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SPACs and the JOBS Act

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Usha Rodrigues †

Public Inroads in Private Equity

The law has long confined the average investor to trading in public securities[1] while allowing wealthy—or “accredited”[2]—individual investors access to a panoply of private securities, including investment vehicles such as hedge funds and private equity funds. Nevertheless, pressure to let the general public into private equity has been growing. Two forces have contributed to this mounting pressure. First, public investors are eager to try their hand at investing in private enterprise. Second, private firms need capital. In the face of these forces, the sharp line that has long separated public and private firms has become increasingly blurred.[3]

Consider the story of the emerging growth company (EGC), or “Initial Public Offering (IPO) on-ramp,” provision of the Jumpstart Our Business Startups Act (JOBS Act). In its first few months on the books, this provision had effects far different from what its drafters envisioned. The JOBS Act’s IPO on-ramp was intended to ease regular companies’ path to going public; instead, it has inadvertently made it easier for the average investor to get a taste of private equity via special purpose acquisition corporations (SPACs). This piece will briefly describe SPACs, the IPO on-ramp, and how shell companies have taken advantage of a legislative provision intended to bring cash-hungry young companies directly to market. This piece will close with a few thoughts on lessons the story of SPACs’ interaction with the JOBS Act may offer regarding the increasingly indistinct line that divides public and private investment.

 Introducing SPACs

A SPAC is a type of “blank-check” company that goes public to raise a pool of cash and then begins a hunt for a target.[4] The bulk of the IPO proceeds are locked up in a trust account, invested in government-backed securities, and kept safe from the interference of the managers.[5] Once a target is identified, the SPAC managers disclose material financial information about it to shareholders, who then have a say on whether the acquisition occurs by way of voting or opt-out rights.[6] If no suitable target is found, or if a shareholder is unhappy with the deal, she can receive most of her money back—an average of ninety-eight cents on the dollar—from the trust account.[7] But if a SPAC shareholder does like the deal, then she will end up having owned a piece of an acquisition vehicle—in essence, a one-off private equity fund.[8]

The beauty of the SPAC model is that it bifurcates the process of going public, making it faster and cheaper. When the SPAC itself goes public, it is basically an empty shell, so any disclosures required under the Securities Act of 1933 (1933 Act) are minimal and cheap.[9] The SPAC’s Securities Exchange Act of 1934 (Exchange Act) filings are likewise minimal; in essence, they involve nothing more than reporting the rate of return generated in the trust account.[10] If and when the SPAC acquires a target—usually a private company—that target immediately becomes public without the hassle, disclosures, and delay that accompany a typical IPO.[11]

JOBS Act and SPACs

SPACs offered a rare chance for the average investor to participate in the rarified world of investing in private targets, while simultaneously offering those targets an easy route to an IPO. The JOBS Act took a decidedly different approach to blurring the line between public and private investment. Rather than letting the general public into private equity investments, the drafters tried the converse: encouraging more private firms to go public. Yet despite the JOBS Act’s focus on making it easier to bring traditional operating companies to the public market, its provisions have proven unexpectedly appealing for SPACs. Thus, legislation intended to help conventional companies go public is also facilitating a form of private equity investment.

SPACs’ business structure was in place long before the passage of the JOBS Act; indeed, they predated the Act by more than a decade.[12] The whole point of the JOBS Act’s EGC provision was to coax small-cap companies into going public by reducing the burdens of public disclosure and ongoing federal regulation, thereby providing the benefit of access to the public capital markets previously unavailable to them. I thought surely the passage of the JOBS Act was bad news for SPACs. Why agree to be acquired by a SPAC when you can easily go public on your own? The JOBS Act, however, had an unanticipated effect on the SPAC market because the JOBS Act’s IPO on-ramp provision makes it easier and cheaper for any small corporation to go public.[13]

As it turned out, the JOBS Act was not all bad news for SPACs because many SPACs themselves decided to go public using the IPO on-ramp. Indeed, in the eight weeks after the JOBS Act’s passage, over a dozen of the companies taking advantage of the new on-ramp option were SPACs.[14] Four months after the JOBS Act’s passage, one out of every nine EGCs was a SPAC.[15] The trend has not abated; in the first half of August 2012, one out of five firms that made use of the IPO on-ramp provision were SPACs.[16] To say the least, SPACs are making good use of the EGC option.

At first blush, SPACs’ use of the JOBS Act’s on-ramp seems counter-intuitive. It already was, and still is, easy for SPACs to go public under the conventional 1933 Act registration process. After all, SPACs’ disclosures at the start-up phase are largely boilerplate, along the lines of “this is who we are, this is how much money we plan to raise, this is how much we are setting aside in trust.”[17] If it is so easy for SPACs to register under the 1933 Act, why should they bother with the on-ramp provision offered by the JOBS Act?

The answer to this question stems from economic realities. As it turns out, successful SPACs—that is, SPACs that complete acquisitions—can save a lot of money in securities regulation compliance costs by making use of the IPO on-ramp. The payoff comes from greatly reduced ongoing reporting requirements imposed by the Exchange Act.In particular, EGC status under the JOBS Act lasts up to five years, as long as revenues, market capitalization, and debt issuances stay low,[18] and with that status come “scaled-back disclosures, certain exemptions to executive-compensation disclosures and attestation requirements for the auditors.”[19] These features make EGC SPACs comparatively more attractive to potential targets. A private company looking to go public on the cheap (i.e., at even less expense than the JOBS Act’s on-ramp promises) might well favor an EGC SPAC acquirer that promises lower disclosure burdens over a traditional public company acquirer—or, for that matter, a non-EGC SPAC—both of which would require the Exchange Act’s more in-depth disclosure. Time will tell whether EGC SPACs prove to be more successful acquirers than traditional acquirers and non-EGC SPACs.

In sum, despite reformers’ best intentions, many of the first companies to file as EGCs were not small operating companies rushing to access the capital markets as soon as regulatory barriers fell away. Instead, they were firms looking to acquire private firms down the road and take them public. Even so, the net effect may be what the JOBS Act’s drafters intended: if these new EGC SPACs have their way, they will acquire private firms, and thus bring more small firms to the public markets. Yet the SPAC EGCs will accomplish this goal in a roundabout way. More small firms will go public, as the JOBS Act envisioned, but by way of shell companies that allow the general public to participate in the uniquely public form of private equity that SPACs offer. While successful EGC SPACs will thus bring more firms public, they will at the same time allow their own investors to participate in a species of private equity investment, a kind of investment traditionally reserved for accredited investors. All of this supports a telling conclusion: both regulators and the market itself are exerting pressure on the line separating public and private investment, and these two separate forces can combine to produce unanticipated results.

Blurring the Line Between Public and Private

In conclusion, SPACs and the JOBS Act, both considered singly and taken together, signal the mounting pressure building over the divide between public and private investment. SPACs are mechanisms that let the public make private equity-like investments. The IPO on-ramp is an attempt to entice private companies to the public markets. Yet even more tellingly, these separate phenomena have recently interacted in an unexpected way, revealing how difficult it can be for reformers to revise the public-private boundary with any degree of certainty.

SPACs and the JOBS Act’s IPO on-ramp are but two examples of recent trends that suggest that the line separating the public and private investment spheres may be blurring. Another example, the CROWDFUND Act, applies pressure on the other side of the public-private line: rather than making it easier for more private companies to access the public markets, it allows unaccredited investors a chance to invest limited sums in private companies for the first time.[20]

Securities regulation ultimately involves a delicate balancing act, with investors’ need for protection and firms’ thirst for capital pulling in opposite directions. The traditional balance reserved robust investor protection for the public markets, and allowed wealthy investors exclusive access to more risky, and potentially more profitable, private firm investment.[21] But SPACs are a sign that the general public also desires to furnish capital to private firms in exchange for the chance to earn a higher rate of return.  At the same time, the JOBS Act signals a desire on the part of regulators and firms alike to allow companies to enjoy the benefits of being public while reducing some of the burdens that have traditionally accompanied public status.  Such examples thus, in different ways, indicate that the public-private boundary may be shifting dramatically.

 

Preferred citation: Usha Rodrigues, SPACs and the JOBS Act, 3 Harv. Bus. L. Rev. Online 17 (2012), https://journals.law.harvard.edu/hblr//?p=2488.

† Associate Professor of Law, University of Georgia School of Law.  I thank Mike Stegemoller and the staff of the Harvard Business Law Review.  Any errors are my own.

[1] See, 15 U.S.C.A. § 77d (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[2] Rule 501 of Regulation D describes several categories of accredited investors, including certain banks, charitable organizations, and certain high net worth individuals, who may invest in securities that are not registered. 17 C.F.R.  § 230.501(a) (2012). Most notably, individuals with a net annual income of over $200,000 or a total net worth of over one million dollars may invest in securities that are not registered provided that those securities meet the general disclosure requirements of Rule 502. 17 C.F.R. § 230.502 (2012).

[3] For a few recent scholarly discussions of the public-private divide, see Donald C. Langevoort & Robert B. Thompson, “Publicness” in Contemporary Securities Regulation After the JOBS Act (Georgetown Law and Econ. Research Paper, No. 12-002, 2012) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1984686; Adam C. Pritchard, Revisiting “Truth in Securities” Revisited: Abolishing IPOs and Harnessing Private Markets in the Public Good (Univ. of Mich. Law & Econ. Research Paper No. 12-010, 2012) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2103246; Usha Rodrigues, Securities Law’s Dirty Little Secret, 81 Fordham L. Rev. (forthcoming 2013) (on file with the author).

[4] Usha Rodrigues & Mike Stegemoller, Exit, Voice, and Reputation: The Evolution of SPACs, 37 Del. J. Corp. L. (forthcoming 2012).

[5] Id.

[6] Id.

[7] Id.

[8] See Steven M. Davidoff, Black Market Capital, 2008 Colum. Bus. L. Rev. 172, 225 (2008) (“SPACs are a species of private equity: these are capital pools organized to acquire individual businesses. But because of the general requirement that the initial acquisition comprise eighty percent of its assets, SPACs typically only acquire a single privately-held business. Despite these important distinctions, SPACs otherwise attempt to mimic private equity returns by employing comparable structures and practices. For example, SPACs utilize similar leverage to increase the size and potential returns of their acquisitions. The managers of SPACs are also typically provided twenty percent of the initial share offering at nominal amounts; ownership they are required to maintain until and after consummation of an acquisition.”).

[9] Daniel S. Riemer, Special Purpose Acquisition Companies: Spac and Span, or Blank Check Redux?, 85 Wash. U.L. Rev. 931, 950–51 (2007) (describing typical SPAC registration disclosure).

[10] Rodrigues & Stegemoller, supra note 4.

[11] Some call SPACs back-door IPOs, but SPACs differ from the seedier reverse mergers that led to so many Chinese companies with questionable accounting practices going public. Id.

[12] Riemer, supra note 9, at 944–45.

[13] For example, emerging growth companies need to disclose only two years of audited financial information prior to going public. 15 U.S.C.A. 77g(a)(2)(A) (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012). They are not subject to Sarbanes-Oxley’s dreaded internal controls provision. 15 U.S.C.A. § 7262(b) (West 2009& Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[14] Emily Chasan, Meet the JOBS Act’s Jobs-Free Companies, Wall St. J., June 4, 2012, at B1.

[15] Chris Hitt, “I Am Shocked, Shocked”: Blank Check Companies and the “Scandal” of the JOBS Act, Blogmosaic (Aug. 16, 2012), http://blogmosaic.knowledgemosaic.com/2012/08/16/spacs-as-egcs/.

[16] Id.

[17] See, e.g., Acquicor Tech. Inc., Registration Statement (Form S-1) (Sept. 2, 2005).

[18] 15 U.S.C.A. 77b(a) (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[19] Chasan, supra note 14.

[20] Title III of the JOBS Act, the CROWDFUND Act, allows issuers to sell up to one million dollars of securities in a twelve-month period without Securities Act of 1933 registration. Any investor can invest in these companies—they are not reserved for accredited investors only. If an investor’s annual net worth or income is less than $100,000, she can invest no more than 5% of her net worth or annual income or $2,000, whichever is greater. Jumpstart Our Business Startups Act, Pub. L No. 112-106, sec. 302, § 4(a)(6)(B)(i), 126 Stat. 306, 315 (2012). If an investor’s annual net worth or annual income is equal to or more than $100,000, then she can invest no more than the greater of 10% of her net worth or annual income and $100,000. Id.

[21] Individuals qualify as accredited investors by having a net annual income of over $200,000 or a total net worth of over one million dollars. 17 C.F.R. § 230.215 (2012).  SEC regulations and industry practice dictates that only this special class of individual investors can invest in hedge funds, private equity funds, and venture capital funds. Thus, historically at least, ordinary investors have been shut out of the private market, except via pension funds that in effect pool the resources of many investors into an accredited-investor fund. No private market mutual funds currently exist.

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Restructuring Sovereign Debt Under Local Law: Are Retrofit Collective Action Clauses Expropriatory?

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Melissa A. Boudreau*

The European sovereign debt crisis has generated a number of controversial restructuring proposals that would have seemed appropriate only for emerging markets just a few years ago, but now are among the few options available to sustain the Eurozone. The leading proposal involves legislation that would mandate collective action clauses in untendered bonds governed under local law.  This Note evaluates whether enacting this legislation and utilizing it in a debt restructuring would engender successful investor claims of invalid expropriation against the sovereign in American courts, and concludes that a successful claim of invalid expropriation is unlikely.

Introduction

On April 23, 2010, Prime Minister of Greece George Papandreou called his country’s economy a “sinking ship” and requested an international bailout package.[1]  If he had revisited the maritime analogy two years later, Papandreou likely would have described Greece’s economy in early 2012 as resting upon a fragile life raft.  Despite receiving two separate bailout packages and implementing austerity measures, Greece has been unable to get its deficit under control.[2]  This sovereign debt crisis is not unique to Greece,[3] and many believe that the solution to the Eurozone’s economic woes must involve persuading bond investors to accept less than the obligation owed to them.[4]  Sovereigns could use a number of different methods to achieve this result, all with varying levels of state coercion.[5]  One such method is examined below.

Greece will be used as a case study in this paper, but the analysis presented here is by no means limited to Greek bonds.  Indeed, a surprising number of Eurozone periphery countries have significant amounts of local-law debt.[6]  Therefore, the applicability of the analysis presented below should be far-reaching in the Eurozone crisis, as the outcome in Greece may establish a template for future Eurozone restructurings.[7]  As one insider acknowledged, “It is not about Greece.  It is not about the money.  Most banks have written down their Greek bonds.  It is about a precedent for the rest of Europe and how the rules will be set going ahead.”[8]

I.   Background

After much media speculation throughout January 2012,[9] the Greek Parliament approved Law 4050/2012 on February 23, 2012.[10]  This law, known as the Greek Bondholder Act,[11] closely mirrors the model outlined in a 2010 paper by Lee C. Buchheit and G. Mitu Gulati.[12]  This similarity is unsurprising, for Buchheit is the head of the legal team retained by Greece to navigate the restructuring.[13]  Because the Greek government has not yet released an official English translation of the Greek Bondholder Act,[14] this Note will reference the issues presented in the Buchheit and Gulati model along with its so-called “Mopping-Up Law.”[15]

A.   Relevant Aspects of Greek Bonds

The critical aspect of Greek bonds for the purposes of this analysis is the governing law.  “Local law” governs an estimated 90% of these bonds.[16]  Generally, investors are wary of bonds with local-law clauses because they present the possibility for the sovereign to change its law to facilitate a restructuring of its own debt.[17]  In the past, these doubts predominantly have been associated with bonds in emerging markets; investors have not had similar misgivings with bonds issued under local law in industrial markets because the reputational sanctions that inevitably would result have offered sufficient deterrence.[18]  Even with the threat of reputational sanctions, however, countries have restructured under local law,[19] but in none of these instances were the stakes as high as those in the Greek restructuring.[20]  In fact, according to Buchheit and Gulati, “No other debtor country in modern history has been in a position significantly to affect the outcome of a sovereign debt restructuring by changing some feature of the law by which the vast majority of the instruments are governed.”[21]

Additionally, the bonds governed under Greek law were not drafted with a collective action clause (“CAC”).[22]  CACs are clauses in loan agreements that provide a supermajority of investors with the power to modify essential payment terms of the agreement.[23]  Because this provision was absent from the original local-law bonds, Greece was not given the power to amass a supermajority of investors to facilitate a debt restructuring for these particular bonds.

B.      Overview of the Mopping-Up Law

The Greek restructuring proposed by Buchheit and Gulati is a bond exchange offer with a state-mandated collective action clause.  It likely drew inspiration from a bond exchange offer with exit consents, so a brief explanation of exit consent restructuring is helpful.[24]  In a bond-exchange offer with exit consents, the debtor offers investors the option to swap their bonds with bonds having more flexible payment terms.[25]  To encourage other bondholders to take part in the exchange, the sovereign will require consenting bondholders to waive certain protections in the old bond that do not require unanimity for amendment.[26]  In this way, holdout bondholders could be left with bonds lacking certain contractual protections.[27]  Unfortunately, because the Greek local-law bonds disallow amending the terms of the bonds after issuance,[28] restructuring via traditional exit consents is unworkable in this instance.[29]

Thus enters the Mopping-Up Law.  Instead of directly modifying contractual language, the Mopping-Up Law would change local law to effectively incorporate a collective action clause in all untendered local-law bonds.[30]  Buchheit and Gulati suggest that the law could work as follows:

[L]ocal law would be changed to say that if the overall exchange offer is supported by a supermajority of affected debtholders (say, 75%, to use the conventional CAC threshold), then the terms of any untendered local law bonds would automatically be amended so that their payment terms (maturity profile and interest rate) match those of one of the new instruments being issued in the exchange.[31]

The incorporation of this clause via the contract’s governing law does not result in the sovereign directly taking tangible assets from investors.  Instead, it leaves the dirty work to the consenting bondholders.[32]  In this way, it is comparable to an exit consent restructuring.[33]  Similarly, the sovereign is still tasked with convincing a supermajority of investors to support the overall exchange offer.  This is “consistent with the fundamental principle that a sovereign debtor bears the burden of persuading its creditors that a debt restructuring is essential, that the terms of the restructuring are proportional to the debtor’s needs, and that the sovereign is implementing economic policies designed to restore financial health.”[34]  The central question is whether the sovereign must convince all investors or just a supermajority.[35]

C.     Scope of This Inquiry

The scope of this Note is narrow.  It examines whether American courts would find the Mopping-Up Law to be an invalid expropriation under international law.  This is certainly not the extent of a general inquiry into the Mopping-Up Law—other questions of international law will remain, such as those raised under Article 17 of the Greek Constitution, the European Convention on Human Rights and its Protocols, and unfair or inequitable treatment[36]—but addressing this particular element is far more manageable for one short paper.

Moreover, the American legal system is among the most protective systems in the world with regard to private property rights.[37]  Therefore, “[W]hile a U.S. court’s interpretation of the international law of expropriation may not be representative of the views of all or even most countries, a U.S. court’s interpretation does represent a kind of floor for assessing the legality of government action under international law.”[38]  Assuming that U.S. courts are highly protective of bondholder rights, this analysis presents a perspective of what government actions are “clearly permissible” within the context of international law.[39]

II.   Potential Sovereign Immunity

Before embarking on an expropriation analysis, courts must address the threshold issue of sovereign immunity.  Sovereign immunity stems from two sources in U.S. law: the Foreign Sovereign Immunities Act and the act of state doctrine.

A.   Foreign Sovereign Immunities Act

The Foreign Sovereign Immunities Act (“FSIA”)[40] provides the “sole basis” to bring claims in the United States against a foreign state.[41]  Under the FSIA, foreign states are immune from the jurisdiction of U.S. courts, subject to certain exceptions.[42]  Therefore, if a claim does not fall within a statutory exception, U.S. courts lack jurisdiction and will dismiss the claim.[43]  These statutory exceptions range from waivers of immunity to terrorism.[44]

Most relevant to the immediate inquiry, a sovereign may be haled to U.S. court if its actions constitute an expropriation.[45]  For this exception to apply, “rights in property” must be taken “in violation of international law,” and that property must be related to “commercial activity” carried on in the United States by the sovereign.[46]  In interpreting this particular provision, U.S. courts have attempted to square their interpretations with the law of expropriation under international law.[47]  Unfortunately for investors, many courts have interpreted the term “property” in this provision to be tangible property only, not including contractual rights.[48]  Part III provides an in-depth discussion of U.S. courts’ expropriation analyses arising under the FSIA.

B.   Act of State Doctrine

If investors persuade the court that a FSIA exception applies, they still must overcome the act of state doctrine to proceed with their claims.  Put simply, the act of state doctrine “provides . . . that United States courts will not judge the validity of official acts of a foreign government carried out within its own territory.”[49]  The Supreme Court articulated this doctrine in Underhill v. Hernandez[50]:

Every sovereign State is bound to respect the independence of every other sovereign State, and the courts of one country will not sit in judgment on the acts of the government of another done within its own territory. Redress of grievances by reason of such acts must be obtained through the means open to be availed of by sovereign powers as between themselves.[51]

More recently, the Court has declared that the act of state doctrine applies when “the relief sought or the defense interposed would . . . require[] a court in the United States to declare invalid the official act of a foreign sovereign performed within its own territory.”[52]  The foundation for this doctrine lies in the separation of powers inherent in the U.S. federal government.[53]  To ensure harmony in conducting foreign affairs, decisions of the judicial branch cannot be in conflict with those of the executive branch.[54]  Courts commonly fail to reach the merits of an expropriation claim because of the act of state doctrine.[55]

But there are exceptions to this broad doctrine.  In 1964, Congress passed the Second Hickenlooper Amendment[56] in an effort to limit the application of the act of state doctrine in expropriation claims.  It states, in relevant part:

[N]o court in the United States shall decline on the ground of the federal act of state doctrine to make a determination on the merits giving effect to the principles of international law in a case in which a claim of title or other right to property is asserted by any party including a foreign state (or a party claiming through such state) based upon (or traced through) a confiscation or other taking . . . by an act of that state in violation of the principles of international law . . . .[57]

This would suggest that claims of expropriation are within the purview of U.S. courts, without regard to the act of state doctrine.  However, most courts have found the Second Hickenlooper Amendment to be a very narrow exception to the doctrine.[58]

One case that solidly supports a limited reach of the act of state doctrine is Allied Bank International v. Banco Credito Agricola de Cartago.[59]  The facts of Allied Bank are somewhat analogous to the current events in Greece.  In the midst of a financial crisis, the Central Bank of Costa Rica issued regulations that effectively suspended all external debt payments.[60]  This constituted an event of default under the terms of the relevant notes, and investors sued for the full amount outstanding.[61]  The district court had held that the act of state doctrine applied, noting that to hold otherwise would “put[] the judicial branch of the United States at odds with policies laid down by a foreign government on an issue deemed by that government to be of central importance.”[62]  On appeal, the Second Circuit first held that the actions of the Costa Rican government were “fully consistent with the law and policy of the United States,”[63] but on rehearing en banc, the court reversed its prior decision on policy grounds.[64]  In arriving at this determination, the Second Circuit relied upon the policy outlined in the amicus brief proffered by the Department of Justice.[65]  The government’s brief noted that the court’s prior interpretation of U.S. policy was incorrect, and that the proper means for restructuring this debt was in an International Monetary Fund (“IMF”)-approved economic adjustment program.[66]  The brief then remarked that U.S. policy was “strongly supportive of this approach to resolve the current international debt problem.”[67]  Persuaded by the Justice Department’s policy argument, the Second Circuit concluded that investors’ “extinguished” right to receive interest payments constituted a “taking”[68] and therefore that the act of state doctrine was inapplicable.[69]

However, the Second Circuit’s subsequent rulings caution against drawing broad conclusions about expropriation and the act of state doctrine from Allied Bank.  Just a few months after deciding Allied Bank, the Second Circuit held that the act of state doctrine applied in another expropriation analysis.[70]  Indicating that the doctrine was still strong in light of Allied Bank, the court noted that “each case [must] be analyzed individually to determine the need for a separation of powers.”[71]  Thus, absent an explicit request from the Executive Branch—which is especially unlikely for the immediate inquiry, as the IMF has signaled its approval of a retrofit collective action clause[72]—it seems clear that courts tend to err on the side of deference to the sovereign.

Although scholars have argued that courts’ unwillingness to scrutinize expropriation claims is contrary to the plain language and congressional intent of the Second Hickenlooper Amendment,[73] courts continue to apply the act of state doctrine frequently and with little regard to expropriation limitations.[74]

III.  Would the Mopping-Up Law Be an Expropriation Under International Law?

If investors manage to overcome sovereign immunity, the court would then move into an expropriation analysis.  U.S. courts have not developed a consistent framework with which to analyze questions of expropriation.[75]  In fact, as exemplified above within the Second Circuit, even the same courts vary in their analyses of expropriation claims.[76]  Oftentimes, the facts of the case are more determinative of the ultimate result than the absence or presence of specific criteria.[77]  However, courts have tended to focus on four key factors: the coerciveness of the state’s action with regard to renegotiating or repudiating contracts, the underlying purpose of the action, whether the action was discriminatory, and the amount of loss to the claimant.[78]  This Part will examine each of these factors in turn.

A.    What Degree of Coercion in Repudiating or Renegotiating a Contract Warrants a Finding of Expropriation?

Most courts that have examined whether a repudiated contract is an expropriation under international law have determined that repudiation does not constitute expropriation.[79]  The few courts that have held that breach of contract is an expropriation have done so only upon finding that another prong of the expropriation analysis has been violated.[80]  One exception to this general rule is the Ninth Circuit’s finding in West v. Multibanco Comermex, S.A.[81] that contracts constitute property under international law, and the taking of contract rights alone constitutes an expropriation.[82]  However, even with this broad finding, the Ninth Circuit held in favor of the defendants, concluding that “[a] state has a strong interest in its monetary policy” and that “[u]nder international law, the legislature generally is free to impose exchange controls.”[83]  This interest in regulating monetary policy is discussed further in Part IV.

The analysis is slightly different for a renegotiated contract.  At what point does a coercive restructuring become expropriatory?  The question of what constitutes a “voluntary” restructuring has been a major point of disagreement throughout the Greek crisis.[84]  Although scholars differ on what “should” qualify as an expropriation,[85] the only consensus is that the threat or use of physical force in a renegotiation is expropriatory.[86]  Short of that, the law is hazy.[87]  Therefore, because much of the inquiry would likely be fact-based,[88] the court probably would look to the other prongs of the expropriation analysis to determine whether a coercive—but nonviolent—restructuring would be an expropriation.

B.     What Is the Purpose of the Mopping-Up Law?

When addressing a claim of expropriation against a sovereign, courts often focus on the purpose of the state’s action to determine whether the taking is improper.[89]  An important distinction to make here is whether the purpose inquiry is used as an affirmative defense[90] or as part of the analysis to determine whether an expropriation has occurred.  The purpose analysis within an affirmative defense is discussed at length in Part IV; in this Section, the purpose analysis is limited to ascertaining whether an expropriation has occurred.

In determining whether an expropriation has occurred, courts tend to distinguish between commercial and governmental purposes in state action.[91]  Typically, international law is not implicated if the state acts pursuant to a commercial purpose only, whereas international law may be implicated if the state acts pursuant to a governmental purpose.[92]  At first, this may seem counterintuitive; one would think that the sovereign should be given more leeway when acting pursuant to a governmental purpose.  However, because expropriation is a “quintessentially sovereign act,”[93] the state must “slip[] into its . . . sovereign shoes” to be liable to investors.[94]  Therefore, if the state took only actions that a commercial entity could also take, then its breach would not be an expropriation under international law.[95]  Because a retrofit CAC requires the sovereign to take legislative action, further inquiry into this point of the expropriation analysis is unnecessary: the Mopping-Up Law undoubtedly would be recognized as the state working within its governmental capacity, and therefore the sovereign would not be granted the “commercial activity” exception in this prong of the expropriation analysis.[96]

C.    Would the Mopping-Up Law Be Discriminatory?

Some courts have concluded that a sovereign’s action is expropriatory only if it is discriminatory.[97]  Though not all courts adhere to this reasoning,[98] a court is more likely to find an expropriation if it senses some inherent unfairness in the way a sovereign is treating foreign nationals.[99]  The Mopping-Up Law would not raise such questions of discrimination against foreign nationals.  It would treat all investors holding local law bonds—including Greek investors—the same.[100]  Therefore, if a court were to consider discrimination only to the extent of unfairness toward foreign nationals, then it is highly unlikely that it would find the Mopping-Up Law to be discriminatory; indeed, a court might not even consider this particular factor in its analysis.

However, it is possible that a court could view the Mopping-Up Law as discriminatory toward holdout creditors, regardless of nationality.  Although U.S. courts have not yet extended the concept of discrimination to bondholder status, at least one scholar believes that it is within the realm of possibility—but unlikely—for international law to recognize this particular form of discrimination.[101]  Interestingly, the actions of officials inside the Greek restructuring have not indicated any concern about violating this particular factor in the expropriation analysis.  On February 17, 2012, the European Central Bank (“ECB”) announced a swap of its Greek bond holdings for new bonds that are exempt from collective action clauses.[102]  Other bondholders were not offered this option, prompting some to question whether the preferential treatment granted to the ECB—or, put less favorably, the subordination of the non-ECB bondholders—would trigger credit-default swaps.[103]  While this factor is not dispositive in the expropriation analysis, officials guiding the Greek restructuring certainly are not helping their case.[104]

D.    What Degree of Economic Loss Would Result from the Mopping-Up Law?

The final prong of the analysis concerns the degree of economic loss without compensation borne by the potential creditors.[105]  As with the other factors in the expropriation analysis, this particular prong does not provide a clear framework for judicial scrutiny.  Courts have recognized that a total deprivation of property would violate international law, but short of that, the law is unclear.[106]

In analyzing this particular factor, the structure of the Mopping-Up Law is important to keep in mind: the effect of the law on investors would be to allow other bondholders to execute a “take” in the future.[107]  There are two related points here.  First, by enacting and utilizing the Mopping-Up Law, the sovereign itself would not be taking directly from investors—at least, not in the traditional sense.  Instead, unwilling or uncooperative holdouts would be forced to participate in the bond exchange only if a requisite supermajority of investors willingly participated.[108]  Second, questions would remain as to whether any rights had been “taken” at all.[109]  The legislation is designed to work within the agreed-upon terms of the bonds to facilitate a restructuring.[110]  Therefore, a claim that the Mopping-Up Law somehow removed valuable protections from the bonds is dubious, as those protections are not guaranteed in the first instance.[111]

If a court were to determine that the sovereign had taken action that resulted in economic loss, valuation of that loss would still be a problem for investors.  Greek bonds have been downgraded to junk status,[112] and courts have taken into account the “acknowledged state of the [sovereign’s] economy” when valuing a loss.[113]  Therefore, if the bonds’ value decreased as a result of a restructuring that took advantage of the Mopping-Up Law, any resulting economic loss might be measured against the bonds’ junk status today.[114]  Thus, it is possible that the investors’ economic loss could be considered de minimis.

E.         So . . . Would Courts Find the Mopping-Up Law To Be an Invalid Expropriation?

It is unclear whether a court would find the Mopping-Up Law to be an invalid expropriation, although the lack of physical force in the restructuring, the equal treatment of foreign nationals, and the junk status of the bonds weigh against potential creditors’ claims.  Moreover, courts often rely upon a fact-specific analysis,[115] so the apparent restraint of the Mopping-Up Law might sway the court in favor of the sovereign.[116]

The most important point to stress here is that the critical aspects of the court’s analysis are not in the expropriation test itself, but in determining whether sovereign immunity applies or an affirmative defense is available.  The majority of expropriation claims are adjudicated at the threshold questions or the finding of an affirmative defense.[117]

IV.   Is an Affirmative Defense Available?

If the court were to find for the investors in its expropriation analysis, Greece could still present an affirmative defense that would excuse an otherwise invalid expropriation: a compelling public need for action in light of a financial crisis.[118]  Both U.S. courts and international tribunals have recognized that an attempt to mitigate a financial crisis serves an important public purpose and is a qualifying affirmative defense.

A.   Precedent from U.S. Courts

The relevant precedent from U.S. courts is derived from both cases that interpret international sovereign actions and cases that interpret domestic sovereign actions.

1.   Actions Concerning International Sovereigns

  U.S. courts generally offer wide latitude to sovereigns dealing with fiscal crises.[119]  For example, in West v. Multibanco Comermex S.A.,[120] the Ninth Circuit concluded that although Mexico’s exchange control regulations were expropriatory[121] and therefore the claim could be adjudicated on its merits,[122] Mexico’s strong public purpose rendered its actions lawful.[123]  Because “Mexico’s institution of exchange controls was an exercise of its basic authority to regulate its economic affairs,”[124] its actions did not “constitute takings under international law.”[125]  The Second Circuit came to a similar finding in Braka v. Bancomer, S.A.[126] on affirming the district court’s dismissal on act of state grounds.  The district court concluded, “Mexico’s act in this instance cannot be construed as a simple repudiation of a government entity’s commercial debt [because] the mechanisms used by Mexico are conventional devices of civilized nations faced with severe monetary crises, rather than the crude and total confiscation by force of a private person’s assets.”[127]  The Mopping-Up Law not only would be enacted in response to a fiscal crisis, but in fact would be attempting to mitigate such a crisis.[128]  Therefore, courts may afford the same deference to Greece that Mexico enjoyed in West and Braka.

Another important consideration for this prong of the analysis concerns the nature of the investment.  If the investor was aware of the credit risk upon entering the investment and was receiving higher yields as a result, why should the court bail out potential creditors when the investment does not deliver as expected?  As the Ninth Circuit observed, “The courts of this country should not operate as an international deposit insurance company . . . .  The actions of the [sovereign] and the losses [it] occasioned were within the purview of the risks associated with those potentially extraordinary returns.”[129]  International tribunals have noted similar sentiments.[130]  These comments are especially relevant for analysis of the Mopping-Up Law, as scholars have assessed the local-law Greek bonds to have higher yields than the Greek bonds governed by English law.[131]  One particular study concluded, “[T]he markets seem to recognize the greater vulnerability of local-law governed bonds to debtor misbehavior as compared to bonds governed by foreign law. The evidence shows that Greek bonds governed by different laws were priced differently even prior to the crisis.”[132]  This study continues on to note that the pricing premiums likely reflected the price that investors were willing to pay for holdout protections.[133]  Therefore, courts may be skeptical of investors’ cries for fairness when the investors had assumed a greater risk when they had invested in local-law governed bonds.[134]

2.   Actions Concerning Domestic Sovereigns

U.S. courts have shown similar deference to important public purposes in cases concerning domestic sovereign entities.  The central case about the protection of public contracts from legislative interference is United States Trust Co. v. New Jersey.[135]  The case arose when New York and New Jersey attempted to repeal a statutory covenant enacted a decade earlier to protect the holders of bonds issued by the Port Authority of New York.[136]  The Supreme Court held that the repeal of the covenant was unconstitutional because it violated the Contract Clause,[137] but the critical aspect of the Court’s decision for purposes of the present analysis lies in the test that U.S. Trust set forth.[138]  The third step in the U.S. Trust test asks whether the legislative modification was “reasonable and necessary to serve an important public purpose.”[139]  This “important public purpose” test has validated legislation ranging from imposing price controls on intrastate gas markets[140] to legislatively reducing the annual salaries of state employees.[141]

Similarly, in the Gold Clause Cases,[142] the Supreme Court deferred to the federal government’s interest in regulating the nation’s monetary policy.  In 1933, Congress passed a joint resolution declaring that all clauses that stipulated payment in gold in public and private contracts were against public policy.[143]  This effectively forced all payments on contract obligations to be made in devalued currency, regardless of the terms of the contract.[144]  The Court concluded that Congress’s comprehensive power over monetary policy, especially in a financial crisis, outweighed any fairness concerns.[145]  Most relevant to the immediate inquiry is the particular Gold Clause Case of Perry v. United States,[146] which concerned government bonds.  The Court held that the joint resolution as it applied to government bonds was unconstitutional, as the government was impairing its own obligations.[147]  However, in determining actual loss, the Court concluded that the nation’s economic conditions must be taken into account.[148]  Because the damages would be “nominal,”[149] the plaintiff “fail[ed] to show a cause of action for actual damages.”[150]  This would be similar to a court finding that the Mopping-Up Law was, in fact, expropriatory, but that any economic loss would be considered de minimis and therefore not recoverable.[151]

Granted, courts’ overall analyses of actions by domestic sovereign entities are far from analogous with their analyses of actions by international sovereigns.  Nevertheless, the examination of an important public purpose in domestic legislation lends credence to the notion that international sovereigns will be afforded similar deference if their actions further an important public purpose.

B.     Precedent from International Tribunals

Because U.S. courts often derive guidance from international law,[152] the reasoning in international tribunals and arbitral bodies can be illuminating.  The International Centre for Settlement of Investment Disputes (“ICSID”) provides arbitration for public debt disputes,[153] and in some cases has found that a compelling public need may trump the interests of a private entity or investor.[154]  For example, in Olguín v. Republic of Paraguay,[155] the tribunal noted that the taking “occur[ed] within the broader context of a national financial crisis,”[156] and ultimately concluded—albeit on different grounds—that the sovereign default was not an expropriation.[157]  In another international case, the Italian Corte di Cassazione focused only on whether the sovereign acted in response to a financial crisis, and—finding in the affirmative—consequently declined jurisdiction.[158]

A more recent example of public necessity trumping investors’ rights is in Iceland.  When Iceland’s three largest banks collapsed in 2008, its legislature passed emergency legislation that put the interests of ordinary account holders ahead of the banks’ bondholders.[159]  The bondholders challenged the legislature’s action, but Iceland’s Supreme Court upheld the emergency law in light of the financial crisis that the legislation was intended to alleviate.[160]  The Court concluded:

[A] major threat was present to the whole society because of the catastrophic effect of the collapse of the largest commercial banks, which could end with the collapse of economic life in the country.  The legislature, for these reasons, had not only a right but above all a constitutional duty to protect the welfare of the public.[161]

Ragnhildur Helgadóttir, Professor of Constitutional Law at Reykjavik University, was likely unsurprised at this ruling, as she concluded in an October 2011 presentation that a financial crisis could fall into the scope of emergency powers when “more than financial interest[s] [are] at stake,” such as the consequences that inevitably would accompany a systemic economic collapse.[162]  Similarly, Prime Minister of Iceland, Jóhanna Sigurðardóttir, said that there was “no other option” than to have the majority of the banking collapse borne by the bondholders.[163]  Therefore, recent international precedent indicates that when a sovereign is left with few options, courts will not stand in the way of a proportional legislative response that infringes upon private investors’ economic rights.

Conclusion

Decades ago, a prominent international law scholar concluded that sovereign bond default does not necessarily trigger international responsibility:

[A]s international law stands today, a debtor state commits an international delinquency by annihilating a debt entirely through repudiation, confiscation, or virtual destruction (interference with the substance of the debt), but . . . international law has not yet reached the point where all lesser acts causing defaults and damage to creditors give rise to legal protests based on international law.[164]

International law has developed for nearly eighty years since Professor Feilchenfeld’s conclusion, and the law has, in fact, reached the point at which legal protests arise from sovereign actions that fall short of a complete taking; yet the success of such claims is still largely fact-specific and unpredictable.  However, two conclusions from this Note’s analysis are quite clear: U.S. courts are hesitant to take potentially controversial stands in foreign policy without unequivocal support from another government branch, and courts are deferential to sovereigns whose actions are proportional and in response to apparent crises.

Normative questions remain.  Should courts grant immunity to a sovereign nation because the sovereign’s actions precipitated a financial crisis?  Why should private investors shoulder a disproportionate amount of a sovereign’s debt burden?  Greece is far from faultless in its role in the current debt crisis.[165]  However, no one is likely to argue that Greece is getting off scot-free.  It has implemented a series of severe austerity measures and is fighting simply to keep its head above water.[166]  An exchange offer with a retrofit collective action clause would be painful, yes, but it also would be proportional and restrained in light of the crisis in the Eurozone.  Courts likely will take note of this restraint, and so should investors.

 

Preferred citation: Melissa A. Boudreau, Restructuring Sovereign Debt Under Local Law:  Are Retrofit Collective Action Clauses Expropriatory?, 2 Harv. Bus. L. Rev. Online 164 (2012), https://journals.law.harvard.edu/hblr//?p=2283.

* Duke University School of Law, J.D. expected 2013; University of Maryland, B.A. 2007.  Many thanks to Professor Mitu Gulati for his invaluable assistance throughout the Note-writing process. Copyright © 2012 by Melissa A. Boudreau.

[1] Niki Kitsantonis & Matthew Saltmarsh, Greece, Out of Ideas, Requests Global Aid, N.Y. Times, Apr. 23, 2010, http://www.nytimes.com/2010/04/24/business/global/24drachma.html.

[2] Q&A: Greek Debt Crisis, BBC News, Nov. 10, 2011, http://www.bbc.co.uk/news/business-13798000.

[3] See generally Euro in Crisis, Fin. Times, http://www.ft.com/indepth/euro-in-crisis (last visited May 6, 2012).

[4] See Douwe Miedema, Europe Might Force Greek Deal on Creditors – Source, Reuters, Nov. 2, 2011, http://www.reuters.com/article/2011/11/02/idUSL5E7M23PA20111102.

[5] Id.

[6] Unilateral Action Threatened by Greece Is Also Available to Other Sovereigns, Weekly Credit Outlook (Moody’s Investors Service, London), February 6, 2012, at 2 (noting that local law governs 88%–100% of the outstanding sovereign debt of eleven Eurozone member states); Stephen J. Choi, Mitu Gulati & Eric A. Posner, Pricing Terms in Sovereign Debt Contracts: A Greek Case Study with Implications for the European Crisis Resolution Mechanism 3 (The Chicago Working Paper Series Index, John M. Olin Law & Economics Working Paper No. 541, 2010), available at http://www.law.uchicago.edu/files/file/541-eap-Greek.pdf (“[R]eports suggest that a similar pattern [in local-law governed bonds] emerged with a number of the other Eurozone periphery countries that are in crisis today, including Spain, Portugal and Ireland.” (citation omitted)). See generally Jens Nordvig, Currency Risk in the Eurozone: Accounting for breakup and redenomination risk, Nomura Securities International (Jan. 2012).

[7] Richard Milne, Deal Over Greek Bonds to Set Template, Fin. Times, Nov. 21, 2011, http://www.ft.com/cms/s/0/ff8b3d14-1463-11e1-85c7-00144feabdc0.html#ixzz1gS4gtsVP.

[8] Id. (internal quotation marks omitted).

[9] See Matina Stevis, Greece to Introduce Retroactive Collective Action Clauses to Bonds – Troika Source, Wall St. J., Jan. 9, 2012, http://online.wsj.com/article/BT-CO-20120109-704688.html (“The Greek government will retroactively introduce collective-action clauses (CACs) to its existing bonds, a source from the troika of Greece’s creditors—the International Monetary Fund, the European Central Bank and the European Union—told Dow Jones Newswires Monday.”); Patrick Jenkins & Richard Milne, Greek Bondholders Poised to Accept Higher Losses, Fin. Times, Jan. 8, 2012, http://www.ft.com/intl/cms/s/0/acaa7900-3891-11e1-9ae1-00144feabdc0.html#axzz1ipczGdVy (“Collective action clauses are likely to be introduced into Greek bonds by the PSI deal . . . .”); Yiannis Papadoyiannis, PSI Agreement Draws Ever Closer, Kathimerini, Dec. 20, 2011, http://www.ekathimerini.com/4dcgi/_w_articles_wsite2_1_20/12/2011_419381 (“There already are some alternative solutions on the table in case the private sector participation rate is limited. One of these options . . . is the forced participation of the minority that wanted to abstain from the PSI through a collective action clause (CAC).”). See also John Dizard, Greek Debt Crisis No Nearer Resolution, Fin. Times, Dec. 11, 2011, http://www.ft.com/intl/cms/s/0/4b931eec-1f5a-11e1-ab49-00144feabdc0.html#axzz1hHvrJOY5 (“I’ve been suggesting for over a year that the only way to make sure that over 90 per cent of the existing bondholders are pushed into making the exchange will be through the passage through the Greek parliament of a ‘retrofit collective action clause’ covering the roughly 93 per cent of Greek debt that is governed by Greek law.”).

[10] Greek Government’s Terms for Bond Swap with Creditors: Statement, Bloomberg, Feb. 24, 2012, http://www.businessweek.com/news/2012-02-27/greek-government-s-terms-for-bond-swap-with-creditors-statement.html.

[11] Rules for the amendment of securities, issued or guaranteed by the Greek Government by consent of the Bondholders (36 Α’/23.02.2012) (Gr.) available at http://www.hellenicparliament.gr/UserFiles/bcc26661-143b-4f2d-8916-0e0e66ba4c50/k-omolog-pap.pdf.

[12] Lee C. Buchheit & G. Mitu Gulati, How to Restructure Greek Debt (Duke Law Working Papers, Paper No. 47, 2010), available at http://scholarship.law.duke.edu/working_papers/47.  This paper was published under a slightly different name in the International Financial Law Review (Restructuring a Nation’s Debt, 29 Int’l Fin. L. Rev. 46 (2010-2011)).  However, because the current volume is available only to IFLR subscribers, this Note will cite to the Duke Law Working Papers version that is readily available to all online.

[13] John Dizard, Opinion, In an Ideal World, Kafka Would Restructure Greece, Fin. Times, July 31, 2011, http://www.ft.com/intl/cms/s/0/da876352-b9c9-11e0-8171-00144feabdc0.html#axzz1hHvrJOY5.

[14] See Rules for the amendment of securities, issued or guaranteed by the Greek Government by consent of the Bondholders (36 Α’/23.02.2012) (Gr.) available at http://www.hellenicparliament.gr/UserFiles/bcc26661-143b-4f2d-8916-0e0e66ba4c50/k-omolog-pap.pdf.

[15] Buchheit & Gulati, supra note 12, at 12.

[16] Id. at 2.

[17] Id. at 5–6.

[18] See id. at 10–11 (“[I]ndustrialized countries are less likely than some of their emerging market brethren to risk eroding future investor confidence by opportunistically changing their own law in order to reduce government debt service burdens.”).

[19] Russia and Uruguay, for example, both restructured local-law bonds.  Id. at 6.

[20] See id. (“In each of these prior cases, however, the local law bonds were also denominated in local currency and formed only part of the overall stock of the debt being restructured. While the Euro is certainly now the local currency of Greece, it is a good deal more besides that.”).

[21] Id.

[22] Id. at 2.

[23] Steven L. Schwarcz, “Idiot’s Guide” to Sovereign Debt Restructuring, 53 Emory L.J. 1189, 1190 n.5 (2004).

[24] Katz v. Oak Industries Inc., 508 A.2d 873 (Del. Ch. 1986), is the first U.S. case in which exit consents were recognized and validated in commercial bonds.  Exit consents have also been used in sovereign debt restructurings, such as those in Ecuador and Uruguay.  Dr. Rodrigo Olivares-Caminal, To Rank Pari Passu or Not to Rank Pari Passu: That Is the Question in Sovereign Bonds After the Latest Episode of the Argentine Saga, 15 L. & Bus. Rev. Am. 745, 765 (2009).

[25] See Lee C. Buchheit & G. Mitu Gulati, Exit Consents in Sovereign Bond Exchanges, 48 UCLA L. Rev. 59, 71 (2000) (describing the Katz v. Oak Industries exchange offer with exit consents).

[26] Id.

[27] Id.

[28] Buchheit & Gulati, supra note 12, at 2.

[29] But see Gulati & Zettelmeyer, Making a Voluntary Greek Debt Exchange Work (Duke Law Faculty Scholarship, Paper No. 2481, 2011), at 10, available at http://scholarship.law.duke.edu/faculty_scholarship/2481/ (“In the Greek case, all that needs to be done is for the bondholders in the exchange to be given better terms.  If the exchanging bondholders are given new contracts that provide the comforting warmth of strong contract protections . . . then that will make it perilous to remain out in the cold with a contract that provides no protection.”).  Therefore, while a traditional exit consent structure is infeasible for these local-law bonds, a “reverse engineered Exit Exchange offer” effectively could provide similar benefits within the bonds’ limited parameters.  Id. at 9–10.

[30] Buchheit & Gulati, supra note 12, at 11.

[31] Id.

[32] See id. at 12 (“Once the supermajority of creditors is persuaded to support an amendment to the payment terms of the instrument, their decision automatically binds any dissident minority.”).

[33] See id. (“Viewed another way, the Mopping-Up Law would merely replicate at the level of the sovereign borrower the same protection enjoyed by corporate borrowers in many countries, including Greece. For example, we understand that in corporate reorganization proceedings under Greek bankruptcy law, if a plan of reorganization is accepted by two thirds of the affected creditors[,] . . . it will . . . bind all creditors.”).

[34] Id.

[35] Id.

[36] Id. at 12–13.

[37] See generally Harvey M. Jacobs, U.S. Private Property Rights in International Perspective, in Property Rights and Land Policies 52 (Gregory K. Ingram & Yu-Hung Hong, eds., 2009).

[38] Peter Charles Choharis, U.S. Courts and the International Law of Expropriation: Toward a New Model for Breach of Contract, 80 S. Cal. L. Rev. 1, 6 (2006).

[39] Id. at 7.

[40] Foreign Sovereign Immunities Act of 1976 (“FSIA”), 28 U.S.C. §§ 1602–11 (2006).

[41] Argentine Republic v. Amerada Hess, 488 U.S. 428, 434 (1989).

[42] FSIA, 28 U.S.C. § 1604 (2006).

[43] See Argentine Republic, 488 U.S. at 434 (“Sections 1604 and 1330(a) work in tandem: § 1604 bars federal and state courts from exercising jurisdiction when a foreign state is entitled to immunity, and § 1330(a) confers jurisdiction on district courts to hear suits brought by United States citizens and by aliens when a foreign state is not entitled to immunity.”).

[44] See generally FSIA, 28 U.S.C. §§ 1605–07 (2006).

[45] FSIA, 28 U.S.C. § 1605(a)(3) (2000) (“A foreign state shall not be immune from the jurisdiction of courts of the United States or of the States in any case in which rights in property taken in violation of international law are in issue and that property or any property exchanged for such property is present in the United States in connection with a commercial activity carried on in the United States by the foreign state.”).

[46] Id.

[47] See, e.g., Aquamar S.A. v. Del Monte Fresh Produce N.A., Inc., 179 F.3d 1279, 1294 (11th Cir. 1999) (“We may look to international law as a guide to the meaning of the FSIA’s provisions.”); Trajano v. Marcos, 978 F.2d 493, 497–98 (9th Cir. 1992) (“Congress intended the FSIA to be consistent with international law.”).

[48] See, e.g., Peterson v. Royal Kingdom of Saudi Arabia, 416 F.3d 83, 85 (D.C. Cir. 2005) (“[A]n expectation interest in payments[] does not qualify as a right in tangible property and the [FSIA] expropriation exception does not apply . . . .” (internal quotation marks omitted); Brewer v. Iraq, 890 F.2d 97, 101 (8th Cir. 1989) (“Defendants’ breach of contract did not create ‘rights in property.”’); Daventree Ltd. v. Republic of Azerbaijan, 349 F. Supp. 2d 736, 749–50 (S.D.N.Y. 2004) (“As numerous courts have held, for purpose of the expropriations exception to the FSIA, the property taken . . . means physical property and not the right to receive payment.” (internal quotation marks omitted)).

[49] Michael D. Ramsey, Acts of State and Foreign Sovereign Obligations, 39 Harv. Int’l L.J. 1, 1 (1998).

[50] 168 U.S. 250 (1897).

[51] Id. at 252.

[52] W.S. Kirkpatrick & Co. v. Envtl. Tectonics Corp., Int’l, 493 U.S. 400, 405 (1990).  The Court went on to conclude that the doctrine “requires that, in [courts’] process of deciding, the acts of foreign sovereigns taken within their own jurisdictions shall be deemed valid.”  Id. at 409.

[53] See Banco Nacional de Cuba v. Sabbatino, 376 U.S. 398, 423 (1964) (“[The act of state doctrine] arises out of the basic relationships between branches of government in a system of separation of powers.”).

[54] See id. (“[The Judicial Branch’s] engagement in the task of passing on the validity of foreign acts of state may hinder rather than further this country’s pursuit of goals both for itself and for the community of nations as a whole in the international sphere.”).

[55] See Ramsey, supra note 49, at 17 n.63 (citing a number of courts that found that the act of state doctrine applied in claims of expropriation of contract rights).

[56] 22 U.S.C. § 2370(e)(2) (2006).

[57] Id.

[58] See, e.g., Compania de Gas de Nuevo Laredo S.A. v. Entex Inc., 686 F.2d 322, 327 (5th Cir. 1982) (“Congress intended [the Amendment] to be limited to cases involving claims of title with respect to American owned property nationalized by a foreign government in violation of international law, when the property or its assets were subsequently located in the United States.”); Empresa Cubana Exportadora de Azucar y Sus Derivados v. Lamborn & Co., Inc., 652 F.2d 231, 237 (2d Cir. 1981) (“[The Amendment] has been interpreted . . . as applying only to cases in which the expropriated property has found its way back into the United States.”); Menendez v. Saks & Co., 485 F.2d 1355, 1372 (2d Cir. 1973) (“[T]he intent [of the Amendment] was to exclude all contract claims from the amendment.”), aff’d in part and rev’d in part on other grounds sub nom. See also Ramsey, supra note 49, at 45 n.174 (“[The Amendment] . . . is problematic as a protection for contractual obligations . . . .”).

[59] 757 F.2d 516 (2d Cir. 1985) (en banc).

[60] Id. at 519.

[61] Id.

[62] Allied Bank Int’l v. Banco Credito Agricola de Cartago, 566 F. Supp. 1440, 1444 (S.D.N.Y. 1983), rev’d, 757 F.2d 516 (2d Cir. 1985).

[63] Allied Bank, 757 F.2d at 519.

[64] Id. at 522.

[65] See id. at 520 (“In light of the government’s elucidation of its position, we believe that our earlier interpretation of United States policy was wrong.”).

[66] Brief for the United States as Amicus Curiae at 9, Allied Bank, 757 F.2d 516 (No. 83-7714), available at http://www.archive.org/details/AlliedBankInternationalV.BancoCreditoAgricolaDeCartago.

[67] Id. at 10.

[68] Allied Bank, 757 F.2d at 521 n.3.

[69] Id. at 522.

[70] See Braka v. Bancomer, S.N.C., 762 F.2d 222, 224 (“[T]he relevant considerations mitigate against judicial intervention.”).

[71] Id. at 224.

[72] See International Monetary Fund, Country Report No. 11/351, Greece: Fifth Review Under the Stand-By Arrangement, Rephasing and Request for Waivers of Nonobservance of Performance Criteria; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Greece, 31, 33 (Dec. 2011) available at http://www.imf.org/external/pubs/ft/scr/2011/cr11351.pdf (“A next key step now under consideration is the inducement(s) to use to ensure near-universal participation (including the possible legislation of CACs in domestic law bonds). The steps taken to date give confidence that the operation will be able to attract the needed level of creditor support and that it will go forward consistent with contemplated parameters. . . . [T]he Greek and European authorities are encouraged to consider tools to attain near-universal creditor participation.”).

[73] See Choharis, supra note 38, at 48–49 (“Where there are sufficient links to the contested property to satisfy jurisdiction for purposes of due process, U.S. courts should not decline to hear cases based upon judicial squeamishness about judging the legality of foreign sovereign acts.”). See also Malvina Halberstam, Sabbatino Resurrected: The Act of State Doctrine in the Revised Restatement of U.S. Foreign Relations Law, 79 Am. J. Int’l L. 68, 70–71 (1985) (“While some lower courts have limited the Hickenlooper Amendment to property located in the United States, and there is legislative history to support the narrow construction adopted by the Restatement, there is also legislative history to the contrary.”).

[74] See, e.g., Ramsey, supra note 49, at 17 n.63 (citing a number courts that found that the act of state doctrine applied in expropriation claims).

[75] See Bernard Kishoiyian, The Utility of Bilateral Investment Treaties in the Formulation of Customary International Law, 14 Nw. J. Int’l L. & Bus. 327, 329 (1994) (“[I]nternational law has not kept pace with the developments that have taken place in the last thirty years in foreign direct investment.”).

[76] Compare Banco Nacional de Cuba v. Chem. Bank N.Y. Trust Co., 822 F.2d 230, 238 (2d Cir. 1987) (“In general, if a state merely expropriated a debtor’s assets and treated all of its creditors alike, both foreign and domestic, the state would not be liable under principles of international law to foreign creditors for a taking of their property.”), with First Fid. Bank, N.A. v. Ant. & Barb.—Permanent Mission, 877 F.2d 189, 193 (2d Cir. 1989) (“A breach of a commercial contract . . . is not a violation of international law unless the breach . . . occurs for governmental rather than commercial reasons and the state is not prepared to pay damages for the breach.” (citation omitted)).

[77] See, e.g., discussion in Part II.B supra regarding Allied Bank.

[78] Choharis, supra note 38, at 11.

[79] See, e.g., Brewer v. Socialist People’s Republic of Iraq, 890 F.2d 97, 101 (8th Cir. 1989) (“[P]laintiffs’ contract rights were not expropriated—rather, the contract itself was repudiated by defendants. . . . [S]uch a repudiation is not equivalent to expropriation.” (citation omitted); Verlinden B.V. v. Cent. Bank of Nig., 647 F.2d 320, 325 (2d Cir. 1981), rev’d on other grounds, 461 U.S. 480 (1983) (“[C]ommercial violations . . . do not constitute breaches of international law.”); Jafari v. Islamic Republic of Iran, 539 F. Supp. 209, 215 (N.D. Ill. 1982) (“We cannot elevate our American-centered view of governmental taking of property without compensation into a rule that binds all civilized nations.” (internal quotation marks omitted)); Daventree Ltd. v. Azerbaijan, 349 F. Supp. 2d 736, 751 (S.D.N.Y. 2004) (“[P]laintiffs’ failure to privatize claims do not arise from the taking of tangible property without compensation, but instead from the Sovereign defendants’ failure to honor an alleged contractual obligation to carry out an orderly privatization program. Therefore, because those claims pertain to contract rights or the right to receive payments, the expropriations exception does not apply . . . .” (internal quotation marks omitted)).

[80] See supra text accompanying note 76. See also Zappia Middle E. Constr. Co. v. Emirate of Abu Dhabi, 215 F.3d 247, 252 (2d Cir. 2000) (“[B]reach of a commercial contract alone does not constitute a taking pursuant to international law.”).

[81] 807 F.2d 820 (9th Cir. 1987).

[82] See id. at 830 (“[A]lthough the certificates of deposit may be characterized as intangible property or contracts, they are ‘property interests’ that are protected under international law from expropriation.”).

[83] Id. at 831.

[84] See Matt Levine, Mandatory Greek CDS Post, Dealbreaker, Oct. 27, 2011, http://dealbreaker.com/2011/10/mandatory-greek-cds-post/ (discussing whether the Greek “pseudo-voluntary pseudo-default” exchange qualifies as a credit event for CDS purposes).

[85] Compare G.C. Christie, What Constitutes a Taking of Property Under International Law?, 38 Brit. Y.B. Int’l L. 307, 338 (1962) (“Where a State compels an alien to sell his property for less than its true value either to the State or to a third party, a compensable claim arises”), with W. Michael Reisman & Robert D. Sloane, Indirect Expropriation and Its Valuation in the BIT Generation, 74 Brit. Y.B. Int’l L. 115, 121 (2004) (“[E]xpropriation must be analyzed in consequential rather than formal terms. What matters is the effect of governmental conduct—whether malfeasance, misfeasance, or nonfeasance, or some combination of the three—on foreign property rights or control over an investment, not whether the state promulgates a formal decree or otherwise expressly proclaims its intent to expropriate”), and Choharis, supra note 38, at 86 (“While the forced renegotiation of a contract is not as well-established, if the state uses its governmental powers to coerce more favorable contractual terms, this too would violate international law.”).

[86] See, e.g., Detlev F. Vagts, Coercion and Foreign Investment Rearrangements, 72 Am. J.Int’l L. 17, 22 (1978) (“The leading cases [in the state-investor coercion field] come from national tribunals considering claims asserted under international law. . . . [A]bout all those cases seem to settle is the point, which one hopes is obvious, that raw physical pressure vitiates consent.”).

[87] For example, Allied Bank Int’l v. Banco Credito Agricola de Cartago, 757 F.2d 516 (2d Cir. 1985) is the only U.S. case to conclude that a forced but nonviolent renegotiation of a contract was expropriatory.  As noted above in Part II.B, however, the precedential value of Allied Bank is questionable.

[88] See, e.g., supra note 71 and accompanying text.

[89] See, e.g., Banco Nacional de Cuba v. Sabbatino, 376 U.S. 398, 429 (1964) (“There is, of course, authority, in international judicial and arbitral decisions, in the expressions of national governments, and among commentators for the view that a taking is improper under international law if it is not for a public purpose.”).  But see Choharis, supra note 38, at 20 n.78 (noting that courts generally do not address the state’s purpose when analyzing a forced renegotiation of a contract “because of the limited circumstances that courts and scholars argue warrant finding that such forced renegotiations may violate international law”).

[90] In other words, an expropriation no doubt has occurred, but questions remain as to whether that expropriation was invalid.

[91] See Restatement (Third) of Foreign Relations Law of the United States § 712 rptrs’ n.8 (“The prevailing view is that, in principle, international law is not implicated if a state repudiates or breaches a commercial contract with a foreign national for commercial reasons as a private contractor might, e.g., due to inability of the state to pay or otherwise perform, or because performance has become uneconomical . . . . It is a violation of international law if, in repudiating or breaching the contract, the state is acting essentially from governmental motives . . . rather than for commercial reasons, and fails to pay compensation or to accept an agreed dispute settlement procedure.”).

[92] Id.

[93] Banco Nacional de Cuba v. Sabbatino, 376 U.S. 398, 428 (1964).

[94] Michael Waibel, Opening Pandora’s Box: Sovereign Bonds in International Arbitration, 101 Am. J. Int’l L. 711, 744 (2007).

[95] See id. at 745 (“Lack of performance does not amount to a treaty breach unless it is proven that the state has gone beyond its role as a mere party to the contract and has exercised the specific functions of a sovereign authority.”).  For a cogent analysis of the policy implications involved in this distinction between commercial and sovereign actions, see generally Choharis, supra note 38, at 27–29.

[96] “Commercial reasons” include those that a private contractor could proffer in breaching a contract.  See supra note 92 and accompanying text; see also Waibel, supra note 94, at 745 (“Could a private corporation have successfully carried out a similar restructuring implemented by a country? In other words, did the government use specific regulatory, administrative, or governmental powers in its sovereign bond exchange? . . . A host state acting as a contractual party does not interfere with the normal exercise of the investors’ rights, but rather fails to perform the contract.”).

[97] See First Fid. Bank, 877 F.2d at 193 (“A breach of a commercial contract . . . is not a violation of international law unless the breach is discriminatory . . . .”).

[98] See, e.g., West v. Multibanco Comermex, S.A., 807 F.2d 820, 822–23 (9th Cir. 1987) (finding an expropriation even though Mexico did not distinguish between foreign nationals).

[99] See, e.g., Banco Nacional de Cuba v. Chem. Bank N.Y. Trust Co., 822 F.2d 230, 237 (2d Cir. 1987) (“As a general principle of international law, a state is liable to a private person who is a national of another state if it takes the foreign national’s property and the taking is ‘discriminatory.’ A taking pursuant to a program that excludes from compensation all aliens or all aliens of a particular nationality is discriminatory.”).

[100] See Buchheit & Gulati, supra note 12, at 6 (“A significant percentage (perhaps more than 30 percent) of the bonds are believed to be owned by Greek institutional holders.”).

[101] See Waibel, supra note 94, at 747 (“Whether this particular form of discrimination violates international law depends on whether international law requires countries to treat all creditors equally. It is at least doubtful, however, that international law incorporates such a general equal treatment obligation, over and above an obligation not to discriminate against creditors by nationality.”).

[102] Richard Barley, ECB Teaches Bondholders Greek Lesson, Wall St. J., February 17, 2012, http://online.wsj.com/article/SB10001424052970204059804577229351454312864.html.

[103] Paul Dobson & Abigail Moses, ECB Greek Plan May Hurt Bondholders While Triggering Debt Swaps, Bloomberg Businessweek, February 19, 2012, http://www.businessweek.com/news/2012-02-19/ecb-greek-plan-may-hurt-bondholders-while-triggering-debt-swaps.html.

[104] Commentators noted these concerns over a month before the ECB deal was made.  For a thorough analysis, see Joseph Cotterill, To ring-fence the ECB in Greece . . . or not, Fin. Times Alphaville, January 10, 2012, http://ftalphaville.ft.com/blog/2012/01/10/823321/to-ring-fence-the-ecb-in-greece-or-not/.

[105] If the loss is compensated, it likely would be considered a valid expropriation.  See Restatement (Third) of Foreign Relations Law of the United States §§ 712(1)-(2) (validating expropriation if compensation is “just” or “compensatory”).

[106] See Choharis, supra note 38, at 34–35 (“[A]uthorities offer little additional guidance on what degree of loss is necessary to constitute an expropriation. Few courts have mentioned the issue of the degree of loss necessary to result in an expropriation, and they have done so only incidentally, usually quoting secondary sources. The only principle that can be distilled from these dicta is that total deprivation of property violates international law. Short of that, the courts provide little or no guidance.”).

[107] See supra note 32 and accompanying text.

[108] See supra notes 32, 34 and accompanying text.

[109] See supra note 33 and accompanying text.

[110] See supra note 30 and accompanying text.

[111] See infra notes 131–134 and accompanying text.

[112] Greek Bonds Rated ‘Junk’ By Standard & Poor’s, BBC News, Apr. 27, 2010, http://news.bbc.co.uk/2/hi/8647441.stm.

[113] Banco Nacional de Cuba v. Chase Manhattan Bank, 658 F.2d 875, 893 (2d Cir. 1981).

[114] See Restatement (Third) of Foreign Relations Law of the United States § 712 cmt. d, rptrs’ n.3 (1987) (advocating compensation “based on value at the time of taking”).

[115] See, e.g., supra text accompanying note 71.

[116] See supra text accompanying note 34.

[117] See, e.g., supra note 48 and accompanying text; supra note 58 and accompanying text; infra note 119 and accompanying text.

[118] See Waibel, supra note 94, at 739 (“[I]nternational law [is] underdeveloped in a central respect. Under the general principles of law found in many municipal systems, extraordinary circumstances may occasionally warrant a modification of contractual claims. The lack of payment capacity and the use of general regulatory powers in national economic emergencies are pertinent examples.”).

[119] See Braka v. Bancomer, S.A., 589 F. Supp. 1465, 1472 (S.D.N.Y. 1984), aff’d, 762 F.2d 222 (2d Cir. 1985) (“[Mexico exercised] the recognized governmental function of setting monetary policy. Mexico acted in response to a fiscal crisis and its mandate touched all foreign currency obligations, private as well as public”); Callejo v. Bancomer, S.A., 764 F.2d 1101, 1116 (5th Cir. 1985) (“Were we to disregard the exchange regulations by enforcing the [plaintiffs’] certificates of deposit, we would render nugatory the attempts by Mexico to protect its foreign exchange reserves. While we are doubtful of our ability to foresee what will vex the peace of nations, we have no doubt that disregarding the Mexican regulations would be very vexing indeed.”).

[120] 807 F.2d 820 (9th Cir. 1987).

[121] Id. at 830.

[122] Id. at 831.

[123] Id.

[124] Id. at 832.

[125] Id. at 831.

[126] 762 F.2d 222 (2d Cir. 1985).

[127] Braka v. Bancomer, S.A., 589 F. Supp. 1465, 1472 (S.D.N.Y. 1984), aff’d, 762 F.2d 222 (2d Cir. 1985).

[128] See Papadoyiannis, supra note 9 (“Bank sources told Kathimerini that the efforts to find a solution have intensified in the last few days, emphasizing the absolute need for PSI+ to succeed. If that fails, given the country’s loan requirements in the first quarter of 2012, Greece will find itself at a dead end with unpredictable consequences.”).

[129] West, 807 F.2d at 833.

[130] See, e.g., Emilio Agustín Maffezini v. The Kingdom of Spain, ICSID Case No. ARB/97/7, Award, para. 64 (Nov. 13, 2000) (“[T]he Tribunal must emphasize that Bilateral Investment Treaties are not insurance policies against bad business judgments.”).

[131] Choi, Gulati & Posner, supra note 6, at 24.

[132] Id.

[133] Id. at 25.

[134] See id. (“These purchasers took advantage of the higher yields on this risky debt. Other investors took lower yields in exchange for lower risk (or greater holdout rights).”).

[135] 431 U.S. 1 (1977).  The most favorable case to support the Mopping-Up Law is Faitoute Iron and Steel Co. v. City of Asbury Park, 316 U.S. 502 (1942), in which the Supreme Court upheld a state modification of a bond contract.  However, because Faitoute’s broad holding was somewhat limited by U.S. Trust, a fair analysis of the present question should instead focus on the narrower (and less favorable) U.S. Trust test.

[136] Id. at 13.

[137] Id. at 32.

[138] See Michael L. Zigler, Takings Law and the Contract Clause: A Takings Law Approach to Legislative Modifications of Public Contracts, 36 Stan. L. Rev. 1447, 1455 (1984) (“The Court’s opinion established a three-step test for determining whether a legislative action is an unconstitutional impairment of a public contract. To be a violation of the contract clause, the state action must (1) not be pursuant to its reserved powers; (2) constitute a substantial impairment of the contractual obligation; and (3) be neither necessary nor reasonable.”).

[139] United States Trust, 431 U.S. at 25.

[140] See Energy Reserves Group, Inc. v. Kansas Power & Light Co., 459 U.S. 400, 416–17 (1983) (“[T]he Kansas Act rests on, and is prompted by, significant and legitimate state interests . . . [in] protect[ing] consumers from the escalation of natural gas prices caused by deregulation . . . [and] in correcting the imbalance between the interstate and intrastate markets.”).

[141] See Baltimore Teachers Union, Am. Fed’n of Teachers Local 340, AFL-CIO v. Mayor & City Council of Baltimore, 6 F.3d 1012, 1021 (4th Cir. 1993) (“We . . . conclude that the salary reductions were reasonable under the circumstances.”).

[142] Norman v. Baltimore & Ohio Railroad Co., 294 U.S. 240 (1935); Nortz v. United States, 294 U.S. 317 (1935); and Perry v. United States, 294 U.S. 330 (1935).

[143] Norman, 294 U.S. at 291–92.

[144] Id. at 292–93.  For a modern analog, see New Law Limits Claims by Vulture Funds, Reuters, Apr. 8, 2010, http://uk.reuters.com/article/2010/04/08/uk-britain-debt-idUKTRE63748920100408 (discussing how the U.K. enacted legislative measures—with no successful legal challenges—in placing restrictions on the recovery of heavily discounted debts).

[145] Id. at 316.

[146] 294 U.S. 330 (1935).

[147] Id. at 350–51 (1935) (“There is a clear distinction between the power of the Congress to control or interdict the contracts of private parties when they interfere with the exercise of its constitutional authority and the power of the Congress to alter or repudiate the substance of its own engagements when it has borrowed money under the authority which the Constitution confers.”).

[148] Id. at 355 (1935) (“The question of actual loss cannot fairly be determined without considering the economic situation at the time the government offered to pay . . . the face of his bond, in legal tender currency.”).

[149] Id.

[150] Id. at 358.

[151] See supra note 114 and accompanying text.

[152] See, e.g., West v. Multibanco Comermex, S.A., 807 F.2d 820, 831 n.10 (9th Cir. 1987) (“It is appropriate to look to international law when determining whether the institution of exchange control regulations constitutes a ‘taking’ for purposes of FSIA. We note, however, that in ascertaining the content of international law, we may look to various sources of law, including United States law.”).

[153] International Centre for Settlement of Investment Disputes, http://icsid.worldbank.org/ICSID/Index.jsp (last visited May 2, 2012).

[154] See Waibel, supra note 94, at 745 (“[I]f the exercise of governmental powers is both in the public interest and non-discriminatory, the act in question would not be considered an expropriation [by the ICSID tribunal], with the consequence that no compensation was due on that basis. In national economic emergencies the legitimate scope of governmental measures in the public interest might be greater; hence, economic policy measures adopted in response to financial crises would need to rise to a higher level of intensity to constitute expropriation.” (citation omitted)).

[155] Olguín v. Republic of Paraguay, ICSID Case No. ARB/98/5, Award (July 26, 2001), 18 ICSID REV. 160 (2003) (unofficial English translation).

[156] Id., para. 69.

[157] Id., para. 84.

[158] Borri v. Argentina, 88 Rivista di diritto internazionale 856, paras. 4, 4.2, 5 (May 27, 2005) (“While the issuance of bonds is per se ‘private’, the Argentine legislative acts extending the payment term were undeniably acta iure imperii and thus exempt from domestic jurisdiction.”).

[159] Tom Braithwaite, Reykjavik Steps In with New Powers, Fin. Times, Oct. 8, 2008, http://www.ft.com/intl/cms/s/0/64b062aa-94d3-11dd-953e-000077b07658.html#axzz1iRylBZol.

[160] Jim Pickard & Clare MacCarthy, Icelandic Court Rules to Repay British and Dutch, Fin. Times, Oct. 28, 2011, http://www.ft.com/intl/cms/s/0/18152320-018d-11e1-8e59-00144feabdc0.html#axzz1iRylBZol.

[161] Hæstiréttur Íslands (Icelandic Supreme Court), Case No. 340/2011, (Oct. 28, 2011) (unofficial English translation).

[162] Ragnhildur Helgadóttir, Professor, Reykjavik University School of Law, Constitutions and Government Responses to Financial Crises (Oct. 2011) (“If economic or financial crises are serious enough to warrant government intervention, let alone government intervention which may run afoul of the constitution and international obligations, the crisis will presumably affect other interests than financial.”). For a more extensive analysis of the emergency powers, see Ragnhildur Helgadóttir, Economic Crises and Emergency Powers in Europe, 2 Harv. Bus. L. Rev. Online 130 (2012), https://journals.law.harvard.edu/hblr//?p=1981.

[163] Jóhanna Sigurðardóttir, Prime Minister of Iceland, International Conference at Reykjavik, Welcoming Remarks (Oct. 27, 2011) available at http://www.imf.org/external/np/seminars/eng/2011/isl/pdf/js.pdf (“In effect . . . the lion [sic] share of the banking collapse was borne by foreign creditors. There was no other way, there was no other option, considering that the banks’ assets were ten times Iceland’s GDP.”).

[164] Ernst H. Feilchenfeld, Rights and Remedies of Holders of Foreign Bonds, in 2 Bonds and Bondholders, Rights and Remedies 130, 170 (Silvester E. Quindry ed., 1934).

[165] See Louise Story, Landon Thomas, Jr. & Nelson D. Schwartz, Wall St. Helped to Mask Debt Fueling Europe’s Crisis, N.Y. Times., Feb. 13, 2010, http://www.nytimes.com/2010/02/14/business/global/14debt.html?pagewanted=1&hp (“[R]ecords and interviews show that with Wall Street’s help, [Greece] engaged in a decade-long effort to skirt European debt limits.”).

[166] See Ioannis Kokkoris, Rodrigo Olivares-Caminal & Kiriakos Papadakis, The Greek Tragedy: is there a Deus ex Machina?, in Managing Risk in the Financial System 159–60 (John Raymond Labrosse, Rodrigo Olivares-Caminal, & Dalvinder Singh, eds., 2011) (“The biggest challenge that Greece is now facing is how to effectively implement the tough measures required in order to comply with IMF/EU requirements and more importantly to sustain these measures through the delicate situation of its economy.”).

By

Capturing Time in Financial Statements

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George M. Williams jr*

The Dodd-Frank Wall Street Reform and Consumer Protection Act[1] applies a number of heightened standards to bank holding companies with consolidated assets of $50 billion or more and to nonbank financial companies that have been subjected to supervision by the Board of Governors because of their systemic importance. Among these standards are new liquidity and capital requirements (the “Liquidity Standard”)[2] and a new requirement (the “Resolution Plan Requirement”) to prepare and maintain a resolution plan that articulates how the relevant company could best be dismembered if it represented a threat to the financial stability of the United States.[3] One of the, perhaps unintended, effects of these new standards may be to provide an additional reason for rethinking the form and purpose of financial statements prepared by financial institutions.

The recent financial crisis and the resulting increase in the recognition of how important capital and liquidity requirements are for financial institutions have already exposed some of the ways in which financial statements in their current form are inadequate for complex financial institutions.[4] The usual way of dealing with this inadequacy is to require the institutions to provide supplementary information, rather than to rethink the nature of the basic financial statements.[5] Having the supplemental information is helpful and is often sufficient to re- or deconstruct the standard financial statements, and making the financial statements of certain companies look completely different from those of others does, after all, have disadvantages.

The Liquidity Standard and the Resolution Plan Requirement are examples of how extensive these demands for supplemental information can become. The core requirement of the new liquidity standards is the imposition of periodic stress-testing coupled with liquidity and corporate governance standards.[6] Other portions of the Liquidity Release elaborate on the precise types of information and testing required, establish new capital and leverage requirements and introduce new limits on credit exposures to counterparties.[7]

The Resolution Release requires covered companies to provide resolution plans that extensively articulate how they could be liquidated with minimal harm to the financial system.[8] The provisions of the Resolution Plan Requirement that set forth the precise details are lengthy, and relate to entity structure, investment strategy, documentation of practices and extensive financial data.[9]

The Temporal Dimensions of Capital and Liquidity

Although the requirements spelled out in the Liquidity Release, on the one hand, and the requirement to prepare resolution plans, on the other, nominally relate to different aspects of a financial company’s business, the intense focus on and interlinks between capital, liquidity and liabilities suggests a deeper relationship. The possibility of such a relationship makes it worthwhile to consider the ways in which capital, liquidity and liabilities are related and how these relationships could affect the structure of financial statements for financial institutions.

 

Time and Capital

Capital can be considered either as the number that results from subtracting the value of a company’s liabilities from the value of its assets or as the amounts that have been contributed as consideration for certain kinds of financial instruments, such as common or preferred stock or deeply subordinated, long-term debt.[10] These values can differ, but each purports to represent the ability of a company to withstand losses and continue in business.

In the context of insolvency, capital expressed as the excess of assets over liabilities isolates the point in time where society has determined that it is unfair for a company to continue in business, in the sense that the certainty of loss justifies some notion of structured sharing. On the other hand, capital expressed as consideration received highlights the extent to which the capital remains available over time, with common capital generally never having to be returned while deeply subordinated debt must eventually be repaid. This focus emphasizes the relative usefulness of different kinds of capital, especially the relative ineffectiveness of subordinated debt if repayment roughly coincides with severe financial stress or insolvency. If capital must be repaid at a particular point in time, then to some extent it is not quite (regulatory) capital, at least if capital is considered to be assets over which no one has any claims except shareholders (or their equivalent).

These differences in repayability also introduce a temporal factor into the nature of capital that is typically obscured by the standard company balance sheet. Time is furthermore implicit in the notion that capital must be available as a buffer to intermittent shocks and as a way of accommodating creditors at insolvency, meaning that capital must be reliably available over a range of times. While the standard balance sheet presumes by its structure that capital will be available at insolvency, in reality—at least for financial institutions—the time prior to insolvency or prior to a potential insolvency is perhaps even more crucial, because insolvency can be unpredictable[11] and because the time frames during which creditors and investors (and, in all likelihood, managers) believe they must act become increasingly abbreviated when insolvency appears likely.

Time and Liquidity

The concept of liquidity further expands the role of time in the presentation of a company’s financial position. If liquidity is thought of as the ability to obtain funds in the market, then planning for liquidity requires consideration of both the times at which funds might be needed as well as their likely availability. Similarly, if liquidity is thought of as a store of assets that will be readily accepted as means of payment, then calculating the available level of liquidity requires keeping track of when inflows from investments and transactions are expected to occur. Amounts in deposit accounts and in the form of Treasury securities can in effect be treated as inflows that can occur at any time.

Deposits and Treasurys also represent a third aspect of the way time plays a role in the nature of capital and liquidity. In calculating the extent to which a company’s assets exceed the claims of its creditors and the extent to which the sale of assets can generate liquidity, the ability of assets to retain their value over time is crucial. The closer an asset is to being treated as if it were money, the greater its ability to fulfill at any given time the role to be played by liquidity or capital. This is particularly true for systemically important financial institutions (whether they are bank holding companies or not). Preventing the collapse of the financial system or reducing the risk of such a collapse depends in part on the availability of sufficient funds and fund-like assets to repay the counterparties of the insolvent company and to convince other participants that the system will not freeze up or collapse. The inability (or perceived inability) to obtain such funds in turn signals the possibility of failure (or, equivalently, exclusion from the financial system).

The distribution across time of collateral provided by or to a financial institution is another instance in which the timing of the potential uses of financial instruments or devices can be as significant as their aggregate amount. For example, the aggregate amount of all collateral made available by a financial institution in connection with its borrowings might appear adequate while at the same time actually failing to be so because of an insufficiency of collateral for financings that might need to be re-collateralized in two days or two months. Similarly, a review of the collateral posted to cover various obligations might show that the collateral preferred for certain kinds of obligations, such as repurchase agreements, might be losing value and require supplementation (or replacement) at a rate or in a manner that differs from the behavior of collateral posted for other purposes. This could signal the arrival of financial difficulties at a particular time more clearly than a look at aggregate collateral.

In addition to playing an important role in understanding a company’s financial circumstances in the ordinary case, time becomes increasingly important whenever insolvency is, or appears to be, imminent. Typically, understanding the aggregate cash inflows and outflows over a modestly long period of time (e.g., a quarter or a year) might suffice for understanding the nature and risks of a particular company. In the zone of insolvency or at a time of generalized financial crisis, however, not only the aggregate flows of a one-day period but also even their relative order can be crucial.[12]

Restructuring the Financial Statement

Shortcomings of the Standard Balance Sheet

The basic form of a balance sheet largely obscures all of the ways in which time plays a role in the state of a company’s finances. The principal reflection of the role that time plays is found in categorizations such as “current assets,” “current liabilities” and “long-term debt.” Other information that is relevant to time is found, among other places, in notes to the financials, in the discussion that accompanies the financial statements in reports filed with the Securities and Exchange Commission by publicly-traded bank holding companies or in the specialized reports filed by regulated institutions with their regulators, such as the call reports that are available from the Federal Deposit Insurance Corporation. Information of that kind needs to be combined in some way with the balance sheet and income statement in order to render those statements useful. That still leaves the question of what a balance sheet, even if so supplemented, is supposed to represent. Even though in some sense a balance sheet represents what would happen if a company were liquidated on the date as of which the balance sheet speaks, it does not generally reflect the values that could actually be realized in such circumstances, principally because the valuation conventions on which the balance sheet is based reflect a going-concern assumption, an assumption that obviously plays no further role once an insolvency actually arises.

Given these different ways in which time constitutes an essential part of a company’s financial structure—even for balance-sheet purposes, and not just in the sense that revenues are measured over time—finding a way of representing directly what might be called the time structure of the balance sheet might more adequately model the state of a financial institution than do balance sheets in their current form. Any such representation should allow the various relationships between capital and liquidity to appear and should be capable of natural contraction and expansion in order to reveal the different degrees of detail that are relevant in times of crisis and non-crisis. One possible way of accomplishing such a task may be to create a model of a company’s financial situation that can be viewed at either a level of minute detail or at other levels of aggregation.

Building in Extensible Time Frames

This might be done by converting the basic “vertical” distinction of a standard balance sheet (the separation of assets from liabilities) into a “horizontal” distinction of time frames,[13] thereby creating the ability to separately represent the dynamics over time of different classes of assets and their associated liabilities. For example, a liability to be paid on June 1 would be grouped together with an asset that is intended to be used to satisfy the liability and is liquid or capable of being liquidated.[14] In many ways, this would amount to building some of the notes to the financial statements directly into the statements themselves. There are surely other ways. The purpose of the following discussion is to conduct a thought experiment and consider the usefulness and consequences of the experimental model, particularly with respect to the regulatory goal of understanding, and perhaps partially taming, systemic risk.

Aggregating cash flows (including anticipated borrowings, purchases, interest and dividend payments and receipts) over designated time frames would directly represent anticipated liquidity conditions. The trustworthiness of any such representation would naturally decrease out into the future. It should be noted, however, that conventional financial statements also contain estimates of various future values. Practices could be established to standardize estimates of future payments and receipts. In addition, as future payments change in their status from reasonably anticipated to contractual and from contractual to essentially certain, the way in which the changes take place will be visible as movements in the entries in the “balance sheet,” for example from a column indicating anticipated payments or receipts to one indicating a contractually agreed payment or receipt. Changes of this kind might prove indicative of various kinds of potential success or difficulty.

Different “kinds” of capital could be stratified in terms of their ability to be liquidated within particular time frames and in connection with the satisfaction of particular kinds of liabilities. For example, large investments in corporate real estate would put a company in a different capital position than would small or modest investments of that sort, as would large holdings in certain investment funds as opposed to large holdings of Treasurys. Highly liquid assets would be treated as available at any time to cover any required outflow (i.e., they would be treated in effect as if they were an offsetting cash inflow at the desired point in time), while real property, for example, could be classified as available to cover only obligations that might mature only in the more distant or indefinite future. Collateral supporting the obligations of the financial institution could be similarly stratified, since the distribution of the collateral over time[15] and the changes in the amount and nature of the collateral deployed relates closely to liquidity needs and uses.

A convention would have to be developed for what would constitute the “balance sheet” for a given day, such as the last day of a given reporting period. One possibility might be a summary four-quarter look into the future, with all inflows and outflows after that date either ignored or aggregated as if they took place simultaneously. There might not need to be a separate line for, say, common stock, since the relevant fact is the lack of any constraint forcing a payment at a particular time, although there could, of course, automatically be such a line because the very lack of such constraints might compel or strongly suggest a particular graphic or structural positioning of that information. On the other hand, a “capital” security with required payments could show up in a horizontal line that represents the spread of the required payments over time. Asset valuation adjustments that now are distinguished from one another by either showing up in the income statement or as an adjustment on the balance sheet could now all be represented in different ways on the balance sheet, based on the ways in which they affect actual or projected inflows and outflows. For example, the likely future value of assets that are currently illiquid and perhaps impaired could be shown as having a value at some future date, resulting in the categorization as unavailable for current payments but still ultimately convertible into cash, and any payments currently being made on such assets could be shown as expected receipts at the appropriate times. This would fit with the intuitive notion that an amount that is uncollectable is collected in the extremely distant future, at infinity.

Such a representation of a financial company’s transactions over specified time frames essentially makes the statement that a financial company simply is a financial company because it continuously engages in liquidity transactions. The failure of such liquidity transactions in effect opens a time gap, another way in which time plays a role in the structure of financial statements and financial activity. The existence of an unclosable or unbridgeable time gap constitutes insolvency, regardless of whether the gap arises from the inability to liquidate otherwise unencumbered assets or from the lack of assets.

A crude approximation of a remodeled balance sheet might have the following structure:

Benefits of Time Frames

A representation of a company’s financial situation in this form would appear to be useful both in managing liquidity in an ongoing business and in planning for a resolution in the event of an insolvency or similar crisis. The relationships between certain kinds of assets and liabilities would be represented directly. All levels of detail would be directly accessible and capable of either aggregation or magnification. All time frames would be immediately accessible, so that planning could be carried out for different time frames, including minute-by-minute (maybe) in a crisis.

In some respects, a representation and analysis in this manner of a company’s capital and liquidity resembles the ways in which stress testing affects (or potentially affects) our understanding of the company’s financial condition. Testing of that sort forces consideration of time frames of varying lengths and of the ways in which affected financial exposures can be dealt with and has become a standard regulatory device, at least in connection with the supervision of large financial institutions.[16] Something like this is precisely what the matching of inflows and outflows into the future represents and accomplishes. A stress test requires consideration of the ways in which the size and relative timing of the projected or contracted inflows and outflows might be affected, and how to plan for and alleviate the consequences.[17] A modified “balance sheet” with a “horizontal” time component accommodates such variation, testing and planning quite easily and, furthermore, suggests in a fairly direct way what the relevant factors are and what the consequences of changing their values might be. In other words, developing a modified balance sheet for at least certain financial institutions would simplify the conduct of stress-testing and would, in fact, provide a factual and conceptual framework for articulating what a stress test does.

The single counterparty exposure limits contained in the Liquidity Release also reflect an awareness of flows, and not just a static conception of liability, in the following way: An exposure can be reduced by obtaining a guarantee or other form of credit support; however, even though the one exposure is reduced, another exposure is created, namely to the guarantor. The networking of exposures models, implicitly, the potential direction and timing of flows.

The ways in which the treatment of capital and liquidity in the Basel III Framework relate to the modified “balance sheet” described above are slightly more indirect. The discussion of capital in the Basel III Framework emphasizes the kinds of capital that are completely or largely free of any provision that would compel or provide an incentive for payment or repayment. In the discussions on adjustments (e.g., with regard to deferred tax benefits and good will) the emphasis is understandably on the extent to which the value assigned to the capital indicates the availability of real means to make payments. Any requirements that capital be repaid or redeemed, that payments, whether in the form of interest or dividends, be made with respect to capital, or that some kinds of capital, upon the occurrence of certain events, become less restricted and more available for the payment of creditors in general[18] obviously link the idea of kinds or qualities of capital to the idea of time. The availability of capital that is not subject to requirements that it be returned remains a rather general notion except at insolvency, since the fact that it is unrestricted does not mean that capital is currently available. It could, for example, for locked up in illiquid investments.

The liquidity requirements established as part of the Basel III efforts attempt to overcome somewhat that (potential) lack of availability in several ways.[19] A Liquidity Coverage Ratio mandates that the “stock of high-quality liquid assets” must equal or exceed the “total net cash outflows over the next 30 calendar days.”[20] “High quality liquid assets” are identified by reference to both “fundamental characteristics,” such as low credit risk and ease of valuation, and “market-related characteristics,” such as the size of the relevant market and the diversity of buyers and sellers in that market.[21] “Total net cash outflows” include outflows that are likely to occur under conditions of market stress.[22] The liquid assets that count toward the satisfaction of this ratio must be unencumbered and may not serve as hedges or as collateral.[23] Net cash outflows are calculated by subtracting a portion of the expected cash inflows from the expected outflows in the stress scenario.[24]

In addition, a “Net Stable Funding Ratio” must be met, which requires that the “available amount of stable funding” must always exceed the “required amount of stable funding.”[25] “Stable funding” is characterized as “the portion of those types and amounts of equity and liability funding expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress. The amount of such funding required of a specific institution is a function of the liquidity characteristics of the various types of assets held, [off-balance-sheet] contingent exposures incurred and/or the activities pursued by the institution.”[26] Note, however, that what counts as stable funding does not have to be liquid at any time prior to the time at which it is needed to cover payment requirements. For example, amounts that constitute common capital might at any given point in time be invested in assets that are not currently available for liquidation. As a consequence, “stable funding” must be understood to mean something like “capable of being liquidated without too much trouble and without conflicting with liabilities associated with such sources of funding.” In other words, stable funding consists of access to assets that are not constrained or are loosely constrained by any commitments that can, hopefully, be sold to cover cash needs with respect to assets that cannot otherwise be easily monetized. In this respect, the manner in which required stable funding is calculated resembles the calculation of one-year’s worth of liquid risk-based capital. It is somewhat unclear whether values characterized as equity and equity-like will necessarily be available as sources of funding just because they are nominally not subject to payment constraints. To some extent, the various monitoring procedures proposed by the Basel III Liquidity Framework may provide information that could at least partially overcome the lack of any necessary connection between equity and liquidity.

It is fairly clear how a balance sheet that is “stretched out” horizontally to reflect timing could accommodate both liquidity coverage ratios and net stable funding ratios. It would do so by allocating various assets to the payment of either stressed or expected payouts over the required time periods. Using such a remodeled balance sheet would make the intended function of both ratios graphically apparent. The remodeled balance sheet would, however, in all likelihood require more precise decisions to be made about (i) which of the assets whose value might be encompassed by the number representing equity capital are actually reasonably capable of monetization in the time frames required, and (ii) which times are the relevant times at which monetization must occur. Changes in the values represented by the remodeled balance sheet would appear not just as aggregates but as sub-aggregates allocated to specific times or time periods, potentially creating a (near) continuum of changes over projected time. By disaggregating much of the information represented by the Liquidity Coverage Ratio and the Net Stable Funding Ratio, a remodeled balance sheet potentially enables insights into the ways that the distribution of flows across time (including the different distributions of inflows and outflows and the distribution of the differences or net values), rather than just the aggregate values on a calculation date, might affect or predict the financial well-being of a large, active financial institution.

In addition to time, the practicalities of dealing with a potential crisis and with the proposed requirements for living wills compel the incorporation of at least one more dimension, namely “space,” in any remodeled balance sheet. Information must be available regarding not only the times and amounts of inflows and outflows, but also about the persons to and from whom flows are owed or expected.[27] For example, all swaps between an insolvent financial company being resolved by the FDIC and the same counterparty must, if transferred, be transferred to the same replacement for the insolvent company, whether the transferee is an existing market participant or a new bridge institution.[28] Any determination of possible setoffs obviously requires an awareness of all transactions between the insolvent institution and each particular customer, client or counterparty. Part of being alert for potentially risky situations consists in monitoring the behavior, creditworthiness and asset concentrations of each other company with which a significant financial company does business. The kind of “space” involved is the position of the significant financial company in the total network of other financial institutions that constitutes the financial system, although this “space” can in all likelihood be determined only for the nearest neighbors of the significant financial company (i.e., those with which it directly engages in transactions).

In principle, the ways in which a significant financial company’s exposures (cash inflows and outflows, collateral) relate to other financial companies can be indicated in a remodeled balance sheet by typographical convention. For example, at each point in, or for each period of, time, the portion of each number displayed horizontally in the remodeled balance sheet that relates to another financial company can be displayed separately in a vertical column. This would allow separate (i) disaggregations of relationships with a given financial company at each point in time; (ii) aggregations of all exposures to a given financial company at each point in time; and (iii) analyses of the development over time of both the disaggregated and the aggregated exposures.

Remodeling balance sheets of large financial institutions to reflect both the temporal and spatial aspects of the institutions’ activities would display directly the way assets, inflows and outflows vary over time and shift (in terms of the other parties involved) over space. A joint representation of inflows and outflows over both space and time should provide, at a fairly basic level, some direct indication of what financial company’s systemic position is and how it is constituted. Representations of systemic importance are uncommon and controversial. One virtue of a spatially and temporally remodeled balance sheet might be its potential ability to resolve some of this controversy. By its very nature, a remodeled balance sheet would also permit the rapid adaptation of plans as trends change, for example, as relevant time periods close to the present increase in importance.

Any indication of an individual financial company’s systemic position would need to be complemented by similar information regarding the other large financial companies with which any given financial company is linked. Whether such information would in theory be available in all relevant cases would in all likelihood depend on whether all the relevant financial companies are regulated and whether their regulators impose similar reporting standards. If it were practical to collect remodeled balance sheets, prepared on a consistent basis, from most or all of the significant financial companies, not only the systemic importance of each institution but the fundamental behavior of the system as a whole might be more easily observed.

Even a collection of remodeled balance sheets of all financial companies in the U.S. or world financial system would presumably be incapable of revealing the potential existence of a dangerous exogenous shock, such as a housing crisis—simply because it is exogenous. Nevertheless, it seems possible that the appearance in remodeled balance sheets of certain kinds of data will be suggestive of a coming exogenous shock, which could be further studied and perhaps verified using other kinds of data. In addition, remodeled balance sheets may show more clearly than ordinary balance sheets how a shock might propagate, both from institution to institution and from some aspects of the financial system to others.

It might be argued that value-at-risk models that are continuously updated already take into account the temporal aspects of balance sheets (or of the overall financial situation of a company). While models of that kind do in fact consider future exposures by calculating their present value, they essentially erase the distribution of exposures with respect to one another because the results are numerical aggregations. This has two effects. First, the focus of the calculations amounts to a generalized insolvency test which neither relates to the potential results of an actual insolvency on the date of calculation nor provides a direct indication of the timing of the potential difficulties. Rather, it reflects what might be called the likely results of a controlled run-off of a liquidating trust for the company in question. This is not to deny that the results of making the necessary calculations can serve a usual early warning function. Second, given a proper distribution of values and times, the results of calculating value-at-risk can conceivably obscure the existence of periods of significant risk for a company if those risks arise from mismatches in the availability of funds in comparison to the temporal distribution of liabilities. A remodeled balance sheet provides the necessary temporal distributions without interfering with any calculations of value at risk. By providing these distributions in detail, however, such a balance sheet potentially raises the question of whether such calculations are necessary, or, phrased differently, whether the information such calculations provide useful information in addition to that provided by the balance sheet. To take a simple mathematical analogy, calculating value-at-risk might be like integrating (or trying to integrate) certain expressions when what we really want to find out is whether the curves represented by the expressions are discontinuous at any points (where, by analogy, the discontinuities represent liquidity or solvency problems). The answer might be that it provides redundant information that is nevertheless useful for quick or more tractable evaluations or evaluations by outsiders who are not entitled to all of the information in an extensive, remodeled balance sheet.

In this regard, it is interesting to consider the information that a remodeled balance sheet would provide in connection with certain more specific requirements of the Liquidity Regulation and the Resolution Regulation.

Under the Liquidity Regulation it will be necessary, among other things, to keep track of which assets are unencumbered, what the credit exposures are to counterparties, and how financial companies are to control their liquidity and capital needs and exposures by corporate governance mechanisms. Which assets are unencumbered (in the sense of being subject to a lien) and which have not already been allocated to serve as a hedge or source of future payment would already be indicated (or be capable of being indicated) by the kind of modified balance sheet described earlier, as would credit exposures to any combination of counterparties. The fact that information of this kind, as well as more standard information about flows and projected flows, would in effect constitute the balance sheet would provide any corporate governance arrangement that might be implemented with a very large portion of the information the governing persons and bodies might need, and do so in an accessible, replicable and stress-testable form. Much of the information necessary for capital planning would also be available “free” as a result of the modified balance sheet.

As far as the informational requirements of the Resolution Requirement are concerned, a remodeled balance sheet would appear to supply directly, even without explicit consideration of an insolvency, almost all of the required information. It addition, given the interrelationships that such a balance sheet would display, many of the plans and strategies seem likely to be easier to articulate, since they could be linked directly to the financial interrelationships. In all likelihood, a substantial number would not need to be articulated at all, except in a trivial sense, since they would reveal themselves on the face of a detailed version of the balance sheet. A remodeled balance sheet would also provide a significant amount of the information required for the credit exposure reports that may also ultimately be implemented in connection with the Resolution Regulation, once the counterparty credit limits have been finalized.[29] Roughly speaking, the Resolution Regulation seems in essence to require the financial picture of an organization that would be given by a remodeled balance sheet plus some names and addresses that would make finding the right people, machines and documents easier in a crisis.

Conclusion

The important roles accorded to liquidity and resolution plans in Dodd-Frank and the centrality of liquidity in any understanding of large financial institutions as they are structured today and, more importantly, as they interact with other financial institutions, all suggest that something like a modified balance sheet should not just be a response to these regulatory demands but should instead be a candidate for itself being the central regulatory demand, around which other demands could be organized and take shape.

A recent report[30] by the Federal Deposit Insurance Corporation on how it would have resolved Lehman Brothers Holdings if the resolutions provisions of Title II of Dodd-Frank had been in effect at the time provides an interesting, indirect and somewhat ironic—given the content of the Resolution Regulation—confirmation of this conclusion. The report describes the principal advantages of Title II over bankruptcy proceedings: the availability (i) of dedicated sources of liquidity to prevent relevant markets from seizing up and (ii) of bridge institutions for holding derivatives and thereby preventing their termination while holding other activities that should be preserved or maintained. These advantages purportedly follow from an understanding of the unique ways in which the insolvencies of certain kinds of financial institutions might affect certain markets or even the larger economy.[31] These effects are considered to be significantly different from the effects of the insolvencies of large industrial companies. The nature of the new possibilities created by Title II makes it immediately clear what kinds of information and planning are necessary to benefit from them.[32] This kind of information and planning can be derived directly from modified balance sheets, as described above, without starting from any supposed special requirements of resolution plans and, unlike the requirements set out in the Resolution Regulation, without any particular reference to the way a financial company would be resolved under the Bankruptcy Code.

 

Preferred citation: George M. Williams jr, Capturing Time in Financial Statements, 2 Harv. Bus. L. Rev. Online 150 (2012), https://journals.law.harvard.edu/hblr//?p=2140.

* George M. Williams jr is a partner at Dewey & LeBoeuf where he specializes in corporate, banking and securities law and is also the chairman of the firm’s Corporate Opinion Committee.  The views expressed in this article are his own and do not necessarily reflect those of the firm or its clients.

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[2] Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 594, 604 (proposed Jan. 5, 2012) [hereinafter Liquidity Release].

[3] Resolution Plans Required, 76 Fed. Reg. 67,323 (proposed Nov.1, 2011) [hereinafter Resolution Release].

[4] For example, discussions of when or if asset values are to be marked to market, difficulties in valuing asset-backed securities, the relative lack of information about a company’s liquidity and collateral position, and the opacity of balance sheets with regard to the nature (other than arithmetic) of shareholders’ equity all reveal a need for having more information than that provided in ordinary financial statements. For a discussion of some of these data issues, see Dimitrios Bisias et. al., A Survey of Systemic Risk Analytics 38–39, (Office of Financial Research, Working Paper No. 0001, Jan. 5, 2012) [hereinafter Risk Analytics], available at http://www.treasury.gov/initiatives/wsr/ofr/Documents/OFRwp0001_BisiasFloodLoValavanis_ASurveyOfSystemicRiskAnalytics.pdf.

“[L]egacy supervisory accounting systems sometimes fail to convey adequately the risk exposures from new complex contingent contracts, and from lightly regulated markets with little or no reporting requirements. In fact, supervisors do not even have consistent and regularly updated data on some of the most basic facts about the industry, such as the relative sizes of all significant market segments.”

Id. at 9.

[5] This can be seen by reviewing the periodic reports of public bank holding companies.

[6] Liquidity Release, supra note 2, at 599.

[7] A counterparty can actually consist of a number of related individuals or entities.

[8] See generally Resolution Release, supra note 3, at 67,323.

[9] See generally Informational content of a resolution plan, 12 C.F.R. § 381.4 (2012).

[10] These two perspectives are implicit throughout the structure of balance sheets, corporation law definition of capital and surplus and regulatory releases regarding risk-based capital, such as those found in the appendices to Regulation Y of the Federal Reserve Board.  12 C.F.R. pt. 225 app. A–G (2012).

[11] This is due uncertainties such as asset prices, the availability of funding, forbearance, customer and market reactions, and regulatory decisions.

[12] For example, whether sufficient funds are available will depend on whether large inflows or outflows occur early or late in the day, and whether closing out all transactions occurs periodically or all at once.

[13] For something similar in terms of a more purely cash-flow analysis, see Liquidity Release, supra note 2, at 607 n. 66.

[14] For example, by placing it above or below the liability on parallel, horizontal lines.

[15] That is, the time at which it could be called upon for payment purposes.

[16] For a condensed description, see Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems 46–47, (June 2011)  available at http://www.bis.org/publ/bcbs189.pdf. The Liquidity Release requires ongoing stress-testing, conducted in a prescribed manner. See Liquidity Release, supra note 2.

[17] See Risk Analytics, supra note 4, at 100; Liquidity Release, supra note 2.

[18] In other words, various kinds of conditional capital.

[19] See generally Basel Committee on Banking Supervision, Basel III: International framework for liquidity risk measurement, standards and monitoring, (Dec. 2010) [hereinafter Basel III Liquidity Framework], available at http://www.bis.org/publ/bcbs188.pdf.

[20] Id. at 3.

[21] Id. at 4–5.

[22] Id. at 4.

[23] Id. at 6.

[24] Id. at 12.

[25] Id. at 25.

[26] Id. at 25–26.

[27] See the remarks supra regarding counterparty exposure limits.

[28] Dodd-Frank Act, supra note 1, § 210(c)(9).

[29] Resolution Release, supra note 3, at 67,327.

[30] The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act, 5(2) FDIC Q. 31 (2011), available at http://www.fdic.gov/bank/analytical/quarterly/ 2011_vol5_2/FDIC_Quarterly_Vol5No2_entire_v4.pdf.

[31] These effects are considered to be significantly different from the effects of the insolvencies of large industrial companies due to the unique nature of financial businesses, the tightness and complexity of their interrelations, and the manner in which markets can freeze when the value of a whole class of assets becomes suspect.

[32] This includes comprehensive information regarding capital and liquidity needs, asset and liability classes and the respective counterparties and collateral, as well as the computational power and general financial databases necessary to keep track of, evaluate and manage all of these matters.

By

Comments on Seasoning of Reverse Merger Companies Before Uplisting to National Securities Exchanges

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David N. Feldman*

Introduction

Blockbuster Entertainment, Occidental Petroleum, Turner Broadcasting, Tandy Corp. (Radio Shack), Texas Instruments, Jamba Juice, and Berkshire Hathaway are just a few well-known companies that went public through a “reverse merger.” To the uninitiated, a reverse merger is a deceptively simple concept. Instead of pursuing a traditional initial public offering (IPO) utilizing an investment bank as an underwriter, a company arranges for its stock to be publicly traded following a merger or similar transaction with a publicly held “shell” company. The public shell has no other business but to look for a private company to merge with. Upon completion of the merger, the private company instantly becomes public. The shareholders of the private company typically take over the majority of the stock of the former shell, enabling them to still operate the business of the formerly private company.

As laid out below, the process is generally quicker, cheaper, simpler, less dilutive, and less risky than an IPO, but it has its own unique risks and challenges.  Reverse mergers are typically complex transactions with hidden traps that even practitioners experienced in this technique easily fall into.  When done right, however, these hidden dangers can be avoided and the transaction can move forward quickly and smoothly.

The dramatic increase in popularity of reverse mergers in the last decade resulted from a confluence of factors. These include the fickleness of the IPO market and its near universal unavailability for companies with less than $150 million in market value, more willingness in certain hedge fund investors to seek greater potential upside in exchange for more patience with respect to liquidity, and SEC regulatory action in the area bringing greater transparency and legitimacy to the technique. In addition, a type of shell company known as a “special purpose acquisition company,” or SPAC, became tremendously popular in the mid-2000s, attracting such luminaries as Goldman Sachs, Apple founder Steve Wozniak, and many more to the world of shells. Finally, as will be discussed below, there was until recently, a large number of companies from China seeking a US public listing through a reverse merger.  On average, about 200 reverse mergers are completed each year.[1]

 

Comparing Reverse Mergers and IPOs

The process of a reverse merger is much speedier than an IPO, allowing needed capital to be raised more quickly and more easily. Typically, reverse mergers can be completed in three to four months, whereas IPOs can take nine to twelve months or more.[2]  Reverse mergers also are much less expensive.  Depending on the cost of a shell, a reverse merger can be completed for less than $1 million and sometimes even less than $200,000.  IPOs, on the other hand, cost millions.[3]

IPOs also are more dependent on market conditions than reverse mergers. In the end, an IPO comes down to how the market is behaving during the week that the IPO is slated to be carried out.  If the market is down, the deal may be delayed, the offering price may be reduced, and some deals simply get shelved at the last minute.  Because there is generally not much trading immediately following a reverse merger, current market conditions are simply less important.

IPOs also typically involve the sale of a fairly large percentage of a company’s stock. In general, reverse mergers tend to raise less money initially, allowing a company’s founder to retain a greater percentage of his company’s equity. Additional funds are raised later, hopefully at a time when the stock price has risen and the offering would thereby be less dilutive.

It is often said that one advantage of an IPO is the robust trading that takes place after the offering. The primary goal of the syndicate of underwriters is to get initial investors in, and then out, of the stock relatively quickly, within hours or a few days. They support the stock during this time. Whether they support it after that initial burst of activity depends on many factors and cannot be assured.

It is true that initial trading after a reverse merger is often thin. Companies are trained to think differently with a reverse merger and work on building market support over a reasonable period of time, rather than expecting a “pop” in the stock as with an IPO. Many reverse merger companies pursue larger public offerings after they go public to gain some of the trading benefit that attaches to an IPO.


Basics of Reverse Mergers

In a 2005 rulemaking, the SEC defined a shell company as a registrant that has (1) no or nominal operations and (2) either: (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.[4]  In a 2007 rulemaking, amending Securities Act’s Rule 144,[5] the SEC further indicated that a start-up company with limited operations could be considered as having more than mere nominal operations, in other words as not a shell,[6] and in the aforementioned 2005 rulemaking, the SEC generally declared “that companies and their professional advisors often use shell companies for many legitimate corporate structuring purposes.”[7]

Shells are valued in the marketplace based on how many shareholders they have, whether the stock is trading, whether the company is required to file periodic reports with the SEC, and how “clean” the shell is. Shells come about in one of two ways. In one type, a public operating business is sold or goes out of business; while the company remains public, its operations have ceased. This leaves behind a public shell whose shares typically can continue to trade. Shells can also be created from scratch, utilizing SEC Form 10 to register a shell’s common stock so that the company becomes fully SEC reporting but has no shares to be traded until a business combination is completed and a full SEC registration process is undertaken. These “Form 10 shells” had become very popular in the last six years as they are completely clean, with no past operations to scrub for liability exposure.

If one is completing a reverse merger with an SEC reporting shell company, a variety of special rules apply. For example, SEC Form 8-K requires, within four business days after the completion of the transaction, a filing on that form of all information that would be in an SEC Form 10 for the combined company.[8] This is effectively the equivalent of an IPO prospectus, with fully-audited financial statements, detailed company description, executive compensation, ownership chart and the like.  The industry refers to it as the “super” Form 8-K.  In addition, certain rules allowing the public resale of shares that have not been registered with the SEC require a delay following the completion of a reverse merger before these shares can begin to be sold.[9]

In the 2007 rulemaking on Rule 144, mentioned above, the SEC imposed an additional requirement on public companies that were at one point shell companies, mandating that such companies complete all of their regular filings with the SEC for the last 12 months if a shareholder wants to publicly sell shares that have not been registered.[10] This rule applies forever and the industry has dubbed it the “evergreen” requirement. In October 2008, this author, along with nine law firms, submitted a petition for rulemaking requesting that this limitation be reversed and that former shells be treated like any other public company.[11] To date, the Commission has not taken any action on the petition.

In addition, as will be discussed in greater depth below, the New York Stock Exchange, NYSE Amex, and Nasdaq have all imposed special limitations on when a company completing a reverse merger can be permitted to apply to “uplist” to their exchange.


Brief History and Rule 419

In the 1970s and 1980s, a number of unsavory players entered the reverse merger space, forming new shell companies, raising money through IPOs of these shells, and simply taking the money as fees for themselves.  Other abuses, some relating to trading of the stock of the shells, were also rather rampant.  However, a number of legitimate players also emerged.  Other fraudulent “boiler room” abuses also were common in lower priced stocks.  This resulted in the passage of the Penny Stock Reform Act of 1990.[12]  Among other things, it directed the SEC to segregate registration statements (including IPOs) that relate to offerings by shell companies.  In response, in 1992 the SEC passed Rule 419 under the Securities Act of 1933.[13]

Rule 419 placed significant restrictions on any attempt to complete a traditional IPO for a shell company (they then called them blank check companies with a little bit different definition). The rule requires virtually all cash raised in the shell IPO to be placed in escrow, no trading in the shell’s stock prior to a reverse merger, a time limit of 18 months to complete a transaction or return all invested cash, and shareholder approval of the merger transaction. Shareholders also have an “opt out” to receive their money back if they vote against the transaction. The restrictions do not apply to a public offering by a shell of at least $5 million- this exception ultimately spawned the SPAC movement described above.

Passing this rule eliminated most of the abusers from the market. But the rule also hurt many quality players. Most discovered quickly that, as a practical matter, it was going to be nearly impossible to take shells public under Rule 419, much less have an easy time getting the SEC to approve the proxy disclosure required to obtain shareholder approval for a transaction. As indicated above, this ultimately led many to acquire shells from the carcasses of former public operating companies or set up new shells using Form 10, which is not subject to the Rule 419 restrictions.[14]


Recent Developments

As mentioned above, in the last decade hundreds of companies located in China became US public companies through reverse mergers. A number of other Chinese companies completed traditional IPOs during this time. But in the late 2000s, before the market meltdown, Chinese companies represented about one-quarter of all reverse mergers. The Public Company Accounting Oversight Board (PCAOB), which oversees auditing firms of public companies, discerned that of the 603 reverse mergers between January 2007 and March 2010, 159 were Chinese companies, about 26%.[15] However, starting in early 2010, the financial press and short sellers began reporting allegations of primarily accounting fraud in a number of these companies.[16] A number of class action lawsuits are now pending against Chinese companies, although some have been dismissed.[17]

These developments also led the SEC to begin actively investigating not only these companies but microcap fraud in general. This review also encompassed the reverse merger industry, including attorneys, accountants and investment banks. It also led the SEC to issue a recent “investor bulletin” on the risks of reverse mergers, which mostly described the risks inherent in investing in any small or microcap stock.[18] In addition, the PCAOB has issued warnings to accountants about reverse mergers.[19] The US Justice Department also is now involved in the investigation of alleged accounting fraud in reverse mergers.[20]


“Seasoning” Requirements

In recent months, in large part as a result of the actions of the SEC, PCAOB, and others, the SEC approved rules permitting the three largest US stock exchanges to build a speed bump to exchange listing for companies completing reverse mergers.

The original proposals for a so-called “seasoning” period for post-reverse merged companies were first published in the middle of 2011. The Nasdaq proposal[21] (as amended) was filed on June 8, 2011. The New York Stock Exchange (NYSE)[22] and its affiliate’s, NYSE Amex (Amex),[23] proposals were filed on August 4, 2011. The author submitted a comment letter[24] to the NYSE Amex proposal on August 29, 2011, and a comment letter[25] to the Nasdaq proposal on August 30, 2011. The NYSE and Amex proposals were virtually identical in both their justifications for the proposed action and the structure of the new limitations. Nasdaq’s justifications were slightly different, as was their proposed solution.

NYSE and Amex Proposals

The NYSE and Amex proposals would have required that a company completing a reverse merger with a shell company “season” its trading on an over-the-counter market or another national securities exchange for 12 months before an “uplisting” would be permitted to either of these exchanges. The only exception would be if the company were conducting a large public offering to raise net proceeds of at least $40 million in a so-called “firm commitment” transaction.  A broker-dealer acting as underwriter in raising this money must have substantial capital in order to be permitted to conduct a firm commitment offering. Strangely, while every other listing standard for NYSE is higher than those for Amex, the $40 million minimum offering to avoid seasoning was the same in both the NYSE and Amex proposals.

The proposals also required that before uplisting after a year of trading over-the-counter, the company’s stock must have been trading for a “sustained period” at the minimum price required to be listed. Finally, the company must have completed one full year of regular SEC filings. Interestingly, the proposal suggests that it will treat as reverse mergers combinations with certain public companies that would not technically qualify as shells under the SEC definition. If a company is not particularly active, they might consider it as a shell for purposes of seasoning.

The justifications offered as to why these actions are necessary: (1) allegations of accounting fraud, (2) suspension of trading or registration of some reverse merger companies, (3) an SEC enforcement action against an auditing firm involved with reverse mergers, and (4) the issuance of an SEC bulletin on reverse mergers.

Why is seasoning the best response to this? The proposals suggest greater assurance of reliable reporting, time for auditors to detect fraud, ability to address internal control weaknesses, and time for market and regulatory scrutiny of the company.

Nasdaq Proposal

The Nasdaq proposal required only six months of seasoning, but it did not provide an exception for any public offering, even if firm commitment. Nasdaq originally proposed avoiding seasoning with a firm commitment offering, but the June 2011 amendment to its proposal eliminated that exception. It required maintenance of the price you would need to initially list for at least 30 of the 60 trading days before applying. It further required filing at least six months of activity on SEC reports, and similarly expanded the definition of shell company much as in the NYSE and Amex proposals.

Nasdaq used most of the same bases for the proposal as NYSE and Amex but added a few more: (1) concerns raised that certain promoters have regulatory histories or are involved in transactions that are “disproportionately beneficial” to them, (2) the PCAOB has cautioned accounting firms having “identified issues” with audits of these companies, and (3) Nasdaq’s being aware of situations where it appeared that efforts to manipulate prices took place to meet Nasdaq’s minimum price.

An additional reason they believed seasoning would be helpful was that the Financial Industry Regulatory Authority (FINRA), which regulates broker-dealers, can monitor trading patterns and “uncover potentially manipulative trading.” 

Final Rules

Ultimately the final rules on the seasoning requirements passed[26] in November 2011, and each rule essentially harmonized all of the proposals into one so that all three exchanges are applying essentially the same seasoning requirement. In all three final rules, seasoning is required (trading on a market other than the larger exchange) for at least one full fiscal year of the company, the stock must trade for a sustained period at the minimum level required to list before uplisting, and a “firm commitment” underwriting with gross proceeds of at least $40 million allows a company to bypass seasoning on any of the three exchanges. In addition, SPACs that trade over-the-counter would also be subject to seasoning after they complete reverse mergers.


Comment

Unfortunately, the rush to attack reverse mergers because of the issues with Chinese companies fails to acknowledge a number of things. First, a number of Chinese companies facing allegations of fraud completed IPOs rather than reverse mergers.[27] This includes Longtop Financial, whose IPO underwriter was Goldman Sachs and auditor was Deliotte.[28] Second, a good number of the Chinese companies accused of fraud did complete reverse mergers.  However, these mergers combined with Form 10 shells that had no trading in the stock until they completed a full public offering, with all the same investor protections as an IPO.[29] Thus, the problem is not with the method by which these companies went public, it is about the companies themselves. It is disappointing that the regulators chose a broad brush, overly expansive approach in their offensive against reverse mergers.

Not long ago, regulators levied hundreds of millions of dollars in fines against major underwriting firms following illegal activities in the IPO market of the late 1990s.[30] One could therefore ask which approach is the most legitimate way to take a company public.

More specifically, the seasoning rules represent the wrong reaction to a very limited problem. This draconian idea is responding to what to this day remain essentially mere allegations of fraud. Currently the SEC and Department of Justice are investigating whether fraud took place and discovery is beginning in class action lawsuits.[31] There have been no new allegations of fraud in a number of months, leading one to assume that even if fraud is found, the issue is now essentially contained to the several dozen Chinese companies being accused. Also, a number of the cases have been thrown out of court for failure to provide specific evidence of fraud other than the allegations of short sellers.

The exchanges also suggest that seasoning is necessary because some reverse merger companies’ trading was suspended. This has mostly occurred when companies fail and then cease their public reporting, or issue questionable press releases. Since companies completing reverse mergers are generally less mature than companies conducting traditional IPOs, a larger percentage is inherently likely to fail. It is unclear how seasoning will address this problem. In fact, it is likely to make failure more likely since it is more difficult for a company to raise capital when trading over-the-counter.

Regarding the backgrounds of promoters, mentioned by Nasdaq, the exchanges have broad discretionary authority to examine the regulatory histories of and financial arrangements made with these individuals. The exchange can simply refuse to list a company which includes questionable characters or compensation they deem unreasonable. And again, it is not clear how seasoning the company addresses this issue at all.[32]

Nasdaq also suggests that it wants to impose seasoning because some companies uplisting from the over-the-counter markets may have artificially inflated their trading prices to meet the minimum initial listing price. But many reverse mergers are completed with Form 10 shells, after which a public offering is undertaken. In this case there is no trading at all until the company is listed on the national exchange, so the trading price inflation issue disappears completely. Indeed, seasoning might lead to the perverse result of incentivizing artificial price inflation to complete the uplisting after mandatory trading over-the-counter, whereas permitting the continuation of Form 10 shell mergers and public offering uplists would have clearly eliminated the concern.

To suggest that the issuance of an SEC bulletin warning of the risks of reverse mergers or the PCAOB’s having “identified issues” with reverse merger audits is a reason for tightening exchange regulation, respectfully, does not in and of itself provide substantive support for this extreme reaction. And the fact that there has been only one SEC enforcement action against one accounting firm does nothing to suggest there is a systemic problem requiring such a dramatic response.

Even if one assumes the justifications for action are legitimate, requiring trading over-the-counter results in a number of unintended consequences without adequately addressing the alleged reasons for the proposals.

The exchanges all now require prices in over-the-counter trading during seasoning to be at the same level as they expect for an initial listing on the exchange. But as we know, governance and other obligations on the over-the-counter markets (such as the OTC Bulletin Board and the platforms of OTC Markets Group) are substantially less stringent than on exchanges. Therefore, it is a much greater challenge to develop volume in stock trading because analysts do not generally follow these stocks and certain funds and brokerages are prohibited from purchasing their stock.

As a result, the requirement to maintain a particular stock price as high as one expects on the exchange is simply unfair and unrealistic to achieve on the OTC markets. Trading in the stock should not be a requirement of seasoning.  A period where all SEC filings are made in a timely and complete fashion and can be examined by exchange officials would have seemed sufficient enough. This could well result in the next great software or defense company being denied the opportunity for an uplisting because of the very challenges of the trading platform that the new rules relegate them to.  Indeed, a primary reason that Form 10 shells became so popular was the opportunity to complete a reverse merger and private financing, followed by a public offering directly onto a national exchange, all while completely bypassing the over-the-counter markets and their unique challenges. Seasoning may well skewer this efficient and investor-protective method of financing and listing a company.

It also makes no sense that both the NYSE and the Amex have imposed the same minimum offering amount to bypass seasoning when all other listing criteria are lower on Amex than on NYSE. It would have been preferable, as pointed out in this author’s comment letters, that there be no minimum to a public offering, or if a minimum is required, offer a lower one for Amex, perhaps $15 million. This might also have worked for Nasdaq. The same investor protections apply in a small firm commitment public offering as a larger one.

Historically, regulators targeted reverse mergers because there was a period during which fraud was a serious problem.  It was unfortunate that there is now another attempt to dismantle a technique which the SEC itself had declared to be legitimate, and where the alleged fraud took place, if at all,  in a narrow and potentially severable corner of the space, and where the same alleged fraud may have occurred in IPOs and transactions where full public offerings took place.

In 2010, at the SEC’s Government-Business Forum on Small Business Capital Formation, SEC Chairman  Mary L. Schapiro said “reliable data suggests that small businesses have created 60-to-80 percent of net new American jobs over the last ten years. Making sure small businesses can attract the investments they need to grow and thrive is vital to America’s economic recovery.”[33] One can only hope that Chairman Schapiro and her fellow commissioners reconsider their position on this ill-advised set of new rules and instead do all they can to reduce impediments to capital formation for these key engines of the American economy, with an appropriate balance to ensure that small company investors are well protected.

 

Preferred citation: David N. Feldman, Comments on Seasoning of Reverse Merger Companies Before Uplisting to National Securities Exchanges, 2 Harv. Bus. L. Rev. Online 140 (2012), https://journals.law.harvard.edu/hblr//?p=2133.

* David N. Feldman is a partner at Richardson & Patel and is considered one of the country’s leading experts on alternatives to traditional initial public offerings, including reverse mergers.  He is the author of Reverse Mergers and Other Alternatives to a Traditional IPO (Bloomberg Press, 2d ed. 2009), which has been translated into Chinese and is regarded as the “seminal text” on reverse mergers.  Mr. Feldman also maintains and contributes to www.reversemergerblog.com, a blog discussing the latest issues in reverse mergers and visited by thousands of professionals each month.

[1] See, e.g., Bill Meagher, Year in Review: Deal Flow, APOs Grow Significantly, 7 The Reverse Merger Report, No. 1, Jan. 13, 2011 (reporting 246 completed reverse mergers in 2010, a 25% increase from the prior year).

[2] David N. Feldman & Steven Dresner, Reverse Mergers: Taking a Company Public Without an IPO 23 (Bloomberg Press, 2d ed. 2009) (noting that most reverse merger “transactions involving legitimate players completing proper due diligence and negotiation of documents” can be completed within a “three- to four-month process if there is a contemporaneous financing,” but that a typical IPO “usually takes nine to twelve months from start to finish and can easily take longer”).

[3] Id. at 22 (noting that “[m]ost reverse mergers can be completed for under $1 million” including “the cost of acquiring the public shell” and “transactions costing less than $200,000 [are] not unusual;” however, an IPOs are “much more expensive, costing at least several million dollars”).

[4] Use of Form S-8, Form 8-K, and Form 20-F by Shell Companies, Securities Act and Exchange Act Release No. 8587, 85 SEC Docket 2825 (July 15, 2005).

[5] General Rules and Regulations, Securities Act of 1933, Persons Deemed Not to Be Engaged in a Distribution and Therefore Not Underwriters, 17 C.F.R. § 230.144 (2012).

[6] Revisions to Rules 144 and 145, Securities Act Release No. 8869, 92 SEC Docket 110, at n.172 (Dec. 6, 2007) (noting that “Rule 144(i)(1)(i) is not intended to capture a ‘startup company’ … in the definition of a reporting or non-reporting shell company, as [the staff] believe[s] that such a company does not meet the condition of having ‘no or nominal operations’”).

[7] Securities Act and Exchange Act Release No. 8587, supra note 4, at 2.

[8] Id. at 10.

[9] See Rule 144(d), supra note 5 (“Holding period for restricted securities”).

[10] Securities Act Release No. 8869, supra note 6, at 21 (revising paragraph (i) of Rule 144).

[11] Letter from David Feldman, Esq., et al. to SEC (Oct. 1, 2008), available at http://www.sec.gov/rules/petitions/2008/petn4-572.pdf.

[12] Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Pub. L. No. 101-429, 104 Stat. 931 (1990).

[13] Regulation C-Registration, Securities Act of 1933, Offerings by Blank Check Companies, 17 C.F.R. § 230.419 (2012).

[14] Form 10 is a registration under the Securities Exchange Act of 1934 while Rule 419 was promulgated under the Securities Act of 1933.

[15] Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 31, 2010, Public Company Accounting Oversight Board, Mar. 14, 2011, available at http://pcaobus.org/Research/Documents/Chinese_Reverse_Merger_Research_Note.pdf.

[16] See, e.g., Bill Alpert & Leslie P. Norton, Beware this Chinese Export, Barron’s, Aug. 28, 2010, available at http://online.barrons.com/article/SB50001424052970204304404575449812943183940.html.

[17] See Timothy P. Harkness, Chinese Companies Under Fire: The Recent Boom in U.S. Securities Cases Against Chinese Public Companies, Thomson Reuters Business Law Currents, Feb. 24, 2012, available at http://currents.westlawbusiness.com/Article.aspx?id=eff19be9-2bfc-4568-95b3-f0a263919b8e (noting the increasing pace of securities class action filings against Chinese companies during 2011, especially against companies employing reverse merger techniques to raise money).

[18] Investor Bulletin: Reverse Mergers, Office of Investor Education and Advocacy at the SEC (Jun. 2011), available at http://www.sec.gov/investor/alerts/reversemergers.pdf

[19] Activity Summary and Audit Implications, supra note 15.

[20] See, e.g., Harkness, supra note 17 (noting an FBI raid on New York Global Group, a company known for helping arrange so-called “reverse mergers” for Chinese companies).

[21] Proposed Rule Change to Adopt Additional Listing Requirements for Reverse Mergers, Exchange Act Release No. 64633, File No. SR-NASDAQ-2011-073, 2011 WL 2292155 (June 8, 2011)..

[22] Proposed Rule Change Amending Sections 102.01 and 103.03 of the Exchange’s Listed Company Manual to Adopt Additional Listing Requirements for Reverse Mergers, Exchange Act Release No. 65034, File No. SR-NYSE-2011-38, 2011 WL 3407846 (Aug. 4, 2011).

[23] Proposed Rule Change Amending Section 101 of the NYSE Amex Company Guide to Adopt Additional Listing Requirements for Companies Applying to List After a Reverse Merger, Exchange Act Release No. 65033, File No. SR-NYSEAmex-2011-55, 2011 WL 3407845 (Aug. 4, 2011).

[24] Letter from David Feldman, Esq. to SEC (Aug. 29, 2011), available at http://www.sec.gov/comments/sr-nyseamex-2011-55/nyseamex201155-1.htm.

[25] Letter from David Feldman, Esq. to SEC (Aug. 30, 2011), available at http://www.sec.gov/comments/sr-nasdaq-2011-073/nasdaq2011073-1.htm.

[26] Approval to Rule Change, Release No. 65708, File No. SR-NASDAQ-2011-073, 2011 WL 5434020 (Nov. 8, 2011); Granting Approval to Rule Change, Release No. 65709, File No. SR-NYSE-2011-38, 2011 WL 5434021 (Nov. 8, 2011); Filing of Rule Change, Release No. 65033, File No. SR-NYSEAmex-2011-55, 2011 WL 3407845 (Aug. 4, 2011).

[27] Floyd Norris, The Audacity of Chinese Frauds, N.Y. Times, May 26, 2011, at B1.

[28] Id.

[29] David Feldman, Reverse Merger Report Touts Form 10 Shells, Reverse Merger Blog, Feb. 21, 2011, available at http://www.reversemergerblog.com/2010/02/21/reverse-merger-report-touts-form-10-shells.

[30] See, e.g., Andrew Countryman, Regulators Join Forces in Effort to Curb Conflicts, IPO Excesses, Chicago Tribune, Oct. 4, 2002, available at http://articles.chicagotribune.com/2002-10-04/business/0210040097_1_ipo-process-analyst-conflicts-gen-eliot-spitzer.

[31] See Azam Ahmed, Chinese Reverse-Merger Companies Draw Lawsuits, N.Y. Times DealBook, July 26, 2011, available at http://dealbook.nytimes.com/2011/07/26/chinese-reverse-merger-companies-draw-lawsuits.

[32] NYSE Listed Company Manual §703.08, available at http://nysemanual.nyse.com.

[33] Mary L. Schapiro, Remarks to the SEC Government-Business Forum on Small Business Capital Formation (Nov. 18, 2010), available at http://www.sec.gov/news/speech/2010/spch111810mls.htm.

By

Economic Crises and Emergency Powers in Europe

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Ragnhildur Helgadóttir*

1.  Introduction

This article discusses the state reactions to financial crises from the point of view of domestic constitutional law and the main international obligations of European countries. State reactions in such circumstances have been very different, and so have the legal questions they raise. This article will describe the legal framework that applies to state action in such circumstances. Part 3 will briefly describe how Iceland reacted to its crisis in October 2008 and how courts and international organizations have dealt with its reactions.

The essential issue here is what state reactions are permissible. They sometimes involve the state taking over property and prerogatives belonging to private actors. It does seem clear that such state reactions may violate the respective domestic constitution, e.g. its expropriation or anti-discrimination clauses, or the international obligations of the state. Is it then possible for states to use emergency arguments (in some cases, declaring a state of emergency) to justify their reactions?

Constitutions and constitutional orders in Europe differ, of course. Therefore, it is not useful to try to draw a broad picture of constitutional protection and how recent state reactions to economic crises comply with them. But it can be safely stated that most European constitutions, if not all, have an expropriation (or property) clause, and many have anti-discrimination or equal protection provisions.[1] These are the provisions that have been most relevant regarding state reactions to economic crises.[2]

In the case of most European nations, and all those who are now embattled economically, the international obligations in question primarily result from their obligations under the European Convention on Human Rights on the one hand,[3] and their membership of the European Union or the European Economic Area on the other.[4]

2.  The Relevant Law

Domestic constitutional law

In many states, inter alia all of the Nordics, the circumstances surrounding legislation play a role in the interpretation of constitutional provisions by courts reviewing the law’s constitutionality.[5] However, the elasticity of constitutional provisions is limited, and many constitutional orders permit derogations from the regular constitutional order in exceptional circumstances. These exceptions—emergency powers—are sometimes explicitly described in the constitution. Such provisions often permit the executive to declare a state of emergency or permit certain derogation from normal procedure when important decisions are made. Examples include section 23 of the Finnish constitution,[6] section 10 of Chapter 2 and Chapter 13 of the Swedish Instrument of Government,[7] and section 16 of the French constitution.[8]

In some countries, such exceptions are not spelled out in the constitutional text. Unwritten constitutional principles are recognized in countries such as Denmark, Norway and Iceland, where derogations from the constitutions have been accepted in wartime by the courts.[9] Such derogations have concerned both individual rights and procedural questions. None of the Nordic states have declared a state of emergency or openly derogated from their constitution since World War II. While it is clear from Nordic practice that the use of emergency powers is mainly limited to times of war, constitutional theorists agree that international law plays a role in whether emergency powers can be invoked; that emergency powers mainly apply to procedures (rather than individual rights); and that a balancing test (proportionality test) always applies.[10] Constitutional theorists also agree that emergency powers can only be invoked in extreme circumstances.

The European Convention on Human Rights

It is widely accepted in northern European constitutional theory that any use of emergency powers or derogations would be evaluated in light of Article 15 of the European Convention on Human Rights.[11] And since the Convention is binding on all of Europe, Article 15 would be relevant if governments elsewhere on the continent want to derogate from rights protected in the convention. The text of Article 15, titled “Derogation in time of emergency,” is as follows:

1.  In time of war or other public emergency threatening the life of the nation any High Contracting Party may take measures derogating from its obligations under this Convention to the extent strictly required by the exigencies of the situation, provided that such measures are not inconsistent with its other obligations under international law.

2.  No derogation from Article 2, except in respect of deaths resulting from lawful acts of war, or from Articles 3, 4 (paragraph 1) and 7 shall be made under this provision.

3.  Any High Contracting Party availing itself of this right of derogation shall keep the Secretary General of the Council of Europe fully informed of the measures which it has taken and the reasons therefor. It shall also inform the Secretary General of the Council of Europe when such measures have ceased to operate and the provisions of the Convention are again being fully executed.[12]

It is clear from paragraph 2 that a government cannot derogate from the right to life, the prohibition on torture and slavery, and the principle of nulla poena sine lege. In other cases, the conditions for derogation are (according to paragraph 1):

a)                 war or another public emergency threatening the life of the nation;[13]

b)                 that the derogation is strictly required by the exigencies of the situation;

c)                 that the measure is consistent with other obligations under international law; and

d)                 that the state informs the Secretary General of the Council of Europe.[14]

There have been notifications under Article 15 regarding around thirty situations.[15] Some were long lasting (almost 30 years in Northern Ireland[16]) while others were resolved quickly (Georgia declared derogations for 7 days following an attempted coup d’etat in 2007[17]). All but one of the notifications by states invoked the danger of war, terror threats, disturbances or riots. They frequently refer to loss of life and damage to property that have already taken place and to the function of authorities being endangered.  However, their merits are clearly debatable. It is very hard to sympathize with the rationale for certain derogations, such as the declarations of the Greek generals in 1961, derogating from the ECHR based on “internal dangers which threaten public order”.[18]

No government has ever declared a derogation from the ECHR based on an economic or financial crisis. The derogations that have been adjudicated before the European Court of Human Rights have all involved either (civil) war, armed attack, or threats of terrorism.

The European Court of Human Rights has never challenged a member state’s evaluation regarding the existence of an emergency.[19] By contrast, it has often found that individual derogations were not strictly required by the exigencies of the situation. This has resulted from the use of a proportionality test asking what rights are being derogated from; for how long; and what the guarantees against abuse exist. The court has also found a number of times that a state has violated the convention by using emergency measures outside their territorial or temporal scope.[20]

The International Covenant on Civil and Political Rights

Principles regarding limitations and derogations from the UN Covenant on Civil and Political Rights­—known as the Siracusa Principles—have been formulated by a group of experts within international law:

A state party may take measures derogating from its obligations under the International Covenant on Civil and Political Rights pursuant to Article 4 (hereinafter called “derogation measures”) only when faced with a situation of exceptional and actual or imminent danger which threatens the life of the nation. A threat to the life of the nation is one that:

(a)  affects the whole of the population and either the whole or part of the territory of the State, and

(b)  threatens the physical integrity of the population, the political independence or the territorial integrity of the State or the existence or basic functioning of institutions indispensable to ensure and project the rights recognized in the Covenant.

Internal conflict and unrest that do not constitute a grave and imminent threat to the life of the nation cannot justify derogations under Article 4.[21]

Economic difficulties per se cannot justify derogation measures.[22]

It is clear, that for an emergency to be accepted as a reason for derogation under those international obligations, which also play a role in the evaluation of constitutionality in most European countries, the circumstances must fulfill the criteria set out by Article 15 of the European Convention on Human Rights and possibly the Siracusa principles. This means that for an emergency to justify derogations from the ECHR, the ICCPR and most European domestic constitutions ask if there is an exceptional situation of crisis or emergency that affects the whole population and constitutes a threat to the organized life of the community of which the state is composed.  Economic difficulties are, according to the Siracusa principles, not enough per se, so values and interests other than economic ones must be at stake. Finally, it is clear that the danger in question “should be actual or imminent, . . . affect the whole nation, . . . exceptional, in that the normal measures or restrictions, permitted by the Convention for the maintenance of public safety, health and order, are plainly inadequate”[23] and that “[t]he continuance of the organised life of the community must be threatened.”[24]

In order to evaluate whether a financial crisis can constitute an emergency that justifies derogations from domestic constitutional law or the international obligations mentioned (the ECHR or the ICCPR), it is necessary to determine whether they fulfill those criteria.

A general note on EU/EEA law 

State reaction to economic crises can run afoul of rules found in the EU treaties (e.g. the four freedoms and ban on discrimination), rules found in secondary EU legislation, or fundamental principles of EU law.[25]

While there are express clauses allowing states to justify exceptions (such as Article 36 of the Treaty on the Functioning of the European Union regarding free movement of goods),[26] there are also exceptions developed by the European Court of Justice: the so-called mandatory requirements that apply only when no secondary legislation applies. By contrast, no general emergency powers have been accepted: EU law can only be deviated from if there is an express provision to that effect or if one of the mandatory requirements apply. All justifications for exceptions are interpreted very conservatively, and the proportionality principle (balancing test) is key.[27]

3.  The Icelandic example: EU/EEA Law and Icelandic Constitutional Law

In October 2008, all three of Iceland’s biggest banks were taken over by the state.[28] In the course of these development, the Icelandic Parliament passed the so-called “Emergency Act” aimed at safeguarding the functioning of the banking system and restoring public confidence.[29] The Act granted depositors priority ranking in insolvency proceedings over that of other unsecured creditors. It also enabled the Icelandic Financial Supervisor to transfer assets and liabilities from the collapsed banks to newly established banks. Obviously, creditors other than depositors were deeply unhappy and challenged this under both EEA law and Icelandic constitutional law.[30] In addition, the Icelandic Government made a distinction between depositors in domestic and foreign branches. Domestic deposits continued to be available after they were taken over by New Landsbanki, whereas the foreign depositors lost access to their deposits and did not enjoy the minimum guarantee, or at least not right away.[31]

ESA on granting depositors priority 

In December 2010, the EFTA Surveillance Authority (“ESA”) concluded that the Icelandic Emergency Act granting depositors priority ranking in insolvency proceedings over that of other unsecured creditors[32] and the decisions of the Icelandic Financial Supervisory Authority to transfer assets and liabilities from the failed banks to newly established entities, taken on the basis of Article 5 of the Act, neither constituted discrimination nor a limitation of the free movement of capital.[33] But in astonishing obiter dictum, it also discussed the hypothetical situation that would have arisen if the actions of the Icelandic state had been viewed as discrimination or restrictions.

ESA stated at the outset that economic interests were not enough to justify deviations from fundamental principles,[34] but concluded that if the entire banking, and payment system is in danger, then the interests being protected are no longer “merely economic”.[35] The next step would then be to determine whether the proportionality principle had been respected. ESA referred to the IMF’s appraisal of the situation in Iceland in the autumn of 2008, discussing the significance of the country’s three large banks and painting a gloomy picture of the worst case scenario without government intervention: “Limits in accessing such accounts would have instantly risked causing a full run on the banks with consequent serious risks for public security. Businesses could not have used funds to pay for their resources and to pay wages to employees; retail suppliers could not have imported necessities for the public, drugs and food, etc. . . This would have increased the already existing risk of systemic financial collapse.”[36]

The reasoning of ESA echoes domestic constitutional theory, Article 15 of the ECHR, and the Siracusa principles: The measures were justified because of the risk for public security and the risk of a stop on imports, including of food and drugs.

The Icelandic Supreme Court on granting depositors priority 

On October 28, 2011, the Icelandic Supreme Court handed down a landmark decision on the constitutionality of the Emergency Act no. 125/2008. The plaintiffs in case 340/2011 argued that certain provisions of that law were not compatible with the Icelandic Constitution and certain specified international agreements ratified by Iceland.

When examining the constitutionality of the emergency law, the court stated:

The plaintiffs support their grounds in particular on the protection of property rights and equal treatment… It has earlier been established that their claims should enjoy protection as property rights within the meaning of article 72 of the Constitution and that they have demonstrated a loss, but not to the extent that they themselves maintain. After reaching this conclusion, it is necessary to examine whether the provisions of article 6 of law 125/2008 involve an impairment of the rights of the plaintiffs which should be deemed to be expropriation or such a restriction of property rights as to breach article 72 or article 65 of the Constitution.”[37]

The Court rejected the property rights and equal protection arguments of the plaintiff, as well as their arguments that their legitimate expectations had been frustrated, their rights impaired retroactively and that the state reaction was disproportionate. The court then concluded:

In the resolution of the part of the proceedings about the constitutional validity of law 125/2008 reference has earlier been made to the broad margin of appreciation of the legislature in the assessment of the need for the measures which were involved in the law, on the grounds that a major threat was present to the whole society because of the catastrophic effect of the collapse of the largest commercial banks, which could end with the collapse of economic life in the country. The legislature, for these reasons, had not only a right but above all a constitutional duty to protect the welfare of the public and financial activity against the collapse of the banks first and foremost by the objective of the law and be equivalent to the approach which was taken.[38]

The Icelandic Supreme Court upheld the disputed legislation, just like ESA stated it would have done if necessary. But it is noteworthy that the Court did not do so based on emergency powers. It did so, according to the judgment itself, because it found that the reactions of the state were within the bounds of the constitution, as it should be interpreted in the light of the circumstances.

ESA on the difference between depositors in domestic and foreign bank branches

In a decision dated June 10, 2011, ESA decided on the “compliance, by Iceland, with [its] obligations … according to which all depositors whose deposits in branches of Icelandic banks became unavailable must be compensated according to the terms of the protection laid down by Directive 94/19/EC and without discrimination.” [39]

Iceland tried, again, to argue that the action was justified based on special circumstances. Here, the ESA disagreed, saying “The terms of the Directive itself cannot support such an argument. According to the case law of the Court of Justice, a Member State cannot plead exceptional circumstances to justify non-compliance with a directive in the absence of a specific legislative provision in the directive to that effect.”[40] ESA cited the ECJ on the undesirability of recognizing “the existence of a general reservation covering exceptional situations, outside the specific conditions laid down in the provisions of the Treaty and the second directive, would, moreover, be liable to impair the binding nature and uniform application of Community law.”[41] This illustrates that when there are express emergency provisions in EU legislation—in this case sections allowing late payment—other emergency measures are unacceptable. There is thus no unwritten emergency derogation clause in EU law. This decision also suggests that even if some measures may be warranted by emergency situations, others—in particular discrimination based on nationality—are unacceptable.

4.  Conclusion

Governments have been given certain leeway to deal with serious economic crises, constitutions and international obligations notwithstanding. Each case is, of course, unique, as are the desired actions by governments are. However, the principles described in Part 2, apply to most of Europe, and the principles set down by the European Court of Human Rights and the Siracusa principles apply to all of Europe. The Icelandic example shows that these derogations or exceptions must be taken into consideration and that it is not only question of “home court advantage;” international organization are ready to take financial crises into account as well, provided that the conditions described earlier apply.

It is extremely important to discuss these derogation clauses or exceptions. As all exceptions undermine the role of constitutions, public debate on their scope and justification every time they are used is a key mechanism in minimizing the risk of abuse. This is also the rationale behind the requirement that all derogations be publicly proclaimed, a requirement found both in the European Convention on Human Rights and in many domestic constitutions.

 

Preferred citation: Ragnhildur Helgadóttir, Economic Crises and Emergency Powers in Europe, 2 Harv. Bus. L. Rev. Online 130 (2012), https://journals.law.harvard.edu/hblr//?p=1981.

* Ragnhildur Helgadóttir (cand.jur. University of Iceland, LLM and SJD Virginia) is a professor of law at the University of Reykjavik, and can be contacted at ragnhildurh@hr.is.

[1] See e.g., 1975 Syntagma 4, 17 (Greece); Iceland Const., 1944, arts. 65, 72; Ireland Const., 1937, arts. 40, 43; Norway Const., 1814, art. 105.

[2] This is based on the Icelandic example from 2008, as well as the Argentine example and the Norwegian example in the early 1990s, supra.

[3] European Convention for the Protection of Human Rights and Fundamental Freedoms, Nov. 4, 1950, 213 U.N.T.S. 221, E.T.S. No. 5 (hereinafter “ECHR”). Forty-seven states, with a population of over 800 million people, are now members.

[4] I include the European Economic Area here, because Iceland is a member of it and that had certain implications for Iceland’s possibility to react to the 2008 crisis. There is a difference between EU and EEA law, but it is not relevant for discussion here. I will therefore use the term “EU/EEA law“ even though those laws are not completely identical in all cases and the term is therefore imprecise.

[5] See e.g., ISC No. 340/2011 (Oct. 28, 2011) (Ice.), discussed infra; Ola Rambjør Heide, Konstitusjonell nødret – sett i lys av Den europeiske menneskerettighetskonvensjon artikkel 15 [Constitutional Emergency Powers – In light of Art. 15 of the European Convention on Human Rights] 89 & 150 (1998).

[6] Article 23 of the Constitution of Finland is titled, “Basic rights and liberties in situations of emergency.” Finland Const., 1999. It says:

“Such provisional exceptions to basic rights and liberties that are compatible with Finland’s international human rights obligations and that are deemed necessary in the case of an armed attack against Finland or in the event of other situations of emergency, as provided by an Act, which pose a serious threat to the nation may be provided by an Act or by a Government Decree to be issued on the basis of authorisation given in an Act for a special reason and subject to a precisely circumscribed scope of application. The grounds for provisional exceptions shall be laid down by an Act, however.

Government Decrees concerning provisional exceptions shall without delay be submitted to the Parliament for consideration. The Parliament may decide on the validity of the Decrees.”

[7] Regeringsformen [RF] [Constitution] 2:10 (Swed.).

[8] 1958 Const. 16 (Fr.).

[9] The fundamental idea behind emergency powers is “needs must,” in other words, powers whose legitimacy stems from necessity. Obviously, this causes all sorts of theoretical problems when the norm derogated from is a constitution. That seems to counteract the very purpose of constitutions. But those issues will not be discussed further here; it’s sufficient to say that this legal institution exists in the Nordics and in the ECHR regime and has (arguably) not been abused. On emergency powers in Iceland, see Gunnar G. Schram, Stjórnskipunarréttur [Constitutional Law] 646 (1999) and Bjarni Benediktsson, Stjórnskipulegur neyðarréttur: Fyrirlestur við lagadeild Háskóla Íslands [Constitutional Emergency Powers: A Lecture given at the University of Iceland], 1 Tímarit lögfræðinga, 4 (1959); Regarding Norway, see Johs. Andenæs, Statsforfatningen i Norge [The Constitution of Norway] 455 (8th ed. 1998), Helset & Stordrange, Norsk statsforfatningsrett [Norwegian Constitutional Law] (1998) and Heide, supra note 5.

[10] See e.g. Helset & Stordrange, supra note 9, at 88.

[11] See Heide, supra note 5.

[12] ECHR, supra note 3, art. 15.

[13] The European Court of Human Rights has held that these words refer to “an exceptional situation of crisis or emergency which affects the whole population and constitutes a threat to the organised life of the community of which the state is composed”. A. & Others v. United Kingdom, App. No. 3455/55 ¶ 176 (Eur. Ct. H.R. Feb.19, 2009) (citing Lawless v. Ireland, App. N. 332/57 ¶ 28 (Eur. Ct. H.R. July 1, 1961). It referred to the premises used by the European Commission of Human Rights in the Greek Case “that the emergency should be actual or imminent; that it should affect the whole nation to the extent that the continuance of the organised life of the community was threatened; and that the crisis or danger should be exceptional, in that the normal measures or restrictions, permitted by the Convention for the maintenance of public safety, health and order, were plainly inadequate.” Greek Case, 1969 Y.B. Eur. Conv. on H.R. (Eur. Comm’n H.R.) 1 ¶ 153.

[14] This is very important in order to make derogations public and open and minimize the risk of secret derogations and human rights violations

[15] See the Treaty Database of the Council of Europe, available at http://conventions.coe.int/Treaty/Commun/ChercheDeclSTE.asp?CM=9&CL=ENG, which allows a search for derogations by country.

[16] Derogation contained in a Note verbale, from the Permanent Representation of the United Kingdom, to the Secretariat General, June 27, 1957, available at http://conventions.coe.int/Treaty/Commun/ListeDeclarations.asp?NT=005&CV=0&NA=&PO=UK&CN=999&VL=1&CM=9&CL=ENG.

[17] Declaration contained in a letter, from the Minister of Foreign Affairs of Georgia, to the Secretariat General, Nov. 9, 2007, available at http://conventions.coe.int/Treaty/Commun/ListeDeclarations.asp?NT=005&CV=0&NA=15&PO=GEO&CN=999&VL=1&CM=9&CL=ENG.

[18] See Derogation contained in a letter, from the Permanent Representative of Greece, to the Secretariat General, May 3,1967, available at http://conventions.coe.int/Treaty/Commun/ListeDeclarations.asp?NT=005&CV=0&NA=&PO=GRE&CN=999&VL=1&CM=9&CL=ENG. After the 1967 coup d‘etat, the country was governed by a military junta until 1974.

[19] On the other hand, the European Commission on Human Rights found, once, that no emergency situation existed. See Greek Case, supra note 13.

[20] See Jens Elo Rytter, Undtagelsestilstanden og dens judicielle efterprøvelse – Suspension af menneskerettigheder i kampen mod terrorisme [The State of Emergency and its Review by the Courts: The Suspension of Human Rights in the War on Terror], 2009/4 Juristen 103, at 112.

[21] U.N. Comm’n on Human Rights, The Siracusa Principles on the Limitation and Derogation Provisions in the International Covenant on Civil and Political Rights, E/CN.4/1985/4 (1984), available at http://www.unhcr.org/refworld/docid/4672bc122.html.

[22] Id. ¶¶ 39–41.

[23] A. & Others v. United Kingdom, App. No. 3455/55 ¶ 176 (Eur. Ct. H.R. Feb.19, 2009) (citing the premises used by the European Commission of Human Rights in the Greek Case, 1969 Y.B. Eur. Conv. on H.R. (Eur. Comm’n H.R.) 1 ¶ 153.

[24] Id.

[25] In EEA law there is no difference between the two first groups of rules.

[26] On the use of this and other exceptions from free movement of goods, see Steiner &Woods, EU Law 442-454 (10th ed. 2009).

[27] On these questions, see, for example, Catharine Barnard, The Substantive Law of the EU – The Four Freedoms 149-192 (3rd. ed. 2010). Which justifications come into play depends on the reactions of the state in question.

[28] See, e.g., David Teather, Takeover and currency slide fuel fears for economy built on credit, Guardian, Oct. 3, 2008, http://www.guardian.co.uk/world/2008/oct/04/iceland

[29] Emergency Act (Act No. 125/2008) (Ice.), available at http://eng.efnahagsraduneyti.is/media/acts/Act_No._125-2008__unusual_financial_market_circumstances_13.10.2008.pdf

[30] See EFTA Surveillance Authority Decision of 15 December 2010 to close seven cases against Iceland commenced following the receipt of complaints against that State in the field of capital movements and financial services (Dec. No. 501/10/COL) (2010), available at http://www.eftasurv.int/media/decisions/571071.pdf; ISC No. 340/2011 (Oct. 28, 2011) (Ice.).

[31] The British and Dutch governments paid out deposits that covered the minimum guarantee and more. Negotiations as to repayment by the Icelandic government are ongoing as this is written. See, e.g., Fact Sheet: The Icesave Issue (Iceland Ministry for Foreign Affairs,2010), available at http://eng.utanrikisraduneyti.is/media/MFA_pdf/Fact-Sheet—The-Icesave-Issue-June.pdf.

[32] See Article 6 and 9 of Act No. 125/2008.

[33] EFTA Surveillance Authority Decision of 15 December 2010 to close seven cases against Iceland commenced following the receipt of complaints against that State in the field of capital movements and financial services (Dec. No. 501/10/COL) (2010), available at http://www.eftasurv.int/media/decisions/571071.pdf.

[34] Id. ¶ 87 (citing Case E-10/04 Piazza, [2005] EFTA Ct. Rep. 76, paragraph 42; Case E-3l98 Rainford-Towning 1998 1EFTA Ct. Rep.205, ¶ 42.)

[35] Id. ¶ 89.

[36] Id. ¶ 99.

[37] ISC No. 340/2011 (Oct. 28, 2011) (Ice.), at 18–19.

[38] Id. at 23.

[39] Reasoned Opinion delivered in accordance with Article 31 of the Agreement between the EFTA States on the Establishment of a Surveillance Authority and a Court of Justice concerning Iceland’s failure to comply with its obligations under the Act referred to at point 19a of Annex IX to the EEA Agreement (Directive 94/19/EC of the European Parliament and of the Council of 30 May 1994 on deposit-guarantee schemes) and/or Article 4 of the EEA Agreement (Dec. No. 180/11/COL) (2011), available at http://www.eftasurv.int/media/internal-market/RDO-180_11_COL.pdf.

[40] Id. at 17.

[41] Id.