The Euro Crisis - Contingency Planning for Asset Managers

1 Background

1.1 EU legal background

1. This paper seeks to identify, as a matter of contingency planning, legal issues which might arise for asset managers as a result of a contraction or restructuring of the eurozone (a "euro event"). It considers the issues principally with regard to contracts and proceedings which are governed by English law. Where a different governing law applies, many of the issues are likely to be similar but consideration should be given to any differences.

2. A euro event is likely to take the form of either (1) a "controlled exit" by agreement with other states, or (2) a "unilateral exit" by one or more individual states an ("exiting state").

3. A controlled exit is likely to be flagged well in advance and preceded by extensive and public negotiations. A unilateral departure could happen much more rapidly.

   1.2 Legal basis for a controlled euro-event

4. Even assuming a controlled exit, the effectiveness of the available legal mechanisms is open to question. The consolidated treaty of European Union ("TEU") contains no predesignated legal mechanism for a country to leave the euro. Because of this, to be completely legal within the framework of the TEU itself, such a departure would require the consent of all 27 EU states. Negotiations are likely to be lengthy and during this process the financial condition of the exiting state is likely to destabilise dramatically.

5. TEU article 50 (introduced by the Lisbon treaty) permits a member to withdraw voluntarily from the EU. It has therefore been suggested that an exiting state should resign from the EU and reapply immediately for membership with an opt-out from the euro zone. However in reality this probably does not improve the position since readmission would also require ratification by all 27 EU states.

   Unilateral action by the EU council

6. Arguably, a political agreement at the council level followed by the issue of a simple European regulation would avoid the inherent problems involved in a full TEU renegotiation. However this would technically be an infringement of the TEU and therefore open to legal uncertainty and challenge

   The Vienna Convention

7. An exiting state (whether exiting on a controlled or unilateral basis) might seek support from international law in the shape of the Vienna Convention on the Law of Treaties.1

   Article 61 allows a unilateral withdrawal from a treaty because of the impossibility of keeping certain obligations. Article 62 allows a country to withdraw from a treaty because of fundamental changes in circumstances from those which prevailed at the time the treaty was written, resulting in radical transformation of the exiting state's obligations. Article 44 allows a state to withdraw from certain clauses of a treaty provided those clauses can be separated from the rest of the treaty and were not an essential reason for the other treaty signatories accepting the treaty. 8. This approach might be challenged on grounds that community law is not part of international public law, though apparently there are several European court rulings which assume that the Vienna convention can be applied in an EU context.

   Enhanced cooperation

9. Another mechanism, known as "enhanced cooperation", which has been contemplated in the context of the fiscal cooperation proposed before Christmas 2011 by Germany and France, might also be employed, in some degree, to deal with a euro event.

10. TEU, article 20, provides that EU states which wish to establish enhanced cooperation within the framework of the union may make use of its institutions and apply relevant provisions of the treaties. Any decision enhancing cooperation may be adopted by the Council as a last resort if they cannot be attained within a reasonable period by the union as a whole and provided at least nine EU member states participate.

11. If the area of enhanced cooperation relates to an exclusive competence of the EU then all EU states must consent to it. It is arguable that since article 3 of the TEU provides that the union shall establish economic and monetary union whose currency is the euro, the operation of the euro zone is an exclusive competence of the EU.

12. The Treaty for the Functioning of the European Union ("TFEU") requires expenditures resulting from enhanced cooperation other than administrative costs to be met by the participating states unless the council, after consulting the parliament, decides otherwise. So states planning for such cooperation may want to consider keeping their use of council and commission facilities to a minimum.

    1.3 Possible scenario for a unilateral euro event

13. Prior to actual default or exit a weak euro zone state is likely to experience some of the following:

    increased cost of sovereign borrowing; restructuring (i.e. reduction in value) of outstanding internationally-denominated sovereign debt without actual default; sovereign bond defaults; or a run on its banks as depositors seek to move their assets abroad. Unilateral euro-event

14. This might arise from a sequence of events on the following lines.

15. Default on payment of sovereign debt, probably when existing debt was due for refinancing. A defaulting state might still be able to stay within the euro if sufficient external financing was forthcoming .

16. If not, there could be extensive damage to domestic banks in the run up to and after such a default. They could be threatened both by their exposure to domestic sovereign debt and bank runs/withdrawal of deposits. The defaulting state would need to recapitalise its banks to restore confidence and this might prove impossible given the state's own weaknesses.

17. Faced with the collapse of its domestic banking system and economy, the defaulting state might now feel compelled to take emergency measures:

    reintroduction of capital and exchange controls, initially to prevent assets moving abroad and later to prevent a newly created currency being exchanged for foreign currency; temporary suspension of bank payments to prevent withdrawals of euros (an extended bank holiday); a new law establishing a new national currency and redenomination of existing euro-denominated payment obligations into the new currency at a fixed exchange rate; there might need to be restrictions on freedom of movement to prevent the workforce moving en mass to another EU state. TEU article 63 prohibits restrictions on the free movement of capital and capital controls so this would prima facie be a breach. Article 65(1b) gives a limited exemption for public policy or public security reasons. 18. This in turn would probably lead to the following:

    the new currency would fall significantly in value against its original euro exchange rate. Domestic borrowers whose debt was redenominated would benefit from the reduction in their obligations while their creditors would suffer; euro or dollar debt which had not been redenominated would now be much more expensive in local currency terms. Domestic borrowers of such debt would have major solvency problems and would probably default; the exiting state and its businesses would be unable to raise funding in the international markets; their ability to pay for imports would also be much reduced; there would be a likelihood of high inflation; and in the medium term the exiting state would regain control of its monetary policy, while the falling exchange rate would boost the exiting state's competitiveness and allow it to re-enter the international markets at its natural level. Impact

19. As one EU state moves into default, bond yields for other weak EU states would increase dramatically and could make private funding unaffordable, moving them into the potential defaulter category. There could be runs on banks in any state which was thought to be close to leaving the euro, which might in itself force an exit.

20. The balance sheets of banks in other countries with exposure to the sovereign defaulter/exiter would be detrimentally affected.

21. Stock markets would fall in most countries, including outside the EU.

22. Yields on non-EU government bonds issued by states perceived to be "safe" would fall further.

23. In the currency markets the euro might fall in value, particularly during any prolonged period of uncertainly during which investors and depositors sought "safe havens".

24. If a series of sovereign withdrawals left a...