The prospect of Greece's potential default to the International Monetary Fund and European Union lenders and de facto exit from the EU single currency looms larger day by day. The next week—until the June 30 repayment due date to the IMF—will be filled with high stakes political brinkmanship on all sides. The IMF has raised the stakes by clarifying that there is no grace period beyond the June 30 deadline. If default were to take place, the expectation is that the European Central Bank will cut off emergency liquidity support to the Greek banking system and that the Greek authorities will have little choice but to impose extensive capital and exchange controls to stem the capital flight that would be expected otherwise to ensue. Already €4 billion were reported to have been drawn from the Greece banking system last week.
The financial markets appear less jittery this time round about the prospect of a Greece exit from the EU single currency system (Grexit). They have had a few years to manage the financial risks and emotional anxieties of contagion. However, significant legal and financial consequences, such as from counterparty defaults, bankruptcies and potential triggering of credit default swaps need to be analyzed.
This note focuses on a legal consequence that arises from provisions of the IMF's Articles of Agreement, which is an international treaty binding in each of the IMF's 188 member countries. A default by Greece on the €1.6 billion due to the IMF on June 30 would not be a default under a loan contract. The IMF in this context does not provide financing through contractual loans. Rather, it would be a direct breach of Greece's international law obligations under the IMF's Articles, which require Greece to make timely repayments to the IMF (technically, timely "repurchases"). While even in default of these financial obligations to the IMF, Greece would remain a member of the IMF—although the ultimate sanction for an IMF member country in persistent breach of obligations under the Articles is a compulsory withdrawal from the IMF. Accordingly, a Grexit from the EU single currency system would not imply an exit of Greece from the IMF.
This latter point is important as there are other provisions of the IMF's Articles which would continue to be material to Greece and third-parties across the global financial system. Some of these provisions are in the area of exchange and capital controls and they are often misunderstood by the financial markets. They warrant very careful attention both in the run-up to potential default and thereafter.
A basic summary of these complex provisions are as follows:
- Article VIII, Section 2(b) of the IMF Articles of Agreement provides that: "Exchange contracts which involve the currency of any member and which are contrary to the exchange control regulations of that member maintained or imposed consistently with this Agreement shall be unenforceable in the territories of any member." In this respect, the IMF's Articles give some extraterritorial effect to such exchange control regulations across all of the 188 IMF member countries, where, inter alia, the controls are imposed consistently with the IMF's Articles. Note: the legal consequence of unenforceability means that a court cannot enjoin or award damages for nonperformance of the offending contract provision, but it does not imply that the contract provision is legally void—this distinction can be material particularly for third parties to the contract.
- The analysis of whether an exchange control regulation is consistent with the IMF's Articles depends, in part, on whether the control affects international payments for current transactions (which are defined broadly to include "payments due in connection with foreign trade," "normal short term banking and credit facilities," and "interest due on loans"); or whether the control affects international capital transfers.
- With regard to the first category, the IMF Articles generally prohibit restrictions on payments for international currency transactions, absent IMF approval. IMF policy sets out the grounds for approval by the IMF Board—generally, where the restrictions are non-discriminatory, temporary and imposed for balance of payments reasons. Upon IMF approval, a restriction on international currency transactions becomes consistent with the IMF's Articles and the extraterritorial unenforecabilty pursuant to Article VIII, Section 2(b) would come into play.
- In contrast, with regard to the second category of international capital transfers, the IMF's Articles generally authorize member countries to "exercise such controls that are necessary to regulate international capital movements." Accordingly, to the extent imposition of controls by Greece restricted capital transfers, they would be consistent with the IMF's Articles and no issue of IMF approval would arise in order for contract provisions inconsistent with those controls to be rendered internationally unenforceable. This is a key distinction that is often missed in legal advice provided to financial institutions and other counterparties that could be affected by the imposition of extensive controls by Greece.
The application of Article VIII, Section 2(b) is complex and has given rise to competing interpretations in courts within major financial jurisdictions, such as New York, England and Germany. A ramification for financial institutions and their counterparties is that they may need to seek legal advice in multiple jurisdictions in which their major payments are to occur.
You can hold your breath as the drama of a potential Grexit unfolds over the next week or make sure that you have the appropriate legal advice in order to manage exposures.