slaughter and may What do clients need to know? BRIEFING OCTOBER 2011 In light of the continuing uncertainty about the resolution of the eurozone crisis, we are issuing this briefing to highlight some of the potential scenarios and legal issues which may have practical implications for our clients. There are some points which will have an immediate bearing on clients risk management, including the terms of contracts being negotiated now, and we highlight these in Section C. A. OVERVIEW OF THE CRISIS 1. The Greek debt crisis continues, and there remain concerns that other countries will become further embroiled in the eurozone crisis. The lack of a clear response by European governments is having a negative impact on the economies, financial systems and markets not only of countries within the eurozone but also of countries outside such as the United Kingdom. The situation has been made worse by the recent economic slowdown in Europe and the United States. 2. In recent weeks, liquidity in the funding markets has tightened significantly with banks that are perceived to be exposed to the eurozone periphery bearing the brunt. As a result of their funding challenges, but also because the capital position of many banks has not been definitively strengthened, many banks in the eurozone remain cautious and reluctant to lend money to companies (and, in some cases, to each other). Due to the complexity of the various transmission mechanisms within the eurozone, it is difficult to predict with any certainty what the knock-on effects would be if there is a more significant haircut or write-down of Greek debt or an unplanned default, so risk of contagion has come to the fore. 3. There are multiple ways in which the eurozone crisis might unfold or be resolved. What is clear is that there is no easy solution or quick fix. Some of the possible scenarios and outcomes for the eurozone are outlined in Box 1. This briefing does not comment on the likelihood of the various scenarios or outcomes but focuses on some of the consequences. B. WILL EUROPE FIND A SOLUTION? The majority of commentators still believe that the eurozone crisis can be resolved without a member state withdrawing from the euro or a break-up of the currency, at least in the medium-term. For a brief overview of potential short-term and longer-term solutions refer to Box 2. C. PRACTICAL IMPLICATIONS FOR CLIENTS What could the different scenarios and outcomes outlined in Box 1 mean for clients and what are the likely practical implications? The legal issues and implications will depend, amongst other things, on the relevant
scenario, the terms of the contractual arrangements in question and, if there is a withdrawal or break-up, the facts and circumstances relating to such withdrawal or break-up. The following is a list of some of the potential issues which we believe our clients should be thinking about. Volatility and uncertainty the usual rules apply 1. As with all periods of volatility and uncertainty, clients (particularly in-house lawyers and corporate treasurers) need to pay even more attention than usual to the full range of financial and legal risk management issues, including dependencies on financial and commercial counterparties who may face severe challenges or capital controls affecting their ability to perform under some of the eurozone scenarios. 2. Lawyers should keep in mind that in contracts currently being negotiated or amended, boilerplate clauses such as those dealing with the currency and place of payment, the impact of market disruption on pricing of loans, force majeure, material adverse change and governing law may need more attention than they usually receive, particularly where the counterparty is in a peripheral eurozone country or may be affected by its difficulties. Treasurers will also be thinking about such matters as the robustness of their existing liquidity facilities and whether their company or any counterparty is exposed to rating downgrade risk that would be heightened by a eurozone default or eurozone-induced recession. 3. In addition to these general rules, we highlight some particular areas of focus below with reference to the scenarios outlined in Box 1. Restructuring 4. The legal issues which may be relevant in the context of a restructuring of Greek or, potentially, other sovereign debt will depend on the proposed terms of any restructuring. However, some or all of the following issues could be relevant: Impact on Greek government debt: The impact on Greek government debt and related contracts will depend on the governing law of the debt and whether or not the haircut or write-down is (i) compulsory (e.g. implemented and imposed on bondholders by legislation); or (ii) voluntary (e.g. implemented by obtaining bondholder consent through contractual mechanisms in the bond documentation or through a consensual exchange offer). These mechanisms could be combined with the threat of non-consensual write-down used to force bondholders to agree to a haircut or lengthening of a maturity especially where the relevant debt includes collective action clauses (provisions which enable a majority of bondholders to bind all bondholders). The majority of Greece s government debt is governed by Greek law which means that it may be possible for the Greek government to pass legislation to implement the haircut or write-down which could be enforced as a mandatory law by the Greek courts. Impact on other contracts: If there is a haircut or write-down of debt and Greece remains part of the eurozone, it is unlikely that there would be a significant impact on other contractual arrangements denominated in euro. Exit: If the implementation of a restructuring is combined with an exit by Greece or any other member state from the eurozone, this would raise a number of other complex legal issues, some of which are highlighted in the Withdrawal or break-up section below. 02 SLAUGHTER AND MAY
Withdrawal or break-up 5. A number of complex legal issues are in addition likely to arise in a withdrawal or break-up scenario. Exit mechanism: The eurozone is currently a one-way street in that the EU treaties do not contemplate the unilateral withdrawal by a member state from the euro (without withdrawal from the EU in its entirety). Neither do they contemplate any means by which a member state which is not in compliance with its EU obligations might be forcibly ejected from euro participation. However, there is the possibility of a lawful exit by one or more member states on a consensual basis, although this would require the agreement of each of the other member states and careful planning (e.g. legislation is likely to be needed to address the mechanics of withdrawal and conversion of obligations in the new currency and other measures, such as capital controls and/or caps on bank withdrawals, would probably be required to manage the transition). In addition, there is also the possibility of a unilateral exit in which a member state chooses to leave the euro and replace it with a national currency. Such unilateral withdrawal would involve a breach of EU treaties and would, therefore, raise the question whether the exiting state or states could continue to be members of the EU. Continuity of contracts: Withdrawal or break-up could potentially disrupt the continuity of some contracts. Although contracts commonly used in the financial markets do not usually provide for the possibility of euro break-up (either in terms of continuity or termination), there is the possibility that material adverse change or force majeure type clauses, if broadly drafted, could be triggered in certain scenarios. In addition, the commercial repercussions of a withdrawal or break-up scenario could have adverse effects on contractual performance. As a general principle, it is not anticipated that many contracts governed by English law are likely to be frustrated by the withdrawal of one or two member states from the euro, as the legal criteria for frustration are difficult to satisfy. Redenomination risk: Another key issue to consider in the context of a withdrawal from the eurozone is whether an outstanding euro obligation should be paid in euro or in the new national currency of the withdrawing member state converted at the official changeover rate. Determining in which currency payment should be made will clearly be important as it seems likely that any new domestic currency would fall in value against the euro if it is a weaker eurozone member state that withdraws. Where a monetary obligation is expressed in a particular currency, there is an implicit choice of the law of the country of that currency to determine what that currency is. This is known as the lex monetae principle, which generally applies regardless of the governing law of the contract. This is a principle of English law but it is also recognised with certain differences in most developed jurisdictions. However, where an obligation is expressed in euro, there is no single country of that currency designating the lex monetae. In a withdrawal scenario, the question will arise of the currency in which payments under the contract should be made, and (if not euro) the conversion rate that will apply. Where the contract is purely domestic to the exiting country (for example, a contract between two Greek parties, providing for performance and payment in Greece and governed by Greek law), the lex monetae is more likely to be Greek; and in any event, legislation binding on the Greek courts may be passed at the point of exit which requires payment in the new Greek currency. Where one of the parties is not Greek and the contract is governed by, say, English law, there is scope for legal disagreement about the lex monetae and 03 SLAUGHTER AND MAY
significant contracts therefore need to be examined carefully. Again, the terms of the relevant contracts, the intention of the parties and the circumstances of the withdrawal will be relevant to the legal analysis. We expect that the majority of English law contracts would be interpreted so as to require payment in euro notwithstanding the departure of one or two member states from the eurozone, but the counterparty s ability to perform may be affected by Greek legislation or capital controls. Price sources: Difficulties may arise with regard to the interpretation of contractual provisions which operate on the assumption that payments will be made in a particular currency. For example, references to EURIBOR may no longer be appropriate where the underlying payment obligation has been redenominated. Faced with an English law governed contract which specifies EURIBOR, an English court may be prepared in certain circumstances to imply a term into the contract to the effect that the rate is calculated with reference to the nearest comparable index or source, although there is clearly the potential for disputes as to what that source should be as economic results may vary. Points to consider in relation to new contracts and transactions 6. New contracts: While a withdrawal or break-up scenario is still considered unlikely in the medium-term by the majority of commentators, the potential impact it might have on contractual arrangements and monetary obligations means that consideration should be given to addressing some of these issues expressly in new contracts. By way of example: Jurisdiction and governing law clauses: These clearly require careful thought. Drafting changes: Certain drafting changes may be helpful in order to demonstrate the intention of the parties and reduce the risk of disputes. For example, it would be appropriate to consider whether (i) euro has been appropriately defined or whether a definition should be included; (ii) the proposed place of payment is appropriate (i.e. location of relevant bank accounts); (iii) any additional termination rights should be inserted; (iv) the netting provisions require amendment; and (v) any other bespoke provisions which might be considered helpful to mitigate against redenomination risk. 7. Acquisitions: The following issues may require further thought if an acquisition is contemplated: Due diligence: As part of the due diligence process, it would be appropriate to (i) consider whether the relevant target has material exposures to weaker eurozone member states or counterparties or to vulnerable EU banks; and (ii) identify any assets whose value, or any material contracts whose payment obligations, might be affected. Accordingly, it may be necessary to tailor the due diligence questions and contract review templates to ensure that the relevant issues are flushed out and considered properly. Material adverse change ( MAC ): The scope of any MAC clauses in the relevant share purchase agreement or business purchase agreement may need to be considered with reference to the potential scenarios. Commitments: The precise terms of any financing or equity commitments for the acquisition (including any conditions and termination provisions) should also be considered with reference to the potential scenarios. 04 SLAUGHTER AND MAY
BOX 1: POSSIBLE SCENARIOS AND OUTCOMES FOR THE EUROZONE Possible scenarios Some of the possible scenarios for the eurozone are outlined below: Orderly restructuring: An orderly restructuring of Greek sovereign debt and potentially the sovereign debt of other weaker states. By way of example only, this could involve a more significant haircut of the Greek debt to ensure that it is sustainable and the expansion or leveraging of the European Financial Stability Facility (refer to Box 2 below). If a more significant haircut of Greek debt is proposed, it is likely that this would need to be coupled with an appropriate support package for some of the EU banks which have significant exposure to the eurozone periphery. However, in the scenario that only the Greek sovereign debt issue is solved, the focus of the financial markets attention will quickly move to other eurozone member states. Disorderly default/restructuring: A disorderly default and/or restructuring of Greek debt could occur if no solution to the Greek debt crisis can be agreed by the eurozone member states or if there are unplanned defaults (for example, if Greece rejects further austerity measures and/or continues to fail to satisfy funding conditions). There is also a risk that once an orderly restructuring process commences, it fails to secure the necessary support from investors, triggers contagion and leads to a more comprehensive and disorderly default and restructuring. The occurrence of default in itself would not necessarily involve an exit from the eurozone by Greece, although a disorderly default may make an exit more likely. In this scenario, there is a more significant risk that a number of other weaker eurozone member states would be unable to finance themselves. Withdrawal or break-up: Although previously regarded as nearly unthinkable, there are also a number of exit and break-up scenarios and exit candidates which commentators are increasingly discussing. For example, Greece and/or other weaker states could withdraw from the monetary union (theoretically at least, Germany and/or other stronger states might wish to withdraw if the terms of euro membership ceased to be sufficiently attractive for any reason, but this remains highly unlikely). Any such withdrawal could either be (i) a consensual withdrawal negotiated with the other member states; or (ii) a unilateral and unlawful withdrawal by the exiting country (refer also to Withdrawal or break-up Exit mechanism in Section C above). Possible outcomes If an orderly restructuring of Greek sovereign debt and a convincing expansion of the eurozone s capacity to support other weaker states cannot be achieved, possible outcomes may include (i) a worsening funding environment for all weaker eurozone member states; (ii) continuing bank liquidity pressures; (iii) further bank restructurings and recapitalisations; (iv) potential bank failures; (v) pressures on non-bank financial institutions; (vi) a worsening credit squeeze affecting non-financial companies; and (vii) an increasing negative impact on business and consumer confidence. In addition, if there is a withdrawal from the eurozone by one or more member states, it seems likely that the exiting country would need to introduce new legislation, capital controls (including caps on bank withdrawals to protect the new currency and prevent runs on euro deposits) and other protective measures to manage the implications of withdrawal. Capital controls would not necessarily be limited to the exiting country, given the likelihood of contagion. Redenomination of governmental and possibly other public sector debt and private sector debt would follow raising the question of whether such redenomination would be recognised outside of the departing country (refer also to Section C above). 05 SLAUGHTER AND MAY
BOX 2: WILL EUROPE FIND A SOLUTION? It has been suggested that a potential solution to the crisis may involve a further strengthening (or leveraging) of the European Financial Stability Facility (the EFSF ) in the short-term and the introduction of an enhanced European Stability Mechanism ( ESM ) as a more permanent support mechanism in the longer-term. A number of other potential solutions (such as the use of eurobonds backed by the eurozone countries) have also been debated. European Financial Stability Facility The EFSF is a public limited liability company (société anonyme) incorporated in Luxembourg whose shareholders are the eurozone member states. The EFSF Framework Agreement dated 7 October 2010 sets out the terms on which the EFSF may make loans to eurozone member states. During July 2011, an amendment to the EFSF Framework Agreement was agreed by the eurozone finance ministers, subject to ratification by the eurozone member states in accordance with their national laws. In summary, this amendment will mean that: the maximum guarantee commitments under the EFSF will be increased to 780 billion; the effective lending capacity of the EFSF will be increased to 440 billion; the EFSF will be able to purchase bonds on the debt primary markets on an exceptional basis; and it will be possible for the EFSF to make loans to governments which are not themselves part of a bail-out programme to recapitalise financial institutions. These amendments are expected to enter into force by the end of October 2011 once the relevant parliamentary approvals are obtained. The amended lending capacity of the EFSF is likely to be significantly less than 440 billion as the existing loans to Ireland and Portugal as well as loans under the second bail-out package for Greece will need to be deducted from this revised limit. Accordingly, it has been suggested that it may be necessary to (i) significantly increase the 440 billion limit; and/or (ii) leverage the EFSF, for example by using the EFSF s funds to provide first loss protection to support a much larger volume of ECB lending. It remains to be seen whether further changes to the EFSF Framework Agreement will be proposed. However, any such changes are likely to require the unanimous agreement of the eurozone member states and ratification in accordance with national requirements. European Stability Mechanism The ESM is intended to replace the EFSF (which is due to expire in 2013) as a permanent bail-out mechanism. It also needs to be ratified by members of the eurozone to come into force. The ESM is likely to retain many of the features of the EFSF but, if further amendments to the EFSF are required, this could mean that additional changes to the ESM will be necessary, giving rise to the same questions as mentioned above. 06 SLAUGHTER AND MAY
It is envisaged that the ESM facility will have a capital base of 700 billion with an initial lending capacity set at 500 billion. The capital base and lending capacity will remain subject to regular review, at least every five years, to determine whether it remains adequate. Any increase in authorised capital or lending capacity will require the unanimous consent of the eurozone member states. Like the EFSF, it is also contemplated that the ESM facility would permit financial assistance in the form of loans or through the purchase of bonds on the primary markets. Other measures? The EFSF and the ESM have been designed to address the sovereign financing needs of eurozone member states. However, it is increasingly accepted that EU banks require more capital to cover potential losses on exposures to eurozone sovereigns facing difficulties as well as their banking systems. The Commission has proposed co-ordinated action by member states although the extent to which this will materialise remains uncertain. Equally unclear is the amount of new capital required, and the extent of which it will be provided by the private sector, national governments, the EFSF through loans to eurozone member states as contemplated by the July 2011 amendments to the EFSF, or by a mixture of the three. In addition, Germany and France have indicated that they are working on proposals to bolster and recapitalise certain EU banks and that further details will be available by the end of October 2011. If the crisis continues to worsen, other measures are likely to be needed. In addition, despite the clear warnings sent by the first phase of the financial crisis in 2008, many member states still do not have the legal or institutional structures in place to take resolution action in respect of failing banks. A further deterioration in the eurozone crisis is likely, therefore, to trigger further institutional and legislative actions both at an EU and eurozone level and at national member state level. If you would like to discuss the issues raised in this briefing paper, please contact one of the following or your usual Slaughter and May contact: Ian Johnson: ian.johnson@slaughterandmay.com Andrew McClean: andrew.mcclean@slaughterandmay.com Charles Randell: charles.randell@slaughterandmay.com Sanjev Warna-kula-suriya: sanjevwks@slaughterandmay.com Slaughter and May One Bunhill Row London EC1Y 8YY United Kingdom T +44 (0)20 7600 1200 www.slaughterandmay.com Slaughter and May 2011 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. isj12.indd1011