Many international investment and trade transactions are built on a single, key document, such as an investment agreement, a loan agreement or a contract for the sale of goods. An issue that arises for insurers of these transactions is who takes documentation risk. In other words, who takes the risk that the underlying documents are not legally valid?
While many are quick to say that “we don’t take documentation risk,” it is often misunderstood in several ways. Generally speaking, parties (1) overestimate the level of documentation risk, including the likelihood that relevant laws will change; (2) mistakenly assume that it exists in all coverages; (3) misunderstand when enforceability issues might arise; (4) fail to spot the elements of a transaction that increase documentation risk; and (5) overemphasize ways to shift documentation risk, rather than mitigate it.
Definition of Documentation Risk
Documentation risk (also known as “enforceability risk”) is the risk that insured obligations under a particular contract are, or will become, unenforceable against the relevant obligor.
More particularly, it is the risk that either:
- an insured has incurred a loss under a contract, but cannot make a claim to the underwriter because of an exclusion from coverage if there is a legal defect with respect to the obligor’s duty to pay under the insured contract; or
- an underwriter that has paid a claim under a contract coverage will then be unable to recover against the obligor because of a legal defect with respect to the obligor’s duty to pay under the insured contract.
Examples of Documentation Risk
Consider these examples of documentation risk:
• A political risk insurer pays a claim under loan coverage for default on a scheduled payment, and then is unable to recover against the borrower because of a legal defect that was there from the outset with respect to the borrower’s obligation to make that payment under the loan agreement.
- A trade credit insurer pays a claim under trade credit coverage for buyer non-payment, and then cannot recover against the buyer because the buyer’s duty to pay under the sale contract is unenforceable due to a new interpretation of public policy in the host country.
- An ECA (export credit agency) issues non-honoring of sovereign obligation coverage for a host government guaranty of an offtaker’s PPA (power purchase agreement) payment, and then is blocked from recovery because of a defense with respect to the offtaker’s (or the sovereign’s) duty to pay under the PPA or the host government guaranty.
In each case the insurer/ECA’s recovery rights depend on the enforceability of the underlying contract against the party obligated to make the missed payment that triggered the claim.
Note that, conversely, in many insurance markets documentation risk does not arise, because the coverage is not based on any contract:
- Expropriation coverage – does not relate to a contract with the host government
- Regulatory takings coverage – arises from regulatory action by the host government, not contractual disputes
- Inconvertibility/non-transfer coverage – for these purposes, foreign exchange is a spot market, not a contract market
- Political violence coverages – the rebels and the rioters are not under contract!
- Commercial property and casualty coverages – these are asset coverages, not contract coverages
Why Documentation Risk Matters
Documentation risk matters to an underwriter. If an obligation is unenforceable it creates at least two problems: (a) it may be more likely that the obligation will not be paid, and thereby lead to a claim, and (b) if a claim is paid, the underwriter may have trouble recovering against the obligor.
Documentation risk also matters to an insured. If enforceability of an obligation is a condition to a claim with respect to that obligation, any unenforceability could bar the claim.
Scope of Documentation Risk
Any analysis of documentation risk raises a number of narrower questions and sub-issues:
- What does enforceable mean in the context of contracts and contractual obligations? Must all the obligations be enforceable?
- If not, what obligations of which obligors under what documents must be enforceable?
- What degree of enforceability is required? More likely than not? 99% probability? Absolute metaphysical certainty?
- When might enforceability issues arise? Is it enough that obligations are enforceable when documents are signed, or must they also be enforceable at a later date?
This last question, about timing, is at the core of most discussions about documentation risk.
The next section considers each of these questions in turn. Ultimately, the question is who should (and who does) take documentation risk—the underwriter or the insured…or both?
IDENTIFYING ENFORCEABILITY ISSUES
“Enforceable” means legally enforceable
To start with, everyone agrees that “enforceable” means only legally enforceable. In legal opinions this concept is often expressed as “legal, valid and binding and enforceable in accordance with its terms” (hereafter, “LVBE”).
LVBE means (more or less) that, following a breach by the obligor, the counterparty can take the obligor to court and obtain a judgment or other remedy to enforce the obligation. For example, if a borrower has failed to make a payment on a loan, a court can render a judgment against the borrower ordering it to pay.
Note that LVBE does not mean collectible. In the same example, if the lender demands payment and the borrower is financially unable to pay, and any collateral is unavailable or valueless, then the debt may be uncollectible even though it is legally enforceable.
It also does not mean practically enforceable. In the example, the pledged collateral may be difficult to locate, hard to sell, and inadequate in value to repay the loan.
Identifying specific obligations that must be enforceable
Sometimes parties discuss in loose terms whether a document is enforceable. However, the more precise issue is whether the key obligation (usually payment) under a document is LVBE against the relevant party (the payor).
These payment obligations are typically what the insurer is covering. The many miscellaneous promises that the payor makes in contract—e.g., to deliver financial information, maintain its business and assets, meet financial ratios—are of small consequence compared to nonpayment.
Degree of enforceability required
Laws and court interpretations can change.
Enforceability can never be known with certainty, because it involves prediction about future changes of law, or lack thereof, and future determinations of a court or arbitral panel.
Despite all this, the enforceability of a key obligation (such as payment) in a standard document (such as a loan agreement) against a legal entity (such as a corporation) under the laws of a commercially mature jurisdiction with a sound judicial system (New York, England, and many others) is virtually certain. Putting aside bankruptcy-related exceptions, the probability of enforceability is likely above 99%.
(The reasons for this—including restrictions on ex post facto laws, incentives of commercial centers to maintain predictability, and careful lawyering—are well beyond the scope of this article.)
When might enforceability issues arise?
One complication is enforceability issues may arise at various times during a coverage period, so that an obligation that is enforceable may later become unenforceable.
To address this, some underwriters require that obligations be LVBE at each stage of the coverage, or some combination of these:
- At document signing – obligations are LVBE at outset of transaction;
- At policy inception – obligations are LVBE when the underwriter evaluates the risk;
- At policy claim payment – obligations are LVBE when the underwriter succeeds to the rights of the insured; and
- At (attempted) recovery – obligations are LVBE when the underwriter learns if the rights that it has can be enforced.
Often there is a disconnect in the way the underwriter and the insured approach the risk. Although the underwriter is concerned about enforceability principally at the time of recovery, examination by the parties to the transaction is typically made much earlier, as of signing. This problem can be exacerbated if the policy provisions are not clear about when enforceability is tested.
For instance, depending on the wording of the policy, a representation that “the obligations are enforceable” may speak only as of inception, not as of a later date. If an underwriter pays a claim, the insured has taken the enforceability risk for the period from signing to inception, and the underwriter has taken enforceability risk for the period following inception.
On the other hand, if the policy contains a condition precedent to claim payment that “the obligations are enforceable” the insured has taken the enforceability risk for the period from signing to claim payment—but (often without realizing it) the underwriter still has enforceability risk for the period following claim payment.
Frederick E. Jenney is a partner at Morrison & Foerster LLP in Washington, D.C. This article will appear in the RW political risk newsletter in two parts: Part I focuses on an overview of documentation risk issues and on identifying enforceability issues and Part II, in the May 2016 edition, will discuss assessing, quantifying, mitigating and shifting enforceability risk.