Investors sweat the small print as Brexit fragments bond laws
The shift underscores how Britain’s impending departure from the European Union (EU) is affecting its status as a go-to jurisdiction for international commerce.
The English legal system’s reputation as a neutral venue for resolving disputes has made it a favourite option for bond investors in Europe. But some borrowers, banks specifically, are starting to issue debt governed by laws from the other 27 EU member states to ensure their bonds are compliant with European rules ahead of Britain’s exit from the bloc on March 29.
Fragmentation of the legal fine print is an unwelcome development for investors. Post-crisis developments in Greece and Portugal have shown that bonds governed by local laws can more easily be wiped out and some fund managers say they would need a higher return to compensate them for that risk.
“You do have to be very careful what jurisdiction your bond falls under,” said David Zahn, head of European fixed income at Franklin Templeton, which manages investments worth over $750 billion. “I would never say steer clear of an issue but I would say look at the price."
English law remains sought-after by European companies looking to raise debt but its popularity has fallen since Britons voted in 2016 to leave the EU.
It is not clear if Brexit is responsible for the shift, which last year saw 28 percent of European corporate bonds issued under English law compared to 34 percent in 2017. The proportion of European corporate bonds governed by the laws of other European countries has risen to 38 percent from 36 percent in the same period, with France and Germany both seeing a jump in bonds issued using their laws.
U.S. law applied to 25 percent of European corporate bonds last year up from 17 percent the year before, Dealogic data shows.
The dominance of English law for international commercial contracts and London’s status as a financial hub have made Britain second only to the United States as a market for legal services.
London’s lawyers, working from ancient chambers and sleek skyscrapers, generate tens of billions of dollars every year in fee income, much of it from advising banks, investors and insurers on deals and disputes.
So far, uncertainty around Brexit has been a boon for lawyers, driving demand for their services. But there are also threats. One third of dispute resolution lawyers surveyed by Thomson Reuters last year said the businesses they advise on were considering selecting different governing law and jurisdiction clauses outside the English system.
At the heart of the rethink on legal jurisdiction is Europe’s ability to restructure troubled banks.
In the wake of the financial crisis, new rules required lenders to raise hundreds of billions of euros in bonds to bolster their balance sheets.
To get regulatory approval, banks had to sell some bonds that could be written down or ‘bailed in’ to absorb losses during a crisis. Such bonds need to be governed by the law of an EU member or a regime recognised as equivalent.
Europe has agreed to continue to recognise English law bail-in bonds during a 21-month transition period while London negotiates its trading relationship with Brussels. But if Britain leaves on March 29 without a divorce deal that arrangement may not apply.
The risk for European authorities is that holders of English law bonds could delay bank restructurings, complicating a process that is meant to happen swiftly.
In the meantime, Europe’s Single Resolution Board, the body in charge of dealing with failing banks, said in January that European banks should insert a bail-in clause in new bond documentation and consider issuing bonds governed by the laws of one of the remaining 27 member states.
Last year, there was a steep drop-off in the amount of subordinated bonds issued by European banks using English law with just 38 percent governed by the English legal system compared to nearly 60 percent in 2017.
Banks are also inserting clauses into their bond documentation to ensure their bonds still count towards capital ratios in Europe after March 29.
In an English law bond issued in June, Portuguese bank Novo Banco included a clause which allowed the bank to make changes to the law governing the bonds “without the noteholders’ consent” if Brexit meant the debt no longer qualified as regulatory capital.
The clause struck a raw nerve for investors in Europe, where the application of local law in Greece and Portugal has meant losses for bondholders. Investors including BlackRock and Pimco are suing Portugal's central bank after it transferred more than 2 billion euros of bonds out of Novo Banco in 2015, effectively wiping them out.
The investors and the central bank declined to comment on the lawsuit.
Antonio Ramalho, chief executive of Novo Banco, said the Portuguese lender did not expect to have any problem raising debt in the future.
“We can do it under English law, but we can also do it under another European law and we can do it according to a model that refers to the Portuguese legislation,” Ramalho told Reuters. "There is always a way to do it.”
Novo Banco's bond offering in June sold at a 8.5 percent yield, the highest for any eurozone subordinated debt sold publicly that year.
A spokesman for the bank declined to comment on the price of the debt.
For corporate and sovereign borrowers from countries such as France and Germany, where investors feel more comfortable with the legal protections, issuing debt in the local law is not a concern.
But a working paper by the European Central Bank last year showed that sovereign debt issued under Greek and Portuguese law would have to pay investors a premium of up to 45 basis points, equivalent to 45,000 euros on every 10 million euros raised.
Greece currently issues its sovereign debt under English law and a government official said there had been no discussion about changing that. Portugal's state debt agency, IGCP, did not respond to a request for comment.
Outside of the banking sector, UK-based investors fear that a future default on an EU-law bond could leave them struggling to recoup losses in a continental court.
“In the past, it has been an area that we wouldn’t have to worry about as it was the law and it was straightforward but obviously this will become a bigger issue,” said Zahn.
European courts might not recognise a ruling from an English court or non-EU investors could be at the back of the queue when trying to seize assets in European countries, some investors say.
"A lot of the bonds we invest in are New York law or English law because they are the two jurisdictions which provide certainty," said Cecely Hugh, investment counsel at Aberdeen Standard Investments.
"There is predictability about how the courts will interpret the contracts. All that is very important for investors."
(Additional reporting by Lefteris Papadimas in Athens, Sergio Goncalves in Lisbon and Simon Jessop and Ritvik Carvalho in London. Editing by Carmel Crimmins.)
By Virginia Furness