Talks to create the world's largest aerospace and defense company broke down last week with French and British officials accusing Germany of blocking the deal, something Berlin denies.

The failed merger attempt has raised questions about EADS' structure and strategy as its shareholders fall back on a decade-old pact designed to balance French and German interests.

The pact - a tangle of restrictions designed to regulate the Airbus parent group - is booby-trapped against predators. But the BAE saga has exposed trip wires that could now ensnare the German government as it tries to become a direct shareholder of EADS and exercise more control.

Germany's state-owned development bank KfW has been in talks for a year with Daimler (DAIGn.DE), a founder of EADS, to buy a 7.5 percent stake as the automaker refocuses on cars. The talks paused during the $45 billion merger bid but will now resume.

The problem, experts say, is that it is difficult for KfW to enter the EADS pact alongside Daimler without seeing its rights curtailed - an unappealing prospect given post-merger politics which have highlighted German unease over French power in EADS.

The operation is especially delicate because a misstep could result in a dramatic mandatory bid for the whole of EADS and an accidental nationalization. A prolonged stalemate could handicap the group's efforts to overhaul its strategy.

"Germany has a clear deal with Daimler, which allows Daimler to reduce its stake," said a person familiar with the talks.

"However, if KfW bought the stake for a couple of billion euros, it would still not get the power to veto a big plant closure in Germany or the sale of a subsidiary to someone it doesn't like. They would have to solely rely on France, and that is definitely something Germany doesn't want."

Originally designed to mask the role of the French state at the insistence of Daimler, anxious to block political interference when EADS was created in 2000, the pact gives control of Europe's aerospace giant to two industrial groups.

Daimler (EAD.PA) owns 15 percent and exercises the votes for another 7.5 percent parked with a semi-private bank consortium.

On the French side, the government owns 15 percent and media firm Lagardere (LAGA.PA) has 7.5 percent but acts as a buffer between state and industry by representing the whole block. Still, the state can veto strategic moves and board nominations.

Daimler has said it still aims to reduce its stake this year. KFW and EADS declined to comment.

The original plan, reluctantly approved by the Berlin government after a coalition debate last year, was for KfW to buy 7.5 percent from Daimler as a first step. Later, it could buy the economic portion (but not the voting rights) of the 7.5 percent parked with the Daedalus bank consortium -- aptly named after the mythological creator of the Minotaur's labyrinth.

Even the first limited operation proved difficult without putting the pact at risk, according to people familiar with the discussions, and progress has been slower than expected.

After sitting idle during BAE negotiations, doubts over the pact now leave EADS in unexplored territory.

LEGAL CATCH

The pact's members own 45 percent of EADS. Under Dutch law, an individual or consortium with more than 30 percent must bid for the whole company, currently worth 22 billion euros.

That's unless the shares were acquired before the Dutch bidding rules went into force on October 28, 2007 -- so the pact's current 3-way membership is safe. For the past year the dilemma has been how to let KfW in without upsetting this arrangement.

Then on July 1 this year, after some lobbying, Dutch rules were loosened and a further exemption became available that seemed to favor KfW: anyone joining a consortium that existed before October 2007 law would also be able to avoid a forced bid.

But there was a catch. The new exemption only applies if the new member abandons the right to influence how the consortium should vote. In short, any newcomer to the pact is muzzled.

"It should not be the case that a party entering the pact will gain control over the consortium," said a partner with a Dutch law firm, speaking like other experts contributing to this article on condition of anonymity to protect future business.

This might not have been a problem as long as KfW was acting as a passive buyer of last resort, stepping in when other industrial buyers such as Siemens had declined to take part.

But the BAE merger flop has added a political twist as Germany becomes increasingly vocal about maintaining parity with France, which has state shares in EADS.

If the logic of parity were applied in full, Berlin would strive for a voting stake of 15 percent, but legal experts say this would bring down the pact. EADS managers would probably welcome the fresh start, but it could also risk months of instability over a group still haunted by past in-fighting.

Unless a new solution can be found, the legal jigsaw leaves Berlin with a potentially awkward set of choices:

- buy Daimler shares and risk a mandatory bid;

- buy shares from Daimler and enter the protection of the pact but with fewer rights than the French government;

- buy shares on the market but stay outside the pact;

- leave things as they are and risk the prospect that a restless Daimler would eventually decide to sell on the market.

Under the last scenario, the pact would remain intact if Daimler kept 15 percent of EADS. It would collapse automatically once Daimler fell below 10 percent, unless the French government also reduced its stake, thus crossing one of its own red lines.

Even if these technical problems could be overcome, there remains another politically sensitive hurdle: members of the pact must agree to a new entrant. Given the bitter atmosphere and recriminations left behind by the failed merger, it remains unclear for now how Paris would greet such a request.

Added to this is uncertainty over Lagardere's stake, which it hopes to sell when Airbus finishes its A350 development. Accords between Lagardere and the state are secret but extracts suggest their holding would collapse if either party dropped below one fifth of its capital. Lagardere currently has a third.

The dilemma could accelerate management and market pressure for a new structure for EADS, whose strategic options are seen as curtailed by the tectonic structure of block-shareholdings.

As a first step, market sources say, EADS is expected to step up efforts to find ways to increase its free float.

"For now it is back to the old EADS. It will be interesting to watch Daimler and see what they do," a sector analyst said.

(Additional reporting by Hendrik Sackmann; Editing by Giles Elgood)

• A Permanent Economic Emergency