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From: Sovereign Defaults Before Domestic Courts

Hayk Kupelyants

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2023. All Rights Reserved. Subscriber: null; date: 06 June 2023

Debt — Sovereign debt — Hedge fund

(p. 1) Introduction

I.  A Problem Stated

I.01  ‘The progress of the enormous debts which at present oppress, and will in the long-run probably ruin, all the great nations of Europe, has been pretty uniform.’1 These words of Adam Smith written as early as 1776 in the seminal Wealth of Nations could easily have been written today, illustrating the bleak realities of the modern global financial predicament.

I.02  Sovereign debt obligations account for more than 25% of the world’s global debt (as of 2014), approximately US$58 tn.2 Sovereign debt takes a wide variety of forms and sources. The forms of sovereign debt are multiple: domestic debt and external debt, bonds and syndicated loans, cheques, and trade credits, ‘garden-variety’ instruments and more sophisticated, ‘tailor-made’ instruments. The counterparts of the sovereign debtor also vary—funds may be extended by bilateral, multilateral, or private creditors.

I.03  Notwithstanding this variety of forms and sources, ever since the 1990s there has been a clear shift in international markets in favour of financing sovereigns predominantly through bond markets, rather than syndicated loans. For this reason, sovereign bonds will be the core focus of this book. Official lending and syndicated loans will only be discussed in passing as and when required.

I.04  Sovereign bonds, whether external or domestic, are at first issued in so-called primary markets, a term of art used to denote the initial issuance of sovereign bonds to subscribers. A typical characteristic of sovereign bonds is that they may later be traded in so-called secondary markets, where sovereign bonds will change hands following the primary issuance of bonds. The secondary markets are the medium through which primary subscribers may assign their rights under the bonds to other actors in financial markets. Such assignees assume risks in the hope of securing a windfall.

(p. 2) I.05  Notwithstanding the apparent risks of investing into sovereign bonds, private markets have little, if any, hesitation to lend to the State, subject of course to a commensurate interest rate. And the States are rarely prudent in the magnitude of their borrowings: examples of States that overborrow much beyond their repayment capacity abound in history. Reasons for overborrowing are manifold and are beyond the scope of this study. Suffice to say that the direct consequence of overborrowing is that States (developing and developed alike) sooner or later face the harsh reality of lacking the wherewithal to stay current on their debt obligations and the economic growth is no longer sufficient to service the increasing debt and interest payments.

I.06  States have various options at their disposal to deal with the excessive level of public debt, such as the spiking of inflation, imposition of capital controls, and other forms of financial repression.3 They may also have recourse to bailouts offered by international financial institutions (typically, the International Monetary Fund (IMF)). But in times of extreme indebtedness these measures often prove inadequate and States resort to defaulting and/or restructuring to reduce their mountainous debt.4 While the prospects of a default or debt restructuring are so daunting as to send shivers through the world of global finance, at times the only optimal solution is the outright default on or restructuring of the sovereign debt despite the significant costs they entail.5

I.07  In light of this, it stands to reason that sovereign debt defaults and restructurings are a pervasive feature of the international financial system as it currently stands. Nevertheless, the law has failed to address them systematically through a set of coherent rules. Instead, sovereign debt bankruptcies are addressed on an ad hoc basis through the medium of a contractual renegotiation of sovereign bonds (‘sovereign debt restructuring’). Sovereign debt restructurings are in essence a vehicle for the reduction of the State’s debt level through the contractual renegotiation with creditors. What will commonly happen is that the State will approach creditors to restructure/reduce its debt composition by exchanging old bonds for new bonds that are more favourable to the debtor (‘exchange offer’). Upon obtaining the consent of its creditors to the exchange, the restructuring of sovereign bonds will result in the reduction of the nominal value of bonds, extension of maturities, decrease of interest rate, and combinations (p. 3) thereof. The sovereign debt restructuring thus secures some level of debt relief to the insolvent sovereign debtor so as to ensure the sustainability of its debt. Under this practice, bondholders are in fact shouldering the costs of sovereign debt crises (the idea of ‘private sector involvement’).

I.08  As this summary account suggests, the rules on sovereign debt restructurings are rather rudimentary in their scope and nature; they are in essence a technique of purely contractual renegotiation devoid of the intricacies of bankruptcy law proper. The efforts to establish a sovereign bankruptcy regime (akin to the insolvency regimes in domestic laws)—which to some was a panacea for sovereign debt crises and for others a quixotic enterprise6—have failed.7 Most prominently, in the early 2000s, the IMF proposed the creation of the Sovereign Debt Restructuring Mechanism (SDRM), which did not see the light of the day due to the absence of political support. Instead of the statutory mechanism of sovereign debt restructurings, the system that has been put in place relies on adoption of contractual clauses that will ease the operation of sovereign debt restructurings (discussed in Chapter 2). A permanent bone of contention among experts in sovereign debt is which of the following is the most efficacious solution: the establishment of a proper bankruptcy mechanism for sovereigns (‘statutory approach’) or the mirroring of bankruptcy procedures through the inclusion of contractual clauses (‘contractual approach’).

I.09  Aggressive holdout litigation may serve to highlight the apparent conflict between the two approaches. In the absence of compulsory bankruptcy protections for sovereigns, a category of holdout creditors—often specialised hedge funds (sometimes pejoratively dubbed ‘vulture’ funds)—have established the practice of buying distressed sovereign debt or judgments issued against a sovereign on the secondary market at a deeply reduced price to their par. And by consistently refusing to join the renegotiation process and aggressively litigating, they attempt to recover the full value of the debt thus purchased. What happens in practice is that a supermajority of bondholders are cajoled into accepting the ‘haircut’ (reduction) to their bondholding in view of the precarious nature of the sovereign debtor’s economy and finances. By contrast, the remaining 10% of bondholders, often the litigious hedge funds, refuse to exchange their bonds for new, reduced-in-value bonds, attempting to enforce their bonds at face value.

(p. 4) I.10  The average recovery rates for this sort of tactics have been estimated to range from three to twenty times the investment in the bonds.8 Were the sovereign debtors subject to bankruptcy protections, the legal actions by litigious hedge funds would have been stayed and the holdout creditor would have undergone a compulsory reduction of its claims.

I.11  One group of policymakers, organisations, and scholars have consistently underlined the adverse effects of holdout litigation and subjected them to moral obloquy. They have argued that the sort of arbitrage strategies that ‘vulture’ funds employ have the effect of harassing the sovereign debtor and potentially jeopardising the restructuring process.9 Opportunistic holdout litigation is said to delay settlement, negatively affect the economic situation of the sovereign debtor, block the access to international capital markets, and increase the costs of restructuring.10 In addition, the holdout strategy may potentially trigger legal actions from other creditors by sending a clear signal that the sovereign debtor’s assets are not unlimited.11 Further, holdout litigation may limit the ability of the State to use its resources abroad by subjecting these assets to the constant risk of attachment. Lastly, holdout creditors seek to attach the funds that are meant to be used for payment to the majority of creditors and push the sovereign debtor to the brink of default. These deleterious effects obviously exert pressure on the sovereign debtor and the holdout creditor is able to demand a large recovery rate.12 Empirical data suggests that aggressive holdout litigation may have a negative impact on the pricing of sovereign bonds and creditors may charge less for bonds that face lesser risk of holdout litigation.13

(p. 5) I.12  The opposite camp claims that the troubles in sovereign debt markets arise from the weakness of the rights of bondholders. The initiatives to weaken them even further might lead to undesired results. The right of creditors to request repayment of debt is said to ensure the survival and long-term health of debt markets, and is conducive to continued borrowing in the future.14

I.13  The broader idea underpinning the attitude of the second camp is that too inconsiderate restraints on the activity of litigious hedge funds might have long-term damaging side effects.15 Litigious hedge funds have their own mission to play: by purchasing bonds in the secondary market they provide liquidity,16 enable banks to sell off the ‘bad’ bonds to comply with bank regulatory requirements, create an opposition to the almost exclusive power of the State in sovereign debt restructurings, and impose discipline on sovereign debtors.17 Devoid of this function, primary bondholders would have been all the more exposed to the wide-ranging bargaining power of the sovereign debtor.18 Recalcitrant funds thus take on the role of defeating ‘opportunistic defaults’, ie, defaults where the State, albeit having the capacity to pay up, is unwilling to do so.19 In addition, the presence of a liquid secondary market may arguably drive down the yields and costs of borrowing for sovereign debtors.20

I.14  The first camp rebuts this by claiming that in practice, the individual rights of creditors play to the powerful funds that possess the necessary (p. 6) knowledge and funds to ensure that the judgments are enforced in their favour, whereas the remaining bondholders do not fully enjoy the benefit of enforcement rights.21 Yet, it is an exaggeration to claim that sovereign debt litigation is necessarily initiated by sophisticated hedge funds—retail bondholders may on occasions litigate, too.22

I.15  This debate clearly demonstrates that sovereign debt adjudication conflates issues of policy, principle, pragmatism, and moral choice that are often hard, if at all possible, to reconcile. The principle of recoverability of debt may conflict with the practical inability of the State to meet its financial obligations, and, by contrast, an issue of policy might often prevail over moral choice.23 A decision-maker would often walk a fine line in manoeuvring between these conflicting and perhaps irreconcilable issues.

I.16  The clash of various considerations in legal disputes is further exacerbated by the political repercussions of one or another solution on a sovereign debt crisis or the fate of a political/economic union. In sovereign debt litigation, politics and economics are never off the court’s radar and are inexorably entwined. Ostensibly, neutral domestic courts in the exercise of their discretion are leery to jeopardise political agreements and economic considerations underlying the resolution of sovereign debt crises. The arguments constructed in this book are not oblivious to the realpolitik present in the adjudication of international financial transactions, but the book seeks to take a purified view of the legal side of sovereign debt disputes.

I.17  With the failure to establish an international bankruptcy court, the default forums for the resolution of external sovereign debt remain English and New York courts—the bastions for the protection of pecuniary interests of bondholders. Typically, States choose English or New York laws as the governing law of external bonds. It is estimated that English law governs a very sizeable portion of sovereign bonds (around 40% of bonds in the 2000s).24

(p. 7) II.  Objectives and Scope

I.18  In spite of the practical importance of the topic, it has received little sustained legal analysis. Nor has any attempt been made to combine legal and practical analysis in a comprehensive account of the law and practice governing the resolution of sovereign debt disputes before domestic courts.

I.19  This monograph examines the resolution of sovereign debt disputes before English courts, and, to a lesser degree, New York courts. The purpose of this monograph is to set out a legal framework for the litigation of sovereign debt and provide guidance to the litigants and adjudicators of sovereign debt disputes alike. The practice of sovereign debt litigation is at times obscure, conducted in the shadow of vague financial covenants and complex negotiation patterns. The discussion focuses on those aspects of sovereign debt litigation which are under-analysed in scholarly writings or unsettled in practice, so as to inform future developments.

I.20  This book concentrates on diverse litigation tactics and arbitrage strategies available to bondholders and sovereign debtors before English (and New York) courts. In most cases, private creditors may obtain summary judgments with relative ease, which indicates that the defences that the sovereign may rely upon would disclose little prospect of success. That said, often serious issues arise during the stages of assumption of jurisdiction, determination of governing law of sovereign bonds, or substantive resolution of the claims in English proceedings.

I.21  In the first two chapters, the monograph first examines the theoretical underpinnings of sovereign debt litigation and then sets out the contractual background of sovereign debt litigation. Chapter 3 examines the jurisdiction of English courts and cognate matters (standing, pre-emptive strikes and stays of proceedings, interim measures). Chapters 4 and 5 consider the governing law: Chapter 4 analyses the law applicable to sovereign bonds in the absence of a choice of law clause, and Chapter 5 addresses the power of the State to unilaterally modify the bonds governed by its own domestic law.

I.22  Chapter 6 addresses the defences in sovereign debt disputes and Chapter 7 examines the challenges to sovereign debt restructurings. Lastly, Chapter 8 set outs the enforcement of sovereign debt and the doctrine of sovereign immunity.

I.23  A particularity of this monograph is that, in stark contrast to many publications on sovereign debt litigation, it examines both the external bonds (p. 8) of a sovereign, namely, the bonds issued in foreign markets, and, to a comparable degree, the domestic bonds, that is, the bonds issued in the territory of the sovereign debtor. As will be seen, domestic debt is increasingly coming to the fore of sovereign debt litigation.

I.24  The adjudication of sovereign debt by international courts and tribunals will be treated only incidentally. Drawing analogies from the public international law of sovereign debt might not be a safe path since public international law may be driven by considerations different from those prevalent under English law.25

I.25  Some may be pessimistic about the very need to examine the topic of sovereign debt litigation. It is frequently doubted that holdout litigation poses serious risks to the successful deployment of sovereign debt restructurings.26 Among other arguments undermining the risks of holdout litigation, scholars sceptically point to the limited incidents of holdout litigations, absence of coordination efforts between holdouts, high costs of minority creditor litigation, necessity of specialised knowledge, and so on. A common claim is that despite the alleged problem of holdout litigation, sovereign debt restructurings have operated smoothly due in part to the extensive sovereign immunity from execution which precludes any chances of judgment recovery27 and the fact that sovereign’s assets are predominantly located within the territory of the sovereign thus excluding the prospects of attachment.

I.26  It is an assumption of this monograph that creditors do have realistic prospects to seize sovereign property—although not without major difficulties—or at least to settle with sovereign debtors. This assumption is supported by three factors. First, the relatively small holdouts to date were often paid in full following the successful completion of a sovereign debt restructuring.28 Second, sovereign creditors have at times been (p. 9) successful in directly attaching sovereign property,29 tracing sovereign debt and obtaining third-party orders,30 or securing explicit and wide-ranging waivers of State immunity from execution.31 The issue is examined in more detail in Chapter 8.

I.27  Third, most scepticism focuses on the litigation of sovereign debt disputes, but it seems to miss the point that litigation may play a subdued role in sovereign debt restructuring when the creditor threatens to hold out and litigate, thus prompting the State to settle.32 The risk of litigation might be a sword of Damocles hanging over the sovereign debtor and might eventually force the debtor to settle on terms favourable to the holdout creditor. Also, it is telling that following the default in 2001, Argentina has not issued any debt in New York as the creditors are likely to attach the proceeds from debt issuance. In the view of the long-lasting threat of attachment and disruptions of normal trade, many sovereigns are willing to pay the holdout creditors either in full or partly (as did Greece with around one-third of all foreign-law governed bonds in 2012).33

I.28  As statistics suggests, sovereign debt litigation is clearly on the rise.34 No doubt, creditors will not always be able to enforce meaningfully their rights in courts. State immunity and practical considerations may prevent an attempt of litigation and judicial recovery of the contractual entitlement under the bonds. That said, the law and contractual covenants are not epiphenomenal in that they are the background against which the sovereign and its creditors negotiate and upon which they act. The law has the potential for steering sovereign debt negotiations, even though at times it might lack in actual enforcement.35

(p. 10) III.  Methodology

I.29  This book mostly employs black-letter law analysis. In addition to the legal analysis, the monograph rests on extensive empirical research. It relies on empirical data collected through questionnaires distributed to debt management agencies. Furthermore, the research is enriched through the examination of a dataset of approximately 1,800 bonds (mostly consulted at Thomson One Banker or confidentially provided by market participants). A further practical dimension derives from approximately fifteen interviews with practitioners working in the field of sovereign debt.


1  Adam Smith, An Enquiry into the Nature and Causes of the Wealth of Nations (2007) 595.

2  McKinsey & Company, ‘McKinsey Global Institute: Debt and (Not Much) Deleveraging’ (2015) 15.

4  Thomas Piketty, Capital in the Twenty-First Century (2014) 542, 544–47.

7  But see UN General Assembly, ‘Towards the Establishment of a Multilateral Legal Framework for Sovereign Debt Restructuring Processes’ (2014) UN Doc A/Res/68/304.

9  See generally Anne Krueger, ‘New Approaches to Sovereign Debt Restructuring: An Update on our Thinking’ (2002) IMF Publication. The UN General Assembly recognised the ‘concerns about vulture fund litigation’ (UN GA Res A/RES/66/189, External Debt Sustainability and Development, 14 February 2012, para 29).

10  Julian Schumacher, Christoph Trebesch, and Henrik Enderlein, ‘What Explains Sovereign Debt Litigation?’ (2015) CESIFO Working Paper No 5319, 1; Jill Fisch and Caroline Gentile, ‘Vultures or Vanguards?: The Role of Litigation in Sovereign Debt Restructuring’ (2004) 53 Emory LJ 1043, 1092.

11  Eric Robert, ‘Rééchelonnement de la dette ou règlement judiciaire?’ in Dominique Carreau and Malcolm Shaw (eds), La Dette éxtérieure: The External Debt (1995) 620; Lee Buchheit and Mitu Gulati, ‘Sovereign Bonds and the Collective Will’ (2002) 51 Emory LJ 1317, 1320.

12  Singh (n 8) 13.

13  Michael Bradley, James Cox, and Mitu Gulati, ‘The Market Reaction to Legal Shocks and their Antidotes’ (2010) 39 J Leg Stud 289, 312–17. On the truthfulness of the claims on pricing see Chapter 1.

14  Andrei Shleifer, ‘Will the Sovereign Debt Market Survive?’ (2003) 93(2) Amer Econ Rev 85.

15  The idea received the imprimatur of the Second Circuit (Elliott Associates v Banco de la Nacion and Republic of Peru, 194 F3d 363, 380 (2d Cir 1999) (stressing ‘the long term effect’ of limiting the rights of creditors). See also John Armour, Antonia Menezes, Mahesh Uttamchandani, and Kristin van Zwieten, ‘How Do Creditor Rights Matter for Debt Finance? A Review of Empirical Evidence’ in Frederique Dahan (ed), Research Handbook on Secured Financing of Commercial Transactions (2015) 13–25 (finding that the reduction of the rights of creditors leads in many cases to more onerous access to credit).

16  Jonathan Goren, ‘State-to-State Debts: Sovereign Immunity and the “Vulture” Hunt’ (2010) 41 Geo Wash Intl L Rev 681, 692–93. The level and significance of this liquidity is unclear—some argue that it is negligible to justify the holdout tactics of hedge funds (Martin Wolf, ‘Holdouts Give Vultures a Bad Name’ (2 September 2014) Financial Times). In support of hedge fund litigation, see Hal Scott, ‘Sovereign Debt Default: Cry for the United States, Not Argentina’ (2006) Washington Legal Foundation Working Paper Series No 140.

17  Natasha Harrison and Fiona Huntriss, ‘Hedge Funds and Litigation: A Brave New World’ (2015) 10(2) CMLJ 135.

18  For an opposite view, see Schumacher et al (n 10) 22 (who do not find that the presence of secondary markets increases the probability of litigation).

19  On other benefits of holdout litigation, see Fisch and Gentile (n 10) 1051, 1102–05.

20  See for an example of the secondary market of mortgages Vicki Waye, Trading in Legal Claims (2008) 215–16.

21  Sönke Haseler, ‘Individual versus Collective Enforcement Rights in Sovereign Bonds’ (2008) German Working Papers in Law and Economics, 9; Lee Buchheit, ‘Supermajority Control Wins Out’ (2007) 26 IFLR 21.

22  See, eg, Jackson v People’s Republic of China, 550 F Supp 869, 873 (ND Ala 1982); Fontana v Republic of Argentina, 415 F.3d 238 (2d Cir 2005) (one of many cases brought by individuals against Argentina). In the context of investment arbitration see Abaclat and others v Argentine Republic, ICSID Case No ARB/07/5, Decision on Jurisdiction and Admissibility, 4 August 2011.

23  See, eg, Chapter 1 (contrasting the sanctity of contract with distributive fairness in the context of sovereign debt litigation).

24  Michael Bradley and Mitu Gulati, ‘Collective Action Clauses for the Eurozone’ (2014) 18(6) Rev Fin 2045, 2055–56; Das et al (n 6) 41–43 (showing slightly smaller numbers).

25  Loan Agreement between Italy v Costa Rica, 27 June 1998, XXV Reports of International Arbitral Awards 21, 72–74 (distinguishing technical, contractual adjudication in national courts as against public international law adjudication which is more flexible).

27  Netanella Zahavi, Sovereign Default: Analyses and Remedies (JSD thesis, Yale Law School, 2005) 157–90; Jeremy Bullow and Kenneth Rogoff, ‘A Constant Recontracting Model of Sovereign Debt’ (1989) 97(1) J Polit Econ 155, 157 (occasional attachments of sovereign property are far from fully repaying the debt).

28  Federico Sturzenegger and Jeromin Zettelmeyer, Debt Defaults and Lessons from a Decade of Crises (2007) 256–61.

29  See, eg, NML Capital Ltd v Republic of Argentina, 680 F.3d 254 (2d Cir 2012); EM Ltd v Republic of Argentina, 389 F Appx 38 (2d Cir 2010); Singh (n 8) 9–10, 22–24.

30  NML Capital Ltd v Republic of Argentina, 699 F3d 246 (2d Cir 2012); National Union Fire Insurance Co v Congo, 1991 US Dist LEXIS 21581 (ND Ill 1991) (the claimant sought an order directed at a third party which led to a settlement between the parties). See also Patrick Wautelet, ‘Les Fonds Vautours—Vulture funds, Creditors and Sovereign Debtors: How to Find a Balance?’ in Mathias Audit (ed), Insolvabilité des États et dettes souveraines (2011) 112–14.

31  See, eg, Republic of Estonia, Offering Circular for 5% Notes due 2007 (cited in Mark Weidemaier, ‘Disputing Boilerplate’ (2009–10) 82 Temp LR 1, 36).

32  See, eg, IMF, ‘A Survey of Experiences with Emerging Market Sovereign Debt Restructurings’ (2012) 15 (a survey of recent restructurings shows that the overwhelming majority of disputes ended up in settlements).

33  Jeromin Zettelmeyer, Christoph Trebesch, and Mitu Gulati, ‘The Greek Debt Exchange: An Autopsy’ (2013) 28 Econ Pol 513, 527 (out of twenty-four foreign-law bonds, only 71% agreed to the restructuring, and the remaining 29% were paid in full).

34  Schumacher et al (n 10) 4, 34.

35  For a similar argument in public international law, see Surabhi Ranganathan, Strategically Created Treaty Conflicts and the Politics of International Law (2014) 38–41, 94.