Managing Foreign Exchange Risks in Commercial Contracts

We are often asked to advise contractors, suppliers and other businesses who believe they have lost a significant portion of the commercial value of their contracts following a change in foreign exchange rates.

The issue is particularly common in Nigeria, where significant movements in the exchange rate can fundamentally alter the economics of a commercial transaction between the time a contract is negotiated and the time it is performed.

A contractor who agreed to execute a project for ₦500 million, for instance, may have priced the contract on the assumption that the naira would exchange at a particular rate against the dollar. Where the project requires imported equipment, materials or other foreign currency-denominated inputs, a substantial depreciation of the naira could leave the contractor with costs far exceeding the assumptions on which the contract price was based.

The resulting disputes often involve contractors seeking to revise contract prices, employers resisting additional payment, disagreements over responsibility for increased costs, and, in some cases, contractors abandoning projects or failing to meet their contractual obligations.

We highlight a few considerations on the question of which contractual party bears the risk of foreign exchange movements. 

1.Understanding FX Risk in Contracts

Foreign exchange risk arises where the value of a contractual obligation or the cost of performing that obligation is exposed to movements in the exchange rate between two currencies. 

This exposure can arise in several ways. First, a contract may be denominated in a foreign currency, such as US dollars, while one of the parties generates its income or holds its funds in naira. A depreciation of the naira increases the local currency cost of meeting the payment obligation.

Second, a contract may be denominated in naira but require the contractor or supplier to procure equipment, materials, software or other inputs from foreign markets. Although the contract price remains unchanged, the cost of performance may increase substantially.

Third, a contract may involve payments over an extended period. The exchange rate applicable when the contract is executed may be materially different from the rate prevailing when subsequent payments fall due.

These are all different forms of FX exposure and should not necessarily be addressed in the same way.

2. Common Sources of FX Disputes

A recurring source of disputes is the assumption that an adverse exchange-rate movement automatically entitles the affected party to an increase in the contract price.

For example, a contractor may argue that the original contract sum is no longer sufficient to complete a project because the cost of imported materials has increased following the depreciation of the naira. The employer, on the other hand, may insist that the contractor agreed to a fixed price and must bear the consequences of its commercial assumptions.

Other disputes arise where the contract provides for payment in foreign currency but does not clearly identify the applicable exchange rate, the date for determining that rate or the mechanism for making payment in the event of foreign exchange restrictions.

There are also disputes concerning the interpretation of force majeure provisions, particularly where a party seeks to rely on currency depreciation as justification for non-performance.

The difficulty in many of these situations is that the parties are attempting to resolve an allocation of risk that should have been addressed during contract negotiations.

3. Does Currency Depreciation Excuse Contractual Performance?

The starting point under Nigerian contract law is that parties are generally bound by the terms of their agreements. A party does not ordinarily become entitled to vary an agreed contract price simply because the transaction has become less profitable or more expensive to perform.

This is particularly important when considering the doctrines of force majeure and frustration. A force majeure clause generally operates according to its contractual wording. The fact that a party has suffered financial loss or that the cost of performing its obligations has increased will not usually, without more, establish a force majeure event.

Similarly, the doctrine of frustration is generally concerned with circumstances that make contractual performance impossible or fundamentally different from what the parties originally contemplated. A mere increase in the cost of performance will not ordinarily satisfy this legal threshold. Consequently, a contractor who has entered into a fixed-price contract should not assume that a subsequent depreciation of the naira automatically entitles it to additional payment or excuses non-performance.

The position may, however, be different depending on the facts of the case or where the contract expressly provides for price adjustments, currency variations or hardship arising from exceptional economic circumstances.

In the concluding part of this series, we highlight some contractual mechanisms for addressing foreign exchange risks in commercial contracts