Odd Lots Podcast: The Narrowly-Avoided Russian Debt Default

Mitu and I have posted a few times (here, here, and here) about some of the odd features in Russia's bond contracts. Perhaps the weirdest (and most odious) is the Alternative Payment Currency Event clause, in which investors effectively insure the Russian government against the risk of future sanctions. Anyway, we had a chance to discuss these clauses, and the general complications of a potential Russian default, with Bloomberg's Tracy Alloway and Joe Weisenthal on their fabulous Odd Lots podcast:

There’s a big question over whether Russia will be able (or willing) to make payments on billions of dollars it’s borrowed from investors given its current situation. Not only does the country have a history of previous major defaults, but some of its outstanding bonds are also structured kind of strangely. On this episode of the Odd Lots podcast, Tracy Alloway and Joe Weisenthal speak with University of Virginia law professor Mitu Gulati and University of North Carolina's Mark Weidemaier. They describe how odd some Russian bonds are and what might happen after default.

Spoils Don't go to the Aggressor

Mark Weidemaier & Mitu Gulati

Ukraine has suffered an unprovoked invasion by a militarily more powerful neighbor, Russia, that covets its territory. The weaker Ukraine, in danger of being overrun, desperately seeks external financing for defense and to support its population. What might we think the rules of international law would be regarding the responsibility to pay that debt?

The relevant law here is antiquated. There are a handful of precedents from the nineteenth and early twentieth centuries where, best we can tell, the law was whatever it was convenient for the victor to assert. But, if one were to try and extract a doctrine out of those precedents, it would be that, while a victorious invader inherits the debts of the nation it invaded, it does not necessarily inherit debts incurred to resist the invasion. The doctrine even has a name: the law of “war debts”. To quote a 1924 treatise, “A creditor who advances money to a belligerent during a war to some extent adventures his money on the faith of the borrower’s success”.

That’s nuts. That doctrine incentivizes potential lenders to invest in the debt of the more powerful actor, even if the less powerful actor has a legitimate right to self-defense. It is perhaps not surprising that such an upside-down rule existed in the colonial era, when great powers constructed the law to justify their acquisition of territory (the original articulation of this doctrine seems to come from Britain after the Boer War). But today? In the supposed post-colonial era when borders are supposed to be sacrosanct absent the most egregious violations of human rights and colonial acquisitions by force are not supposed to happen? When an aggressor launches an unprovoked attack (Mr. Putin has his own version, we recognize), it seems logical both that that the aggressor should bear the cost of the victim’s self-defense and those who funded it should be the ones at risk. This rule internalizes the cost of misbehavior and might help deter aggression. This rule seems to set the right incentives whether or not the aggressor nation winds up being victorious.

In the Russia-Ukraine context then, who should be responsible for the extra borrowing that Ukraine has to do to defend itself? If the goal is to cause the misbehaving actor to internalize the costs it is imposing, the answer is surely Russia. Furthermore, to the extent lenders helped finance the Russian invasion, they are the ones who should face a high risk of nonpayment, not those who funded the Ukrainian defense. If we were to imagine a situation, post-war, where the international community had to allocate a limited pool of assets (e.g., frozen Russian reserves), we’d probably say that claimants who funded Ukraine’s self-defense should have a higher priority than claimants who helped fund Russian misbehavior. That is especially so if the lenders to Russia had reason to expect misbehavior. Maybe Russia even told them in its risk disclosures whilst borrowing – “Hey, don’t be surprised if I get sanctioned in the future – because I tend to misbehave”. (see Tracy Alloway (here), Adam Tooze (here), and us (here) on this).

None of this is rocket science. One of the things that legal rules are supposed to do is to incentivize good behavior and disincentivize bad behavior. As of this writing, the World Bank has just announced an emergency financing package of $700 million for Ukraine. Maybe that lending will be repaid by Russia, in a post invasion scenario on the theory that multilateral institutions such as the World Bank are not allowed to finance military expenditures. We don’t remember seeing any multilateral organization exception in the law of war debts though.

More important though, Ukraine needs financial assistance to defend itself and is surely going to be trying to borrow from the private markets. And lenders are going to be reluctant to fund it (or, will charge more) if they think they face significant risk of non-payment if Russia wins. Whether one liked it or not, risk disclosures would probably have to be made in the prospectus regarding the doctrines of state succession and war debts.

But what if the rule instead were that those who provided financing to Ukraine during these dire times were to have first shot at those frozen Russian assets in the post war period? (in legal lingo, priority)? Those risk disclosures and the pricing of the financing of the Ukrainian resistance might be different.

Maybe, just maybe, the free nations of the world (including those former colonial powers who created these doctrines) should announce a new and improved doctrine of war debts for the modern era: Spoils don’t go to the aggressor.

Should Investors Who Care About ESG Buy Russian Sovereign Bonds?

Mark Weidemaier and Mitu Gulati

Umm... no?

We can think of two models of ESG investing. (At Bloomberg, Matt Levine has a more sophisticated take; also here.) One is normative, simple, and apparently held by very few investors. It goes something like, don’t invest in “bad” activities or borrowers. A second model, apparently more common, is that investors rely on ESG metrics to inform them about potential risks and economic implications of a borrower’s ESG-related practices. As Sustainalytics puts it, “Material ESG issues (MEIs) are business issues related to environmental, social, and governance factors that may have a measurable impact on financial performance.” We confess that we don’t really understand this second model, or how it differs from an investment approach that puts risk-adjusted returns above all else. But it seems to make people feel good.

Anyway, you probably were not wondering about the link between Russian sovereign debt and ESG investing. Neither were we, because, well, why would anyone wonder about that? It seems obvious that investors buy Russian sovereign debt specifically because they do not care about ESG goals, at least for purposes of that investment. The ESG part of the investor’s brain is off doing something else while the part that chases yield buys Russian bonds. But most investors claim to care about ESG goals. And some people seem to be wondering what it means that investors who make this claim sometimes hold Russian bonds too. One way to understand this fact is to posit a flaw in ESG metrics. As the Financial Times summarizes one expert in sustainable finance, “Russia’s invasion of Ukraine has exposed the failings of asset managers and data analytics firms in their assessment of environmental, social and governance risks.” An implication is that “ESG data firms need to look at [the war in Ukraine] and ask themselves what they have missed.”

Another way to put the problem is to say that what ESG data firms have missed is that investors do not care about ESG. Yet a third way to put it is to say that investors cannot be bothered to read contracts, so you can get them to agree to the most outrageous things if you just have the chutzpah to write it down and hope they don't notice. The Russian sovereign bonds nicely illustrate both of these latter possibilities.

The Alternative Payment Currency Event Clause in Russian Sovereign Bonds

Mark Weidemaier and Mitu Gulati

A clause in recent Russian dollar and euro currency bonds – presumably written in anticipation of the possibility of sanctions from the US or the European Union -- allows payments to be made in a currency other than Euros and US dollars under certain conditions. Russia’s 2019 bond issuances in US dollars and Euros says, for example, that the Russian Federation may, under conditions “beyond its control”, make payments in an “alternative payment currency."

“Alternative payment currency” in the US dollar issuance is defined as “Euros, Pound sterling or Swiss francs or, if for reasons beyond its control the Russian Federation is unable to make payments of principal or interest (in whole or in part) in respect of the Bonds in any of these currencies, Russian roubles."

What's unclear is what makes a reason “beyond the control” of the Russian Federation in case it finds itself "unable to pay" in the specified currency. Presumably the fact that Vladimir Putin has forbidden something does not make it beyond the control of the government; he can choose not to forbid it. But could Russia plausibly argue that it is unable to pay because of western sanctions, and these are beyond its control?

Are Russian Sovereign Bonds Now Worthless?

That is the question Mitu and I discuss in the latest Clauses and Controversies episode. We were prompted by a Bloomberg story quoting Jay Newman (formerly of Elliott Associates), who expects Russia to default and points out that its international bonds lack waivers of sovereign immunity. But this doesn't mean investors can't sue. To the contrary, investors probably can convince courts in New York and other places to accept jurisdiction and enter favorable judgments. It won't be quite as easy as in cases where the bond includes a waiver of jurisdictional immunity and related provisions, such as appointing an agent for service of process, that ease the path to the courthouse. But it's certainly do-able.

The harder problem is finding attachable assets. Having a waiver of the sovereign's immunity from attachment and execution makes things much easier, but it's possible to attach assets even without a waiver, and especially so when the foreign state lacks the support of the U.S. and most other governments.

It turns out that Russia's international bonds have all kinds of interesting clauses. Some are very investor-friendly, including a super-broad pari passu clause. Some aren't investor-friendly at all, such as a very short, three year prescription clause. And others are just weird, including a clause in a subset of bonds that potentially allows the Russian government to pay in roubles. We discuss all of these in the podcast.

Maybe investors won't line up to sue the Russian government. But if ever there was an opportunity for distressed debt funds to be on the side of the angels, this is it. So perhaps this will be the assignment we give students in our sovereign debt classes to work on for the rest of the semester:

Your client is Rick Blaine, manager of the New York based hedge fund Ilsa Capital.

A few things you should know about Rick.

He is rumored to have run guns for the anti-Franco side in the Spanish Civil War.  He never drinks Vichy mineral water. And he hates thugs of all types and nationalities.

Ilsa Capital owns positions in each of the Russian Federation foreign currency/ foreign law bonds that are outstanding as of March 1, 2022. 

Rick wants to join the fight in the Ukraine but his employees have persuaded him that he can do more for the cause by increasing the financial pressure on Mr. Putin. For this he needs your counsel.

Rick assumes that the Russian Federation, in light of the painful financial sanctions being imposed on it by the EU and USA, will stop paying interest on all of its US dollar and euro-denominated bonds.

His question to you is simple — “once they default, what can we do to cause trouble?” Rick is very popular in the hedge fund industry and has assured you that once you design a strategy, Rick is more than happy (in his words) to round up the usual suspects.

Rick does not like to read lengthy documents from lawyers. Hence, please keep your memorandum to under ten pages (double spaced).

The Texas Two-Step? Just Don't Go to the Dance

Suppose a company facing mass tort liability to U.S. citizens produced a piece of paper that read "Cook Islands Liability Extinguishment Corporation." The company then says to the tort victims, "We have formed this corporation under the law of the Cook Islands, which allows us to assign any liability we want there and extinguish it. And, that's exactly what we did with your tort claims." The legal response would surely be that the law of the Cook Islands does not govern the company's tort liability under U.S. law.