Legal term “Funds” – Definition, legal classification, and key aspects
Definition and general characteristics
The term “Funds” (plural of fund, also investment funds) refers, in the context of capital market law, to a legally independent pool of assets managed by a capital management company (KVG) for a multitude of investors according to the principle of risk diversification. These funds can include various types of investments, such as securities, real estate, money market instruments, or other assets. The legal structure, management, and supervision of funds are generally strictly regulated by national and European laws and regulations.
Legal bases and statutory frameworks
European legal bases
The foundation for the regulation of funds in Europe is in particular Directive 2009/65/EC (UCITS Directive), which contains provisions for undertakings for collective investment in transferable securities (UCITS). Supplementary to this, Directive 2011/61/EU (AIFM Directive) regulates alternative investment funds (AIFs) that do not fall under the UCITS Directive. Both frameworks have been enacted with the goal of enhancing investor protection, promoting market stability, and safeguarding the integrity of the financial market.
National legal bases (Germany)
In Germany, the relevant provisions are primarily specified by the German Investment Code (KAGB) as well as by ordinances issued by the Federal Financial Supervisory Authority (BaFin). In addition to the licensing, organization, and supervision of capital management companies, the KAGB also governs the types and structures of funds, as well as the requirements for fund management and the custody of fund assets.
Types of funds and their legal implications
Open and closed-end funds
A fundamental distinction is made between open-ended and closed-ended funds:
- Open-ended funds are characterized by the fact that investors can generally purchase and redeem shares during the fund’s term. The KVG is obliged to allow redemption of shares at the current net asset value, subject to legal exceptions (e.g., suspension of redemption in the case of liquidity shortages).
- Closed-ended funds allow the acquisition of shares only during a placement period; redemption prior to the fund’s liquidation is generally not intended. During the fund’s term, investors are bound to their investment.
Investment funds and special funds
Within open-ended funds, a further distinction is made between retail funds, which are open to a broad range of investors, and special funds, which are reserved exclusively for institutional investors. Special funds are subject to less restrictive investment requirements but are subject to specific transparency obligations.
Contractual and corporate law foundations
Funds can take various legal forms:
- Funds in contractual form (e.g., German Sondervermögen): A contract between the investor and the management company (fund terms) governs the fiduciary management of the assets in the interests of the investors. The assets are legally separated from the management company’s own assets.
- Funds in corporate form (e.g., investment stock corporation, limited partnership): Here, the fund is operated as a separate legal entity, investors are shareholders and hold corresponding shares in the company.
Supervision and management
Capital management company
The management of a fund is the responsibility of a licensed KVG, which is subject to national and European licensing requirements and statutory conduct rules. The KVG is obliged to invest investors’ assets according to legal requirements and the fund’s specific investment terms. It is subject to ongoing supervision by BaFin or the relevant national regulator.
Depositary
The safekeeping of fund assets is carried out by a depositary (custodian bank), which must be institutionally and personally separate from the management company. In addition to safekeeping duties, the depositary is particularly responsible for monitoring and controlling the legality of the fund’s transactions (especially the use of assets and the valuation of the net asset value).
Investor protection and transparency regulations
A central element of fund regulation is the protection of investor interests. Key measures include:
- Disclosure requirements: Funds are required to publish regular reports (annual report, semi-annual report), sales prospectuses, and key investor information (KIID/KID).
- Information obligations: Investors must be clearly and comprehensively informed about risks, cost structures, investment goals, and opportunities.
- Segregation of special assets: Legally, fund assets must be separated from the assets of the management company to ensure creditor protection for investors in the event of insolvency.
Tax aspects
In many countries, including Germany, funds are subject to special tax treatment. Of particular significance since 2018 is the German Investment Tax Act (InvStG), which regulates tax liability at both fund and investor level and deals with different types of funds in varied ways for tax purposes (e.g., retail funds, special investment funds).
Civil liability and legal protection
In connection with fund investments, civil liability can arise for capital management companies, depositaries, and intermediaries in the event of breaches of duty, in particular relating to defective information, misadvice, or breaches of duty in the context of fund management. Investors have civil claims, such as for damages or rescission. In Germany, fund products are also subject to collective legal protection through the Capital Markets Model Case Act (KapMuG).
International perspective
In addition to European regulations, various fund regimes exist worldwide (e.g., U.S. mutual funds under the Investment Company Act of 1940). Cross-border fund investments are thus subject to further regulatory, tax, and supervisory requirements.
Summary
Funds is a central concept in financial and capital markets law, encompassing a range of legal structures, regulations, and protective mechanisms for collective asset investments. The legal framework is highly differentiated at both the European and national levels. Objectives range from investor protection and market integrity to the promotion of efficient collective asset management in the interests of institutional and private investors.
Frequently Asked Questions
What regulatory requirements apply to the establishment of a fund?
The establishment of a fund is subject to strict regulatory requirements which may vary depending on fund type, target market, and regional legal framework. Within the European Union (EU), the regulatory framework is primarily provided by the Directive on Undertakings for Collective Investment in Transferable Securities (UCITS) and the Directive on Alternative Investment Fund Managers (AIFMD). Key requirements include authorization and registration with the relevant supervisory authority (e.g., BaFin in Germany), compliance with minimum capital requirements, preparation and regular updating of sales prospectuses and key investor information (KID/KIID), as well as comprehensive transparency and reporting obligations towards investors and authorities. Additionally, the appointment of independent depositaries and adherence to strict risk management, corporate governance, and compliance guidelines are required. Breaches of these regulations may result in legal consequences up to and including prohibition of fund operations.
What is the role of prospectus and disclosure obligations for funds?
Prospectus and disclosure obligations are a core element of investor protection and serve to enable investors to make informed decisions regarding the acquisition of fund shares. The issuer of a fund is legally required to prepare a sales prospectus and a key information document, which must present all legally required relevant information clearly and comprehensibly. This includes information about the fund manager, investment strategy, costs and fees, risks, performance, and tax aspects. The prospectus must be updated regularly and upon significant changes. There are also ongoing publication requirements so that changes are documented promptly and transparently to investors. Breaches of these obligations can lead to investor claims for damages as well as regulatory sanctions.
What is the significance of licensing and supervision of fund companies?
Licensing and ongoing supervision of fund companies are mandatory and serve to uphold the integrity of the financial market and protect investors’ interests. Fund companies must apply to the relevant supervisory authority (in Germany: BaFin) for authorization and provide extensive evidence of their organizational, personnel, and capital resources, their reliability and qualifications, as well as appropriate business processes and control systems. Ongoing business operations are subject to requirements for risk management, compliance, and reporting. Supervisory authorities monitor ongoing compliance with regulatory requirements, conduct audits, and may impose sanctions in the event of violations, ranging from fines to revocation of authorization.
What legal requirements apply to the management and custody of fund assets?
Fund law prescribes a strict separation between the management of fund assets and their custody in order to prevent conflicts of interest and abuse. The fund manager is responsible for the selection and monitoring of investments, while the fund assets must be held by an independent depositary (custodian bank). The depositary is obliged to monitor ownership rights, control transactions, and ensure that the issuance and redemption of shares, as well as the use of funds, comply with legal and contractual provisions. This legal structure aims to protect investors in the event of insolvency of the management company or the depositary and ensures that the fund assets are used exclusively in the interests of investors.
What tax regulations apply to funds and their investors?
Funds and their investors are subject to different tax regulations, which may vary nationally and internationally. In Germany, for example, the Investment Tax Act (InvStG) distinguishes between retail funds and special funds and regulates taxation at the fund and investor level. While funds classified as “investment funds” are generally tax transparent and certain income is taxed at the investor level, domestic and foreign funds are subject to different taxation procedures. Specific rules also apply to distributions, reinvested earnings, and capital gains. Funds are required to disclose tax-relevant information and report to tax authorities. Investors should also check whether double taxation agreements or exemptions apply.
What legal risks exist for investors in connection with funds?
Investors face various legal risks in connection with funds. These include the risk of incorrect or incomplete prospectus information, resulting claims for damages, the insolvency risk of management companies or depositaries, and risks arising from changes in the regulatory and tax environment. Furthermore, fund structures that do not meet legal requirements may lead to the fund not being allowed to operate as intended and potentially needing to be unwound. In cases of prospectus errors, breaches of fund management duties, or other violations, investors have legal avenues to assert claims for damages.
What statutory requirements apply in relation to sustainability aspects and ESG criteria for funds?
As part of the EU Sustainable Finance initiatives, fund companies are required to consider sustainability aspects and ESG criteria (Environmental, Social, Governance). The Disclosure Regulation (SFDR) requires transparency regarding strategies for dealing with sustainability risks and their potential impact on returns. Furthermore, funds that expressly pursue ESG objectives must report on their specific ESG strategy and relevant indicators and disclose these in the sales prospectus and on the company website. Violations of disclosure and documentation obligations can have both regulatory and civil law consequences.
