Vol. XII No.2
February 2007



Covering Price Risk in International Trade Agreements...

Trade between Romania and the rest of the world has been steadily increasing annually. As in any emerging market with occasional volatile economic, social and political fluctuations, both foreign and domestic trading partners must seek ways in which to minimize the risks attendant to such fluctuations. Romania’s accession to the European Union in January is expected to substantially enlarge its annual trade with EU member states, affording business partners with both unique opportunities as well as with the archetypal risks associated with international trade. This article reviews the steps that such parties can take to protect themselves from price risks in international trade agreements involving Romanian partners - risks incurred from outside factors such as exchange rate fluctuations in different currencies, the increase in the price of raw materials and of energy, and sudden changes in the economy. These risks all influence the extent of the obligations of parties who must pay more or less than what they agreed to pay when they concluded their agreement. They are risks that affect the contractual balance between the parties; and, most importantly, they are risks that can easily be avoided by introducing certain provisions into the contract. (Risks of nonperformance of contractual obligations including nonpayment are not the subject of this article.)

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Commercial Risks
Romania’s major trading partner is, of course, the European Union, with a total balance of €37.9 billion in 2005 of imports and exports representing 68.9% of Romania’s overall foreign trade. Other important trading partners include the NAFTA countries - the US, Mexico and Canada - with a total balance of trade of €1.8 billion representing 3.3% of overall trade; the EU candidate states and Bulgaria (in 2005) with €4 billion at 7.2%; and the ASEAN countries with €344 million at 0.6%. Trading partners in all of these countries continually assess the commercial risks associated with business opportunities in Romania such as the possibility that a future and probable event might cause negative pecuniary consequences to one of the parties. Such risks include economic, political, administrative, and natural risks. Economic risks are determined by the evolution of the company and the quality of the services and commodities it provides. They are, in turn, divided into currency risks incurred by changes in exchange rates or the official parity of the payment currency in comparison with the reference currency, and non-currency risks. The latter include: inflation, changes in the bank interest rate, changes in the price of the raw materials, equipment, labor, transportation, insurance premiums, commissions, interest, technology, the balance between supply and demand, and financial and investment risks. Price risk is included in this category, since all of these factors influence the cost of production and, consequently, the obligations of the contractual parties.

An example of currency risk is the way changes in the currency exchange rate of the leu have affected long term international transactions. The leu appreciated in real terms by 11% against the euro from September 2004 up to December 2005, and by a further 5% in the first three months of 2006. Therefore, all the long term international agreements that had as object the supply of certain products or services in Romania or to Romanian companies that had prices expressed in US dollars or in euro were affected by the changes in the exchange rate. The Romanian buyers gained from the change since they were now paying in a currency that had depreciated at a price that had been settled before the depreciation and, thus, they were paying less for the same product or service. The foreign sellers incurred certain loses since they now received the same amount in a currency that in the meantime had lost value. Thus, they were receiving less for the same product or service. At present, due to the National Bank of Romania’s disinflation efforts and large foreign cash inflows, the leu is expected to remain strong over the next year and the exchange rate is expected to remain stable. Therefore there is currently no perceived currency risk which might influence the extent of long term contractual obligations.

Other risks that might affect prices are those incurred from the situation the Romanian economy finds itself in right now. Therefore an analysis of monetary policy and the evolution of the inflation rate should be made when considering the conclusion of a long term transaction. The authorities face a dilemma imposed by EU constraints on inflation since a tightening of monetary policy to reduce inflation will detrimentally affect Romania’s external competitiveness which needs to be preserved in order for the country’s economy to expand. For the latter to happen, the exchange rate of the leu is bound to be subjected to further pressure since capital inflows will increase due to higher domestic interest rates. Experts predict that with a significant loosening of the fiscal policy in 2007, year-end inflation will run about 6.8% and the current-account deficit is forecast to rise to about 10% of GDP.

Romania’s country risk combines political with economic and social elements that are heightened by the nation’s current internal political situation in which the two senior government coalition parties, the National Liberal Party (NLP) and the Democratic Party (DP), and the President and Prime Minister, trade angry accusations back and forth at each other each day – a situation that could lead to a breakup of the ruling coalition and new elections influencing the economy and business transactions.

Prices are closely linked to changes in the economy and in the general social, environmental and political situation in Romania. Recent changes in climate that have subjected Romania to certain natural weather-related risks have indirectly influenced the level of prices. There has been a 12.6% decrease in agricultural output caused by recent floods. The prices of agricultural products could also be affected in 2007 by the droughts that have been predicted.

Developments in 2005 can serve as an example of the impact on prices, as consumer prices increased by 8.6%, exceeding the 7.5% inflation target. This increase was mainly due to price adjustments for utilities, as well as the unfavorable impact of some incidental factors like floods on the price of food. For example, if a long term transaction involving agricultural products had been in place during this increase in the costs of production and in the prices, the seller would have incurred losses from the deal since he agreed to supply the products for a certain price, but due to floods or drought the crops were not the expected ones and his costs increased a great deal. The increase in costs should have been covered by an increase in the price of the transaction, but this could not have happened unless the agreement contained a price adjustment clause.

Legal risks incurred due to changes in national and international provisions of relevant commercial legislation can be devastating to a long-term international trade agreement that lacks suitable protections. Such risks relate to new taxes and levies, property loss and so on. Among the legal risks that affect prices, troublesome and non-transparent bureaucratic procedures remain a major problem in Romania. International experts point to the excessive time it takes to secure necessary zoning permits, property titles, licenses, and utility hook-ups, causing the skyrocketing of construction costs. Moreover, there are frequent changes in legislation and regulations, especially fiscal rules, often without prior notice and without a transition period. These changes significantly add to the costs of doing business in Romania, create difficulties for investors, and can cause increases in the prices provided for in long term agreements.

All these risks can be covered through special clauses inserted into international trade agreements. There are specific clauses for currency risks, non-currency risks and force majeure, and for political, social, administrative and natural risks. These clauses can also be categorized as: clauses for the maintenance of the value of the agreement as the parties had initially agreed and clauses for the adaptation of the agreement to the new conditions on the market. The different varieties of clauses are, of course relative, since there are some which could be included under more than one category.

Clauses used to cover price risks are briefly described below.

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Price Risk Protection

Price is a strategically important element in a sale-purchase, licensing or distribution agreement as it sets forth the most important obligation for a party - the pecuniary side of the transaction. In an international trade agreement, the price can be fixed. This is used most often in one time transaction agreements. In respect to long term deals, agreements are usually concluded containing variable price clauses as the relationship between the business partners is deemed to be a strong one - otherwise they would not enter into such agreements.

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Contractual Clauses that Prevent Price Risks
Long term trade agreements usually incorporate a special provision showing the price of the transaction. This price can be a fixed one or it can be conveyed through a price determination formula. Price-protection clauses that should be included in international trade agreements are either currency adjustment clauses - gold clauses and currency clauses; or non-currency clauses, such as price adjustment clauses, depending on the type of risk they cover.

The gold clauses, i.e. the gold-value clause and the gold-coin clause, use gold as a reference for the value of the currency in which the price is expressed or express the price directly in gold. Other currency clauses use as reference an internationally tradable currency other than the one from the agreement, the conjunction of two or more tradable currencies in previously determined percents or an institutional currency combination (for example: the Special Drawing Rights of the International Monetary Fund and the Asian Monetary Unity of the Clearing Asian Union.).

The non-currency clauses refer to price adjustment. The most important one is the escalator clause, also called the escalation clause. It is a provision in an agreement stipulating an increase or a decrease of a price based upon increased costs of wages, benefits, or other prices, under certain conditions, i.e. changes in the cost of living, energy and raw materials, such as in an unstable, volatile market like Romania. Escalator clauses frequently appear in business contracts in order for them to raise prices if the supplier of a particular service or type of merchandise is forced to pay more for labor or materials. They are inserted after careful consideration and evaluation of the market determining that it is in fact more likely for it to shift than remain the same. When a raw material with a volatile value is a major cost component for an asset that is the subject of a transaction, risk identification is required. Understanding the risk factor is essential to any entrepreneur or executive manager concluding an agreement for the future when the costs are not determinate.

This risk-neutral position in an agreement could also be accomplished through concluding a Cost-Plus agreement through the use of an escalator clause.

There are several variations of a Cost-Plus agreement, but the guiding principle is to determine amongst the parties a percentage or mark-up margin against the price of a raw material that fluctuates regularly and significantly on the basis of a previously published Price Index. Therefore, the automatic adjustment in payments based on an economic index that is independent of the will of any of the parties involved becomes effective. The clause, thus, provides for a price increase mechanism. The result is that, no matter what the price of the asset is today, tomorrow or three months from now, the buyer will pay the same amount (i.e. percentage) over the seller’s prices for that period.

Nowadays, Cost-Plus agreements are used in transactions that involve technology products, equipment, gasoline and other petroleum products, and certain food products, which are all traded on highly volatile markets with pricing changing every hour on the hour.

The most common way in which an escalator clause acts is by a mechanism through which only if the increase or decrease in the costs is greater than a certain percentage, previously determined by the parties, does the adjustment of the price become operable.

Another way in which escalator clauses operate is by a notification that the seller/vendor sends to the other party showing that he desires an increase in the price due to the change of the price of raw materials and/ or energy on the market. If the escalator clause is operational by a notification, than the buyer has the benefit of a period of time prior up to the moment in which the price increase enters into force. During this period, the buyer is entitled to place orders at the original price. The same mechanisms apply in case of a price decrease on the market for raw materials and/or energy.

Another price clause commonly used to avoid risks is the price re-determination clause. This gives either party the right to ask for a recalculation or renegotiation of the price from the agreement at intervals which have been previously established by the parties. Usually an adjustment of the price is done once a year. The common procedure for a price re-determination is to average three or more of the prices of other competitors on the market.

Agreements could also contain a clause for the post calculation of the price, the Cost and Fee clause. In this case the price of the agreement is determined after the performance of the obligations by calculating the production costs with other expenses, like the cost of labor.

Price risk can also be covered by clauses for the adaptation of the agreement, by way of including it amongst the other obligations undertaken by the parties to the agreement. These clauses do not refer only to the pecuniary value of the agreement, but to the entire performance of the agreement (transportation, packaging, quality and so on); however, price plays, yet again, a crucial role since it represents the most important obligation.

Such provisions are: “the most favored customer”, “the most favored nation” and the “best price” clauses. In all these, the seller undertakes to provide the buyer with the lowest price and the best trade conditions he would offer his most favored customer. In this way the buyer is never at a disadvantage towards that seller.

The hardship clause is also included in this category. It has been defined by the UNIDROIT Principles of International Commercial Contracts under Section 2, Article 6.2.2. as “the occurrence of events fundamentally altering the equilibrium of the contract either because the cost of a party’s performance has increased or because the value of the performance a party receives diminished.” In case hardship occurs the party that has become disadvantaged has the right to request the renegotiation of the agreement and, consequently, of the price.

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Price Risks in the Future
In practice, price adjustment clauses are widely used and have been used for some time in long term international trade agreements concluded in Romania or with Romanian companies. This is demonstrated in the annual reports of some Romanian companies which show that price risk has been covered either by the fact that the raw materials had prices expressed in euro or by the adjustment of prices with inflation and by their escalation according to the cost of the raw materials.

Price risks, currency exchange risks and interest risks can also be covered by the use of different derivative financial instruments like: futures, options, swaps, hedging. Companies often cover price risk by concluding futures agreements through which they establish with a certain buyer the sale-purchase terms, including the price, of a transaction that will take place in the future, for some products they do not yet own.

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Because the Romanian market is at all times quite volatile, risks can never be fully perceived and companies need to pay close attention to risk management as well as make efforts at risk avoidance, such as the aforementioned clauses covering price risk and financial instruments. This is necessary for diminishing the effect of risks that may still be incurred. Risks should be handled, and controlled as far as possible.

As a transitional emerging economy, the Romanian economy still has a long road ahead before reaching a reasonable state of stability. Moreover, as not even stable economies offer complete protection against the risks incurred in long term transactions, changes in the economic, political and social environment should be expected in Romania. Indeed, this is the very purpose of the clauses covering price risk and of all the risk protection mechanisms, i.e., to bring about the desired stability of long term agreements and the desired results from transactions.

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Editors Note: It is our policy not to mention our clients by name in The Romanian Digest™ or discuss their business unless it is a matter of public record and our clients approve. The information herein is correct to the best of our knowledge and belief at press time. Specific advice should be sought from us, however, before investment or other decisions are made.

Copyright 2007 Rubin Meyer Doru & Trandafir, societate civila de avocati. All rights reserved. No part of The Romanian Digest™ may be reproduced, reused or redistributed in any form without prior written permission from the publisher.

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