As the recent economic and financial crisis in the Eurozone continues with no clear and comprehensive resolution in sight, the possibility that certain member states may elect to withdraw from the Eurozone becomes an increasingly real possibility. As a result of the potential legal and commercial consequences of such an election, many lenders and financial institutions are actively assessing the impact of such a withdrawal on existing Euro exposure. In particular, many institutions are undertaking a review of the agreements governing Euro-denominated loan facilities (i.e., loan facilities requiring repayment in Euros) to ensure that adequate protections are in place to shield themselves from the economic ramifications of a “redenomination event.”
What is Redenomination Risk?
A “redenomination event” refers to an event which has the effect of converting obligations payable in one currency (e.g., Euros) into a new currency (e.g., new Drachma). Since the new Drachma, once issued, would almost certainly depreciate and fall in value as compared to the Euro, holders of Euro obligations could suffer substantial losses. This inevitable devaluation resulting from a redenomination event is frequently spoken of nowadays in the context of the Eurozone crisis and is referred to as “redenomination risk.”
The key question that redenomination risk poses for lenders and financial institutions is: when and under what circumstances may obligations payable in Euros be redenominated into the new currency of a member state upon a member state’s exit from the Eurozone (even when an agreement expressly requires payment in Euros)? When reviewing Euro-denominated financing agreements to assess this issue, there are certain basic contractual provisions that lenders pay particular attention to:
- Governing law;
- Jurisdiction for dispute resolution;
- Currency definition; and
- Place of payment.
Redenomination risk will be greatest where an agreement is governed by the law of a member state exiting the Eurozone (a “Departing State”). Therefore, in terms of governing law, lenders and financial institutions must determine the likelihood that the governing law of an applicable agreement is that of a member state that is likely to become a Departing State. Ultimately, this determination may be difficult to make and is likely to prove inconclusive. Therefore, many lenders are electing to amend financing agreements to provide for English or New York law as these jurisdictions by definition do not present the withdrawal risk inherent to the members of the Eurozone.
Jurisdiction for Dispute Resolution
The jurisdiction provision of an agreement, which sets forth the courts which the parties have mutually agreed to litigate disputes in, is also important to review. A Departing State would likely pass legislation establishing its new currency and setting the exchange rate for conversion to the Euro. While the courts of a Departing State would almost certainly give effect to such redenomination legislation, courts outside the jurisdiction of the Departing State would in most cases follow their own internal laws in resolving the disputed issue. As a result, actions brought in the courts of a Departing State would be more likely to uphold the satisfaction of payment obligations in the new currency notwithstanding an agreement’s express requirement that payment obligations be satisfied in Euros. Therefore, similar to amendments intended to address choice of law concerns, many lenders are seeking to avoid this potential issue by amending financing agreements as appropriate to provide for exclusive jurisdiction of the courts of New York or England.
Currency Definition and Place of Payment
The definition of “Euro” (to the extent that an agreement even contains such a definition) can also have a significant impact on the possible effects of a redenomination event. The most protective definition of the term Euro would refer to the currency introduced at the start of the “third stage of the European Economic and Monetary Union” rather than to the currency of a particular country from time to time. For example, if “Euro” is defined in an agreement with a Spanish borrower as the “legal currency of Spain from time to time,” the definition by its terms contemplates that the currency may change over time and evidences an intent to use a particular country’s currency (Spain) rather than a specific currency (Euro). The more protective definition, on the other hand, does not by its terms contemplate that the contractual currency will change over time and, therefore, is less susceptible to an argument that the contractual currency should change to the extent the borrower is a Departing State whose currency has been redenominated.
The required place of payment will also be important in assessing the redenomination risk associated with a particular agreement, mostly in cases where Euro is not defined at all. For example, if an agreement specifies the place of payment as an account in Ireland and Ireland becomes a Departing State and redenominates its currency, it will likely be presumed that payments to such Irish account going forward should be made in the new Irish currency. If, however, payments are made to accounts located outside a Departing State, there should be less risk that such payments will be subject to a presumption of redenomination. Given these circumstances, lenders are seeking to include a clear definition of Euro which is tied to the Eurozone rather than the country of the obligor and to have payments made to accounts located outside of countries that have a high probability of becoming a Departing State.
Guarantee Specific Considerations
In addition to the provisions discussed above which will apply to finance documentation generally, further consideration is needed if the specific document in question is a guarantee. This is due to the fact that a guarantee obligation is secondary in nature and will not be triggered unless there has been a failure to pay by the underlying obligor. If the relevant underlying obligor pays the obligations under its Euro-denominated agreement in the new currency but, given devaluation, such payment does not make the lender whole, the question becomes whether the lender can call on the guarantor to cover the resulting shortfall.
If the guarantor’s obligation is simply triggered by a failure to pay, a guarantor could potentially argue that no trigger event occurred since the obligor paid (albeit in a different currency). Consequently, lenders and financial institutions will likely start requiring language regarding the trigger of a guarantor’s obligation to be worded more specifically as a failure to pay in accordance with the strict terms of the underlying agreement. By way of illustration, consider a guarantee which provides that the guarantor must pay upon “a failure to pay by the borrower” versus upon “a failure by the borrower to pay in accordance with the strict terms of the [underlying agreement].” While the first formulation leaves room for the guarantor to argue that it is off the hook to the extent the borrower paid in Euro or in the new currency, the second formulation more clearly evidences an intent for the guarantor to ensure that the lender is not just paid but paid in the same currency and manner as was agreed by the parties in the underlying agreement. Lenders will likely also consider including language providing that the underlying agreement will be construed without giving effect to the laws and regulations in effect from time to time in the jurisdiction where the underlying obligor is located. They will also likely propose a waiver by the guarantor of a defense to the same effect in order to further evidence such intent to be made whole in accordance with the contractual terms irrespective of any redenomination event that may have occurred in the borrower’s jurisdiction. The inclusion of such language in a guaranty should better allow lenders to make a claim on the guaranty as an alternative source of repayment to cover a shortfall resulting from a redenomination event.
Individual Facts and Circumstances
Equally, if not more, critical than the areas of particular focus discussed above that apply to finance documentation generally are the specific facts and circumstances surrounding particular agreements, as the ultimate assessment by the lender of the degree of redenomination risk presented by any given Euro-denominated agreement is necessarily going to be impacted by such facts and circumstances. For example, if the obligor under the Euro-denominated agreement is located in a state such as Greece or Spain, which are currently thought of as having higher probabilities of becoming Departing States, redenomination risk will be higher than if the obligor is located in Germany or another Eurozone state not seen as likely to become a Departing State.
In addition, it is necessary to verify that there is nothing in any individual agreement that expressly shows an intent for the obligor not to be responsible for losses associated with redenomination or similar events or that otherwise provides the obligor with a colorable argument that the obligations should be paid in the new currency despite the fact that they were originally extended under the agreement in Euros. For example, if an agreement carves out from borrower or guarantor liability certain sovereign risk events, a lender may seek to clarify that redenomination is not included in such carve-out.
As lenders and financial institutions continue to review and analyze their existing finance documentation to ensure it contains the documentary protections noted herein, companies can expect that lenders and financial institutions will actively seek amendments to any existing documentation that does not contain some or all of such protections, requires clarification or contains language that would appear to subject the obligations to redenomination. In addition, it can certainly be expected that lenders will endeavor to have such protections built into any new finance documentation governing Euro exposure going forward.
Although these documentary protections that lenders are seeking in response to the current Eurozone crisis are seen as critical from their perspective in order to attempt to ensure that they receive payment in full as contracted for, it should be noted that even if the agreements contain all of the provisions discussed herein, the outcome of the issue will nevertheless remain surrounded by ambiguity given the plethora of variables surrounding any particular exit from the Eurozone and the legislation that may or may not be adopted in connection therewith.