Legal Options for Ukraine's Russian Debt Problem
Ukraine's financial position is worsening, restructuring seems likely, and the big question is what to do about the $3 billion loan Victor Yanukovych saddled the country with before fleeing. Coverage of the loan here and here on Credit Slips, and bonus coverage on FT Alphaville (free registration required). Though a government-to-government loan in substance, the loan is disguised as an ordinary eurobond issue, with contract terms that give Russia extraordinary leverage. These include the right to accelerate early, trigger cross-default, and block or impede restructuring. That may be why recent reports suggest the plan is to pay Russia in full when the bonds mature in December 2015, though I can't imagine either Ukraine or its official lenders are thrilled at the prospect.
Perhaps there are other options. The academic literature on sovereign debt often discounts the relevance of law and legal institutions, although Mitu Gulati and I argue here that this may be a mistake. Ukraine's case may illustrate the point. The country's leverage - what little it has - depends in part on whether it can place meaningful legal barriers in the way of any effort to enforce the bonds. That would likely involve English law and courts (see par. 16, page 35 of the prospectus). Below the jump, I discuss two possibilities. The first is a proposal by Anna Gelpern described in detail in this paper (which also has good background on the loan) and this blog post. The second is a brief but tantalizing proposal by Joseph Blocher and Mitu Gulati in the final section of this paper. In short, Anna proposes legislation making the debt unenforceable in English courts. Joseph and Mitu suggest that Ukraine is entitled to compensation for Russia's annexation of Crimea and can use this claim as a set-off against the debt. Both proposals raise unique challenges and questions.
The proposal is elegant, and it has the advantage of being a transparently political solution to what is, after all, a political problem. But it's also easy to imagine objections. Some are hard for me to take seriously on the merits. These include the usual objections made whenever anyone proposes to change, well, pretty much anything in a major legal and financial market: (1) Contracts must be enforced! and, relatedly, (2) the UK will destroy its reputation as a place to issue and enforce debt. As Anna points out (pp. 21-22), sanctions always impair contract enforceability, so argument (1) makes little sense unless you either oppose all sanctions or can identify something uniquely objectionable about this proposal. And (2) is an argument against wanton sanctions, not targeted ones. Still, these objections have rhetorical force, and the broader political and economic dynamic is not favorable to Ukraine. What's the incentive for financial and legal intermediaries in the UK to support this kind of sanction? And without that support, what are the chances that a proposal like this will come to fruition - much less by December 2015, when the bonds mature?
Joseph and Mitu's proposal is premised on a more radical idea but, as I explain below, it might be possible to justify their result on more traditional grounds. The bulk of the paper is devoted to arguing for a "market for sovereign control" in which control over a region may be transferred from one nation to another, for a price. The exact mechanism for transfer and for setting the price varies by context, but transfer requires the approval of a super-majority in the affected region. Their argument will prove controversial, but it responds to a genuine need in international law. State succession (i.e., the transfer of responsibility for a territory) happens all the time, but international law provides no real guidance on the many resulting questions, such as how to allocate a territory's debts. The paper offers one way to think about handling such transitions.
Importantly, I don't think you need to accept their broader premise to believe that Joseph and Mitu might be on to something about Ukraine's debt. But I do wonder whether there might be a simpler path to their desired end. Here, in grossly-simplified form, is their proposal as it relates to Crimea (pp. 40-43): Although international law does not clearly recognize such a right, Ukraine ought to be entitled to compensation for Russia's annexation of Crimea. Ukraine can use this claim to offset what it owes on the bonds - perhaps by paying the funds into an account at the Ukrainian Central Bank but refusing to release them until someone (presumably an English judge) determines the compensation owed. Normally, I wouldn't think that a borrower could assert such a set-off right against a subsequent holder of the bonds. But that wouldn't necessarily follow if the holder was closely related to, or controlled by, the Russian government.
It seems to me this proposal faces at least two significant objections. I already noted the first: it isn't clear that international law recognizes such a right to compensation, so the proposal depends on the willingness of a tribunal to recognize this novel claim. Second, the proposal requires an extraordinarily complex and normatively-charged valuation. What was Crimea worth? There is no market to consult for pricing information, even assuming one accepts that method of assigning value. How about the discounted value of future revenues from taxation and natural resource exploitation in Crimea, net of expenditures by the national government on services in the region? Seems....imperfect, no? Certainly Russia's valuation of Crimea was much higher, as the annexation conferred domestic political benefits on Putin and other government figures, increased the country's leverage in other international contexts, etc. Should the valuation take these into account?
I wonder whether it is necessary to recognize a brand new claim under international law or to tackle such difficult valuation questions. To be a bit tendentious, let's say Lender lends money to Borrower, structures the loan to give Lender an unusual degree of control, and then, shortly before the loan matures, funds a private army that so disrupts Borrower's affairs that Borrower cannot repay the principal without making itself insolvent. I am not an expert in English law, but I doubt it would take a super-lawyer to come up with a plausible defense to an action by Lender to enforce the loan. Nor is it clear that transfer of the bonds to someone else would change the result, especially as the holder's good faith, its knowledge of potential defenses, and the extent to which it is under Russia's control, would all be in question.
Of course, I have described the facts in as one-sided a manner as possible. The point isn't that this line of argument is a slam dunk for Ukraine. Rather, it is that Ukraine may have plausible arguments under English law, which a sympathetic court could recognize without having to create new rights under international law. True, the court might have to address some questions of international law - perhaps to decide whether Russia's actions in Ukraine were legitimate - but it would be on somewhat firmer turf in answering those questions. The valuation question would also be much simpler and less value-laden; it would be something more like, "Did Russia's conduct materially impair Ukraine's ability to pay the loan?".
In any event, the stakes are immense, as the Russian bond amounts to a substantial chunk of Ukraine's currency reserves. Payment in full means near-certain restructuring of other indebtedness, with distributional consequences that are distasteful, to say the least. So I am hoping that early reports that Ukraine plans to pay in full prove wrong. The legal options aren't great, but they are more potent than one might think.