Legal and Practical Issues in the Run-Up to the Introduction of the Euro
Dorothy Livingston and Herbert Smith
(This article represents the up-dated text of a lecture given by the author to members of the Association)
(taken from Isssue No 3 – August 1997)
A Key aspects of Monetary Union
Monetary union is currently expected to commence in 1999 or very soon thereafter. At that point, exchange rates of those Member States taking part will be fixed and the euro will be created as a currency. No euro notes will be created at this time, instead `national currency units` will continue to exist for a period of approximately three years, but as denominations of the euro and not as separate currencies in their own right. At the same time, the new European Central Bank will assume control of monetary policy in all EMU countries.
During the three year transitional phase, consumers may continue to use national currency units although businesses may choose to change their accounting systems and non-consumer trading activities to the euro. The euro will therefore co-exist with the various national currency units during the transitional phase.
The first euro notes and coins will be introduced in the first six months of 2002, during which time old national currency units will be withdrawn. This six month overlap period is intended to give consumers time to adjust to the new currency and dual pricing will operate during this time. The initial date of 1.1.2002 for the introduction of the euro notes and coins is currently under review, because of pressure from the retail sector who claim that to do so during the Christmas period would cause chaos. A consultation meeting on this issue will take place in Brussels in September and a final decision will be made at the end of this year.
2. Membership of EMU
In order to qualify for membership of EMU, Member States will have to satisfy the European Monetary Institute that they meet various economic convergence criteria. These criteria are:
- PSBR must not exceed 3% of GDP;
- Total Government borrowings must not exceed 60% of GDP;
- Inflation rates and long-term interest rates must be within 1.5 percentage points and 2 percentage points of the average of the three countries with the lowest inflation; and
- The currency must have stayed within the Exchange Rate Mechanism for a period of two years.
These criteria can be interpreted flexibly: the Maastricht treaty indicates that debts that are falling towards the target may be acceptable.
3. Control of Economic Policy
After 1999, monetary policy will be solely in the hands of the European Central Bank whilst Member States will remain, in theory, free to control their own fiscal policy. However, to help ensure sufficient fiscal stability in the euro area, Member States will be obliged to agree to a fiscal Stability Pact. The details of this Stability Pact were finally agreed at the Amsterdam Summit on 16 & 17 June. It consists of a Resolution and two Regulations. The Resolution lays down the firm commitments of the Member States, the Commission and the Council regarding the implementation of the Stability and Growth Pact and was formally adopted at the Summit.
The Regulations set out a framework for effective multilateral surveillance and contain the details of the excessive deficit procedure. The first Regulation establishes compulsory stability programmes for countries that join the single currency on 1 January 1999 and compulsory convergence programmes for countries remaining outside. The second Regulation is designed to clarify the excessive deficit procedure. The sanctions system will apply solely to single currency countries. In the case of Denmark, which has an opt-out from the single currency, the Council is not entitled to urge it to take steps to correct the government deficit. The UK enjoys the same immunity as long as it does not join the single currency. The Regulation provides for exceptional and temporary circumstances within which a violation of the reference level of 3% of GDP will not be sanctioned. These circumstances are however very precisely defined.
An additional Resolution on Growth and Employment was adopted as a supplement to the Stability Pact. This new Resolution goes some way to meeting the French concern for improving the co-ordination of the entire structure of economic policies and facilitating job creation in the EU.
B Continuity of Contract
1. Principle of Non-Revocability
`To prevent contractual parties who find themselves disadvantaged by the introduction of the single currency citing the introduction of the single currency as an event entitling them unilaterally to terminate or vary their contractual obligations`.
Identified by the Commission in its Green Paper of December 1995 as the key principle in converting to the single currency.
2. Lex Monetae and the Nominalistic Principle
Most legal systems (including English) provide that the continuity of currency obligations are determined by the law of the country which issued that currency (the lex monetae).
A debt denominated in the currency of any country is treated as an obligation to pay the nominal amount of the debt in whatever is legal tender at the time of payment, according to the law of that country (nominalistic principle).
These two principles are the starting point in ensuring continuity of contract. In order to activate them, the Member States participating in EMU need simply to pass laws converting their currencies into the euro, at specified conversion rates, or be party to a legal system, such as that of the European Community, which will do this in a way which is legally binding on them.
Frustration operates where:
`a supervening event occurs which renders it physically or commercially impossible to fulfil the contract or transforms the obligation into a radically different obligation from that originally undertaken`.
Frustration cannot be invoked:
(i) to relieve a party of an imprudent commercial bargain; or
(ii) where the parties have foreseen the relevant event and provided for it.
Under English law, frustration arises by operation of law and not by the exercise by one party of a right to terminate the contract. The equivalent concept in continental legal systems operates by one party unilaterally terminating the contract.
Furthermore, under the Law Reform (Frustrated Contracts) Act 1943 all sums paid under a frustrated contract governed by English law are recoverable by the payer, unless the recipient is able to establish that the part of the contract already performed should be severed, notwithstanding the frustration of the rest of the contract. The effects of frustration can therefore be substantial, and retrospective.
Most contracts, especially those entered into since monetary union became foreseeable, will not be frustrated. The areas where problems may arise are principally in the sphere of derivatives; especially contracts which refer to two or more participating currencies or continue for a very long time after EMU and are based on current patterns of interest rates.
4. Legal Certainty
In view of the need for legal certainty, it has been decided that an EC Regulation on the adoption of the single currency should address the issue of continuity of contracts.
Following a six month period of wide-spread consultation with organisations representing lawyers and financial institutions, the Commission adopted two draft Regulations, which were generally approved by the Heads of Government at the Dublin summit in December last year. The first one was formally adopted on 17 June.
This first Regulation is based on EC Treaty Article 235, the general `sweep-up` article which enables the European Union to enact legislation in areas which are not specifically covered by other parts of the Treaty. The quid pro quo of this general legal scope is that regulations passed under this Article must be passed unanimously by all Member States. The purpose of this first Regulation is to address all the issues of legal certainty which arise as a result of the introduction of the euro, and will have to be faced by Member States whether or not they participate in EMU. The Regulation will therefore apply in allMember States (irrespective of whether they participate in EMU). The text of the draft Regulation was approved at the Dublin summit in December and was adopted on 17 June. It came into force on 20 June, the day after its publication in the Official Journal.
The key provision of the first Regulation is Article 3, which provides that:
`The introduction of the euro shall not have the effect of altering any term of a legal instrument or of discharging or excusing performance under any legal instrument, nor give a party the right unilaterally to alter or terminate such an instrument. This provision is subject to anything which parties may have agreed.`
The second Regulation is based on EC Treaty Article 109(4) (the part specifically dealing with monetary union). It addresses the mechanics of the introduction of the euro and the transitional arrangements. Unlike the first Regulation, it will apply only in those Member States who participate in monetary union, and so can only come into force once the list of participating Member States is known.
5. Freedom of Contract
Under the EU’s stated principle of `no compulsion, no prohibition`, parties will be free to agree to provide for termination or variation of contracts upon the introduction of the single currency. The principle of non-revocability therefore should only apply where the contract is undecided or unclear on the question of continuity.
The second sentence in Article 3 of the first Regulation (see above) provides for this. Previous working drafts of this provision required that the parties specifically refer to the introduction of the single currency if they wanted to override the continuity of contract provisions.
6. Force Majeure and Change of Circumstance Clauses
A party to a contract may well claim that the parties had addressed the issue of the introduction of the single currency by the insertion of a force majeure clause. It is at this point that the principle of non-revocability conflicts with the principle of freedom of contract. The central issue in drafting the Regulation is to what extent and how specifically the parties must have addressed their minds to the introduction of the single currency in order for their agreement to override the principle of non-revocability.
The final text of the first Regulation does not require the parties to have addressed specifically the introduction of the euro in order to override the non-revocability principle. The effect is that even generally-worded force majeure clauses may potentially be invoked by a party. The courts will apply the ordinary rules of contract law in deciding whether such clauses are activated.
7. Conflict of Laws and Recognition Outside the EU
The nominalistic principle and the principle of lex monetae, having the characteristic of private international law, are generally expected to apply in most other jurisdictions, so that the euro will be recognised as the currency of participating Member States, and existing payment obligations in national currencies shall be converted to the euro at the conversion rates. The Financial Law Panel is carrying out research and encouraging the formation of working groups in Japan, Hong Kong, Singapore, Switzerland and New York to ensure that this is indeed the case. However, the same problems arise in relation to frustration and equivalent legal concepts in other legal systems. Early indications from these countries are that the position is broadly similar to that within the EU: in general, continuity should not be a problem, but further consideration needs to be given to specific kinds of contracts.
Legislation by foreign governments, possibly on the model of the Regulations, would certainly be beneficial. Early indications are that New York (which for financial contracts is the most important foreign jurisdiction) may look sympathetically on the need for legislation. Various market organisations, including ISDA, are currently engaged in putting proposals before the New York state legislature.
C. ECU-DENOMINATED OBLIGATIONS
The ECU is not a currency and so the rule that its replacement is automatically recognised by other countries does not necessarily apply.
The ECU (as presently defined) has a role separate to that of the euro. Much thought has been given as to whether the ECU should continue to exist as a separate measure of value after introduction of the euro in order to facilitate the private ECU bond market and as a unit of account within the European Union for those countries which do not participate in EMU. However, the approach taken by the Commission in the first Regulation is for a complete replacement. As provided by Article 2 of this Regulation, every reference to the ECU (as defined in the EC Treaty) is to be replaced by reference to the euro, at a conversion rate of one euro to one ECU.
The effect of this will, for example, be that the trigger mechanism in ECU bonds and loans for payment in an alternative currency in the event of the ECU ceasing to exist, will not be activated as these references to the ECU will be replaced by references to the euro.
However, the definition of the ECU as used in commercial contracts is far from universal. Many do not use the `official` definition, as set out in the EC Treaty – will these `private` ECUs also be converted into euros? The answer in almost all cases will be yes. Article 2 of the first Regulation solves the problem by creating a (rebuttable) presumption that references to the ECU without the `official` definition shall be presumed to be references to the ECU as defined in the EC Treaty.
In addition, ISDA and IPMA have issued revised wording for ECU-denominated obligations providing a new definition of the ECU to take account of the introduction of the euro as a single currency. This wording provides for payments on ECU-denominated obligations to be paid in euro from the start of the third stage of monetary union, and that in such circumstances the trigger mechanism will not be activated.
Commercially, there may be perceived differences in the value of the euro and the old ECU, despite the fact that the ECU is to be converted to the euro at a rate of 1:1. The euro will replace a small number of strong currencies whereas the ECU represented a much wider basket of currencies. The euro can therefore be expected to appreciate in relation to excluded currencies and may have lower interest rates. The economic effect of being required to make a payment in euro rather than in ECU may be significant.
Parties remain free however, to agree specifically that when the euro is introduced, their contractual obligations are to be performed in a currency other than the euro (e.g. the US Dollar) and to provide the mechanism for valuing those obligations. In the case of most existing ECU agreements this will require an amending agreement between the parties.
D ROUNDING AND NETTING
In relation to rounding, Article 4 of the first Regulation specifies that the conversion rates will be expressed as one euro in terms of each national currency, to six significant figures. The conversion rates shall not be rounded or truncated when making conversions, and the use of inverse conversion rates (e.g. the value of one pound in terms of euros) will be prohibited. Conversion from one national currency unit to another will be done via the euro unit, with the amount being rounded to at least three decimal places in euro units before being converted into the second national currency unit. As these rounding conventions are being set in the first Regulation, they will be in place very soon, so as to enable companies to make the necessary adjustments to their systems.
Article 8(6) of the second Regulation provides that national legal provisions permitting or imposing netting, set-off of similar provisions shall apply between national currency units and the euro unit.
E TRANSITIONAL PERIOD
The second Regulation will list the countries who are to participate in EMU and will provide for the replacement of their national currencies by the euro. However, while the currencies will be replaced by the euro on 1st January 1999, references in legal instruments to the national currencies will not (unlike the ECU) be automatically replaced by references to the euro. This replacement will only occur at the end of the transitional period (31st December 2001 at the latest).
As mentioned in the introduction, during the three-year transitional period `national currency units` will continue to exist, but as denominations of the euro, and not as currencies in their own right (Article 6). This is to enable, essentially for political reasons, a gradual changeover under the principle of `no compulsion, no prohibition`.
The co-existence of many different currency units does, however, throw up its own problems. Acts to be performed under legal instruments which specify the use of national currency units shall continue to be performed during the transitional period in national currency units although, of course, the parties may agree to convert payments into euro (Article 8(1) and (2)).
Furthermore, the payment of a debt may be satisfied by payment of either national currency units or the euro unit (Article 8(3)). While currency units will, by this stage, merely be rather awkward non-decimal fractions of a euro, there are clearly substantial practical implications for banks and how they intend to handle such dual payments.
F. CAPITAL ADEQUACY AND ASSET/LIABILITY MATCHING
Both capital adequacy and liability/asset matching raise a similar point: how are assets in, say, Deutschmarks, treated for the purposes of matching liabilities in, say, French Francs, or assessing the capital adequacy of a French bank? The answer in both cases should be the same: during the transitional period, both Deutschmarks and French Francs are interchangeable and fungible denominations of the euro and all assets and liabilities should be treated as euro assets or euro liabilities, notwithstanding the fact that they may be expressed as Deutschmarks or French francs. The interesting question, and which commentators are understandably reluctant yet to face, is what happens if a country participates in EMU, but bails out during the transitional period, leaving its banks and institutional investors with grossly mis-matched assets/liabilities and capital adequacy. Some investors have therefore expressed some reluctance initially to take advantage of the larger, more liquid pools of equity and debt offered by EMU until it has been shown that EMU is a success and the risks of a country withdrawing from it are negligible.
G. RE-DENOMINATION OF EXISTING DEBT
From the beginning of the transitional period, it is intended that all new government debt of participating Member States will be denominated in euro. Article 8(4) of the second Regulation enables Member States to take measures to re-denominate their existing debt. Some governments have already made this commitment, others are in the process of doing so. Private parties will be free during this period to continue to issue debt in national currencies although large international corporate entities may however chose to issue new debt in euro.
Euroclear has identified several possible ways in which re-denomination could be handled in order to avoid the undesirable consequence of having the new denominations in euro including fractional amounts. Possibilities would include exchanging national currency denominations into euro denominations plus a cash payment equivalent to odd lots, or the issuer supplementing such odd lots in order to create the nearest minimum nominal denomination.
Although much depends on the approach taken by the market to re-denomination of existing debt, there are unlikely to be major legal implications arising here. However, some amendments to company law will be necessary in order to give companies scope to re-denominate their shares in a satisfactory manner (i.e. without fractional amounts), and it can be anticipated that this will be considerably more difficult than the UK’s previous experiences of re-denomination of share capital following decimalisation.
Both Euroclear and Cedel have been undertaking work on the changes necessary in order to implement the single currency. The changes needed will largely be determined by the methods in which re-denomination of existing debt is handled. However, what is clear is that euro-denominated issues will co-exist alongside national currency issues, sometimes from the same issuer.
As mentioned earlier, Article 8(3) of the second Regulation provides that during the Transitional Period monetary debts denominated in the national currency may be paid in euros, and vice versa. The result is that the clearing houses will have to adapt their systems to receive different currency instructions, even on different sides of the same deal. Provided that the technical aspects of this can be sorted out so as to maintain a transparent system which recognises the fungibility of the participating national currency and the euro, the legal implications should be minimal.
I. NEXT STEPS FOR MARKET PARTICIPANTS AND THEIR LEGAL ADVISERS
- Review all contracts extending, or proposed to extend, beyond 1 January 1999.
- Check all definitions of ECU/E.C.U/ecu/XEU and any references to monetary union already in documents.
- Check force majeure clauses and consider whether these deal adequately with the parties’ desired intentions.
- Consider what approach to re-denomination of existing debt is most appropriate, and check what consents/authorisations are necessary.
J. OTHER ISSUES AFFECTING THE CITY
In addition to the legal implications of the introduction of the euro, as discussed in this talk, many other issues will exercise the minds of those working in the City over the next few years. The implications of the TARGET payment system have been well documented, and work is in progress in consulting practitioners on the Commission’s proposals for a Settlement Finality and Collateral Security Directive. This, along with the recent introduction of CREST and the technical problems in adapting computer systems to cope with the year `2000` mean that the late 1990’s will be just as much a time of change for the City as the Big Bang of the 1980’s.
All of these legal changes will result in the loss of old markets and the creation of new ones. Clearly the intra-European currency swaps markets will disappear and exciting opportunities will be created by a large, pan-European `domestic` debt and equity market. The UK may be an insider or an outsider. Each scenario has its opportunities. The City flourished in the decades following the Second World War as an offshore financial centre for the eurodollar market and, even if the UK initially opts out, may continue to flourish as a discrete `euroeuro` market (or `yo-yo` market as some commentators have called it). Coupled with its natural advantages of time zone and an English-speaking workforce, the City has the flexibility and the skills, legal and financial, to adapt to whatever situation in which it finds itself.
K. EFFECT ON BUSINESS
UK companies whose activities are purely domestic to the UK, both in relation to their inputs and output, will not be affected by the introduction of the euro, unless the UK is `in`. UK companies with international activities will be affected by the introduction of the euro from the outset, even if the UK is `out`. They may have overseas subsidiaries, may be involved in external trade or they may have significant treasury activities in wholesale financial markets.
Earlier this year the Hundred Group of Finance Directors published a practical guide to the introduction of the single currency, with assistance and contributions from a number of other parties.
The European Commission has published a (non-legally binding) document entitled `Accounting for the Introduction of the euro` which contains guidelines aimed at facilitating a smooth and orderly transition to the euro in company accounts. The document covers the following issues in detail:
- Exchange rate differences between participating currencies are realised as a result of the introduction of the euro, and they must be accounted for in the profit and loss account on December31, 1998. The realisation of these exchange differences will occur even if an enterprise does not change over to the euro immediately.
- Currency translation differences resulting from the consolidation of accounts of foreign subsidiaries in other participating Member States cannot be accounted for in the profit and loss account.
- Setting up provision for the costs associated with the changeover to the euro is possible only under restricted circumstances. Normally, changeover costs are to be charged to expenses in the year in which they are incurred.
- Comparative figures in financial statements must be translated into euros at the irreversibly fixed exchange rates. However, in comparing financial statements that were originally measured in different currencies it is necessary to keep in mind the historic exchange rate fluctuation between these currencies.
© Dorothy Livingston 1997