Reduction of liability and plausibility checks for investment advisors in closed-end fund offerings – Part 2

The investment adviser must fulfil his main duties. He cannot rely on the assessment of third parties. One will be able to trust an experienced investment advisor that he is able to carry out a plausibility check based on the basic investment criteria and specific extensions to the investment category.


Plausibility is the estimation of the correctness or consistency of information. Example: A prospectus offers the investor the prospect of receiving a total of 180 % of the distributions for his or her capital investment in 10 years. This represented an investor return after tax of 7,80 % per annum according to the IRR method. A financial mathematical professional will immediately realize that something can be wrong here, because a capital doubles only after 10 years at an interest rate of 7.2% p.a. (200% return on 100% capital investment). Here, too much IRR yield is given and it must be recalculated under which conditions this is achieved. The financial professional will then quickly notice that it has been assumed that the time-distributed returns are to be reinvested by the investor and that the IRR yield results from these additional returns in addition to the “normal” returns (170%). He will further note that the reinvestment of the returns distributed over time (distributions per year on average slightly more than 9% and returns from sales proceeds approx. 100%) need only amount to 7.80% reinvestment interest after tax. Why? In order to achieve the IRR yield of 7.80% p.a. on the capital invested, the latter must earn interest at 7.80% p.a. and, after 10 years, have final assets of approximately 284,200. This will be difficult because only 180 % will flow back according to the prospectus and a further 84.20 % from reinvestment because of the IRR method. If the investor wants to convert the returns immediately into consumer spending, there is nothing left for reinvestment and he should still achieve an (IRR) return of 7.8% p.a., which is completely implausible from a financial mathematical point of view in view of the returns. From this, the responsible investment advisor realizes that he must have a thorough command of the yield methods in every detail if he does not want to fall for false information. The plausibility of the profitability or earning power of the proposed investment remains his responsibility. He will not be spared his own business considerations if he wants to satisfy the strict BGH requirements. Of course, he must carry out his own considerations and document them sufficiently for the investor. On this point the plausibilities are in a mess.


The plausibilities in the security area (economic, legal and fiscal) must be checked. This begins with the seriousness and interconnectedness of the investor’s partners involved. The prospectus-checking auditor should have carried out a credit assessment of the initiators and guarantors, because almost only he is allowed to make an official insight into intimate company documents. Nevertheless, the investment advisor must keep his eyes open in the press and specialist bodies for the reputation of the providers. Negative reports from specialized organs are to be disclosed to the investor. Selected ratings are to be evaluated and also allocated to the investor. Since most ratings are paid for by the initiators, particular caution must be exercised in the evaluation. Depending on the type of product, the other contractual partners, especially the guarantors (rents, placement, etc.) must be checked. Those who have to pay for rent guarantees in the millions cannot plausibly ensure this with a newly founded limited liability company and minimum capital resources. The contents of existing letters of comfort from mothers with a good credit rating should be checked. With regard to the legal structure, it is advisable for the investment advisor to inspect the articles of association (usually printed in the prospectus) and to have the usual rules and regulations enforced by an experienced lawyer. It is no secret that in recent years the total loss risk has been described in dry words. After the slogan that with yielding the complete insert no additional payment obligation develops, …. however with present distributions the adhesion can revive again. Provided that the distributions are only made from liquid surpluses without a profit under commercial law at the same time, these can be claimed back from the creditors of the fund company (mainly financing banks) in accordance with § 172 para. 4 HGB. The fact that the investor, as a legal layman, has received and may keep the liquidity distributions in good faith (§172 para. 5 HGB) does not count for the insolvency administrator (see insolvency of the falkgroup). A legally experienced investment trustee, who holds the investor’s KG shares in trust and is also entered in the commercial register in place of the direct limited partner, does not always protect against damage by reclaiming the distributions already paid out. One cannot expect the layman to recognize the dangers of the execution of distributions, but one can expect highly decorated lawyers as investment trustees. The same applies to the controllers of the use of funds. What are their responsibilities? Just to send the transfers or to coordinate the payment obligations from the contracts with the services provided by the contractual partners and then to release the funds of the investors ? Anyone who, as an MV controller, finds out after debiting almost all funds that he does not yet have the power of attorney to release the funds from the investor’s account, is completely out of place. Tax security is only provided when the tax authorities have completed their final tax audits and have confirmed the tax declarations of the fund in their content. Deviations can occur from time to time, whereby plus/minus 5% of the estimated value is not usually considered a devaluation. One can be reasonably certain if the tax concept has already been approved by the tax authorities. Otherwise, the sword of Damocles of the tax authorities hangs over the fund. The tax authorities do not stop at newer product lines in particular, as the latest developments in multi-million film investments suggest. Otherwise the tax assessments in the age of yield-oriented investments are limited to the recognition of double taxation agreements and the flat-rate tonnage tax option. Both of these are regulations that are not particularly on fire because the state wants them. Newer forms of participation such as private equity funds are in the tougher focus of the tax authorities. Tax reports from renowned international tax consultancy firms make it easier for the investment consultant to gain an insight, but they are no last resort. Local legal opinions do not necessarily reflect the opinion of the tax authorities.


In the past, the tax burdens from the progression clause were handled lightly. The DTAs make the foreign earnings with the tax-free amounts there almost tax-free or under a comparatively low tax burden. This does not mean, however, that the German tax burden within the scope of the progression proviso is insignificant or negligible. This tax burden is by no means negligible in the case of earners far below the maximum progression, because the latter are able to determine their relevant average tax rate by attributing it to the taxable dt. income can be increased considerably. In contrast, high earners, who hardly experience any increase in their relevant average tax rate, which is relevant for the final additional burdens from the progression clause. This applies in particular to the acquisition of real estate abroad.

In addition to unobjectionable audit reports and tax reports, technical reports (real estate and ship appraisals, etc.) are often offered. It should be noted that only the time until the brochure is printed is included in the content. No information can be given with sufficient certainty about future developments. Accordingly, the investment advisor should be cautious in his future assessments. He should be particularly vigilant in the presence of witnesses whom the investor has invited to the meeting. The recording of the contents of the conversation (documentation) must therefore be carried out very carefully and countersigned; a newer additional burden, which can be a curse or blessing for the investment advisor in terms of liability.


This should in any case specify the risks, but under no circumstances should it be without reference to the risk of total loss. Similarly, no mention should be made of the lack of availability of the invested funds, even though the secondary market is still a small seedling (barely 1% of annual deposits). A long list of risks must be addressed and it is not sufficient to refer to the list in the prospectus, which systematises the risks and divides them into risks that threaten the investment and risks that threaten the investor. The risk notes, which are all without exception multi-page, have a disadvantage because they do not show individual and cumulative risk figures that show a dynamic risk-return structure in the past and quite not for the future. A plausibility check with regard to the risk is thus not possible, as is the case with the arithmetical yield check.


Current account balances, which accompany the fund statuses from the past and follow developments, are indeed informative about the work of the funds and their initiators. But what economic success can be read from this ? The example of a well-known provider, who proudly prices the IRR returns of his extensive sales of over 20 ship investments since then, still shows an IRR return of 5.9% (exactly 5.87%) for a fund in which €105,000 was invested and in which only €69,500 was returned after taxes in the total 16 years of the fund’s term. Imagine this : less is returned than invested (loss of about 35.000 €) and the IRR method wants to show an investor that he has still achieved a return ? This is a completely absurd result in terms of returns and is by no means acceptable. It is unacceptable because, according to the current account data, the time-distributed actual returns are smaller than the capital invested. The IRR terminal value formula suggests an IRR terminal value of €264,500 for the 16.2-year investment period and the 5.87% return on the capital invested, even though the investor has demonstrably only received €69,500 back after tax. A completely impossible result in reality. It further assumes that the investor could have always reinvested all initial positive returns at 5.87% p.a. The initiator is not at all aware whether reinvestment took place or could take place at all in view of the huge losses in distributions. The investors who immediately consumed the reflows had nothing to reinvest anyway. Here, the IRR method is used in a completely confusing way to prove the return without considering whether this can be proven in an economically reasonable way. A simple plausibility consideration tilts the IRR yield indication out of the shoes. The mere fact that a positive IRR return is shown in the event of a loss shows plausibly the weaknesses of the IRR method.


Does it help that the specialist journalists and rating agencies are drumming on the IRR yield and reverently praising new asset classes when the IRR yields of individual product lines leap for joy because of the supposedly faster returns (multiples of 2 and average capital commitment periods of less than 5 years are hailed as quality features)? Very little happens without reinvesting the returns at the IRR rate, and which investors succeed in reinvesting at the IRR rate, which is usually an after-tax rate of return? In the current IRR explanations, investors are not presented with the special reinvestment requirement.


A further plausibility check must be carried out for currency effects. Rarely is it made clear to the investor in the prospectuses how serious the influence on the yield can be. The sample calculations for the investor almost all calculate in the EURO for better understanding, although the lion’s share of charter or rental income is in the dollar. With expenditures in dollars, currency development does not play such a major role in the current phase of use. Only when exchanging dollars back into euros does it become somewhat more critical, which becomes significant at the latest when selling a ship on a one-off basis, because a larger amount is involved that has to be exchanged into euros. Let’s take the distributions in the above example and assume that these are USD amounts. For the investment expenditure with an exchange rate of 1 Euro to a USD 1.20 at the time of the purchase, he only spent 83,333 EURO and the US exchange rate in 10 years would be as weak as today with 1 EURO to 1.40 USD. When exchanging the invested 100,000 USD, which at the same time represents the sales proceeds in the example, only 71,248 EURO flow back in EURO plus the last current distribution of 6,429 EURO. In total 83.333 € would be invested and 137.023 EURO would be tiled back. If the EURO would be at par with the USD after 10 years (USD is getting stronger again), the reflux sum would be 168,167 EURO, which means 30,000 EURO additional proceeds. These are quite strong yield-influencing currency influences that no one can predict with certainty, but which should be explained to the investor if there is not to be disagreement between investor advisors and investors. Just as currency losses can occur, currency gains should also be addressed. It becomes even more complicated if a third currency (JPN or CHF) is added, which was built into the fund because of the low interest rates in the debt capital area. What is their influence over time and what will happen in 10 years or where will this currency stand in relation to the EURO then?



What is currently even less frequently mentioned is the influence of inflation. How does the local and the inflation rate in the fund currency influence the profitability in the selected investment form? Income from asset values is normally protected against inflation. But how is this to be assessed if the substance is invested in the dollar and inflation rates diverge against the EURO? Who are the winners and losers, and what are the investor’s real losses and gains in each currency at the end of the day?


Who can estimate the development of currencies and inflation rates with a reasonable degree of reliability? Who calculates the real cash flow course under different currency developments and who realistically shows real loss zones and real profit zones of the investors under these influences? After all, invested 100,000 EURO today do not have the same purchasing power as 100,000 EURO in 10 years as a return in the form of sales proceeds.


All these plausibility checks of individual characteristics of the fund investment to be assessed require a broad field of experience and intimate legal, tax and economic knowledge on the part of the investment advisors. How difficult is this for beginners and less experienced investment advisors to master? Where does he find support in the undergrowth between liability risks and pressure to succeed?


Other solution topics : coaching, advising the consultants and software programs and training on plausibility, etc. Information and clarification obligations, as well as documentation on the consulting process.


by Dr. Johannes Fiala / Diplom-Kaufmann Edmund J. Ranosch / Prof. Dr. Hans Jürgen Ott


published in Kredit & Rating Praxis 02/2008, page 29

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Dr. Johannes Fiala Dr. Johannes Fiala

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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