what happens if a sovereign defaults

Sovere

ign D

ebt: W

hat H

appens If A

Sovere

ign D

efa

ults

?Specia

l Com

ment

July 2000

Contact Phone

New York

Farisa Zarin 1.212.553.1653Vincent TrugliaDavid LeveyChris Mahoney

SummaryFor the first time in 50 years, the international bond market is confronted with sovereigndefaults. As each default, or near default, occurs, we at Moody’s are being asked a series of ques-tions that run common among the various situations.

One area of growing interest is the extent of a creditor’s legal rights vis-à-vis the sovereignissuer. To put it simply: in case of a default or a restructuring, can a sovereign issuer be com-pelled to make good on its original debt obligations? This line of questioning is particularly ger-mane, as the threat of legal action could alter the underlying incentives of creditors and the sov-ereign debtor, which in turn could affect restructuring negotiations.

Although the purpose of this comment is to try and shed some light on the relevant issues, itshould be noted at the very outset that Moody’s neither professes nor assumes expertise in inter-national law. The notions presented here are simply a restatement of the various sovereignimmunity statutes, relevant court cases, legal scholarship, and customary practice as it has devel-oped over the past years. This caveat notwithstanding, we will try to reply to five very specificquestions that have repeatedly been asked of us:

1) Can a holder of sovereign debt sue a sovereign in case of a default or a restructur-ing?Quick and dirty answer: Yes. If the creditor was not party to the restructuring agree-ments and still retains full rights under the original terms of the debt, it can sue the sov-ereign.

Sovereign Debt:What Happens If A Sovereign Defaults?

Special Comment

continued on page 3

2 Moody’s Special Comment

© Copyright 2000 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN ISCOPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISEREPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FORANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIORWRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility ofhuman or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes norepresentation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information.Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to,any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents inconnection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct,indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of thepossibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information containedherein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NOWARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OFANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or otheropinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user mustaccordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it mayconsider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY’S hereby discloses that most issuers of debt securities (includingcorporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay toMOODY’S for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.

Author

Farisa Zarin

Editor

Susan Schwartz

Senior Production Associate

Mark A. Lee

2) Given the availability of legal recourse, can a holder of bonds (or bank loans) realisticallyexpect to get monetary compensation?Quick and dirty answer: It depends. Like most contractual obligations, many questions can beanswered through a close reading of the language of the instrument. But, on a very general level, aclaimant can recover through legal channels if: a) the sovereign has assets in the country whereinthe suit is brought; and, b) those assets are directly associated with the defaulting instrument.Needless to say, there are many factors that complicate the matter.

3) How does sovereign debt become more vulnerable to legal attack? Quick and dirty answer: Sovereign debt is generally governed by either New York State law orEnglish law. With very few exceptions, issuers of bonds will adopt the documentation practicesprevailing in the jurisdiction whose law is chosen to govern the bond and related documents.Generally speaking, New York law bonds do not permit debt rescheduling without the consent ofall creditors. By contrast, English law bonds allow changes to payment terms when those changesare accepted by a supermajority of bondholders. Once the changes are approved, the restructuringterms are binding on all creditors. The absence of the supermajority clause in a debt instrumentleaves the sovereign more susceptible to legal attack, as the sovereign cannot “cram down” arestructuring agreement on stubborn creditors.

4) Who would sue a sovereign? Quick and dirty answer: The most likely candidates are secondary purchasers of sovereign debtand small bond-holders. Generally referred to as the “free-rider problem,” legal claims against sov-ereigns are brought by creditors who do not participate in restructuring talks and who hold out onthe payment rescheduling decision of the majority of debt holders. If the particular instrument doesnot have a supermajority clause, which crams down the new terms on the dissenting minority,uncooperative creditors remain in possession of their legal rights to force the sovereign into com-plying with the original terms of the debt. They should be able to sue in most cases.

5) Could a proliferation of lawsuits alter the incentives of creditors and sovereigns to lend,borrow, and restructure? Quick and dirty answer: As the bond market and the secondary debt market gain significance forsovereigns, the threat of suits increases. To date, claims against defaulting states have not madetheir way up through the US appellate system (i.e. the U.S. Supreme Court) because a bindingjudgment would ill serve the interests of either party. In fact, the standard course for legal actionseems to be settling out of court. Traditionally, major lenders, specifically London Club banks andthe IMF, have had long-term interests, which made rescheduling an attractive alternative to sover-eign default. However, the proliferation of small, speculative creditors, interested in quick-fixreturns, place debtor-sovereigns at greater risk of suits. The emphasis on the short-term, asopposed to the long-term, perspective may re-focus negotiation talks on the interests of all con-cerned parties, especially the small creditor.

I. WHAT IS SOVEREIGN IMMUNITY?A sovereign debtor is not the same as any other type of debtor. The same rules do not apply because his-torically sovereigns have had rights, which were, in essence, absolute in nature. Black’s Law Dictionarydefines sovereignty as:

“The supreme, absolute, and uncontrollable power by which any independent state is governed. …The power to do everything in a state without accountability, - to make laws, to execute and toapply them, to impose and collect taxes and levy contributions, to make war or peace, to formtreaties of alliance or of commerce with foreign nations, and the like.”1

1 Black’s Law Dictionary, Sixth Edition, pg. 1396 (1990).

Moody’s Special Comment 3

Linked to this notion of sovereignty is that of “sovereign immunity,” a judicial doctrine that precludesbringing suit against a government without its consent. Nevertheless, there are two broad exceptions tosovereign immunity, which, when combined, are referred to as “the modern restrictive theory of sovereignimmunity”. Those exceptions are:

a) where a sovereign explicitly waives its immunity and agrees to be sued in the jurisdiction of anothercountry; and,

b)where the sovereign’s actions are commercial in nature.

Many countries, either through implementing statutes, deciding case law, or by virtue of being signa-tories to international conventions and covenants, have adopted the modern restrictive theory of sovereignimmunity.2

A.Can a Holder of Sovereign Debt Sue in Case of Default? If a sovereign defaults, either on a bond or a bank loan, it is not immune to legal process by its creditors.Bonds and bank loans are considered commercial in nature, regardless of the ultimate use of funds.Consequently, in case of a default, a creditor may bring action in any country where the commercial activ-ity exception of sovereign immunity is recognized.3 However, for all practical purposes, US and UKcourts are the favored venue. This is primarily because both countries have opened their court systems tosuch claims, and because most bond instruments or bank loan agreements contain clauses which recognizeUK and or US jurisdiction.

Out of the two court systems, the majority of cases seem to be brought before US courts, possiblybecause of the more litigious nature of its legal tradition. Furthermore, New York State law bonds gener-ally require creditor unanimity when restructuring which renders unlikely the desirable outcome of anexchange offer, explained in greater detail below. As a result of the greater frequency with which USCourts have been accessed, the discussion here with respect to sovereign immunity will focus on the rele-vant US statutory and judicial decisions. It should, nevertheless, be noted that the same paradigm holds,more or less, for other countries.

1) US Sovereign Immunity Law The US Foreign Sovereign Immunities Act (FSIA)4 adopts the modern restrictive theory of immunity andthus provides that in the United States foreign sovereigns are immune from law suits, unless: 1) the sover-eign has waived its immunity; or 2) the subject of the suit concerns a commercial activity.

Most bonds and bank loan agreements contain clauses that expressly waive any right of immunity andin many instances recognize New York law and New York courts for legal proceedings.5 After a period ofuncertainty over the status of sovereign debt, the United States Supreme Court made clear in Republic ofArgentina v. Weltover6 that sovereign borrowing is “commercial activity.” More important, in Weltover,the Court decided that a national of any state could bring a suit against any sovereign in a US court solong as there exists some connection between the commercial activity and the United States. That nexuswas very loosely defined. It is sufficient, for example, if the interest payments received by a creditor, beforethe bond’s default, was made payable to an account physically located in the United States.

As a result of both the FSIA and the US Supreme Court decision, any creditor may successfully take adefaulting sovereign to court in the United States.7

2 The “restrictive” view of sovereign immunity was adopted by the United States Department of State after World War II, under which foreigngovernments are not entitled to absolute immunity for their actions.

3 See generally, “Thinking the Unthinkable; Attaching Sovereign Assets,” International Financial Law Review October 1984; United States, TheUS Foreign Sovereign Immunities Act (FSIA) 28 U.S.C.S. 1602 et seq.; 1972 European Convention on State Immunity; United Kingdom,Section 3, state Immunity Act 1978; France, signatory, see case law, e.g., Eurodif v. Iran, Cour de Cassation 14 Mars 1984; Spain,signatory, see case law, e.g, El Encinar De Los Reyes, SA v. Government of the United States, municipal court number 24 of Madrid ofApril 4, 1963; Canada, State Immunity Act; Japan, driven only through bilateral treaties.

4 US Foreign Sovereign Immunities Act, FSIA, USCS 28, Chapter 97, section 1602-1611.5 That is to say, personal jurisdiction, subject matter jurisdiction, conflict of law issues are expressly addressed and conceded in most debt

instruments. 6 112 S.Ct. 2160 (1992). 7 Again, this is true if the creditor can establish the nexus, as defined by the Supreme Court, with the US. There are instances wherein the

debtor sovereign strictly guards against such a nexus through ensuring that no interest is payed out in the U.S. Additionally, it is important tonote that similar practice has been accepted in most other jurisdictions.


B.Can a Creditor Get Payment in Case of a Favorable Judgment? That a claim can be brought, although fascinating from an academic stance, is mute if the claimant isunable to recover. Under US law, creditors could obtain a pre-judgment attachment of the assets of a for-eign state to secure payment in case of a favorable judgment.8 Consistent with the rest of the statute, how-ever, only the sovereign’s commercial assets may be attached.9 The statute places further restrictions onthe commercial assets that can be successfully attached.

It is true that a sovereign can waive immunity to all its commercial assets. However, if such a waiver isnot explicitly made, the statute strictly limits the claimant’s access to property which: 1) is physically locat-ed in the United States, and 2) “…is or was used for the commercial activity upon which the claim isbased”.10 Although the courts have not had an opportunity to clarify what is meant by “commercial activi-ty upon which the claim is based,” it is safe to assume that, in case of a sovereign default, only those assetsdirectly related to the defaulting bond would be attachable.

For all practical purposes, if a claimant were to choose to press on with the suit and arrive at a judg-ment, he or she would be limited to a small pool of assets. Moreover, because of the various contractualobligations that creditors have to one another, which will be discussed in greater detail below, the pro rataportion that the individual creditor would receive at the end of a legal proceeding may be close to nothing.Yet, the threat of a decision against the sovereign has, until now, been viewed as sufficiently damagingsuch that sovereigns have found it more advantageous to settle out of court.

II. DEFAULT, RESTRUCTURINGS, AND THE SECONDARY MARKETCountries have always borrowed and lent money to one another. Over the course of centuries, there havebeen many instances where the debtor nation was unable to make good on its obligations. In Moody’s1995 Special Comment, “Sovereign Risk: Bank Deposits vs. Bonds,” we presented a comprehensive surveytracing the evolution of sovereign lending, borrowing and occasional defaults. We noted in that comment,that generally, when making a decision on whether to default, a sovereign balances the internal repercus-sions of fiscal and monetary constraints against the external consequences on short-term borrowing andaccess to the capital market.11

Because only few players lent to sovereigns, if a sovereign were to default, it would temporarily bemarked with a scarlet letter for unreliability within that small group. But, through international pressure,negotiations, or the simple passing of time, the sovereign would eventually have access to external capital.Lawsuits were never a threat.12

A.Historical Perspective on Restructuring – Unilateral or NegotiatedTraditionally, a heavily indebted country could either renegotiate with its creditors or unilaterallyreschedule its debt simply by announcing the new terms. On the surface, unilateral rescheduling mightseem to be an appealing option for a sovereign debtor.13 Yet, the fear that unilateral action on existingdebt, tantamount to a default, would close the debtor nation’s access to credit rendered this alternativeunsavory. This disincentive was generally overstated for several reasons. For example, sovereigns wereunlikely to endure lasting suffering if they reneged on their debts. Lenders to sovereigns were large banksor other countries, which were more interested in future economic indicators. Furthermore, the fear thattrade credits to the sovereign nation would be damaged ignored the underlying long-term interests ofthese creditors in maintaining open lines of trade with the country in question. Nevertheless, the misper-

8 It is important to note that section 1611(b)(1) states: “the provisions of the statute on waiver relating to property do not apply to the property ofa foreign state if the property is that of a foreign central bank or monetary authority held for its own account unless such bank or authority, orits parent government, has explicitly waived its immunity from attachment in aid of execution.” It has been argued, therefore, that pre-judgmentattachment is simply not possible where central banks are concerned, because the statute is silent on this point. For a detailed discussion onthe extent to which central banks are immune, see Ernest Patrikis, “Sovereign Immunity and Central Bank Immunity in the United States,”159-167 and, Whitney Debevoise, “Comment” at 168 – 171 in Robert C. Effros (ed.), “Current Legal Issues Affecting Central Banks, Volume 1.

9 The statute, and indeed international law, deem all political property, such as embassies or homes of UN mission chiefs, off limits.10 U.S.C.S., Chapter 97, Section 1610. This is especially relevant to Brady Bonds, as they are collateralized by US Treasury notes.11 When a sovereign defaulted, historically, its ability to borrow was drastically impaired, but only in the short run. 12 Although, on occasion, military invasions occurred. See, e.g., Charles Lipson, “International Debt and National Security; Britain and America,”

p, 189 – 226, in The International Debt Crisis in Historical Perspective, eds., Barry Eichengreen and Peter H. Lindert13 Unilateral reschedulings were not uncommon during the sovereign bond defaults of the nineteenth century and the 1930s. A government in

financial distress could, and often did, simply announce a rescheduling of its bonds to its bondholders. In its decree, the government wouldannounce modifications of the terms of the original loan and “offer” the new terms to the existing bondholders. Because the original obligationsprovided no other remedy, there was no realistic choice but to accept the changed terms.


ception that breaking existing debt obligations endangers a country’s credibility and creditworthinessproved to be a strong disincentive. As a result, renegotiations were the usual course of business.14

Interestingly, a stronger deterrent of default or unilateral action is the creditor’s legal claim.Historically, investors in sovereign debt have been in a weak position because they were compelled toaccept any new terms.15 Today, however, it is highly doubtful that a creditor, who for example is awarethat a collateral agent bank is in possession of interest collateral, would submit to detrimental terms ratherthan pursue some other more aggressive course.

B.The Secondary MarketIn the 1980s, sovereign debt began to be traded at a discount.16 This trend spawned and fostered an inter-national secondary market, which has since grown exponentially.

The growth of this market has brought a series of positive effects. For example, secondary trading hasallowed conservative banks to exit unstable cycles of crises, rescheduling and involuntary lending by trans-ferring risks. The secondary debt market has also given financial analysts an incentive to monitor and col-lect information about sovereigns issuing debt, the absence of which played a significant part in the early1980s crisis as banks made bad loans. Yet, it is this same secondary purchaser of sovereign debt whoresorts to the courts in case of defaults.

1) Collective Action Clauses (CACs) – Creditor Solidarity Although the secondary buyer has purchased the debt at a fraction of its face value, it nevertheless assumesall the rights of its predecessor, including the legal right to receive principle and interest payments underthe original terms. Whether a buyer will sue to win special treatment, rather than enter a restructuringagreement, is based on two important considerations. The first, of course, is whether the secondary pur-chaser will be able to assert its interests at the various restructuring negotiations. Generally speaking, itcannot. On a very practical level, it can either take the restructured agreement, or it can sue.

The second consideration before a small holder of sovereign debt is, therefore, the contractual andbinding language in the debt instrument. Original debt agreements could include a number of provisionsthat bind the fortunes of the secondary purchaser to that of his fellow creditors.17 The presence orabsence of these collective action clauses (CACs)18 is significant because their underlying purpose is toalign the interests of large creditors.

As banks and countries have historically been the primary source of capital to sovereigns, CACs havehelped link their interest so that they act as one negotiating unit. But, the emergence of and the increasingpotency of the secondary market have undermined CACs and restructuring negotiations because sover-eigns are faced with numerous small creditors with quick-fix short-term interests.

14 See, e.g., Barry Eichengreen and Richard Portes, “After The Deluge: Default, Negotiation, and Readjustment during the Interwar Years,” inBarry Eichengreen and Peter H. Linder, “The International Debt Crisis in Historical Perspective.

15 See id. Short of government action or negotiations through bond-holder committees, there was little that the individual creditor could do.16 As it had before the 1930s. 17 See Appendix I for three of the more prevalent such clauses.18 See, supra, note 20. The presence of collective action clauses (CACs) is somewhat determined by the practices of the place where

the bond is issued. The two competing jurisdictions are, of course, New York, where CACs, and in particular supermajority clauses, are as a matter of practice not inserted into the language of the bond instrument, while in London, and under English Law, as a matter of practice, CACs are included in the language of the bond.


2. Free-Riders19

Most emerging market sovereignbonds and bank loans are issuedeither in New York or in London,and therefore they explicitly recog-nize either New York State Law orEnglish law, respectively. It shouldbe noted at the outset, that regard-less of where a bond is issued, it isthe language of the bond instru-ment that governs. However, as amatter of practice, when bonds areissued in London as opposed toNew York certain super-majorityclauses are inserted into the bondinstrument. Consequently, sover-eign debt issued in New York, gen-erally speaking, does not allow forsubsequent changes to its paymentterms – or restructuring – withoutthe consent of each creditor.Because of the “unanimity require-ment,” New York Law bonds aremore difficult to restructure thantheir counterpart. By contrast, sov-ereign debt instruments issued inLondon, and thus under Englishlaw, will usually contain languagethat makes changes to the terms ofthe original debt binding on allcreditors if those changes wereapproved by a “supermajority” ofcreditors (usually 662/3% or75%).20

When a sovereign issuer is con-fronted by New York law’s unanim-ity requirement or when it is uncer-tain about its ability to secure thenecessary supermajority approvalunder English law, it may turn toalternative means. Through the useof the exchange offer,21 the sover-eign debtor offers to exchange itsexisting debt for new instruments.Creditors willing to accept the offerare lifted out of the old debt.Creditors unwilling to accept theoffer remain in full possession oftheir legal rights and remediesunder the original debt instrument.

19 The International Financial Institutions Financial Advisory Commission, submission by Lee C. Buchheit, Cleary, Gottlieb, Steen & Hamilton“Sovereign Debtors and Their Bondholders,” (January 14, 2000). (The majority of this section is based on the cited work.)

20 See Yianni, “Resolution of Sovereign Financial Crises: Evolution of the Private Sector Restructuring Process”, in Bank of England, FinancialStability Rev. 78, 80-81 (June 1995), for a more detailed discussion on the differences between US and English practices.

21 For a more detailed discussion of exchange offers and Moody’s analysis thereof, see “Moody’s Approach to Evaluating Distressed Exchange,”Special Comment, July 2000.

Some Examples of Creditor Agreement Clauses (CACs)

A) Cross-Default Clause Cross default clauses link togetherthe sovereign’s various creditors bymaking it an event of default if itdefaults on any other debt agree-ment to which it is a party. In suchan event, creditors armed withcross default clauses will be enti-tled to declare a default, renderingall relevant loans subject to accel-eration. These provisions arepressed upon debtor nations on thegrounds that all creditors, includingcommercial creditors, should betreated in pari passu, notwithstand-ing that they may individually beparty to diverse agreements.

The existence of such clauses couldencourage large creditors, which,when considered individually, toparticipate in consensual renegotia-tions, to align interests and behaveas one unit in negotiation.Conversely, it could induce smallercreditors to act independently andbegin prompt litigation to enforceexisting debt agreements. As it linksvarious debt instruments to oneanother, it could also provide a larg-er pool of assets for the creditor toattach in case of a judicial proceed-ing. The presence of sharing claus-es, however, may still make it unat-tractive for an excluded creditor tosue in its own right.

B) Sharing ClauseThrough a sharing clause eachcreditor agrees to share any fundsreceived from the debtor pro rata,with all other parties to the syndi-cate, or possibly all other commer-cial creditors. The clause will typi-cally cover both voluntary pay-

ments by the debtor and proceedsfrom judicially imposed judgments.The motive behind this type of lan-guage in a debt instrument is toensure that no creditor receivesmore favorable treatment than oth-ers and to encourage creditors notto hold out from renegotiation. Thisgoal is particularly relevant in situa-tions where commercial creditorsare fearful that the proceeds fromnew credits are being used to payoff pre-existing loans in a mannerprejudicial to their interests.

In combination with the cross-default clause, this could meansharing with hundreds of banksand other creditors whatever sum acourt seizes and makes accessible,leaving a small pro rata fraction leftin the hands of the original suingparty. Of course, out-of-court set-tlements do not necessarily fallunder either of the scenariosdescribed above.

C) Super-Majority or Required Banks Clause

“Super-majority” or “required-banks” clauses, set forth a thresh-old percentage of banks, or bondholders, required to take certainactions pursuant to an original orrenegotiated debt agreement. Theparticular actions for which con-sent is required will vary, as willthe percentage threshold for differ-ent actions. These clauses typicallyrequire that a majority or super-majority of all creditors agree to arenegotiations plan in order to bindnon-consenting creditors to thenew plan.


22 CIBC Bank and Trust Company (Cayman) Ltd. V. Banco Central do Brasil, 886 F. Supp. 1105 (S.D.N.Y. 1995) hereafter, Darts Litigation. Anexample of the use of legal action as a threat against the Sovereign is that of the Darts Family against Brazil, for an explanation of that casesee Theodore Allegaert, “Recalcitrant Creditors Against Debtor Nations, or How to Play Darts, 6 Minn. J. Global Trade 429 (Summer, 1997),pg. 446-447. (“The controversy that brought the potential profitability of secondary purchases of LDC (less-developed countries) debt to theworld’s attention arose between Brazil and Florida’s Dart family. The Darts instructed traders … to begin buying Brazilian debt paperunobtrusively on the secondary market, which they then assigned to a specially created Cayman Islands ‘bank’. Within a year, after buyingfrom creditor banks at prices between 25 and 40 cents on the dollar, the Cayman bank became the fourth largest single holder of BrazilianDebt. In 1993, however, Brazil cut a deal with … large US bank creditors to convert 35% of its outstanding debt, including the Darts’ holdings,into other bonds at substantially less than face value. The Darts refused to accede to this. “Instead, the Darts brought suit in federal court in New York a year later, seeking accelerated repayment of principal and interest on theirbonds. …Ultimately, the two sides reached a settlement….”)

23 Banks have tried to exit by securitizing the debt and by engaging in debt-for-debt or debt-for-equity swaps.

24 Despite the scarcity in case law, litigation by individual creditors are much more common than would otherwise be assumed. See, e.g., ChristineA. Bogdanowicz-Binder, The Role of Financial Advisors in Bank Debt Reschedulings, 23 Colum. J. Transnat’l L. 49, 54 (1984); see also, e.g.,Weston Compagnie de Finance et d’Investissement, S.A. v. La Republica del Ecuador, 823 F. Supp. 1106, 1108 (S.D.N.Y. 1993) (suit bySwiss financial institution, a substantial part of the business of which involved the acquisition and trading of Latin American debt); Banque deGestion Privee-Sib v. la Republica de Paraguay, 787 F. Supp. 53, 54 (S.D.N.Y. 1992).

25 See e.g. Supra note 22, Darts Litigation.26 Such dynamics seem to operate anytime lawyers develop a novel or unusual type of nuisance suit. See, Theodore Allegaert, Comment,

Derivative Actions by Policyholders on Behalf of Mutual Insurance Companies, 63 U. Chi. L. Rev. 1063, 1066 n. 15 (1996).27 Most notably the “Brady bonds”. In March 1989, US Secretary of the Treasury, Nicholas Brady, announced a plan under which the United

States government would back efforts to resolve the sovereign debt crisis. This included the Brady bonds, which were the securitization ofsovereign debt into marketable bonds of long maturity, backed by US treasury securities.

Obviously, the dilemma in using exchange offers for carrying out sovereign restructuring is that it doesnot bind abstaining debt holders. Due to peer pressure and regulatory coaxing, the free-rider problem wastrivial in the commercial bank debt restructurings of the 1980s. But, today, because so much of sovereigndebt has traded into the hands of non-banks and with the prevalence of Brady transactions (structured asexchange offers), the hold-out problem may be a concern.22

III. LITIGATION THREATS COULD ALTER THE INCENTIVE TO RESTRUCTUREOriginal debt-holders, such as big banks, have rid their balance sheets of distressed debt by trading themoff to secondary purchasers.23 Because this debt is bought and sold at less than its face value, its sec-ondary-market price more accurately reflects realistic prospects for repayment. Nevertheless, countriesare still liable for the face value of the debt. This disparity translates into the possibility of enormous prof-its for purchasers of discounted debt. Small creditors have, in essence, bought cheap securitized debt withan eye on the potential upside.

The upside comes in the form of quick-strike suits. It is interesting to note that in the face of therecent defaults and restructurings, although legal action has clearly been possible, there have been rela-tively few published cases.24 This is probably because speculative purchasers are unlikely to want a bindingappellate court decision. A precedent declaring that such lawsuits are, for whatever reason, not viablewould take away a fairly potent weapon in the creditors’ arsenal. Nor would sovereign defendants want torisk having an appeals court declare in a published opinion that these suits are proper as that would makethe threat of legal recourse even more credible, necessitating higher settlement offers. Put simply, bothsides benefit from the uncertainty that shrouds this type of litigation. To date, these suits are used primar-ily as coercive tactics.25 The desire to settle remains strong for both sides.26

A. Change in IncentivesThe players in renegotiations have historically been the sovereign debtor, Western banks, (the LondonClub), the governments of creditor nations (the Paris Club), and multi-lateral organizations such as theIMF. Over the past several decades, these players have devised a variety of methods to quell the panic thatsurrounds imminent sovereign default.27 These measures, in essence, have attempted to strike a balancebetween the limited ability of debtor nations to service external debt with the desire of creditor institu-tions, especially private banks, to recoup some part of their losses in this market.

That the courts and the legal process are being employed as tactical tools by secondary purchasers forquick-cash settlements indicates that the motivators behind rescheduling and restructuring have changed,or at the very least are beginning to change. The driving consideration in restructuring has traditionallybeen the long-term interests of the large creditors. These interests are, at their core, tempered by politicalconcerns. The chaos that would ensue if one government were to sue another government, for example, ina US court is difficult to imagine. It goes without saying, that in case of such a suit diplomatic relations


would be damaged on various fronts. These same political barriers are not in place for small-stake bond-holders and secondary purchasers.

Furthermore, until this point in time, a kind of a taboo has existed. Very few creditors would dare totake a sovereign to court. However, as the quasi-mythological stature of a sovereign entity diminishes, assecondary creditors become more courageous, and as their lawyers sharpen their legal arguments, thethreat of suits in case of a default or an exchange offer will become dauntingly real. The result could meanacceleration, at least in the short run, in the rate at which these suits are brought.


Sovere

ign D

ebt:

What

Happens I

f A S

overe

ign D

efa

ult

s?

To order reprints of this report (100 copies minimum), please call 800.811.6980 toll free in the USA. Outside the US, please call 1.212.553.1658.Report Number: 57753

Specia

l Com

ment

what happens if a sovereign defaults

Documents