When the IRR return becomes a liability risk for the distributor

A guest article by Dr. Johannes Fiala and Edmund Ranosch.

In a recent judgement of the LG Munich II (Az.: 9B O 3493/05 of 17.8.2006) a bank was condemned to the payment of damages, because its member of the board of directors had used in particular the IRR (Internal rate of return) yield method already in the year 1994 investor recruiting with the consulting discussion, without this method had been described sufficiently in its effects in the folder. One of the reasons given was that an average investor would not be able to make sense of a mathematical formula.

Not only the private investor, but also many client advisors are overwhelmed with such formulas. In doing so, the bank and the advising employee must take particular care in examining the products they are selling. The Federal Court of Justice requires a separate plausibility check, among other things for the economic viability of the product. No adviser should rely on the fact that auditors and the bank’s own audit department have already done so. The crux of the matter is that most prospectuses misrepresent the IRR calculation method in short form. Knowledge of the internal rate of return (IRR) method is still extremely patchy and flawed because hidden assumptions in prospectuses are not seen through, giving investors a false picture of returns. Why is that?

In financial mathematical terms, the IRR ratio assumes that the money is reinvested: In addition to the increase in value up to the end of the term, the IRR yield measurement is also based on the additional income from the reinvestment of the investment returns (current distributions and sales proceeds), although these are only fictitiously available.

The investor who consumes the returns, for example his current distributions, cannot reinvest anything and certainly not at the high IRR return rate mentioned in the prospectus. Rather, most shareholders in closed-end funds use the returns to immediately increase their standard of living.

It can be assumed that only a few shareholders reinvest their returns in a disciplined manner. And if they do, the real capital market interest rates at the time of the respective reflux differ significantly from the fictitiously assumed IRR rate of return. So the biggest shortcoming of the IRR method is the theoretical and unrealistic notional IRR rate of return.

This is because the desired result from the IRR sham return can never exist in reality. It is also unrealistic to assume that this reinvestment rate also applies to shorter residual investment periods towards the end of the term. Only in the case of accumulating zero bonds are the IRR requirements for reinvestment automatically met. In the case of non-accumulating investments and participations, the automatic reinvestment of reflows at the IRR rate of return does not occur under any circumstances.

An advisor who does not inform the investor about the fictitious additional returns of the IRR method not only damages his reputation and the reputation of the bank, but also massively deceives the investor about the true earning power of the fund participation. This can result in corresponding claims for damages up to a reversal of the fund shares at the expense of the bank.

If the IRR method is not made sufficiently clear to an investor, the bank, as the employer of its hired advisor, is liable if it turns out that the return ratio was overstated in the first place. Freelance employees of the bank are left to fend for themselves, despite their pecuniary loss liability policy, if the insurance does not kick in. The Federal Court of Justice (BGH) has obliged advisors and intermediaries to independently check products for plausibility.

It is also of no use to switch to the capital commitment method as an alternative to the IRR, because the same implicit reinvestment assumptions apply here. In any case, the necessary know-how is required for the plausibility check. The liability situation is further exacerbated if, in order to leverage the IRR return, a favourable share debt financing is sold by the company’s own credit institution.

Pointing to the huge IRR yield increase reinforces the flaw in the reinvestment premise because the reinvestment rate or IRR yield turns out to be even higher. In the years of loan repayment, nothing is reinvested because all returns go to interest and repayments of the share financing.

In the worst-case scenario of reversal, the bank is left with a mediocre yielding fund share and must also forego the interest margin income from the share financing. In addition, there is the wasted time for the consultation and, in addition, an image damage with a broad effect, which could result in customer losses.

If the IRR method continues to be applied so uncritically in practice, this could lead to claims for damages or, in the worst case, to reversals. Meanwhile, case law is becoming more and more pro-investor. The courts are now well on their way to uncovering the implications of the IRR methodology to the benefit of private investors. As a result, it is to be expected that the sometimes more harmless so-called yield lie will be exposed as a drastic yield swindle.

Not advising an investor transparently on IRR returns is likely to be incompatible with the mandatory risk management of a credit institution (Section 91 II AktG).

If the advisor claims “personal trust”, for example as an expert in his field, he may also be personally liable under certain circumstances (§§ 311, 241 BGB).

If the yield of a product is “glossed over” and the investor is thus deceived, the objective facts of capital investment fraud may be fulfilled. This legal opinion, which is held, among others, by the well-known senior public prosecutor Dr. Hans Richter, is known to numerous pecuniary loss liability insurers. There would be no liability coverage whatsoever in such a claim.

The case law on the duty to inform the investor about negative press can also affect yield advertising (§ 280 BGB).