In a nice coincidence of timing, while observers in the U.S. were awaiting the 9th Circuit decision in U.S. v. Arnold, on February 27, 2008, the German Federal Constitutional Court (Das Bundesverfassungsgericht (BVG)) announced an historic decision in a case also involving the individual's right to privacy of personal data stored in digital form. Whereas the 9th Circuit found such data to be no more entitled to constitutional protection at the border than underwear in a suitcase, the BVG held that the general Right of Personality (for our purposes, the Right of Privacy) contained in Article 2 the German constitution (das Grundgesetz) includes the fundamental right to a guarantee of the confidentiality and integrity of IT systems.
(German cases are not cited by reference to the names of the parties, but are cited in the form, BVerfG, 1 BvR 370/07 vom 27.2.2008, which is the cite for the case in question. In the press, however, the case is referred to as the "Computer Rights" case, so we will use that name here.)
The Computer Rights case came to the BVG on a challenge by a group of private individuals to the constitutionality of a recently-enacted statute of the state of North-Rhine-Westfalia (the capital of which is Duesseldorf) enabling the state investigative agency to secretly hack into the computers of targeted individuals while they were online and search and copy data stored there. Thus, the case does not involve a non-consensual laptop border search, but involves instead a non-consensual online computer search. German legal counsel, consulted in connection with this post, are of the opinion that the Computer Rights case would apply to a laptop border search.
And while the 9th Circuit in U.S. v. Arnold relieved the government of the necessity of meeting any legal standard whatsoever as a prerequisite to a border search of a laptop, the NRW statute did at least contain a "reason to believe it may be helpful" standard. Nevertheless, the BVG said this was too broad and articulated a higher standard: a secret infiltration of an individual's IT system by means of which the system can be observed and its storage media read is only constitutionally permissible when grounds exist in fact which show a danger to an important legally-protected interest such as the safety, life and liberty of persons or the fundamental principals or existence of the state. And, further, the exercise of such a secret IT system search is subject to judicial oversight.
It is notable also that in its opinion the BVG used the generic term "IT system" rather than specific term "computer," evidencing the court's intention that its decision should have broad application over the entire realm of digital devices and networks.
The BVT reached these results only after an exhaustive, painstaking and detailed examination of the nature of data stored on computers in the present age. The court's review is akin to that conducted by Judge Pregerson in the U.S. District Court in U.S. v. Arnold and which Judge O'Scannlain conspicuously did not do in the 9th Circuit.
In particular, the BVG recognized that people store on their computers their most personal data, including private correspondence, photographs, sound files, etc., which contain detailed information about the relationships and conduct of the individual's life, which if obtained and disclosed can enable the government or third parties to build an extensive picture of that individual's behavior and communications. Furthermore, the secret capture of such data from the computer of one person damages third parties with whom the targeted individual has had communication, which third parties then find their own privacy violated even though they are not targets of an investigation. This in turn impinges upon the general freedom of the citizenry, who now must fear surveillance and therefore find themselves inhibited in their digital communications and relationships with their fellow human beings. In U.S. constitutional law terms, warrantless searches of laptops can have a chilling effect upon free speech.
The BVG thus developed an incisive understanding of the extent of private data now stored by the population in their "IT systems" and a realistic, even street-wise, appreciation of how that information can be in fact be used by agents of the government once it has been captured. It then concluded that the rights of individuals to be secure in the privacy of their digitally stored data were so important they were entitled to constitutional protection, and, there being no exact constitutional provision covering such "computer rights," the court fashioned a new constitutional Computer Right.
Would that the 9th Circuit had taken the same pains and worked conscientiously through the emerging privacy issues of the present digital age and come to a better appreciation that the rights of traveling citizens to privacy of their stored data deserve protection even at the border unless the CBP has at least a reasonable suspicion that illegal data may be stored on the traveler's laptop, and even that is a preciously loose standard. As U.S. law develops and as other circuit courts, and ultimately the U.S. Supreme Court, consider the problem they would do well to follow the lead of the Bundesverfassungsgericht.
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Sunday, June 22 2008
As reported by Lynnley Browning in the New York Times UBS finds itself in the middle of a sensational IRS investigation into the conduct of its private banking division and its U.S. clients. The bank is accused of advising, aiding and abetting evasion of U.S. taxes by wealthy U.S. clients. The bank is under pressure from the Department of Justice to turn over the names of no less than 20,000 U.S. clients of UBS. It is hard to imagine a worse nightmare for the venerable Swiss bank.
According to the Times report, one Bradley Birkenfeld, an American citizen and a former senior UBS private banker, has pleaded guilty in Ft. Lauderdale, Florida, to abetting tax evasion by U.S. clients of UBS. Birkenfeld has apparently submitted a statement of facts to the federal prosecutors describing, among other almost comical practices, smuggling a client's diamonds into the U.S. in a toothpaste tube, urging his clients to destroy offshore banking records, recommending the use of Swiss credit cards not discoverable by the IRS and recommending the characterization of withdrawals from clients' Swiss accounts as loans rather than withdrawals of the clients' own funds. In the words of one of Birkenfeld's former clients, "He's going to sing like a parakeet."
In the face of these astonishing disclosures UBS is understandably getting nervous about travel by its private bankers to and from the U.S. According to one report UBS has advised some of its U.S. clients to travel to Switzerland if they wish to confer with their advisers. The bank has taken the further prudent step of advising its private bankers not to travel to the U.S according to the Financial Times.
We do not know but we can assume that UBS has also advised its private bankers never to travel to the U.S. carrying laptops. It would be a simple matter for the IRS and the SEC to identify the entire UBS private banking staff, input their names to the IBIS databank, notify the CBP that when any of the names in the databank appear at the border they are to targeted for further examination including, in particular, search of their laptops, Blackberries and other digital storage media. As we know (see the prior posts to this blog) on the present state of U.S. law the U.S. border is not only a privacy-free zone it is a Constitution-free zone and the CBP need show no legal basis whatsoever for a laptop search other than the presence of the traveler at the U.S. border.
We can only speculate about the kinds of data stored on UBS laptops, but the IRS and the SEC do not need to speculate, they have the right to go in and find out. Whether this is a proper result of the CBP's right to engage in warrantless laptop searches at the border is a question that we hope will be addressed in the U.S. Senate Constitution Subcommittee hearings on June 25.
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Sunday, June 22 2008
To appreciate the power and potential of warrantless laptop searches at U.S. borders as investigative tools, consider the following two cases, both of which are true cases, one is currently in the daily news and the other was related to me by the attorney in question:
ATTORNEY Z
Attorney Z is a partner in a prominent Toronto commercial law firm. His practice includes giving advice and support to business clients around the world wishing to immigrate to Canada. He travels frequently to foreign destinations, including the U.S., to meet with his clients. He visits the U.S. frequently because it is convenient and many of his clients also travel there on business or are residing there on short term visas.
When traveling to the U.S. attorney Z is “pre-cleared” in Canada by the U.S. Customs and Border Protection service (CBP). This means he must present his credentials to the CBP agents, answer their questions and supply the information they request or he will not be allowed to board his plane for the U.S. On a recent trip to the U.S. he was questioned during pre-clearance along the following lines:
Q. What is your occupation?
A. I am a lawyer.
Q. What is your field?
A. Immigration
Q. Why are you traveling to the U.S. today?
A. To meet with clients.
Q. Where are they located?
A. New York city.
Q. What are their names and addresses?
A. [Answer unknown]
Q. Are your clients in the U.S. legally, and if so on what kind of visas?
A. [Answer unknown]
Q. What is the nature of your business with these clients on this trip?
A. [Answer unknown]
Q. How much are you being paid for representing these clients?
A. [Answer unknown]
Just consider now the position in which this puts Attorney Z. He is being asked to divulge confidential attorney-client information. That information, in the hands of the U.S. government, could be detrimental to his clients -- suppose, for example, they are in the U.S. illegally, having overstayed their visas. Attorney Z has a professional duty not to reveal privileged attorney-client information whether detrimental or not. He also has a duty not to aid and abet violations of U.S. law. So what can Attorney Z do? If he answers truthfully he is violating his duty to his clients and possibly exposing himself to criminal charges under U.S. law. If he lies to the CBP agent he commits a federal crime. If he refuses to answer, invoking the attorney-client privilege or otherwise, he may be denied entry to the U.S. and his business trip will fail.
[For the purpose of this post I will skip over the question of whose attorney-client privilege law applies to Attorney Z, the U.S.'s or Canada's, but the question lurks.]
I hope it will come as a shock to the reader, as it did to me, to learn that CBP is asking such intrusive and improper questions of a lawyer traveling to the U.S. on business. Clearly the CBP is doing more here than simply checking the credentials of an inbound traveler. It should not be relevant, e.g., to any legitimate border inquiry to determine how much a Canadian lawyer is being paid by his clients. With this kind of examination the CBP is using the pre-clearance procedure as a general investigative tool.
Now consider the unrestricted laptop search as an additional tool in the hands of the CBP in connection with the examination of a traveler such as Attorney Z. If Attorney Z gives the CBP agent sufficient information on his clients or his business to create suspicion or excite interest in further inquiry, or if Attorney Z declines to answer the agent's questions, then the next step for the CBP agent is to search his laptop. The decisions of the Fourth and Ninth Circuits in Ickes and Arnold give the CBP agent an unrestricted right to require Attorney Z to boot his laptop and then to stand aside while the agent, and perhaps an ICE (U.S. Immigrations and Customs Enforcement) team, conduct a search of the files on his hard disk. If Attorney Z is like most traveling attorneys he will in fact be carrying a laptop and it will not be encrypted, either in whole or in part, or, even if it is, Attorney Z may feel it the better part of discretion to enter the passwords or encryptions keys or to divulge them to the agent. (See the discussion of the encryption dilemma on Jennifer Granick's blog on the EFF website.) The CBP will therefore readily discover the names of his clients, his correspondence with his clients, the documents involved in the matter he is handling for the clients and the his fee agreement with his clients. [In the actual case Attorney Z was carrying a laptop but it was not searched -- he dodged the Black Swan on that trip.]
"Laptop Searches and Other Violations of Privacy Faced by Americans Returning from Overseas Travel " Senate Judiciary Committee Subcommittee on the Constitution, Civil Rights and Property Rights
DATE:June 25, 2008 TIME: 09:30 AM
ROOM: Select Building-226 OFFICIAL HEARING NOTICE / WITNESS LIST:
June 11, 2008
NOTICE OF SUBCOMMITTEE HEARING
The Senate Committee on the Judiciary has scheduled a hearing before the Subcommittee on the Constitution on “Laptop Searches and Other Violations of Privacy Faced by Americans Returning from Overseas Travel” for Wednesday, June 25, 2008, at 9:30 a.m. in Room 226 of the Senate Dirksen Office Building.
Chairman Feingold will preside.
By order of the Chairman
WIth this notice of hearing by the Subcommittee on the Constitution of the U.S. Senate Committee on the Judiciary we have evidence that the laptop searches conducted by the Customs and Border Protection (CBP) service have become a subject of concern at the highest levels of the U.S. government. This, in general, is good news. Some of the senators most concerned with issues of constitutional and civil liberties sit on this subcommittee, e.g., Chairman Feingold himself, Senator Dianne Feinstein of California, Senator Ted Kennedy of Massachusetts (now, of course, at home recovering from brain surgery), and Senator Arlen Spector.
The committee's website does not yet disclose the names of the witnesses to be heard, but we can assume there will be witnesses from the Electronic Frontier Foundation and the Association of Corporate Travel Executives, both of which appeared as amici curiae in the U.S. v. Arnold case (see preceding post on this blog) in opposition to the position of the government that the CBP does not need a reasonable suspicion to search a laptop at the border, together with witnesses from the relevant governmental agencies. One must hope that the hearing will give the public its first opportunity to learn about the policies and practices of the CBP concerning laptop searches and the frequency with which they are being conducted.
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Wednesday, May 21 2008
A Border Laptop Search is a Black Swan
The United States Customs and Border Protection agency (CBP) asserts the unrestricted right to search laptop hard disks at the border. The Fourth and Ninth Circuit Courts of Appeal in the federal judicial system have recently given the CBP a green light to continue such searches. As the law now stands the CBP does not need a court order, a search warrant, a finding of probable cause or even a reasonable suspicion in order search your laptop hard disk. The CBP may pick travelers out for laptop searches entirely at random.
In short, for the laptop-carrying business traveler entering the U.S. from Germany (or anywhere else for that matter) a CBP search of his or her laptop is a Black Swan -- a highly improbable event but one carrying potentially disastrous consequences. See, Taleb, The Black Swan, Random House (2007).
The German business traveler might be tempted to think that CBP is only interested in terrorism, child pornography and drug trafficking and has no interest in searching the laptops of ordinary business travelers. This is wishful thinking. The two cases referred to above (U.S. v. Ickes and U.S. v. Arnold) do happen to have involved child pornography. But that fact was incidental to the holdings in the cases. So far as the facts recited in the two opinions show, the agents who conducted the searches had no idea what they were going to find. Neither traveler was a target of an investigation and neither did anything at the border to draw attention to himself as a potential carrier of child pornography. Mr. Ickes and Mr. Arnold simply had the bad luck to singled out for searches which extended to their laptops. The met the Black Swan.
Furthermore, if you think the CBP is unlikely to search your laptop because you are a respectable, well-dressed traveler, then consider this answer from the CBP website to the question, "How do officers decide which passengers to examine or search?"
Please be aware, some of CBP's biggest seizures have come from inspections of "respectable looking" people, such as grandmothers, corporate executives, college professors, etc. Everyone is subject to a CBP inspection when they arrive in the U.S.
If even grandmothers are potentially suspect, then German venture capitalists and lawyers must be even more so.
And if this sweeping everyone-is-a-potential-suspect attitude were not enough to constitute a risk to business travelers, the CBP has an explicit policy of conducting random inspections of air passengers as shown in this excerpt from the CBP website:
In other words, data in IBIS can by used to target specific persons for border searches, including, in particular, border searches of laptops. And the list of agencies given in the above quote from the CBP website can be extended to include, e.g., the Securities and Exchange Commission, The Food and Drug Administration and the Department of the Treasury, among others.
Properly understood, as it undoubtedly is by the agencies mentioned, the power of CBP to conduct at-will border searches of laptop hard disks, memory sticks, external hard drives, CD's and handheld devices such as Blackberries is a potent investigative tool for agencies of the federal government. This power gains a special potency from the fact that CBP is able to exercise it free from the legal protections of U.S. law, such as the Fourth Amendment guarantee of freedom from unreasonable searches and seizures, otherwise applicable to searches carried out by these agencies.
Business travelers therefore need to recognize that although the liklihood of a laptop search at the border may be slight (or it may not be -- we do not know, although a lawsuit has been filed to obtain policies and procedures on border laptop searches under the Freedom of Information Act), the consequences of such a search can be enormous. The data captured from your laptop may travel a long way through the channels of the U.S. government, branching into many interested departments along its way. If that data is confidential client information on the laptops of lawyers, sensitive intellectual property or economic information on the laptops of VC's or entrepreneurs, or private health or financial information about the traveler, then the traveler in question must carefully consider his position. You can protect against the extreme impact of a border laptop search, e.g., by leaving your laptop at home or by carrying only non-confidential data, but there is nothing you can do to assure your laptop will not be searched, i.e., that you will not meet the Black Swan.
In subsequent posts we will examine three specific cases in which the possibility of a border laptop search exposes the travelers in question, and their clients or employers, to dangerous risks. We will also consider what measures a traveler might take to minimize the impact of a border laptop search if it should occur.
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Friday, April 25 2008
In a long-awaited decision the Ninth Circuit Court of Appeals held on Monday, April 21, 2008, inUnited States v. Arnold that a U.S. Customs and Border Protection agent may search the hard drive of a laptop carried by a traveler entering the United States even though the agent lacks any reasonable suspicion that the laptop's hard drive contains illegal data.
The trial court in the case had granted the defendant's motion to suppress evidence of illegal pornography found on his laptop on the basis that laptop searches are not the same as searches of luggage and require that the customs agent have at least a reasonable suspicion of illegal activity before conducting a laptop search.
The government appealed to the Ninth Circuit, and in an unfortunate and misguided opinion by Judge Diarmuid F. O’Scannlain the Ninth Circuit reversed the trial judge and upheld the legality of the search. These excerpts from the opinion illustrate the court's decision:
We must decide whether customs officers at Los Angeles International Airport may examine the electronic contents of a passenger’s laptop computer without reasonable suspicion.
[The court then reviewed the case law on border searches]
Therefore, we are satisfied that reasonable suspicion is not needed for customs officials to search a laptop or other personal electronic storage devices at the border.
...
We are persuaded by the analysis of our sister circuit and will follow the reasoning of Ickes [an earlier case decided by the Fourth Circuit Court of Appeals] in this case.
VI
For the foregoing reasons, the district court’s decision to grant Arnold’s motion to suppress must be
REVERSED.
The state of the law in the United States as it has developed to date is that two circuit courts of appeal have upheld laptop searches without reasonable suspicion, no circuit courts have ruled to the contrary and the U.S. Supreme Court has not yet considered the question (and it may be years before the Supreme Court does so).
The Customs and Border Protection service is thus entirely free to search your laptop when you enter the United States for any reason or for no reason or at random. Business travelers to the U.S. must recognize this risk and adjust their conduct accordingly.
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Tuesday, January 15 2008
This post departs from the usual theme of this blog in order to bring an alarming practice of the U.S. Customs and Border Protection service (the CBP) to the attention of persons in the European venture capital industry -- fund managers, managers of venture-financed companies, and professionals advising them -- who travel from time to time to the U.S.
A series of recent cases in the federal courts in the U.S. have brought to light the fact that the CBP claims an unrestricted right to search hard disks on laptops of persons entering the U.S. The policy behind the practice is not written down and has no formal guidelines, so far as we know. It is therefore difficult to know anything about it unless one has the bad luck to experience it or has read some of the cases challenging it.
The policy and practice of the CBP, as reflected in the cases now moving through the U.S. courts, may be summarized as follows:
Customs agents have the unrestricted right to search hard disks on laptops of persons entering the U.S. They do not need probable cause or even a reasonable suspicion to do so. They may act on the basis of hunches, whims or at random. It is the same as searching a traveler's suitcase.
The right to search hard disks extends to searches of other devices or media such as Blackberries, CD's and memory sticks.
Customs agents conduct such searches by requiring the traveler to open and boot his laptop. The customs agent then takes over and systematically searches files on the laptop's hard disk.
If the agent finds files of interest he confiscates the traveler's laptop, and the traveler must continue his travel without it.
While it has the laptop in its possession the CBP may create and retain a mirror image of the hard disk.
Copies of the hard disk may thereafter be circulated by the CBP to other U.S. governmental agencies.
In due course, the laptop will be mailed back to the traveler, unless criminal charges are brought, in which case it may be retained as evidence.
As it happens, the three principal cases challenging the CBP practice of searching laptops have all involved child pornography. The business traveler from Europe can take no comfort from that fact, however. In one case the search was apparently triggered by nothing more than the fact that the traveler arrived at Los Angeles International Airport from the Phillipines and had a goatee (U.S. v. Arnold). In another case the search was triggered by the fact that the CBP agent spotted a laptop in the back seat of the defendant's car as he crossed the border with his father from Canada to the U.S (In re Boucher).
Recognizing the threat this practice of the CBP poses for business travelers, a business travel organization, the Association of Corporate Travel Executives, intervened and filed a brief on behalf of the traveler in the Arnold case. And just this month (February 2008) a leading U.S. law firm based in Washington, D.C., Arnold & Porter LLP, issued a Client Advisory, entitled "Working on the Plane? How International Travel can Result in Government Officials Examining Your Electronic Data," bringing this risk to the attention of their clients.
The CBP's interest in intercepting pornographic material not only offers no comfort to business travelers it may itself heighten the risk of a laptop search for those travelers whose passports show recent travel to countries known as sex tourism destinations, e.g., Thailand.
To date the results of the cases involving laptop searches are mixed. One appellate court has ruled that the CBP has the unqualified right to search a laptop hard disk and does not need a reasonable suspicion in order to do so (U.S. v. Ickes). The laptop search was likened to a search of a suitcase, which everyone agrees is permissible. The U.S. District Court in the Arnold case went the other way and ruled that the CBP must have a reasonable suspicion of wrongdoing in order to search a laptop, else the search violates the Fourth Amendment. The judge said such a search is not like a search of a laptop, it is like a search of the traveler's own memory. In the case before it the court found that the CBP officer who conducted the search did not have a reasonable suspicion and therefore entered an order suppressing the evidence obtained in the search of Arnold's laptop. The Arnold case is now on appeal to the Ninth Circuit Court of Appeals. It was argued in October 2007 and now awaits decision.
In the Boucher case the traveler had saved his pornographic photos on a separate drive on his laptop and had encrypted the drive using Pretty Good Privacy (PGP). The CBP was unable to break the encryption and access the drive, so the prosecution had a grand jury subpoena issued compelling Boucher to divulge his password. Boucher moved to quash the subpoena on the ground that it violated his Fifth Amendment privilege against self-incrimination. The federal Magistrate hearing the motion agreed and quashed the subpoena. The case contains some important lessons for travelers carrying laptops. We will come back to the question of encryption in a subsequent post.
The probability of a laptop search of an innocent traveler coming into the U.S. from Europe on a business trip may be low. Then again it may not be. We do not know. And we have no way of finding out. Therefore, it is in the interest of business travelers from Europe to proceed with extreme caution when entering the U.S. carrying a laptop.
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Sunday, January 13 2008
If I were to be appointed a deputy minister for venture capital tax policy in the finance ministry of a western European nation, and if I were then mandated to construct a framework of rules designed to suppress and hinder the development in my country of a venture capital industry, I would promulgate a set of rules along the following lines:
Investment Holding Period: I would impose a mandatory minimum holding period of three years for all investments within a venture fund. Venture capital investment is, of course, short to medium term by definition. It is the job of a venture fund investment manager to exit an investment as soon as it is possible to capture a desired gain. This rule would, therefore, put the venture fund manager in conflict with his duty to his investors. This rule would be a stand-alone venture-fund-breaker. But it would be a stealth rule -- only knowledgeable venture industry insiders would appreciate its devastating effect.
No majority holdings: I would prohibit a venture fund from taking a majority interest in a portfolio company. There are times in the lives of many venture investments that an investment manager musttake control of a portfolio company in order to save the company and/or protect the fund's investment. Likewise, a venture fund might find itself to be the only possible source of new capital for a struggling start up company under circumstances in which the depressed valuation of the company would lead inevitably to the venture fund's stake exceeding 50% if it were to inject additional capital. This rule would therefore force the venture fund to let the company go under or to lose all or part of its investment notwithstanding its willingness to provide additional capital.
No active participation in management: Venture fund investment managers would be prohibited from taking an active role in the management of their portfolio companies. It is part of the job of venture fund investment managers to bring not just capital but also experience, expertise and special skills to their portfolio companies. Those companies are normally early stage and are often managed by unproven, inexperienced, first-time entrepreneur-managers. This rule would therefore tie an investment manager's hands and force him or her to stand on the sidelines while a portfolio company management team struggled and failed.
No re-investment of gains. Investment managers would be prohibited from re-investing proceeds acquired, e.g., through the IPO or trade sale of a portfolio company. Instead, they would be required to distribute such proceeds to the venture fund's investors. Such a rule would, of course, normally be left to agreement between the managers of the venture fund and its investors. By imposing this rule we would seek to limit the growth of venture funds in our country by allowing them to grow only through infusions of outside capital.
The penalty for violation of any one of these rules would be a re-classification of the venture fund as a trade or business, with the resulting imposition of our standard trade tax. This would dramatically lower the IRR of the venture fund and impair its ability to raise capital. We would further provide that violation of any of the rules in connection with even one portfolio company would subject the entire fund, and all of its investments, to re-classification as a trade or business.
As deputy minister for venture capital tax policy I would confidently tell the Finance Minister that we had hereby crafted a framework that could not fail to limit the growth of the venture capital industry in our country. Our proposed regime would simultaneously restrict the ability of venture fund investment managers to rationally conduct their business and would inhibit the flow of capital from outside investors into venture funds based in our country.
German readers will recognize, of course, that this regime is in fact the regime adopted by the German Finance Ministry. It helps explain why at least one leading German venture fund has left the country and re-incorporated itself elsewhere and why 50% of the members of the German venture capital association are considering doing likewise.
On the face of it, it is absurd to think that the motivation given above, to deliberately suppress the development of a venture capital industry in Germany, is in fact the motivation of the German Finance Ministry. Yet, if that is not in fact the policy, then it is difficult to see what is the policy.
A possible alternative explanation is that the tax policy officials within the ministry are simply profoundly ignorant of the nature and character of venture capital investment. That, too, is implausible. These officials have had voluminous input from the venture industry, have seen the public studies showing Germany at or near the bottom of venture-capital-friendly jurisdictions within the European Union, and have witnessed the withering of the venture capital industry in their country over the last seven years. This regime, which is so toxic to the venture industry, is no accident.
Whatever the true German policy may be the result is painfully clear: (1) no sensible venture fund group would today form a fund in Germany, and (2) no institutional investor that had done its due diligence and fully understood the German rules would invest in a German venture fund.
So far as it appears at this time, the battle is over. These are the new rules, and there is no liklihood that they will change in the foreseeable future.
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Tuesday, July 17 2007
In an extraordinary and little-noticed announcement on May 11, 2007, the BVK, the German Private Equity and Venture Capital Association, released the results of a poll of its members showing that fully 50% of the membership are considering moving their funds out of Germany.
The cause of this discontent is of course the unsatisfactory and unworkable legal and tax framework within which German funds are forced to operate -- what we refer to in this blog as the Toxic German Legal Landscape for venture capital and private equity.
These views of the BVK membership are not merely theoretical. Some major German funds have already left Germany; for example, the current Chairman of the Board of the BVK, Rolf Dienst of Wellington Partners has recently moved his own fund out of Germany.
One should bear in mind that the BVK only has 185 members, a tiny number of venture capital and private equity funds in a country which has the world's fourth largest economy (after the U.S., Japan and China). That is to say, an already weak domestic German venture capital/private equity industry is about to become weaker.
The poll taken by the BVK was taken in part to demonstrate to the Bundesministerium der Finanzen (BMF) the seriousness of the German legal and tax situation for the industry. The poll was released on May 11.
On May 31, 2007, the BMF announced its decision to apply the VAT to the management fees of German venture capital and private equity funds. Clearly the BVK's poll did not have the intended effect. The BMF is either not listening or is unmoved.
It is difficult to escape the conclusion that, taken in the broader European context wherein other countries are moving positively to create favorable legal and tax regimes for investment funds, the BMF has take a policy decision that the venture capital/private equity industry is not an appropriate industry for Germany.
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Friday, July 13 2007
The response of the tax bar in Germany to the April 1, 2004, to the imposition of VAT on management fees was to create a work-around known as the "priority profit share." This work around, though artificial, worked and was tolerated by the BMF. On May 31, 2007, however, the BMF ended its tolerance and published an administrative pronouncement on its website declaring that as of June 1, 2008, the priority profit share will be subject to the 19% VAT.
It appears that the BMF has taken a policy decision that venture capital is not an appropriate form of financing for Germany.
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Friday, July 13 2007
I. The German Economic Landscape
The them of this blog is the German venture capital scene today. We need to begin with a view of the current German economic landscape from 30,000 feet above the ground. That aerial view shows the follow features:
Germany is a high-tax jurisdiction, and its taxes are about to climb even higher -- the maximum income tax rate will move from 42% to 45%, and the VAT rate will climb from 16% to 19% -- this is the explicit policy of the new coalition government led by Angela Merkel.
German has high unemployment -- at this writing the rate is 11.2%
The Germany economy is in zero-growth mode and has been stuck there for several years.
Consumer demand in Germany is low.
The German population, including its representatives in the factions of the major political parties, have little appetite for reform of Germany's social welfare state, even though the costs have become unsustainable.
The level of technological innovation is presently at a dangerously low ebb.
The fires of entrepreneurial spirit in Germany burn dimly today, when they burn at all.
Germany is now governed by a tenuous coalition of the CDU and the SDP, who are not good friends in the best of times, led by an untried, untested and inexperienced Chancellor, Dr. Angela Merkel. (I have to admit, however, that I have tremendous admiration and sympathy for Angela Merkel -- this 51 year old Ossie with a PhD in Physics who has defied political gravity by ascending to the top position in a political party dominated by a rather unpleasant group of Alpha males. Notwithstanding this extraordinary achievement she somehow gets almost no respect among the German population, including, amazingly enough, among German women! The standard comparison is to Margaret Thatcher, the implication being, apparently, that Angela Merkel is not bitchy enough to be taken seriously.)
Most of these observations are truisms and I need not dig deeper into them here. The critique of the current German economy has been done many times by numerous other writers, including Dr. Norbert Walter, Chief Economist of the Deutsche Bank, to name one of the best.
My purpose in re-capping these features of the current German economic landscape is to remind us all of the sad state of current affairs in Germany and of the self-evident need to create and foster a powerful, vibrant, well-financed, and cleverly-managed venture capital and private equity fund industry. It is precisely such an industry that can fan the entrepreneurial flame, stimulate technological innovation, finance the formation and growth of new German companies, create new employment and help get the Germany economy back on track.
Notwithstanding this obvious need, the German government, above all the Federal Ministry of Finance (the Bundesministerium der Finanzen), instead of making Germany a haven for venture capital and private equity investment funds is marching exactly in the opposite direction and appears to be hell-bent on making Germany a venture-capital-free zone. And that claim leads to my thesis, namely, that the German legal and tax landscape as it applies to such investment funds is toxic.
My critique has three main parts, which will be addressed in subsequent installments:
A. Taxation of Venture Capital and Private Equity Funds
The Federal Ministry of Finance (the BMF) promulgated a decree on November 20, 2003, pertaining to the taxation of venture capital and private equity funds which contains a set of rules which make impossible the competent and intelligent management of such funds when organized under German law. The decree is in fact having the effect of driving existing funds out of the country.
B. The Application of VAT to Management Fees
Effective April 1, 2004, the management fees received by general partners of German venture capital and private equity funds are subject to Germany's 16% VAT. As indicated above, that tax is about to go to 19%. This is an historic change and sets Germany apart from almost every other important venture capital/private equity jurisdiction. This tax charge undermines the economics of the fund business for German general partners, having in mind that German funds are on the whole much smaller than US funds and German management fees are accordingly much smaller. There is no room for 19% off the top.
C. The German Stock Corporation is a Dysfunctional Legal Form
The German Aktiengesellschaft is outdated, outmoded, complicated, expensive and dysfunctional as a corporate vehicle for growth companies. The German AG is not new, but its dysfunctionality as a vehicle for growth companies has only become painfully evident in the last several years. German corporate lawyers and German notaries, however, love the AG and have been very slow to take advantage of the new flexibility to adopt other EU country corporate vehicles flowing from the 2002 Ueberseering decision of the European Court of Justice.
[Coda: I do not want my critique of the German economic and legal landscape to be misunderstood as a critique of Germany per se. To the contrary, and apart from the sorry economic situation, I am prepared to argue that in terms of quality of life, standard of living, level of public safety, quality of infrastructure, transportation, health care, public education, cultural resources, cuisine, and adoption of new technology, including, in particular, broadband and mobile telephony, there is no better place to live on the planet -- including my native US, which is paradisiacal for the few but a hard row to hoe for the many.]
