BAIL-OUT DÉJÀ-VU

In 1975, New York City on the verge of bankruptcy appealed to then United States Presi-dent Gerald Ford for a Federal bail-out. His response prompted the iconic headline in the tabloid New York Daily News “Ford to City: Drop Dead”. Financier Felix Rohatyn, leading the City’s debt restruc-turing effort, noted that "New York City was going to be their sym-bol of what could happen if you let liberalism take hold in a big city". Two months later, having recognised the potential widespread adverse consequences of such a bankruptcy, a chastened President Ford and Congress approved a USD 2.3 billion bail-out from the Federal government.

Nearly forty years later and 10,000 kilometres away, Cyprus has this past fortnight re-ceived a President Ford response from the Troika to its request for a Eurozone bail-out. Citing Cyprus’ lax financial regulation that has cre-ated a banking system which is approximately eight times its GDP and which is comprised, according to Moody’s, of ap-proximately USD 31 billion or one third by Russian money (which Germany in particular alleges is dirty money), the European Union, the European Central Bank and the In-terna-tional Monetary Fund have decided that Cyprus is going to be their so-called symbol. After days of frantic negotiations, Cyprus was granted a EUR 10 billion bail-out conditioned upon raising EUR 5.8 billion on its own through bank depositor levies, bondholder haircuts, shareholder wipe-outs.

The two episodes contain some interesting ironies. Whereas German Chancellor Angela Merkel and IMF Director (and former French Finance Minister) Christine Lagarde have in-sisted on unprecedented tough love measures as to the Cyprus bail-out, then German Chancellor Helmut Schmidt and French President Valéry Giscard d’Estaing were at the fore-front of those supporting an unconditional bail-out of New York City in or-der to avoid global financial sector meltdown.

The two episodes also contain some interesting parallels. In both cases, a proportionately small but economically important member of a political un-ion has sought financial support from that union during a time of fiscal cri-sis. In both cases, the union has responded that the member is profligate and undisciplined and should bear the consequences. In both cases, the member has ultimately received a bail-out from the union, but with strict conditions.

The bail-out of New York City was structured so that the burden of the bail-out fell upon its major stakeholders: residents, employees, banks, and businesses. Amongst the measures imposed were reduction of or fee in-creases for such services as transportation and education, a tax increase, a mandatory investment by City employee pension funds in New York City municipal bonds, and a requirement that banks which had underwritten New York City debt increase their holdings and/or reschedule such debt. By 1979, New York City was able to re-enter the financing market and in 1981, issued its first invest-ment grade bond since its fiscal crisis.

The Troika similarly has required that Cyprus stakeholders share a signifi-cant burden of its bail-out. While the basic terms of such bail-out have been disclosed, the more granular implementation and impact on Cyprus and its stakeholders remains to be seen.

The bigger question is what will be the long term consequences of such bail-out on offshore investment in general. There has been much discus-sion about the transformation of offshore investment. While the transfor-mation of offshore investment may be hastened by the Cyprus bail-out, with a great deal of offshore capital actually flowing onshore to New York City, according to The Guardian, such transformation in fact pre-cedes Cy-prus and is well underway.

BUTTERFLY EFFECT

In a variation of the Butterfly Effect (a view of cosmic interdependence in which a butterfly flapping its wings causes a chain of events which ulti-mately lead to a hurricane), the decision of the European Union to post-pone until January 2014 the originally scheduled January 2013 introduction of Basel III rules had the surprising effect of bringing offshore finance on-shore. This trend is most evident in Central and Eastern Europe (CEE) and South Eastern Europe (SEE).

In the absence of Basel III implementation and a harmonised regulatory framework, European banks in general, and banks operating in CEE and SEE in particular, have been struggling to integrate the often countervail-ing demands of local bank regulators and competitive commercial envi-ronments. At a January 2013 Euromoney Conference held in Vienna, Aus-tria, Herbert Stepic, CEO of Raiffeisen Bank International, characterised the competing demands on banks as leading to a “Balkanization of bank-ing”, noting that “[o]ne country is forbidding us to transfer dividends; other countries are forbidding us to transfer liquidity within the group…I cannot satisfy my investors’ needs for dividends, and I can’t transfer [the cash].” Gianni Franco Papa, UniCredit Supervisory Board member in charge of CEE/SEE, also raised the issue of “…different regulators impos-ing contradictory regulation”.

As a result, CEE and SEE banks have been forced to implement domestic initiatives leading to Basel III in a somewhat inconsistent and occasionally draconian manner. In certain perceived high risk/weak return CEE and SEE countries, subsidiaries and assets have been jettisoned, access to foreign exchange has been restricted, and lending has contracted. Historically pro forma short term loan rollovers, waivers and loan reprogramming have all but ceased. Overall, there has been an increased scrutiny of and pressure on all CEE and SEE borrowers. Accordingly, there also has been an in-creased scrutiny of and pressure on offshore investors in CEE and SEE.

OFFSHORE INVESTMENT IN CEE AND SEE

Offshore investment vehicles have long been popular amongst investors in CEE and SEE. Aside from allegedly facilitating money laundering, offshore investment vehicles have served a legitimate purpose. They enable such investors as hedge funds, private equity funds, insurers, banks and trusts (as well as individuals) to make and manage their CEE and SEE invest-ments in what have been viewed as politically, economically and legally stable, transparently regulated, and tax efficient environments. Offshore jurisdictions have traditionally mitigated the country risks associated with investment in such developing markets as CEE and SEE.

Offshore investment vehicles account for 30% of all foreign direct invest-ment, according to The Economist. Such vehicles are domiciled in over 50 locations throughout the world, including the Caribbean, the United States, Europe, Asia and the Indian and Pacific Oceans. Estimates of offshore in-vestment range from USD 21 trillion to over USD 50 trillion. Cayman Is-lands, for example, has over 18,000 registered companies and is the world’s leading domicile for hedge funds.

The basic offshore structure involves an offshore holding company (Holdco) and an onshore revenue generating operating company (Opco). The Opco may be funded by debt from the Holdco, where the Holdco re-ceives revenue through loan repayments from the Opco, and/or equity from the Holdco, where the Holdco receives revenue through dividends from the Opco. This simple structure may be expanded to accommodate several tiers of subsidiary and affiliate companies and may include a vari-ety of debt and/or equity instruments.

Irrespective of the variable offshore structure, a single constant has been that the Opco is onshore. This means that the Opco typically is the bor-rower in local bank financing arrangements, such as term and revolving loan facilities, guarantees, financial leases, and mortgages. The Opco’s as-sets typically are pledged to local banks as collateral for such financing. Accordingly, the Opco is subject to the issues affecting local banks and borrowers. And increasingly, the offshore Holdco is being brought onshore to address such issues.

Legal and financial advisors working in CEE and SEE already have seen a growing number of offshore investment funds and other investors, along with their offshore advisors, initiating and participating in onshore CEE and SEE restructurings and so called “Special Situations”. While offshore Hold-cos and their stakeholders may be legally ring-fenced from their onshore Opcos, they are commercially integrated and inter-dependent. Investors whose offshore investment vehicles are domiciled from the Netherlands to the Caribbean are finding themselves in refinancing discussions with banks in Bulgaria, Slovenia and Ukraine, for instance. Ironically, this is occurring in the very environments that such investors sought to avoid by domiciling in an offshore jurisdiction.

OFFSHORE COMES ONSHORE

Irrespective of whether or not Cyprus survives its bail-out and ultimately thrives like New York City and irrespective of whether or not the Cyprus bail-out becomes the template for other Eurozone bail-outs, including, if necessary, such other Eurozone offshore jurisdictions as Luxembourg and Malta, it is clear that the offshore investment model in general, and in CEE and SEE in particular, has already begun a transformation and offshore has already come onshore.