FT Alphaville " When a derivatives counterparty leaves the euro... Law firm Clifford Chance must be tired of fielding questions about what would happen to derivatives contracts should one's eurozone counterparty exit the single-currency. So much so that they've put a document together covering 20 of what we imagine have been the most frequently asked questions. FT Alphaville has waded through the legal mists, guided by Clifford Chance, to give you a bit more pedantic detail than "it depends." Question 1: If the Departing State were to leave and establish its own currency, would I still be entitled, and my counterparty still be obliged, to make payments in Euro? The answer to this hinges in part on how the country in question goes about exiting and redenominating, e.g. whether they leave the EU too. We all know we're are beyond EU Treatyland here, and that we should perhaps be more worried about tinned food if this actually were to go down, but bear with us... Isda industry gonna work together? Now, in all likelihood, trade body Isda will likely step in and issue a protocol for participants to sign that dictates how to address at least some of the problems that arise with euro-exit, where possible. That is, however, likely to take time and not preclude counterparties taking the matter to the courts, if only out of what their lawyers will tell them is an abundance of caution. Ashes, ashes, we all file suit While the Isda Master Agreements that govern derivatives contracts will specify what the relevant governing law is - most commonly New York or English law - it may well be that the counterparty in the de-euroed country tries to lodge a case in their home jurisdiction (too). That would throw a spanner in the works, and may in some cases result in the redenomination being upheld. Who files first may influence the outcome, so expect a rush of cases. Get out the dictionary Once accepted by an English or New York court though, the subsequent ruling will in part hinge on how the "euro" is defined in the contract, e.g. " (i) the single European currency or (ii) the currency for the Departing State." Clifford Chance think it's likely that the courts will go for (i) but it's hard to predict and derivatives that are designed to hedge changes in the FX rate of the Departing State versus another currency may prove even more tricky. Pay you where? All of this gets especially interesting when the "place of payment" to be made under the derivative is taken into consideration. If said place was the departing country, would an English court rule that payment should be made in euro in the Departing State when it may well be illegal by that country's laws (enacted to affect redenomination)? Maybe... but maybe not. Clifford Chance thinks it will in part hinge on whether said new laws are "contrary to English public policy." New York courts, meanwhile, are likely, but by no means guaranteed, to be more respectful: The Act of State Doctrine requires that the acts of foreign sovereigns taken within their own jurisdiction shall be deemed valid. Accordingly, if the contract were by its terms payable in the Departing State, a New York court might apply the legislation of the Departing State even if the contract is otherwise governed by New York law. Just to keep everyone on their toes, Isda Master Agreements allow counterparties to change the accounts where they receive payment, i.e. they can be moved into and out of jurisdictions, with five days" notice. That is unless the non-account-moving counterparty raises a "reasonable objection." FT Alphaville's crystal ball tells us that what constitutes a "reasonable objection" may well be challenged in the courts in the future. It's against the law A country leaving the euro isn't itself a Termination Event or Event of Default, hence contracts don't automatically close out because of it. However, there is a concept of "illegality" in derivatives agreements that might give rise to such an ending. Basically if laws are enacted in the Departing Country that make it illegal to make payments or deliveries as specified in the derivative contract, that may result in a termination. "May" because some contracts expect one or both parties to try to find a workaround, e.g. by transferring to the contract to another office or affiliate that won't experience the illegality. Next to the illegality question, expect fights concerning: Whether parties are required to continue to perform under the contracts while the illegality exists, and whether such obligations are merely deferred or extinguished. How contracts are valued upon a termination event, should it not be possible to get around the illegality. Events of default If the company fails to pay, then it's obviously an Event of Default. The slightly more subtle point is that it isn't necessarily a default if the counterparty makes a payment in the new currency that can be converted to an amount of euros that does cover the full payment. The obligations of counterparties when one of them is experiencing an Event of Default of Potential Event of Default is something that has been challenged in courts with some frequency. So much so that Isda is looking at redrafting it. Basically this concerns how much you can get away with, in terms of acting to your own maximum advantage, if your counterparty has defaulted. Quickfire round Good luck getting a remedy if the counterparty in question doesn't have assets outside the Departing State... If the counterparty is the sovereign state itself, they may have immunity. Oh, and you can forget about being able to net payments. There may also be changes to calculations involving "local business days" since the Departing State may well need a few extra bank holidays to get the redomination ball rolling. Additional legislation may be passed by the Departing State to manage the anticipated wave of insolvencies, which may involve unfavourable exchange rates being applied to claims. Some collateral posted according to support agreements may cease to be eligible if subject to redenomination. Uncertainty reigns Are we having fun yet? Clifford Chance concludes with some understatement... The accompanying economic difficulties would give rise to severe and untested eventualities. Followed by something that clearly comforts them more than it comforts us: However, understanding the applicable contractual framework for financing and derivatives transactions provides greater certainty at a time of market turmoil. Well, we're "certain" that this will be a legal train wreck, and that's about all we're confident about. Related links: The Eurozone Crisis and Derivatives - Clifford Chance Clifford Chance Advises Swaps Users On Possible Euro Break-Up - WSJ Guest post: Thinking the unfolding - the break-up of monetary union - FT Alphaville The legal aspects and abstractions of a euro redenomination - FT Alphaville Mechanics of a euro breakdown - FT Alphaville This entry was posted by Lisa Pollack on Monday, January 23rd, 2012 at 12:54 and is filed under Capital markets. Tagged with derivatives, euro, Euro redenomination, eurozone sovereign debt crisis, isda, swaps.