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Contract Law and Ukraine's $3 Billion Debt

posted by Mark Weidemaier

The Russian government has announced announced that it plans to initiate legal proceedings against Ukraine by the end of the month to recover the $3 billion in bond debt now in default. It's not yet clear whether the proceedings will be in English courts or in arbitration. Officials in Ukraine say they expect to win. At first glance, that seems like posturing; after all, Ukraine borrowed $3 billion and didn't pay it back. But as it turns out, Ukraine has some pretty decent arguments, which if successful might excuse (or allow it to defer) the obligation to pay. Some of those arguments involve international law, and I'm a bit skeptical that those will succeed. But as I explain in a short new paper, Ukraine's contract-law arguments might fare somewhat better. Here's the abstract to the paper:

Russia has announced that it will initiate proceedings by the end of January (likely in arbitration) to recover the $3 billion debt owed by Ukraine. The Russia-Ukraine dispute is unique in the annals of sovereign debt litigation. It is a politically and militarily fraught conflict wrapped in a garden-variety, English-law contract dispute. The dispute may settle, and if so its resolution will depend largely on political and economic considerations. Yet the resolution will occur in the shadow of basic contract law, which is surprisingly relevant. Indeed, there are a number of plausible arguments available to Ukraine, which, despite the unusual facts, may excuse (or allow it to defer) its obligations to Russia. It would be understandable for judges and arbitrators to hesitate before weighing in on such a politically-charged dispute, but Russia’s insistence on acting like a private creditor leaves little choice.


In my opinion, the interest rate charged on the bonds poses a significant problem for Ukraine (5% v. 12%). As you point out, this concession could simply be viewed as Russian attempting to keep Ukraine from deepening its ties with the rest of Europe. However, Russia will likely argue that part, if not all, of this concession could be viewed as Ukraine bargaining to pay a lower rate in exchange for assuming various risks– including, among other things, economic instability in Ukraine. While this doesn't defeat the contract claims you discuss, it would seem to raise the level of proof Ukraine must show in order to succeed on these contract defenses. To me, this is a big negative as there seems to already be significant "proof problems" since the events are so politically charged and would require showing what Russia's intent was at the time the bonds were issued.

If I were Ukraine, I would be arguing that this isn't a setoff case but a foreclosure/repossession case. This isn't 1) Ukraine owes Russia a debt; 2) Russia is holding assets owned by Ukraine; 3) Russia elects to take ownership of the assets as payment against the debt. This is 1) Ukraine owes Russia a debt; 2) Russia forcibly takes possession of Crimea; 3) fair market value of Crimea far exceeds the debt; 4) Russia can pay itself from part of the assets it has seized, and Ukraine retains its claims to the balance. If you want to characterize the situation creditor-in-possession because the default occurred after Russia took possession that changes nothing other than to convert Russia from a regular lender to a pawn shop.

Although no clause is present in the prospectus, I initially wondered about the applicability of the concept of common law force majeure. But after more research, it seems the the level of proof for frustration under English law is lower than that of force majeure or the concepts of impossibility or illegality (not to mention that English common law does not automatically apply force majeure principles to contracts). To be sure, according to Davis Contractors v. Fareham UDC, 2 All ER 145, frustration requires more than a showing of new circumstances that cause contractual performance to be arduous or even prohibitively expensive. There, terrible weather and labor shortages rendered housing construction some 14 months overdue. The court deemed the contract enforceable because economic hardship does not sufficiently frustrate a contract. However, the court juxtaposed the events at hand with that of “a job of a different kind from that contemplated in the contract.” Surely the annexation of Crimea and civil unrest in the east could constitute circumstances “of a different kind” than those contemplated in the contract. Of course, you mentioned that there must be a finding that Ukraine played no inducing role in the frustrating circumstances, a fact-finding that Russia surely would dispute.

I think for both Prof. Weidemaier's prevention arguments and even Mr. Biv's force majeure argument rest in large part of the significance and nature of the annexation of Crimea in regards to its relationship to Ukraine. In monetary terms which of the following should be the considered in determining why Ukraine is currently without the $3 billion dollars it otherwise should have had: the cost of the conflict to Ukraine, the market value of land, buildings and other property that were confiscated by Russia during the conflict, the lost taxes and natural resource revenues, all of the above? The inherently political questions that underlie this very foundational fiscal question will make it very precarious for an arbitration panel to reduce this international conflict to private law terms.

In regards to the comment about foreclosure, it seems like any foreclosure argument would really just be a set off argument in disguise, which would be prevented by the no-set-off clause. Foreclosure presumes that creditor and borrower have agreed that, in the case of default, creditor has a right to the property securing the obligation to repay. In this context, Russia certainly did not have a right to Crimea under the terms of the bonds, nor to any other property in lieu of payment as the bond itself is unsecured. Thus, the claim that Crimea's value somehow makes up for what Ukraine owes can only really be argued in the set-off context. This is not to mention the fact that to presume Russia has a right to Crimea, as would be necessary to argue that territory's annexation as a foreclosure, would set a dangerous precedent for international law. Anytime a sovereign creditor desired to take over a sovereign debtor's territory, they could simply "foreclose" on it. This would have profound implications for other nations within Russia's sphere of influence.

Although we see the plausibility of the contract arguments for prevention and impracticability, we echo the fear of earlier commentators that the factual questions involved in concluding these defenses apply are inherently intertwined with political questions. Indeed, one has to wonder whether any judge or arbitrator would be eager to play the role of the international sovereign referee. In the United Kingdom, courts generally exercise restraint where it might involve making enquires into the activities and decision-making processes of a foreign State and its representative bodies, by virtue of the subject matter of the claims. Indeed, we briefly pause to note the comparisons that one could draw between the English practice of judicial restraint and the United States’ judicially created political question doctrine; we think further inquiry into such a comparative analysis could prove fruitful.

Returning to the present situation, we also stress that this is a sensitive international dispute with a ton of historical baggage. This begs the question of whether the rule of law would actually be undermined were three English arbitrators or a single judge to decide to incorporate fundamentally political questions into their analysis of contract law? However, we are somewhat sympathetic to the foreclosure argument because we note that “set-off” is not a defined term from what we can recall, at least within the context of international debt disputes. For example, while we do not doubt that the term would encompass any deal struck by the two parties during the pending Eurobond arbitration or litigation, we are unsure whether the term would also include an agreement reached after a judgment on that matter is entered and collection actions have commenced wherein Russia allows Ukraine to partially satisfy its debt by recognizing and deducting property owned by the Ukraine before the annexation of the Crimean territory that is know in possession of Russia.

The repossession/foreclosure argument is interesting, but from my understanding wouldn't part of the benefit of a set off be to avoid that talk?
The possibility of negotiations seems to make the set-off argument more viable because it removes the valuation problem of, "how in the world do you begin to put a price on Crimea?" Let's say Crimea is valued at $5B by both parties, but Ukraine only owes Russia $3B in bond obligations. What if Russia offered Ukraine $2B cash (or in other methods of payment), in addition to forgiving the $3B bond payment, in exchange for Crimea? It seems like under Mitu's "market for sovereign control" this could be a legal negotiation/transaction.
I would be interested to see more case law, especially in the UK, dealing with Force Majeure. Its a creative and interesting concept but I don't see how it would apply here based just off the case you gave. It seems like a direct act by one of the contracting parties (assuming the SWF is an agent of Russia) wouldn't fall in this category. Again, I could be misunderstanding the doctrine.

PutInOrPutOut wonders whether we might be looking at this situation backwards. A Bad-Mother-Russia-defense (or counterclaim) strategy to get Ukraine off the hook for repaying its publicly-listed Eurobonds should not hold up against a true third-party holder of the notes such as an independent institutional investor. (And maybe not even against the NWF as long as we’re talking about pure contract claims.) Why? One reason is that the facts Ukraine would use to argue impracticability or prevention conflict with the timeline of how events unfolded since the issuance of the notes. Another is the reasonable expectations Ukraine may have created among (hypothetical) independent third party holders to honor its obligations under the notes.

Let’s look at the timeline first. The whole story started when Ukraine issued the Eurobonds in December of 2013. Unrest started to unfold in February of 2014. Despite the increasing financial instability of the issuer, Ukraine continued to meet three semiannual interest payments on the notes. By the last payment in June of 2015, one could argue, the economic ramifications of Mother Russia’s *liberation* of Crimea and the uprising of the *oppressed* ethnic minorities in the East had fully unfolded. If Ukraine was able to meet its interest payments in June of 2015, why did it default on the interest payment due in December of 2015? Six months is a pretty short time frame in a conflict that has seen decreasing intensity over the course of two years. Ukraine would have to show that economic conditions deteriorated materially in the second half of 2015 which would force a court to choose whose side’s cooked books it is going to use as the factual basis on which to adjudicate this claim. We have a feeling no English judge or arbitration panel will be excited to get involved in a mess like that.

Then there are the reasonable expectations of (hypothetical) independent third party holders based on Ukraine’s actions. Russia happens to have held on to the entire issue of the notes, but, throughout the two-year holding period, was completely free to sell part or all of its holdings to any willing buyer in the (public) bond markets. For obvious reasons, such a sale seems rather unlikely today. But that wasn’t always the case. Surely, some hedge funds looked at this investment opportunity, and, for the sake of argument, lets pretend Russia had been willing and able to sell (parts of) its holdings, let’s say, in July of 2015. Assuming our above timeline assumptions hold up, on what grounds would a court allow Ukraine to invoke an impracticability or prevention claim to get out of repaying the notes? Surely, an independent tribunal would have to view Ukraine’s ongoing interest payments on the notes as recognition of the legitimacy of the bonds. We would argue that Ukraine also created a reasonable expectation among (hypothetical) independent third party purchasers that it will continue to honor its obligations under the notes. To succeed on its claim, Ukraine would thus have to show that such a holder did something that so dramatically changed Ukraine’s economic situation that it could no longer meet its (interest and principal) obligations only six months and $4 billion in IMF debt relief after its last interest payment in June of 2015 and our (hypothetical) purchase one month later. What possible assertion could Ukraine make against a holder that bought the notes in July of 2015 at which time the conflict had been in full swing for well over a year and Ukraine was still *happily* complying with its obligations under the notes? We think the claims against an independent third party holder are much more difficult than they appear on the surface.

Lastly, why should the NWF be treated any differently? A judge can’t really do that without opening the same Pandora’s Box that we are seeking to avoid by adjudicating this dispute as a pure contract claim in the first place. As a result, we are more skeptical of Ukraine’s prospects to be successful in bringing an impracticability or prevention defense/ counterclaim.

Team Chaos raises an important point: to what degree does the instability in Crimea impair the ability of Ukraine to meet their obligations. This goes to the heart of both the Prevention and Impracticability arguments. If, say, Crimea was insignificant with respect to Ukraine's aggregate economic output, then these the arguments raised by Prof. Weidemaier will likely fail for the simple reason that performance is not prevented nor impracticable.

Disregarding the political dimensions, a quick google search indicates that Crimea's GDP is about $4.3B compared to Ukraine's total GDP of about $132B (i.e., Crimea represents about 3% of total GDP). Is this so significant as to support the contract claims Prof. Weidermaier suggests

Just a quick thought on the set off argument: I would imagine that any version of the set off argument would be extremely unlikely to be accepted by an English court. The UK has a strong incentive to keep their lending markets emerging market friendly or at least neutral, and allowing Crimea as a set off could potentially scare away any other emerging markets from contracting under english law. The set off argument is an idea that is certainly worth exploring and developing, just seems like it may have its most realistic shot under arbitration or negotiation.

@ Linds & Ted: We found an article indicating that the loss of Crimea wiped out about 1.3% of Ukrainian GDP. (http://voxukraine.org/2015/09/28/the-geostrategic-games-around-the-word-investment-in-crimea/). This article also raises an interesting observation—that Russian control of Crimea has led to economic losses for Russia. The non-recognition of Crimea has scared off international investment in an area that was getting a great deal of FDI. Any kind "valuation of Crimea"/ set-off argument seems difficult to defend due to the explicit contractual problems and the difficulty in valuing the "loss."
@PutinPutOut— I think the difference between the earlier interest payments and the payment due in December 2015 was that the note was fully due and payable on December 20, 2015. The interest payments were much smaller than the full amount that came due.

Responding to Russian Sovereign Wealth Fund-General Counsel's comment at 2:49, we agree with the basic premise that the English Court would be unlikely to accept the set-off argument. However, we believe this is so because of the following reasons: 1. the explicit provision of the contract specifically prohibiting a set-off from being used to avoid full payment, 2. Ukraine has the burden of proof to demonstrate why the set-off provision would not prevent this set-off argument from being valid (showing bad faith, impracticability, etc.).

We disagree with the premise that English courts would not accept this argument so as to avoid scaring off developing countries from contracting under English law. As history has shown, very rarely is it the emerging/developing country that is annexing land from the developed country, but rather the other way around. For that reason, finding a set-off argument valid under this set of facts might actually encourage developing, vulnerable countries to contract under English law, as this doctrine would protect them from the developed, more powerful countries that they are contracting with.

In regards to Professor Weidemaier's paper, Russia must take the good with the bad with its contract claim. However, this means that the same must apply to Ukraine's counter-claim. We question the ability of an English court to make a decision regarding international law, as this is clearly not just a case between two private parties. If this were just a pure contract claim where Russia sought to enforce repayment of its loan then it would be simple. However, Ukraine's counter-claim complicates this to the point where it is beyond the jurisdiction of the English court because the counter-claim is not a pure contract claim. Mark argues for two contract defenses that Ukraine could potentially assert, but Ukraine's counter-claim could go far beyond those to include other various issues under international law. Thus, we question the capability of the court to here this "contract "case" because of the complications stemming from the counter-claim.

Like Argentina or Peru or ... have any EM oriented hedge funds bought the Ukraine bonds at issue and gotten on Putin's side of the litigation?

My point, and I did have one, was that foreclosure/repossession is far more analogous to this situation than set-off. Unless I missed something, and Russia took possession of the Crimea with Ukraine's permission. So as long as we're going to play along with Russia's efforts to characterize this dispute as a contract claim (which frankly raises "legal fiction" to a whole new level), I submit we should use the closest analogy.

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