The International Financial Market in the 21st Century - Essay Example

The International Financial Market in the 21st Century Part A The growth of the international financial market in the 21st century is so staggering that it has reshaped the global capital markets. International finance involves cross-border capitals flows brought about by financial transactions between entities originating from different legal jurisdictions. The primary issue in such kind of transactions is the absence of a single international law that could govern them considering that there is no international body that is tasked with legislating laws applicable to cross-border transactions. This is what makes international finance a particularly risky business. To protect themselves against these risks, parties to international transactions, especially the lenders, should take it upon themselves to ensure that the eventuality of disputes in the future will not catch them off guard by conducting extensive assessment of potential risks attached to the transaction in the early stage of the documentation of the transaction and protecting themselves by adopting well-thought out strategies to eliminate or at least minimise those risks. Roger McCormick (2007) defines legal risk as chiefly referring to the risk of loss when the document evidencing the transaction subsequently turns out not having the same legal effect as the parties intended it to be or when either or both parties institute adverse claims. Moreover, insuring protection against legal risk is difficult considering that most of this type of risk, such as credit risk, currency rate and interest risk, is volatile as well as usually brought on by the parties themselves. 1 The legal aspect of international finance is concerned with the assessment and identification of these legal risks, quantifying them and developing strategies that would completely eliminate and if not, at least minimise, them. Table 1 Risk in International Finance 2 In assessing the risk of lending to an entity with cross-border operations, the first step is to identify the risks that such entity is involved. Table 1 summarises the general risks entailed in conducting international financial transactions. These risks are categorised into firm-specific risks, country-specific risks and global-specific risks. Firm-specific risks refer to the risk of loss resulting from the company’s structure as an operating business and country-specific risks are those endemic in a particular country because of its political, social, and legal structures. Global-specific risks, on the other hand, are those that are attached to forces operating on a global scale that may interrupt business operations such as terrorism. 3 The roles of these risks in the legal aspect of international finance is their general potential to cause business disruption and subsequent losses to business operations that may alter contractual terms between parties who had previously entered into a contract of loan to finance a business operation in a territory outside of the state of the lender. In the example of the Oceania International and Lehman Wrecker proposed transaction, the risk of lending to the former by the latter can be first assessed by looking into the risks covered by Fig. 1. The loss or losses that Oceania International might incur if any of the risks enumerated therein materialises will necessarily affect the agreement between the two considering the possibility that Oceania International might not be able to meet its obligation of paying its loan. Of all the risks that a lender faces when lending money to an entity conducting business operations outside of the lender’s state country risk is the most significant. Country risk has become so important in the conduct of international finance that according to Hoti and McAleer (2002), various country risk rating agencies, such as the Economist Intelligence Unit, Euromoney, Institutional Investor, International Country Risk Guide, Moody’s, Political Risk Services and Standard and Poor’s, have recently surfaced. Specifically, country risk refers to the probability that a country that has made a cross-border loan will not subsequently be able or will be unwilling later on to pay its debts. Country risk assessment is the appraisal of the risk involve in lending to a foreign borrower by appraising the economic, political and financial factors as well as the interaction of these factors that are particularly associated with a specific country. The purpose of this assessment is to anticipate the possibility of debt repudiation, default or delays in the payment of loans and adopt legal strategies that will eliminate or minimise their impact in the event they materialise. 4 The identification of all the risks, discussed in the previous paragraphs, which may potentially hamper international finance contracts, is important so that the parties to it can adopt strategies to eliminate or at least, minimise them. Examining closely the local law of the place where the project is located, especially if the latter is located in an emerging economy or in a region whose municipal laws are not well developed, is important during the stage when the contract is being crafted or documented. In most emerging countries, laws are not well-developed as that of highly industrialised countries and this factor could affect the stability of the business environment. Specific factors such as “access of foreign entities to the judicial system, enforceability of foreign judgments, whether arbitration is permitted for dispute resolution, and enforceability of decision awards” 5 should be determined of existing in such countries to ensure that its judicial system are friendly and open to the judicial systems of other countries in the event a judgment issued in the latter needs to be reinforced in the former. Hoffman (2008) suggests the legal options that must be taken into consideration when entering into international financing, which include among others: choice of law; agent for process and submission into consideration; dispute resolution; fees, approval and filings; legal expertise and experience; general business law and regulations; waiver of sovereign immunity, and; legal culture. The choice of law refers to the law that the contract parties choose and identify in the facility instrument as the governing law that should govern the contract in the event of a dispute. The sovereign law of the jurisdiction of the project’s location, according to Hoffman, seldom gets to be selected by parties, but most opt for either London or New York. This is because these two jurisdictions are deemed to have comparative more settled commercial laws and legal precedents. In any case, the law of the local sovereign still need to be scrutinised to determine if it is likely to enforce the parties’ choice of law. 6 Nonetheless, parties may choose public international law to govern their contract instead of municipal law or the court itself may imply the “principles of law recognised by civilised nations,” when the chosen law itself is inadequate to resolve the dispute. In Petroleum Development (Trucial Coast) Ltd v Sheikh of Abu Dhabi, 7 the Court applied the aforesaid principle to interpret and apply oil concession because of the lack of coherent contractual rules on concessions by the Islamic municipal law. Another important strategy is the appointment beforehand of an agent to serve the function of serving processes in the lender’s country as well as a provision in the contract facility where the borrower agrees to submit itself to the jurisdiction of the courts of the lender’s country. Moreover, some jurisdictions where projects financed by foreign lending have additional requirements imposed on the borrower under financing agreements. This includes registration in various agencies of the government such as loans registrations. These various requirements need to be looked into especially if the failure to comply results into the voiding of the loan transactions or the unenforceability of the collateral agreements. The lack of expertise and experience of lawyers and judges in the host country may also hamper international financial agreements because of potential issues in the proper and fair adjudication of disputes that may arise between the parties. Thus, there is a need for parties, especially the lender to take a keen interest in this factor to ensure that it will not be legally shortchanged in any eventuality. In addition, parties need to examine the general business law and regulation that protects business operations in the host country such as those related to Intellectual Property Law, competition and other forms of protection offered to businesses to ensure that it offers the best possible business environment. Finally, when a financial transaction involves a sovereign or is controlled by a sovereign or partially affects a sovereign, it is important that parties, especially the lender requires a waiver of sovereignty clause in the facility instrument to ensure the prevention of the application of sovereign immunity from hampering any suit in the event of a dispute later on. Sovereign immunity is a doctrine that precludes a party from bringing an action against a sovereign unless the latter gives its consent. 8 The various and many risks attached to cross-border financial transactions upset the predictability that many contractual counterparties ideally want to be present in their contracts. This, according to Buchheit (2007), is even more important than the result produced by the application of the governing law in a dispute because if the parties are able to predict the outcome they can adopt various recourses such as adjusting its terms, change the governing law, or completely abandon the agreement. Thus, in entering into an international financial agreement, most parties naturally opt for a legal regime that will provide them the most predictability. Between the borrower and the lender, it is the lender that is most affected by the choice of the legal regime considering the “asymmetrical” nature of the transaction where he is obliged to produce the money first and the lender’s obligations come much later after that. 9 In choosing the legal regime that should govern international financial transactions, Buchheit (2007) believes that common law systems, such as those offered in the US and the UK, can give the most assurance that in the event of any dispute later on, enforcement of obligations or an award of fully compensatory damages can be had. Nonetheless, the ability of common law judges to apply common law doctrines that essay fairness and justice may still prevent a strict interpretation and enforcement of the contractual terms, according to Buchheit (2007) because of the possibility that subjectivity may find its way into the maneuvering space allotted to the judges by virtue of such doctrines. 10 Part B a) International lending, like all other conduct of international business, entails risks. The proposed loan by Oceania International, a subsidiary of a foreign holding based in Oceania, is likewise fraught with risks. There are three types of international lending risks: credit risk; country risk, and; currency risk. Credit risk is the possibility that a “borrower or counterparty will fail to meet its obligations in accordance with agreed terms.” 11 Country risk, on the other hand, refers to risks that are political in nature and stems from governmental actions involving economic policies as well as other political developments such as wars. Finally, currency risk is economic in nature and refers to the volatility of exchange rate and currency depreciation and appreciation. This kind of risk also includes restriction of fund movement from one country to another. 12 In the present case, the applicant debtor is the Oceania International, which is based in the UK, and is a subsidiary of Oceania Holding based in an island in the Indian Ocean. Subsidiary companies are independent from parent companies and have juridical personalities of their own apart from their parent companies and are therefore liable only for their own debts and liabilities in accordance with the principle of limited liability of corporations. Under s. 1159 of the Companies Act 2006, a subsidiary of a holding company is one, which, in relation to a parent company, has the following: a majority of the voting rights; the right to appoint and remove most of the members of its directors, or; controls alone in accordance to an agreement with such subsidiary, a majority of the voting rights. 13 Parent companies can only be held liable for the debts of its subsidiary under the principle of lifting the veil of incorporation if it is shown that the latter has acted as a shadow director of the subsidiary or if the subsidiary is shown to have acted as an agent of the parent company and that the debt is actually the debt of the parent company. 14 This dictum was likewise essayed by the Court in the case of Re Southard & Co Ltd, 15 where it held that if a subsidiary company becomes insolvent the parent company and its other subsidiary companies are unaffected by it and may continue enjoying their prosperity. Technically, therefore, Oceania International is independent from its parent company and should be liable only for its debts without that liability attaching to the latter and Lehman Wrecker cannot hope to claim from the parent company in the event Oceania International defaults in paying its debt. Lehman Wrecker should protect itself from the eventuality of the risks previously discussed by including in the contract certain covenants that should anticipate changes in the condition in the business environment as well as Oceania International’s capacity to pay. In addition, it must require certain security such as government guarantee, bank guarantee or mortgage on assets to add protection to the credit. According to Apte, these covenants can be broadly classified into: those that protect it from adverse regulatory changes or circumstances, also called reserve clauses; those which are designed to protect it from the possibility of default, such as cross-default clause, pari passu clause and the negative pledge, and; those that are intended to lessen funding risk, such as the “subject to availability” clause, which protects the lender from being compelled to issue in a specific currency previously agreed upon when its access has subsequently become limited. 16 b) In the present case, the loan contemplated by the parties can be characterised as medium term loan because it involves a maturity period of 5 years. Some of the clauses that may be included in the documentation of this type of loan are: change of circumstances; the Eurodollar disaster clause; sovereign immunity; governing law and jurisdiction; cross default; material adverse change; notes, such as promissory notes; financial covenants and ratios, and; negative pledge. A material adverse change clause or MAC, for short, is an inclusion in the contract between a buyer and seller or between creditor and borrower that allows either party to back out of the arrangement once an unforeseen event occurs that renders the same arrangement to a party prejudicial. An example of this type of clause is the WPP and Tempus agreement where the former attempted to withdraw from a prior agreement using the September 11, 2001 terrorist attack in the US as the material adverse event as a prejudicial basis. 17 In the English decided case of BNP Paribas SA v Yukos Oil Company, 18 a syndicate of banks accelerated the payment of a loan incurred by a Russian oil company under a MAC clause in the contract that allowed it to do so in the event of the happening of a MAC, which in that case was determined to be the arrest of its CEO, the fixing of its tax liability by the Russian government and the freezing of its assets, The Court upheld the banks’ acceleration move. Applying the MAC clause to the present case, Lehman Wrecker can include this clause to ensure that any event that takes place even before the consolidation of the agreement or subsequent to it that changes things adversely for the lender should gives it a basis to abandon the agreement or institute measures to ensure that the debt be paid such as an acceleration of the payment. To prevent any challenge on the term “materially adverse” the instrument must specify and explain the term.19 Likewise, there must specific details as to who should make a determination of the occurrence of a MAC and a potential adverse effect that will jeopardise the payment of the debt to the lender such as the circumstances surrounding the operation of gold extraction in Oceania, the ability of Oceania International to pay its loan and the validity, legality and enforceability of the facility documents. Closely resembling MAC, a change of circumstances clause in the facility instrument allows the party to vary or renegotiate the agreement upon the occurrence of certain events that could materially change the basis of the agreement. An example to this is the Ghana and Shell Exploration Agreement in 1974 where the instrument included a clause that parties are allowed to negotiate and modify the terms of the agreement if changes in the financial and economic circumstances relative to the petroleum industry occur that would fundamentally affect the basis of the agreement.20 In the present case, the agreement between Lehman Wrecker and Oceania International can likewise include this clause to the effect that any change in the circumstances pertinent to the gold extraction activities of the company in Oceania that would materially alter the economic and financial basis of the agreement should be a basis for the renegotiation for the purpose of modifying the terms of the agreement. A sovereign immunity clause entails a waiver by a state of its immunity from legal proceedings and enforcement that may be instituted by the other party to the agreement. A typical example of this clause is as follows: “The State irrevocably waives all immunity to which it may be or become entitled in relation to this agreement, including immunity from jurisdiction, enforcement, prejudgment proceedings, injunctions and all other legal proceedings and relief, both in respect of itself and its assets, and consents to such proceedings and relief.” 21 In the present case, Oceania International’s parent company is partly owned by the state of Oceania and a sovereign immunity clause may just be the right clause to include for the purpose of ensuring that it cannot invoke state sovereignty in any of possible proceedings against it. The basis for waiver of sovereign immunity in the English law is Thai-Europe Tapioca Service v Government of Pakistan, The Harmattan [1975] 1 WLR 1485 at 1491F where Lord Denning remarked that a foreign government which enters into a commercial agreement with an ordinary trader must abide by his obligations under that agreement like ordinary traders, otherwise; it shall be subjected to the same sanctions and laws as others. The governing law and jurisdiction clause set out the national law that shall govern the agreement including its interpretation and which jurisdiction the parties shall submit themselves to in the event a dispute arises as a consequence to the agreement.22 In the present case, it would be wise for the Lehman Wrecker to insist that the English law and jurisdiction should govern both the agreement and any subsequent cause of action relative to it to protect itself. A cross default clause allows the lender to accelerate the maturity of the borrower’s payments in the event that the latter has defaulted in its debt to another creditor. The underlying rationale for this clause is for the lender to get payment first before the other lender can file any action against the borrower. 23 Lehman Wrecker can use a clause like this to secure payment of its loan to Oceania International and protect itself from being defaulted by the latter after it will be compelled by another creditor to pay its debts to it. In the alternative or in conjunction with a cross default clause, Lehman Wrecker can also include the pari passu clause, which simply refers to a term obligating the debtor to honour its debt to a financier in the same level of priority as it does to its other loans. The implication is that the borrower must treat all debtors alike and should not grant special privileges to just one or some of the creditors. 24 According to Buchheit and Pam (2003), the pari passu clause has four implications: it serves as a legal basis to ask the court to impose specific performance; it serves as a legal basis to ask the court to prohibit a third party from accepting payment from the debtor until after it has been determined that it is in accordance with the pari passu clause; it may serve as a legal basis to ask the court to issue an order against a third party financial intermediary to freeze any payment not done in accordance with the pari passu clause and to give it to a creditor with a pari passu clause protection, and; it serves as a legal basis for a protected creditor to go after a third party creditor who has received and accepted payment knowing that the same is covered by a pari passu clause. 25 One of the well-known pari passu cases is that Elliott Associates v. Banco de la Nacion and the Republic of Peru 26 where the Brussels court granted an injunction against the government of Peru at the behest of Elliott to prevent Euroclear from accepting payments from two banks under the pari passu clause. Elliott previously purchased debts from two Peruvian banks, but subsequently the Peru government restructured the banks’ debts, which Elliott refused to participate in. After a NY court granted it the full face value of loans plus interest, Elliot, instead of enforcing the judgment in Peru, filed for an injunction in Brussels. After succeeding in Brussels’ CA, the Peruvian government, which was pressed for time as the deadline for payment of restructured debts was fast approaching, was compelled to pay Elliott the amount of the award. The pari passu clause is therefore, a significant inclusion in the Lehman Wrecker facility instrument to ensure that it gets equal treatment with other creditors of the debtor. The negative pledge clause, on the other hand, refers to a clause that prohibits the debtor from pledging any of its assets as collateral to other creditors without offering them to the financial institution except when such assets are newly acquired and were still not in existence when the loan was obtained.27 In conclusion, Lehman Wrecker can include several clauses in the facility agreement to protect itself as a creditor against credit risks, currency risks and other forms of risks that may jeopardise the payment of the credit. These clauses may be classified into clauses that protect it from changes in regulations and conditions that will have adverse effect on the credit, clauses that protect it from defaults by the borrowers, clauses that reduce funding risks. 28 c) Oceania International Portfolio References: Apte, P.G. (2008) International Finance. Tata McGraw-Hill Education. Aswathappa (2010) International Business 4E. 4th Edition. Tata McGraw-Hill Education. 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