Local law risk: Overriding mandatory provisions and Article 9 of the Rome I Regulation

Banking and finance disputes review

Publication November 2015


Introduction

Local law risks are a concern for financial institutions that operate across different jurisdictions. They try to mitigate these risks by choosing a particular governing law for their contracts, such as English governing law, and granting exclusive jurisdiction to particular courts, such as the English courts. But there are circumstances where an English court, even considering an English law contract, will apply provisions of a foreign law that render a contract unenforceable. Issues arising from the recent temporary imposition of Greek capital controls show that the scope of this power contains many uncertainties and ambiguities.

Consider an example, which we shall develop throughout this article: a bank lends money to a special purpose vehicle set up as part of a project financing in Greece. The transaction documentation requires the special purpose vehicle to accumulate money in specific accounts in Greece and then to repay the lender from those accounts. The loan is denominated in euros. It is governed by English law and subject to the exclusive jurisdiction of the English courts. The question for the bank is: what Greek law risks is it exposed to, notwithstanding those choices of English governing law and jurisdiction.

Rome Regulation: Overriding mandatory provisions

English courts, together with all other courts within the European Union, determine the applicable law of a contract in accordance with the Rome I Regulation (Regulation No 593/2008, the “Regulation”). Article 9 of the Regulation provides as follows:

“1. Overriding mandatory provisions are provisions the respect for which is regarded as crucial by a country for safeguarding its public interests, such as its political, social or economic organisation, to such an extent that they are applicable to any situation falling within their scope, irrespective of the law otherwise applicable to the contract under this Regulation

3. Effect may be given to the overriding mandatory provisions of the law of the country where the obligations arising out of the contract have to be or have been performed, in so far as those overriding mandatory provisions render the performance of the contract unlawful. In considering whether to give effect to those provisions, regard shall be had to their nature and purpose and to the consequences of their application or non-application.”

This Article allows English courts (or the courts of another EU Member State) to apply a foreign law to a contract, irrespective of its governing law. However, it only applies to ‘overriding mandatory provisions’. This is generally a small, easily identifiable class of laws and so the extra local law risk imposed by this Article is often seen as limited.

However, the temporary imposition of capital controls in Greece earlier this year provided an example of provisions that arguably fell within this definition. Financial institutions were suddenly faced with urgent questions of interpretation of Article 9. And it emerged that there were a number of hitherto unforeseen ambiguities and uncertainties within this Article. In particular:

  • Whole or part
    Did the test for a rule of law to count as an ‘overriding mandatory provision’ apply to a piece of legislation as a whole or to each individual rule within it?
  • Location of obligations
    What jurisdictions fell within the category of those where the obligations have to be performed and did there have to be any connection between the performance of that obligation and the obligation which was to be rendered unlawful?
  • Meaning of unlawful
    What doctrines of local law applied to make a contract ‘unlawful’?
  • Unlawful for whom?
    Did the performance have to be unlawful for a party to the contract or another person?
  • Effect on default provisions
    Given the discretionary application of Article 9, what was the effect on illegality events of default?

We consider each of these issues below and highlight the resulting risks by reference to our continuing example.

Note that English law may also contain a separate rule that covers the same ground as Article 9(3), although it is of slightly wider scope, but which applies only to English law governed contracts (the rule stems from Ralli Brothers v Compania Naviera Sota Aznar [1920] 2 KB 287). There is some doubt as to whether this rule still exists (although recent authority suggests that it does – see Eurobank Ergasias v Kalliroi [2015] EWHC 2377 (Comm)). In any case, we will concentrate in this article on Article 9, which is of pan-European relevance.

Whole or part

Suppose that performance of an obligation is contrary to a rule in a piece of legislation in the jurisdiction where it is to be performed. Article 9 requires a determination whether that rule is an ‘overriding mandatory provision’, using the examples set out in Article 9(1). But does the test apply to the particular rule or the whole piece of legislation? The legislation as a whole may be significant enough to fall within the definition, whereas the particular rule – being only a minor part of it – may not, if considered in isolation.

Using the example of Greek capital controls, the legislation that brought it into effect arguably fell within the definition as “regarded as crucial by a country for safeguarding its public interests”, given the context of Greece’s financial and political crisis. However, a particular rule within it, such as, for instance, an obligation to provide information to a regulator, might not, in isolation, fall within this category.

Although there is no authority on this issue, a granular approach does not appear consonant with the aims of Article 9. If a particular sub-rule is of less significance, a court may deal with that by a non-exercise of its discretionary power. Applied to our example, it means that any contravention of capital controls legislation would be relevant, without having to undertake a further analysis of whether that part fell within the definition of ‘overriding mandatory provisions’.

Location of obligations

English courts have traditionally taken a strict view as to where payment obligations ‘have…to be performed’. The contract must effectively specify a place of performance for the obligation, so that it cannot be performed in any other country while complying with the contract (see Tamil Nadu Electricity Board v ST-CMS Electric Company [2007] EWHC 1713 (Comm)). As a payment obligation will generally only specify where the payment is to be made, rather than where it must originate, mandatory overriding obligations of the payor’s country will not be relevant. That is, if the payor is prevented from paying from an account in its own jurisdiction, the English courts will expect it to pay using some other means.

Our case study is a rare example of a payment obligation that is required to be performed in the payor’s jurisdiction. The contract specifies a particular transaction account in Greece which must be used to accumulate all the borrower’s income and which must be used as the source to repay its loan.

Article 9(3) does not link the place of performance with the obligation that is unlawful. The first half of the clause refers to “the obligations arising out of the contract” but the second half refers to “the performance of the contract”. There is no link in the Article between obligations that have to be performed in a certain place and the obligations that are rendered unlawful. A connection between those obligations might be implied by the process of statutory interpretation, if the courts took the view that the purpose of the Article was to restrict unlawfulness only to obligations that had to be performed in the relevant jurisdiction. However, in the absence of any authority, it is uncertain whether this purposive interpretation would be adopted.

The implication of this for financial institutions is that they must enumerate all the jurisdictions where performance of any part of a contract is required and determine whether any overriding mandatory obligations affects any obligations of the contract. At least until this is clarified by the courts, this ambiguity adds extra due diligence overhead.

Meaning of unlawful

Article 9(3) refers to the contract being rendered ‘unlawful’. This is to be interpreted not in accordance with the law of any particular jurisdiction but in a supra-national sense. Accordingly, for each local jurisdiction, it is necessary to determine exactly which doctrines of local law correspond to unlawfulness within Article 9(3).

It is easy to overlook this issue when restricted to an English law perspective. There is an English law doctrine of illegality and it appears to coincide with unlawfulness, as set out in Article 9. However, other jurisdictions may have a less well-developed doctrine of illegality, or it may overlap with related doctrines.

Take our continuing case study: a payment is required to be made from a particular bank account; a law is passed which makes it illegal for the bank to effect this payment but does not directly address the position of the payor. Assume that, as a matter of statutory construction, it is not then illegal for the payor to make the payment, but it will be impossible for it to do so because it is illegal for the bank to transfer the funds. It is clear, as a matter of English law, that the payor’s obligation is not illegal, although it is impossible. Depending on the terms of the contract, similar consequences might follow – the contract may be terminated by frustration, for instance. But this is still distinct from the consequences of illegality.

Yet it is quite plausible that another legal system might treat this fact-situation as an example of illegality, rather than some other doctrine. In that case, the question arises whether the local law definition of illegality prevails over any floating European concept. If it does, the scope of Article 9 might be substantially expanded.

Unlawful for whom?

A related ambiguity is that Article 9(3) states that performance of the contract must be unlawful, but it does not say by whom. Not only does Article 9 not make any explicit connection between the obligation that is to be performed and the obligation that is unlawful, but it does not link the person for whom performance is illegal with the parties to the contract.

In most cases, this will not cause a problem: it will clearly be a party to the contract who must perform the obligations under the contract and any illegality will be in respect of that party. But the case study illustrates a common situation where that is not the case. The contract states that a payment must be made from a bank account – although the bank is not a party to the contract, this is an action that only it can undertake. That is, the obligation on the party to the contract is to procure that the bank transfer funds from its account with the bank to another account.

It is not uncommon for a contract to contain such a provision: an obligation on a party to procure that something be done, or that a third party do something. At present, it is unclear whether Article 9 will be engaged when that act is illegal for the person who, as set out in the contract, is required to do it, if they are not a party to the contract.

Effect on default provisions

Many contracts contain an event of default or other termination provision that refers to illegality of the contract. They may either refer to illegality according to relevant local laws or illegality according to the governing law of the contract.

If the event of default extends to illegality according to the local law of any relevant jurisdiction, there has to be some limit to which jurisdictions are considered relevant. One option is to include all jurisdictions where an obligation under the contract is to be performed. As discussed above, this may itself be a complex question. It avoids all the subsequent questions about the operation of Article 9 although, of course, this is at the cost of including a much wider range of illegality than Article 9, depending on how the various ambiguities noted above are resolved.

If a clause is restricted to illegality under the governing law of the contract, that effectively refers back to Article 9. That is, there will be illegality under the governing law of the contract if there is illegality under a relevant local law and Article 9 applies. Accordingly, the various ambiguities noted above are still relevant. But there is another problem. Article 9 renders a contract illegal on a discretionary basis – so even if all the preconditions are satisfied, it is not possible to say with certainty that a contract is illegal until a court has exercised its discretion accordingly. This makes it inherently risky to rely on a governing law illegality clause based on a local law illegality translated to the governing law by Article 9.

Conclusion

The ability of a court under Article 9 to declare a contract illegal under its governing law based on non-compliance with local law obligations adds to the local law risks faced by a bank in its cross-border transactions. The various ambiguities of Article 9, many of which have only recently become apparent, increase the scope of this risk. Banks will meet this risk by careful drafting and further due diligence. However, this can only be of limited help where political or economic crises cause drastic changes to local laws in the future.



Recent publications

Subscribe and stay up to date with the latest legal news, information and events...