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Necessity in the Time of COVID-19

posted by Mark Weidemaier

Mark Weidemaier and Mitu Gulati

COVID-19 has wrought an unprecedented economic crisis, which will most severely impact the poorest countries. Anna has written insightfully (here and here) about the G-20’s agreement to a temporary debt standstill for a subset of poor countries. And there have been numerous proposals (e.g., here and here) for a broader standstill to allow all countries the ability to devote necessary financial resources to the crisis. The basic idea behind these proposals is that countries should have the option to defer debt payments to both official and private creditors during the time of the crisis. A limitation of these proposals is that their efficacy depends on high levels of voluntary participation by private creditors. What is to stop less public-spirited creditors from insisting on full payment, even filing lawsuits or arbitration claims to enforce their debts? One answer to this question is that borrower governments could invoke the defense of necessity—long recognized as a rule of customary international law—as a defense to such lawsuits. We want to address that defense here briefly, recognizing that the topic deserves a lengthier treatment than we can give it here.

To clarify, here is how we understand the necessity defense: If successfully invoked, a sovereign could defer payment of any principal and interest that came due during the crisis, although it would have to make the payments once the crisis ended. It might also (although this is less clear) have to pay some compensation, likely in the form of interest on the delayed payments. But any compensation would reflect a below-market interest rate. In this sense, investors would suffer a real loss. They would be subsidizing the crisis response, although this does not make them unique. So is every other person with a claim on the sovereign’s resources, including the citizens and residents for whose welfare the state is responsible.

As a doctrinal matter, it isn’t hard to see the argument that the necessity defense is available here. In brief, the defense excuses a state’s non-performance of international obligations when non-performance is the only way to safeguard an “essential interest against a grave and imminent peril” and when the state itself has not contributed to the situation that has produced this necessity. (We’re quoting here from Article 25 of the International Law Commission’s Articles on State Responsibility.)  Unlike force majeure—which involves supervening events that prevent an obligor from performing its obligations at all—necessity applies when performance is possible but represents the greater of two serious evils. These are cases in which the state’s obligation to ensure citizen welfare must trump other obligations. We are simplifying. For instance, it isn’t clear how dire the threat to citizen welfare must be to trigger the defense. Some decisions suggest that necessity is available only when the state’s very existence is threatened; others have a more capacious view of the doctrine. The fundamental point is that, in cases of necessity, a state can perform its obligations only by subordinating some other, greater interest.

A fundamental question—currently at issue in the litigation between Casa Express and Venezuela—is whether the defense is available only when the relevant obligation is owed to another state (rather than, say, to private bondholders). We’re going to set this complicated question to one side for purposes of this post, although we should make clear that we see no good reason for making such a distinction. The distinction in effect treats private investors as having superior rights to sovereign states, which strikes us as odd. It also leads to hard-to-defend distinctions between private creditors. For instance, the defense would be available to a sovereign defending against a private bondholder’s claim in arbitration under a bilateral investment treaty (where the sovereign’s obligation to the private creditor implicates a treaty) but would not be available to an identical bondholder bringing suit in national court. In Germany, the Federal Constitutional Court embraced such a distinction, but it has little to recommend it.

Here, we want to make a more fundamental point. The prospect that a sovereign might invoke the necessity defense often prompts the following objection: Recognizing this defense will ultimately harm sovereigns and sovereign debt markets. It will drive up borrowing costs by creating a real risk of borrower-side moral hazard (because governments will be tempted to default opportunistically). But this is not at all likely. To the contrary, recognizing the defense in the context of COVID-19 is consistent with investors’ reasonable expectations. It is, in fact, the outcome that reasonable investors would have agreed to if they had thought about these precise circumstances at the time of the investment.

It is clear that it can be in the best interests of the sovereign and its creditors for the sovereign to get some breathing room to respond to a crisis. (If nothing else, this will allow it to limit the economic fallout and resume payments more swiftly.) From the creditor’s perspective, the primary fear is that an opportunistic sovereign will invoke necessity to defer its obligations when it can afford to fulfill them. Whether this is a serious risk depends on whether a tribunal can accurately verify that a state of necessity has really occurred. If not—if the defense is not easily verifiable—then the risk of opportunism is enhanced.  

In this context, creditors could potentially bring claims before many different tribunals. Probably the two most important forums, however, are the Southern District of New York and the High Court of Justice in London (where most sovereign bonds and direct loans envision enforcement). From the perspective of judges in these courts, perhaps the central concern will be whether it is possible to embrace the necessity defense without opening the floodgates, allowing sovereigns to invoke necessity in all sorts of dubious circumstances. But in connection with COVID-19, this is not a serious concern. We refer not just to the acknowledged severity of the economic crisis caused by the response to the virus. More important still, official sector actors like the G-20 can play a certifying role—as the proposals linked above make clear—to confirm the severity and global effect of the crisis and to provide clear guideposts for when the crisis ends.

We have much more to say on this topic. We acknowledge, for instance, that it will raise a host of new questions to recognize the necessity defense in the context of claims by private creditors. (For some discussion, see Matthias Goldmann here.) For instance, can a private creditor expressly contract around the defense of necessity? We’ve never seen a contract that does this, so it is a question for another day. But the question asks whether there are limits to a government’s ability to make credible commitments to prefer financial creditors to residents. The formal doctrine of necessity seems to recognize that an international obligation can “exclude the possibility of invoking necessity” (again, quoting Article 25), but do private creditors have the power to bargain for similar priority?  

We’ll close by quoting this remarkably (and unfortunately) prescient paragraph from Alan Sykes, who wrote about this question in Economic Necessity and International Law:

In individuals, risk aversion is a product of the diminishing marginal utility of money. Governments may also experience shocks that affect the marginal utility of money… For a government facing a fiscal or balance-of-payments crisis, when the funds to provide essential public services or to support the local currency may be lacking, the implicit marginal utility of money may increase much as it does to individuals who experience an adverse shock to wealth. A justification might then arise for shifting the risk of fiscal distress from the government to investors…

But host governments may experience other shocks to the implicit marginal utility of money. Imagine a developing country facing a deadly tropical disease, and suppose that a costly cure has just been discovered. The government may then have an extremely valuable use for funds that it did not have before. Accordingly, to the list of economic exigencies plausibly justifying measures to conserve government funds, we might add certain scenarios in which the government experiences a new and pressing need for funds to address some unanticipated domestic emergency--a public health crisis, a natural disaster, and the like.

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