Country risk in unprecedented times: A precedent for cross-border loan documentation?

Country risk

The term “country risk” covers a broad spectrum of risks:

• political: such as changes in government or law, political instability, conflict and expropriation;

• economic: such as inflation, devaluation of currency, low economic growth, economic policy;

• sovereign: a government defaulting on its own debt or interfering with the private sector’s ability to repay international debt; and

• foreign exchange: restrictions on the transfer of currencies across borders, which can impact a borrower’s ability to make payments in a certain currency.

While the jurisdictions of incorporation, operations and flow of revenues of a borrower will be the most significant factors in determining the level of country risk in a transaction, any cross-border financing transaction will involve a degree of country risk. Country risk is one of the many factors that influences whether a borrower will have the ability to meet their obligations under a loan – but a risk that can change the lender’s risk exposure overnight.

Country risk has always been key to the bankability analysis of any cross-border loan, but international events in recent years such as COVID-19, supply chain pressures, nine military coups in Africa since 2020 and some consequent regime changes, sovereign defaults in Zambia, Ghana and Ethiopia and increased instability in Western politics has brought assessment of exposure to country risk into even sharper focus.

Although it is difficult to be shielded from country risk in an increasingly globalised world, lenders will seek to mitigate their exposure to an acceptable level through pricing, structuring, and contractual protections in loan documentation. Different lenders will have different risk appetites – consider a commercial bank compared to a development finance institution – and so striking a balance that meets the lender’s requirements for return on investment, whilst providing the borrower with an economically viable loan with terms that the borrower can comply with, is a challenge, and one that varies depending on the specifics of the financing.

Pricing

When assessing country risk, lenders often look to a sovereign’s credit rating, published by international ratings agencies. Combined with other structural and legal factors, credit ratings inform the cost of capital and required internal rate of return for a transaction. The higher the risk, the higher the reward, and the lender’s perceived country risk can be reflected in the pricing of the loan.

The margin and other risk premiums set by lenders on transactions with high levels of country risk can be very expensive. To mobilise financing on economically viable terms for all parties, other structural and legal protections will often be implemented.

Structuring

Financings with significant levels of country risk require careful structuring, often involving multi-sourced financing solutions, coupled with insurance and guarantee credit enhancements, and a blend of onshore and offshore elements, such as offshore holding companies and offshore accounts. Any security package required by a lender must be designed to be readily enforceable, if ever required.

Insurance and guarantees

Lenders often require insurance and/or guarantees to reduce their exposure to country risk. International finance Institutions such as the Multilateral Investment Guarantee Agency (MIGA) have strong risk appetites and provide credit protection for non-commercial risk to lenders, facilitating access to capital for development projects in emerging markets, which are prone to country risk. MIGA’s guarantees can be issued in favour of lenders and cover transfer and inconvertibility, breach of contract, expropriation and war and civil disturbance. Other insurers, ranging from organisations such as the African Trade Insurance Agency, to export credit agencies and traditional commercial insurers, also offer insurance products covering certain types of country and political risk.

These political risk instruments and guarantees are issued in favour of lenders but will not usually cover the entirety of the debt. Combinations of different insurance or guarantee products can reduce the lender’s exposure, but needs to be balanced against premium costs and the overall economics of the deal. This coverage will reduce the lender’s country risk exposure and credit risk, which is usually reflected in reduced margins and other pricing.

Lenders will require the coverage to be effective prior to advancing funds. The coverage provider may have a subrogated right to recover losses from the responsible party for claims paid under the insurance or guarantee cover, and often requires various consent rights and policy related protections, including those triggers relating to drawstops, prepayment, and events of default be included in the loan documentation.

Syndicated loans and participations

Country limits are placed by a lender on the amount lent to borrowers in a particular country – to ensure an institution maintains a diversified spread of investments and is not over-exposed to particular locations. A lender’s country limit may change over time, so that a lender’s right to transfer all or part of its commitment and participation in a loan will also be a key consideration – particularly for loans with longer tenors.

Structuring a deal as a syndicated facility enables a group of lenders to share the risk, and any single lender the ability to reduce its exposure, or even exit completely, by transferring all or part of its participation. Funded or unfunded risk participation arrangements are another way for lenders to reduce their exposure at any time, while still remaining lender of record.

Multilateral and development finance

Transactions involving a developmental purpose may also attract access to concessional debt from multilateral development banks and development finance institutions (MDBs and DFIs respectively). MDBs, such as the World Bank, are set up by a group of sovereign states, who are their members. DFIs are specialised development organisations that are usually majority owned by national governments and can either be bilateral, implementing their government’s foreign development and co-operation policy, or multilateral.

Many MDBs and DFIs (Preferred Creditors) will benefit from preferred creditor status (PCS), which is acknowledged by the member countries who are party to the treaty, charter or articles of agreement of that institution. PCS is a custom which enables Preferred Creditors to be repaid before other lenders in the event of a default, restructuring, or a restricted currency transfer scenario.

Where a Preferred Creditor is part of a broader lending group, PCS provisions will need to be included in the loan documentation to bind all parties to Preferred Creditor terms contractually. These PCS provisions acknowledge that any funds recovered by Preferred Creditors are excepted from any other provisions relating to the pro rata sharing of proceeds among the lenders. Investors with exposure under risk participation arrangements with these Preferred Creditors, as opposed to direct lending arrangements, may indirectly benefit from such contractual PCS rights of the Preferred Creditors.

Aside from assisting with the economics of a financing, the involvement of risk insurers such as MIGA, MDBs and DFIs, and export credit agencies, creates the opportunity to leverage the status, country knowledge and relationships of these institutions. This is useful not only to the other lenders, but also the borrower, its shareholders, and other counterparties who have an interest in the success of the financing.

Security and other collateral

Security provides lenders with additional credit support – but this is of little comfort where the realisation of that security may be vulnerable to risks such as expropriation, changes in law, transfer restrictions or devaluation of currency. Therefore, security packages for transactions with increased country risk need to be designed carefully.

Onshore and offshore security structures can help achieve this. For example, a requirement that an appropriate level of cash is held in a relatively stable currency (ideally in the currency of the loan), in offshore secured accounts can mitigate the borrower and lender’s exposure to currency devaluation, transfer risk, and facilitate faster, effective enforcement. Similarly, the introduction of holding companies –incorporated offshore, in tax efficient jurisdictions – into a shareholding structure, can enable lenders to enforce share security offshore, instead of needing to navigate local courts and enforcement processes which may not be friendly toward foreign lenders who are seeking to take ownership or sell local assets. The security structure needs to be prepared with reference to the needs of the relevant transaction and borrower, and with advice from local lawyers and other advisers to ensure that relevant consents and licences are obtained to effectively create, perfect and enable enforcement of such security.

Contractual protections in loan documentation

Market standard loan documents include a number of country risk protections, but there is no one-size fits all approach. Provisions should be tailored to address transaction-specific risk.

Events of default and prepayment

Triggering events of default will enable lenders to call for the debt to be repaid ahead of maturity, and either exit the transaction if repaid, or failing that, take other enforcement measures to recover amounts outstanding such as security enforcement or pursuing guarantors or credit insurance.

Below are some of the standard events of default which are included in most loan agreements. They are often highly negotiated, particularly for financings involving country risk:

• Expropriation: a default will arise where the authority or ability of an obligor to conduct its business is curtailed, or any of its assets are affected by any seizure, expropriation, nationalisation, intervention, restriction or other action by or on behalf of any governmental, regulatory or other authority. Extension of this default to certain affiliates of an obligor, other secured assets, or other key stakeholders in a project, and the degree of such expropriation may be negotiated on a case-by-case basis. The creditors’ process default often references expropriation, so consistency between these two provisions should be carefully considered.

• Unlawfulness and invalidity: a default will arise where it is unlawful for the obligors to perform their obligations under any finance document, or where any finance document ceases to be enforceable. Similarly, most loans include an illegality prepayment event, where it becomes unlawful in any applicable jurisdiction – including the borrower’s jurisdiction of incorporation – for a lender to perform any of its obligations, exercise its rights, or to fund or maintain its participation in a loan. While a prepayment event avoids a default, it still enables the affected lenders to be repaid early, which is important if not all lenders are impacted. These events may arise as a result of changes in the law of the country or transfer restrictions applying to the lender or borrower.

• Cross default: where political or country risk leads to an obligor defaulting on any other debt obligations, this may trigger a cross default across all of its loans. It may be appropriate to extend the application of this default beyond just the obligors to other key stakeholders in the financing (eg a government, or offtaker), to cover sovereign risk.

• Material Adverse Effect (MAE): this creates a catch-all default for circumstances that do not fall under the other specific heads of default and that have or are likely to have a “material adverse effect” on the obligors or the rights of the finance parties. The scope of the MAE definition is usually highly negotiated. Lenders will want it to extend to the business, assets, operations, condition (financial or otherwise) of any member of the group, as well as their performance under the loan transaction documents specifically, whereas borrowers will want to limit the scope of non-performance to non-payment and financial covenant breaches or a material adverse effect on the validity or enforceability of the loan transaction documents. Lenders will want the MAE to be in the lenders’ opinion to avoid further debate, whilst borrowers will seek to maintain objectivity to avoid the uncertainty of hair-trigger defaults being called by sensitive lenders. The expansion of the MAE definition to capture a material adverse change in the political or economic situation in a jurisdiction is not unheard of in transactions with high degrees of country risk. Even if not specifically drafted to cover sovereign and political risk, a widely drafted MAE definition may provide lenders with control over the borrower in the context of other representations and undertakings that are qualified by reference to materiality, which borrowers will want to avoid. However, lenders will often be reluctant to act on an MAE default alone. The imprecise test of whether the MAE has occurred, combined with the financial and reputational consequences for a lender that enforces without adequate grounds, can be a significant deterrent for a lender. An MAE may be more likely to be used to restrict further drawdowns.

In addition, the Loan Market Association’s Developing Markets Facility Agreement and exposure draft of the multi-jurisdictional African Facility Agreement released in July 2024, includes a number of additional defaults which specifically address certain country risks:

• Convertibility/transferability: a default arises where a foreign exchange law is amended, enacted or introduced and has or is reasonably likely to have the effect of prohibiting, restricting or delaying any payment that an obligor is required to make under the finance documents. The starting position is that this is a look-forward test, enabling lenders to demand repayment before the law comes into effect.

• Moratorium: a default will arise where a moratorium is called on payments by borrowers in relation to, or by third parties under guarantees of, foreign debt by entities in the relevant country, either generally or as a class to which that entity belongs.

• Political and economic risk: this default arises when there is a deterioration in the political or economic situation generally in the relevant country, or an act of war or hostilities, invasion, armed conflict or act of foreign enemy, revolution, insurrection, insurgency or a threat thereof occurs in the relevant country. This default is often resisted by borrowers: the nebulous concept of a deterioration in political or economic situation could be applied to many countries which are seen as having relatively low country risk. Providing lenders with an exit right in such circumstances, where lenders knowingly enter into a financing where exposure to this type of risk is identified upfront and priced accordingly, may not always be appropriate.

Recovery of costs

There are certain “boilerplate” costs, expenses and indemnity provisions which may enable a lender to recover costs and losses arising in relation to country risk, including costs and expenses incurred in enforcing a lender’s rights under a finance document, and the currency indemnity. The currency indemnity ensures a lender is made whole if payments are made in another currency to that of the amount that is due. This may be particularly useful to a lender where, due to currency devaluation or transfer restrictions, payments are received in local or other currency. The obligor must pay any shortfall arising as a result of the lender converting such payment to the relevant currency.

Enforcement

Lenders providing cross-border financing often require their loan documentation to be governed by a law that is transparent and predictable, such as English or New York law. Similarly, lenders will want any disputes to be determined in a venue with neutral and independent decision makers, that enforce recognisable rules of procedure, and is easy to access as a foreign entity. Parties may not be comfortable submitting to the courts of a local jurisdiction due to unfamiliarity and/or actual or perceived bias of decision makers. As such, international arbitration under LCIA, UNICTRAL or ICC rules has become a popular forum for resolving cross-border disputes. Both the governing law and dispute resolution provisions for enforcement must be agreed by the parties in the loan documentation, and advice will need to be sought on whether any judgment or award will be enforceable in the relevant jurisdictions.

Conclusion

There is no one size fits all approach when it comes to country risk. However, a carefully structured transaction with documentation that has been sensibly negotiated can achieve a balance between appropriately mitigating the lenders’ exposure to country risk, while providing the borrower with a financing solution that is economical and effective for its intended purpose.

This article first appeared in Butterworths Journal International Banking and Financial Law