I. The German Ringfencing Act

As a reaction to the financial crisis in 2007/2008 and to address risks in connection with the “too big to fail” phenomena, the German legislature issued the Ringfencing Act in 2014 (the “Act”).

In a nutshell, the Act forbids big CRR-credit institutions (depending on certain balance sheet thresholds) to engage in proprietary business (Eigengeschäft), proprietary trading (Eigenhandel) and credit/guarantee business with hedge funds (i.e., AIFs whose leverage exceeds three times their NAV).

The Act is mainly addressed to German CRR-credit institutions exceeding the relevant thresholds but is also applicable to foreign institutions – however, the Act’s effects are limited to business operations in Germany that maintain a branch or other physical presence in Germany or operate in Germany by way of cross border provision of services. EU CRR-credit institutions using the cross border passport do not fall under the Act.

The above-mentioned proprietary and lending/guaranty business is only permissible under the Act if it is completely ringfenced from the CRR-credit institution by using a financial trading institution (Finanzhandelsinstitut) for such business. The main reason for the ringfencing is the protection of (retail) deposits held with the CRR-credit institution. More generally, the ringfencing of the deposit business from risky investment banking activities is intended to avoid situations where the German government has to decide about the rescue of banks that failed due to the realization of risks arising from investment banking activities with taxpayer money.

A violation of the Act constitutes a criminal offence.

II. Recent Developments

The Federal Financial Services Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – “BaFin”) provided detailed Interpretive Guidance on the Ringfencing Act in 2014, which has been updated in August 2020.

Main updates of the Interpretative Guidance relate to (i) the exception that fully secured loans do not fall under the ban, (ii) structures of indirect credit business with hedge funds, i.e. where loans are granted to SPVs which are controlled by a hedge fund, and (iii) the treatment of investment companies that are registered as U.S. 1940 Act funds with the SEC and companies that are regulated as BDCs under the 1940 Act.

(i)         Fully Secured Loans

Regarding the “fully secured loans exception,” BaFin particularly provided detailed clarification under which circumstances sub-participations in relation to credit and guarantee business with hedge funds qualify for this exception. Such sub-participations can only be supported with collateral of sufficient quality and quantity if the collateral embedded in the sub-participation can be classified as typical banking collateral for loans.

(ii)        Indirect Lending Structures

As to indirect lending structures, BaFin clarified the requirements when such indirect lending is in scope in its recent Interpretative Guidance. As a general rule, the following two requirements must be met:

a)      The hedge fund or its asset management company must have control over the SPV which is deemed to exist if the hedge fund or its asset management company can decide discretionarily about the business activities of the SPV (‘look through’ approach).

b)      The SPV is exclusively used for the implementation of the hedge fund’s investment strategy, which is not the case for operative companies.

(iii)      U.S. 1940 Act Funds and BDCs under the 1940 Act

Under current legal restrictions, investment companies which are registered as U.S. 1940 Act funds with the SEC and companies that are regulated as BDCs under the 1940 Act are not allowed to use leverage that would lead to their qualification as hedge funds for purposes of the Ringfencing Regulation. Accordingly, BaFin ruled that CRR-credit institutions can generally assume that such companies do not qualify as hedge funds and, thus, are out of scope of the Ringfencing Regulation. However, this does not hold true in cases where the CRR-credit institution has knowledge that such companies use leverage on a substantial basis, possibly even in contravention of the legal restrictions.

III. Relevance of the Ringfencing Act

The Act becomes relevant in private equity transactions with large banks involved as financing institutions. As long as banks falling under the Act have not yet completed the separation of business as required under the Act, they are generally not allowed to (indirectly) grant loans to hedge funds. In such cases, the exception about fully secured loans might pave the way to grant the loan anyway. Another potential solution is to get a written confirmation from the PE fund that the borrowing fund does not qualify as a hedge fund. However, this is only an option in cases where it is absolutely clear that the borrower is not a hedge fund.

On the whole, one can say that the recent updates of the BaFin Interpretative Guidance provide further clarifications on practically relevant questions, in particular in connection with the treatment of loans/guarantees in private equity transactions under the Act.

The Covington Financial Services team will continue to monitor the situation and update you on any new developments.