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The Changing Environment For Derivatives In Germany--Part 2

Last week's Learning Curve dealt with new legislation and supervisory regulations and directives, while this week's will look at judicial decisions, tax and accounting.


The Federal Supreme Court of Germany (the Bundesgerichtshof) recently ruled that structured products such as convertible bonds (and by analogy reverse convertibles, exchangeables and reverse exchangeables) do not constitute financial derivatives and are therefore not subject to the stricter investor protection rules applicable to derivatives transactions. According to the Federal Supreme Court, the fact that an investor buying a convertible bond has to pay the full market price upfront means that the risk inherent in buying convertible bonds is generally comparable to that of buying normal shares. The ruling reverses a decision by the Berlin Court of Appeal last June that required banks to adhere to the disclosure standards for derivatives when offering convertible bonds. The case concerns an unnamed 79-year old investor who had bought DEM50,000 (USD24,000) of convertible bonds but only received DEM33,000 worth of shares on redemption and alleged that the bank did not provide fair and appropriate advice. The case has been referred back to the Court of Appeal.


Tax and Accounting

The use of special purpose entities is coming under increasing scrutiny. From a German trade tax perspective, the full deductibility of interest expenses incurred by an SPE is threatened where the SPE can be construed to have a permanent establishment or place of central management in Germany. German tax authorities have unofficially taken the position that an SPE which purchases receivables from a German originator will become tax resident in Germany by virtue of the continued administration and collection of the sold receivables by the originator. While this position has not been extended to SPEs used in synthetic transactions (which do not purchase receivables, but only assume risks inherent to such receivables), caution should nevertheless be exercised to ensure that the SPE in a synthetic structure is not (factually) managed from within Germany. This is an issue of particular concern in collateralized debt obligation transactions, whether synthetic or true sale, sponsored by a German bank or asset manager; while the seat and management of the SPE is located outside Germany in such transactions, the German asset manager often factually manages the SPE.

The consolidation of SPEs has become a hot topic since the Enron debacle. Amendments to FASB 140 in the U.S. are anticipated to be released shortly. These changes to the principles of consolidation applicable to SPEs under U.S. General Accepted Accounting Principles are also expected to impact International Accounting Standards. Of course, the increasing number of German corporates which report under U.S. GAAP or IAS are monitoring these developments with great interest. At the time of writing, it is generally thought the amendments will see an SPE consolidated with the party deriving the greatest benefit from the relevant transaction. It is conjectured that such a change in the principles of consolidation could require that the SPE in a CDO transaction be consolidated with the asset manager of the transaction or that the SPE in an ABS transaction be consolidated with the originator of the transaction.

There is also a debate surrounding the application of the German Foreign Investment Act to notes issued and offered for sale in Germany by a foreign SPE in an ABS or a CDO transaction. The issue is of equal application to an SPE in a true sale structure (which purchases a portfolio of bonds or other debt instruments) and to an SPE in a synthetic structure, which uses the proceeds of the relevant note issue to purchase a portfolio of bonds or other debt instruments. To the extent an SPE falls within the definition of an investment fund and the notes issued by the SPE are construed to constitute participatory interests in such investment funds under the Foreign Investment Act, a punitive tax would be levied against German purchasers of those notes unless the SPE has a tax representative in Germany. The debate is accordingly focussed on the question of whether the risk diversification afforded to noteholders of an SPE in an ABS or CDO transaction is sufficient to characterize the SPE as an investment fund and, if so, whether the notes can be characterized as participatory interests therein irrespective of their possible legal characterization as debt instruments. Irrespective of the outcome of this debate, the risk that an ABS or a CDO transaction falls within the scope of the Foreign Investment Act can be mitigated through proper structuring.


This week's Learning Curve was written by Oliver Kronatand Francesca Guolo, associate lawyers at Clifford Chance Pünder in Frankfurt.

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