by Johannes Fiala, lawyer
Leveraged transactions are in practice referred to by financial service providers as “savings annuity”, “savings annuity”, “lex annuity”, “interest rate differential transaction”, “loan-financed annuity”, “immediate annuity”, “leveraged annuity”, “guaranteed annuity”, “loan-financed life insurance”, “leveraged life insurance”, “fixed loan with redemption replacement”, “leveraged pool”, “loan-financed investment”, “fixed loan with repayment substitute”, “leveraged investment fund”, “loan-financed participation”, “special loan scheme”, “UK life insurance combined with a loan”, “financed unit-linked life insurance”, “snow annuity”, “mixed leveraged annuity”, “leverage effect”, etc. denoted. The public prosecutor’s office is dealing with this under the aspect of fraud or capital investment fraud. BaFin sometimes examines such transactions from the point of view of whether the necessary permission under the KWG has been granted.
The initial case: Dr. Peter Fleißig, physician with a well going practice, 45 years old, a wife, two children lets himself be informed by his financial advisor how he can earn even more money with his unencumbered house (market value 250,000 euros) and even come to an immediate pension. The model: The property is mortgaged: Bank loan with a mortgage as collateral. Of course, the loan is taken out in YEN or francs, because there the money is ‘apparently cheaper’. The money (loan) is paid into an immediate annuity (life insurance). With the pension also the loan ? ZINSEN are paid, and in the remainder the pension is to help to improve the family income. Additionally a savings plan (further life insurance with investment) is locked: With this money then at the end the mortgage loan (TILGUNG) is to be paid back. The bank lets itself assign this contract as security. The tax: Actually this model cannot go well before taxes, because the yield of the life annuity is mostly smaller than the costs of the loan. According to tax law, however, such annuities are only at the so-called share of income, so only partially taxable. The loan interest is deductible as income-related expenses. The horse foot: a) There is in addition no supreme court decision: It requires an individual case decision by the tax authorities ? and that is rarely caught up before conclusion of a contract, in order to go surely. b) There is the question whether an ?intention a profit and/or a total surplus to obtain ? (before taxes!) will be provable: Without the investment and a link to the loan and the annuity, this will hardly succeed. A model which, by the way, often only pays off with a constantly (!) high tax burden.
Termination: Investor Dr. Fleißig only notices the risks after years. Just when the stock market is experiencing massive price drops, the bank gets in touch with a request to strengthen the collateral. Dr. Fleißig has expanded his practice and cannot offer any additional collateral. The bank sets a deadline and threatens to cancel. The intermediary helplessly scolds the bank, because the credit institution was informed about the model before signing the loan. Dr. Fleißig lets his tax advisor do the math: If the contracts are terminated (prematurely), a ‘loss’ of 300,000 euros remains ? his inherited house will then be auctioned off. Dr. Fleißig thinks about how he should explain this to his wife.
The risks: the investor has not been advised about the following risks. 1st risk There is no case-by-case decision by the tax authorities. The tax office can change the “calculated profit after tax” into the opposite by a stroke of the pen. 2nd risk Even if the tax authorities recognise the model, this can in principle be cancelled at any time by the legislator. References to expert opinions of so-called tax experts? and circulars of the tax authorities do not help here either. 3rd risk No life annuity insurance gives a guarantee for the total return. With the minimum interest rate (for German life insurances 3.25% – formerly 4%) the model does not pay off. Profits in the future are uncertain. Only very few companies on the European market can be trusted to manage the ?non-binding? projections with a 7% return. Only very few companies on the European market can be trusted to actually achieve the ?non-binding? projections of a 7% return (and more) over the terms of such models of 10 to 20 years. 4. risk Numerous freelancers and self-employed persons have bought their investments (funds, real estate etc.) on credit: Due to the currency exchange rate risk, many a credit customer has already Later on, the borrower notices that, in addition to the seemingly low interest rate, he actually has to pay back considerably more because the foreign currency has become more expensive for him. 5. Depending on how the stock market situation has developed at the time the loan expires, there is a risk that the expected return will not have been achieved by the time the loan matures. Then the loan must be extended or the investment must be sold in a bear market at low prices. Dr. Fleißig has the risk that the loan is not extended, an option in the loan agreement is missing and, above all, the bank can demand additional collateral at any time. 6. risk Without a fixed interest rate, possibly also for the extension option, rising interest rates can at any time result in an additional burden that is no longer bearable, which leads to the liquidation of the collateral by the bank. Thus the model “bursts” like a soap bubble. 7. risk The model calculations assume that the investor has a certain tax situation. If the income is lost for a longer period of time, e.g. due to an accident or illness, or if there is a separation or divorce, the model usually no longer pays off. 8. risk It is a speculation with various assumptions: This can be referred to as a risk bundle, because numerous parameters must occur for it to work. Without hedging measures through contractual arrangements (vis-à-vis the bank and insurance companies), it can be a time bomb. Liability for advice: a) Documentation The advice given by the intermediary was not documented. Dr. Fleißig did not sign any instructions. He is considering suing for defective advice. Dr. Fleissig recalls that he was not informed about currency or leverage risks. The BHG decided such a case, with which the bank had required a subsequent additional collateralization of the credit because of currency rate decline: The customer could not add and thereupon the collateral (also the insurance) was used. Consequence: Compensation for damages ? similar risks await the consultant in the case of the financed immediate annuity if no information is given about conceivable risks (occupational disability, accident, loss of income, tax changes, etc.) or if these risks are not covered as far as possible. BGH judgement 09.07.1998 ? III ZR 158/97, BGH judgement 13.05.1993 ? III ZR 25/92, BGH judgement 04.02.1987 ? IV a ZR 134/85. b) Trade press The trade press must be read by the agent: The information is to be passed on to the customer: This also applies to incorrect or false information in the trade press. Even in the case of leverage transactions, the investor can claim years later that he would never have decided to invest if he had known the specialist info. Typical examples: Financed capital investment (rented property, closed real estate fund, combinations of loan and life insurance, etc.). Here there is a chance for investors to hold the intermediary and/or the financing bank liable. Also the seller of an investment (insurer, real estate seller) is basically responsible if the intermediary made incorrect calculations that became the basis for the investment decision. To the Nachlesen: BGH judgement 5 June 2000 ? III Z?RR 305/98 BGH judgement 9 March 1999 ? 1 StR 50/99 BGH judgement 6 April 2001 ? V ZR 402/99. c) Tax advice In numerous calculation examples, costs or expenses are not stated or are stated much too low or tax credits are stated excessively. Thus the investor can refer to a consulting error. In the case of public companies and builder-owner models, prospectus liability comes into question. BGHZ 71,284 BGHZ 111, 314. As soon as the investment intermediary makes his knowledge and experience available to the investor, an advisory contract comes into being. Thus the mediator guarantees (also for the partners standing behind the mediator) in their obligation circle also the correctness of the ?sample computations? to the individual case. BGH judgement 6 April 2001 ? V ZR 402/99. BGH judgement MDR 00, 405. Dr. Fleißig determines with entrance of the credit notice: First the mediator had the experience and I the money ? now it is reversed ?!
The tip for brokers, consultants, customers: Numerous banks like to finance according to the ?umbrella principle? When it is sunny, the credit is available ? when it rains (market price adjustment, reduction of the surrender value, reduction of the final bonus, etc.) the credit institution demands an increase of the credit collateral or makes the leverage transaction ?flat? by realization. The only protection: agreement of a clause in the credit contract ? e.g. after assignment of the policy to the bank as security, the agreement would be ?for the rest as a bank credit? or ?without further (going) securities? With it however also the banker carries a risk and exposes itself also to personal responsibility. Conclusion: This procedure ensures that the banker carefully checks how he evaluates the loan collateral, even if the capital investment develops differently than hoped.
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About the author
Dr. Johannes FialaPhD, MBA, MM
Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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