The German regulator BaFin is being sued for abuse of authority following one of the biggest fraud scandals of the decade with German payment processor, Wirecard AG, filing for insolvency owing €3.5 billion and its chief executive arrested on suspicion of accounting fraud and market manipulation. This article looks explores the situation and considers the need for change.

Wirecard’s collapse – the activities of BaFin (and the FCA)

Valued at over €20 billion less than 2 years ago, the financial technology group’s share price plummeted by a dramatic 95% in a matter of days in June this year, before the company ultimately succumbed to its fate after repeatedly failing to explain its accounts. This rapid decline occurred after it came to light that the company had deceived shareholders and creditors about the company’s balance sheet, allegedly inventing €1.9 billion assets that executives have since admitted probably does “not exist”.

After the first suggestion of balance sheet irregularities arose in 2008, Wirecard AG appears to have successfully misled investors, its auditors EY and the regulator, the German Federal Institute for Financial Services Supervision (“BaFin”), for over a decade. In 2015, the Financial Times began publishing its House of Wirecard series, in which it raised doubts about the legitimacy of the group’s accounts. Wirecard AG responded to the criticisms with allegations that this was an attempt to manipulate share prices.

However, Wirecard AG had, it appears, been falsifying documents, and had invented €1.9 billion that it said were held in escrow accounts in two banks in the Philippines. These banks have since denied having any relationship with the company. This deception was an “elaborate and sophisticated fraud” according to EY, after they were unable to verify the €1.9 billion when conducting an audit of the group. The big four firm is now under intense scrutiny and criticism for its handling of the company, as is the German Regulator, BaFin, for its inaction. Both now face legal action; the former facing a class-action lawsuit brought by investors, and the latter facing allegations of inadequate investigation and supervision.

In the UK, in order to safeguard customers’ money in the wake of Wirecard AG’s collapse, the Financial Conduct Authority (“FCA”) imposed heavy restrictions on one of the company’s subsidiaries, Wirecard Card Solutions (“Wirecard UK”), including a prohibition on carrying out regulated activities or disposing of any assets or funds. This had a large knock-on effect for companies, such as prepaid credit card issuer, Pockit, and their customers, who relied on Wirecard UK’s payment processing services. The FCA has since removed most of these restrictions, but Wirecard UK remains unable to transfer its own assets and is subject to restrictions on where it is authorised to hold customer funds.

The BaFin and EU response

The German regulator has come under intense scrutiny since the scandal was revealed. While there has been some commentary about BaFin’s limited prosecution and investigation powers, there are widespread allegations that the regulator was intentionally protecting Wirecard instead of conducting proper investigations.

The head of BaFin tried to defend its omissions by telling German MPs that the regulator’s ability to act was limited because Wirecard was classified as a technology company rather than a financial services provider – so even though BaFin supervised “Wirecard Bank” (the deposit-taking part of the group), Wirecard itself was considered by BaFin to be outside its remit. This explanation in itself has highlighted the deficiencies in the regulator’s approach.

The EU’s financial watchdog, the European Securities and Markets Authority (“ESMA”), is currently investigating BaFin’s handling of the Wirecard affair. In addition, Valdis Dombrovskis, Vice-President of the EC, has announced a review of ESMA itself to determine whether any restructuring (financially and operationally) is required in order to strengthen defences against fraud in the EU.

Investor action against BaFin

In a very unusual step, a class action has been filed in Frankfurt on behalf of Wirecard investors against the German regulator BaFin for “abuse of office” in relation to its failure to investigate Wirecard. A statement by Tilp, the German law firm representing investors, explained that:

“In our view, BaFin grossly neglected its statutory tasks and powers by refusing to pursue investigations of its own against Wirecard AG for market manipulation, while taking biased action against journalists and short-sellers even though the agency was fully aware of the media reports about massive irregularities at Wirecard AG.”[1]

This is a significant development because (like many regulators internationally) BaFin is protected by an immunity (referred to in German law as a “liability privilege”) which generally prevents any action against it. However, a German Court has previously recognised that the immunity does not protect BaFin from liability in cases in which an abuse of authority has been committed.[2] Andreas Tilp of Tilp announced that they will be relying on this point in the Wirecard class action:

“In particular, our analysis shows that Section 4 paragraph 4 of the Act on the Federal Financial Supervisory Authority (FinDAG) is not applicable here. The reason is that the adjudication handed down by the Federal Court of Justice has recognized that this particular rule of law does not serve to protect BaFin from liability in cases in which an abuse of authority was committed”[3]

FCA immunity in comparison

Like BaFin, the UK financial regulator, the FCA, has statutory immunity under the UK Financial Services Act 2012 (“FSA”).[4] However (unlike BaFin), there are explicit legislative carve-outs, albeit very limited ones, which mean that the FCA does not benefit from the immunity if the relevant act or omission was:

• in bad faith; or
• in breach of Section 6(1) of the Human Rights Act 1998, the FCA has acted in a way which is incompatible with the European Convention of Human Rights.[5]

While there have been previous attempts to sue the FCA under the Human Rights Act in the European Court of Human Rights,^[6] there have been no reported attempts to utilise the FSA carve-outs in litigation against the FCA. If a Wirecard-esque scandal occurred in the UK – with a repeat of such extreme failings on the part of the FCA – it might be that investors would try to rely on the bad faith route in order to make a claim against the FCA.

The need for change

The class action against BaFin has put a spotlight on regulators’ immunity where there have been allegations of gross failings in regulatory duties.

More broadly, the Wirecard saga has been a wake-up call for the German financial system and ESMA’s supervisory powers.