5.01  The unilateral modification of sovereign bonds has recently loomed large following the Greek sovereign debt restructuring of 2012. In the wake of a severe financial crisis, Greece sought to restructure its Greek law governed bonds, only to face the requirement of unanimous consent for the amendment of the terms of bonds and the lack of majority action clauses in the sovereign bond documentation. To ensure higher participation of bondholders in the restructuring, the Greek parliament passed the Greek Bondholders Act on 23 February 2012, which retroactively incorporated majority action clauses into the Greek law governed bonds. Under the majority action clause, two-thirds of the bondholders were given the power to amend the entire mass of Greek law governed bonds, provided there was a quorum of 50% of the face value of all the bonds.¹ The specificity of this majority action clause was that it applied across the entire mass of Greek sovereign bonds, and not bond by bond—a proviso which precluded individual bondholders from tactically blocking the restructuring in a single bond issue.²

5.02  This manoeuvre was achievable because the absolute majority of Greek bonds (more than 85%) were governed by Greek law, and hence were within the reach of the Greek parliament. Although the retrospective inclusion of collective action clauses (CACs) caused considerable consternation in financial markets,³ the restructuring was successfully completed. Old Greek law bonds were exchanged for new bonds which this time contained a choice of English law. As a matter of English law, the (p. 142) inclusion of an English choice of law clause would in future insulate the bonds from unilateral changes of law by the Greek parliament.⁴ Thus, in National Bank of Greece and Athens v Metliss, the House of Lords was adamant that a Greek moratorium act should not affect contractual relations governed by English law.⁵ Conversely, in cases where the loans were subject to a foreign law, the English courts took the view that the rights and obligations under a loan agreement were the province of its governing law and would give effect to, among other things, foreign moratorium acts and foreign exchange regulations.⁶

5.03  The lesson to be learned from the Greek debt restructuring of 2012 is that in cases when the law of the borrowing State governs sovereign bonds, the State may seek to amend its law in a unilateral and retrospective fashion.⁷ And the State may seek to do so even when the bonds contain a majority action clause which contemplates the very modification sought by the State (eg, the State seeks to redenominate its bonds but there is a majority action clause which vests in the majority the power to redenominate the bonds).⁸

5.04  However, controversy surrounds the exercise of such power. The general assumption was and still is that the State has the power to amend the terms of the bonds governed by its local law as it sees it fit and these changes need to be accepted as part and parcel of the applicable law.⁹ The proponents of this view argue that the investors consciously accept the (p. 143) risk of unilateral legislative changes¹⁰ à la Greece by subscribing to the bonds governed by the local law of the sovereign debtor. Therefore, they ought to assume that the law might change over time.¹¹

5.05  The competing line of thought suggests that it would be inconsistent with the principle of pacta sunt servanda and legitimate expectations of creditors to recognise the changes to local law adopted by the sovereign who is simultaneously a party to the contract it seeks to amend unilaterally.¹² How can a party to a contract, whatever its status, change the terms of the contract in a unilateral fashion and eviscerate any vested rights that a party contracting with the sovereign debtor by mutual agreement enjoys?¹³ A State should not be its own judge.¹⁴ If it were possible to change the legislation unilaterally of the State’s own volition, this school of thought contends that the scope for abusive legislating and debt repudiation would be far-reaching. Such action is also macro-economically suboptimal as it is liable to lead to a political risk premium for the bonds issued by sovereigns under their local law.¹⁵

5.06  An intermediate position is advocated by Mann who sets forth a distinction between legislative amendments of general reach—adopted within the ambit of the State’s power to regulate—and those directly aimed at (p. 144) contracts to which the State is a party.¹⁶ Under this approach, a private creditor may not complain of unilateral changes to the legislation governing the contract which are not directly addressed to the contractual relations which the State has undertaken. Another intermediate position is to draw a distinction between the abrogation of fundamental terms of the bonds and the abrogation of ancillary clauses/obligations.¹⁷

5.07  And lastly, Buchheit and Gulati, supporting the retrospective introduction of majority action clauses into Greek bonds, drew on the argument, among others, that majority action clauses are a technique in spirit of the established practice of sovereign debt restructurings.¹⁸ This begs the obvious question of what the established practice is and why it should matter.¹⁹

5.08  The legality of unilateral amendments to sovereign domestic bonds has not yet been tested in any judicial or arbitral proceedings²⁰ and the speculations have mainly been limited to analyses concerning the human right to property²¹ and the international law of expropriation.²² The lingering (p. 145) uncertainty over the issue requires revisiting the issue from the viewpoint of English conflict of laws.

5.09  Before doing so, a preliminary question arises. It has been suggested that a distinction has to be drawn between unilateral modifications of the local law by the sovereign and defaults under sovereign bonds. In the first case, it is argued, the sovereign debtor does not breach any express contractual provisions and therefore no cause of action should arise against the sovereign.²³ The falsity of the logic is exposed the moment one remembers that the State is bound by the original, intact version of the contract and the introduction of new contractual provisions inconsistent with the original contract amounts to a breach of contract.²⁴ Sovereign bondholders consent to release the necessary funds under the original, unamended sovereign bond documentation. In their eyes, the unilateral modification is as much a breach of contract as a non-payment under bonds.

5.10  The initial step for an English court may be to review the foreign statute that purports to modify the bonds in a unilateral manner as to its constitutionality. It is arguable that the courts of the forum (in this case, England) have the power to review the constitutionality of the statutes of a foreign State (the sovereign debtor).²⁵

5.11  Assuming that the courts of the forum do indeed enjoy such powers, the limitations on the constitutional review of foreign statutes are several. (p. 146) English judges could not examine the constitutionality of the foreign statute should the local courts of the sovereign themselves not have the power to do so or if the exclusive power of constitutional review were concentrated in the hands of a local specialised court, by necessity excluding the power of foreign courts.²⁶ Kahn-Freund suggested that a court is empowered to review whether the foreign law had been properly enacted, however, it could not review the conflict of the foreign statute with the substantial provisions of the constitution.²⁷

5.12  Should such power be accepted in principle, and following the reasoning to its logical conclusion, one might argue that it would not be legitimate for the English courts to rule on the legality of a domestic debt restructuring, unless the claimant bondholder has brought a constitutional action in the courts of the sovereign debtor.²⁸ Nevertheless, forcing such a ‘local remedy’ may seem unwise if the remedy is ineffective,²⁹ which might often be the case in times of economic and social turmoil. Equally, it does not seem that if the local courts of the sovereign debtor come to the conclusion that the statute modifying sovereign bonds is constitutional, that would necessarily prevent the English courts from holding that the same statute offends English public policy.

5.13  If an English judge were to assess the unilateral modification of domestic bonds through the prism of English conflict of laws, the orthodox position is clear. The well-established position is that the governing law is not frozen at the time of entering into a contract and courts will apply the law as it exists from time to time.³⁰ The transitory rules of the foreign applicable law will, as a result, be given full effect.³¹

(p. 147) 5.14  That said, the readiness of courts to apply the transitory laws of the sovereign is, as is always the case in the conflict of laws, constrained by the public policy exception.³² This chapter will argue that a claimant in proceedings before English courts may advance the argument that the unilateral modification of bonds is inconsistent with English public policy.

5.15  The first issue that needs to be addressed is the threshold of public policy in the context of a unilateral modification of sovereign bonds. Under Art 21 of the Rome I Regulation, to eschew the application of the otherwise applicable foreign law, that law has to be ‘manifestly incompatible’ with the public policy of the forum. The Court of Justice established that a court might resort to the defence of public policy where the enforcement of a foreign judgment (and mutatis mutandis the application of foreign law) ‘would be at variance to an unacceptable degree with the legal order of the State in which enforcement is sought’ (and application of the foreign law is sought).³³ Allied to this is the requirement to demonstrate that the unilateral modification is inconsistent not merely with domestic public policy but with international public policy in England, that is to say the core principles that cannot be derogated from even in situations presenting cross-border elements.³⁴ The Court of Justice determined that public policy cannot solely be invoked on the ground of a mere discrepancy between the law of the forum and the foreign court.³⁵ Public policy seeks to ‘protect legal interests which are expressed through a rule of law, and not purely economic interests’.³⁶ This is thus a demanding standard but the pertinent question is, however, how demanding it is in the face of a unilateral and retrospective modification of the rights of creditors.

5.16  English courts have at times applied a lower threshold of public policy to unilateral and retrospective legislation. In Lynch v Provisional Government of Paraguay,³⁷ a Paraguayan decree retroactively invalidated the will of the ex-dictator of the country, with the intended effect in England and elsewhere. The English court seised of the dispute refused to give effect to the retroactive changes adopted in the legislation as that would be ‘both inconvenient and unjust’ (the old nomenclature for public policy exception). Some of the glosses on the holding in Lynch is that the law governing the succession to moveables is the law of the domicile at the time of (p. 148) the death,³⁸ or the law retroactively invalidating the will of the ex-dictator of the country was a penal law that would not lend itself to enforcement in English courts.³⁹ An equally valid interpretation is that the retroactive application of the will of an ex-dictator was shocking to the conscience of the judge and triggered the application of the public policy exception.⁴⁰

5.17  Adams v National Bank of Greece concerned mortgage bonds that were issued by a Greek bank in the United Kingdom.⁴¹ The bonds were guaranteed by another Greek bank, which was later amalgamated with a third Greek bank. Initially, a Greek parliament statute declared the third bank to be the universal successor of the obligations previously held by the two amalgamated banks, including the obligations of guarantee under the mortgage bonds. Although, as it was decided in the lower court, the proper law of the bonds was English law,⁴² Greek law was the law applicable to the issues of status, including the succession as between two entities through amalgamation.

5.18  Four days after the bondholder obtained a favourable decision from an English court, the Greek parliament passed a law which excluded from the succession of the third bank the obligations arising out of foreign currency bonds and de facto absolved the third bank of any liability under the English law governed bonds. In a new action brought against it in the English courts, the new Greek bank argued that this statute should be accorded full recognition in England because the succession was a question of status properly falling within the reach of Greek law. Rebuffing the argument, three Law Lords held that it would be neither just nor convenient to recognise the effects of retrospective alterations that in effect sought to alter or discharge the obligations accrued pursuant to English law governed obligations.⁴³ While Greek banks had personality separate from the Greek State, the latter had globally profited or intended to profit from the legislation.⁴⁴ The Greek parliament’s evasive approach to obligations undertaken by the Greek banks clearly influenced the decision that the House of Lords reached.⁴⁵

(p. 149) 5.19  Lord Denning took a more nuanced approach which echoes the intermediary position taken by Buchheit and Gulati enunciated above. He first qualified the Greek parliament’s legislation as pertaining to the status of companies and hence governed by the Greek law. This qualification notwithstanding, he held that the exclusion of liability of the third, amalgamated company ‘is such an unusual provision in an amalgamation, and is so inconsistent with the essence of the transaction, that there is no comity of nations which requires the English courts to recognise it’.⁴⁶ An open question is whether Lord Denning’s analysis in terms of usualness and comity is more compliant with the review of the legislative acts of a foreign State, evidencing a heightened level of deference to a foreign legislator.⁴⁷

5.20  These cases denote a lower threshold of public policy in respect of foreign retroactive legislation. This can tentatively be explained by the idea—affirmed by Phillips v Eyre⁴⁸—that the retroactive application of law is a deviation from the common practice of the nations of mankind⁴⁹ and may be inconsistent with public policy.⁵⁰ Thus, the retrospective and unilateral character of these modifications may trigger the defence of public policy.

5.21  Kahler⁵¹ and Zhivnstenska⁵² are the cases commonly cited for the proposition that to refuse their application the foreign retrospective laws have to be ‘penal or confiscatory’. However, upon closer examination, it transpires that these two cases did not concern the retroactive application of foreign law. At all material times in those cases, including the date of entering into contract, foreign currency regulations were in force in the territory of the foreign State.⁵³

5.22  While defining the correct threshold of public policy is undoubtedly helpful, one is still left with the task of identifying the precise contents of English public policy in relation to the unilateral modification of a sovereign’s domestic-law bonds. To elucidate the contents of English public policy, English courts typically refer to the comparable English domestic (p. 150) practice on the subject.⁵⁴ Equally useful is the practice of foreign States in defining the extent of the public policy exception.⁵⁵ Given the paucity of authorities on the matter, this chapter undertakes a similar enquiry: if retrospective legislation of a certain sort is unobjectionably accepted in the domestic practice in England and foreign States, the public policy exception would not inhibit the recognition of comparable foreign legislation. If, by contrast, unilateral modifications of sovereign bonds are generally condemned in international practice, this can (and perhaps should) inform the approach of English courts. With this in mind, the following analysis addresses English and foreign judicial practice, although few and far between, on the unilateral modification of State contracts, in particular, sovereign bonds.

5.23  Drawing on the analysis of judicial practice, the section argues against the fully fledged right to modify unilaterally domestic-law bonds in sovereign debt restructurings. Such comparative research suggests that the State in issuing debt and later embarking on its restructuring is acting in a private capacity and should not be allowed to modify its debt in a unilateral fashion.

5.24  The orthodox view in English domestic law is that the UK Parliament has absolute supremacy and any legitimate expectations can be overcome by a properly worded statute.⁵⁶ The conventional doctrine was expressed by Bowett as follows:

Indeed, in English law not only is ‘stabilization’ impossible against future legislation but, because of the doctrine of Parliamentary supremacy, no English court could challenge the assertion that Parliament was acting in the public good.⁵⁷

5.25  A line of English cases upholds the view that the sovereign, when entering into contracts, is certainly not enjoined from using its sovereign (p. 151) prerogatives so as to amend the scope of its contractual obligations.⁵⁸ Thus, the Court of Appeal in William Cory and Son Ltd v City of London held that the City of London, as the port health authority, could not be held liable for passing by-laws which imposed further conditions on the private contracting party, even though the by-laws made the contract commercially impossible to perform. An administrative body charged with statutory powers for public purposes is incapable of divesting itself of such powers or fettering itself in the use of such powers. Thus, any clauses purporting to do so will be held invalid.⁵⁹ Yet, there is a caveat: all this is true, unless the public company is entering into ‘trading contracts’.⁶⁰

5.26  On the other hand, opinions are uttered with increasing frequency that the supremacy of Parliament is no longer as absolute as it was historically.⁶¹ Judge Higgins expressed her voice in favour of that development as early as 1977:

[I]t is widely accepted that no compensation is due for government legislation which adversely affects individual contracts. The answer to this must surely be that there is no reason why that principle should apply to contracts to which the government itself is party.⁶²

5.27  To date, the courts have never ruled on the question of whether the UK Parliament can retrospectively and unilaterally abrogate mercantile or financial obligations that the government has undertaken to abide by.⁶³ Irrespective of its status in modern English law,⁶⁴ the doctrine of executive necessity, according to which the Crown can renege on its assurances ‘as to what its executive action would be in the future’, does not extend to commercial contracts which the government should perform ‘like anybody else’.⁶⁵

(p. 152) 5.28  The Court of Appeal in Page v Commissioners of Crown Lands affirmed that the contracts entered into by the Crown contain an implied term to the effect that the Crown is not precluded from taking measures for the public good.⁶⁶ However, recognising that a court may enquire into the importance of the public interest invoked by the governmental agency,⁶⁷ Devlin LJ stressed that:

5.29  The Court of Appeal then drew a crucial distinction between acts of the Crown entered into for the purposes of public good and those taken ‘for the purpose of achieving a particular result under the contract in question’—a distinction which resonates with the one proposed by Mann above. As explained by Lord Denning in Czarnikow v Rolimpex,⁶⁸ the State would seek to achieve a particular result under a contract when it intends ‘to avoid its own liabilities under a particular contract or contracts’. It follows from this that if a particular course of action is taken by the State for the public good, such as health, public morals, or safety, then the action may well be defendable. Note that the actions taken in Page were adopted under wartime powers. However, actions taken so as to put into effect a discharge of onerous obligations cross the line.⁶⁹ Mayer, intuitively following this stance, cites a compelling example based on the abrogation of gold clauses: the abrogation of gold clauses will generally seek to reduce inflation, however, when applied to State contracts, it will retain another function, ie, reducing the debt of the State.⁷⁰ That said, quite how extensive such a review would be, and quite where the line between the two types of measures would lie, is unclear.⁷¹

5.30  In principle accepting this distinction for domestic purposes, Lord Wilberforce in Czarnikow v Rolimpex (with whom Lords Fraser and Keith (p. 153) agreed) was reluctant to apply said distinction to the arguably distinct context of dealings with foreign sovereigns,⁷² whereas Lord Salmon felt no hesitation in doing so.⁷³ Reason suggests siding with Lord Salmon. If domestic analogies (combined, perhaps, with a comparative analysis) were not well suited to the scrutiny of foreign retroactive legislation, one would be left with applying only the foreign constitutional law, the inherent limitations of which have been exposed above. The alternative would be to have no standard against which one could ever review the attempts of a foreign sovereign to frustrate its own contracts.

5.31  There is some authority for the proposition that the retrospective abrogation of gold clauses may infringe English public policy. In New Brunswick Ry v British and French Trust Corporation Ltd,⁷⁴ Lord Maugham LC suggested that an abrogation of a gold clause by a statute ‘cannot be held to diminish or destroy the rights of an English creditor, and it may be added without compensation, after he has commenced an action in this country. A fortiori is such a statute incompetent to affect the course of justice here after trial and judgment.’ The editors of Dicey, Morris & Collins treat this as an ‘isolated dictum’.⁷⁵

5.32  In light of this discussion, the solution under English law is at best unsettled, necessitating an analysis of the practice of foreign States on this subject.⁷⁶ This is all the more necessary given the lack of a specific precedent under English law on the modification of financial obligations of the State, which, as the discussion of the US law will evidence, present a peculiarity which calls for the application of special rules.

5.33  The position in US law is less murky. In a landmark judgment Perry v United States, the US Supreme Court emphatically confirmed the view that the US government cannot unilaterally renege through legislative amendments on its contractual obligations embedded in governmental bonds.⁷⁷(p. 154) The case arose in the context of the Great Depression of 1929. To deleverage the public and private debt alike, the US Congress passed the Joint Resolution of 1933, which abrogated all gold clauses contained in loan agreements, including those issued by the US government.

5.34  When a disgruntled bondholder challenged the abrogation of the bonds it held, the Supreme Court first distinguished between, on one hand, the powers of Congress to control or interdict the contracts between private parties, and on the other hand, to alter or abrogate the substance of its own engagements under which it borrowed money. For the latter cases, the Supreme Court established the ‘fundamental principle’ that the validity and integrity of public debt should not be questioned and the abrogation of gold clauses in sovereign bonds was to be without effect. This followed from the confirmation that when Congress enters into binding legal obligations, they are in essence similar to the obligations incurred by private parties and hence Congress does not enjoy police powers (power to regulate) to abrogate its own engagements.

5.35  In a similar vein, the US Supreme Court in Murray v City of Charleston stated that:

5.36  It is worth contrasting the ruling in Perry with the decision of the House of Lords in Rex v International Trustee, where the same US legislative act, the Joint Resolution of 1933, was recognised as abrogating the gold clauses in the bonds issued by the UK government. The difference is that in Perry, the debtor (the US Congress) sought to reduce its own obligations through domestic legislation, whereas in Rex v International Trustee, the UK government merely relied on a foreign statute (which benefited the UK government immensely).

5.37  Mann, referring to Perry v United States, suggested that ‘[t]here would seem to be no justification for founding upon this exception [Perry v United States] a general principle of law applicable to state loans’, given that the decision in Perry was expressly based on the provisions of the US Constitution.⁷⁹ One has to disagree with the learned author’s reading of Perry. It is true that the Supreme Court relied on various provisions of the (p. 155) US Constitution in its analysis of the constitutionality of the Joint Resolution of 1933, in particular the 14th Amendment of the US Constitution which provides that ‘[t]he validity of the public debt of the United States, authorized by law … shall not be questioned’.⁸⁰ However, this provision, as the US Supreme Court expressly stated, merely confirms a fundamental principle applicable both to the bonds issued after and those issued before the adoption of the Amendment. The unacceptability of unilateral changes to government bonds was not a mere peculiarity or idiosyncrasy of the US constitutional regime. The principle was indeed fundamental, for it derived its force from the general framework of contract law which governed contractual undertakings of the US government, as well as from the implied ability of the sovereign to bind itself contractually as a manifestation of its sovereignty.

5.38  As a general proposition of US constitutional law, the power of Congress to unilaterally modify contracts strictly correlates with the level of police powers inherent in the contract that is sought to be modified.⁸¹ The crux of the problem would generally lie in distinguishing between (i) purely financial obligations, such as the bonds in Perry v United States, where no or little police power is engaged. The Supreme Court has confirmed that ‘financial obligation … may not be said automatically to fall within the reserved powers that cannot be contracted away’,⁸² and (ii) a modification of sovereign bonds conducted in the context of the exercise of a police power.⁸³ Although the precise scope of police powers is hard to ascertain,⁸⁴ purely financial obligations do not seem to involve police powers strong enough to vest the Congress with the power of unilateral modification or repudiation.⁸⁵

5.39  Quite surprisingly, the Supreme Court eventually determined that the revocation of the gold clause did not result in any actual damages.⁸⁶ It may well be the case that there was no majority in the Court for a finding that the US government could not abrogate gold clause and be required to pay (p. 156) damages. But the reasoning behind what seems to be a U-turn from the preceding reasoning of the Supreme Court may be more complex. Gold coins had already been withdrawn from circulation—an action that the Supreme Court did not judge to be arbitrary or capricious—which barred the repayment of the debt in gold. Neither was the claimant able to establish the amount of currency equivalent to the promised gold coin for the simple reason that the market of gold was at the time subject to strict regulations. The claimant’s action would therefore result in damages exceeding the nominal value of the bonds, which the Supreme Court was leery to award. Nor did the claimant establish any loss in respect of buying power as a result of the abrogation of the gold clause, for the value of bonds had soared due to the falling price level and thereby the claimant would have been unjustly enriched upon the payment of damages.⁸⁷ Four justices strongly dissented from the holding that no damages were available to the bondholder.

5.40  In so deciding, this part of the judgment effectively defeats the finding of unconstitutionality of the Joint Resolution of 1933 and in fact bolsters Congress in its economic reforms by denying effective relief to the bondholder.⁸⁸ Relying upon, what seems to be, the pyrrhic character of this victory, it has been suggested that no damages should arise out of the unilateral modification of the bonds by the Greek parliament in the course of the 2012 bond restructuring since the bonds were already rated as ‘junk’ bonds.⁸⁹ The argument is based on flawed understanding. The situation in Perry v United States was not ordinary since the gold clauses, although protected by the fundamental prohibition on modifying unilaterally sovereign bonds, impeached the power of the US Congress to exercise monetary regulation by withdrawing gold from the national economy.⁹⁰ In contradistinction, in the Greek debt restructuring episode of 2012, the insertion of CACs into Greek law bonds resulted from no apparent police powers of the Hellenic Republic. Furthermore, influential authorities contend that Perry v United States was ostensibly limited to the actions brought exclusively by local bondholders, who and only who were subject to the compulsive gold regulation within US territory, whereas foreign bondholders (p. 157) should see no obstacle to availing themselves of the action in damages against the government.⁹¹

5.41  In light of the Supreme Court’s decision not to award damages, one might think that the prohibition on unilateral changes is a rule with no teeth. But there is a cluster of cases which actually prohibited unilateral modification of sovereign bonds and restored the bondholder to its original position: Lynch v US⁹² at the federal level, and at the municipal level—Murray v City of Charleston,⁹³US Trust Co v New Jersey,⁹⁴ and Flushing Natl Bank v Municipal Assistance Corp for City of N.Y.⁹⁵ These cases show that the holding in Perry was not a simple rhetorical attempt at obtaining a majority in a divided court but was a case where the existence of the police power to regulate gold affected the outcome of the case.

5.42  So far as individual US States are concerned, the Contract Clause of the US Constitution directly prohibits US States from passing laws that retroactively affect contractual obligations, including the obligations under bonds, unless the impairment of contractual rights is both reasonable and necessary to serve an important public purpose.⁹⁶ In assessing the later requirement, the court should enquire whether the public purpose pursued could have been attained by less drastic measures, and if the public purpose should have been foreseeable at the time of signature of the contract.⁹⁷ The US courts have gone to considerable length to stress that the desire to reduce the level of government expenditure is not in itself sufficient to justify abrogation of financial contracts. The State cannot ground its refusal to meet its legitimate financial obligations in the desire to divert the funds intended for the repayment of creditors to the promotion of the public good.⁹⁸

(p. 158) 5.43  Quite when an act of legislation taken in times of financial dire straits will be in breach of the Contract Clause is somewhat uncertain. In Faitoute Iron & Steel Co v City of Asbury Park, a case decided prior to the enactment of the favourable regime of Chapter 9 of the US Bankruptcy Code on the bankruptcy of municipalities, the US Supreme Court had to rule on the validity of a New Jersey statute that established a regime for restructuring the debt of a highly indebted municipality. The restructuring regime shared similar traits to a majority action clause—the restructuring plan was contingent upon receiving the consent of the supermajority of bondholders which would thereby bind the minority (but only upon obtaining the ex ante judicial approval). In a challenge to this regime based on the Contract Clause, the Supreme Court held that the introduction of this restructuring regime did not impair the Contract Clause in light of the fact that the raising of taxes would not have brought the municipality back to solvency.⁹⁹

5.44  Nevertheless, the precedential value of Faitoute, ostensibly overturned by Congress,¹⁰⁰ may hardly be extended to other instances of unilateral modifications of municipal (sovereign) bonds. A later decision, US Trust, distinguished Faitoute on the grounds that the debt restructuring in Faitoute was exceptional since it was performed for the benefit of creditors as evidenced by the consent of the supermajority of bondholders, and the fact that the price of bonds soared after the debt restructuring.¹⁰¹ Two lower US court decisions have equally questioned the holding in Faitoute.¹⁰² Thus, the court in George Hardin v The Village of Mount Prospect noted the atypical character of the facts in Faitoute, where the creditors enjoyed extended protection, ie, the bankruptcy repayment plan required approval of 85% of all creditors, and non-consenting creditors were to be bound by the plan only after a State court determined that the municipality could not otherwise pay its creditors and that the repayment plan was in the best interest of all creditors.¹⁰³ In the recent litigation over the insolvency of Puerto Rico, the US District Court for the District of Puerto Rico examined the legality of Puerto Rican restructuring procedures that would have allowed the (p. 159) public corporations to restructure their debt with the authorisation of the Government Development Bank, majority of creditors and a special court. The Court distinguished the authority in Faitoute on the ground that the valid restructuring in Faitoute merely extended maturities and reduced interest rates, but did not go so far as to allow a haircut to the principal.¹⁰⁴

5.45  In another case reinforcing the doubts over the wide precedential value of Faitoute, Flushing Natl Bank v Municipal Assistance Corp for City of N.Y., the New York Court of Appeal decided that a moratorium on the short-term obligations of New York City was illegal.¹⁰⁵ It is striking that so innocuous a tool as the debt moratorium was judged unacceptable in Flushing Natl Bank, whereas a full-scale debt restructuring involving interest rate reduction and extension of maturities in Faitoute was squarely upheld.¹⁰⁶ The following reasons, not only of degree but of kind, are put forward to explain the difference in treatment:

1. (1)  In Faitoute, the State did not unilaterally impose the restructuring on the creditors, but introduced a regime whereby 85% of the creditors could consent to the terms of the restructuring (we will return to this point later).

2. (2)  In Faitoute, the debt restructuring was ex ante reviewed and approved by a court.¹⁰⁷

5.46  Upon a closer look, secondary differences between Faitoute and Flushing Natl Bank appear:

1. (1)  Conditions relating to the financial capacity of the debtor. In Faitoute, the financial crisis was judged to be unforeseen, whereas in Flushing Natl Bank it was deemed to be foreseeable;¹⁰⁸ in Flushing Natl Bank, the city of New York had the capacity to increase its taxes to pay the debt, whereas in Faitoute the court was persuaded that the further levying of taxes would not rescue the municipality.

2. (p. 160) (2)  Conditions relating to the conduct of the sovereign debt restructuring. In Flushing Natl Bank, the legislature was selective as to the creditors to bear the burden of the moratorium and the creditors affected were denied court access.

5.47  The application of the two main benchmarks of Faitoute—the consent of creditors and judicial review—may be rather misguiding if extrapolated to sovereign debt restructurings. First, creditors are often cajoled into giving consent. The States often obtain the consent of creditors through varying degrees of economic coercion and duress. The borderline between cases of voluntary consent or coercion of bondholders is often thin.¹⁰⁹

5.48  Second, it has strongly been argued that the favourable reasoning of Faitoute should not apply to sovereign debt restructurings because the current regime of sovereign debt restructurings lacks an impartial third party capable of reviewing the restructuring of the sovereign debt.¹¹⁰ There are two potential existing candidates for such a role—local courts of the sovereign and external courts. Local courts of the State in default often lack the impartiality required. In Faitoute, the supreme court of the State was the competent jurisdiction to sanction the restructuring programme of a municipality which is likely to indicate sufficient distancing between the impartial third party—the court of a State—and the debtor in distress, namely, a municipality, the political subdivision of the State. By contrast, in sovereign debt restructurings the foreign residence of bondholders justifies the need for an international tribunal which could review and approve the terms of the debt restructuring programme ex ante. As for the control by external courts (mostly New York and English courts), the extent of their ex post review of the debt restructuring programmes is very lightweight, as seen in Chapter 7.

5.49  Coherent with the authority in Perry v United States, the Russian courts have come down in favour of the proposition that the State does not enjoy the power to modify its bonds in a unilateral fashion. In the aftermath of the Russian sovereign debt crisis of 1998, the government of the Russian Federation issued a decree which sought to restructure its domestic bonds in a unilateral manner. A local holder of Russian foreign-currency (p. 161) domestic bonds, OOO Rusatommet, sued the Ministry of Finance and the government of the Russian Federation requesting payment under the original terms of the Russian bonds and challenging the unilateral restructuring. The Federal Moscow District Arbitraj (Commercial) Court of the Russian Federation held that the restructuring decree was issued within the constitutional competence of the government to regulate the market of securities and the internal and external debt of the Russian Federation, and consequently, should prevail over the contractual obligations of the State.¹¹¹

5.50  The Presidium of the Supreme Arbitraj (Commercial) Court of the Russian Federation chastised the District Arbitraj court for the misplaced reliance on the governmental decree. It held that the government loan was subject to the contractual regime prescribed by Art 817 of the Civil Code of the Russian Federation which expressly provided that State loans could only be modified by the mutual consent of contracting parties.¹¹² Furthermore, the court held that the application of the governmental decree with the effect of unilaterally modifying the State loans would violate the right to property, enshrined in the Russian Constitution.

5.51  However, the court added a proviso that the lower courts should enquire into the existence of a State-imposed moratorium, subject to an extensive judicial review, and referred the case to the lower courts (no moratorium was found in the event).¹¹³ It is perplexing why the court was ready to grant legal effect, albeit subject to a judicial review, to the moratorium, while denying effect to a governmental decree purporting to restructure the sovereign debt. Arguably, the moratorium acts only as a temporary stay on legal claims, whereas the decree had irreversible consequences on the rights of bondholders. The deferral of payment maturities (although within the confines of reasonableness) was also supported by the decision of the Russian Constitutional Court, which received the imprimatur of the European Court on Human Rights.¹¹⁴

5.52  In a 1962 judgment, the German Federal Constitutional Court recognised the legislative cancellation, without any compensation, of the Third Reich’s government debt.¹¹⁵ It held inter alia that the legislative cancellation of the debt did not fly in the face of the right to property embedded in the German Basic Law (the German Constitution). One is struck by the inconsistency of this judicial pronouncement with a much later pronouncement of the same judicial instance on the Argentine debt restructuring of 2001, where the court found that Argentina could not avail itself of the exception of the state of necessity in restructuring its debt in the time of a severe crisis.¹¹⁶

5.53  The rather peculiar facts of the case explain the 1962 judgment by which the Federal Constitutional Court embraced so draconian a measure. The legislative cancellation in question was based on the express provisions of the German Basic Law. Art 134(4) delegated the legislator with the task of regulating the debt of the Third Reich, while Art 135(a) (‘Old obligations’) stipulated that federal legislation might exempt the German State from complying with the obligations accrued by the Third Reich. In applying these constitutional provisions, the German parliament passed in 1957 the Act on War Reparations that declared the debt owed by the Third Reich cancelled.

5.54  It transpires from this overview that the legislative annulment of the debt, endorsed by the Federal Constitutional Court, did not relate to the debt of the Federal Republic of Germany contracted in the ordinary course of its existence but rather incurred by its predecessor, the Third Reich. The peculiarity of the Third Reich’s debt justified its express regulation in the German Basic Law.

5.55  In 1998–2002, Argentina was struck by a severe economic crisis which led the State, among other things, to a forceful debt restructuring and alleged repudiation of its debt. The crisis has sparked a welter of cases before ICSID tribunals and foreign courts. Interestingly, local Argentine courts also were seised of the actions of dissatisfied bondholders, who argued (p. 163) that the pesification of sovereign bonds expressed in foreign currency and the statutory prohibition on reaching any kind of agreement with holdout bondholders flew in the face of the rights embedded in the Argentine Constitution.

5.56  Underlying the judicial enquiry of the Supreme Court, and of other judicial instances seised of similar requests, was the standard of reasonableness of the measures adopted. In Brunicardi, Adriano c/ Banco Central, the Supreme Court held that a mere deferral of the payment did not amount to a substantial degradation or concealed confiscation of the property, and was reasonable considering the financial situation present at the time of its adoption. In Civit Félix Guillermo v Poder Ejecutivo Nacional, the Court of Appeal decided that the pesification of the bonds together with the diminution of the guarantee provided to the bondholder crossed the line. It declared the decrees effecting such amendments unconstitutional albeit holding the bondholder to the reduction of interest rate.¹¹⁷

5.57  In respect of the constitutionality of compulsory pesification, the Supreme Court in Galli¹¹⁸ upheld the decision of the Argentine government to pesify bonds, considering that the financial situation in the country was such as to justify such a course of conduct. In deciding that the pesification legislation did not confiscate sovereign bonds, the Supreme Court was clearly guided by certain statutory mechanisms that the Argentine government introduced to minimise the loss suffered by the bondholders from the forcible conversion of currency. Such mechanisms were the inclusion of a consumer-based inflation index so as to profit from the economic growth when the crisis abates, and the option to partake in future public debt exchanges in foreign currency.

5.58  Another measure that Argentina resorted to over the course of the restructuring and that proved rather controversial was the Law No 20,617 which prohibited negotiating or reaching any type of agreement with the creditors who held out from the initial debt restructuring. The Supreme Court judges in Galli were divided in their obiter statements as to the constitutionality of such statute. Lower courts did not speak with a single voice—some of the courts decided that the rights of bondholders were left untouched by the Law No 20,617,¹¹⁹ whereas others applied the law on its face.¹²⁰

(p. 164) 5.59  At a different level, Argentine courts have confirmed something that was implicit, namely that recognising a foreign judgment against Argentina resulting from the sovereign debt restructuring which seeks to circumvent the debt restructuring process would contravene Argentine public policy and therefore could not be afforded recognition.¹²¹

5.60  Following the 2012 sovereign debt restructuring, multiple holders of Greek bonds brought legal actions in local Greek courts challenging the constitutionality of the unilateral and retroactive introduction of majority action clauses into Greek law governed bonds. The Greek Council of State dismissed the action by holding that the introduction of majority action clauses did not violate the Greek Constitution and the European Convention on Human Rights (ECHR) on numerous grounds.¹²² First, it held that the legislative act introducing CACs did not result in actual damage to bondholders: only the subsequent modification of the bonds by the majority of bondholders inflicted the actual damage. The distinction strikes as too formalistic: but for the majority action clauses, the majority of bondholders would have been incapable of reducing the debt owed to the bondholders with the binding effect on minority bondholders.

5.61  Further elaborating on the argument of ‘no harm’, the Council of State reasoned that in the absence of a restructuring, Greece would have been unlikely to perform on the bonds through constant economic growth and the bondholders would inexorably have suffered a bigger loss had the restructuring failed.¹²³ Following the successful restructuring, the bonds enjoyed a higher creditor rating and were valued at least at the same price level as the one preceding the restructuring.

5.62  Second, the Council of State found that the introduction of CACs satisfied the proportionality requirement under the ECHR. It also determined that the prohibition in the Greek Constitution to expropriate without full compensation applied only to rights in rem and not to contractual rights.

(p. 165) 5.63  Lastly, the Greek Council of State highlighted that national emergency prompted the introduction of CACs and the measures resorted to were necessary and proportionate for the protection of the public interest. The judgment was accompanied by a strong dissent of seven out of twenty judges.

5.64  Having exhausted local remedies, the disgruntled creditors initiated proceedings before the European Court of Human Rights. The Court largely confirmed the findings of the Council of State and held that the unilateral introduction of CACs into Greek law governed bonds did not amount to a breach of the ECHR, namely the right to property (Art 1 of Protocol 1) and the prohibition of discrimination (Art 14).¹²⁴ First, the Court established that the modifications of bonds did not amount to a ‘deprivation of property’ within the meaning of the first paragraph of Art 1 of Protocol 1 since the bondholders had made an investment the value of which could fluctuate as a function of the uncertainties of the markets and the economic situation of the issuing State.

5.65  The Court, however, considered that the unilateral modification did amount to an ‘interference’ with the right to property. That said, that interference was justified on the facts for an array of reasons: (a) the State enjoyed a wide margin of appreciation in times of economic crises; (b) the interference was prescribed by law; (c) was in the public interest; (d) was proportionate given that Greece was in the situation of ‘imminent insolvency’, the commercial value of the bonds was already affected by the insolvency of the State and the bonds were subject to a risk of default.

5.66  Subject to the discussion of tolerable unilateral modifications in the next section, there are two conclusions to draw from the perusal of this case law (especially the common law portions):

1. (1)  the sovereign debt issuance is subject to the common regime of private contracts; and

2. (2)  the State does not enjoy police powers to alter the obligations it has entered into in a unilateral manner, or at least there are limits to those police powers.

5.67  It is true that the capacity to regulate and unilaterally abrogate State contracts is strictly correlated to the degree of the public interest involved.¹²⁵(p. 166) Clearly, the principle of pacta sunt servanda is not absolute and might be subject to exceptions in certain spheres such as natural resources.¹²⁶ Unlike other spheres where the State might be called to exercise its sovereign prerogatives more often, in the field of financial contracts the public interest is not directly at the forefront.¹²⁷ The US Supreme Court has correctly noted that purely financial contracts with the State do not in principle give rise to police powers.¹²⁸

5.68  That said, the prohibition to modify sovereign bonds unilaterally is without prejudice to three distinct matters. First, the argument presented here is restrained exclusively to situations where the State purports to change the express terms of the contract. Changes to the broader legislative framework of the sovereign debtor, adopted within its right to regulate, that might have collateral effect on the financial expectations of investors (eg, currency rate fluctuations or tax measures) are assumed to be objectionable to a much lesser degree.¹²⁹ The argument is that the expectations of creditors, not expressly set out in the contract, should more effortlessly yield to the State’s right to regulate. Conversely, financial terms expressly agreed upon are believed to give rise to higher and more stable expectations.

5.69  Looking at the matter more pragmatically, the State may use the threat of modifications of the broader legal framework as a measure of coercion on the bondholders in an effort to force them to accept the terms of a debt restructuring. This tactic was used by New Zealand in 1933 when the parliament imposed on domestic bondholders a 33% tax on interest paid under those domestic bonds that were not voluntarily converted into new, restructured bonds.¹³⁰

5.70  In any event, the scope of unilateral amendment of the general legal environment that will affect the extent of the State’s obligations has dwindled in relevance with the increasing sophistication of the modern bond (p. 167) documentation. The sovereign bond documentation often explicitly elevates various parts of the legal system onto the sovereign bond terms and conditions. A cursory overview of bonds shows that the following matters, among others, are covered by the bond documentation: taxation, currency, interest payments, transfer of bonds, and prescription. For instance, in respect of the currency fluctuations, bonds often stipulate that:

If the amount received or recovered is less than the amount expressed to be due to the recipient under any Note, Receipt or Coupon, the Republic shall indemnify it against any loss sustained by it as a result. In any event, the Republic shall indemnify the recipient against the cost of making any such purchase.¹³¹

5.71  Second, the modes of payment (not the substance of the debt) is a matter subject to the State’s prerogative to regulate. As a matter of example, the Permanent Court of International Justice held in the Serbian and Brazilian Loans that although Serbian and Brazilian laws applied as regards the substance of the debt, French law applied to the currency of payment since the place of payment was in France.¹³² Similarly, the French Conseil d’Etat judged that for the debt payable in France, French law would govern the conversion rate of the currency of the payment, even though the obligation was subject to some other law.¹³³ This fits rather neatly into the principle of conflict of laws that the method of payment shall be governed by the place of its performance.¹³⁴

5.72  Lastly, a separate and complex issue is whether sovereign bonds, irrespective of their governing law, may be treated as property and be affected by the legislation of the country in the clearing system of which they are registered. For example, the legislation of the State of the location of the clearing system may constrain the transferability of the title to the bonds outside the clearing system or may introduce statutory novation by transferring the liability of the debtor to another person. It needs to be stressed that the English courts have historically been adamant in subjecting the release or transfer of securities to the proper law of the contract, and not to the law of the place where the securities were situated.¹³⁵ An idea that (p. 168) received the imprimatur of the Privy Council is that measures short of expropriation are subject to the proper law of the contract.¹³⁶

5.73  It remains true that, assuming the State is on the verge of bankruptcy, the extreme financial burden can seriously affect the proper function of the State. Financing—in aggregate, not bond by bond—goes to the heart of the State’s public interest and its capacity to deliver a wide range of public goods. State infrastructures might not exist or might not be able to be maintained without what might seem to be a necessary sovereign debt restructuring.

5.74  Having said that, an idea permeating this monograph is that the state of necessity of a sovereign debtor does not give an unrestricted carte blanche to act ultra legum. With that idea in mind, this chapter has argued that the State does not have the power to modify unilaterally its domestic-law bonds. While that is the starting point of enquiry, the private creditor would still need to convince the English courts that the unilateral modification is manifestly in breach of public policy. To do something exceptional—refuse recognition of a law on the ground of public policy—the foreign legislation ought to be manifestly in breach of public policy.¹³⁷

5.75  It is submitted here that certain more or less innocuous unilateral modifications may fail to meet the bar of manifest breach of public policy:

1. (1)  Unilateral modification of bonds when conjoined with a valid exercise of power to regulate. To draw on the examples discussed here, a valid exercise of power would include the regulation of gold (Perry v United States) or the exercise of wartime powers (Page v Commissioners of Crown Lands; the German repudiation of the debt of the Third Reich). In those instances, the modification of bonds speaks in a fundamental manner to the concurrent exercise of a police power. This explains why in Perry v United States, where the police power relating to gold regulation was at stake, the Supreme Court refused to award damages to the aggrieved bondholder, but in a case decided a year earlier, in Lynch v US, the Supreme Court upheld the validity of war insurance contracts in spite of a legislative act that purported to annul them.¹³⁸

2. (p. 169) (2)  Declaring a moratorium (stopping payments for the duration of the moratorium) or re-profiling bonds (extending maturities of bonds). This was implicit in the Russian litigation, discussed above.¹³⁹ Proving the manifest contrariety of these two ventures to the English public policy would undeniably be a burdensome task.¹⁴⁰

3. (3)  Injection of majority action clauses (or other CACs) into contracts that did not have them in the first place is more uncertain. The retrospective introduction of a regime to restructure debt did, however, receive judicial imprimatur in Faitoute (with important constraints) and the judgment of the Greek Council of State.¹⁴¹

5.76  Furthermore, one could temper the effects of the public policy exception by relying on the so-called public policy attenué. In other words, the idea that the public policy exception would only be triggered when the application of the foreign law, allegedly in breach of manifest principles of the legal system of the forum, is also detrimental to the interests of the forum (eg, interests of local claimants).¹⁴²

5.77  The foregoing analysis demonstrates that public policy is largely an unruly horse and prudent lenders might be better advised to deal with the transaction risk by ex ante tools. Risk-averse bondholders would be better insulated from unilateral amendments brought in by the sovereign debtor through the insertion of stabilisation clauses into sovereign bonds.¹⁴³

5.78  One is left with perhaps not the most beguiling idea that whether the retrospective legislation contravenes public policy is at the end an issue of balancing.¹⁴⁴ That the sovereign can amend its legislation is beyond cavil. It is also beyond cavil that a State may not rely on the very event it has itself (p. 170) brought into existence to frustrate its own mercantile undertakings.¹⁴⁵ The difficulty is the haze that overlies the boundary between what is acceptable as a legitimate change of contractual terms and what is not. There is no denying that the State has a wide interest in regulating the volume and content of the debt in the national economy. National sovereignty is unimaginable without a significant degree of economic independence and freedom in regulating national economy. However, such power needs to be carefully balanced against the fairness of the action of the State that seeks to interfere with its own obligations.