European Union: Withdrawal From The Eurozone: Implications For Global Markets

Last Updated: 14 February 2012

The cloud of uncertainty hanging over the European Union ("EU") and the future of the European single currency (the "Euro") was exacerbated on a day which historians may yet consider one of the unluckiest Fridays on record.

Alongside the grounding of the Costa Concordia cruise ship, on 13 January 2012 the EU's economic stability was further challenged by Standard & Poor's decision to downgrade the long-term credit rating of nine of its members. The growing concerns regarding the mounting debt levels within the Eurozone has led to much speculation that a number of vulnerable Eurozone Member States ("EMSs") may soon default. The combination of the European Central Bank ("ECB") being unable to accept a reduction on its own sovereign debts and private creditors being loath to accept deeper losses, has brought the risk of default into stark focus.

The Eurozone is finding itself in uncharted territory and the (once thought to be) "nuclear option" of a EMS defaulting and returning to its previous currency is now being considered as a viable measure to alleviate financial woes for the Eurozone as a whole. Regardless of such considerations, should a EMS fail to agree a suitable repayment package of its debts EU policymakers may be left with no other option but to expel them from the Eurozone. This note examines how a EMS's potential departure from the Eurozone might be engineered, the potential consequences and the steps companies might consider to protect their interests.

Mechanism for leaving the Euro

A significant challenge is the fact that there is no mechanism within EU Law for a member state to do so – voluntarily or otherwise. Despite the viability of a "one size fits all" currency being challenged long before the Maastricht treaty, it now means that there is much uncertainty as to how an exiting EMS would revert to its original currency. The legal position is that whilst withdrawal from the EU is a right of member states under Article 50 of the Lisbon Treaty (the "Treaty"), there is no equivalent right of exit from the single currency. In September 2011, following rumours that Germany and the Netherlands were considering exiting the Euro, the European Commission insisted that no member of the Eurozone was legally entitled to withdraw. In the absence of prescriptive legislation it is uncertain as to whether a EMS would be able to withdraw from the Euro without also having to leave the EU too.

Article 50 of the Treaty provides that upon receipt of a notification to withdraw, the EU is to "negotiate and conclude an agreement with that State, setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union". Where the exiting EMS and the EU cannot come to an agreement, withdrawal would take effect two years after notification. Should the exiting EMS choose to unilaterally withdraw from the EU it is not clear whether any legal redress would be open to the EU, although such a move might damage any future ambitions to re-apply for membership once its economy has stabilized... Although such political ramifications will be of concern to an EMS that withdraws from the Eurozone, it is the colossal financial implications that are likely to accompany any exit that will be of greater concern to businesses globally.

The likely fallout from withdrawal

As there is no precedent for a EMS exiting the Eurozone, any predictions as to the impact must necessarily be speculative. However, there is a consensus that the likely effects will be both bleak and widespread.

There is wide-scale uncertainty as to how an exiting EMS might redenominate all of its domestic bank deposits. Choosing not to do so would inevitably result in its new currency being simply a chimera, therefore inhibiting the EMS's ability to trade, however by opting to redenominate it runs the risk of its domestic banking system collapsing. As reversion would inevitably result in significant depreciation in the new currency's value – some analysts estimating as much as 80% against the Euro – those with exposure to the exiting EMS's banking system would seek to withdraw money immediately, making a run on these banks inevitable. Furthermore it is not clear whether redenomination would simply be applied to monies held by domestic citizens or more widely to monies held by foreigners in all currencies. Such uncertainty poses serious dangers to an exiting EMS's hopes to restore its economy. Whilst a number of measures to protect an exiting EMS's banking systems have been mooted, such as capital controls on the new currency's value and limiting deposit withdrawals, it is evident that the future of the exiting EMS's economy would be precariously balanced.

Given the logical assumption of a devaluation of the new currency, a likely run on the banks and (with an increase in prices of imported goods) a surge in inflation, there are other concerns around the potential for widespread political unrest in the exiting EMS. For those companies that trade with businesses from an exiting EMS, or which have operations in that country, significant business interruption would be expected.

Currency considerations

Under English law the parties to a contract are free to select a particular currency of payment. If a company sells goods to an exiting EMS and the parties select Euros, what is the impact on them if the country leaves the Euro? The answer is critically important should, as is likely, the new currency rapidly devalue against the Euro: one of the parties will be substantially worse off. If payment remains due in Euros but the buyer's cash reserves have been converted to the new currency or its income now comes from that currency there is a heightened risk of insolvency. Alternatively the seller will suffer if the contract price is converted to new currency at the official exchange rate. Runs on the national banks may also mean that businesses in the exiting EMS cannot access their own funds, and will have little opportunity for locally sourced credit, potentially pushing companies further towards insolvency.

Any redenomination of contractual payments due from a company in an exiting EMS would be subject to the legal principle of "nominalism". This internationally recognised principle provides that where a monetary obligation is stipulated in a particular currency, an implied choice of law of that currency's country – the "lex monetae" – determines the currency to be applied. However, applying this to the Euro will create complexities since the Euro – established under European law and implemented under the national law of each EMS - is not the currency of one particular country. As historically the principle has been applied with reference to the currency of the particular country it is not certain how the courts will deal with this unprecedented scenario, although an implication is that a court is likely to uphold that a contract can be redenominated to the exiting EMS's new currency. As the lex monetae in the context of contracts with companies from an exiting EMS will be identified by reference to the intentions of the contracting parties at the time that the contract was entered into, if the exiting EMS were to leave the Euro unilaterally this could complicate the analysis, because this could be viewed as contrary to European law.

Where all aspects of a contract (parties, performance, etc) are based in the exiting EMS and the governing law of the contract is that of the exiting EMS too, Euro-denominated payment obligations would be expected to be redenominated into its new currency. However, where the contract has an international element it will be for the courts to determine whether Euro-denominated payment obligations are to be redenominated (and the answer may depend to some extent on which country's courts decide the issue). Some of the factors which the courts may take into account when interpreting the lex monetae of the contract are:

  • The governing law of the contract;
  • Place of payment/performance;
  • Status of the debtor (public or private?);
  • Course of dealings between the parties, in particular relationships between parties which pre-date the exiting EMS's entry into the Eurozone;
  • Place of residence/incorporation of counterparty; and
  • Location of counterparty's assets.

In any event there is the real risk that, in order to protect its economy and new currency, the exiting EMS may be forced to impose exchange control restrictions on any payments out of the country in its new currency. Under the terms of the Treaty, member states are constrained from imposing capital and exchange controls. However, should the exiting EMS also depart from the EU, subject to the terms of any possible withdrawal agreement, its government would be able to introduce such measures to protect its economy. Therefore, even should member states' courts determine that the lex monetae of contracts is in Euros, any such payment may be illegal under the exiting EMS's law. This could conceivably mean that an illegality defence could be raised which make the contract unenforceable.

Furthermore, it might prove to be impossible to enforce a judgment for non-payment and/or to enforce any guarantees or security against a party's liability. Under the Brussels Regulation (EC Regulation 44/2001), there is reciprocal enforcement of judgments amongst member states, however should a EMS also depart from the EU and implement monetary restrictions it is foreseeable that its courts would be prevented from recognising or enforcing any judgments which are not in its new currency. This could have serious consequences for those companies that have, for example, security over assets in the exiting EMS, a Letter of Indemnity ("LOI") with an exiting EMS bank or a relevant parent company guarantee.

Contractual protection

English law stipulates that a contract, once made, must be performed and parties are hence legally bound. An exception to this rule is the doctrine of frustration, however in this potential scenario it would appear that a contract would not be frustrated by a contracting party's country withdrawing from the Euro. It is clear that several elements of the five-part test to invoke the doctrine of frustration would be unlikely to be satisfied. For example, it must be shown that, as a result of the change in circumstances, performance of the contract in accordance with its stated terms would be unlawful or impossible, or would otherwise be radically different from that contemplated by the parties when the contract was originally made. It could be argued that there would be no radical change in the nature of the payment obligation since the new monetary law likely to be imposed by the exiting EMS will set out the substitution rate at which the Euro obligation is to be paid. In any event, if the substitution of the new currency renders performance more expensive, this is not necessarily a basis on which frustration can be invoked (Davis Contractors Ltd v Fareham UDC [1956] AC 696 (HL)).

Steps to consider

In light of the potential ramifications of the withdrawal of a EMS from the Euro, there are a number of measures which should be considered by those entering into contracts with companies located in vulnerable economies:

  • Denominate the contract in a currency other than the Euro, such as US Dollars or UK Sterling.
  • If the Euro is selected, insert language to the effect that any references to the Euro are to the currency of the Eurozone from time to time.
  • Alternatively insert clauses which require the parties to consult and agree upon amendments to currency exchange provisions should the EMS withdraw from the Euro and/or the value of the Euro falls below a certain exchange rate (compared to the US Dollar for instance).
  • Add a term to the effect that each party waives any right under the applicable domestic law to satisfy payment in any currency not specified under the terms of the contract.
  • Ensure that suitable restrictions on assignment/novation of rights and obligations are in place and that force majeure/Material Adverse Change ("MAC") clauses are drafted in a manner which specifically deal with the possibility of a EMS's withdrawal from the Eurozone.

This is the first in a series of papers and talks on the Eurozone and the implications for global business which we will be circulating.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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