Euro exit and redomination risk: a UK perspective

Author: | Published: 3 Oct 2012
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

Approximately €1.16 trillion ($1.46 trillion) of European securitisations outstanding at the beginning of 2012 were originated in member states within the eurozone and a sizeable portion of these are likely to include euro-denominated Notes (AFME's securitisation data report for Q1 2012). While it is hoped that continuing efforts to hold the eurozone together will succeed, there remains a real risk that one or more weaker member states may be forced (or decide) to leave the eurozone.

Several issues could arise in a securitisation in this context.

Mechanism for withdrawal

It has been widely commented that European legislation provides no mechanism for the exit of a member state from the eurozone, save in the case of a withdrawal by a member state from the European Union (EU) under article 50 of the Treaty on European Union (TEU).

For the purposes of this article, a full break-up of the eurozone is not considered, and it is assumed that the euro will continue as a lawful currency within the remaining eurozone countries.

A departing member state looking to arrange a negotiated withdrawal would need to arrange for the EU treaties to be amended to contemplate an exit from the eurozone, potentially using the ordinary revision procedure in article 48 TEU (although this would need to be ratified by the other 26 member states before withdrawal could take place), or using article 50 TEU and then reapplying for accession to the EU (but not the eurozone). In both cases, a negotiated withdrawal is likely to be long and complex, and a departing member state may come under internal political pressure to withdraw in advance of a negotiated exit.

A departing member state could also unilaterally withdraw from the eurozone and/or the EU, or could even be expelled (although note that, while Greece was threatened with expulsion at Cannes in November 2011, this mechanism does not actually exist under the TEU). In each case this course of action would need to be ratified by all other 26 member states.

Consequences of withdrawal

The departing member state is likely to adopt transitional provisions to return to its local currency and may also implement exchange controls to protect its banking system and local currency.

The initial question is whether the new national legislation would allow the issuer or another party in the securitisation to treat its obligations as discharged without payment.

It seems unlikely that the validity of existing contracts would be affected. The principle of continuity of contracts, enshrined in the legislation implementing the monetary union to ensure that contracts in the currency of an acceding member state would not be set-aside following the introduction of the euro, should apply in this reverse scenario to ensure the continued validity of contracts involving entities connected to the departing member state (see Article 3 of Council Regulation (EC) No.11 03/97 of June 17 1997). The transitional provisions implemented by the departing member state are also likely to specifically endorse this principle to ensure the continued efficacy of contracts governed by the law of the departing member state.

There are a number of issues that could impact securitisations connected to the departing member state. These are analysed below.

Redenomination risk

Any local law dealing with exit from the eurozone may create redenomination risk in a securitisation.

If the issuer is incorporated in the departing member state its obligations under the Notes may be redenominated in the local currency. This may also be the case if the issuer has another connection with the departing member state (for example, the paying agent or clearing system is located in the departing member state).

Irrespective of where the issuer is incorporated, if the underlying assets (consumer loans, commercial mortgages, and so on) supporting payments of principal and interest under the Notes (the underlying obligations) are governed by the law of the departing member state they may be redenominated into the local currency, potentially leaving the issuer with a currency mismatch.

There could be an impact on other features of the transaction such as hedging or bank accounts held in a departing member state.

If the Notes are governed by the law of the departing member state and the courts of that member state have jurisdiction to hear disputes arising under the Notes, they are most likely to apply the new currency and exchange controls, in which case euro-denominated obligations would be treated by courts in that member state as redenominated into the new currency at a rate prescribed by the departing member state. Judgments of those courts could in theory be enforced throughout the EU (assuming the departing member state remains in the EU) under the Brussels I Regulation (Council Regulation (EC) 44/2001), although an affected party could seek to resist enforcement action in the courts of other member states if it is "manifestly contrary to public policy" in the member state in which enforcement is to take place. This could be the case if the departing member state had unilaterally left the eurozone.

If the Notes are governed by the law of the departing member state, but the English courts are given jurisdiction, then the English courts would be required to give effect to the law of the departing member state pursuant to the Rome I Regulation. The English courts have discretion not to follow the redenomination law of the departing member state if it is contrary to overriding English mandatory laws or if it would be manifestly incompatible with public policy (as to which see the paragraph above).

If the Notes are governed by English law and the English courts have jurisdiction, then subject to the comments below, the English courts would be expected to apply the law of the country of the relevant currency. There is a risk that even in these circumstances, if proceedings are first commenced in the departing member state's courts, the English courts would have to give effect to any judgment of the departing member state (on the basis the court in the departing member state determined that it had jurisdiction) under the Brussels I Regulation.

Where obligations in a contract are expressed in a particular currency, the general rule is that the law of the country of that currency will be applied to determine in which currency that contract should be paid. The law of the country of the relevant currency may therefore be different to the governing law of the contract.

The law of the country of the relevant currency for the euro is the EU legislation which introduced the euro and not the law of any particular member state, assuming that the relevant court recognises EU law as a distinct legal system. It is, however, a question of contractual interpretation as to which currency the parties intended to apply to their obligation when they entered into the contract.

In determining the law of the country of the relevant currency, an English court is likely to first consider the definition of euro within the contract. If it is clear from the definition or from surrounding circumstances that references to "euro" in the Notes are to the euro as adopted by the member states participating in the single currency from time to time, then this is a strong indication that the Notes should continue to be denominated in euro. If, on the other hand, reference is made to the euro as the currency of the departing member state then the Notes are at risk of redenomination.

If the euro is not defined, or its definition is unclear, the English court will also look at other factors, such as whether the parties intended the contract to be international or domestic in nature and the place of payment. The Rome I Regulation requires the governing law of a contract to have regard to the law of the country in which performance takes place when determining the manner of performance. The place of payment is the place in which the debtor is obliged to make payment and if not specified in the contract will generally be where the creditor carries on its business. If the place of payment is specified in the Notes as the departing member state, the Notes are at risk of redenomination (Adelaide Electric Supply Co v Prudential Assurance Co. [1934] AC 122).

For Notes settled through a clearing system, the place of payment will be the jurisdiction of the clearing systems (Belgium in the case of Euroclear, for example) which may be outside the departing member state. For Notes held in definitive form, payment is made to the account specified by the holders or otherwise notified to the paying agent. The place of payment could therefore be outside the departing member state if the clearing system or Noteholders are based in other jurisdictions.

Clearing the Notes does not automatically mean that the place of payment will be outside of the departing member state, however. First, the Notes may be cleared through a domestic clearing system. Secondly, even if Notes are held through a clearing system, the paying agent is likely to be located in the departing member state. Thirdly, the issuer (or a court considering the transaction) is unlikely to know in which jurisdictions the investors are domiciled. These factors could change the characterisation of the transaction from one that is international in character into one that is domestic, and increase the risk of redenomination of the Notes.

In addition to the risk of a technical redenomination of the Notes, various factors may require payment of a euro-denominated debt in the new local currency. For example, under the Rome I Regulation the choice of law (including a choice of EU law) may be overridden by mandatory rules of the place of performance insofar as those mandatory rules render the payment in euros unlawful. An English court may therefore require payment in the new local currency if payment is required to be made in the departing member state and payment in euros would be unlawful under its laws. In this case though, it should be for the English court, as a matter of contractual interpretation (rather than applying the laws of the departing member state), to determine the conversion rate at which the payment in euros should be made in the new currency of the departing member state.

Impact on underlying loan agreements

The analysis set out above will also be relevant to the underlying obligations.

If loans are made with borrowers in the departing member state, they are likely to be governed by the law of the departing member state particularly if the borrowers are consumers. It is expected that these would be redenominated into the local currency. The result of this redenomination, assuming that the Notes continue to be payable in euros, is that the issuer will have a currency mismatch.

If these loans are governed by English law, it is unlikely that an English court would redenominate them into the local currency, although in the face of exchange controls they would likely allow payment in the local currency but at market exchange rates (as opposed to those specified by the law of the departing member state).

Hedging and bank accounts

The analysis above is also relevant to derivative transactions that have been entered into with a counterparty in a departing member state and where payments are expressed to be made in euros.

Under the 2000 and 2006 ISDA Definitions, the euro is defined as "the lawful currency of the states of the European Union that adopt the single currency in accordance with the EC Treaty". This is helpful as it clearly refers to the euro as the currency unit of the European Union and not the currency of a particular member state. The governing law will generally be English or New York law and so will be outside of the departing member state unless local law is applied by a local law annex.

Given the importance of the place of payment, it is also worth checking whether the payee has specified a place of payment outside of the departing member state.

This combination of factors should ensure that redenomination of the swaps is unlikely.

This analysis is also relevant to bank accounts and guaranteed investment contracts in the departing member state. The risk of redenomination will be much higher, however, given that the account agreements are likely to be governed by the law of the departing member state.

Effect on contracts

The departing member state is likely to adopt exchange controls to make it difficult for payments (both in euros and the new local currency) to be made from the departing member state which would cause liquidity issues for securitisation transactions; in Iceland in 2010, for example, exchange controls were imposed with IMF approval. The question is whether an English court would recognise the exchange controls and what impact this could have on the analysis above.

The IMF Articles of Agreement (implemented in the UK by way of The Bretton Woods Agreement Order in Council, 1946 ((SR & O) 1946 No 36) permit the imposition of exchange controls without IMF approval in circumstances that could impact on payments under the securitisation documents. All IMF members would be required to recognise exchange controls once implemented by another member.

As a consequence, transaction documents which are "exchange contract" and in breach of the exchange control regulations imposed by the departing member state could become unenforceable pursuant the IMF Articles of Agreement regardless of the governing law of the contract. The result is that the affected contract is unenforceable and so any breach thereunder cannot be enforced by legal action.

English courts have taken a fairly restrictive view of what constitutes an exchange contract, interpreting it as an agreement to exchange the currency of one member for another. (This restrictive interpretation has been followed by the US and Belgium, although other IMF members have interpreted this much less restrictively.) It is unlikely the Notes would be construed as an exchange contract by the English courts, whereas currency swaps are likely to be.

If the departing member state sought to remain in the EU, the exchange controls would also need to be recognised under EU law. The TEU allows member states to implement exchange controls in very limited circumstances, and the departing member state would have to show that the exchange controls were justified on public policy grounds, such as safeguarding the financial stability of the eurozone (articles 63 and 65(1)(b)).

Iceland (an EEA country) is a recent European example of national exchange controls being imposed. Since the Icelandic banking system collapsed in the autumn of 2008, the Rules on Foreign Exchange (adopted by the Central Bank of Iceland) have imposed stringent controls on the cross-border movement of capital and related foreign exchange transactions, although certain exemptions apply. The practical impact of this is that creditors of Icelandic counterparties (including Noteholders in securitisations) faced restrictions on cross border cash withdrawals from foreign currency denominated accounts.

The imposition of exchange controls also came at a time when Iceland's currency had been sharply devalued as a result of the financial crisis (a fate which is likely to befall the currency of any departing member state) which adversely impacted the underlying asset values and cash-flows that supported a number of structured finance transactions

The departure of a member state from the eurozone is unlikely to directly give rise to an event of default under Notes but it may trigger a breach of one of the issuer's other obligations. In particular, if redenomination causes a mismatch between collections from the Underlying Obligations or from hedging and the issuer's payment obligations under the Notes, there could be a non-payment event of default .

Simply declaring a non-payment event of default is unlikely to increase the prospects of repayment where exchange controls have been imposed, as it may be legally impossible for the security trustee or an enforcement agent, on its behalf, to enforce in the departing member state or make payments from accounts in the departing member state.

If the issuer can make payments in the new local currency, then creditors could rely on the currency indemnity provisions or increased costs provisions to gross-up the issuer's obligations. This may cause a loss for junior noteholders and other parties at the bottom of the payment priorities.

To realign the mismatch, the issuer could (or could come under pressure from junior noteholders to) consider changing the currency of the Notes to the new local currency. Under the terms of the note trust deed this is usually an entrenched right that can only be made if approved by each class of Noteholder.

A second alternative, if the issuer is domiciled in the departing member state, is to remove the connection with the departing member state by substituting the issuer with an SPV incorporated in the eurozone. Substitution is only generally provided for in the note trust deed for tax reasons and it will not mitigate the risk if the underlying obligations remain denominated in the currency of the departing member state.

Parties could seek to avoid performance if the contracts contain force majeure or material adverse change clauses which can be construed to include a eurozone exit. Force majeure clauses provide for performance to be suspended throughout the duration of a relevant event and sometimes also allow for performance to be terminated should the event be incapable of remedy. Material adverse change clauses could apply to drawstop liquidity facility drawings. As a general rule Notes do not include force majeure clauses or material adverse change clauses. Service providers (eg servicers and account banks) often seek to include these provisions in their contracts. The clauses usually provide for the determination of what constitutes a force majeure event or a material adverse change to be made by the service provider. This places the issuer in a weak position should one of these events arise.

If there is no force majeure or material adverse change clause, or if they cannot be construed to include a eurozone exit, a party seeking to avoid performance of an English law contract could seek to rely on the doctrine of frustration. This allows for the contract to be discharged from the moment the frustrating event occurs with the parties no longer liable for future performance. The party seeking to rely on the doctrine of frustration must show that the event, which was beyond the contemplation of the parties when they entered into the contract, has made the contract radically different, illegal or impossible to perform.

A party to a securitisation transaction is unlikely to be able to rely on the contract being impossible or radically different to perform, especially where the currency of payment is redenominated into the new local currency. However, where exchange controls or other local legislation apply so as to make performance illegal in that member state, the doctrine of frustration could apply if that member state was the place of performance under the contract.

Other effects

From a practical perspective, a number of consequential changes to the securitisation documents may be required to give effect to the redenomination. First, floating rate interest provisions linked to Euribor may no longer be appropriate where the currency of a departing member state is redenominated to the new national currency. The transitional legislation implemented by the departing member state may seek to address this imbalance by amending the terms of contracts governed by local law. If the agreements are governed by English law, it is open to an English court to imply a term to give efficacy to the contract.

The departing member state is also likely to leave the Target payment system. References to Target business days in the interest calculation provisions would need to be adjusted.

Fitch recently confirmed that should a member state withdraw from the Eurozone, it would expect to withdraw the rating on any securitisation whose assets are located in the departing member state (see Ratings Under a Eurozone Country Redenomination, May 2012, Fitch Ratings). Fitch sees the devaluation risk as high, and believes that following the redenomination of the Underlying Obligations the issuer will not have sufficient euro-equivalent cashflows to continue to service interest and principal on the Notes.

Think ahead

As with many areas of business, one or more member states exiting the eurozone will have significant impact(s) on a number of securitisations. At this stage, in the absence of specific local laws on redenomination and exchange control, there is little that can be done in terms of specific actions; but it pays to be prepared. Investors, funders, originators, trustees and other counterparties may want to:

  • identify transactions connected to member states that may exit the eurozone;
  • ensure they have up-to-date transaction documents for those transactions; and
  • consider which transactions (by reason of governing law or other factors) are at great risk of redenomination.
Julian Craughan

Hogan Lovells

Julian is a partner in our debt capital markets group in London. He has extensive experience in capital markets and structured finance transactions. He has advised lenders, arrangers and originators on asset backed financings and securitizations of various asset classes.

Tel: +44 20 7296 5814

Tauhid Ijaz

Hogan Lovells

Tauhid is a partner in our debt capital markets group in London. He advises on all types of securitisation, structured debt and capital markets transactions and related restructurings in relation to a wide range of asset classes.

Tel: +44 20 7296 5221

Click here to return to IFLR supplements