Bankers with long memories will remember when a sovereign guarantee from a less developed country was regarded as safe. Then came Mexico’s insolvency and the 1980s emerging-market-debt crisis. Now lenders to European borrowers are becoming vigilant – not because they are worried about borrowers’ incipient insolvency, but because of EU rules governing guarantees provided by member states or state-owned entities.
Under the EC treaty, anything which threatens to distort competition between member states is deemed to be incompatible with the common market. So the provision by a member state of finance – either directly or (by way of a guarantee, for example) indirectly – can be in breach of the EC treaty and, in particular, articles 92 and 93. These cover the provision of what is called “state aid” by member states.
There is a pre-clearance procedure: basically, the member state concerned informs the European Commission, which then has a set period, usually two months, in which to respond. But this can interfere with market-driven decisions and is often honoured in the breach. Lenders tend to rely on other parties to make the necessary application, but no central record of such applications is maintained.
Assuming that the pre-clearance procedure is not followed, a bank can be affected in one of four ways. First, it may find that an otherwise healthy borrower has, in fact, received state aid by way of a subsidy, loan or injection of capital, so jeopardizing the borrower’s credit standing.
Second, the bank may find that the guarantee received from a member state or a state-owned entity risks being adjudged to be state aid. Third, the bank may discover that a provision of the borrower’s national law effectively puts the state behind it, so amounting to state aid. Finally, the bank may be an unwitting recipient of state aid if it is itself state-owned or state-backed. Note that capital-markets transactions can be affected just as much as commercial loans.
Taking the EU’s side for a moment, it is clear that the provision of state backing automatically enhances a borrower’s credit standing. It may be able to raise finance not otherwise available or gain better terms than it could if free-standing. The desire to stamp out unfair competition is laudable. But the problem is one of definition. Soft loans are a form of state aid (indeed, the European shipbuilding industry is subject to a separate body of legislation on state aid). Some forms of trade finance also amount to state aid; it is difficult to know where to draw the line.
Failure to pre-clear state aid with the European Commission does not make that aid illegal, although the commission can order the member state to suspend it. There is case law and a commission notice to suggest that the enforceability of state aid which is not submitted for preclearance will be called into question by national courts. There is no discussion in the case law of the effect of invalidity of state aid on a third party such as a lending bank, but English law treats illegal contracts as unenforceable and there is every indication that in future it will be national courts which will be asked by affected third parties to render such contracts unenforceable. This means that it may be necessary to know how the national courts of the borrower’s member state are likely to stand on such questions, so introducing a degree of inconsistency and uncertainty. There is also the risk that a borrower in receipt of illegal state aid may have to repay the loan if it would not have been possible to borrow, or borrow as much, without the state aid.
All of this may strike a banker as hypothetical. After all, the thought of eu competition law affecting the provision of loans is enough to have any traditional commercial banker turning in his or her grave. Yet in a case involving the German state of Bremen, a company was ordered to repay a loan guaranteed by Bremen because the guarantee was held to be state aid. In another case involving a German company, the European Commission judged a state guarantee to be illegal and ordered the amounts advanced under it be recovered, even though the company, Bestwood ef Kynder, subsequently became insolvent. The position of a lending bank, which was owed DM25 million ($14 million), was not addressed.
It may only be a matter of time before a bank is embroiled in state-aid litigation. In Breda v Manoir, a Belgian national railway company issued an invitation to tender and received bids from French and Italian companies. The French company argued successfully before the Belgian courts that the Italian company, Breda, had benefited from state aid granted by its parent, Efim, Italy’s third-largest state holding company, and that this aid had enabled Breda to submit a more competitive bid. The court agreed and Breda’s bid was set aside.
Sooner or later a state-owned bank may find itself on the receiving end of a similar case concerning, for example, the mandate for a project financing. Or a competitor of the borrower may join the lending bank as a third party on the basis that the terms of the loan were softened because of a state guarantee without which the competitor would not have been able to raise the necessary finance so easily or cheaply.
However, even in EC law there can be a twist. When Efim – Breda’s parent – collapsed owing massive debts, the European Commission objected to the stipulation of Italian law which provides that the sole shareholder of an entity is responsible for the whole of its debts. Since Efim was state-owned, it had in effect an unlimited state guarantee. The commission eventually consented to the Italian authorities’ request that the guarantee be honoured because of the adverse consequences for the European manufacturing sector if it were not. So the old adage that the more you owe the bank the better off you are holds true in EC law too.
There may be a happy ending in prospect. The European Commission has been subject to lobbying – from, among others, the UK’s Financial Law Panel – to follow up a questionnaire it issued to member states in 1995 on the subject of state aid. The panel has been in recent discussion with the commission to encourage it to issue a series of short statements clarifying various areas of uncertainty, including confirmation that banks will not be prejudiced by commission action in respect of unlawful guarantees.
