BaFin plans to ban the sale of credit-linked notes to retail investors

The German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht “BaFin”) published a draft order to prohibit the distribution of credit-linked notes to retail investors on 28 July 2016. Issuers and consumers can comment on the draft order until 02 September 2016. According to BaFin, the high complexity of credit-linked notes requires the prohibition to ensure effective consumer investor protection.

The proposed order would ban issuers, companies and persons from marketing, distributing or selling credit-linked notes to retail investors. Any activity designed to promote the sale of credit-linked notes to retail investors would be subject to the prohibition. This would include investment advice recommending credit-linked notes as well as sale of credit-linked notes without investment advice. Only future activities will fall under the order upon its enactment. Activities already concluded would not be affected by the order.

In its main argument, BaFin weighs the complexity of the financial instrument against the type of clients. BaFin asserts that retail investors would typically not be able to cope with the high complexity of credit-linked notes because of the relevant type of underlyings. Unlike for ordinary underlyings which are more familiar to retail investors, retail investors would generally not be in a position to estimate the probability of a credit event occurring. Retail investors usually lack relevant information and access to relevant information to estimate the performance of the instrument.

BaFin further bases its proposed ban on the argument that the product name being used to market credit-linked notes would be misleading to retail investors. The name “note” (in German “Anleihe”) would suggest that a buyer becomes a debt investor whereas, in reality, it is to a greater extent a “protection seller” providing insurance cover against default. Finally, BaFin highlights risks of conflict of interests in the product structure as the issuer and its affiliated undertakings might have a stake in the sold credit risks or entertain business relationships with the reference entities.

In determining whether credit-linked notes should be banned from the retail market, BaFin assesses criteria, which the European Securities and Markets Authority (ESMA) laid down in relation to product intervention measures that form the basis of BaFin’s restriction power under national law. Furthermore, BaFin employs very similar arguments to the ones ESMA used in a recent warning on the sale of speculative products to retail investors issued only a few days before the proposed BaFin ban. While the ESMA warning did not specifically relate to credit-linked notes, the BaFin line of thought is very much in tune with ESMA’s reasoning for investor protection.

Concluding, issuers, companies and persons that wish to sell credit-linked notes to retail investors in Germany should closely monitor further publications by BaFin in this regard. In case the proposed order comes into effect unmodified, the marketing, distributing and selling of credit-linked notes constitute a regulatory offence exposing them to supervisory authority sanctions under German law.

We will keep you informed about further developments.

See here the BaFin proposed order.
See here for ESMA’s recent warning about CFDs, binary options and other speculative products, p. 190 et seq.
See here for ESMA’s criteria to determine “significant investor protection concerns”.