The Puzzle of Diaspora Bonds: A Case Study of Israel's Program

Many countries have attempted to tap their diasporas by issuing bonds.  This has particularly been the case in times of dire need (wars, pandemics, international sanctions, financial crises, and more).  Ukraine is the most recent to have attempted to do this and failed.  Other recent failures include Pakistan, India, Ethiopia and Greece, some of whom turned to bank deposit schemes when attempts to do full scale bond issuances did not succeed

A superb new paper by Doug Mulliken, motivated by the many failures to issue diaspora bonds, does a deep dive into the one program that has not only been successful, but has remained so for over a seventy-five year period: The Israel Bonds program.  

Doug's paper, titled, "It’s not just money; you are investing in your identity”: Israel, the Jewish Diaspora, and the Israel Bonds program,is on ssrn.com.

The abstract reads:

Israel has been selling diaspora bonds for almost as long as the country has been in existence, with the original 1951 Independence Bonds being issued just three years after the State of Israel’s establishment as an independent nation. For over 70 years, both in times of crisis and times of strength, Israel has used the Israel Bonds program to call on the Jewish diaspora — most significantly in the United States but also in Canada and across the world — to provide the country with a layer of financial security that is, in many ways, unprecedented in modern history. The importance of Israel’s diaspora bond sales has evolved over time: it functioned as a load-bearing support of Israel’s economy in the program’s early days when, in the aftermath of World War II, sovereign debt markets had essentially disappeared; it now serves a far more important symbolic function, allowing Jews across the world to develop a connection with Israel by contributing some modest amount to the country’s well-being.

This analysis considers the social and historical context of the Israel Bonds program, taking into consideration the almost emotional connection that the bonds allow members of the Jewish diaspora to feel towards the State of Israel. Most importantly, this study examines the terms of the bonds themselves, comparing both how Israel Bonds mirror traditional Eurobonds and, in particular, how the two types of issuances differ. With this, the analysis hopes to shine a light on an under-studied, but incredibly significant, aspect of Israel’s economic development.

 

The Debt Limit Is Unconstitutional—But It's Not What You Think!

Anna Gelpern, Stephen Lubben and I have an article in The American Prospect entitled The Debt Limit Is Unconstitutional—but Not for the Reason You Think. Various commentators—and members of Congress—have suggested that the President “invoke the 14^th Amendment” to declare the debt limit unconstitutional. They're right to argue that the debt limit is unconstitutional, but the constitutional problem isn't the 14^th Amendment. Instead, it's Article I of the Constitution, namely Congress's power to enter into contracts. The tl;dr version is that Congress has a power to make binding commitments for the United States and the President is constitutionally obligated to perform those commitments. If the Treasury lacks the funds, then the President must borrow. No specific authorization is needed. Instead, it is implicit every time Congress appropriates funds to perform a binding commitment.

Relocating the constitutional problem with the debt limit isn't merely an academic exercise. It has two implications.

First, it changes the nature of the legal debate and puts the administration on much, much firmer legal footing. The 14th Amendment argument is weak because it simply is not a prohibition on defaulting. It's a prohibition on repudiation, and a default is not a repudiation. An Article I argument reframes the issue as being about the validity of the debt ceiling, rather than the ability to default. In other words, it goes to question of whether the House GOP has holdup power, rather than whether the administration is under some cryptic constitutional limitation that it must affirmatively "invoke."

Second, it means that the President not only can, but must disregard the debt limit in order to fulfill his own constitutional duty to "Take Care" that the laws are faithfully executed. In other words, breaching the debt limit is not merely an option, but a legal requirement if Treasury is short of funds. Once Congress has appropriated funds, the President must carry out the authorized spending.

Debunking Debt Ceiling Myths

The commentary on the debt ceiling standoff has featured a bunch of mistaken conceptions from across the political spectrum. Let's address them. 

Myth #1:  The 14th Amendment Prohibits a Default

A variety of commentators claim that the 14th Amendment prohibits the United States from defaulting. It does nothing of the sort. Read the text of the Public Debt Clause: 

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.

The Public Debt Clause is a prohibition on disputing the validity of US debt obligations--that is disputing whether they are legitimately owed. There's not a word in the 14th Amendment about default. The drafters of the Public Debt Clause included some very experienced commercial lawyers. They understood the difference between defaulting on an obligation and disputing or repudiating an obligation.  For example, I might acknowledge that I owe a loan, but just not be able to pay it. That's different than saying "I don't owe the money."

The Public Debt Clause is a prohibition on Congress, the Executive, and the Courts from disavowing US debt obligations. It's not a prohibition on defaulting because such a prohibition would be meaningless. If a country is unable to pay its obligations, no constitutional commitment device can change that. A constitution cannot fill a bare cupboard. And if a country is simply unwilling to pay its obligations (but admits to them), then its creditors are left with whatever legal recourse they might have. But prohibiting default doesn't get creditors anything. Prohibiting disavowal does because it means that creditors retain their right to be paid.

What all this means is that "invoking the 14th Amendment" is meaningless, unless it is shorthand for "treating the debt limit as unconstitutional." Now it just so happens that the debt limit is unconstitutional—but not because of the 14th Amendment!

 

14-4: Any Questions?

Anna, Adam, and myself have a piece up on Alphaville about section four of the 14th Amendment, which is all the rage these days.

#PublicDebtIsPublic and #DebtCeilingIsStupid

What could possibly trigger me enough to break a two-year blogging hiatus? A sudden burning desire to consider the difference among budget accountability, debt accountability, and the inane, moronic, irrational, exploding human appendix ****show that is the debt ceiling.

Yehuda Adar on Contract Damages -- In a Bond Default

Figuring out the right damages measure for default on an actively traded financial asset such as a government bond is, at first, obvious -- just pay what you promised on the bond.  But then, when one thinks about features of damages law such as the option to substitute performance or mitigation, things get murkier.

Yehuda Adar, a guru of the messy law of damages at Haifa, has a super new paper on ssrn.com (here).  How he manages to be so very clear and coherent about a topic that is so messy is beyond me. 

Here is the abstract:

What are the damages to which an investor facing a repudiation or a material breach by a government issuer is entitled? The conventional answer that most investors would probably give is that, in the face of such a default on the bond indenture, damages should include both the repayment of the principal (‘par’) and the payment of any remaining (i.e., unpaid) coupons (discounted to present value). Is this conventional understanding warranted? For at least some sovereign bond experts, the answer is not at all obvious and straightforward at it might seem at first blush. Aren’t such damages over-compensatory? Indeed, by obtaining – prior to maturity – both the par and every remaining coupon payment, isn’t the bondholder being put in a better position than if the contract had been performed? Indeed, if there had been no breach, wouldn’t the bondholder have to wait for those payments to be made until maturity date? Secondly, if damages are to be calculated this way, isn’t the bondholder going to receive something more valuable than what he had before the breach? More concretely, whereas prior to breach the bond’s market value reflected the issuer’s credit ranking, the conventional measure of damages seems to treat the bondholder as if he owned a U.S. treasury bond. Third, shouldn’t the investor be expected to purchase a substitute on either the primary or secondary market to eliminate or at least minimize his damages? Shouldn’t this option significantly reduce the scope of the issuer’s liability?

As basic as these questions sound, they have managed to escape rigorous analysis in the sovereign bonds literature. One can hardly find a comprehensive analysis of remedial issues within this vast body of scholarship. What, then, is the correct measure of damages for the breach of a government bond? By closely inspecting this deceptively simple question, this Article highlights the availability, under the general law of contract damages, of no less than four different methods for measuring a bondholder’s expectation damages. The Article presents to the reader each of these alternative measures and illustrates how to implement each of them in a hypothetical case described at the outset of the Article. Then, the Article addresses two analytical challenges facing a court (or an arbitrator) wishing to reach the correct decision on the damages issue. The first involves a choice between two ways of conceptualizing the bondholder’s loss; namely, the loss of the promised performance of the indenture on the one hand, and the market value of the bond on the other hand. The next challenge is that of applying the mitigation of damages doctrine. Considering the normative and practical considerations pertinent to each of these challenges, the Article ultimately concludes that in most cases courts will tend to implement the ‘Gross Lost Profit’ measure of damages, which is the most generous of the four expectation damage measures. Surprisingly or not (depending on one’s intuitions), this measure coincides with the wisdom of the crowd.

 

 

Confiscating Russian Assets (Now?)

As the Russia-Ukraine conflict continues and the amount of destruction to lives and property grows exponentially, a question that has come up is whether Russian assets overseas should be confiscated and made available to those who the Russian invasion has harmed  (e.g., here).  The list of those is growing larger minute by minute:  refugees, families of those who have died, people whose homes and livelihoods have been blown apart and on and on and on.

The amount of harm that Mr. Putin's craziness has caused is already far greater than the value of the frozen assets -- in the many trillions whereas the frozen assets (even if one adds in the oligarch properties) is in the hundreds of billions.  But should we wait until Mr. Putin has taken whatever portion of Ukraine he wants (e.g., 20-30%), installed some puppet government, and is finally willing to negotiate for peace?  At that point, as part of the negotiation, he is going to want to ask for his frozen assets back.  And the leaders of the countries where the frozen assets are located, who will be desperate for peace, might be tempted to give the assets back.  Let us not kid ourselves.  The political flesh is weak.  If those politicians see themselves garnering advantage at the ballot box by negotiating a quick peace (to the detriment of the claims or refugees and others), they will do that.  So, maybe there is an argument to confiscating the assets now while there is political will to do so.

On the other hand, there is the small matter of the law.  Due process before taking people's property and all that.  Does it allow for the confiscation of the property of a sovereign engaging in an egregious violation of international law by invading a neighbor?  There is the proverbial slippery slope of countries confiscating the property of other sovereigns whose behavior has displeased them without first ensuring that they are legally entitled to.

To my mind, these are fascinating questions to which there are not clear answers.

Two giants of the legal academy, Larry Tribe and Paul Stephan have been debating this in the context of what Mr. Biden is allowed to do.  The assets can be frozen. But can they be confiscated?

Here is the abstract of Paul's superb new paper that describes the issues:

This article addresses the legal issues that the United States would confront were it to move from freezing to seizing. It looks first at the executive branch’s existing legal authority to confiscate foreign property. It considers legislative proposals to extend that authority. Both existing law and possible future legislation face constraints under constitutional law. These constraints are unique to the United States but reflect principles of legality and due process that western states generally embrace. Finally, it provides a snapshot of the international legal issues that seizure of Russian state assets might present.

First and foremost, existing law does not permit the executive branch to dispose of Russian state assets in advance of a settlement with that state. A civil process exists to forfeit assets to the state, including those of state-owned entities, but that entails resort to the courts and requires some evidence of criminality. Legislation currently under consideration in the United States would enhance that process but not abandon it. It would not apply to the largest portion of assets, the deposits of the Russian Central Bank in US financial institutions, absent some proof that those deposits can be traced to criminal activity. US constitutional guarantees against expropriation in the absence of compensation and of civil forfeiture in the absence of due process almost certainly apply.

Finally, the seizure of assets belonging to the Russian state outside of normal criminal and regulatory processes would violate international law. What international law probably would permit, however, is the use of these assets to satisfy legal judgments rendered against the Russian Federation by duly constituted international investment tribunals established under treaties to which Russia is a party. The United States and other countries in the West might explore ways of encouraging the beneficiaries of these awards, both present and future, to devote their recoveries to Ukrainian reconstruction.

A Tournament of Lawyers: Who Should Sri Lanka Hire to Manage its Debt Restructuring?

Rumor is that close to thirty leading international law firms have put in bids to assist Sri Lanka in its upcoming debt restructuring.  Makes sense -- there is a fat paycheck for whoever gets the mandate.  Given the stakes, my guess is that these firms -- and I'm just guessing -- are busy trying to "influence" whomsoever they can in both the current government and in the opposition (after all, the current government might fall any day now) to get ahead in the competition.  Yuck.

Having a good adviser can make a huge difference in terms of how well one's debt restructuring goes.  Hopefully, the decision will made as a function of which adviser will give Sri Lanka the best restructuring design and not made as a function of who is best buddies with the President's closest flunky.  I'm not optimistic though.

I have a suggestion.  I know it has zero chance, but I'm going to make it anyway.  We should have a competition, a tournament of lawyers. Each of these firms should have to put up on  ssrn.com a ten page plan as to how it plans to solve the likely holdout problem with Sri Lanka's restructuring.  Then, Sri Lanka could have a neutral panel of respected restructuring experts pick the firm with the best plan. Or the experts could pick four semi finalists and those semi finalists could be given the opportunity to present their plans and answer questions in an open setting. 

Wouldn't it be a lot better for these firms to be spending their resources competing to design the best possible plan for Sri Lanka than competing to please the president's best friend or the cousin of the leader of the opposition?

These foreign advisers are expensive. And perhaps rightly so, given what they provide.  But they should have to earn every penny they charge a country in deep distress.  Maybe some of them with a really good plan might even offer to work pro bono?  After all, fame and fortune can come alongside a beautifully conducted restructuring.

Let the games begin.

 

Can Russia Pay its 2022 Dollar Bond Obligation in Rubles? (More dodgy Russian bond clauses?)

I didn't think so. But one of my students has me questioning myself.

As of this writing, in April 2022, the press is reporting that Russia is on the brink of default because its foreign currency funds are frozen (here). Russia says that it is not in default because it is unable to make the dollar or euro payments as a result of the sanctions and is entitled to make its payments in rubles.  Investors have dismissed this idea – saying that it is “crystal clear” that payments on the bonds with payments due April 2022 have to be paid in foreign currency (here).

Yes, there are some bonds, containing an “Alternate Payments Currency” clause issued in the post-2014 period, where Russia is arguably entitled to make payments in rubles if, for reasons out of its control, it is unable to pay in the primary currency specified in the bond (here).  But the bonds that have come due in April 2022 do not contain that Alternate Payment Currency clause. And hence the assumption seems to be that the ruble payment constitutes a default.  And I confess that that was my assumption until a student, Doug Mulliken, pointed out a clause that I had previously missed.

It is clause number 15, titled “Currency Indemnity.”  The first sentence of the clause says:

The U.S. dollar is the sole currency of account and payment for all sums payable by the Russian Federation . . . in connection with the Bonds, including damages.

That’s well and good.  The US dollar is the currency of payment.  But then the clause goes on to say:

Any amount received . . . in a currency other than the U.S. dollar . . . by any Bondholder in respect of any sum . . . due to it from the Russian Federation shall only constitute a discharge to the Russian Federation to the extent of the U.S. dollar amount which the recipient is able to purchase with the amount so received or recovered in that other currency on the date of that receipt or recovery . . . If that U.S. dollar amount is less than the U.S. dollar amount expressed to be due to the recipient under any Bond, the Russian Federation shall indemnify such recipient against any loss sustained by it as a result. In any event, the Russian Federation shall indemnify the recipient against the cost of making any such purchase.

To my reading, Doug is right. Boiled down, the clause seems to say that payment in a different currency (e.g., rubles) can constitute a “discharge”, so long as the recipient can use those rubles to buy a sufficient number of dollars.  That seems to mean that Russia, can discharge its obligations by paying in rubles.

Now, maybe I have missed some other clause in the document that negates this.  It would not be the first time that that’s happened.  But I do remember reading a chapter in Lee Buchheit’s, How to Negotiate Eurocurrency Loan Agreements, (Chapter 20, if memory serves) that not only describes clauses like this, but also explains how they are a potential source of mischief if the clause was not written tightly enough to protect against the debtor using capital controls in a sneaky fashion.

The sneaky thing for Mr. Putin to do would be to make the payments in rubles into an account in Russia, immediately convert the rubles to dollars and then say that the dollars are frozen in place under capital controls.  Pay enough rubles and, according to the strict terms of the contract, that would be a discharge.  And Mr. Putin could say that those dollars would be frozen until his foreign assets in the west were unfrozen.

One might ask here: Doesn't the bond require payments to be made in NY?  Yes, but Section 15, the Currency Indemnity clause, describes what happens if the holder “recovers OR RECEIVES” a payment in another currency, presumably in another place.

And it says that the USD payment is “discharged” if the holder receives a sufficient amount of that other currency to buy $$$ in the amount originally due on the date the other currency is received or recovered.

All of that will have happened.

Would a court buy any of this? Probably depends on where the court is located.  London, NY or Moscow.

The problem probably could have been obviated had the Currency Indemnity clause specified that the dollars acquired with the other currency (rubles, in our hypothetical) be "freely transferrable dollars". But it doesn't say that.

Aiyiyiyi

Credit to Doug Mulliken. Errors are mine.

That Odd Sri Lankan Airline Guaranteed Bond

Mitu Gulati & Mark Weidemaier

After months of waffling, Sri Lanka’s head-in-sand government has finally acknowledged that it cannot pay its debts. The cavalry (IMF) has been called in and we guess that hordes of potential restructuring advisers are flying to Colombo to offer their services. Assuming they have done their homework, their proposals surely will consider both the government’s own debt and a Sri Lankan airline bond that the government has guaranteed.

Sri Lankan airlines used to be profitable. From 1998-2008, it was partially owned and run by Emirates. One of us recalls it being a special treat to fly on. But the government decided in 2008 to run the airline itself and, since then, it has performed terribly.  There have been corruption scandals, accusations that Emirates was pushed out after the airline refused to bump paying passengers to make room for the royal family, and reports that local banks have been strong-armed into lending and will be in trouble if the airline collapses. Perhaps it’s no surprise that it needed a government guarantee to borrow money.

Sovereign guaranteed bonds often carry a higher coupon than a bond issued by the sovereign, perhaps because the sovereign is viewed as the safest credit. But this logic seems upside down. Unlike a pure sovereign bond, a guaranteed corporate bond is backed both by the sovereign’s credit and by a separate pool of assets (e.g., airplanes). Even if the company is literally worthless, there is still the full sovereign guarantee. Obviously there will be other factors that affect price, such as liquidity (the market for pure sovereign bonds may be much larger). But in crisis, when the bonds are sure to be restructured, there seems every reason to favor the guaranteed bond.

Another reason to favor a guaranteed bond is that these often have less effective restructuring mechanisms than are found in the sovereign’s own bonds. Oddly, then, a guaranteed bond that was viewed as riskier at issuance can end up being a safer bet. Greece’s 2012 restructuring imposed haircuts of over 50% on pure sovereign bonds but most holders of guaranteed bonds got paid in full. There is even some evidence suggesting that investors had figured this out towards the end game in Greece and favored guaranteed bonds. 

Here are some of the provisions in the airline guaranteed bond that could cause Sri Lanka’s restructuring advisors a giant headache.

How to Destroy the Collective Action Clause

Mark Weidemaier & Mitu Gulati

We almost hate to post this, because it is so simple, and so fundamental, that it seems almost surely wrong. But if it’s wrong, we can’t see why. Maybe a reader can explain? Here goes.

For at least 20 years, reform efforts in sovereign debt markets have promoted collective action clauses (CACs) (here and here). The current version of the clause was drafted by a super-committee of senior lawyers, investors, and finance ministers – many of them people for whom we have enormous respect. It lets the sovereign bond issuer hold a restructuring vote across multiple series of bonds in a so-called aggregated vote. Before, most CACs in the market required a vote for each series of bonds. The point of the reform was to make it impossible for litigious holdouts to exclude one or more individual series of bonds from a restructuring that had garnered the support of a creditor supermajority. But—and here’s the important point—outside of the euro area, these aggregated CACs are reserved for bonds issued under foreign law. They don’t have to be. But contract reform to solve the holdout problem hasn’t seemed important for bonds governed by local law, which the sovereign can already restructure just by changing its law.

Most sovereigns issue most debt under local law. So, here’s the CAC destroying idea:

Phase 1, the sovereign restructures its local law debt (either by passing legislation or by asking bondholders to tender). The restructured bonds might or might not include new financial terms. What they definitely will now include is a modification provision substantially similar to the one that appears in its foreign law debt. However, the restructured bonds are still governed by local law.

Phase 2, the sovereign proposes a restructuring of the entire debt stock, aggregating the vote of local and foreign law bonds together.

Ukraine versus Russia, English Supreme Court

Bailiffs for Gunboats is the title I have given to a short paper to be published in a Festschrift for the famous German scholar, Christoph Paulus, lately head of the law faculty at Humboldt, Berlin. It discusses a case remarkably overlooked despite its unusual facts, its major legal and political implications, and its role as a prelude to the horrors of the current war in Ukraine.

The case of Ukraine v. Russia (“Ukraine-Russia”), pending decision in the Supreme Court of England for more than three years, lies at the intersection of traditional public international law and private international law. It presents the question of court enforcement of a debt that is intertwined with sovereign political relationships. More broadly, it reflects the great power that private enforcement of a commercial instrument may nowadays give to a creditor that has goals beyond repayment. In the special context of a sovereign creditor of a sovereign debtor, the case reveals the potential role of privately enforceable debt in achieving the creditor’s political ends.

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 "American Default" of 1933 and Some Possible Sanctions

Last week, my International Debt class was fortunate last week to have the opportunity to talk to Sebastian Edwards about his wonderful book “American Default”.  The book tells the astonishing (to me at least) story of the abrogation of gold clauses in US corporate and government bonds in 1933 and how that abrogation is then upheld by at 5-4 vote of the US Supreme Court in 1935.  Equally astonishing, as Sebastian’s book describes, the spillover effects in terms of costs to US future government borrowing, were near zero.  If anything, USG bonds were oversubscribed.

Our class session with Sebastian was last Wednesday and the world has witnessed some remarkable and disturbing events since then in Ukraine.  In the wake of our discussion of FDR’s 1933 abrogation of the gold clauses though, I found myself wondering about the following hypothetical for purposes of class discussion.

A large country, Bearland, brags that it has $630 billion of international reserves, the largest portion of which is held in the form of US Treasury bonds. 

Tomorrow afternoon the US Congress passes the following law:

Commencing at 12:00 noon EST on February 26, 2022, holders of US Government debt securities will be required, in order to redeem those instruments at maturity, to certify that neither they nor any predecessor in title to the securities has ever invaded the Republic of Ukraine.   Securities owned by any holder who cannot make this certification will be redeemed at maturity and the proceeds deposited in a blocked account at the Federal Reserve Bank of New York.  

Context: Acme Capital, a New York based hedge fund, has acquired $1 billion of US Treasury bonds previously owned by Bearland.  Acme sues to declare the law unconstitutional and unenforceable. You are a law clerk to Justice Gelpern on the US Supreme Court.   She has asked you this question:  Don’t the Gold Clause cases from 1935 control this issue?   After all, Acme is getting its money so they are not harmed in that sense.  Acme just doesn’t like the fact that the money is blocked at the Fed”.

The foregoing strikes me as example of a situation in which the justices (and law clerks) must not only consider the legal correctness of the advice, but also its real world consequences.  In other words, very much the situation in 1935.

In the Bearland example, the legal question is whether the Bearland legislation imposes an ex post interference with contract or unconstitutional taking of Acme’s property by requiring the no-invasion certification.   

Advising that the measure is kosher, however, potentially puts all USG debt at risk of political interference. To see this, just change the words “invade Ukraine” in the Bearland certification to “invade Taiwan”.  Would any foreign state be prepared to buy US Treasury bonds knowing that they could be weaponized at any moment?  How much would that add to the interest rate on those bonds? Anything?

I wonder whether folks at the UST are considering strategies along these lines.  Maybe?

Clauses and Controveries: From Commercial Bank Loans to Blue Bonds

Mark Weidemaier and Mitu Gulati

After a short hiatus (we like to say we are between seasons), the Clauses and Controversies podcast has resumed. This week's episode, From Commercial Bank Loans to Blue Bonds, features Antonia Stolper from Shearman & Sterling:

Sovereign debt markets have evolved significantly over the years, from syndicated bank loans, to bonds, to the current infatuation with ESG lending. Antonia Stolper (Shearman & Sterling) joins us to talk about the evolution of sovereign debt practice over the course of her eminent career. We also talk about Belize's recent debt restructuring, where some say creditors agreed to significant additional reductions in exchange for promises by Belize to invest the savings in environmental conservation projects. Antonia helps us understand what actually happened in this deal and what its implications might be for future sovereign restructurings.

More on Belize: Marine Conservation is Nice; Deeper Haircuts Are Better

A couple of additional thoughts on Belize’s debt workout, especially the relatively novel aspect involving the pre-funding of a marine conservation trust. The deal has featured prominently in the financial press lately, with great coverage in the FT (here by Robin Wigglesworth and here by Tommy Stubbington), Bloomberg (here), and elsewhere. For details, see Mitu’s posts here and here. Mitu has a relatively optimistic take, which I’m mostly on board with. It would be wonderful if countries could both ease debt burdens and increase investment in marine conservation and other forms of sustainable growth. It would be even more wonderful if investors paid for some of this by granting significant debt relief. But even if that’s what happened with Belize—and I’m not entirely sure that it is—the Belize deal may not be replicable at a scale that would matter.

The plan is for Belize to repurchase and retire its outstanding international bond. Reports suggest that negotiations over the repurchase price were stalled at around 60 cents on the dollar. Ultimately, investors agreed to take 55. In return for that concession, Belize will prefund a $23.4 million trust to support future marine conservation projects. One potential takeaway is that investors agreed to the additional 5 cent reduction after being presented with the debt-for-nature idea, perhaps in part because intense media coverage created pressure to demonstrate their ESG bona fides.

The first point to note here is that the additional 5 cents per dollar is very large in comparison to the concessions investors seem willing to make to achieve ESG goals in other contexts.

The Super Cool Belize "Debt for Coral Reefs" Restructuring

This blog post draws on ideas developed with Ugo Panizza (Professor of International Economics, Graduate Institute) that form part of a paper we are working on. I am to blame for any errors though. 

In 2020, the stock of public debt in debt in developing and emerging market economies surpassed $19 trillion and reached 63% of the group’s GDP (up from 55% in 2019). Such levels of debt significantly increase the risk of multiple devastating debt crises hitting the global economy at the roughly the same time; a situation not seen since the Latin American debt crisis of the 1980s. This is a scary prospect at a time when nations need to scale-up investment in climate change and sustainable growth.

The recent restructuring of Belize’s sovereign debt is an example of how a country can address a debt crisis while preserving investment that can promote sustainable growth. Hard hit by covid-19, Belize is restructuring its sovereign debt for the fifth time in two decades. So, why is this debt restructuring so exciting?

Coral Reef Protection in Exchange for Debt Relief: Could it Really Work?

Belize, as of this writing, is undertaking a restructuring of its sovereign bonds. Hard hit by covid and general economic woes, this is that nation’s fifth debt restructuring over the past decade and a half. This time though, Belize is trying to do something different with its restructuring.  Something that just might contain lessons for other emerging market nations struggling with covid related economic downturns.

Using funding from the environmental group, The Nature Conservancy (TNC), Belize is doing a bond buyback, offering investors around 50% of face value.  Once purchased, the bonds are to be cancelled.  Belize has collective action clauses in the so-called superbond in question, so the deal will be binding on all holders of its external debt if a supermajority of creditors (75%) agree to the deal.  The dynamics of collective action clauses have been examined in excruciating detail elsewhere and I won’t get into that here. What interests me, and has intrigued many in the financial press (e.g., see here,  here, here, here, and here) is Belize’s attempt to tie a promise to behave in a greener fashion in the future to its request for debt relief from investors.

Specifically, Belize is promising investors that it will, in conjunction with TNC set aside a significant portion of the funds that it will save from doing the restructuring for environmental protection endeavors in the future (Belize's gorgeous coral reefs feature prominently in most accounts of the deal). As explained by a Belizean official:

As an integral part of the offer to repurchase the bonds, Belize will commit to its bondholders to transfer an amount equal to 1.3% of the country’s 2020 GDP to fund a Marine Conservation Endowment Account to be administered by a TNC affiliate. After a period in which the Endowment Account will retain its investment earnings in order to reach a targeted aggregate size, the annual earnings on the Account will thereafter be used, in perpetuity, to fund marine conservation projects in Belize identified by TNC and approved by the Government of Belize.

I have at least four questions that strike me as relevant to figuring out whether this strategy can work for other nations also facing covid related debt restructuring needs.

Might PBA Creditors Take a Lesson From the Black Widow?

Mark Weidemaier and Mitu Gulati

We’ve had lots of interesting responses to our earlier post on debt restructuring shenanigans engaged in by the Province of Buenos Aires. Many on the creditor side are miffed. Two issues raised by these responses seemed worth another post. So here we go.

Why not use the Black Widow Strategy?

At first, we didn’t understand the reference. But Google helped. Black Widow is the new Marvel movie starring Scarlett Johansson, who is suing Disney because it, and its subsidiary Marvel, did not do an exclusive release of the movie in theaters before selling it on the new Disney Plus streaming service (here). Instead of suing Marvel for breach of contract, she is suing Disney for tortious interference with contract. This is a standard move for parties bound, like Ms. Johansson, by an arbitration clause they would prefer to avoid. By suing a related third party, they get to proceed in court—unless the third party can argue that it is a third party beneficiary or otherwise entitled to invoke the arbitration agreement.

Why mention tortious interference in the context of the Province of Buenos Aires’ recent exchange offer? Tortious interference is an old common law tort action. It is typically brought against a non-party who induces one of the contracting parties to breach. Since it is a tort, one has to show causality and, in some circumstances, also that the non-party not only interfered but did so with some improper motive or by some improper method. (And defining what counts as improper has proven difficult). A senior lawyer who hated Ecuador’s original exit exchange in 2000 once commented that he was inclined to organize a tortious interference action and believed he would win. The logic then and now is that, by inducing participating creditors to vote to impair the rights under the contract they are exiting, the issuer is inducing a breach of that contract.

But we are less confident that tortious interference is a helpful way of thinking about behavior like PBA’s.

Why Are Creditors OK With The Province of Buenos Aires’ Dodgy Use of Exit Amendments?

Mitu Gulati and Mark Weidemaier

For the most part, the financial press has not scrutinized the details of the ongoing restructuring by the Province of Buenos Aires (PBA), which is nearing completion. The details are worth considering. Some aspects of the exchange offer might have crossed the line between good and bad faith and might have been subject to legal challenge. But this turns out be an uncertain area of law.

The basic transaction is structured as an exit exchange, and this technique raises some legal uncertainties even if we ignore the dodgy particulars of PBA’s restructuring. A debtor in financial distress needs to negotiate a debt reduction with its creditors. The debt contracts allow creditors to consent to reduce the amounts owed them, but only on condition that a majority or supermajority vote in favor. Let’s say, hypothetically, this requires the support of 90% of creditors. And let us say that the debtor has managed to persuade only 60% of creditors to support its restructuring proposal. So the debtor would seem to be out of luck.

Enter the exit exchange.

Investors in Province of Buenos Aires Bonds Might Want to Look at their Prescription Clauses

Mark Weidemaier & Mitu Gulati

The Province of Buenos Aires (PBA) is about to conclude its much delayed exchange offer. The exchange offer has been revised over and over and has featured many restructuring techniques detested by investors (Pac Man, re-designation, hard-nosed exit consents). But it seems as if the exchange may finally go through.

Rather than write about redesignation or any of the more salient features of the exchange, we want to discuss a more obscure feature, which differs in the two types of bond contracts PBA is offering. (Investors don’t have a choice; those with old bonds (from 2006) get one set of provisions and those with newer bonds (from 2015) get another.) This post is about the different prescription provisions being offered to the two types of bondholders, old and new.

The Emperor's Old Bonds

Andres Paciuc, Mike Chen & Charlie Fendrych, have just published their delightful paper on Chinese Imperial Debt in the Duke Journal of Comparative and International Law. This is a version of a paper that they did for my sovereign debt class with Mark Weidemaier a few years ago. Bravo! The paper is available here.

Here is the abstract:

Recent news articles have suggested that Trump’s trade war may finally provide relief to American holders of defaulted, pre-1950s Chinese bonds. Here, we examine the hurdles set before these bondholders, namely establishing jurisdiction over the People’s Republic of China as a sovereign and the long-lapsed statute of limitations. We also evaluate the Chinese government’s possible recourse.

Our investigation yielded key takeaways. First, to establish jurisdiction in the U.S., the bond must be denominated in U.S. Dollars or state a place of performance within the country. Second, to overcome the long-expired statute of limitations and win an equitable remedy, it must be shown that the PRC violated an absolute priority or pari passu clause and is a “uniquely recalcitrant” debtor. Finally, despite China’s commitment to the odious debt doctrine, the doctrine is unlikely to provide meaningful legal protection in an otherwise successful suit. Overall, it is a difficult suit to bring. However, through our investigations, we have discovered one issue in particular which holds the greatest danger—or perhaps the greatest promise: the Chinese Government 2-Year 6% Treasury Notes of 1919.

(Why) Are ESG Sovereign Bonds (Such) Scams?

Mark Weidemaier and Mitu Gulati

Environmental, social, and governance (ESG) investing is all the rage, with heaps of money pouring into sovereign and corporate bonds intended to finance efforts to meet climate-related goals and other worthwhile objectives. We have been skeptical of these commitments for some time, mostly because we aren’t persuaded investors care about much other than yield. And in fact, yields on ESG bonds seem to be a bit—but only a bit!—lower than yields on non-ESG bonds (the so-called “greenium”). As Matt Levine pointed out a couple of days ago, it’s not obvious how socially responsible investing will affect investors’ returns. But we are a little bit suspicious of the market for sovereign ESG bonds.

In part, we’re suspicious for the usual reasons. The basic transaction structure is that the bond issuer says it will use the proceeds for some beneficial environmental or social purpose. But the commitments are often defined so vaguely that it is hard to verify compliance. This is a pretty standard complaint, and a lot of smart people are thinking about how to define “green” investments and develop verification tools. But we’re suspicious for a more fundamental reason: The contracts are absolute b.s. Many issuers don’t commit to anything at all, or so the documentation suggests.

Antique Chinese Debt - The Latest

Mark Weidemaier and I have talked about antique Chinese (mostly Imperial) debt often on this site.  And we've also discussed these debts on our podcast with sovereign debt gurus Tracy Alloway and Lee Buchheit (here).  Yes, we are a bit obsessed. Part of our fascination with this topic is that the Chinese government asserted a defense of odiousness to paying these debts.  The lenders (backed by western powers, seeking influence in China) and the Imperial borrowers (seeking to sell access to their country in exchange for self preservation) had, in essence, sold out the people of China.  End result: Revolution and refusal of successor communist governments to pay these debts, no matter what - even today, when China is a financial behemoth.  

Below is the abstract for a wonderful new paper, "Confirming the Obvious: Why Antique Chinese Bonds Should Remain Antique" in the U Penn Asian L. Rev. by two of our former Duke students, Alex Xiao and Brenda Luo.  Bravo! We are so proud.

As the Sino-U.S. relationship goes on a downward spiral, points of conflict have sparked at places one might not expect: antique sovereign bonds. In recent years, the idea of making China pay for the sovereign bonds issued by its predecessor regimes a century ago have received increasing attention in the U.S. This note takes this seeming strange idea seriously and maps out the possible legal issues surrounding a revival of these century-old bonds. Although two particular bonds show some potential for revival—the Hukuang Railways 5% Sinking Fund Gold Bonds of 1911 and the Pacific Development Loan of 1937—the private bondholders would unlikely be able to toll the statute of limitations on the repayment claims based on these bonds. Even in the unlikely scenario that they succeed, the Chinese government would have an arsenal of contract law arguments against the enforcement of these bonds, most notably defenses based on duress, impracticality, and public policy. By going into the details of the legal arguments and history behind these bonds, we seek to confirm the obvious, that is, the idea of making China pay for these bonds is as far-fetched as it sounds and would not be taken seriously by courts.

The Haitian Independence Debt

Mark Weidemaier and Mitu Gulati

The Haitian Independence Debt of 1825 is perhaps the most odious in the history of sovereign debt. France agreed to grant recognition to the Haitian state in exchange for a massive indemnity payment, ostensibly intended to compensate French plantation owners for losses suffered during Haitian revolution. With French gunboats lurking in port and offshore, the French imposed a massive and unpayable debt burden equal to roughly 5 times the annual French budget.

Surprisingly, the literature on odious debt pays fairly little attention to this episode. Perhaps this because the doctrine of odious debt was developed with a view towards borrowing by a despot who is subsequently overthrown. Must the populace repay money borrowed to oppress it? Thus, when Haiti does show up in the odious debt literature, the question typically involves debts incurred by the despotic Duvalier regimes. The Independence Debt, by contrast was incurred in the context of a colony escaping the control of an imperial power, and the modern odious debt literature generally ignores this context. We discuss this in a recent Clauses and Controversies podcast with the wonderful Gregoire Mallard, that should be out soon.

This semester, we asked students in our international debt class what they would say if either the French or the Haitian governments came to them today, asking for advice on whether Haiti had a viable legal claim arising from these 1825 events.

The Argentine 2020 Restructuring Drama: An Insider's Perspective

There has been much discussion of the recent (2020) Argentine restructuring on creditslips, including by Anna Gelpern (here) and Mark Weidemaier (here), two people who know more about these matters than pretty much anyone else anywhere.  And significant portions of that discussion have been critical (or at least questioning) of the wisdom of two of the strategies that Argentina attempted to utilize during its recent restructuring: Pac Man and Re-designation.  These criticisms also showed up in the financial press, in articles by Anna Szymanski (here) and Colby Smith (here), among others.

Yesterday, two of the key players on the Argentine restructuring team, Andres de la Cruz and Ignacio Lagos (both of Cleary Gottlieb) put out on ssrn a spirited defense of the Pac Man and Re-designation strategies.  The article, “CACs at Work: What Next?” is available here (and should be forthcoming in the Capital Markets Law Journal soon).  To cut to the chase, Andres and Ignacio argue that their strategies were misunderstood by commentators and, in the end, were actually embraced by investors.

SDNY Upholds Pledge of Collateral for PDVSA 2020s

Today, Judge Failla of the Southern District of New York issued an opinion rejecting PDVSA's request for a declaration invalidating the PDVSA 2020 bonds. These bonds, which we've written about before (e.g., here, here and, here) are backed by a pledge of 50.1% of the equity in Citgo Holding. The argument for invalidating the bonds contends that the 2016 exchange offer and collateral pledge was a contract in the "national public interest," which, under Venezuelan law, required but did not receive the approval of the National Assembly. PDVSA argued, first, that under the act of state doctrine, the court had to defer to a series of National Assembly resolutions declaring the exchange offer invalid. It also argued that Venezuelan law governed disputes over the validity of the contract, even though the governing law clause in the bonds specified New York law.

The district judge rejected these arguments in a lengthy and thoughtful opinion. (There is one clear but fairly tangential mistake, when the opinion implies on p. 59 that PDVSA is neither a "foreign state" nor an agency or instrumentality of a foreign state for purposes of the Foreign Sovereign Immunities Act.*) On the governing law question, the judge ultimately decided that New York law applied because--to oversimplify a bit--New York had a significant connection to the transaction. The bonds were negotiated and paid in New York, etc. For more on this conflict of laws issue, see here.

I'd expect to see an appeal, although whether that will benefit PDVSA (even if just by giving it more time) will probably depend on whether the district judge or court of appeals issues a stay of the current order. [edit: And of course on further developments in the U.S. sanctions regime.]

*Technically, the court said only that neither party argued that PDVSA was such an entity. The court made this point to help it distinguish FSIA cases that supported PDVSA's position. But this is no distinction at all. It is beyond dispute that PDVSA is an agency or instrumentality of Venezuela (or is indistinguishable from the government if treated as its alter ego). In either case, the FSIA unquestionably applies to PDVSA, so it is not obvious why cases under the FSIA would be irrelevant to the dispute.

The Sideshow about Venezuela's Prescription Clause

Mark Weidemaier and Mitu Gulati

We’ve written before about the perplexing prescription clause that appears (in one form or another) in Venezuela’s bonds. A common version of the clause says something like this:

Claims in respect of principal and interest will become void unless presentation for payment is made within a period of ten years in the case of principal and three years in the case of interest from the Relevant Date, to the extent permitted by applicable law.  “Relevant Date” means whichever is the later of (i) the date on which any such payment first becomes due and (ii) if the full amount payable has not been received by the Fiscal Agent on or prior to such due date, the date on which, the full amount having been so received, notice to that effect shall have been given to the Bondholders.

The clause is weird. Because Venezuela’s default in the payment of interest is now approaching its 3-year anniversary for some bonds, some investors worry that, unless they file suit, claims to recover those missed payments will become void. Seeking to reassure them, the interim government has released a statement saying not to worry. In the interim government’s view, the clause “addresses situations where the Fiscal Agent holds amounts paid by the Republic that are unclaimed by, or otherwise not distributed to, bondholders.” The statement asserts that the prescription period has not started to run because the fiscal agent hasn’t yet received the funds.

Argentina-Inspired Reforms to Sovereign Debt Contract Terms (Yes, Again)

In terms of innovations in the boilerplate of sovereign debt contract terms, Argentina is the gift that keeps on giving (and giving and giving).  At least within my lifetime, its behavior has inspired more contract innovation than any other country (even Ecuador, that probably comes a close second).

Here is the abstract of a wonderful new paper by two sovereign debt legal experts from White & Case (London), Ian Clark and Dimitrios Lyratzakis (White & Case has a long history of innovation in sovereign debt contracts; it was one of the firms at the forefront of Collective Action Clause innovations way back in the 1980s):

The Collective Action Clauses published by the International Capital Markets Association in 2014/2015 aim to facilitate orderly and consensual sovereign debt restructurings. The clauses were designed to give sovereigns flexibility in structuring and consummating a transaction that would be capable of attracting broad creditor support, while safeguarding the integrity of the process and the rights of creditor minorities. The recent restructurings of Argentina and Ecuador presented the first opportunities for the ICMA CACs to be tested in practice, but the “re-designation” and “PAC-man” strategies first seen in the Argentine restructuring revealed shortcomings in the ICMA contractual architecture.

Argentina’s and Ecuador’s creditors responded by negotiating tailored refinements to the standard CACs that would mitigate the risk that a sovereign could compel a restructuring that is not supported by the requisite creditor supermajorities. The qualified restrictions on “re-designation” and “PAC-man” adopted by Ecuador and Argentina enhance the ICMA architecture and provide strong incentives for a sovereign to engage constructively with its private creditors in a consensus-building process that results in a restructuring proposal capable of achieving supermajority support.

The paper, "Toward a More Robust Sovereign Debt Architecture: Innovations from Ecuador and Argentina" (forthcoming in Capital Markets Law Journal) is particularly interesting because Ian and Dimitrios are two of the creditor-side lawyers who were involved in creating the innovations that they discuss. (Much of the writing in this area has tended to be from the debtor side). Now, it remains to be seen how the market responds to these innovations. In particular, will other deals embrace the changes that have been made in the Ecuador and Argentine restructuring documents or will there be yet more experimentation?

I'm particularly intrigued by some rather crucial differences in deal documents that seem to correlate to the governing laws (NY v. England).  Informally, there has been much chatter about whether those differences were the product of drafting goofs in the model clauses on one or the other sides of the Atlantic or intentional (Each side asserts that the other has goofed -- albeit in a very polite and passive aggressive fashion). Given that debate, and the unwillingness of anyone to openly talk about the issues, I wonder whether those differences will continue out of a sheer unwillingness to admit error. (Of course, this is a topic that Dimitrios and Ian diplomatically and cleverly avoid).

Episode Two of Clauses and Controversies: Imperial Chinese Bonds

Mark Weidemaier & Mitu Gulati

To prepare for later discussions about how to address the looming debt crisis caused by Covid-19, our first few episodes of Clauses and Controversies look backwards, albeit to historical events with current salience. Episode Two is our first official episode and is about pre-PRC Chinese bonds that have been in default since before World War II. One of us (Mitu) loves this topic and the other (Mark) increasingly flies into a rage whenever it comes up.

Our guests are the wonderful Tracy Alloway of Bloomberg (whose article about these bonds last year went viral), sovereign debt guru Lee Buchheit (who knows more about the history of these types of bonds than anyone – here’s the FT's Robin Wigglesworth on Lee), and Alex Xiao, a former student who is working on a paper on this topic.

The subject of defaulted Chinese bonds is back in the news, largely in connection with U.S.-Chinese trade talks. (Are there trade talks?) A group of ardent Trump supporters have apparently accumulated a bunch of these bonds. Izabella Kaminska of the FT wrote about this a recently, and so did Fox Business a couple of days ago. (The Fox Business piece was a bit more enthusiastic, shall we say, than the others.) Previous lawsuits seeking to enforce them have failed on sovereign immunity and statute of limitations grounds, so these investors are lobbying the President to negotiate a recovery for them as part of his trade talks. And there is some reason to think the administration might be interested. The President is inclined to anti-China and anti-Chinese rhetoric, and these defaulted bonds are an opportunity to indulge that impulse further. Plus, Chinese institutions hold huge amounts of U.S. government debt, and some have floated the loony idea that these defaulted Chinese bonds could be used to offset some of that debt. For a deeper dive, here is a fun piece, The Emperor’s Old Bonds, by three former students.

So, why do we have a love hate relationship with these bonds? Here are the remarks we sent our expert guests as a prelude to asking for their views.

Clauses and Controversies podcast

Mark Weidemaier & Mitu Gulati

Both of us are teaching 1L Contracts online this semester and fear we also may have to do the same for our joint Duke/UNC sovereign debt class next semester. One silver lining is that we have been forced to think of ways to break up the normal class routine. One of these ways is that we are creating a podcast titled "Clauses and Controversies." Thanks to our superb producer, Leanna Doty, the first three episodes are up on iTunes, and Soundcloud, and Overcast. We wanted to come up with something to expose students to ideas and topics that excite us, while giving them a chance to hear conversations with our favorite commentators who study and work on contracts and sovereign debt. The timing seemed right, too, as the economic fallout of Covid-19 may cause many sovereign debt defaults and restructurings.

There is no global mechanism for efficiently and fairly handling a global wave of sovereign financial distress and default. The wave almost hit this past March, when the financial system hit a sudden stop as people seemed to finally recognize the pandemic. Since then, massive infusions of Official Sector capital have allowed government borrowing to continue. But another sudden stop may be in the offing, and even if not the long-term economic damage of the pandemic may tip governments into insolvency.

The first episode is an introduction, which sets out what we hope to do with the series and then gets into the ongoing dispute over whether investors can seize Venezuela’s prize oil refinery in Texas. The absence of a handful of words in the PDVSA governing law clause might make all the difference. But we don’t think it should. (For anyone seeking a deeper dive into the issue, see here.)

We owe an immense debt to our friends in the business who have been so generous in giving us their time, energy, and insight. We also owe a debt to Dave Hoffman and Tess Wilkinson-Ryan for providing us with inspiration with their brilliant contract law podcast series, “Promises, Promises." Fair warning: they are much more brilliant and hilarious than we are. It must be a treat to be in their classes.

Back to the Future (Again): Horatio Gadfly and Those Imperial Chinese Bonds

FT Alphaville has had a long line of quirky and brilliant reporters over the years, something that I've always enjoyed (Joseph Cotterill, Tracy Alloway, Colby Smith, Cardiff Garcia and more). And I've especially liked the pieces that do deep dives into obscure and arcane sovereign debt matters.

The latest such piece is from Izabella Kaminska, on the the topic of antique imperial Chinese bonds and the possibilities for recovery (from about ten hours ago, here).  The likelihood of using purely legal methods and recovering on these today is near zero.  But near zero is not zero and periodically, as a means to get students engaged on the thorny questions of statutes of limitations and sovereign immunity, Mark Weidemaier and I will assign them the task of figuring out which of the defaulted imperial sovereign bonds have the best chance of recovery. The assignment is usually framed in terms of a set of bonds that Mr. Horatio Gadfly inherited (here) (Joseph Cotterill's hilarious piece on Mr. Gadfly's adventures is here)).

This past semester, a group of our students -- Michael Chen, Charlie Fendrych, and Andres Paciuc, dug deep and found a small subset of bonds that maybe, just maybe, had a long shot. Their fun paper, "The Emperor's Old Bonds" (soon to appear in print in the Duke Journal of Comparative and International Law) is here.

Izabella's article today makes a deeper point, which is that these legal claims -- while implausible if viewed in purely legal terms -- can acquire muscle as a function of political context.  Is this such a time?  Maybe.  Coronavirus, trade talks, election rhetoric, Taiwan, and given that some of Trump's supporters have lots of these old Chinese bonds and Trump is . . . well, Trump may have changed the equation from what it has been for the past century.  Steve Bannon, of all people, has talked about imperial Chinese bonds on his War Room show multiple times (e.g., this War Room episode at about 40:50. . . Aiyiyiyi . . . here).  

If you are intrigued and want to go down the rabbit hole, this question of politics and antique Chinese bonds has come up before -- see Tracy Alloway's piece on Bloomberg (here), Cardiff Garcia on NPR (here) and Mark Weidemaier on creditslips (here and here). 

Izabella is (I hope) not done with her writing on this topic and there might be more on Alphaville soon (today's teaser was in the main paper).  This topic connects to so many other fun topics relating to historic wrongs too -- like the fact that the British museum holds the Elgin Marbles and the British crown holds the Koh-i-Noor diamond (US museums undoubtedly have lots of these sorts of items as well). If Chinese imperial bonds need to get paid, maybe it is time to give the Elgin Marbles and the Koh-i-Noor back? Come to think of it, maybe it is time to give them back regardless of the bonds? Sovereigns are infinitely lived, which means that their obligations are too -- if someone can figure out a way to get around the statutes of limitations.

The US Government Mumbles Something in Support of Venezuela

Mark Weidemaier & Mitu Gulati

Judicial outcomes are determined by a variety of factors beyond precedent, statutory text, and other purely legal inputs. One factor, especially in cases involving foreign governments, is the preference of the U.S. government. In the middle of the 20th century, the government’s preferences often were dispositive, because the State Department had final say over whether U.S. courts could exercise jurisdiction over foreign states. The State Department eventually tired of being caught in the middle of  these disputes and Congress passed the buck to the judiciary, which now makes immunity determinations in accordance with the Foreign Sovereign Immunities Act.

Still, U.S. administrations periodically put a thumb on the scale in favor of a foreign state. On occasion, this happens even when relations with the foreign state aren’t especially friendly. Foreign sovereign immunity tends to be reciprocal, and the government worries that an overly assertive approach by U.S. courts will prompt courts in other countries to retaliate by asserting expansive jurisdiction over the United States. Still, what’s happening in the Crystallex litigation is a bit unusual. Until now, U.S. sanctions have been the primary tool by which the government has protected Venezuelan assets in the United States. Thus, the U.S. largely sat idle while the federal judiciary ruled that Venezuela and state-oil company PDVSA were alter egos, such that assets formally belonging to PDVSA could be attached by creditors of the Republic itself. Because of that holding, the District Court in Delaware is currently busy trying to figure out whether and how to conduct an execution sale of PDVSA’s equity in PDV Holding, the ultimate parent company of Citgo. (For more, see here and here).

And then, as Anna Szymanski describes in her piece for Reuters that went up earlier today (here), the U.S. government filed a "statement of interest" in the matter.

Some Confusion About Argentina’s Power to Reverse an Acceleration

Mark Weidemaier and Mitu Gulati

As negotiations between the Argentine government and its creditors have gotten increasingly acrimonious, some have begun talking about litigation. Because Argentina’s bonds have collective action clauses, it can impose restructuring terms on dissenting creditors as long as it has the support of a supermajority. Even if it doesn’t have supermajority support to do the cram down, it still has weapons.

One important weapon that often gets overlooked in discussions of the cram down power is the power to rescind or reverse a decision by creditors to accelerate the debt. In effect, this is a power to create a standstill. Argentina’s bonds have some relatively unusual provisions in this regard. One possible interpretation of these provisions is that Argentina is about to lose the ability to reverse an acceleration. We think this interpretation is wrong, but we have heard it raised with some frequency and want to address it here.

PDVSA’s 2020 Bonds: When and Why Does Venezuelan Law Matter?

Mark Weidemaier and Mitu Gulati

In 2016, the Maduro government bought some time through a debt exchange in which holders of maturing bonds issued by state oil company PDVSA swapped them for new bonds due in 2020. The new bonds were collateralized by a 50.1% interest in the U.S. parent company of Citgo. Now that the U.S. no longer recognizes the Maduro administration, the new Venezuelan government sued in the Southern District of New York asking to invalidate the bonds and the collateral pledge. It points to Venezuelan law requiring legislative approval for contracts in the “national public interest,” which didn’t happen here. For background, see our posts from last October, here and here.

The initial briefs have been filed, and not surprisingly the parties disagree about the relevance of Venezuelan law. The PDVSA 2020 bonds are governed by New York law. Venezuela argues that this does not matter, that Venezuelan law determines whether the bonds are valid. The indenture trustee argues that Venezuelan law is irrelevant, that New York law is all that matters, and that under New York law the bonds are enforceable. We’ve seen similar disputes a lot of late, including in connection with debt issued by Ukraine, Mozambique, and Puerto Rico. A government issues foreign-law debt that it later claims was unlawful under its own law. What law governs the dispute?

We have been mulling this question for some time now. At first, we thought it was straightforward, and we suspect many market participants feel the same way. But it is more complicated than a simple foreign versus domestic binary. The end result is this paper, Unlawfully-Issued Sovereign Debt.

Selling CITGO--Timing and Process

Yesterday was the deadline for opening briefs regarding the writ of attachment and potential execution sale of PDVSA’s shares in PDVH, the parent company of US oil refiner CITGO. As expected, Venezuela has asked the court to set aside the writ of attachment. Other briefs argue about what an execution sale should look like, if a sale goes forward. An execution sale is typically an informal, auction-on-the-courthouse-steps kind of thing. That’s not the usual way to sell a multi-billion dollar oil company.

Here’s a very quick summary of the filings, with links to the briefs. And here’s a bit more background, focusing on the timing and process of any execution sale.

Brazilian 5 Year Sovereign Bonds at a 2.875% Yield: Aiyiyiyi

Paul Krugman had a piece in yesterday’s NYT about the lunacy in the stock market, where a bankrupt company like Hertz is merrily issuing new stock (here).  Matt Levine of Bloomberg has similarly, and hilariously, discussed the Hertz case and other recent examples of this bizarre pandemic bubble (here). Why the rush to buy overpriced rubbish?

I have no answer to the question posed by Krugman. But it is not just the stock market. A similar lunacy is occurring in the sovereign bond markets (here). Exhibit number one: Brazil. Reading the press, it seems clear that Brazil is in deep crisis thanks to the disastrous manner in which it has handled the covid-19 pandemic so far (see here and here, for discussions of how Brazil’s response to the pandemic has been among the worst in the world).  Yet, on June 3, it issued over 3 billion dollars in five- and ten-year bonds.  The five-year bonds had a coupon of 2.875%.  (the ten-year bonds were at 3.875%). I cannot understand this yield. What sane investor could possibly look at the current state of Brazil’s response to the pandemic, the fact that its leadership seems to show no signs of reversing course, and the resulting economic forecasts, and think that Brazil is such a safe bet to repay its borrowing in just five years that it should receive funding at 2.875%. Of course, from Brazil’s perspective, why not issue even more debt, if the response of the market to worsening conditions is to offer even more and cheaper money.

It is worth, however, thinking about what will happen if and when countries like Brazil cannot repay these bonds when they mature. I suspect that investors will not remember that they deliberately anesthetized their risk instincts when they bought the bonds. Some of those investors will loudly demand payment in full -- in other words, it's Brazil's fault for having offered the bonds, not the investors' fault for ignoring the risks when they bought them. Along those lines, I wonder why official sector institutions like the IMF – who know how bleak the latest economic forecasts are -- are not urging sovereigns to take advantage of the market lunacy to put in pandemic clauses. These are clauses that would give the countries like Brazil relief in the future if it turns out that covid-19 causes so much harm to the Brazilian economy that it cannot pay back the debt. After all, if investors are willing to buy any rubbish that is put out there, why not ask for better contract terms for when the party ends?

Italian Sovereign Debt: Time to Worry or Party?

Italian sovereign borrowing is increasing, as the costs of dealing with a stalled economy and the pandemic build.  A recipe for disaster?  Turns out that Italian yields (and spreads with the risk free benchmark rate) are actually going down; down in the vicinity of zero. (for the WSJ's treatment of this last week, see here). And at least some Italian economist friends of mine are beginning to talk about how debt/GDP levels around 180% or maybe even 200% could be sustainable.  Aiyiyiyi. That sounds loony; given that the economic fundamentals -- thanks especially to the horror of covid-19 -- are going in the opposite direction. That said, I'm no economist and I definitely do not understand the current market patterns. As further evidence of this lunacy, Brazil was able to borrow $3.5 billion a few weeks ago at lower rates than it was having to pay before the pandemic; a pandemic to which its response has been spectacularly Trumpian. (And yes, I have economist friends of mine who insist that Brazilian debt is safe and will remain sustainable because of factors such as Fed swap lines and Trump's friendship with Bolsonaro. I'll readily admit that I don't understand the swap line theory of debt sustainability. But on that other point . . . . Really dudes? You are going to bet on Trump bailing out Bolsonaro because of their special relationship?).

Not everyone, fortunately, thinks that the markets are going to continue to adequately and fully fund this covid-19 recovery.  Below is the abstract of Tyler Zelinger's new paper on preparations Italy could make in anticipation of the need to do a debt restructuring someday soon (and he is only using them as an exemplar, since they seem to be on the precipice -- despite their current borrowing costs). If things begin to tank -- as I worry they will sooner rather than later -- papers like this that do the advance preparation that governments are refusing to do, will be invaluable. Tyler even finds a silver lining in all of this for the hypothetical Italian debt restructurer.

The abstract of the paper (just posted on ssrn) is below:

As the global economy has become more integrated and increasingly complex, the need for a system that administers government default has become more and more apparent. The body of "sovereign debt law" that has emerged to fill this need in the context of the Eurozone is an amalgamation of treaty obligations, domestic law constitutional principles, and tensions between state government and supranational government actors. Using a hypothetical Italian restructuring, this paper seeks to explore how these different bodies of law operate together to create a system that protects government function as opposed to guaranteeing creditor recovery. Further, this paper explores how an exogenous shock as the COVID-19 pandemic effects the analyses undertaken at various points in the sovereign debt legal framework.

This analysis reveals a silver lining: although Italy has suffered horrible losses as the result of the COVID-19 pandemic, the effects of the pandemic will help mitigate the legal challenges faced by Italy in the course of a local-law restructuring effort and thus smooth the path to a successful post-COVID recovery.

Keeping Cosy by the Dumpster Fire: Argentina Reads Its Contracts ... Twice ... Quel Scandale!

Argentina's capacity to trigger outrage in sovereign debt circles is to behold. After nine defaults, thousands of lawsuits, and enough intrigue and screaming matches to break Big Data, wouldn't you think that someone somewhere would learn to yawn at another Argentina debt drama. And yet ... on the eve of tomorrow's debtapalooza, the internet is hopping mad again about a restructuring proposal from Bueons Aires--not the money (that's regular old mad), but the red-hot-appalling abuse of the shiny new Collective Action Clauses (CACs) in the 2016 bond indenture. The government again managed to tick off both its private creditors, who discovered that their contracts let the debtor gerrymander bond voting pools after the vote, and the well-wishing policy wonks watching their baby--decades of international bond contract reform--swirl down the drain with this one deal's bathwater. Because much of the technical ground was ably covered by my colleagues earlier this evening (don't miss the link to Rodrigo Olivares-Caminal), I have the luxury of using the rest of this post to speculate about the implications of the brouhaha for sovereign debt policy and sovereign debt markets.

The Argentine Re-Designation Drama: Notes From Two Frustrated Readers

By Mitu Gulati and Mark Weidemaier

In 2014, after much fanfare, a shiny new set of collective action clauses was released by ICMA (the International Capital Markets Association), with the endorsement of the IMF, the US Treasury, and others. The inspiration for these clauses? The fact that Argentina, after its 2001 default, got taken to the cleaners by hedge funds who found ways to exploit ambiguities (pari passu) and oddities (FRANs) in the terms of its debt contracts. The new ICMA CACs were supposed to protect against the risk of holdouts (by letting a super-majority of bondholders quash minority holdouts) while constraining opportunistic behavior by sovereigns (by limiting the sovereign’s ability to coerce creditors into supporting a restructuring). But for all of the good intentions behind these 2014 ICMA CACs, they are long, complicated, and leave gaps for clever parties to exploit. And Argentina’s 2020 restructuring proposal may just illustrate the problem.

Many creditors are irate about Argentina’s exchange offer, so much so that some of them say they no longer want the 2014 ICMA CACs. We have been struggling to understand why the offer got them so upset. Fortunately, Anna Szymanski of Reuters Breaking Views put out a piece titled “Argentina Gets Cheeky With its Creditors” earlier today that makes the basics of the drama clear (here). Cribbing from Anna’s research, here is how we understand what is going on and why creditors are irate.

Keeping Cosy by the Dumpster Fire: A Sovereign Debt Series

Lest anyone thought they could quarantine or protest in peace, no such luck in the sovereign debt world.

Remember when everyone thought a standstill starting May 1 was a great idea, at least through the rest of 2020? For all the good will, May 1 has come and gone, with few takers and fewer givers.

On the subject of give-and-take -- with another default in the rear view mirror, Argentina's government and its creditors are edging closer to a deal this week ... unless their talks get bogged down in extreme distrust, undo more than two decades' worth of sovereign debt contract reform, and drag the rest of the world off the cliff with them ... which would surprise exactly no one who has ever followed that dysfunctional marriage. 

Speaking of no one -- no one seems to have a handle on who owes what to whom on what terms -- not with any precision, in any event -- which is an awkward place to be when pitched warnings of a mega-debt crisis migrate from research volumes to the New York Times.  And no, it is not all China's fault, it's a structural problem with this ecosystem.

Meanwhile, fears of worldwide sovereign debt distress seem to be driving comparisons to the 1980s, which in turn mean different things to different people -- a banking crisis and a Lost Decade to some, market-based (aka publicly subsidized) debt operations to others, and giant shoulder pads to the rest. 

And yet--against predictions and barring classification error--markets have been lending up a storm to vulnerable countries without bothering too much about their contracts.

All this begs two questions--what gives, and what do we do now? -- that are the subject of what should be an excellent Sovereign Debt Forum panel on Wednesday morning, led by Rosa Lastra at Queen Mary, co-sponsored with Georgetown IIEL, and including all the usual suspects. Of course I have no answers, but I will try to noodle these and related questions here in the next few days. In particular, I want to unpack what might have gone wrong with the G-20 call for a standstill, ask whether Argentina's debt restructuring threatens international financial architecture, and yell a bit about our collective obsession with Default ... among other things that will surely come up in the next 24 hours. 

How Are So Many EM Sovereigns Issuing New Debt?

Mitu Gulati and Mark Weidemaier

We have been working on building a dataset of sovereign bonds and their contract terms. Given the economic fallout of the Covid-19 pandemic--close to 100 countries have approached the IMF for assistance--we would not have been surprised if few low- to mid-income countries had issued sovereign bonds in recent months. Instead, there have been large issuances by Guatemala, Paraguay, Peru, Chile, Philippines, Hungary, Mexico and others. 

Take Mexico, one of the biggest players in the sovereign debt market. The country has been badly hit not only by Covid-19 but by brutal drops in oil prices, tourism, and remittances. These developments surely increased the need to borrow in dollar/euro bond markets, but we would have expected investors to balk, or at least to demand punitive coupons. But that doesn’t seem to have happened.

What explains investors’ continued willingness to lend? Might they have drunk the bleach-flavored Kool-Aid and decided that there will be no deep and sustained economic downturn? Possible, we suppose, but unlikely. More plausible explanations include (i) that financial markets are so awash with QE money that investors have few places to go for yield and (ii) that investors may be betting that countries will be bailed out by an official sector desperate to prevent widespread defaults on sovereign debt.

But, because we are interested in the terms of sovereign bonds, we also wondered if investors were demanding extra contractual protections against the risk of non-payment. That would be a sensible precaution given the likelihood that many countries will be unable to make payments. Indeed, colleagues working on M&A contracts have documented a trend towards including risk-shifting clauses that explicitly address pandemic-related events (for a recent paper by Jennejohn, Talley & Nyarko, see here). With superb research assistance from Amanda Dixon, Hadar Tanne, and Madison Whalen, we wondered whether we would find a similar trend in the sovereign bond markets.

Immunity, Necessity and the Enforcement of Italian Debt in the Era of Covid-19

Mark Weidemaier & Mitu Gulati

The sovereign debt world has been debating how to design an emergency debt standstill for the poorest nations, so that they can devote scarce resources to public health rather than debt service. As we’ve discussed on this blog, the question has come up as to whether countries might be able to use the customary international law doctrine of necessity to defend against creditor lawsuits.

Our discussion hasn’t focused on any particular jurisdiction, although we have implicitly assumed that much of the litigation would take place in New York. Now, let us switch gears to assume (plausibly, we think) that Italy is one of the countries that might need a debt standstill. It has been among the worst hit by COVID-19 and will likely soon have a debt/GDP ratio upwards of 150%. To quote a scary new report out from Schroders (here): “Italy is the prime candidate for being the first [Eurozone] casualty [from the Covid-19 crisis]. Its high indebtedness and lack of economic growth require policies that are either illegal in the eurozone, or politically unpalatable domestically.” 

Our work on the mechanics of an Italian debt restructuring—see here (Mark) and here (Theresa Arnold, Ugo Panizza, and Mitu)—has not discussed necessity or other defenses to enforcement. That’s because most of Italy’s debt is subject to Italian law, and our focus was on how Italy might change this law to enable a restructuring. But let us say that Italy does not take this approach. Perhaps it continues to pretend that a debt restructuring is simply inconceivable. It does not lay any legal groundwork for a restructuring. Instead, Italian politicians simply pray for some magical combination of high growth (unprecedented) and a no-strings-attached bailout package from European authorities. In that event, it is conceivable that a sudden spike in interest rates might prevent Italy from making payments. Assuming no immediate European bailout (Italy’s politicians have demonstrated a distaste for any of the conditionality that would come with ESM funding), that means some risk of having to defend the non-payment against creditor lawsuits.

Further Thoughts on Necessity as a Reason to Defer Sovereign Debt Obligations

Mitu and I posted some preliminary thoughts about the defense of necessity, which might be raised as a basis for allowing sovereign borrowers to defer debt service during the crisis. I wanted to follow up on some of the open issues. A few are technical, addressing some potential objections to the defense. I’ll deal with these first and close with a more fundamental question: What good does this potential defense really do for a sovereign? In thinking through that question, my premise is that many sovereigns will need a temporary standstill on debt service during the crisis. For proposals to this effect, see here, here, and here. (Others will eventually need a debt restructuring, but that’s a topic for another day.) But of course private creditors must agree to a standstill on payments. Those who don’t might sue or file arbitration claims, which will potentially put the sovereign's assets at risk and will certainly consume time and resources to defend. [Last sentence edited for clarity.]

Some background

Necessity is a rule of customary international law. As expressed in Article 25 of the International Law Commission’s draft Articles on Responsibility of States for Internationally Wrongful Acts, a state can invoke necessity to excuse its non-performance of an “international obligation” if non-performance is the only way to address “a grave and imminent peril,” as long as non-performance does not seriously impair an essential interest of the “State or States towards which the obligation exists.” Even if these conditions are satisfied, the state cannot invoke necessity to excuse the violation of an international obligation that “excludes the possibility of invoking necessity.” (Put differently, the doctrine purports to treat necessity as a default rule.) Nor can a state invoke the defense if it has contributed to the state of necessity. Finally, even if the defense is available, non-performance is excused only while the threat persists. The state must resume performance when the crisis ends, and it may have to pay compensation for any loss caused by its non-compliance.

It may not be obvious, but this is a remarkably crabbed conception of “necessity.”

State Bankruptcy

So Senate Majority Leader Mitch McConnell says States should be able to file for bankruptcy, to get out of their pension obligations. He'd rather that than give them a federal bailout, given current conditions.

I have long argued that States don't need bankruptcy, because they have stronger sovereign immunity (under the Eleventh Amendment) than most actual sovereigns. But put that to one side.

Why does McConnell think that such a bankruptcy will be limited to single class of creditors? Indeed, I doubt such a bankruptcy system would be consistent with the Bankruptcy Clause.

And quite frankly, I suspect bondholders understand this (even if anti-union activists don't). That is why you never see the municipal bond managers advocating for "State bankruptcy." The bankruptcy of any of the 50 states would look more like Puerto Rico's, where haircuts to bondholders are most definitely on the table. The only question is "how much?"

Necessity in the Time of COVID-19

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.