Purchasing distressed financial assets in Cyprus is the latest potential investment opportunity that demonstrates both the globalization of distressed investing and the complexity of the political and regulatory dimensions of the international arena. The passport of many a hedge fund analyst has been stamped in Iceland, Spain, Italy, Greece and Portugal. We can now add Cyprus to the list.
This memorandum describes the background to the current situation in Cyprus and highlights the issues that will be faced by investors seeking to trade or invest in claims related to frozen Cypriot bank deposits.
Cypriot banks were heavily exposed to Greek debt and suffered major losses as a result of the Greek bailout and the 70 percent “haircut” to holders of Greek debt. In June 2012, Cyprus applied for financial assistance after its two largest banks – Bank of Cyprus (“BoC”) and Cyprus Popular Bank (previously known as Marfin Bank and locally as Laiki Bank) (“Laiki”) – sought state aid following approximately €4.5 billion (25 percent of Cyprus’ GDP!) in write downs of their Greek debt holdings. In March 2013, the European Central Bank, the European Commission, the International Monetary Fund and the government of Cyprus finalized the terms of a €10 billion rescue package to avert a collapse of the Cypriot banking system and to cover both the government’s financial needs and the shortfalls faced by BoC and Laiki.
As part of the rescue, Cyprus has agreed to significantly restructure its banking sector, install capital controls restricting movement of funds, and implement other austerity measures, such as increasing corporate and property tax rates. These measures are designed to raise billions towards the bailout, while protecting, to some extent, bank customers with deposits of €100,000 or less. Unlike other bailouts, however, this rescue is described as a “bail-in” because portions of each bank customer deposits above €100,000 at both Laiki and BoC will be contributed by the government toward the rescue, in effect raiding personal bank accounts to strengthen the country’s financial system. This is the first time that the euro zone has imposed losses directly on bank depositors as part of a rescue package.
Deposit holders at Laiki and BoC will be most directly affected by these measures, but holders of deposits at other Cypriot banks will also be affected. In that light, the current issues regarding Cyprus bank deposits must be considered in three distinct categories: (i) Laiki; (ii) BoC; and (iii) all other Cypriot banks.
Laiki has been placed into resolution and is being wound down. Deposits at Laiki of €100,000 or less (along with certain other “good” assets) have been transferred to BoC. Deposits above €100,000 (totaling approximately €6.4 billion), along with “bad” assets and related liabilities, remain at Laiki and are currently frozen. Holders of deposits that remain at Laiki will have a claim against Laiki and receive a pro rata share of any proceeds from the liquidation of the remaining assets at Laiki. Recoveries from Laiki are expected to be small because “good” assets have been transferred to BoC. However, Laiki itself received a 20 percent equity interest in the restructured BoC, which equity interest will benefit holders of deposits frozen at Laiki.
Bank of Cyprus
Any deposits at BoC of €100,000 or less (including the deposits recently transferred from Laiki) are protected and should not be directly impacted by the bail-in – aside from the temporary withdrawal and transfer restrictions that apply to all Cypriot banks.
With respect to deposit amounts in excess of €100,000 at BoC (totaling approximately €8 billion), some of this amount will be subject to a “haircut,” with any remaining amounts eventually returned to depositors. Specifically:
- 37.5 percent of deposit amounts in excess of €100,000 has been converted into “class A” shares of the restructured BoC, although no shares have yet been issued by BoC;
- 22.5 percent is frozen and being held as a buffer for possible conversion into “class A” shares in the future, depending on the conclusion of the independent valuation of BoC’s assets;
- 30.0 percent is frozen and being held as deposits in order to support the liquidity needs of BoC and as part of the country’s capital controls, with the expectation that this amount will be unfrozen at some future time; and
- 10.0 percent is available to deposit holders, subject to temporary withdrawal and transfer restrictions.
Although the original equity holders of BoC will receive new subordinated shares in the restructured BoC, they will effectively be wiped out as part of BoC’s restructuring.
All Other Cypriot Banks
Depositors at all other Cypriot banks (including domestic deposit holders of certain foreign banks with branches in Cyprus) are subject to temporary restrictions on cash withdrawals and money transfers that are expected to remain in place for six months. There are daily, monthly and other limits on cash withdrawals and money transfers, with the limits being renewed or revised on a weekly basis.1 Cyprus has lifted these limits for international clients of foreign banks doing business in Cyprus, although domestic clients of such foreign banks are still subject to the temporary restrictions.2
The new and unprecedented banking reality in Cyprus has generated considerable interest within the distressed investment community. Deposit holders need liquidity, and potential buyers of a bank deposit (or its related claim against the underlying bank) are formulating plans to purchase the frozen deposits, stand in the shoes of the current Cypriot bank deposit holder, and acquire the bundle of rights that deposit holder would have against the banks. The issues raised by this distressed investment strategy can be grouped into two broad categories: (i) how can a Cypriot bank account be purchased and transferred; and (ii) how does a buyer analyze the potential return and determine a rational purchase price.
HOW TO PURCHASE A CYPRIOT BANK DEPOSIT CLAIM
There are currently several roadblocks to the efficient purchase of Cypriot bank deposits, or interests therein. New deposit accounts cannot be opened in Cypriot banks, and existing accounts cannot be transferred to new holders. Current deposit holders cannot transfer funds in one account to different account held in another name. If a large deposit is the sole asset held by a business entity, it may be possible to transfer the underlying ownership of the business entity to the buyer from the seller through the sale of the equity in the business entity. However, this solution is applicable to only a limited number of business entities.
An extension of this solution involves the creation of an investment vehicle to purchase the equity of entities whose sole assets are deposits in Cypriot banks. The investment vehicle would then issue equity or beneficial interests to potential investors, thereby providing exposure to the underlying deposits. Purchasing a business entity solely for its Cypriot deposit account assumes that the account is the only asset or liability of the business. Buyers will need to perform appropriate due diligence to confirm that point, which diligence may delay settlement and increase transaction costs.
If the accounts cannot be transferred directly, can they be transferred indirectly? Could a selling account holder grant a beneficial interest in the account to a buyer while still maintaining legal title to and record ownership of the account? Indeed, market participants have considered using a participation structure or similar transfer agreement to effect an economic transfer of the depositor’s interest in the deposit – including the right to receive additional future cash or non-cash distributions related to the account.
However, indirect transfers create problems of their own. Most importantly, purchasing a current depositor’s claim with the expectation of receiving a stream of payments from the depositor creates counterparty credit risk that needs to be evaluated and mitigated. Current thinking is focused on the sources of possible collateral support, including obtaining a charge over (or lien on) the deposit account, a pledge over the shares of BoC that are to be issued to the deposit holder, or requiring the deposit holder to post additional (unrelated) collateral as security for all the future payment obligations to the indirect transferee.
ANALYZING POTENTIAL OUTCOMES AND RETURNS
Successfully investing in Cypriot bank accounts ultimately depends upon determining the right purchase price. The twofold difficulty for the investor is determining the expected return and the timing of the return. Currently, uncertainly about when withdrawals will be permitted makes it very difficult to value the deposits. In addition, there is significant uncertainly regarding the ultimate haircut that will be levied on the deposit amounts in excess of €100,000 at BoC. The haircut will depend upon an independent valuation of BoC, which is expected to be concluded by the end of June 2013, but which may take longer to complete. Similarly, the value of the shares of BoC to be issued to deposit holders will depend upon the valuation of BoC as an on-going enterprise.
The pricing calculation is made more difficult by the political environment and the fact that the situation is fluid and unsettled. It is possible that further restrictions on the movement of capital will be found necessary to buy time to resolve the crisis.
Anti-Money Laundering (AML) and Foreign Corrupt Practices Act (FCPA)
Investors in the evolving Cypriot bank deposit market must be prepared to conduct counterparty due diligence sufficient to establish the identity of the underlying account holder and to provide comfort as to the source of the funds in the account. Regulators around the world are focused on money laundering and the flow of illicit funds, particularly the proceeds of corruption, through the global financial system. Widespread concerns regarding the vulnerability of Cyprus banks to money laundering puts investors on notice of the need to diligence what are often complex structures involving nominees and hard-to-identify ultimate beneficial owners. A record of counterparty due diligence is the most effective protection an investor can have in the event regulators take issue with the original account holder or source of funds.
While Cyprus does not currently impose any withholding tax on interest or gains from the sale of debt obligations, other countries facing a debt crisis have changed their tax laws, at times with retroactive effect. The tax treatment of investments in Cypriot obligations is an issue that should be closely monitored.
The events leading up to the current turmoil in Cyprus have been politically charged and Cypriot banks and depositors remain wary of foreign funds looking to profit at the expense of local depositors. The Cyprus government has made it difficult to transfer bank deposits and Cypriot banks are unlikely to cooperate with buyers of bank deposit claims. Direct and indirect restrictions on trading and the movement of funds have been imposed in other jurisdictions that experienced financial crisis and bailouts (e.g., Iceland and Ireland) and political risk evaluation must be part of any investment decision in Cyprus.
Cyprus is keenly interesting to many distressed investors, and the Cypriot bank bail-in may yet offer another novel investment opportunity for sophisticated investors. Given the complexity of the current situation, many investors are performing extensive legal and economic due diligence on Cypriot bank deposits and weighing their options. The current consensus is that investment opportunities in Cyprus are unlikely to evolve into a fullfledged claims trading market similar to the recent experience in Iceland due to the perceived difficulty of transferring deposits, efficiently mitigating counterparty credit risk, predicting political outcomes and evaluating compliance issues, including AML and FCPA. However, no one is betting against the power of markets to evolve once buyers and sellers negotiate pricing, transfer structures begin to evolve and distressed documentation, tailored to acquiring Cypriot bank deposits, is put in draft.