Over the past few months an increasing number of Italian lawmakers have been advocating Italy’s unilateral withdrawal from the Eurozone or even the European Union. These voices seem to join the choir across the European Union supporting a full-blown Euro break-up maintaining that Germany is the only economy really benefiting from the monetary union. Others, instead, are discussing a compromise between full monetary integration and a monetary break-up, the flexible Euro3, arguing whether this approach would address the increasing economic divergence between the growing and receding economies of the Eurozone without endangering the existence of the monetary union.
This article focuses on the impact of these proposals on Italian borrowers and investors in Italian debt, examining first whether there is a legal basis in current EU law allowing Italexit (whether it be forced or voluntary) or the creation of a flexible Euro and, especially, what the legal position of creditors of Italian Eurodenominated debt would be in the event of either a complete Italexit or the introduction of a flexible Euro. While our analysis at this point can only be broadbased and not case-specific, we will determine that an Italexit or a flexible Euro are a possibility and that either of these would not create the systemic risk that some foresee. Our conclusion is that in inflation-related matters Italian statutory and case law is more creditor- and legal certainty-protective than most legal systems. Consequently, in the event of an Italexit, existing and applicable laws and legal principles would generally convert creditors’ Euro-denominated receivables into monetarily equivalent claims and, in most cases, entitle such creditors to be grossed-up for certain possible inflationary effects which might impact their original claim. In the event of a Euro-split, creditors’ gross-up for inflationary effects between recasting date and payment date would still be possible, but would require judicial intervention. In both cases, however, concerns expressed in the market regarding the triggering of chains of termination and cross-default provisions included in standard market documentation can be minimized or even eliminated.
The Legal Debate Concerning a Euro Break-Up
While economists, investors and politicians debate the various merits and faults of the various Italexit or Euro-split solutions, the main underlying concern of most investors is the impact any such solution would have on the value of their Euro-denominated holdings. In the case of holders of Euro-denominated debt, the legal issues are critical to making any determination of post-exit value.
Some commentators and analysts are skeptical as to whether any kind of Italexit or Euro-split is even legally possible because of provisions in the relevant EU treaties which treat the monetary union as irreversible and do not contemplate procedures for a voluntary or mandatory Eurozone exit. Others argue that the other exit options are not included in the relevant treaties and therefore require either new explicit provisions to that effect or a unanimous decision by the European Council with the consent of the European Parliament. A further group of analysts support instead a treaty amendment, a European Council decision or an exit and subsequent rejoining of the Eurozone on different terms upon achieving economic convergence.
The initial reaction of European authorities has not been encouraging but is hardly unexpected: the ECB stated that exit is simply not allowed under the treaties; the European Council affirmed that the irrevocability of membership in the Euro area is an integral part of the Treaty framework; and the European Commission announced that, as a guardian of the EU Treaties, it intends to fully respect that irrevocability, adding that it does not expect to propose any amendment to the relevant Treaties. At first glance, these positions seem to leave very little margin for the negotiation of a withdrawal or break-up or even a flexible Euro.
Other commentators, however, point out that provisions such as those adopted by the United Kingdom to implement its exit from the European Union could be invoked as a justification by analogy for leaving the Eurozone. Other possible arguments can be found in Article 139 of the Treaty on the Functioning of the European Union (TFEU), which could be interpreted as allowing the European Council to “withdraw” its earlier decision that a specific Member State fulfills the necessary conditions for entering the Eurozone and that, on similar grounds, the European Council can retract that decision. The right to leave could also be based on the “flexibility clause” of Article 352 TFEU, which grants the Council the power to adopt appropriate measures to ascertain that staying in the Eurozone would be devastating for the people of such Member State and the rest of Europe. In conclusion, if there is a need there is probably a legal basis in existing EU law on which that need could be addressed.
However, despite any of these differences of opinion as to the impediments imposed by the treaties and EU rules, the possibility of any given country’s exit from the Euro seems, at this point, to be generally accepted.
Legal Analysis Relating to an Italexit
The conflict of laws rules of most legal systems, including Italian private international law, give predominance to the law of the country of the currency in which the debt is expressed (lex monetae). Accordingly, the legal consequences of a Euro-split, break-up, withdrawal or expulsion from the Eurozone on monetary obligations incurred by an Italian debtor must be analyzed differently depending on whether the debt is denominated in Euros or a different currency (most commonly, USD and YEN). Further differences may also apply in function of the jurisdiction adjudicating the case, the law governing the contract giving rise to such obligation, the wording of contractual provisions such as the definition of the euro currency, change of currency, place of payment, market disruption, etc.
The Italian Civil Code (in a manner presumably similar to the statutes of most other countries) provides that a debt due in a currency no longer the legal tender at the time of payment must be paid in the new legal tender in equal value to the former.4 Thus, if a debt incurred by an Italian debtor is denominated in Euros, Italian law, as the applicable lex monetae, will, following an Italexit, “recast” the debt in the new lawful currency of Italy at a rate presumably established by the European Union (in the event of a negotiated exit, break-up or split) or the Italian government (in the event of a forced or voluntary exit). In addition, as discussed in the following paragraphs, there are other mitigating mechanisms provided by Italian law to automatically protect creditors against the almost certain devaluation that would follow during the period between the “recasting” of the currency and actual payment and avoid the triggering of a vicious circle of termination and cross-default provisions or a flurry of conflicting legal proceedings in different jurisdictions.
If Italian law is the law governing a given Euro-denominated debt obligation, in the event of a withdrawal or expulsion from the Euro, interest would be payable in the new currency at the original contractually agreed interest rate (Art.1277(2)) calculated on the basis of the recasting rate established by the EU or the Italian government, as the case may be. Pursuant to this provision of the Civil Code, the debtor would be required to gross-up the creditor against any post-recasting devaluation on the due principal amount only and not on the coupon. However, Art. 1224(2) of the Civil Code allows the creditor to be judicially grossed-up for the accrued interest, as a mere automatic consequence of the debtor’s late payment, without needing to send a default notice, irrespective of any proof of negligence, if the new currency further devaluates between recasting and actual payment, unless an additional default interest rate or other penalty has been previously agreed upon. Similarly, securities posted as collateral denominated in Euros and issued under Italian law would have to be repaid in the new currency in the same manner, at the recasting rate and subject to the Art. 1224(2) gross-up mechanism, irrespective of the law governing the collateral arrangement.
We believe that, in the event of a Euro-split, it would be critical for the treaty regulating the flexible-Eurozone to clearly specify whether the currency applicable to Italy in the agreed “Euro fluctuation band” would be considered “having legal tender in Italy” and, hence, whether the automatic revalorization mechanism of Art. 1277(2) would be applicable. In turn, Italian courts would determine whether and in which circumstances the general judicial gross-up remedy of Art. 1224(2) would still be available.
Apart from the statutory revalorization and judicial automatic gross-up mechanisms discussed above, it is arguable whether Italian courts would apply the other debtor-protective provisions of Italian law, such as rescission for hardship, supervening excessive onerousness or contract terms revisions, because these general rules could be considered incompatible with the nominalism approach of monetary obligations, which is based on the fact that for the sake of legal certainty the creditor has to bear the inflation risk, in the absence of a different contractual determination.
If, instead, English law is the law governing the Euro-denominated transaction from which the debt arises (as the law predominant in the European debt market or governing the master agreements most commonly used in Europe, such as ISDA, GMSLA and GMRA), in the event of a unilateral withdrawal from the Eurozone we understand that the English courts would (i) have jurisdiction (ii) consider a unilateral, non-negotiated Eurozone withdrawal contrary to local public policy5 and (iii) order an Italian debtor to settle its obligations in the “original” Euro currency, possibly by allowing a conversion of the debt in the new currency at the established recasting rate and grossed-up (with respect to principal and accrued interest) for any devaluation between due date and payment date. Similarly, in the event of a negotiated Italexit, it is likely that creditors would have the right to be grossed-up by the debtor because the relevant agreements negotiated in connection with the Italexit, it is presumed, would not allow the debtor to benefit from late payment.
One way to ensure a smooth transition in the event of an Italexit would be to have the treaty establishing a flexible Euro clearly specify that such event does not constitute a statutory or contractual “Change of Currency”; this would avoid confusing debates and guide the English courts to order debtors to settle their outstanding obligations in their original currency or in the new currency calculated at the official recasting rate cum full gross-up. Ensuring a clear avoidance of a “Change of Currency” event in all cases where Euro-denominated financing contracts are governed by a foreign law is critical for avoiding the triggering of the feared chain of termination, default and cross-default clauses often contained in the foreign law denominated debt documentation.
If the debt incurred by an Italian debtor is expressed in a foreign currency, most typically USD, and the law governing the transaction from which the debt arises is Italian law (as is the case with respect to Italian sovereign debt, which is always governed by Italian law with Italian exclusive jurisdiction and sovereign immunity, even if it is denominated in a foreign currency) the debtor would have the choice to discharge its debt in the foreign currency at its nominal amount or in the currency having legal tender in Italy at the time of payment at the exchange rate at the time the payment becomes due. In this case, however, according to the consistent jurisprudence of the Italian Supreme Court interpreting Art. 1278, the debtor would not be allowed to arbitrage between the conversion rate on due date and actual payment date and would be obligated to gross-up the creditor. If, instead, the debt is expressed in a foreign currency but the law governing the transaction is the lex monetae (e.g., New York law), the Italian conflicts of laws rules would unequivocally point to New York law to regulate the effects of the change in currency and it is likely that an Italian court would dismiss any proceeding brought by an Italian debtor trying to avoid enforcement of a New York court judgment ordering the debtor to discharge its debt in USD and gross-up the creditor if the conversion rate on payment date materially differs from the conversion rate on due date. In addition, unlike the rules of civil procedure of other jurisdictions, a (contractual) negative declaration claim proceeding initiated by a debtor in an Italian court in order to establish Italian jurisdiction before the creditor brings legal proceedings in a foreign court would likely be dismissed and it is suggested that the margins for a sustainable action in tort would be very limited, if any.
As a further note, where an Italian debtor has become insolvent, under Italian insolvency proceedings after the automatic stay the lex obligationis and lex monetae would, upon the occurrence of the automatic stay, be converted into the lex fori and, hence, all creditors would have to be paid in the new currency and be grossed-up against any post-recasting devaluation.
The above summarizes our general views on the legal possibility and the impact of an Italexit on obligations issued by Italian debtors; a more detailed review of the relevant factual situation and the specific terms and conditions of a given debt instrument would be necessary to evaluate a creditor’s exact position.