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Do Italian Sovereign Bonds Have an Implicit Force Majeure Clause?

posted by Mitu Gulati

"Are There Force Majeure Clauses in Italian Sovereign Bonds?"

That’s a question one of the students in my sovereign debt class asked a couple of days ago. After reading about some of Christine Lagarde’s recent statements, she was worried about the possibility that the European authorities might not adequately support the Italian authorities in dealing with Covid19 with financial assistance needed to tackle the crisis (for discussions, here and here).  And, if not, she asked:  Could Italy use the force majeure clauses in its bonds to delay payment on its bonds until the crisis was handled?

My first response was that I was optimistic that the EU would provide Italy with any necessary assistance.  And my second response was that Lagarde and the ECB have walked back/clarified the statement in question. Plus, if memory serves, there is a mechanism for emergency financing to be provided via the ESM for adverse shocks beyond the particular country’s control.  Further, the ECB could probably do even more bond buying of Italian bonds in these circumstances.  That said, this is an event that is impacting multiple countries at the same time and it is perhaps worth it for individual countries to consider what they can do on their own if external help is not adequate.

To start with, it isn’t exactly clear what a force majeure clause is.  I’m no expert, but I believe that this is a French concept that is often referred to as an “act of god” provision.  That, on its face is not exactly a helpful description if you, like me, are unclear on what exactly acts of god are.  The basic idea is that the clause helps allocate the risk of contractual non performance when big cataclysmic events occur that are not the fault of one or the other of the parties and make performance extremely difficult. (for a helpful memo from Shearman & Sterling, see here)  The presence of such a clause in the contract, especially if it addressed the risk of Covid19, would help because it would show where the parties wanted that risk allocated. But, of course, no one knew about Covid19 until quite recently.

In the Italian case, best I know, none of their bonds say anything about which side bears the risk of a big unexpected cataclysmic event (here, the covid19 pandemic).  They are, in other words, no force majeure clauses.  Further, my casual examination of a few dozen bonds today suggests that these clauses are absent from sovereign bonds generally. So, the question is one of filling the silence in the contract.

There are three questions to ask here. First, was this risk contemplated?  Second, assuming it was not contemplated, First, how would the parties would have allocated the risk in question.  And third, ask whether is some general market understanding of who would bear the risk in such a case. Let us take them in turn.

Was the Risk Contemplated?  Implicitly, the question here is whether the failure to negotiate for a force majeure clause means that the parties allocated the risk of a pandemic to the Italian government.  In an ordinary international business contract, particularly in common law jurisdictions, where force majeure clauses are sometime included and sometime not, the failure to include such as clause might point in the direction of not excusing the failure to perform.  But the vast majority of Italian sovereign bond contracts are under Italian civil law and they say nothing – they basically have no terms.  So, does that mean that Italy has to perform always, no matter what the circumstances are?  Or does it mean that a court could fill the gap by trying to figure out what the parties would have said, had they contemplated the possibility of a pandemic clause for a sovereign bond?  The fact that private contracts in at least some cases since the SARS and MERS epidemics do in fact sometimes have explicit force majeure clauses that specify pandemics, points in one direction (see here, where a law firm talks about how it advised clients to include such clauses after those epidemics). Whereas the facts that civil law jurisdictions are generally more sympathetic to including an implicit force majeure term and that pretty much no sovereign bond has these clauses – except for a handful of Caribbean nations with hurricane clauses (see here, for a discussion of the Barbados hurricane clause) that all allocate the risk or hurricanes to the creditors – maybe points the other way.

Let us say though that the court is willing to say that the risk in question was not contemplated. That allows us to get to the next two questions.

How the Parties Would Have Allocated the Risk Had They Contemplated It? – Let us imagine there were a single creditor holding Italy’s multitrillion dollar debt.  Would she agree to give Italy a holiday from debt payment for say a year, so that it can devote all of those resources that would be used to service its interest payments to fixing the pandemic. Hell yeah.  This is one of those situations that that creditor would be urging the Italians to take a debt holiday and work instead on rescuing the country. Otherwise the risk is that the situation craters and it is not only the Italian state that suffers, but the creditors too.  In some ways, this is the textbook situation where the gap should be filled to allow the Italian state to extend maturities on its debt.   Or put differently, the better risk bearer in this context is the investor – especially since the investor bearing the risk reduces the risk for the investor. This indeed was the logic behind the allocation of risks to creditors in the case of the Caribbean hurricane clauses. What a court would be doing in filling the gap in the contract would be giving the parties what they would have wanted, jointly, to reduce the risk.

How the Market Generally Allocates This Type of Risk? – The example that I vaguely remember being used in my law school contracts class on this topic was that of war.  That is, a big unforeseeable event that significantly disrupts the ability of parties to perform through no fault of their own.  Although I also remember my wonderful teacher, David Charny, talking about how war was a bad example in some of the old cases where this came up because it was a foreseeable event at the time.  Anyway, the point is that courts will sometimes give the party that is unable to deliver a pass under the rubric of one of the excuse doctrines in contract law (impracticability, usually).  I realize that there is an argument to be made that the fact the parties didn’t explicitly contract for a force majeure clause ahead of time means that they wanted the sovereign to bear the risk.  I don’t think so, for the reason articulated above. This is the type of situation where, if the parties could have discussed it ahead of time, they would have both wanted roughly the same outcome. That is, that the state use of the bulk of its resources to solve the health crisis since the failure to solve that was sure to hurt the country’s ability to pay the debt.

The important wrinkle here is that the Italian debt is 99% governed by local law, with jurisdiction in Italian courts (for discussions of the local-law advantage, see here and here). Does anyone have any doubt as to how this issue would be resolved by a judge in Milan?  And that then brings me to what I think is the crucial question.  If the answer is so obvious that Italy could take a debt holiday, why has it not been taken already? The answer, I worry, is the fear of the government that the markets will penalize it in the future for asking for relief.  But this is precisely that type of situation where the market should want the government to stop paying it.

Last but not least, one might also ask the question of whether the Customary International Law doctrine of necessity might apply.  (for discussions of this doctrine, see here, here and here).  It strikes me that it is perhaps more apt in the current Italian context than in prior situations where it has been tried.  But going down this path requires much more thought than I’ve given the matter.  The necessity doctrine is a cousin of the standard contract excuse doctrines of impossibility, impracticability, frustration and duress, except that it excuses state obligations.  A significant question, however, is whether it applies in when the relationship in question is state to private creditor as opposed to the typical state to state context.

My dear friend and co author, Mark Weidemaier, is the real expert on excuse doctrines (and pretty much everything, including how to make the best cocktails in times of stress) and I always turn to him for for help on these matters.  I'm going to plead with him to join our zoom class discussion tomorrow to help remedy my errors.

As an aside, I am finding that the Netflix show Kingdom (a Korean zombie costume drama) to be a wonderful escape.  And yes, I realize that this reveals my rather low brow tastes.  I probably should be talking about how I'm using my spare time to do virtual tours of some fancy french museum.


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