October 14, 2013

Has the Second Circuit (Unwittingly) Breathed Life Into the Nostrils of

Imperial Chinese Government Bonds?

Mitu Gulati

Abstract

The attached letter from one Horatio D. Gadfly will form the basis of the term project for my class at the Duke Law School in the spring semester of 2014. The course is entitled “International Debt Transactions”.

Holders of long-defaulted bonds issued by the Chinese Imperial Government and Tsarist Russian Government have faced two insurmountable obstacles to the enforcement of those instruments in U.S. courts:

(i) Federal courts had previously ruled that the “absolute” theory of sovereign immunity which prevailed in the United States until 1952 applied to debt obligations issued by foreign governments prior to that time. (Under the absolute theory of sovereign immunity, foreign states could not be sued in U.S. courts without their consent.)

(ii) The statute of limitations (six years for contract cases in New York) will have long since expired on those old bonds.

A Supreme Court case decided in 2004 (Austria v. Altmann) reversed the old rule about applying absolute sovereign immunity to claims arising prior to 1952. Under the Supreme Court’s new approach, a federal judge should apply the U.S. sovereign immunity rules prevailing at the time an action is commenced, not the rules that existed when the debt was issued.

As for the statute of limitations, the Second Circuit Court of Appeals ruled in 2012 that a debt instrument containing a financial covenant (in that case, a promise to maintain the equal ranking of bonds) is breached each time the issuer makes a payment to other creditors in

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violation of the covenant. The decision may imply that the statute of limitations is commenced afresh for the enforcement (by specific performance or injunction) of the financial covenant in the old bonds each time a payment under new instruments is made in violation of the covenant. See NML v. Argentina.

Taken together, these two decisions could possibly, just possibly, breathe life into the nostrils of some sovereign bonds that have for 60 years been esteemed principally for their aesthetic, as opposed to their financial, characteristics. At the very least, magnifying glasses will be trained on framed sovereign bonds hanging in foyers, physician waiting rooms and bathrooms around the country.

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Horatio D. Gadfly 12 Never Street

Elmira, New York

December 31, 2013

Honorable John F. Kerry Secretary of State United States of America Washington, D.C.

Re: People’s Republic of China

Dear Mr. Secretary:

I am taking the liberty of writing to you on a matter of considerable importance both to me and to the foreign relations of the United States.

Background

My name is Horatio D. Gadfly. I am a lifelong resident of Elmira, New York.

I am the sole remainderman on a trust established by my great uncle Waldo Z. Gadfly who died in 1975. Uncle Waldo was also a lifelong resident of Elmira, except for the several years he spent in China (described below). By the terms of the trust, I received clean title to all of the assets in the trust earlier this year.

In one of the boxes that was delivered to me by the trustee, I found a manila folder bearing the cryptic legend “The last camel died at noon.” This, I seem to recall, was Uncle Waldo’s favorite expression for describing a situation or occurrence that was imminently to ripen into a fully-fledged catastrophe. All his life, Uncle Waldo had a keen -- some said clairvoyant -- instinct for sensing imminent catastrophes.

Inside this folder I found fifty bonds issued by the Chinese Imperial Government in 1898.

The bonds are captioned “4½% Gold Loan of 1898”. The bonds are denominated in Great Britain Pounds Sterling. I am attaching to this letter a copy of one of the bonds.

Clipped to this stack of bonds was a note written in Uncle Waldo’s distinctive spidery scrawl. It reads as follows:

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“My dear Horatio,

As you know, in my younger days I was a civil engineer and went out to China in 1895 to make my fortune. The Chinese Government of the day quickly retained my services pursuant to a three-year contract to build railroads in various places in the country. Although my efforts were greatly esteemed by the Government, when my contract ended in 1898 the Government pleaded a “temporary embarrassment of liquidity” (that’s a free translation from the Mandarin). In other words, they didn’t pay me. Instead, the Government promised to send the money due to me by not later than midnight on December 31, 1899.

I returned to Elmira, as the saying goes, poorer but wiser.

But to much my surprise, at 11:45 p.m. on December 31, 1899, just as I was waiting to welcome in a new century, I heard a knock on the door of my little house in Elmira. I opened the door to see a young fellow, covered in snow, clutching an envelope. He handed me a business card saying “Third Deputy Financial Attaché, Embassy of the Imperial Government of China”. This fellow uttered only one sentence: “Honorable Waldo, the Imperial Government of China always pays its debts.” And with that he shoved an envelope into my paw and disappeared again into the snowy night.

The envelope contained the bonds you now are holding. It also contained instructions that I was to present the coupons to the offices of the Hong Kong and Shanghai Banking Corporation in New York City where the Government had apparently made arrangements for payment.

And indeed they had. Every year between 1900 and 1939, I presented a coupon across the counters of the HSBC in New York City and was paid in full. The coupon I presented in 1940, however, was dishonored. No explanation was given.

Naturally, I consulted a lawyer but was told that a foreign Government like China was absolutely immune from suit in a U.S. court and I was advised to forget the whole incident.

Well my lad, who knows. By the time you read this, things may have changed. Good luck and good hunting.

Affectionately,

Uncle Waldo.”

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And, bless his heart, Uncle Waldo actually had that handwritten note notarized.

The Current Situation

Mr. Secretary, I direct your attention to the fifth paragraph of the “Extracts from the Agreement referred to in the Bond” which appears on the reverse of the attached bond.

It reads as follows:

“This entire loan of sixteen million pounds sterling shall have priority both as regards principal and interest over all future loans . . . so long as this loan or any part thereof shall be unredeemed.”

I shall refer to this as the “Absolute Priority Undertaking”.

In other words, the Chinese Government solemnly promised that until the bonds were paid in full, amounts due under these instruments would enjoy a priority over any other Chinese Government debts contracted after the issue date of these bonds. My research has confirmed that the current Chinese Government has indeed issued new debt securities to investors in the United States, and that those instruments are being paid currently. Specifically, the PRC issued a New York-law governed bond (Euro 1 billion; 4.5%) in 2009. All coupons on that bond have been punctually paid in full; the final payment is due on October 28, 2014. It is obvious that each such payment on those subsequently-issued Chinese bonds violates the Absolute Priority Covenant.

Legal Analysis

I have consulted legal counsel skilled in sovereign debt matters and, once again, Uncle Waldo’s premonitions have proven accurate -- things have changed (dramatically) since his day. Set out below is a summary of the legal advice I have received on issues relevant to my Chinese Government bonds.

1. Responsibility of the PRC. Although the Government of the PRC has disclaimed responsibility for the debts of its predecessor governments, these disclaimers are not binding in a U.S. court. The law of the United States provides that successor administrations in a country must honor the debts incurred by their predecessors. See Restatement (Third) of the Foreign Relations Law of the United States § 209(2) (1987).

2. Odious Debts. The PRC has labeled the debts of the Imperial Chinese Government as “odious”. There is some discussion in the academic literature about the possibility that a doctrine of odious debts may

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have evolved in recent years. My counsel, however, is of the view that this doctrine (if doctrine it be) is not recognized in U.S. jurisprudence. See Buchheit and Gulati, “The Dilemma of Odious Debts”, 56 Duke Law Journal 1201, 1228-1230 (2007).

3. Sovereign Immunity. Although Uncle Waldo was correct that in his day a suit could not be brought against a foreign sovereign in a U.S. court without the sovereign’s consent, all of that changed starting in 1952. U.S. law today holds foreign sovereigns accountable at law for their commercial contracts like bonds and loans. See Foreign Sovereign Immunities Act of 1976 (“FSIA”). The PRC takes the view that it has never acquiesced to the evolution of international law from an absolute theory of sovereign immunity to a more restrictive theory. See Qi, “State Immunity, China, and Its Shifting Position”, 7 Chinese Journal of International Law 307, 315-323 (2008); see also Jackson v. People’s Republic of China, 794 F.2d 1490, 1494 (11th Cir. 1986). However, even assuming that the PRC qualifies as a “persistent objector” for purposes of customary international law (a questionable assumption), a U.S. domestic court is not going to read an exception for one nation into the FSIA.

4. Applicable Law. For many years, however, U.S. courts applied the old rule of absolute sovereign immunity to debt obligations issued before 1952. See Jackson v. People’s Republic of China, 794 F.2d at 1497-98. This was expressly altered by the U.S. Supreme Court in 2004. See Republic of Austria v. Altmann, 541 U.S. 677. As a result of the Altmann decision, it is now clear that the PRC would not enjoy immunity in a U.S. court for its obligations under these bonds.

5. Statute of Limitations. I recognize that it may be too late now to obtain a judgment for the unpaid principal and interest on the bonds because they went into default so long ago. See Morris v. People’s Republic of China, 478 F.Supp.2d 561, 571-73 (2007). However, the expiry of the statute of limitations does not extinguish the vitality or validity of a debt instrument. Rather, it just limits the judicial remedies available to enforce the instrument. In the matter at hand, a fresh violation of the Absolute Priority Undertaking occurs each time the PRC makes a payment on one of its new bonds without paying me. The Second Circuit Court of Appeals has recently interpreted a very similar financial covenant in a sovereign bond to require ratable payments on the issuer’s long-defaulted obligations. See NML v. Argentina, 699 F.2d 246 (2d Cir. 2012).

6. Rights Against Third Parties. Quite apart from my claim against the PRC, I am also advised that one implication of the Second Circuit’s decision in NML v. Argentina is that I may have a right to require the holders of all new Chinese bonds -- once I inform them of the existence of the Absolute Priority Undertaking -- to disgorge to me any payment that

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they may receive under those new bonds. See Coast Bank v. Minderhout, 392 P.2d 265 (Cal. 1964) (Traynor, J.).

7. The Uniquely Recalcitrant Debtor. The Second Circuit Court of Appeals has demonstrated that the federal judiciary will stretch to give the aggrieved creditors of “uniquely recalcitrant” sovereign debtors an equitable remedy to redress their grievances. See NML v. Argentina, 2013 WL 4487563 at n.13. Surely, the actions of the Chinese Government in explicitly disavowing predecessor government debts and paying only more recent creditors put it into the uniquely recalcitrant category.

* * * *

Mr. Secretary, I am certain you will concur that my case in this matter, were I to resort to my legal remedies, is invincible. But such a step would undoubtedly create diplomatic friction between the United States and the People’s Republic of China. I have no wish to stir up that trouble. Accordingly, I would be grateful if you could use the influence of the State Department to cause the Government of the PRC to honor the debt that it once owed to dear Uncle Waldo, and that it now owes to me.

Regretfully submitted,

Horatio D. Gadfly

Enclosure

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Citation:

Gulati, G. Mitu, Has the Second Circuit (Unwittingly) Breathed Life into the Nostrils of Imperial Chinese Government Bonds? (October 14, 2013). Available at SSRN: http://ssrn.com/abstract=2340299 or http://dx.doi.org/10.2139/ssrn.2340299

ft.com > Comment > Blogs > FT Alphaville

Back to the future with pari passu Joseph Cotterill

| Nov 05 2013 12:45 | 15 comments | Share

Wait a minute, Doc. Ah… Are you telling me that you built a time machine… out of a sovereign

bond contract?

– Marty McFly (paraphrased)

Imagine the next place to come under the new era of enforcing sovereign debt isn’t Argentina, or

in the Caribbean, or even a future eurozone crisis. Imagine something… older. Much older.

For when historians come to study the Great Calamity of 2014 in international relations between

the United States and China, they shall surely whisper one name, in trembling tones.

Horatio D. Gadfly.*

And they shall doubtless point an equally trembling finger at such ornate and frilly bond

contracts as this one.

That’s a 4½ per cent gold loan issued by the Imperial Chinese government in 1898 — the year

the Hundred Days’ Reform failed and the Empress Dowager led a coup against her nephew, the

Guangxu Emperor.

And yes, this is related to Argentina’s pari passu saga, particularly now that it’s turned into a

huge headache for third-party creditors. We’ve also been thinking about what the case implies

about the practicality of courts granting injunctions against bad sovereign debtors, when the only

realistic place to enforce is on third parties.

Even if the following does sound completely insane, do please at least consider the argument…

Concerning these old Chinese bonds. They have an interesting history. Backed by internal tariffs

introduced during the Taiping rebellion — the likin tax, a symbol of the fiscal disintegration of

the Qing dynasty — they paid out their coupons until September 1940. Not bad going,

considering events between 1898 and then. But they have not paid according to their terms since.

Such mouldering paper vestiges of a dead empire as they are, you can often find the bonds on

Ebay for a few quid.

The Imperial bond might seem a long way away from even the weirder sovereign debt curios of

the 2010s — like Argentina’s defaulted debts, or for that matter, the handful of bonds which the

modern People’s Republic of China has issued under New York law.

Holders of the PRC’s October 2014 bond, for instance, have happily collected payments on it for

almost ten years now, without threat of interruption by third parties. Holders of Argentina’s

restructured debt haven’t been quite so confident lately. That’s the power of ratable payment for

you — especially when ordered as equitable relief by a US federal court. Pay all together, or pay

all nothing.

Although that is where Horatio D. Gadfly comes in.

FT Alphaville recently came across an astonishing letter penned by Mr Gadfly to John Kerry,

regarding ownership of these very Imperial bonds…

In it, the US Secretary of State is alerted to something in the bonds which isn’t quite a pari passu

clause. But it would arguably be even more slam-dunk as basis for an injunction of ratable

payment, enforceable on third-party bondholders.

That is, if Mr Gadfly was to sue the current Chinese government for relief.

It’s a provision for ‘priority… over all future loans‘:

Whereas pari passu is ‘just’ a promise of equal treatment.

Imperialist bond clauses

Funnily enough… late-nineteenth-century contracts (like the 4½ per cent Imperial Chinese issue)

could well be the primeval soup from which the sovereign version of pari passu emerged, along

with its close cousin, negative pledge. No wonder studying them has been called “legal

paleontology”. How these clauses became genuine boilerplate in the twentieth century —

crammed into increasingly unsecured sovereign debt contracts everywhere — is a story for

another time.

They probably made some kind of sense in an era where it was still acceptable for governments

to dedicate a specific stream of tax revenue to specific bonds, but where they could increasingly

sell ever more pieces of debt (using the same collateral) to ever more gullible distant investors.

The latter would therefore increasingly demand equality of treatment (or maybe just direct

priority).

An era when the first age of globalisation rubbed shoulders with financial imperialism, basically.

It is no accident that a bond which handed over railway rights to foreigners helped start China’s

1911 revolution.

So, you might regard the grant of absolute priority to one bond as among the last decadent

insanities of a decrepit dynasty. No modern government would fetishise even general debt

service so ludicrously. (Would they?)

A sovereign bond Delorean?

But we are getting lost from Mr Gadfly. Here’s his take on the absolutely priority clause’s

relevance in 2013, as relayed to (a doubtless alarmed) John Kerry:

In other words, the Chinese Government solemnly promised that until the bonds were paid in

full, amounts due under these instruments would enjoy a priority over any other Chinese

Government debts contracted after the issue date of these bonds. My research has confirmed that

the current Chinese Government has indeed issued new debt securities to investors in the United

States, and that those instruments are being paid currently. Specifically, the PRC issued a New

York-law governed bond (Euro 1 billion; 4.5%) in 2009. All coupons on that bond have been

punctually paid in full; the final payment is due on October 28, 2014. It is obvious that each

such payment on those subsequently-issued Chinese bonds violates the Absolute Priority

Covenant…

In which you may detect a rather familiar modus operandi.

But before we note how familiar, there are two big objections to note first, all to do with the

procedure of suing a sovereign, before the substance of whether it’s been a bad debtor.

1) China could argue that it doesn’t have any responsibility for bonds contracted by the

Qing empire. It might even insist that these debts are odious. In fact the Chinese government

argued some 30 years ago, in an aide-memoire to one of these bondholder cases (yes, Horatio

wouldn’t be the first), that it “recognizes no external debts incurred by the defunct Chinese

Governments and has no obligation to repay them”.

On the other hand, US law on state succession isn’t so clear, and that’s the forum where Mr

Gadfly’s proposing to bring his case. In particular, “odious debt” has few judicial fans.

2) Similarly, the People’s Republic has long maintained that it still adheres to the ‘absolute’

theory of sovereign immunity. Much of the rest of the world moved on to ‘restrictive’

immunity after the Second World War. If states are engaged in the same kind of activity as

anyone else — like commercial transactions — they could be sued in the courts of other states

over that activity. China has always objected, in international law, to this shift. Which might

sound like a dead end for Mr Gadfly.

But the US gradually codified restrictive immunity in its own law from 1952 to 1976, the date of

the Foreign Sovereign Immunities Act. Probably just as well, because modern sovereign bond

litigation could never have got off the ground without it (or its UK equivalent). In any case,

Gadfly has argued that the only relevant law for his suit is US law.

(Holders of the PRC’s modern New York law bonds, meanwhile, were warned on buying that

“China has not waived its sovereign immunity in connection with any action arising out of or

based on United States federal or state securities laws…”)

Now, in US law as of 2004, the courts are supposed to apply the regime of sovereign immunity

that applied when a case was brought, not when a debt was first issued. The FSIA is retroactive.

Assuming that opens the door to Mr Gadfly’s pre-1952 bonds, they still have a problem. New

York contract cases limit claims that are older than six years.

But that (finally) is where NML Capital v Argentina might come in. It could have provided some

guidance to old Chinese bondholders on two other key bits of bringing an injunction against the

PRC. As Mr Gadfly puts it himself:

Statute of Limitations. I recognize that it may be too late now to obtain a judgment for the

unpaid principal and interest on the bonds because they went into default so long ago. See

Morris v. People’s Republic of China, 478 F.Supp.2d 561, 571-73 (2007). However, the expiry

of the statute of limitations does not extinguish the vitality or validity of a debt instrument.

Rather, it just limits the judicial remedies available to enforce the instrument. In the matter at

hand, a fresh violation of the Absolute Priority Undertaking occurs each time the PRC

makes a payment on one of its new bonds without paying me. The Second Circuit Court of

Appeals has recently interpreted a very similar financial covenant in a sovereign bond to require

ratable payments on the issuer’s long-defaulted obligations. See NML v. Argentina…

Rights Against Third Parties. Quite apart from my claim against the PRC, I am also advised

that one implication of the Second Circuit’s decision in NML v. Argentina is that I may have a

right to require the holders of all new Chinese bonds — once I inform them of the existence of

the Absolute Priority Undertaking — to disgorge to me any payment that they may receive under

those new bonds. See Coast Bank v. Minderhout, 392 P.2d 265 (Cal. 1964) (Traynor, J.).

The Uniquely Recalcitrant Debtor. The Second Circuit Court of Appeals has demonstrated that

the federal judiciary will stretch to give the aggrieved creditors of “uniquely recalcitrant”

sovereign debtors an equitable remedy to redress their grievances. See NML v. Argentina, 2013

WL 4487563 at n.13. Surely, the actions of the Chinese Government in explicitly disavowing

predecessor government debts and paying only more recent creditors put it into the uniquely

recalcitrant category…

Ingenious crazy isn’t it?

The focus on payments to other bondholders isn’t just to breathe life into the redress of a seven

decade-old default. It might also allow suing them directly. Argentina’s restructured holders

might end up volunteering to disgorge some payments in order to get holdouts to settle — so

maybe the logic isn’t so crazy.

But also interesting, because you’d hardly expect the People’s Republic of China, rising global

power and guardian of absolute sovereignty, to take being enjoined by US courts lightly. Third

parties would have to be the route to getting the PRC itself to comply. It would probably see

holdouts not as vultures but as annoying gnats (or, well, gadflies). So it would be like testing out

the state of play post-Argentina in extremis.

After all, the mechanism the Second Circuit has used to try and control the consequences of the

pari passu ruling is to say that Argentina has been not just recalcitrant to holdouts but “uniquely”

recalcitrant. This is interesting in itself: the remedy to be derived from a contract is not just about

contractual terms but bad behaviour of one of the counterparties. And sure, it’s been very bad.

But then look at the PRC: it’s directly repudiated Gadfly’s bonds. How recalcitrant is that?

And actually, looking further afield — what about those Tsarist bonds that modern Russia has

never fully repaid? Old-style pari passu clauses were put in this debt too before the Bolsheviks

repudiated it.

So we might be getting a host of Gadflies.

Or perhaps (more seriously) we should be asking whether holes in the law on injunctions and

sovereign immunity — and not holes in pari passu clauses — have been the problem all along…

__________________

*NB — Horatio Gadfly is not actually real. He’s a figment of the imagination of Mitu Gulati of

Duke Law School. Mitu prepared Gadfly’s arguments to test on students of his “International

Debt Transactions” course next year. But those Imperial Chinese bonds are real. People do sue

over them. No one’s used the pari passu template or teased out its full implications… yet.

This entry was posted by Joseph Cotterill on Tuesday November 5th, 2013 12:45. Tagged with

Argentina, China, Sovereign Debt.