Contractual Mechanisms for Managing FX Risk In Commercial Contracts (Part 2)

The most effective way to manage FX risk in commercial contracts is to address it expressly in the relevant contract. Depending on the nature of the transaction, a number of mechanisms could be adopted by parties. 

A. Currency denomination

Where a substantial proportion of the cost of performance is denominated in foreign currency, parties may consider denominating the relevant contractual obligation in that currency. This provides greater certainty regarding the amount payable, although it does not eliminate the exchange-rate exposure of a party whose revenues are generated in naira.

B.Exchange-rate adjustment clauses

A contract may provide that the contract price will be adjusted where the exchange rate moves beyond an agreed threshold. For instance, the parties may agree that where the naira depreciates by more than 10% against the dollar from the agreed baseline rate, the contract price will be adjusted to reflect an agreed proportion of the resulting additional cost.

The clause would typically identify the baseline exchange rate, the applicable exchange-rate source, the measurement date, the adjustment formula and any applicable limits.

C. Price variation clauses

For contracts involving imported materials, equipment or other foreign currency-denominated inputs, parties may agree that only the affected component of the contract price will be adjusted. This claus avoids the need to reopen the entire contract price whenever there is an exchange-rate movement.

D. Hardship and renegotiation clauses

Parties may provide that where exceptional economic circumstances fundamentally alter the commercial equilibrium of the contract, they will enter into good-faith negotiations to agree an appropriate adjustment.

The clause would typically specify the circumstances that trigger renegotiation, the period within which negotiations must take place and the consequences where the parties fail to reach an agreement.

E. Hedging and other financial arrangements

Depending on the size and duration of the transaction, parties may also consider financial arrangements that reduce their exposure to exchange-rate movements.These may include forward exchange contracts and other currency hedging arrangements.

Other Key Commercial Considerations 

FX risk management should not be treated as an afterthought or left entirely to a general force majeure provision. Before executing a contract, businesses should identify the extent to which their obligations or expected costs are exposed to foreign exchange movements. Accordingly, businesses should consider:

1. Whether the contract price is fixed or subject to adjustment.

2. Whether the relevant goods, services or materials are sourced locally or internationally.

3. Which party is best positioned to manage the exchange-rate exposure.

4. Whether the contract should provide for a currency adjustment mechanism.

5. Whether there should be a threshold beyond which the parties must renegotiate.

6. What happens where the parties cannot agree on an adjustment.

7. Whether the contract should provide for suspension, partial termination or termination following prolonged economic hardship.

Importantly, the appropriate mechanism will depend on the nature, duration and commercial structure of the transaction. A short-term supply agreement may require a different approach from a five-year construction, infrastructure or technology services contract.

Balogun Harold advises businesses and individuals on the negotiation and drafting of commercial contracts, including the allocation and management of foreign exchange risk. The firm also provides second opinions on commercial litigation matters and advises on dispute resolution, including litigation, mediation, arbitration and professionally guided settlement of existing and anticipated disputes.