slaughter and may Copenhagen and beyond progress in the Eurozone?

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1 slaughter and may Copenhagen and beyond progress in the Eurozone? Client BRIEFING 4 APRIL 2012 The euro area [has] made substantial progress over the last 18 months to address the challenges stemming from the sovereign debt crisis [our] comprehensive strategy has paid off and led to a significant improvement of market conditions. Statement of the Eurogroup, Copenhagen, 30 March Introduction Since 2010, EU leaders have taken a number of steps with the objective of improving economic conditions in the eurozone. The largest sovereign debt restructuring in history is being implemented in Greece, 25 of the 27 EU member states have agreed the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (the Fiscal Treaty ) and measures taken by the European Central Bank to boost liquidity in the financial markets through Long Term Refinancing Operations ( LTRO ) have had positive effects. In addition, on 30 March, Eurogroup leaders announced in Copenhagen a 200bn temporary increase in the sovereign debt firewall to provide financial assistance to eurozone member states. In the face of such measures, market sentiment improved in the first quarter of 2012 with Spain and Italy, in particular, experiencing falls in bond yields from the highs reached in late However, whether the increased firewall will be strong enough to cope with future crises remains to be seen, and other elements of the reform and rescue packages remain uncertain. The Fiscal Treaty must still be ratified by the required number of member states and in some countries (including France, Italy, Germany and Greece), looming elections have the potential to affect the existing political consensus. Some of the key events expected to occur in are listed below. SOME KEY EVENTS IN April: G20 to decide on increase in IMF s resources Late April/early May: Greek general election expected April/May: French presidential election April, July and October: Spanish bond redemptions in excess of 20bn each 31 May: Irish referendum on Fiscal Treaty June: 10.1bn Portuguese bond redemption July: ESM comes into force 2013 April: Autumn: Italian parliamentary election German parliamentary election

2 If the various measures agreed so far are insufficient to sustain the position of Greece and other periphery states, the prospect of more far-reaching fiscal union among the eurozone, including the possibility of joint debt issuance ( eurobonds ), is contentious. What form any additional measures might take, if required, is therefore unclear, as is the political willingness to continue to support periphery states should they require second or third bail-out programmes. What does seem clear, however, is that while we may be entering a new chapter the crisis has certainly not reached its conclusion. This briefing, the fourth in our series of publications on the eurozone crisis 1 and its implications, contains an update on the current status of the various elements of the EU reform and rescue package following the Copenhagen summit. It also considers some of the key challenges which remain to be addressed by political leaders this year and the implications of this ongoing uncertainty for companies both inside and outside the EU. The headline implications for corporates are outlined in section Reform and rescue Overview Since the first Greek bailout, which comprised bilateral loans from eurozone member states and an IMF standby arrangement, was agreed in May 2010, an increasingly sophisticated set of rescue measures have been developed at the EU level, some of which have been used to assist Ireland and Portugal in addition to Greece. They include fundraising machinery to help ailing member states, the so-called sovereign firewall, measures which encourage private sector involvement in sovereign debt restructuring, ECB monetary operations and various other reforms aimed at strengthening the banking sector. In addition, far reaching fiscal and budgetary reforms have been developed in the form of the Fiscal Treaty, as well as the deficit reduction programmes put in place in several member states as conditions of, or to avoid the need for, bailout funding. The current status of each of the key elements of the package is outlined below. The sovereign firewall The firewall now comprises three separate schemes: the European Financial Stabilisation Mechanism ( EFSM ), the European Financial Stability Facility ( EFSF ) and the European Stability Mechanism ( ESM ). The EFSM was established in 2010 to fund loans to member states, utilising member states contributions to the EU budget to backstop bonds issued by the EU. The EFSM is committed to lending 48.5bn of its maximum capacity of 60bn to Ireland and Portugal and, given its nature, there is likely to be little scope to extend this facility further. The EFSF, also launched in 2010, was the original big bazooka. It is a temporary fundraising facility empowered to raise funds on the capital markets to provide up to 440bn in loans and other forms of financial assistance to eurozone member states, backed by member state guarantees (which are provided on a several but not joint basis). The EFSF has committed approximately 200bn in loans to Greece, Ireland and Portugal to date. The EFSF was set up with the intention that it would be replaced by a permanent bailout fund, the ESM. 1 See for links to our previous briefings. 02

3 The Treaty creating the ESM (the ESM Treaty ) was originally signed in July 2011 and subsequently amended in February The key difference between the ESM and the EFSF is structural. Rather than providing guarantees, each of the eurozone member states will be required to make capital contributions to the ESM (which are originally planned to be paid up over five years). The ESM Treaty is in the process of being ratified by the 17 eurozone member states and is expected to come into force in July Re-assessment of the size of the firewall The ESM was designed to provide further lending capacity up to a combined total with the EFSF of 500bn (subject to periodic re-assessment) from July However, the G20, the OECD and the IMF together with Tim Geithner, Mario Monti and others have all expressed concerns about the adequacy of this firewall, focussing on the likelihood that 500bn of lending capacity would only be sufficient to fund the larger of the weakened eurozone countries, Spain and Italy, for a limited period of time should support be required. Notwithstanding strong resistance from Germany and other member states following public confirmation by G20 finance ministers in late February that further external support for eurozone countries would be conditional upon the eurozone member states increasing their own commitments, it seemed increasingly likely that the original limit would be increased. This was confirmed by the Copenhagen summit. The Copenhagen agreement the public sector amend and extend In essence, the eurozone member states agreed on 30 March that the ESM and the EFSF will be temporarily combined until such time as the ESM is fully capitalised (its lending capacity being dependent on capitalisation by member states). The timetable for the capitalisation of the ESM will also be accelerated, taking place between July 2012 and the first half of 2014 (and can be accelerated further if required). Thus, instead of coming to an end when the ESM begins, the EFSF will be amended and extended such that (i) it will continue to service the 200bn or so that it has already committed to Greece, Ireland and Portugal until such time as those loans are repaid and (ii) its 240bn of unused lending capacity will continue to be available until the full 500bn lending capacity of the ESM has been capitalised. These measures mean that the firewall has a temporary combined lending ceiling of 700bn less the 200bn or so the EFSF has already committed to Greece, Ireland and Portugal. From 30 June 2013, the lending capacity of the ESM will be limited to 500bn. The agreement reached has the benefit of reasonably straightforward implementation, requiring only the endorsement of the ESM Board of Governors when the ESM Treaty comes into force in July. A permanent increase in capacity to 740bn could have been achieved without changes to the ESM Treaty by transforming the 240bn unused guarantee commitments under the EFSF into additional subscribed capital for ESM, but this solution appears not to have found favour as it would have involved a permanent increase in the ESM s capital. Leveraging the firewall The prospect of leveraging the EFSF by using private capital has been on the agenda since It is understood that work is continuing to find a means of leveraging its permanent replacement, the ESM. However, leveraging the firewall is not the only means of securing private sector involvement in sovereign debt restructuring, as illustrated by Greece s recent experience. 03

4 Restructuring Greek debt Greece s debt restructuring is responsible for creating much wider awareness of collective action clauses (or CACs ) which permit the terms of sovereign bonds to be amended with the consent of a specified percentage of bondholders in a manner that binds all bondholders (i.e. CACs enable cram down). The restructuring of Greece s debts governed by domestic law (which comprised more than 90% of its total privately held debt) was in part achieved by the imposition of CACs on all Greek law bonds. Unusually, the CACs operated across all the sovereign s Greek law governed debt without distinguishing between the individual series of bonds. Under the exchange offer private sector debtholders were effectively forced to accept a 53.5% cut in the nominal value of their holdings representing a 74% reduction in the bonds net present value. The bonds were tendered for the following: 31.5% of new Greek bonds maturing between 2023 and 2042 paying a coupon of 2% rising in steps to 4.3% in These new bonds are subject to English law and benefit from a co-financing agreement with the EFSF. 31.5% of GDP-linked securities. These securities will pay interest provided that both nominal and real Greek GDP growth exceeds specified reference levels. These securities are subject to English law and may be called by Greece after 1 January % of the face value of old bonds in the form of short-dated EFSF bonds with a maturity of up to two years. Short-term EFSF notes to finance unpaid interest accrued up to 24 February In the event, investors holding 85.8% of Greek law bonds eligible for exchange agreed to the tender offer. Greece then announced that it would activate the CACs resulting in a 95.7% participation rate. The new bonds were issued on 9 March 2012 and we understand that they have since been trading at distressed levels. The activation by Greece of CACs resulted in ISDA announcing a credit event on Greek sovereign credit default swaps. However, despite earlier predictions of disaster, the first sovereign default by a developed nation in over 70 years failed to roil the markets. Greece was unable to adopt the same approach in relation to its foreign law bonds, hence the debt swap offer to foreign bondholders remains open. Greece s foreign law debt contains CACs, but the lack of consistency makes the offer process and the determination of whether CACs can be invoked more complex. Greece has, however, indicated that it will default on its foreign law bonds if the exchange offer is not successful. The offer is currently expected to close during April Although there is no current indication that the restructuring implemented for Greece will be repeated in other eurozone member states, it is notable that the ESM Treaty requires that all sovereign debt issued after 1 January 2013 with a maturity of more than 1 year must contain CACs in a prescribed form. Thus when the ESM Treaty comes into force, the use of CACs will in time become universal, which may encourage private sector involvement in any future sovereign debt crises. Is the firewall strong enough? Assuming the ESM Treaty is duly ratified, the question is whether the increased firewall is sufficient to satisfy external creditors as well as the financial markets more generally. The views of the G20 and those of the US will be particularly important to ensure the availability of further IMF funding for EU member states going forward. 04

5 However, the firewall is just part of the toolkit for maintaining stability and resolving the crisis, and its adequacy must be assessed in that broader context. Its success depends on a number of additional factors including the Fiscal Treaty and the re-capitalisation of European banks. Private sector involvement EFSF IMF LTRO G20 Investment and growth Will Europe find a solution? ESM Spending cuts Fiscal Treaty Bank resolution/ bail-ins Bank regulation ECB The Fiscal Treaty The Fiscal Treaty, aimed at strengthening fiscal discipline in the EU, was signed by 25 out of the 27 member states on 2 March 2012 (the UK and the Czech Republic did not sign). Among other things, the Fiscal Treaty requires signatories to incorporate into their domestic law a balanced budget rule within a year of the Treaty, according to which their annual structural government deficit must not exceed 0.5% of nominal GDP. The Fiscal Treaty will apply to all eurozone member states. The eight other member states will not be subject to the fiscal restrictions unless they join the euro or declare their intention to be bound by the Fiscal Treaty s requirements. The Fiscal Treaty will come into force once ratified by at least 12 of the eurozone member states. Only Ireland has announced the need to refer the new Treaty to a referendum, which is scheduled to take place on 31 May. In addition, ratification in France is not likely to occur before the outcome of its presidential elections. Ratification by other eurozone countries presents a political risk to the Fiscal Treaty. Access to the ESM is expressed to be conditional upon ratification of the Fiscal Treaty and the incorporation of the balanced budget rule into domestic law, which may provide an incentive for some to ratify. On top of the political controversy surrounding ratification in some countries, there are concerns about the ability of member states to comply with the rules under the fiscal pact, and uncertainty as to the consequences of failing to do so. The requirement to cap annual structural deficits at 0.5% of GDP will impact most heavily on those member states with the highest deficits, which for the most part are the same countries that have been under greatest pressure from the financial markets in recent months. Renewed recession, or prolonged stagnation, in 05

6 those countries may make their existing debt burdens unsustainable. Recognition of this would be likely, sooner or later, to result in a loss of market access and calls on the EU bail-out funds. Spain, for example, recently announced that it will not meet its deficit target (which has since been revised) and there have been reports that the Netherlands may need to take further action to ensure that it meets the 3% of GDP limit on government deficits. The US has recently expressed the view that EU leaders have focussed too much on austerity to the detriment of growth and that it may be inadvisable to impose fiscal targets which are strictly enforced. Strengthening the banking sector the ECB Banks across the EU have undertaken a range of actions aimed at improving their capital position following the results of the European Banking Authority s 2011 stress tests. However, it remains the case that only highly rated banks currently have access to commercial funding markets. Other banks, in particular those based in the eurozone periphery, remain heavily reliant on central bank and ECB support. As financial institutions throughout the EU experienced rising funding costs, and a general contraction in liquidity, it became clear that the ECB needed to find a means of averting a credit crunch in the eurozone. The ECB has therefore implemented the two LTROs, under which the ECB has provided around 1 trillion of 3 year secured funding at a 1% margin to EU banks 2. So far, the LTROs have had a significant impact on the financial markets, and have helped reduce bond yields on Spanish and Italian sovereign debt, with most of that debt being purchased by domestic banks. Nonetheless, a number of commentators have raised concerns that the LTROs are storing up problems for the future. If large numbers of banks borrow at the same time they will need to refinance at the same time, and there is no indication at present whether further LTRO funding will be available in three years time. In addition, the LTROs have done little to lessen (and may even have increased) the inter-dependence between sovereign risk and banking sector risk (discussed further below). Hence the LTROs should not be viewed as a permanent solution to banks funding problems but, at best, providing time during which member states and banks can take further steps to deleverage their position against the backdrop (perhaps) of more stable financial markets. Strengthening the banking sector the regulatory angle Financial institutions across the world are facing structural changes and increasing operational costs as a result of the implementation of Basel III, CRD IV, EMIR, the Dodd-Frank Act and other regulatory reforms conceived in the wake of the financial crisis. As a result of exposures to the debt of weaker sovereigns, the eurozone crisis has exacerbated those pressures, in particular for financial institutions based in the eurozone and, perhaps to a lesser extent, in the EU more broadly. Part of the difficulty is that banks are incentivised to hold sovereign debt. Banks exposures to sovereigns denominated in domestic currency generally do not attract a regulatory capital charge. In the case of exposures to eurozone member states this includes euro-denominated sovereign debt. Practice among banks in provisioning 2 During the first phase of LTRO in December 2011, some 500 banks borrowed 489bn and the second phase during March 2012 saw 800 banks borrow 529.5bn. 06

7 for losses on sovereign debt is, however, inconsistent. Neither Basel III nor the CRD IV directive and regulation currently propose to change this. Moreover, the new liquidity coverage ratio will further encourage EU banks to hold sovereign debt as such debt will be eligible without limit to satisfy that new liquidity test. Whether recent experience in the eurozone will have any impact on those and similar rules remains to be seen. There is also the issue of how to resolve banks while minimising recourse to the taxpayer. A number of EU countries have experience of this difficulty and some have adopted domestic bank resolution statutes that would enable losses to be imposed on shareholders and creditors without their consent (for example, the UK s Banking Act 2009). As yet, however, while the firewall can be used to support the banking system, there is no EU-wide framework for the orderly cross-border resolution of financial institutions. Michel Barnier, the EU Commissioner for Internal Markets and Services, confirmed recently that the Commission is reaching the end of its deliberations on the topic of bank crisis management but wishes to consult further with member states on the topic of bail-ins. Broadly speaking, a bail-in is a mechanism enabling debt of a bank to be written down or converted into equity, either at a defined contractual trigger point or at a point when the authorities are empowered by statute to trigger such a write-down or conversion by statute. The proposals were also on the agenda at the Copenhagen summit on 30 March, although it is still not clear whether proposals will be published before the Summer as promised. 3. Is the bazooka big enough? While there are signs that the steps already taken, together with the actions of the ECB, have helped to relieve market stress, the optimism expressed on 30 March by the Eurogroup is likely to be received cautiously. There are a number of factors which together suggest that while in some areas the crisis may be abating for now, it has not yet been resolved. Portugal s 2013 refinancing requirement is likely to receive increasing attention towards the end of The financial situation of Spain remains a concern and its banking sector is fragile. In addition, notwithstanding its recent second package, the Greek government and the IMF have accepted that Greece may need further official support. The key remaining weapon in the EU s armoury is the possibility of eurobonds. Although the Commission published a Green Paper in November 2011, Germany and some other member states remain opposed. Further, the issue of eurobonds, jointly and severally guaranteed by eurozone member states, would require Treaty changes, meaning that even with political consensus, implementation is likely to take time and could be de-railed by national referendum requirements. 4. Headline implications for corporates Contingency planning remains advisable The events of 2012 may have alleviated concerns about eurozone break-up to some extent, but while conditions remain uncertain, contingency planning for a range of scenarios continues to be advisable. The management of country risk and banking sector risk (in addition to eurozone break-up/withdrawal risk) remain important priorities, including, for example, a review of: bank and supplier relationships; 07

8 cash management policies (to ensure that euros do not remain in fragile economies for longer than necessary); and contractual risk management options. Refer to our client briefing entitled The Eurozone Crisis an indicative approach to contingency planning, which we published on 15 December 2011, for further detail. 3 A close eye on financing options A specific concern is the length of time it will take for the reform and rescue package to mitigate the effects of the sovereign debt crisis and weakened banks on the availability of credit. While there is still demand for toprated relationships and certain event-driven financings, in general banks have tightened their lending criteria and spreads are rising (in particular in the weaker eurozone countries). The capital markets, plagued with volatility, may not always provide a reliable alternative. The result for some corporates is that managing and anticipating their refinancing requirements is an ongoing task and the possibility of utilising alternative sources of finance may need to be explored (e.g. private placements and supply chain finance, as suggested in the recent Breedon Report 4 commissioned by the UK government). Approach to M&A Depressed equity and asset values resulting from the eurozone crisis may provide opportunities for strategic investments. In particular, this is likely to be the case in the infrastructure and banking sectors, which are expected to be some of the busiest areas of M&A activity this year. A cautious approach to M&A may be prudent, but in many cases, provided the potential impact of the crisis on the transaction is properly assessed and factored into the pricing and the structure of the transaction, concerns should be capable of being alleviated. It is likely to be particularly important, for example, to invest in a thorough due diligence exercise, which, in addition to the usual areas of enquiry, includes an assessment of the extent to which potentially worsening economic conditions in particular EU countries, or across the eurozone, could affect the future prospects of the target group or the valuation of the assets being purchased. This may include issues relating to country risk (if the target has exposure to high risk jurisdictions), refinancing risk (if the target s financing arrangements are more vulnerable) and/or currency risk (if contracts are more susceptible to re-denomination in a euro exit scenario). For example, the following questions may be relevant: Is the target exposed to government entities in the weaker eurozone states? Where are the target s key customers and suppliers located? If they are in an at risk jurisdiction, what are the target s rights in the event of non-performance and breach of contract? In which country or countries are the target group s banking relationships and with which banks? 3 See for links to this briefing. 4 Boosting Finance Options for Business, 16 March

9 Is the target group exposed to any of the more vulnerable eurozone banks? Do the terms of its financing arrangements protect it against the risk of bank default? What are the target s future funding requirements? What is the likely effect of the exit of one or more member states from the eurozone on the target group s material contracts and are certain contracts more at risk of re-denomination? Refer to our client briefing entitled The Eurozone Crisis an indicative approach to contingency planning for further detail on the factors which are relevant to the assessment of re-denomination risk. 5 The biggest concern of buyers who invest in an unpredictable environment will be to protect their valuation. It may be possible to take into account the extent and likelihood of any risks posed to the relevant target group by the eurozone crisis by building a risk discount into the purchase price for the relevant asset. However, whether this is possible will depend, among other things, on the buyer/seller dynamic and presence of rival bidders. Therefore, it may also be worthwhile to consider ways to address risks arising out of the eurozone crisis (including any specific risks identified in the course of due diligence) in the contractual documentation. By way of example, the following issues may require further thought in order to seek to address concerns relating to completion risk and valuation risk: Use of material adverse change ( MAC ): It may be appropriate to consider a MAC or force majeure condition which is tailored to particular changes in market conditions (for example, EU member state default or an announcement of euro withdrawal). Completion conditions: Conditions to completion can also be crafted to address risks specific to the relevant business (for example, the continuance of certain important customer and/or supplier relationships or credit lines). Purchase price adjustment: There are a number of mechanisms which it may be appropriate to consider. For example: Use of earn-out provisions: If there are concerns about the future profitability of a business, an earn-out provision may be appropriate. An earn-out requires the purchase price to be adjusted between buyer and seller by reference to the performance of the target group after completion. Deferred consideration and use of escrow: A portion of the consideration may be deferred and/or placed in escrow to secure warranty and indemnity claims or an earn-out. Credit support: The seller could be asked to provide a letter of credit or bank guarantees in support of its obligations (from a provider acceptable to both parties). This is another area where there is no one size fits all solution. Ideally legal advice should be sought as early as possible in the transaction with regard to the most suitable options in the circumstances. 5 See for links to this briefing. 09

10 4 APRIL 2012 Copenhagen and beyond progress in the Eurozone? 5. Further information Slaughter and May has established a working group of practitioners across different practice areas to coordinate its advice on the eurozone crisis, sovereign debt restructuring and bank resolution. This working group is considering these issues as part of a network of lawyers from the leading independent firms in major European jurisdictions. We will continue to publish client briefings as the crisis develops. If you have any questions please contact your usual adviser at Slaughter and May or one of the following: Charles Randell E charles.randell@slaughterandmay.com Ian Johnson E ian.johnson@slaughterandmay.com Andrew McClean E andrew.mcclean@slaughterandmay.com Sanjev Warna-kula-suriya E sanjevwks@slaughterandmay.com Jan Putnis E jan.putnis@slaughterandmay.com Ben Kingsley E ben.kingsley@slaughterandmay.com Tolek Petch E tolek.petch@slaughterandmay.com Kathrine Meloni E kathrine.meloni@slaughterandmay.com Slaughter and May 2012 This material is for general information only and is not intended to provide legal advice. For further information, please speak to your usual Slaughter and May contact. isj14.indd412