The rapid evolution of a robust secondary market for claims against the three largest failed Icelandic banks provides a powerful example of the prompt adaptation of an existing secondary-market legal framework -- originally developed in the US and Europe -- to a complex and novel bankruptcy regime and trading environment.
This memorandum describes the Icelandic crisis, the legal architecture used in Iceland by participants in the global claims markets, and the principal trade documentation and settlement execution issues that remain unresolved in the current Icelandic claims market.
Following Lehman’s bankruptcy and the ensuing global credit crisis, Iceland -- a country of 300,000 people -- experienced one of the most stunning economic collapses in modern history. Iceland’s three major banks, Glitnir banki hf. (“Glitnir”), Landsbanki Íslands hf. (“Landsbanki”) and Kaupthing Bank hf. (“Kaupthing”), had aggregate debt obligations of approximately $75 bn,1 a sum that dwarfed Iceland's gross domestic product.2 Buckling under these obligations and facing constrained credit and the rapid devaluation of the Icelandic krona, each bank was placed in receivership in October 2008, following the enactment of emergency legislation by the Icelandic parliament.3
Today, claims filed against the three banks tied to the bonds, notes, loans and bespoke debt instruments issued by the banks before the crisis total more than $100 billion.4 An active secondary market for complex Icelandic claims has developed among investment banks and hedge funds in the US and Europe -- in spite of the substantial legal and economic difficulties involved in trading the claims across multiple jurisdictions.
Not everything has gone smoothly -- Iceland’s relatively undeveloped insolvency law has hampered legal analysis of the claims and their proper classification for priority of distributions, unexpected domestic taxes were imposed to capture revenue from claims trading, market-wide transfer mechanics were agreed only late in the proceedings and official guidance about transfer documentation was delayed and often inconsistent. These factors created uncertainty, extended settlement times and constrained liquidity. Nonetheless, the legal knowledge base, trade documentation and settlement practices developed over the past two decades in the global claims markets helped spur the rapid development of an Icelandic claims market and allowed that market to function in the midst of an otherwise bleak economic landscape.
BANK INSOLVENCY AND LEGISLATIVE RESPONSE
In response to the 2008 financial crisis, Iceland’s parliament passed Act No. 125/2008 on the Authority for Treasury Disbursements due to Unusual Financial Market Circumstances etc. and granted authority to the Financial Supervisory Authority of Iceland (the “FME”) to take immediate control of the failed financial institutions. The FME assumed control and appointed a “Resolution Committee” for each bank to safeguard assets and maximize creditor recoveries. Each bank was granted a moratorium period on debt payments. At the request of the Resolution Committees, the District Court of Reykjavik appointed “Winding-up Boards”5 to oversee each bank’s claim filing and recognition process.
PRACTICAL EVOLUTION OF THE SECONDARY MARKET FOR ICELANDIC CLAIMS
The American humorist Mark Twain once said, “to a man with a hammer, everything looks like a nail.” That observation surely applied to the traders and lawyers who first attempted to trade Icelandic claims after the bank failures. Market participants in both the US and Europe saw the Icelandic market as an opportunity to deploy familiar legal claims trading tools honed for domestic use -- but they soon discovered a number of unique Icelandic obstacles.
How to Document Transfers: Loan Market Association (“LMA”) vs. US-style
The early development of efficient and liquid trading in Icelandic bank claims depended upon broad-based agreement among market participants on the appropriate legal documentation governing transfers. Early investors identified two options: LMA documentation developed to trade distressed bank debt and claims in Europe, and US-style bespoke documentation developed to trade financial “trade claims.” Differences in these two styles of transfer documentation often influenced trading decisions.
- LMA documentation was perceived to be:
- standardized for claims and familiar to participants in the European secondary loan market, but
- geared toward English law-governed loan-related claims, with substantial revisions required to address the unique features of Icelandic bank claims.
- US-style documentation was perceived to be:
- bespoke and easily tailored to Icelandic claims with useful optional provisions to resolve uncertainty around claim amount (e.g., contractual disallowance and purchase price holdback provisions), but
- unfamiliar to market participants outside of the US and in need of substantial negotiation.
Ultimately, while both sets of documentation developed and continue to be used for Icelandic bank claims, LMA documentation is currently more prevalent for a number of reasons.
- Source of Claims: Because the vast majority of claims sellers (i.e., original claimholders) were located in Europe, LMA-style documentation was familiar to many sellers.
- Applicable Law: Creditors preferred application of English or Icelandic law.
- Claim Amount Risk: European market participants were unfamiliar with the disallowance and holdback provisions common in US-style documentation, and that unfamiliarity, coupled with the impression that such provisions were "buyer-friendly," created further resistance to US-style documentation.
How to Formally Transfer an Icelandic Claim
In tandem with structuring the legal form of documentation used to transfer claims in Iceland, market participants needed to resolve an extremely practical point -- how could ownership of, and legal title to, claims be formally transferred on the books and records of the insolvent Icelandic banks?
Icelandic law permits and recognizes the assignability of claims. This seems basic, but it is not axiomatic. Legal systems can take differing views on the propriety and usefulness of allowing a claimant to sell its claim to a third party unconnected with the underlying dispute or proceeding. In the three Icelandic proceedings, guidance issued by each Winding-up Board contemplated the potential transfer of claims. However, the Winding-up Boards did not publish formal transfer documentation until three months after the deadline for submitting claims. These nearly identical “claim transfer request forms” became the legal documents under Icelandic law that provided notice of the transfer and a mechanism for the Winding-up Boards to monitor current holders of the claims.
Several additional issues related to transferability required market participants to react with flexibility when documenting transfer of claims:
- notes were blocked in electronic settlement and clearing systems, and as a result the ownership of, and legal title to, underlying notes were not eligible for formal transfer,
- “partial transfers” were expressly permitted by the Winding-up Board, but there was an initial concern that claims referencing notes of multiple ISINs6 could only be transferred on a pro rata basis across ISINs, however, subsequent guidance permitted trading of individual ISINs,
- there was initial debate as to whether “participations” (as opposed to outright assignments) in claims were permitted,
- certain information, including the register of claims and list of Winding-up Board determinations, was not publicly available, and
- the calculation methodology of claims related to notes with an original issue discount remains uncertain -- original claimants often filed for par and penalty interest at the statutory rate (approximately 19%) and amounts listed with the Winding-up Board are often inconsistent with respect to the same ISINs.
How to Allocate “Priority” Risk
The priority of claims is set forth in the Icelandic bankruptcy act.7 A basic summary is as follows:
- Article 112 of the bankruptcy act is a priority category that was amended in 2009 to include deposit claims,
- Article 113 is a general category under which unsecured and unsubordinated claims fall -- it is applicable to most bond and loan related claims being traded in the secondary market, and
- Article 114 is a subordinated category.
The level of priority that will ultimately be applied to various claims is still unclear, and this uncertainty affected early trading decisions at all claim levels. Buyers of purported Article 112 claims asserted that sellers of such claims should bear the risk of ultimate priority characterization, particularly where buyers paid a premium based on the expected treatment. Buyers of Article 113 general unsecured claims focused on minimizing the size of the pool of Article 112 claims (which would be paid prior to Article 113 claims) by filing objections to the Article 112 claims with the Winding-up Boards. Reviewing such objections remains an important part of a buyer's due diligence process. Article 114 subordinated claims (including claims for post-receivership interest) are generally viewed as unlikely to receive any recovery and Article 114 claims are not heavily traded in the Icelandic market.
How to View Individual Noteholder Claims as Opposed to Trustee Claims
Individual noteholders generally filed individual proofs of claim consistent with the guidance of the relevant Winding-up Board, but the trustees for certain Kaupthing and Landsbanki notes also filed aggregate proofs of claim on behalf of all noteholders under the relevant indenture. Each of the Kaupthing and Landsbanki Winding-up Boards accepted the trustee-filed claims and rejected the claims filed by individual holders as duplicative.
No guidance has emerged on the procedures for transferring a noteholder's beneficial interest in a trustee-filed claim. Liquidity in the note claims was significantly reduced while noteholders filed objections to the rejection of their individual claims and market participants tried to draft documentation and craft trading structures designed to efficiently transfer only the relevant portion of a trustee-filed claim. After a period of confusion leading to delayed settlement, the market reached a solution: because there was no clear process for transferring a beneficial interest in a trustee-filed claim by assignment, transfer by participation was favored to speed trade settlement. While the substantive issues around the trustee claims are not expected to be resolved by the Icelandic courts until mid-2011, the market adapted to the legal uncertainty by developing an alternative transfer structure, which allowed trading to continue.
Icelandic Tax Issues
Iceland, which previously imposed no withholding tax on interest, enacted legislation, effective September 1, 2009, that imposed such a tax at the rate of 15% for non-resident entities and 18% for non-resident individuals. In addition, the legislation defined “interest” to include any gains realized upon the sale of a claim, including gains due to currency fluctuations. While residents of countries with double tax treaties with Iceland were protected from imposition of this tax, its application to others, including many investment funds which could not qualify for tax treaty protection, was unclear. This uncertainty stalled settlement while market participants focused a great deal of attention on crafting appropriate indemnity provisions to address the risk of unexpected tax liabilities. Fortunately, Icelandic authorities have recently said that the tax does not apply to gains on the sale of a claim between two non-resident entities.
Markets often emerge spontaneously from the collective behavior and independent actions of investors, traders and those who support the legal and settlement frameworks operating behind the scenes. While each participant acts according to its own limited objectives, the resulting collective behavior can quickly form a robust market capable of transferring risk and value across national borders. Along the way, technical and legal issues arise. Sometimes the issues are answered definitively, and sometimes they are put off for resolution on another day.
The Iceland experience demonstrates that the secondary loan and claims trading environment is now sufficiently developed to adapt quickly to novel and unpredictable insolvency situations. Market participants, tasked with creating liquidity in a challenging economic environment, have the ability to apply current established trading principles to different jurisdictions in order to craft tailored solutions to unanticipated complexities. Investors currently monitoring volatile national economies should take comfort that legal and settlement frameworks for global claims trading, which have been successfully employed in Iceland, will continue to be available as new secondary markets emerge.