With EMU getting closer and closer, lawyers are hard at work on the details.

By Margaret Elliott

It's only about 350 working days until European Monetary Union arrives on January 1, 1999. It's not as bad as all that if you throw in the 200 or so extra eight-hour days a lawyer can bill by working evenings and weekends in the run-up. But the legal framework for EMU is not yet set, and that has derivatives specialists in Europe—and increasingly in the United States and Asia—worried.

The good news is that in the last 12 months, the European Union and lawyers in financial centers across the globe have made great strides in tackling the two hairy monsters for derivatives players: contract continuity and redenomination of debt. "The biggest breakthrough,” says Geoffrey Yeowart, a partner of the U.K. law firm Lovell, White and Durrant, and chairman of the working party of the City of London Law Society's banking law subcommittee, "came when two draft EU Council regulations were endorsed by the council of finance ministers last December. Agreement on these proposals gave each EU country and particularly the United States something solid to work on.”

The first EU proposal provides rules for the substitution of the euro for the now-used European currency unit (ECU), and has continuity of contract provisions. The second proposal explains procedures for the redenomination of debt, the substitution of the euro for national currencies and transitional period arrangements.

Each of these proposals is now being scrutinized by the governments of EU countries. The first is expected to be passed this year, while the second cannot be passed until April or May of next year at the earliest, when it is known which countries will join EMU.

Continuity of contract

A key provision of the first proposal establishes that the introduction of the euro will not have the effect of altering any term of a contract or discharging or excusing performance under a contract. Equally, it will not allow one party to alter the contract unilaterally. Parties to a contract will be free to alter the contract subject to mutual agreement, however. "This provision, which will be adopted by the United Kingdom for instance, even if it opts out of EMU, brings us far closer to achieving legal certainty on continuity,” says Jeffrey Golden, a partner of Allen and Overy, a London law firm.

Nevertheless, lawyers say prudence dictates reviewing any contract that extends beyond the start of EMU. Two potential problems still exist under the broad heading of contract continuity. For derivatives contracts, the loss of a pricing source (or interest rate, exchange rate, screen page, index or settlement system) could affect contract continuity. Market associations, derivatives exchanges and investment banks are working out continuity plans for each and every contract where possible. In some cases—say, if no cross-rate exists—then no contract can exist beyond the start of the euro.

The other gray area for derivatives contracts is when it is supported by legislation outside the EU. Most derivatives contracts are governed by English or New York state law. The International Securities Dealers Association (ISDA), along with other trade bodies, has sponsored legislation in New York state that would change the uniform commercial code and the general obligations law to remove contract termination risk.

Redenomination of currency

Although the makeup of the euro won't be known until next year, the actual procedure for moving the national currencies into the euro are being debated. A transition period of three years (until the end of 2001) will allow member states to redenominate all or part of their government debt. But Lovell, White and Durrant's Yeowart says there are at least three possible ways to redenominate: simple redenomination (a simple change in the currency unit in which the debt is denominated); renominalization (a change in the minimal nominal amount in which a debt security is held after redenomination to achieve a round amount); or reconventioning (a change in the terms applicable to the debt security to reflect different conventions on pricing and interest payments).

The second and third proposals throw up huge problems for derivatives contracts, particularly swaps. "We are pressing for the simplest possible procedure to be followed,” says Yeowart. "And of course, no state is obliged to redenominate at all and neither are private issuers.”

It isn't yet clear what the outcome of these debates will be. But Allen and Overy's Golden is pleased that the marketplace is finally grappling with the mechanics of EMU. "We still run the risk of chaos on the day, but it isn't as great a risk as it was.”