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Scotexit and Allocating the UK's Debt

posted by Mark Weidemaier

This is a joint post by Mitu Gulati and Mark Weidemaier.

Scotland voted 62% in favor of remaining in the EU in last June's Brexit vote. Now, with nationalism on the rise in Britain, Scotland has begun to rethink the decision to stay in the UK. Fears of a so-called "hard exit," in which Britain foregoes easy access to the common market, have Scottish leaders like Nicola Sturgeon demanding another referendum on Scottish independence. Which has us wondering: What happens to the (rather large) pile of UK debt if one of its members decides to exit?

It seems like voters in Scotland ought to care about the answer, if given another chance to vote on UK membership. More broadly, one would think voters would want some idea how the UK's assets and liabilities would be divvied up. Things like the public debt, the crown jewels, pension obligations to veterans, the nuclear arsenal, Balmoral castle, and so on. The UK has a lot of stuff. How should it be divided?

Given the number of times countries and empires have broken up, one might expect international law to offer an answer. Perhaps debts and assets might be allocated according to some formula, such as contribution to GDP. Or perhaps there might be a system akin to "fault" (as opposed to "no fault") divorce. For example, if the reason for the break-up was that Britain failed to take Scottish interests seriously in charting the UK's future, then perhaps Scotland should be saddled with less UK debt. Alas, international law provides essentially no guidance on such questions.

Why not? One reason is that powerful governments have outsized influence over the development of international law, and these governments have little interest in creating clear rules to govern the break up of sovereign territories. The result is a structural bias against changes to sovereign borders. This bias in favor of the status quo generally is to the advantage of powerful governments.

But this system is not inevitable. People around the world are beginning to think more transactionally about these kinds of allegiances. To take a non-random example: The President of the United States is a real estate playboy who ran for office on an avowedly anti-science, anti-minority, anti-immigrant, anti-reading, pro-authoritarian platform. No surprise, then, that people in New York, Oregon, and California are contemplating the pros and cons of their union with other states. Or, to take another example: Puerto Rico experiences a serious debt crisis, and many in the mainland US start to wonder just how much they want to take on the burdens of this "unincorporated territory." (It is easier to have such doubts when one has already realized significant benefits from the relationship...)

In general, we each favor a world in which sovereign boundaries are less rigid than they are today. But we disagree on the role international law might play in increasing this flexibility. Mitu and his colleague Joseph Blocher think international law can and should play a key role in facilitating "international divorce." Mark (along with others, like Anna Gelpern and John Coyle) is more skeptical. But we agree that the question is important, and fascinating, and that international law offers nothing coherent to say on the subject. Given the importance of the question, this is a gigantic gap in international law. Certainly it should be of interest to (potential) voters in Scotland--not to mention Spain, and then Catalonia, and then... 

Comments

I share the skepticism of international law playing a key role in sovereign divorces. Because, as noted, powerful sovereigns play such an influential rule in international law -- having international law control or influence the separation might unduly favor the big countries. Even if a hypothetical country, X, were to consent to an international law regime for a sovereign divorce, is there any reason a hypothetical sub-sovereignty seeking independence, Y, would want to acknowledge such an agreement X made for them? Especially if the reasons driving the separations are related to international relations? Could Country X force Country Y to abide by international law until the "divorce" is complete?

Additionally, It will be interesting to see the separation terms Scotland may be willing to accept if the EU is willing to take Scotland back as a separate sovereign. Is it possible that having a potential new suitor in the EU may change the incentives Scotland is motivated by? I think ultimately Scotland would want have some insurance that the EU will let it back in relatively quickly -- making time of the essence.

I am not immediately persuaded that the silence in international law regarding the breakup of sovereign territories is due to the influence (and hence silence) of powerful governments, without exploring what their silence signifies. For one thing, it is unlikely to signify indifference towards the issue. On first look, it seems more plausible that powerful countries (which are mostly relatively large in size and clearly in terms of GDP) would have a clear interest against a sovereign breakup. In that case, wouldn't we expect to see some clear disfavoring of sovereign break-ups in international law?

At the same time, it seems that less powerful countries would be more prone to breakups that large/powerful ones. While we do observe discussions of independence both in the UK and the US, the adverse effects of independence on Scotland and Oregon might be dire precisely because the UK and the US have large economic size and power. These breakups could therefore be avoided "simply" by internal negotiation (although those negotiations will not likely be simple or necessarily successful, as evidenced by Brexit). So perhaps things are the way they are because while powerful countries do have an interest against breakups, international law is not needed to resolve them.

Less powerful countries may be more prone to breakups because they pay less attention to the economic effects and more to other salient factors driving the desire for independence--internal negotiations can be a dead-end. They are the ones in stronger need of international law guidelines on the issue. The Yugoslavian breakup can be a case study on division of assets and liabilities, and on how international law could have played a more prominent role in that. What we saw then was a division of assets and liabilities promulgated by the IMF and famous British lawyer (international lawyer nonetheless) Arthur Watts. While the IMF involvement was expected because Yugoslavia was indebted to the IMF, it also seems possible that in the breakup of less powerful countries in general, more powerful countries (represented by the IMF in 1991-92) will inevitably have a say. Hence the authors could be right: international law is silent because powerful countries chose it so. They do not need it in case of their own breakup, and they do not want to be governed by it in potential dealings with breakups of less powerful countries.

One of the points raised in the questions above, and one that is particularly important when it comes to the rules governing countries, is the general ineffectiveness of international law -- after all, one might argue that it is generally ineffective in forcing countries to behave.

That got me wondering whether things might be different this time--particularly with respect to breakups within the EU. Those countries have consented to the jurisdiction of European courts (like the ECJ and the ECtHR). Now, of course, the ECJ and EctHR also do not have traditional enforcement mechanism against misbehaving sovereigns. But countries within the EU do seem to comply (and the UK and Scotland are, for now, still governed by that regime).

To Dimitrios' point about whether powerful countries would want a rule against breakups, there is a rule about territorial integrity (uti something). In a sense, it is a no-breakup rule. But, of course, breakups and boundary changes still occur. And, when they do, there are no rules about how assets and liabilities get split up.

Perhaps part of the reason there are no clear rules is because the breakup of large nations is infrequent in modern times and is a result of very unique circumstances. When the Soviet Union fell apart it was up to the G7 to forge an agreement of debt apportionment. Originally Russia suggested that all of the Republics be jointly and severally liable for all the debt of the former union which was an absurd proposition. In the end Russia agreed to take on all the debts but only after it was promised almost all of former USSR assets and account and received a big break from official creditors. Even if an official mechanism was in place, the unique situations of sovereign breakups (USSR, Yugoslavia, Chekoslovakia) would have required the types of creative solutions which are difficult to predict until the break up event has occurred?

My question is whether Scotland can and should join the European Union? Are they strong enough as a country and following the debacles of letting weak economies like Greece into the Union, will the rest of Europe be willing to take Scotland?

Like Dimitrius, I am not persuaded that "powerful states" are responsible for international law silence in this area. According to the ILC, "the practice concerning the [division of] State property was homogenous in all the cases of succession" before 1983. It may well be that customary principles were enough to solve this issue, making binding international law unnecessary. When it comes to debt succession, however, there was no universal practice, so it is interesting that international law did not address the issue.
In 1983, the UN approved the text of the Convention on Succession of States in respect of State Property, Archives and Debts, which addressed both transfer of property and debt in cases of state dissolution and separation, but it has only been ratified by 6 states. Since the convention is still open for ratification, it seems that even "weaker states" are not interested in having rules that might constrain their negotiation power in case of dissolution or territorial separation. However, that this convention exists in the first place suggests that States, at least in theory, accept that international law can be used to facilitate the process of changing national borders (although countries clearly disagree on which rules should be adopted for that process).

It is interesting how international law is silent as to debt succession, especially when the international community has created mechanisms such as Chapter 15 to deal with "international bankruptcies." I will be curious to see if Scotland is able to break away from the UK and is ultimately allowed to join the EU. While I agree that the EU might be skeptical in allowing weak economies such as Scotland to join after the crisis in Greece, I do think that because Scotland submits to the jurisdiction of European courts, they might be more likely to take Scotland in.

I can't help but think this will ultimately come to nothing. Scottish independence turns on EU membership, the SNP hasn't come up with even a ghost of an application, and there are EU members with potentially break-away regions (cough**Spain**cough) who are going to be loathe to encourage such behavior.

I agree with Max. The allocation of assets and liabilities would mainly be a negotiation matter between the parties to the split. Providing some default rule may make sense in terms of facilitating and streamlining the negotiation but unique historical/economic background that the party nations are likely to have would make it difficult (or inefficient) to establish fit-for-all rules in advance. However, from the perspective of creditors, it does not sound absurd to me to argue that the party nations should be jointly liable for their debts vis-a-vis creditors. While they should be allowed to decide the ultimate share of burden between them, creditors would find no reason to be bound by the party nation's (possibly ad hoc) arrangement regarding the debt succession without their consents.

Quite a lot was written by Canadians in the 1990's in connection with the Quebec referendum. A random example:

http://global-economics.ca/dth.chap8.htm

As I recall, the Canadian Supreme Court left the debt question wide open.

jay

If we are agreeing to a world where new sovereigns are "jointly and severely liable" for the old union's debt, it will be extremely unclear how much each country is actually liable for. We contend that following dissolution nations must have a specific and easily identifiable number for their total debt, whether that is done via GDP or via a mechanism relating to public spending. (Though we recognize it is going to be extremely hard to decide.) The process and the formula should fit the unique situation, but what must be present is the final number on the outstanding debt of both nations. In the modern world where investors and bond purchasers are often international in nature, and only worried about the bottom line, having a final number on the outstanding debt would allow them to make a proper risk analysis on debt repayment to determine if they want to invest or not. Without this mechanism in place, debt from these new sovereigns would be unappealing to creditors.

In addition, the idea of "jointly and severally liable" would create inefficient incentives for separated countries. We envision a "race to the bottom" scenario where neither side will be willing to pay up, in the hopes that the other side does. When creditors inevitably take both sides to court we would in effect be asking a judicial body to define the financial obligations of the separated countries. The result would be that, not only did the jointly and severally liable approach fail, but also that the resolution is done by a court instead of through sophisticated negotiations between the states.

Even though we do not think "joint and severely liable" should be pursued as a basic framework for dividing debt in a sovereign dissolution, we do not feel like there are other principles to frame this conversation. There is no one size fits all model because each situation is just so different. The satellites breaking apart from Russia into tiny countries seems too different from Scotexit or even the possibility of Catalina spreading from Spain. Ryo is right and we think negotiations between the parties is going to lead how sovereign dissolution unfolds.

Just to clarify, in saying "having a final number on the outstanding debt would allow them to make a proper risk analysis on debt repayment to determine if they want to invest or not," who do "them" and " they" represent? It would apply to new investors, but does it apply to antecedent creditors? They already made their investment decision based on the financial conditions before the split.

What if the party nations agree on assets split 70%:30%, and debt split 30%:70% (or 100%:0%)? Is it fair for the creditors who result in having claims to the new nation having 30% assets of original nation and owing 70% debts of the same (or 70% assets and 100% debts)? Such split would significantly affects the risk profile of the debt repayment which had already been made by the existing creditors. Shouldn't they at least be entitled to object to the way of debt split if it may impair or negatively affect the party nation's ability to repay their debts?

In addition, assuming that A2 becomes independent from A1, from the contract law perspective, are there any legal grounds to release A1 from certain amount of debts (by transferring them to A2), or to allow A1 to set aside substantial amount of assets from creditors' recourse (by transferring them to A2 without receiving any value)? Given the absence of international rules regarding debt assumption in this context, what rules would give effect to such debt reliefs? Should the antecedent creditors rely on and be bound by the presumption that the party nations would negotiate to secure the sustainability of their respective debts?

As I noted, I presume that the party nations agree on ultimate share of burden between themselves. If either one of them pays the debts which fall under the other party's share, it would be entitled to seek compensation or subrogation to the other party. Does it still create extreme unclearness or disincentive to pay the debts in their respective shares?

To Alix and Maxim's concerns about judicial resolution, I would add that bonds that had been own-law debt would suddenly become foreign law debt. The newly independent sovereign's debt is governed by the laws of the sovereign that it used be a part of. Worse still, that foreign sovereign is not neutral but adverse because it has ample motivation to use its legal system to transfer debt to the new sovereign. After all, debt transferred to the new sovereign is debt that it no longer has to pay.

To use Scotland as an example, debt governed by UK law would become foreign law debt. Consent to jurisdiction in English courts would no longer be a "home court" advantage, but a liability as England stands to benefit if its courts deem Scotland liable for more than its fair share of old UK debt.

To clarify, “them” referred to potential investors in bonds of the new country. The stability of this new nation would depend on the ability to finance itself, just like almost every nation needs, and this should be a priority for both new creditors and antecedent creditors. If the new nation is not able to access the debt markets and maintain its ability to function as a country the antecedent creditors would lose the practical ability to recoup their investment and they will suffer. As long as there is payment or a reasonable prospect of payment, the actual dissolution may not change their ability to recoup the full value of their bond.

In addition, while antecedent creditors did make their investment decisions before the split, bond investors are not guaranteed whether the economy of the country they invested it is growing or not, they invested in a bond. Although the risk factor may be higher now, there has been no change in the payment terms of the bond. The United Kingdom has a long history in which of internal conflicts and one could describe Scottish independence as a risk factor in buying bonds. The Scottish Independence movement did not arise overnight, in its modern form its decades in the making.

I tend to find it a good thing that there is no law on the matter. As alluded to in Max and Alix's post, it's impossible to say that there are clear cut solutions that can be applied band-aid style in each situation. The break-up of the USSR, where Russia assumed the liabilities AND most of the assets of the former union, provides an excellent example of where negotiating at the table can lead to a pretty fair outcome for all parties, since at least with my cursory knowledge of the topic Russia was responsible most of the liabilities and assets in the first place.

Of course, this does invite the question of whether powerful governments wield too much influence and would have unfair control over any such process. But I would imagine, to take the Scots as an example, that the fact that Britain does seem incentivized to keep Scotland in the Union could provide added bargaining power for the Scots.

To touch on a final point, I fail to see what value would be created by enacting a coherent body of international law out of the nothingness that currently exists. If there is no international body capable of enforcement then there is nothing changing the status quo as it exists today. Smaller states will still be at the mercy of this new force while countries such as the United States will still do what they like.

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