MCG Consulting Group | Icesave Dispute: Settlement Proposal to Oddný G. Harðardóttir | International Business MGCR 382- 001 Fall 2012 |

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Contents Executive Summary 3 Description of the Icesave Case 4 Overview of the unsustainable growth and collapse of the Icelandic financial sector in 2008 4 The Collapse of Icesave (Iceland’s Landsbanki) 5 Attempts of agreements and Icelandic referendums 6 Ruling: European Free Trade Association v. Iceland – EFTA Court Case E-16/11 References 8 The proposal from MCG Group (MCG) 9 Economic benefits and arguments 12 Legal aspect of the Icesave dispute 14 Appendix A 17 Bibliography 18

Executive Summary Objective MCG Consulting Group is a consulting firm specialized in banking. MCG’s goal is to provide effective solutions for multifaceted issues by researching all avenues of a problem and ensuring to always have supporting evidence for given proposals. The following paper is an examination of the current Icesave loan conflict followed by a proposal which MCG believes takes all stake holders into consideration. Important Acronyms EEA (European Economic Area), EU (European Union), EFTA (European Free Trade Association), ECJ (European Court of Justice), Research Methods * Review of the history of the crisis including previous agreement attempts and referendums. * Review of financial influences including: * The conservation of Iceland’s natural resources which are its major exports. * Consideration towards Iceland’s credit score and therefore its ability to raise capital in the long run and the short run. * The possibility of economic sanctions from England and The Netherlands which represent a huge part of Icelandic exports. * Consideration towards the current state of the European economy as a whole and the potential impact of having yet another country in dire straits. * Review of the legal aspect of the dispute including: * EEA agreements which Iceland has committed to including deposit guarantee schemes. * The complications due to the cross-border aspect of the banking failure. * Weighing the importance of goodwill and therefore more diplomatic actions as opposed to legal actions. Conclusion Completely avoiding payment of loans would be unacceptable and have too many long term consequences. Iceland should make a compromise by taking a course of action which takes all stake holders into consideration without crippling its own economy. Solution Commit to paying half of the approximately €4 Billion debt. Repay this portion by converting it to non-participative preferred shares in Nyi Landsbanki. These shares will pay dividends based on a predetermined formula and not by earnings of the issuer. After 8 years these shares could be redeemed by the Icelandic government for a maximum of 85% of the remains of the loan. This allows for the creditors to potentially earn more returns should Nyi Landsbanki have performed beyond expectations. In addition both creditor countries will be granted a non-voting seat on the board of directors in a show of good faith and transparency while allowing Iceland to maintain sovereign control. Description of the Icesave Case Overview of the unsustainable growth and collapse of the Icelandic financial sector in 2008 Historically, Iceland’s economy was driven by a collection of small, publicly regulated financial institutions. The three main banks (Landsbanki, Glitnir and Kaupthing) were publicly owned, which yielded the government a strong control over the fixation of interest rates and the risk management of those institutions (Sigurjonsson, 2009). To meet the requirements of the European Economic Area, which Iceland joined in 1994, the Icelandic government launched a broad liberalization of the markets that led to massive privatization and deregulation of the banking system (see Appendix A). Foreign ownership was discouraged, which led to a strong cross-ownership of the banks; this ceded strong control of the banks to a small group of individuals that had no real experience in large scale banking (Sigurjonsson, 2009). When Iceland finally joined the EEA common market, allowing free flow of capital, banks expanded their activities abroad and they expanded exponentially. Risk taking by the inexperienced Icelandic international bankers was neglected by the government and was made very easy by the banks solid credit ratings from the large agencies (Gunnarsson, 2011). From 2001, the business model of the Icelandic banks, because of the relatively small size of the local economy (approx. 320,000 in population), relied on “attracting funding from international markets” (Goddard & Molyneux, 2009). The banks, therefore, leveraged their balance sheet with foreign loans for the next 7 years and their growth became highly unsustainable. When the financial crisis hit, banks’ deficit accounted for roughly 15% of Iceland’s GDP in 2006 and 25% in 2007. Iceland’s inflation reached double digits and the overvalued krona (Iceland’s currency) declined by 35% in 2008 (Sigurjosson, 2011). With inadequate liquid reserves to guarantee their loans, and with the turmoil caused by the credit crisis following the collapse of Lehman Brothers, the Icelandic banks access to credit to generate cash inflows was virtually shut down. The Icelandic government had no choice but to declare an Emergency Act to put the three banks into receivership and acquired 75% of their stakes. The Financial Supervision Authority took charge of liquidating the banks’ assets and three new legal entities were put into place to guarantee normal operations within Iceland. The collapse of the three main banks of Iceland represented 85% of their banking system. According to the IMF, this was the largest banking collapse in history relative to the size of a national economy (Méndez-Pinedo, 2011) with the banks’ foreign loans and assets representing about 10 times the Icelandic GDP (Central Intelligence Agency, 2012). The Collapse of Icesave (Iceland’s Landsbanki) In October 2006, Landsbanki started commercializing an online savings account known as Icesave. Offering high yield savings accounts, which yielded interest rates from 5-6%, it was able to attract around 300,000 customers in the UK with deposits of over £4.8 bn and 125,000 depositors in the Netherlands with €1.7 bn. On 6 October 2008, when the Icelandic bank collapsed and the Emergency Act was declared by the Reykjavik government, “All Icelandic deposits were transferred to the new banks, irrespective of whether they were held by domestic or foreign depositors” (Gunnarsson, 2011). The Icelandic government guaranteed that the deposits that were held in commercial and saving accounts on the domestic land would be covered, but didn’t guarantee the same treatment to depositors in foreign branches (Gunnarson, 2011). As the Icesave accounts in the UK and the Netherlands were not incorporated as subsidiaries but as branches, depositors did not have protection from their respective national governments’ deposit insurance (Goddard & Molyneux, 2009). In response to this measure, Her Majesty’s Treasury froze the assets of those accounts under the Anti-Terrorist Crime and Security Act; the Netherlands took similar but less draconian measures (Méndez-Pinedo, 2011). Little liquidity was recovered, as most of it had already been transferred to Iceland or offshore accounts. Both the UK and the Netherlands reimbursed depositors in their countries and defined it as a loan to Iceland (Gunnarsson, 2011). UK and Dutch claims accounted for a total of EUR 3.91 bn with an interest rate of 5.5%. Considering that the Icelandic population is approximately 320,000, this represents an obligation of EUR 48,000 with interest rates of EUR 2,000 per year per Icelandic family; this is equivalent to 50% of the Icelandic GDP (Méndez-Pinedo, 2011). Attempts of agreements and Icelandic referendums Before resorting to the current attempts at resolution through the courts, the Icelandic, Dutch, and British governments went through several rounds of negotiation. However, in every case, these negotiations amounted to nothing. Either talks broke down or the Icelandic people rejected the agreement through a referendum. Almost immediately after Landsbanki collapsed, the governments entered into negotiations to refund Dutch and British depositors. Early in the process these negotiations appeared to be going well. In fact, four days after Landsbanki was placed into receivership, the Icelandic government issued a press release (PMO, 2008a) stating that, “After constructive deliberations, the Dutch and Icelandic governments have agreed on a solution regarding the Dutch depositors of Landsbanki Icesave savings accounts”, and a joint declaration with the UK (PMO, 2008b) saying that “Significant progress was made on retail depositors of Icesave”. Unfortunately, after such an optimistic start, this round of negotiations broke down rather quickly. The end of these talks marked a significant souring in the Icelandic and Dutch relationship; the Netherlands began to threaten to block the IMF’s loan to Iceland if there was not a resolution over Icesave.
Later on the governments began to negotiate in Brussels, with France mediating, which actually went quite well. In June 2009 the governments came to an agreement, with the UK loaning Iceland £2.2 billion and the Netherlands making a loan of €1.3 billion (Waibel, 2010). In December 2009 the Icelandic Parliament, also known as the Althing, passed a bill which was in line with this deal and which the Dutch and British governments accepted. However, after it went through the Althing, the Icelandic President, Ólafur Ragnar Grímsson, refused to sign the bill without putting it to a referendum. This resoundingly rejected the bill; more than 90% of Icelanders voted against the bill. Later, the three governments came to another agreement over how Iceland could repay the debt. This amended the deal, calling for Iceland to repay the debt over an extended period, starting in 2016. In early 2011, this deal once again passed through the Althing, and Grímsson once again called for a referendum on the deal. Once again, the Icelandic people rejected the deal, this time by a margin of roughly 60-40. With a second consecutive vote against paying back the Dutch and British governments, Icelanders made it clear that they did not support repaying the debt unless there was a clear legal obligation to do so (Sigurdardóttir, 2011). This referendum was the last attempt at negotiations, and resulted in the dispute being taken to the EFTA court.

Ruling: European Free Trade Association v. Iceland – EFTA Court Case E-16/11 References Iceland is part of EEA, meaning that it is a member of an internal market that allows it to trade goods, capital, services, and labor with the EU’s members. Even though Iceland is not an official member of the EU, this agreement obligates them to comply with the EU’s economic laws and regulations (The Norway Mission to the EU, 2009). The EFTA Surveillance Authority makes sure that countries within the EFTA (non-EU members of the EEA) comply with these obligations. In December 2011, this organization opened a case against Iceland in the EFTA court. The Surveillance Authority seeks to prove that Iceland did not hold its obligations by not guaranteeing Dutch and British deposits and it also seeks to force Iceland to pay back the UK and the Netherlands. The first pillar of the EFTA’s case is based around articles 3(1), 4(1), 7(1), and 10(1) of Directive 94/19/EC. These articles deal with a state’s responsibility to guarantee deposits in the case of a bank’s collapse (EFTA Surveillance Authority vs. Iceland, 2011). A Joint Legal Opinion concluded that a state has an obligation to make sure that a deposit-guarantee scheme has adequate means and can pay back creditors. Iceland’s argument is that this does not oblige them to pay back creditors, but rather to simply have a deposit-guarantee scheme in line with the norms in other countries. Furthermore, they argue that even if the obligation to pay back everything did exist, they were precluded from doing so by uncontrollable circumstances, specifically a systemic collapse of the Icelandic economy (Waibel, 2010). The EFTA’s response to this is that it would be illogical if “the greater the shock the less coverage for deposit holders” (EFTA Surveillance Authority, 2012; Davíðsdóttir, 2012). The second pillar of the EFTA’s case is that, even if Iceland did not violate Directive 94/19/EC, it did violate Article 4 EEA (EFTA Surveillance Authority vs. Iceland, 2011). This prohibits discrimination on the basis of nationality by a government. The EFTA suggests that Iceland discriminated by guaranteeing Icelandic deposits, but not those in the UK or the Netherlands. Iceland argues that they didn’t actually discriminate based on nationality. Rather, they made their decision on which deposits to guarantee based on which branch the deposits were held at, which is distinct from nationality (Ministry for Foreign Affairs, 2012).
It is important to note that the decision on this case is not necessarily binding on Iceland; even if the court finds for the EFTA, the decision is not wholly enforceable. However, the outcome of this case will have important ramifications on the dispute regardless. Whichever side wins will have a lot more power in negotiations after the decision. Furthermore, if the court finds for the EFTA, it may provide the “clear and unequivocal” legal obligation that Sigurdardóttir (2011) claims the Icelandic public needs to approve a deal which repays the loan.

The Proposal from MCG Group (MCG) Because of Iceland’s fragile financial position and its unfavorable diplomatic situation vis-à-vis the UK and the Netherlands, it is MCG’s opinion that its government should seek for a settlement outside of court that would satisfy all parties. It is in the best interest of the Icelandic government to make a deal that would have future economic and political benefits for all the stakeholders involved in the dispute. The liquidation 90% of the newly nationalized Nýi Landsbanki bank’s assets as an approach to repay the national loan was proposed during the third round of negotiations of the dispute. MCG does not believe that this is the optimal approach, as it would handicap Iceland’s economic recovery (Méndez-Pinedo, 2011). In addition, the proposition of an annual repayment with interest paid by the Icelandic Government would be a measure that would harm the economic growth of the country. Furthermore, this would require austerity measures of the Icelandic government. In order to avoid future economic drawbacks, the Icelandic Finance minister, should propose to her premier counterparts a feasible, firm and final settlement. For this agreement to be feasible it should include a reduction of Iceland’s debts to a level that is manageable from Iceland’s stand of point, while being acceptable to the UK and the Netherlands. MCG Group’s suggestion is to cut the debt by 50% of the total amount owed, which would reduce Iceland’s liability to approximately EUR 1.95 billion. The new Icelandic debt, would take form of a financial instrument issued to the English and Dutch government. MCG Group recommends that this instrument take the form of non-participative preferred shares in Nyi Landsbanki. The dividends paid on these preferred shares would be “calculated according to a predetermined formula and not be determined by the earnings of the issuer” (OECD, 2012). As for capital repayment of the preferred shares dividends, it would only be allowed if the bank met minimum capital adequacy ratios based on Basel iii Accord requirements (BIS, 2012). The investors (UK and Netherlands) would not participate directly in the distribution of earnings and would not be affected by the dilution of shares. This solution allows the UK and Dutch governments to be in a position to receive residual money while giving them an incentive to help Iceland to recover. Moreover, this would represent a chance for Iceland’s economy to improve and this would be an incentive for Nýi Landsbanki to perform. In addition to show good faith and transparency, an observer of both creditor countries would be granted a spot on the board of directors of the bank for the duration of the deal. This would allow the UK and the Netherlands to keep an eye on the bank’s actions while defending their interest, but they would not be able to vote on the decisions of the board, given the Icelandic bank’s total sovereign control. In case of exceptional returns and assuming that the bank exceeded predetermined capital ratios, the Icelandic government could decide to repay more than what was agreed by the predetermined formula. This would show their goodwill towards creditors. MCG Group firmly thinks this measure should be implemented at the sole discretion of the Icelandic government. At that point, the decision should be based on if they consider that the goodwill of this action would overrule the tradeoff of the returns that could be produced by keeping this capital in their bank. After eight years, these non-participative preferred shares could be redeemed by the Icelandic government for a maximum of 85% of what is left to pay on the loan or would be given back to the Icelandic government, if the total repayment has been achieved or surpassed. This would allow the creditors to hope for more returns from the predefined dividends if Nýi Landsbanki performs beyond expectations. Economic benefits and arguments The right proposal for Iceland is one that takes into consideration the will of the people, the need of the creditors and the interests of the European economy as a whole. Iceland is seeing many unprecedented changes in policy which hint towards a true desire to maintain its image in the European Community and truly show that the country has a desire to make drastic changes to reform its economy. One of the most striking examples of this is a complete rewrite of the Icelandic constitution (Robertsson, 2012). More importantly this new constitution is unique in that it directly includes amendments on economic regulation. This suggests that Iceland is invested in making a real effort to maintain its image on the world stage. By showing that it is willing to make such drastic reforms, investors can be more certain about the country’s future which further solidifies MCG Consulting Group’s proposal to repay debts through preferred shares in Landsbanki. With these changes there are true growth prospects for Iceland and a real possibility that the new lowered debt will be paid in full by the repurchase of shares in time. Furthermore this proposal, in MCG’s opinion, would be acceptable to the population of Iceland and would be seen as a compromise that would not impair Iceland’s sovereignty and economic prospects. One of the more obvious proposals, which were considered for the Icelandic government by MCG Group, was to sell off some of Iceland’s national resources and property to settle its debts as the Greek government has done. Looking at the new constitution it is immediately clear that this would not be possible. A staggering 80% of voters voted to declare “all non-privately owned natural resources as national property” (Robertsson, 2012). Although Iceland was recently upgraded by Fitch from a BB+ rating to BBB- ("Reuters", 2012), essentially bringing it out of the “junk” category, the country still has a long way to go. By repaying at least half of its Icesave debt Iceland makes a compromise, which ensures it does not slip back into a junk bond rating among creditors. This allows for more access to capital in the long run while not crippling its economy in the short term by committing to paying a debt in full, which it cannot afford. By choosing to not pay its debt at all, Iceland also runs the risk of economic sanctions by some of its major trading partners. For example 33.9% of Iceland’s exports are to the Netherlands and another 10.1% are to the United Kingdom (“Exports by countries September”, 2012). By refusing to pay its debts Iceland puts 44% of its exports at risk. Avoiding the other extreme solution of full repayment also affects the country in that it can avoid austerity measures, which could result in major civil unrest. This compromise is not only beneficial for Iceland and its people but also for the two other major stakeholders (UK and Netherlands), and for the EEA as a whole. Considering the devastating ripple effect that Greece and Spain have recently had on the European economy, it is not in EEA’s interest to have any more countries in dire straits economically. For obvious reasons, the UK and the Netherlands would not be in favor of Iceland not taking any responsibility for its debt but at the same time the two countries should be wary of pressing for full repayment, since it would cripple the small Nordic country. By accepting shared responsibility of around 50%, as seen in the proposal, the UK and the Netherlands prove to international investors the strength of the solidarity between member countries of the EEA. Although Iceland by itself does not represent a significant portion of these two major stakeholder’s exports, avoiding more bad headlines in Europe would be a wise political move considering the existing forecasts by investors. For example, Morgan Stanley has already made very grim economic forecasts for Europe including GDP growth of -0.5, -0.6 and -0.5 % for the EEA, the Netherlands and the U.K. respectively in 2012, and a meager 0.0, 0.2, and 1% growth in 2013 (Boesler, 2012). Another major European melt down could make investor forecasts even worse and constrict foreign investments and credits even further. Finally, the proposal also encourages the Icelandic bank to perform and allows for the U.K. and the Netherlands to each assign an observer to the board of directors without voting rights in order to keep a watchful eye on their investments and to avoid that the bank once again takes on irrational risks. Legal aspect of the Icesave dispute When Iceland joined the EEA, it had to comply with the agreement and adopt a law for banks to contribute to the deposit guarantee schemes. However, in the case of Icesave, the directions for state liability in the EU and the EEA law were unclear and ambiguous because of the context of the general failure of the banking system. Since the EEA agreement had never anticipated the possibility of a complete banking failure in one country leaving cross-border depositors unprotected, there is no specific guideline for the role of the state if its deposit guarantee scheme fails to have sufficient funds due to a systematic banking crisis (Méndez-Pinedo, 2011b). The Icesave incident is a cross-border banking failure that has generated for the first time in the internal market a number of victims of this magnitude in other European states. Moreover, no comparative data is available concerning the application of the EU laws in other non-EU countries (Méndez-Pinedo, 2011b) and therefore there is no defined milestone on which the legal judgment can be based on. The European integrated international market’s legal system is currently composed of two legal entities: EFTA and ECJ. While the communication concerning the interpretation of laws and their applications between the two courts is strong, no direct legal procedure was implemented to cope with cross-border judicial disputes occurring between countries in EEA and EU (Méndez-Pinedo, 2011b). The ECJ has no real legal power over the Icelandic state, given that Iceland is not a part of the EU and therefore only responds to the EFTA. Furthermore, there is no explicit law stating that after a systematic banking collapse, a country will have to assure sovereign liability for the financial compensation of depositors in other European countries (Méndez-Pinedo, 2011b). However, Iceland should demonstrate its goodwill to the UK and the Netherlands for diplomatic reasons. Since Iceland is presently recovering from the 2008 crisis and its credit rating is BBB-, its refusal to cooperate would translate into harsher economic repercussions for its people and a longer period of recovery. For these reasons, the Icesave dispute has primarily been approached diplomatically rather than legally. MCG Group’s proposition would be in the best interest for the UK and the Netherlands when taking into consideration the three past bilateral propositions. On three occasions the Icelandic government sought to come to an agreement with the UK and Netherlands regarding the compensation payments made by the later governments to the depositors in their respective countries (Méndez-Pinedo, 2011b). Yet, none of the referendums came to a legal agreement mainly due to the many gray areas in the law and a lack of a precedent similar case on which to base a solution. This lack of legal interpretation certainty has played a major role in the outcome of the referendums, “the Icelandic people will not accept a requirement to cover costs related to deposit insurance guarantees, unless the legal obligation for doing so is clear and unequivocal” (Sigurdardóttir, 2011). Therefore, MCG’s proposition of reducing the debt by 50% and converting it to non-participative preferred shares would be ideal. Furthermore, the proposition is clear and leaves no room for misinterpretation. Finally, the UK and the Netherlands should accept this proposition and their legal actions in the EFTA and the ECJ should be dropped because it might be their only way of recovering a part of what they have lost, and as the EU commissioner, Neelie Kroes, said in one of her speeches, “exceptional circumstances would justify exceptional measures” (Kroes, 2008).

Appendix A

Represents the fusion of the several financial institutions from 1990 to 2007 and the growth of the Icelandic's Bank Assets The Icelandic Bank collapse: challenges to governance and risk management

Author: Throstur Olaf Sigurjonsson
Edition/Format: Article

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