ASSESSING AND QUANTIFYING ENFROCEABILITY RISK
How Can Enforceability Risk Change After it is Determined Initially?
So a key question is: what evidence regarding enforceability at an earlier stage is the best predictor that an obligation will be enforceable later, when it counts?
To put it another way, given a typical transaction, what are the chances of a documentation risk arising that impairs recovery by the underwriter against the obligor?
The good news is that, in general under most established legal systems, enforceability can be determined at the outset (i.e., at signing) and is highly likely not to change over time.
Of course, this sort of good news is of limited comfort to most risk-takers, because “highly likely” means that enforceability could change upon certain events or if the status of the obligor changes, and that it might change if the law regarding enforceability of certain obligations changes.
Unfortunately, there is no precise way to quantify the likelihood that a given obligation will become unenforceable. However, there are some warning signals.
Specific Elements that Might Increase Enforceability Risk
Here are some of the elements of a transaction that are likely to increase documentation risk and impair enforceability. In most cases, there are ways to mitigate the risk. (On the other hand, contracts and obligations free from these sorts of elements are very likely to be enforceable—see box.)
Obligor is a Governmental Entity. If the obligor is a sovereign, sub-sovereign or other government entity, it may have sovereign immunity from suit, or from attachment of its assets. This can be mitigated by getting an express written waiver of immunity.
Obligation is a Guarantee. If the obligor is guarantor that is guaranteeing the underlying obligor’s payment, the guarantor may have defenses to payment that are separate from (and in addition to) the underlying obligor’s defenses. For example, if key terms of a loan are changed without notice to the guarantor, it may release the guarantor from its obligations. This can be mitigated by confirming that the guarantee includes standard waivers of guarantor defenses.
Sensitive Subject Matter in Contract. Some types of contract provisions are not reliably enforceable for host country public policy or other reasons. For example, a big interest rate increase upon a payment default may run into usury limits, or a high pre-set liquidated damages amount may be viewed as an impermissible penalty. Mitigating these problems requires a case-by-case review.
Sensitive Industries. Host country courts and arbitral panels may be more reluctant to enforce agreements relating to certain industries, such as arms sales to foreign governments, gambling, or international adoptions. Mitigating these problems requires a case-by-case review and an understanding of the public policy of the applicable country.
Sensitive Countries. The enforceability of obligations against obligors in certain countries may be limited by international sanctions against that country. Recent sanctions regimes against Iran and Cuba are good examples.
Impact of Local Law of Host Country. Host country law (1) may impact obligor organizational (e.g., corporate) formalities, and (2) if elected as governing law, may limit the enforceability of obligations. This can be mitigated by legal due diligence and consultations with local counsel regarding specific issues.
Dispute Resolution By Arbitration. Arbitration is notorious for producing less predictable results than litigation because, among other reasons, there is no appellate review system or principle of stare decisis. If a dispute regarding enforcement of an obligation is subject to arbitration, the arbitrators may consider factors (such as fairness and equity) that would not be part of a judicial review of enforceability. This is why loans and other purely financial transactions are rarely subject to arbitration.
TranslationRequired. If contract enforcement requires that documents be translated, for example from English into the local language in the host country, important contractual concepts can be literally lost in translation. This can be partially mitigated by drafting documents in the local language and then translating them into English—and mitigated even further by an agreement that the local language version is the binding translation from the English.
|Is There a Safe Harbor?
While no contract is entirely free of enforceability risk, a hypothetical transaction with the following characteristics would likely not pose significant enforceability risk or problems:
Legal Opinion as Risk Identifier
Given the consequences of unenforceability, it sure would be handy to have a list of documentation risk issues for the key obligations in a transaction.
Actually, such a list often exists. The standard legal opinion regarding the enforceability of key obligations of a key obligor, called an “enforceability opinion,” invariably has a long list of exceptions and qualifications to enforceability of those obligations.
Some of those exceptions are well-known and untroubling to most readers, such as the common bankruptcy exception:
- “[This opinion is qualified by] the effect of bankruptcy, insolvency, reorganization, arrangement, moratorium or other similar laws relating to or affecting the rights of creditors generally.”
Other enforceability opinion exceptions—typically regarding developing countries with developing laws and legal systems—are more hair-raising:
- “In many cases, applicable laws, decrees, regulations, orders, and other governmental pronouncements are often vague, inconsistent, or unclear. In addition, applicable laws and regulations undergo frequent change, as do governmental interpretations thereof. We express no advice regarding future changes or interpretations of such laws and regulations.”
- “In common with other emerging markets the exercise of the courts may result in decisions or circumstances which are inconsistent with decisions which may reasonably have been expected to be made. We express no opinion as to the observance and compliance by host country authorities with their respective legal obligation.”
- “So far as we are aware host country courts have not had to consider any commercial agreements similar to the Agreement. We express no opinion as to how those courts would interpret or enforce the Agreement.”
Parties are well advised to work with their lawyers to understand what these exceptions and qualifications really mean.
However, note that legal opinions speak only as of the date they are issued; most opinions expressly disclaim anything to do with future law.
MITIGATING AND SHIFTING ENFORCEABILITY RISK
A review of documentation risk also raises the broader questions inherent in any risk analysis: How can the risk, once identified and quantified, be effectively mitigated or shifted?
Relative Benefits of Shifting vs. Mitigation
Too often the parties dealing with documentation risk focus only on ways to shift the risk. As noted above, typical methods include:
- Representations in a political risk insurance policy that the documents are “legal, valid and binding and enforceable in accordance with its terms” (“LVBE”) (at some point in time), coupled with provisions that bar a claim if any representations are untrue.
- Covenants in an ECA guarantee to maintain documents as LVBE (over some period), together with provisions that negate coverage if a covenant is breached.
- Exclusions or conditions to a claim in a trade credit policy that at the time of the claim the documents be LVBE.
As always, a better approach than arguing about who should take a risk is to reduce the risk itself. Happily, most of the typical mechanisms for mitigation work well for parties dealing with documentation risk.
For example, a political risk insurance policy of an investment agreement may require that the insured provide a copy of the host government decree authorizing it. Similarly, a trade credit insurer may conduct its own due diligence on the trade rules of the host country.
Surprisingly, though, one of the best mitigants for documentation risk is often overlooked. Legal opinions are not only one of the best methods for identifying documentation risks, as discussed above, but they also indirectly reduce those risks. Many of the issues identified during due diligence process for a legal opinion are small errors that can be readily fixed, and thereby can materially lower documentation risk.
Frederick E. Jenney is a partner at Morrison & Foerster LLP in Washington, D.C. This article is the second half of a two-part series. Part I of the article, published in the November 2015 edition of the Newsletter, focused on an overview of documentation risk issues and on identifying enforceability issues.