• Dzeneta Schitton

Early risk warning systems legally obligatory in Germany

Updated: Sep 7, 2021


It is clear that global economy is switching to data driven and strategic decision making and that using advanced predictive analytics, in order to detect risks in due time while keeping the competitive advantage, is becoming a standard in many industries. This is something we clearly see and it makes sense from an economic point of view as it follows the newest developments in the world of business and technology.


However, the necessity and the benefits of an early risk detection systems were recognised by the experts, and partially also by the legislators, long time ago, long before we had such a computing power and tech developments as we have today. Here Germany is a great example.


Following experiences and lessons learned when many big companies in the nineties experienced severe crisis (Metallgesellschaft AG and the Schneider Group for example) , some of them resulting in insolvencies, the German legislator recognised the advantage and necessity of introducing an early risk detection system as an obligation for both - stock exchange companies and as well others legal company forms.


Introducing early warning system into legislation


In order to strengthen the general management and other decision making bodies obligations, which are set in Stock Corporation Act from 1965 ( germ. Aktiengesetz ), the legislator passed the new article law - KonTraG (germ. Gesetz zur Kontrolle und Transparenz im Unternehmensbereich). This law regulates, more in detail, obligations of decision makers, supervisory boards and auditors when it comes to achieving a higher level of transparency and control in the company sector.


The aim of the KonTraG was to improve corporate governance in German companies . Therefore, with this article law, a number of provisions from Commercial (germ. Handelsgesetzbuch - HGB) and Stock Corporation Act (Aktiengesetz) have been changed and expanded, especially when it comes to the liability of the board of directors , the supervisory board and the auditors.



The core of the new legal change is therefore a regulation that forces company management to introduce and operate a company-wide early warning system for risks (risk early warning system), as well as to publish statements on risks and the risk structure of the company in the management report of the company's annual financial statements .



The obligation to implement an early warning system is therefore put on the management boards as a part of Article 91, section 2 AktG. It clearly states that:


The management board is to take suitable measures, and in particular is to institute a monitoring system, in order to allow developments jeopardising the company’s continued existence to be identified at an early point in time.


Such "developments that endanger the continued existence of the company" are in the expert discussions usually defined as a result from combined effects of individual risks, which obliges companies to carry out a risk analysis and risk aggregation on a regular basis .


Auditors standards only first step for fulfilling legal requirements?


Auditors are according to article 317 (4) of the Commercial Code (germ. Handelsgesetzbuch HGB) obliged to ensure compliance with the new regulations, in particular with regard to the existence and operation of a risk management system and the associated measures in the area of ​​internal revision and make it part of the audit report.


With this regard, the newest IDW test standard 340 ( IDW PS 340 ) was passed in 2020. It is focusing on the article 91 (2) AktG in order to insure that the suitability of the risk management measures is being checked during the balance sheets examinations.


The fact, that after so many years early warning system being part of German legislation, auditors standards are reflecting it more in detail and inserting at as a part of balance sheets examinations is very positive one.



 


However, based on the expert discussion on this matter. there are a few considerations to be taken into account.



  • The IDW PS 340 standards are not necessarily corresponding to the overall legal obligations companies and their decision makers have according to the subject laws and


  • the positive remark by the auditors does not guarantee that the legal requirements are fulfilled.


  • these auditors standards are referring only to the article 91 (2) of the Stock Corporation Act but not also the other legal requirements such as article 93 from the same law, which is part of another auditors standard (DIIR auditing standard no 2) or the newest StaRUG Law which was not effective at the time of their publishing.


 


So the management and supervisory boards of every single company have to make sure that the measures implemented are right for their industry and will in fact achieve the goal legislator had in mind with early warning system provisions.


The legal requirements are partially exceeding the obligations by the auditors standards.




And what all this means for German real estate companies?


As for any other industry, it is clear that real estate industry has to achieve a general expert consensus what are the suitable measures and tools to be implemented in the risk management systems in order to comply with the auditors standards as well as with broader legal regulations.


The goal is to achieve that the early warning system actually does its role in the practice and enables the company to foresee risks in the due time, acts on them in order to prevent any negative consequences resp. to be aware of the potential dangers on the way. Ideally, company should implement risk management system as a strategic tool.


However, the starting point is that the real estate industry, especially in the field of risk management belongs to "slow industries"- most of the companies in the industry are, when it comes to risk, still in the "best and worst" case analysis, relying mostly on qualitative risk assessments while the quantitative methods are very limited resp.still based on simple "as it is" calculations, without taking into account the inputs such as risk aggregation or risk bearing capacity and especially without future projections.



 


We at, D-Darks are very pleased to find out that the most prominent German experts in this field, such as Werner Gleissner or Cay Oetner are in the opinion that appropriate risk measures to be implemented in the real estate sector would be without any doubt stochastic modelling and Monte Carlo simulations, which represent a big part of our Smart predictive technology solutions.


The primary requirement of PS 340 new version for correct risk aggregation is again a clear sign of the introduction of fully integrated financial planning with the inclusion of stochastic modelling of the risks. This modelling is to be carried out via a Monte Carlo simulation of the individual properties and subsequent aggregation at the portfolio or company level in order to determine the total scope of risk in an aggregated manner. In this context, it is particularly important to note that the threat to continued existence usually occurs as a result of the combined effects of various risks (see Gleißner, 2017a).


This is especially true for real estate portfolios, as the cash risk factors of even supposedly well diversified portfolios are often strongly correlated (see Oertel et al., 2019).



 


Fore sure, with implementing quantitative predictive analytics systems focusing on the financial risk parameters such as liquidity, equity, debt covenants and similar the real estate companies will be on the good way to achieve efficient risk management systems which will enable them, not only to comply with legal requirements but also to to use risk management systems as strategic decision making tool.


Conclusion


We are in the opinion that the tech tools we have at our disposal in recent years are enabling us to go beyond mere legal regulations but complying with the newest requirements.


We are able to quantify different kinds of information and to find tech tools which will help us not only to work with the numbers, but also to implement "soft information" such as expert standpoints and market sentiment into these forecasts. This makes it possible to have the best out of both worlds and by using custom made algorithms, created by the industry experts include all of the real and practical challenges real estate professionals have in their everyday business.


The fact is, this train has come to the station and sooner or later companies will have to go in this direction in order to at least comply with legal requirements. This will bring the necessity for the new way of thinking, seeing the markets and portfolios as well as making the decisions. So why to keep only with legal necessities?


The possibilities the new technologies are offering to the decision makers are endless. Namely, management and supervisory boards have a possibility to embrace the new form of strategic thinking where the automatisation of the risk process, which is based on objective data being deeply analysed, while providing them with simple to use and fast results. Portfolios and markets being implemented in one, simple to use interface is the next step in doing business in the tech dominated world.


Getting away from only gathering endless amounts of the data and basic analytics as this is simply the "business speed" the global economy passed by and moving to the next level sometimes seems a big challenge for such a traditional industry as real estate. But the successes we see happening in the asset management and IoT field does indicate that the industry is ready to innovate also in the other fields, especially important and crucial ones such as risk management.


The time has come when every company has to have ability to see through the market and portfolios in present and future time - real estate companies are no exception!


Some of them are well on that way already so why not to see the whole industry following?


As logical this next step might sound, the true is that implementing these risk management systems does not come without its challenges from different aspects - legal, business and tech related ones.


Speaking as a lawyer, I have to say....legal regulations are always an excellent opportunity and starting point to think about necessity of change, as well as an introduction into a "change mindset" appropriate for a company and its portfolios. More on this topic coming up!