Lawless Loans: Sovereign Debt Restructuring in an International Law Vacuum

By Derek Hunter

When a domestic corporation becomes insolvent – whether in the United States or any other developed country – a detailed set of laws spring into action. In the United States, domestic bankruptcy law supersedes state causes of action, and automatically stays creditor actions against the assets of the debtor. Then, a collaborative process is imposed on the parties in which every creditor will have voting rights, but ultimate decision-making rests with a neutral judge. Congress and the courts are continually honing the bankruptcy process, but the need for such a process has been evident for at least a century. 

Contrast this with sovereign debt restructuring in the international arena, which is essentially a legal free-for-all governed only by the terms of individual bond contracts. Each bond contract has its own terms and has its own choice of law provisions, so a sovereign debtor will have to negotiate a consensual settlement against the backdrop of differing contract terms as interpreted by differing legal systems (a sovereign debtor will usually have bonds that are governed by its own law, British or American law, and international law, to name just a few). While diverse contracts and applicable law are not a uniquely sovereign debt problem, in the domestic context, the complexity is addressed in bankruptcy. Internationally, the law of the jungle attempts to untangle the mess.
This legal vacuum has real consequences. From Argentina’s second default in 2012 to Ukraine’s imminent restructuring, sovereign bond restructuring without international law imposes onerous costs on sovereign borrowers, and, as a result, their populations. It is time for a change.

In Argentina’s restructuring, a vulture hedge fund was able to drive Argentina into default by refusing to accept a restructuring that was endorsed by 92% of creditors. In ruling for the hedge fund, the judge in that case lamented the lack of formal restructuring proceedings, and pointed out that the “creditors of the Republic have no recourse to bankruptcy regimes to protect their interests and must rely upon courts to enforce contractual promises.” By holding out, refusing to accept the restructuring agreement, and choosing instead to enforce its contract rights in domestic court, the hedge fund was able to profit more than the other creditors. This result is the reason formalized bankruptcy exists: rational economic actors will rush to pick the debtor clean before its too late, ruining any chance of a restructuring. If every creditor behaved the way the vulture fund in the Argentina case did, sovereign restructuring would be impossible.

The Ukrainian debt crisis is the latest contentious sovereign debt restructuring, and it marks a new chapter in the lawless sovereign restructuring story. While the traditional dynamic exists between a potential holdout private creditor, beholden only to its quarterly numbers, there is a new and dangerous wrinkle: Russia.

Russia’s geopolitical ambitions in Ukraine, which have resulted in the annexing of Crimea and a stalemated Civil War in the East, contributed to Ukraine’s financial distress. However, before the current conflict Russia lent around $3 billion to Ukraine’s old pro-Russian government. Now, Russia is in a position to jeopardize Ukraine’s entire restructuring effort be refusing to accept any agreement. If Ukraine cannot restructure its debt to write-off around $15 billion, its IMF bailout package would be jeopardized.

Russia’s leverage – whether or not it ultimately uses it – is just another example of why the status quo of sovereign debt restructuring does not work. A vulture hedge fund stymying a consensual restructuring is one thing, at least they are rational economic actors, but using sovereign debt restructuring as a foreign policy tool is quite another. There is at least a plausible argument that the holdout-hedge-fund-problem can be dealt with through contract. But the legal terms in a bond contract are not suited for addressing creditor hold out on geopolitical grounds.

A formalized international bankruptcy process is long overdue. The IMF and the World Bank should take the lead on this issue because their bailouts are often the impetus for sovereign debt restructuring. Their expertise in financing sovereigns in distress makes them likely forums for an international restructuring process. Ultimately, for international bankruptcy to have any hope the United States needs to get on board. The UN approved a resolution to take a more thoughtful approach to develop such a system, but the United States voted against it. Treasury’s position seems to be that the status quo is working and contract law is enough, and it may have been politically convenient for the United States to adopt a position in line with powerful domestic financial players. However, the United States is supporting the bailout package in Ukraine, and Ukraine’s finance costs are greater because of the costs associated with holdout creditors. But more to the point, the United States should be weary to adopt such a pro-creditor position on this international legal issue. After all, with the federal debt at 101% of GDP, it is not so far fetched to think the United States may need to restructure its debt one day.