaFin narrows the group of possible Loan Originating Funds even further in its recommendation, to the effect that only closed-ended specialized AIFs shall be entitled to grant loans. Thus, Loan Originating Funds in the form of a general open-ended specialized AIF (Section 282 KAGB) do not comply with the BaFin s recommendation, even though the BaFin explicitly does affirm that such investment funds which are virtually unregulated as to the product level are permitted to grant loans. It re- 3

4 mains to be seen whether and, if applicable, under which conditions deviations from this recommendation are possible. (ii) no granting of loans to consumers Moreover, it is still not recommended to grant loans to consumers in any case, if acting otherwise, the provisions contained in the BGB [Bürgerliches Gesetzbuch, German Civil Code] regarding consumer loan contracts and the upcoming requirements of Directive 2014/17/EU on credit agreements for consumers relating to residential immovable property should be taken into account. (iii) no granting of loans in the event of any conflicts of interest Granting a loan is equally undesirable if this leads to a conflict of interests and such conflict can be avoided by not granting the loan. This concerns primarily the granting of loans to the fund manager itself, the AIF s depositary, or the outsourcing company of the fund manager or the depositary. In our opinion, the same has to be assumed with respect to granting loans to another AIF managed by the fund manager or to persons belonging to the fund manager s management. (iv) Leverage has to be restricted The BaFin takes up a critical stance regarding the use of leverage in Loan Originating Funds. In the event that, against the BaFin s recommendation, leverage was to be used nonetheless, it should be reduced to a very limited extent. The BaFin does not list any further specifications. However, judging from the BaFin s statements in its letter dated May 12, 2015, it is hard to imagine that the BaFin would permit a leverage of 150 % or 200 % as, e.g., in Italy or Ireland. A guideline may possibly be provided by the ELTIF Regulation draft, according to which an ELTIF is generally permitted to take out loans in the amount of up to 30% of the fund s value, however, it may not use them to grant loans to portfolio companies. It remains to be seen which road German legislation is going to take. (v) No borrowing from the public Moreover, the BaFin points out that no simultaneous borrowing from the public and granting of loans by an AIF is permissible, because according to the BaFin s opinion the Capital Requirements Regulation (EU) Nr. 575/2013 (CRR) may be applicable in such cases (combination of deposit and lending operations). (vi) Requirements as to risk management Account should also be taken of the BaFin s enhanced requirement that the fund manager, when managing a Loan Originating Fund, has to comply accordingly with the MaRisk requirements (circular 10/2012 BA - Minimum Requirements for Risk Management ndschreiben/dl_rs_1210_ba_marisk.pdf? blob=pu blicationfile) to the extent to which they pertain to the lending business and can also be applied to the granting of loans for the account of AIFs. According to the BaFin s opinion, this includes, e.g., the requirements as to credit business procedures, provisions pertaining to the granting of loans, further processing of loans, monitoring of loan processing, intensive support, management of non-performing loans, risk prevention, procedures for the early detection of risks, risk classification procedures, and preparation of risk reports. Regarding the recommendation concerning this matter, it remains to be seen which standard the BaFin is expecting with respect to the corresponding implementation and to which extent concessions are permissible for reasons of proportionality. In this respect, moreover, it has to be questioned whether AIFs which are merely granting shareholder loans to the extent to which this was hitherto permitted also have to comply with the MaRisk requirements. The BaFin, at any rate, has hinted in its statement that, under certain conditions, requirements may be lowered. (vii) Provisions as to maturity transformation In order to avoid maturity transformation, fund managers which are granting loans for the account of an AIF should not take out short-term loans for the purpose of financing the granting of long-term loans. (viii) Risk diversification Even though the KAGB s product rules, in accordance with the requirements pursuant to the AIFM Directive, generally do not require risk diversification with respect to closed-ended specialized AIFs, 4

5 the BaFin recommends but without substantiating this any further to establish certain limits for risk diversification for Loan Originating Funds, as, e.g., a limitation of the risk per borrower (issuer limit). Consequently, for the time being, the decision when an appropriate diversification of the risk of default is ensured remains within the fund manager s discretion. (ix) Liquidity reserve Furthermore, with respect to the management of Loan Originating Funds, the BaFin recommends to maintain a minimum liquidity reserve by investing in assets that are easily disposable, for the purpose of being able to pay any of the AIF s loan liabilities which become due. It is not really possible to understand this demand of the BaFin, because the fund manager has to maintain an appropriate liquidity management for all investment assets that it manages anyways, unless it is a closed-ended investment fund, where there is no leverage (please cf. Section 30 Subsection 1 Sentence 1 KAGB). Since, however according to the BaFin s opinion Loan Originating Funds are supposed to (or should) be set up only as closed-ended specialized AIFs without (significant) leverage anyways, the BaFin s recommendation could be understood as a clarifying substantiation to the effect that the minimum liquidity reserve is only required in the case that against the BaFin s recommendation the Loan Originating Fund itself does also use leverage. Elsewise, it would not be clear which liabilities under the loan have to be serviced. Moreover, the BaFin apparently imputes in this respect that the granted loans themselves have to be classified as assets that are difficult to liquidate. b) as to prolongation and restructuring (i) broad scope of application In contrast to its handling of the situation with respect to loan originating by means of direct lending by an AIF, the BaFin actually expands the group of investment funds that are permitted to restructure and prolongate existing loans, and it permits this for all those AIFs which are permitted to acquire unsecuritized loans pursuant to the KAGB. Therefore, the innovations take effect with respect to (general) open-ended specialized AIFs (with fixed investment conditions), closed-ended specialized AIFs, and other special funds [Sonstige Sondervermögen] as well as AIFs that are simply managed, below the threshold, by a fund manager that ismerely registered (please cf. above). However, when it comes to the enhanced requirements, the BaFin distinguishes between openended and closed-ended specialized AIFs, as follows: (ii) Open-ended specialized AIFs As to the field of open-ended specialized AIFs, the BaFin advises, in general terms, that the risk management and the liquidity management of fund managers that are subject to the obligation to obtain authorization has to be appropriate within context of the new investment opportunities. Therefore, investment in the form of the acquisition of unsecuritized loans for the account of (general) open-ended specialized AIFs (with fixed investment conditions) or hedge funds should not be predominant e.g., not more than 50% of the value of the open-ended AIF should be invested in unsecuritized loans. Most recently, the opportunity for insurance companies to invest their restricted assets also in (open-ended/closed-ended) specialized AIFs that may invest up to 100% of their resources in unsecuritized loans which was created in connection with the amendment of the Anlageverordnung [German Investment Regulation] (please cf. our GSK Update The New German Investment Regulation) was acclaimed, but this enhancement with respect to insurance law is now, in turn, being restricted again under investment law with respect to open-ended specialized AIFs. (iii) Closed-ended specialized AIFs With respect to the field of closed-ended specialized AIFs, the BaFin repeats the general principle that appropriate risk management and liquidity management need to be ensured by fund managers that are subject to the obligation to obtain authorization, however without requesting a corresponding limitation in this respect. Thus, there exists no limitation that is subject to proportionality where closedended specialized AIFs are concerned. IV. Conclusion and prospects The BaFin s change of the administrative practice has to be acclaimed. Its previous dissenting opinion had led to a significant locational disadvantage for fund providers in Germany and, moreover, had 5

6 entailed significant legal uncertainties at least with respect to investments for foreign providers. The trend to promote the loan funds market segment, which had already been started by the adaptation of the Anlageverordnung [German Investment Regulation] (please cf. above), is therefore continued in a consistent manner. However, the change in the BaFin s administrative practice must not be mistaken for a carte blanche granting unconditional authority to loan funds or even for the admissibility of fund managers engaging in the lending business: On the one hand, the BaFin restricts the admissibility of the lending business to the granting, restructuring and prolongation of loans for the account of the corresponding AIF. It still remains to be inadmissible for a fund manager to grant loans for its own account due to the principle that a more specific regulation prevails over a more general regulation. On the other hand, by means of its comprehensive recommendations, the BaFin limits the loan opportunities to certain types of funds also on the AIF level and ties them to rather severe substantive requirements when compared to international standards. Eventually, the decisive factor with respect to the type and the specific scope of the currently recommended restrictions will be the results and/or requirements that the ESMA will reach in the context of its consultations as well as what the legal framework which is yet to be adopted (KAGB amendments) will look like. In any case, it is already clear that the progressive regulation will lead to new challenges for the market participants, at the latest when the current shadow banking initiative by EBA will be implemented (please cf. Draft EBA Guidelines on limits on exposures to shadow banking entities which carry out banking activities outside a regulated framework under Article 395 para. 2 Regulation (EU) No. 575/2013, EBA/CP/2015 / 06, Consultation Paper of EBA dated March 19, 2015). Therefore, it would be a mistake to expect too many liberties and latitude. Dr. Timo Patrick Bernau Lawyer Munich office bernau@gsk.de Dr. Oliver Glück Lawyer Munich office glueck@gsk.de 6

7 Copyright GSK Stockmann + Kollegen All rights reserved. The reproduction, duplication, circulation and/ or the adaption of the content and the illustrations of this document as well as any other use is only permitted with the prior written consent of GSK Stockmann + Kollegen. Disclaimer This client briefing exclusively contains general information which is not suitable to be used in the specific circumstances of a certain situation. It is not the purpose of the client briefing to serve as the basis of a commercial or other decision of whatever nature. The client briefing does not qualify as advice or a binding offer to provide advice or information and it is not suitable as a substitute for personal advice. Any decision taken on the basis of the content of this client briefing or of parts thereof is at the exclusive risk of the user. GSK Stockmann + Kollegen as well as the partners and employees mentioned in this client briefing do not give any guarantee nor do GSK Stockmann + Kollegen or any of its partners or employees assume any liability for whatever reason regarding the content of this client briefing. For that reason we recommend you to request personal advice. GSK STOCKMANN + KOLLEGEN Berlin Mohrenstraße Berlin Tel Fax berlin@gsk.de FRANKFURT/M. Taunusanlage Frankfurt Tel Fax frankfurt@gsk.de HAMBURG Neuer Wall Hamburg Tel Fax hamburg@gsk.de BRUSSELS GSK Stockmann + Kollegen 209a Avenue Louise B-1050 Brüssel Tel Fax bruessel@gsk.de HEIDELBERG Mittermaierstraße Heidelberg Tel Fax heidelberg@gsk.de MUNICH Karl-Scharnagl-Ring München Tel Fax muenchen@gsk.de SINGAPORE GSK Stockmann (Singapore) Pte. Ltd. 25 International Business Park German Centre, # Singapore Tel Fax singapore@gsk.de Our partners of the Broadlaw Group: Lefèvre Pelletier & associés in France, Nabarro in the United Kingdom, Nunziante Magrone in Italy and Roca Junyent in Spain

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