Public Marketing of Hedge Funds in Germany

Selected legal issues

Dr. Stefan Kugler, LL.M. and Dr. René Lochmann, LL.M.
Originally published in the December 2005 issue

The new German Investment Act (Investmentgesetz – GIA) which became effective on January 1, 2004, not only permits the establishment of hedge funds in Germany, but also lays down the rules for the public marketing of German and foreign hedge funds in Germany. These mandatory rules serve to protect inves-tors, mainly by establishing requirements for informing and warning investors properly, and by requiring contracts to be in writing under certain circumstances. Under the statutory concept, the level of protection depends on whether a legal entity or a natural person acquires the hedge fund units. The current distribution practice demonstrates that the complexity of the issues related to these investor protection rules heavily increases in cases in which intermediaries (primarily con-tract and investment brokers as well as financial commission agents) are involved in the distribution process.

I. Public distribution and eligibility of hedge funds for public distribution

The investor protection rules of sec. 121 GIA only apply in cases in which German or foreign hedge funds are sold via public marketing. Public marketing means marketing which takes place by way of public offering, public advertising or in a similar manner (sec. 2 (11) GIA). The opposite is distribution via private placement. Although the distinction between public marketing and private place-ment depends on each individual case, marketing basically is considered to be public if the offer or advertising is addressed to an undefined, individually neither limited nor limitable category of persons. In contrast, marketing is in principle considered non-public if the addressed potential investors are persons which are known to the offeror or approached on the basis of a specific selection using speci-fied individual criteria.

Currently, only units of German and comparable foreign funds of hedge funds which satisfy the criteria of sec. 113 GIA are eligible for public marketing in Ger-many. Sec. 113 GIA, inter alia, provides that only up to 49% of the fund's value may be invested in bank deposits and money market instruments, and that only up to 20% may be invested in one target (single) hedge fund. German and foreign single hedge funds as well as comparable investment stock corporations may be distributed solely via private placement. However, at present the public marketing of single manager hedge funds in Germany is under discussion.

II. Requirements in case a legal entity purchases hedge fund units

In cases in which a legal entity in Germany acquires hedge fund units, the mandatory provisions of the GIA provide that the selling documents must be of-fered to the potential investor before the respective purchasing agreement is con-cluded (sec. 121 (1) GIA). The selling documents comprise of the detailed sales prospectus, the contractual terms and conditions or articles of association, the an-nual report and, if published, the subsequent semi-annual report. The statutory provisions do not require submitting a specific warning, as required for purchases by a natural person (see below), about the risks involved when investing in hedge funds. Since by definition (sec. 13 German Civil Code), except for rare cases, a legal entity cannot qualify as a consumer, the offeror need not comply with the provisions for distance selling (Fernabsatzrecht) which only are applicable to contracts concluded between an entrepreneur and a consumer exclusively by means of a distance selling device (letter, fax, phone, email, etc.). Likewise, the provisions for trading of options and futures, setting forth additional information obligations (Finanztermingeschäftsfähigkeit), are not applicable.

III. Requirements in case a natural person purchases hedge fund units

The mandatory statutory provisions of the GIA increase the level of investor protection if a natural person purchases hedge fund units. First, the sales docu-ments (as set forth above) have to be handed out to the natural person before the respective purchasing agreement is concluded (sec. 121 (3) GIA). The statutory provisions, however, do not define the form in which the sales documents must or can be handed out. It is only safe to say that transmitting the sales documents in hard copy is sufficient to comply with the information requirement. Due to the lack of any respective court or administrative decision it remains unclear whether the document can also be submitted by way of email, compact discs or of any other electronic form. From an investor protection perspective, an electronic sub-mission of the sales documents appears to be satisfactory, as long as the potential investor obviously possesses the technical devices and knowledge to retrieve and read the information. Nonetheless, due to the uncertain legal position it is advis-able for the selling party to submit these documents in hard copy.

Secondly, thestatutory provisions stipulate that the potential investor must be warned about the risks involved with the purchase of hedge fund units by using a standardized text (sec. 121 (3) sentence 3 GIA). This text reads: "Warning by the Federal Minister of Finance: Investors in this investment fund must be prepared and able to sustain losses of the capital invested up to a total loss" (sec. 117 (2) GIA).

Third, the mandatory statutory provisions set forth the requirement that the purchase must be in writing (sec. 121 (3) sentence 2 GIA). The wording of the respective section is imprecise as to the issue of whether the whole agreement or merely the application to purchase the investment units must be in writing. How-ever, the reason given by the German legislator is the provision of an explicit warning to the potential investor by requiring a signature, indicating that merely the investor's application would fulfill the requirement "in writing."

Fourth, since a natural person may qualify as a consumer in the meaning of sec. 13 German Civil Code – which basically is the case if he or she purchases hedge fund units for private and not commercial purposes – the mandatory provi-sions for distance selling (Fernabsatzrecht) have to be complied with if the units are sold exclusively by way of distance selling (letter, fax, phone, email etc.). These provisions generally apply if buyer and seller have not had any physical contact before or at the conclusion of the purchase agreement. In cases in which a physical contact has been established to a certain extent, the applicability of the provisions for distance selling depends on the intensity of the contact. Only if the purchaser had the chance to obtain all material information from the person who actually was present, the consumer protection rules for distance selling do not apply. If the provisions for distance selling apply, and this may be the case where direct or internet banks are involved or investment units are sold through fund supermarkets or the Internet as such, the seller must provide the purchaser with a specific list of information as set forth in sec. 312c German Civil Code and sec. 1 of the respective Ordinance on Information Obligations (BGB-Informationspflichten-Verordnung). Due to an explicit exemption, the provisions for distance selling do not constitute a right of revocation. However, the pur-chaser might have such a right under sec. 126 GIA, which is applicable for cases in which the purchaser of units has been induced to make a declaration of intention directed at the purchase of units through oral negotiations outside of the permanent business premises of the person selling or brokering the sale of the units.

Finally, even if a natural person qualifies as a consumer, the consumer protec-tion based provisions for the trading of options and futures (Finanzter-mingeschäftsfähigkeit) do not constitute any further notification requirements. These provisions only apply for trading of futures and options. Although hedge funds may enter into derivative contracts, units of hedge funds themselves do not qualify as options or futures and therefore do not trigger these requirements.

IV. Public marketing by intermediaries

If third parties (intermediaries) – like financial commission agents or contract-ing and investment brokers – are involved in the marketing process, the German provisions for public distribution unfortunately do to not stipulate (i) who has to comply with the mandatory provisions for investor information and protection, nor (ii) towards whom the information requirements have to be fulfilled. Whether and to what extent the statutory stipulations and principles provide for sufficient an-swers, especially in view of an efficient investor protection regime, requires a separate reflection as to the different transactions.

1. Financial commission business

Certain intermediaries regularly offer and sell investment units on a commis-sion basis. Generally, such commission agentsconduct business in their own name on behalf of a third party (sec. 383 et seqq. of the German Commercial Code). A commission sale comprises of two trading transactions. First, the commission agent purchases the units from the selling party. Second, the commission agent sells these units to the investor. Both trading transactions might trigger the re-quirements of sec. 121 GIA (information, warning, in writing).

Regarding the transaction between the selling investment company and the commission agent, the information and warning requirements of sec. 121 (1) or (3) GIA do not have to be complied with, since they apply only for the purpose of the protection of investors. Commission agents as the purchasers of the units, how-ever, do not intend to invest in units on their own behalf and therefore do not qual-ify as an investor. In contrast, the commission agent selling and transferring units in turn to the investors has to comply with the statutory provisions requiring him to offer or hand out the selling documents and provide the standard warning text. Moreover, the contract between the commission agent and a natural person must be in writing. If the final purchaser also qualifies as a consumer, the provisions for distance selling (Fernabsatz) apply, requiring the commission agent to provide specific additional information to the investor. Conclusively, the investor protec-tion rules only have to be complied with in the relationship between the commis-sion agent and the investor, provided that they publicly market the hedge fund units.

2. Investment broking

Hedge fund units are also marketed and sold through investment brokers. Investment broking comprises of the purchase and sale of financial instruments or their documentation (sec. 1 (1a) sentence 2 no. 1 of the German Banking Act). Investment brokers marketing hedge fund units publicly have to comply with the investment law provisions and, if the purchaser qualifies as a consumer, with the provisions for distance selling (Fernabsatz). As a result, the investment company is exempt from the obligation to comply with these requirements towards both the investor and investment broker. In this case the statutory principles and rules do not raise any specific issues.

3. Contract broking

Hedge funds units may also be marketed and sold by contract brokers. Con-tract broking comprises of the purchase and sale of financial instruments in the name of and for the account of others (as their legal representative) (sec. 1 (1a) sentence 2 no. 2 of the German Banking Act). Following the German statutory provisions and general principles of representation (sec. 164 et seqq. of the Ger-man Civil Code) the contract broker – as the representative of the investors – is the person who has to be informed properly and is decisive as to whether the (intensi-fied) provisions for the purchase by natural persons apply. Furthermore, under the general principles of representation, only the sales contract between the seller of the investment units and the representative must be in writing if the buyer is a natural person.

However, these general principles conflict with an effective protection of the investor, if the contract broker does not care solely about the investor's financial interests, but (also) strives for the financial gain of the investment company and/or of himself, e. g. due to commission payments by the investment company. Hence, in such cases the statutory concept must be modified, i. e. the information and warning obligations must be incumbent on the contract broker. Moreover, in con-trast to the statutory contract, not only the purchase agreement signed by the agent and the selling party, but also the power of attorney provided by the investor to the contract broker has to be in writing in cases in which the purchaser is a natural person.

As a result, since the contract broker bears these obligations, the investment company as the selling party is exempt from the information and warning obliga-tions. The investment company must nonetheless ensure that the sales contract is made in writing if the investor qualifies as a natural person. Moreover, it is rec-ommended that the investment company verifies that the contract broker is prop-erly authorized by a power of representation which is also made in writing and which authorizes the contract buyer to buy the specific hedge funds in the name of and for the account of the investors. Otherwise, the sales contract might be invalid if the investor does not approve the transaction afterwards (see sec. 177 (1) of the German Civil Code).

4. Summary

The public marketing of hedge fund units in Germany requires a strict compli-ance with certain investor protection and information rules under the GIA and, if they are sold exclusively by way of distance selling to consumers, the provisions for distance selling as well. If intermediaries – particularly commission agents as well as investment and contract brokers – are involved in the marketing process, generally it is up to them and not to the investment companies to fulfill the manda-tory requirements. The general principles applicable to such intermediaries re-quire a modification in view of the efficient protection of investors.

For further information please contact Stefan Kugler, Partner, Reed Smith LLP on or Rene Lochmann, Associate, Reed Smith LLP, on or visit