Consequences of a Eurozone Exit

What legal issues does it raise?

Originally published in the May 2012 issue

In a letter to his investors in February 2012, John Paulson (the hedge fund manager who became a billionaire as a result of his bet against Lehman Brothers in 2008) wrote that that “the Euro is structurally flawed and will likely unravel”. He predicted that “it seems likely that the pressure to keep the euro together [will] become too great and it [will] ultimately fall apart”. In contrast, the first draft of this article explained that the prevailing market view was that an exit of a member state from the Euro remained unlikely, notwithstanding the Eurozone’s troubles. This view was premised on the continuation of the significant and unprecedented efforts undertaken by member states thus far to preserve the Eurozone in its current form. However, things have moved on significantly as a result of the recent elections in Greece and a significant restructuring of the Euro looks more likely than ever. This restructuring may well include member state exits.

The consequences of a Eurozone exit will present severe challenges to fund managers. Whilst the current focus is on Greece leaving the Euro, with Cyprus, Ireland, Italy, Portugal and Spain each having come under significant economic pressure, there are a number of other member states for whom such an outcome is not beyond the realms of possibility. Indeed, if Greece were to exit the Eurozone, the chances of further member state exits would probably increase.

Whilst fund managers will already be undertaking credit analysis with respect to their portfolios’ exposure to a Eurozone exit, significant legal uncertainties and challenges may also arise and should be considered. These uncertainties are most likely to materialise where a fund manager has a contractual relationship with a counterparty based in, or connected to, a member state exiting the Eurozone. As a number of the legal issues arising from a Eurozone exit will be contractual, a degree of preparation can be achieved through amendments to existing documentation and considered drafting of new documentation.

What follows is a brief and high level overview of some of the key legal risks that may arise as a result of a Eurozone exit, focusing in particular on fund managers’ trading documentation and general fund documentation.

Trading Documentation
In times of financial instability, it is crucial that trading documentation preserves hedge fund managers’ ability to access or trade assets quickly so as to protect their portfolios. The impact of a Eurozone exit poses significant risks which include: (i) the redenomination of Euro denominated obligations; (ii) the risk of termination following redenomination; and (iii) the ability to access collateral following redenomination.

Redenomination of Euro obligations. On leaving the Euro, an exiting member state will re-establish a national currency. This national currency will be set at a fixed exchange rate and is likely to be subject to capital controls, including exchange controls. As a result, and combined with the financial instability an exiting member state is likely to be facing, any new currency is likely to depreciate sharply against the exchange rate at which it exited the Euro. Therefore, where fund managers trade with entities based in or connected to the exiting member state, there is a risk that contractual obligations denominated in Euros will be redenominated into the weaker national currency causing loss to the fund. Whether or not that happens will depend on, among other things, the wording of the relevant contractual terms, the governing law and jurisdiction of the contract and the interpretation of difficult legal principles.

Event of default following redenomination. If Euro denominated obligations are redenominated, it is unlikely that the contract will become frustrated or discharged. However, it is possible that tendering of payment in the “wrong” currency will trigger a contractual event of default. Depending on the wording of the contractual provisions, this might give a creditor the right to terminate the contract or, more worryingly, the debtor or another party to the contract the right to do the same. Clearly, the termination of a contract is something over which a fund manager will want to have certainty and control, given the potential impact on a fund manager’s investment and hedging strategy.
Collateral Obligations. Where a fund is a creditor to an entity based in or connected to an exiting member state, it will be in a far stronger position where it has access to collateral. Recourse to collateral is particularly important in times of financial volatility, which is likely to precede or follow a Eurozone exit. A number of concerns have been raised regarding the impact of a Eurozone exit on collateral provisions. These concerns include the eligibility of posted collateral which becomes subject to redenomination and the applicability of payment netting where some Euro obligations are redenominated but some are not. Robust collateral provisions that counter these issues to the extent possible are very desirable.

Fund Documentation
A number of legal issues are particularly relevant to investment management and service provider documentation.

Investment Management Documentation. As discussed above, in times of financial volatility, fund managers need to maintain their flexibility to manage their portfolios on a discretionary basis. It is therefore important that the terms of a fund manager’s relevant investment documentation allow that flexibility. This might require amendments to be made to a fund’s investment management agreements and offering memorandum, including in relation to the scope of investment objectives (in particular if there are prescribed percentage thresholds relating to potentially affected assets), risk disclosures and the ability to take all action a fund manager deems necessary to protect its portfolio in the event of a Eurozone exit.

Service Provider Documentation. The redenomination issues identified above are also potentially relevant to service provider agreements including depositary, custody, administration and distribution agreements where they entered into with a party based in or connected to an exiting member state. In particular, in the event of redenomination, issues might arise as to the enforceability of service providers’ obligations, including indemnity provisions. Further, where depositories and custodians are based in exiting member states, difficulties might arise in arranging the transfer of cash and/or other assets from their accounts to the extent that capital controls are introduced.

The foregoing is by no means a definitive account of all potentially relevant issues. A Eurozone exit will raise a number of other legal issues such as the status of any cash holdings held in an exiting member state, the impact of an exit on fund managers’ borrowing arrangements (if any) and the ability to recover assets in the event of the insolvency of a counterparty based in an exiting member state.

The legal impact of a Eurozone exit is not anticipated either in EU treaties or standard contractual documentation. Even the legality of a member state’s exit from the Eurozone is far from clear, even if that exit is effected by agreement with the other member states. Conflict of law issues are also likely to arise. Nevertheless, fund managers can prepare for a Eurozone exit by considered drafting of new documentation and, where practicable, amendments to existing agreements. Any preparation in respect of the risks identified herein should be encouraged, particularly as a Eurozone exit is likely to take place in a period of severe financial instability.

Craig Borthwick is an associate within the Financial Services department at Dechert. He advises on the formation and structuring of a variety of investment funds as well as general corporate, compliance and regulatory issues. He also advises on prime brokerage and derivatives documentation.