On June 2, 2010 the German Federal Ministry of Finances ("Bundesministerium der Finanzen", "BMF") submitted a ministerial bill to prevent abusive security and derivative transactions ("Draft").
An Overview of the Draft
The Draft plans on regulating the following central areas:
- Prohibition of naked short sales in shares and certain sovereign bonds
- Notification and publication duties for holders of net short sale positions
- Prohibition of certain credit derivatives
- Authorization of the Federal Financial Supervisory Authority ("Bundesanstalt für Finanzaufsicht", "BaFin"), to preliminarily prohibit or discontinue trading individual financial instruments
- Authorizations of the BMF, to not only preliminarily prohibit or discontinue trading individual financial instruments.
The planned regulations in the Draft would lead to changes in the Securities Trading Act.
History of the Prohibition of Short Sales
The Draft was preceded by several preliminary drafts. In the Legal Update dated May 10, 2010 we had already reported on another draft law, which, amongst other things, was intended to prohibit certain short sales and certain credit derivatives. The BMF had then decided to commence a separate legislative procedure for that part which should cover short sales and credit derivatives. On May 25, 2010 the BMF had sent out a draft law which had been discussed in an informal hearing on May 27, 2010. The original draft dated May 25, 2010 had more restrictions, e.g. also a prohibition of naked currency derivatives in Euro and of financial instruments, which depict short sales in stocks and certain sovereign bonds. The legislator has maintained the option of granting authority to enact these prohibitions by way of administrative ordinances or regulations.
The legislative procedure is conducted in view of the fact that in the past the BaFin had repeatedly (with interruptions) prohibited certain types of short sales by way of administrative ordinances. Recently, the BaFin had also prohibited the short sale of certain debt certificates and certain credit derivatives, which in turn led to harsh criticism.
The Draft in Detail
The Draft prohibits – as did previous drafts – naked short sales in shares or debt certificates by members of the European Union (whose statutory currency is the Euro), which are each registered with a domestic stock exchange in a regulated market.
From a German point of view the only exceptions are such stocks from a company with a registered seat in a different Member State of the European Union or another state which is a party to the Treaty on the European Economic Area or a third party state, insofar as the stocks are not exclusively traded at a domestic stock exchange in a regulated market.
The Draft's definition of "naked short sales" is based on the definitions used in earlier administrative ordinances issued by the BaFin (as well as previous bills). A short sale will be considered to be a "naked" short sale, if at the closing of the transaction, the seller is not the owner of the shares sold and has neither an unconditional right in personam nor in rem to the transfer of title of a respective number of shares of the same kind. The sale of e.g. borrowed shares will thus not be regarded as a "naked" short sale and still be allowed.
In the previous draft dated May 25, 2010 the prohibition should also extend to transactions in derivatives, the value of which is directly or indirectly deduced from the price of the above mentioned stocks or would correspond to such a short sale according to economic analyses. What was criticized was that this was a quasi "prohibition of all derivatives with a negative delta on all German stocks". Consequentially, this prohibition was excluded from the Draft, however, it can be re-issued by way of statutory regulations or administrative ordinances.
The Draft has remained nearly unchanged vis-à-vis previous drafts in regards to transparency obligations. Net short sales positions, i.e. not only naked short sales positions shall be subject to a transparency system. The information and publication obligations in the case of net short sale positions include all of the aforementioned shares. The threshold for the information obligation is 0.2 percent of the shares issued by a company. Further information and publications will be required for each alteration amounting to 0.1 percent. These obligations also apply to positions existing prior to the effective date of the proposed Act.
A net short sale position includes – after netting out all financial instruments and considering the overall economic interest in the shares – the amount exceeding the short position (whether naked or not). In as far as the actual calculation method is concerned the legislator refers to the possibility of a respective administrative ordinance by the BaFin.
The prohibition of the credit derivatives includes such transactions which have as a reference obligation (the "obligation" as is the case in derivatives) at least also an obligation of corporations or governments of Member States of the European Union, which have the Euro as their statutory currency. The term "credit derivatives" is to be interpreted broadly and also includes Total Return Swaps or Credit-Linked Notes. The prohibition does not apply insofar as the credit derivative causes risks in the reference obligation or another correlating position in a financial instrument when regarded from an economic point of view. This position must either exist or be taken on in an immediate temporal connection with the execution of the credit derivative. The exact determination of the correlation or materiality will certainly still lead to some discussions with the BaFin. On the one hand, it is positive that the legislator has expanded the original restrictions on risks in financial instruments, probably having noticed that this application range of credit derivatives as a permitted hedging measure would have unnecessarily restricted these. The use of credit derivatives can also be economically useful for risks which do not stem from financial instruments (e.g. in the insurance area). On the other hand it is positive that the original restriction on existing positions was expanded in order to not unnecessarily complicate the risk hedging for the secured party.
The prohibition of naked currency derivatives, which was part of the previous draft, has now been deleted from the Draft. The legislator has (as with derivatives, the value of which is deducted from stocks or debt certificates) kept the option open to declare a prohibition later via legal regulations or administrative ordinances.
There is an exception to the prohibition of trading and transparency obligations for securities services companies or comparable companies with a registered seat abroad, insofar as it includes self-trading in stocks or debt certificates, on a regular and stable basis for self offered prices, and they hedge the previous positions arising herefrom. An exception was included in the Draft for proprietary trading with credit derivatives which were not yet covered by an exception in the Draft. Clearly, the legislator has noticed that in this market, in which many deals are conducted over-the-counter, this could otherwise have resulted in substantial liquidity losings (if the market were theoretically restricted to Germany). However, in contrast to the previous draft "persons" are not privileged by proprietary trading but rather "financial services companies" or comparable companies abroad. Generally, the conduct of self-trading will lead to a regulated financial services business according to German regulation. According to the Act's reasoning this exception should in our view also be applicable to banks which – amongst other things – conduct self-trading. A new aspect is the obligation to immediately inform the BaFin of the intent to commence self-trading and name the respective financial instruments. As by way of this regulation the BaFin intends to receive comprehensive information regarding activities in self-trading and the respective exceptions from the above-mentioned prohibitions it is questionable why the existing self-traders were not also included in the oblitation to inform.
If you would like more information about the foregoing, please contact the author of this Legal Update, Andreas Lange at +49 69 79 41 1941.