Both the desire for higher yields and the low interest rate environment of the past years has seen retail investors’ focus increasingly shifting to alternative forms of investment, including asset classes and investment funds that are typically reserved for professional investors. That shift pushed at open doors with asset managers seeking for new sales channels. The opportunities offered by distributed ledger technology through the “tokenisation of fund shares/units” appears to have further accelerated this trend.
Products which enable indirect investments in alternative investment funds that are – by law – reserved for professional and semi-professional investors only have now drawn the attention of the German financial supervisory watchdog BaFin. In a recent article published on 13 November 2023 in the BaFin Journal, BaFin takes a closer look at these products and warns financial market participants that it may open up product intervention procedures, which may ultimately result in a product ban, if required for the sake of investor protection.
I. BaFin’s findings
Retail investors in Germany are not permitted to directly invest in special alternative investment funds (Spezial-AIF) (Special AIF) – fund types which are rather flexible with regard to their structure and investment universe and hence only available to professional and semi-professional investors, as these are deemed to have greater financial expertise. Retail investors may only invest in so called public alternative investments funds (Publikums-AIF) and investment funds complying with the UCITS-Directive (UCITS) which are subject to stricter requirements and need to be approved by BaFin.
BaFin now announced to apply enhanced supervisory scrutiny where retail investors nevertheless gain indirect exposure to Special AIF and the aforementioned access restrictions do not apply for “formal reasons”. BaFin is particularly concerned with structures where the performance of the retail investors’ indirect investment reflects the performance of the underlying investment as if the investor had invested directly.
As an example, BaFin describes a structure which has also been used in the context of “tokenized fund units”: retail investors acquire subordinated bearer bonds (issued and recorded on the blockchain) from a special purpose vehicle (SPV) which invests directly into a Special AIF. Interest paid on such bearer bonds depends on the return of the SPV on its investment in the Special AIF. Thus, if the Special AIF distributes proceeds, is sold or liquidated at a profit, the retail investors will participate in these profits through interest payments on the bonds. Investors’ claims therefore directly depend on the performance of the underlying Special AIF.
BaFin’s warning is based on the assessment that indirect investments in Special AIFs are “complex and not transparent”. This is according to BaFin, first, because it is a “multi-level investment in a professional asset class”. In addition, BaFin criticizes that the indirect investment does not follow general rules, but depends on individually negotiated terms. Further, BaFin states that information material provided to investors does “inevitably” not contain all the details of the investment, but is limited to key information. BaFin draws the conclusion that the investment conditions of such indirect investments are not sufficiently transparent for private investors.
Moreover, BaFin finds that retail investors’ risks of losses are often higher with indirect investments than with direct investments, since both the direct (e.g. the SPV) and the underlying investment (i.e. the Special AIF) must be successful for the overall investment to generate a positive return.
Against this background, BaFin points out that it may open up product intervention procedures in case of concerns from an investor protection perspective. Depending on whether the concerns are substantial and the specific structure of the product at hand, BaFin announces to issue a product ban in “extreme cases”. Generally, as the executive director of BaFin, Thorsten Pötzsch, is quoted in the article, financial products shall not be designed to circumvent investor protection requirements. The legal basis for a product intervention is Article 42 of the European Markets in Financial Instruments Regulation (MiFIR) under which BaFin may prohibit the marketing, distribution and sale of financial products to retail investors.
A closer examination of BaFin’s arguments set out above gives rise to the following questions.
- Under German law, there is a type of investment fund that is explicitly available for retail investors, so-called Closed-ended German Publikums-AIF (Closed-ended Publikums-AIF), which may, in accordance with the list of eligible assets set out in in Sec. 261(1) KAGB, explicitly invest in closed-ended Special AIF (Sec. 261(1) no. 6 KAGB). Hence, it is questionable why the BaFin considers indirect investments in closed-ended Special AIF to be problematic.
- It is unclear why BaFin takes the view that the information material provided to investors for investments in bearer bonds does “inevitably” not contain sufficient information and is not sufficiently transparent for retail investors. Such analysis requires a case-by-case assessment.
- Indirect investments do not necessarily bear a higher risk of losses, especially if the underlying investment is not a single asset, nor do they necessarily cause higher cost. Such conclusion requires, again, a case-by-case assessment of the relevant product. If the first layer of the investment (e.g. the SPV) does not only hold one single but several assets, the risk of loss is decreased due to risk diversification. Further, a comparison of cost of a direct and an indirect investment is not appropriate where the direct investment is not permitted.
- BaFin does also not seem to take into account that indirect investments, e.g. the aforementioned bearer bonds, usually qualify as financial instruments themselves whose manufacturing and distribution is subject to (a different regime of) regulation and supervision. For example, product governance and marketing requirements may apply under MiFID II (as implemented by the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG)), and brokering and advising on financial instruments constitutes licensable business. Further, an investment broker or investment adviser (also if it only holds a license under the Financial Investment Brokerage Ordinance (FinVermV)) is obligated to carry out an appropriateness or suitability test, respectively (except where the financial instrument is acquired by way of execution-only).
Even if not all of the concerns raised by BaFin may be well founded, issuers and product manufacturers are well advised to pay close attention to potential allegations of circumvention structures when setting up multi-layer products enabling indirect investment of retail investors in Special AIF (including fund managers which consider cooperating with them) in order to not risk a product intervention procedure. An immediate measure would be using the aforementioned applicable framework of product governance rules, hence manufacturing the product and defining the target market such that access restrictions are not circumvented (i.e. applying the semiprofessional and professional investor thresholds as an access restriction to the relevant financial instrument). BaFin is said to have accepted products similar to the abovementioned bearer bonds in the past if the manufacturer applied the German investment fund access restrictions irrespective of the fact that the product did itself not qualify as an investment fund. Alternatively, product sponsors could choose structures which enable alternative and private market investments by retail investors at the outset, like the closed-ended Publikums-AIF mentioned above, or the European Long Term Investment Fund (ELTIF) in accordance with the revised “ELTIF 2.0”-Regulation (EU) No. 2023/606. The latter would additionally benefit from an EU-passport for distribution to retail investors in the EU, a concept which is otherwise only available for UCITS, but not for AIF.