6.01  Having examined issues of jurisdiction and governing law, this chapter turns to substantive matters arising in sovereign debt litigation. Section I will examine the obligation to repay and the attacks mounted against it. Section II will consider the defences that a sovereign debtor can raise against the recovery of the payments under the bonds.

6.02  In English law (and the New York courts, for that matter), the private creditors will seek repayment by bringing an action in debt for the principal due, plus the interest accrued on the money. It is a fundamental principle that the creditor may thus recover its contractual entitlement in full (ie, the par value of bonds plus the interest).

6.03  The action in debt is unlike, and not to be confused with, the action in damages where the claimant seeks to recover the damages arising from a breach of contract,¹ and where the issue of evaluation of damages is often acutely posed (eg, mitigation of damages). The distinguishing feature here is that in an action for an agreed sum, the claimant seeks to recover, as of right, a fixed sum of money and no major controversy arises over the quantum of payment. In transactions involving a reciprocal exchange of money, the courts, as a rule, order repayment of the nominal value of the money agreed in the contract. Of course, the calculation of payments under the bonds can be plagued by complications in class actions where the judge may be tempted to issue an aggregated judgment without individualised calculations,² however, this is a separate matter.

6.04  The interest rate in an action in debt will depend on the drafting of the contract and the governing legal system. Some Argentine bonds provided for a floating interest rate under which the contractual rate of interest changed from time to time based on changes in the then-current ‘market (p. 172) yield’ on regular Argentine fixed rate bonds in the secondary trading markets. The floating interest rates proved disastrous for Argentina where the interest rate was 101% at one point.³ Interest on interest, otherwise known as compound interest, is recognised both in English law⁴ and New York law.⁵ Once a judgment has been entered into, the judgment interest rate applies instead of the contractual rate. In England, it is 8% post-judgment (s 17 of the Judgments Act 1838). In New York State, it is currently 9% (NY CPLR §5004).

6.05  English law subscribes to the nominalism of monetary obligations, whereby the nominal value of the debt is not subject to adjustment following inflation.⁶ If a foreign law applies to the bonds, it may provide for a mechanism for adjusting for inflation. For instance, in a bond-related dispute under the US–Peru Trade Promotion Agreement, the bondholder sought to contest the calculations under Peruvian law that recognised the possibility of increasing the value of bonds because of hyperinflation.⁷

6.06  This is the state of current positive law. The law is clear—the creditor is entitled to full repayment. Section I discusses whether deviations from this rule are possible, that is to say, whether bondholders may receive less than full reimbursement.

6.07  All the alternative proposals below share one common objective: they seek to reduce the amount of the debt owed to the private creditors. They do not rely on the majority action clauses or other contractual provisions specifically designed to ease sovereign debt restructurings. Rather, they seek to devise a substantive law approach in favour of the sovereign debtor. Consequently, the substantive approach, outlined below, may also apply in respect of the sovereign debt that does not contain collective action clauses (CACs) (such as, State-to-State bonds bought on the secondary market).

6.08  This section will contain references to the position in public international law. However, the solutions in public international law are not easily transposable into municipal law. In Italy v Costa Rica the arbitral tribunal, chaired by Pierre Lalive, drew a distinction between the technical level (level of contractual provisions) and the equitable decision-making under (p. 173) public international law where the award of compensation is guided by other considerations.⁸

6.09  There is a growing counter-trend that proffers less than full repayment to the sovereign bondholders and relies on the market value of the bonds as opposed to their nominal value. For the purposes of this section, market value is defined as the price at which the bonds change hands on the secondary market of sovereign bonds. The market value is unavoidably lower than the bond’s nominal value in the case of a sovereign debtor in distress, representing the distrust that the financial market has in the State’s financial sanity.

6.10  Various grounds for, and methods of, reducing the contractual entitlement down to the market value have been proposed. Waibel, adducing international legal decisions, suggests the exceptional character of financial crises, the State’s limited payment capacity, and the need to avoid unjust entitlement of creditors to awards less than the nominal value of bonds—the fair market value or even less. He calculates the market value by using the net present value of the old bonds, discounted by the yield of the new debt.⁹

6.11  Glinavos suggests that investors should receive the fair market value of bonds, which for him is the amount invested in the purchase of bonds.¹⁰ This resonates with the position under French law. Under Art 1699 of the French Civil Code (retrait des droits litigieux), the assignor receives the money paid for the assignment of credit when the debt is disputed, not the nominal value.

Lastly, Bohoslavsky argues that the bondholders should bear responsibility for abusive (excessive) lending to the States. The backbone of the argument, allegedly derived from the legal systems of a number of developed countries, is that speculative bondholders should bear responsibility for lending to the State already buried under excessively high levels of debt. The responsibility should come in the form of a set-off or subordination of abusive loans to those classified as not abusive.¹¹

(p. 174) 6.12  These views are essentially attempts to resolve the problem of holdout litigation. They put forward a view that the problems of holdouts may be more satisfactorily addressed by finding a substantive law solution under English law (or New York law) that would limit the rights of distressed debt investors to request full nominal value.

6.13  The grounds adduced in favour of using the market value as the benchmark for the repayment of sovereign debt are numerous, but the reasons against are overwhelming and more convincing. The following analysis would suggest that awarding the market value of bonds is suboptimal on many levels. Even if in practice the creditors might settle for less than the nominal value of bonds, it is imperative that they should enjoy the right to claim the nominal value as of right should they wish to do so.

6.14  Having outlined the various grounds for the partial compensation of bondholders, some clarification is required regarding whose debt entitlement should be reduced. At its strongest, the proponents of the market value compensation claim that the payments to all private bondholders—both initial and secondary—should be equally decreased. At its weakest, it is proposed that the reduction of the creditor rights should affect the holders of sovereign bonds who acquired the bonds on the secondary markets or, even narrower, ‘vulture’ funds.

6.15  The proponents of less than full compensation often allege that the risk of default is a risk that a creditor assumes with open eyes when purchasing the bonds of a State in distress or even in the vicinity of default. If the risk of non-payment does not materialise over time, the creditor will see its bonds completely paid. However, should the circumstances decline and the State default, the sovereign bondholder is bound to the payment of the market value of the bonds, rather than the nominal value. Sovereign bonds do not give an absolute right to repayment and bondholders engaging in speculation should not earn a windfall on their initially limited investment. According to the proponents of this view, this should be all the more the case when the investor purchased an interest in the sovereign debt after the event of default.

6.16  The argument strikes one as specious. On the conceptual level, the investor is contractually entitled to recover the par value of bonds. The bondholder, who acquired the bonds on the secondary market at a steep discount, agreed to pay as little as 10–20% of the nominal value and accept the risk of default, only in the hope of recovering the whole amount due under the bonds. The larger the discount on the par value on the secondary market, (p. 175) the larger the risk undertaken by the bondholder. The risk undertaken is mitigated by the more or less certain probability of the recovery of the full value. Otherwise, such risks would not be taken by reasonable commercial parties.¹²

6.17  Hobhouse LJ, in a slightly different context of champerty defence and validity of assignment, neatly expresses the point in the context of an assignment of the debt of impecunious State entity at a sheer discount: ‘If … assets of the defendant can be found which are amenable to execution, the plaintiff may at the end of the day have made a profit on the transaction. … [W]hy else should a commercial entity purchase a debt?’¹³

6.18  It may well be argued that the risks inherent in the sovereign debt lie with the sovereign debtor. By issuing bonds, the sovereign debtor accepts the risk of changed economic and financial conditions, as well as of the financial difficulties. It is commonly accepted that the party who has been assigned the performance under the contract is under the obligation to perform it notwithstanding changing economic conditions and costs of such performance (unless, of course, it can raise a valid defence, as discussed in Section II).

6.19  Even though the contention might have factual grounding in certain sovereign debt crises (1980s crises in Latin America spring to mind), the counterarguments are not particularly difficult to formulate. First, the legal basis of such argument is shaky and is not tenable in positive law.¹⁴ Examples of abusive lending, derived from national legal systems that are isolated and subject to stringent conditions, do not justify the emergence of a general principle of law that may be extended to the ordinary commercial situation where a State has overborrowed. The State enters into financial markets of its own volition, almost exclusively with the advice of sophisticated legal and financial counsel. In England, the lender is not subject to a general duty to advise a borrower about the prudence or soundness of the borrowing, unless the lender has assumed specific contractual responsibility. In ordinary scenarios, the State would not ask the lenders for advice on its debt burden and whether the debt is sustainable. Nor do the lenders (p. 176) owe a duty of care to borrowers when lending money. The rules are, however, not as strict for consumer (individual) credit.¹⁵ Moreover, the circumstances where the lender will owe a fiduciary duty to the customer are narrowly constrained: the courts would look for vulnerability, reliance/dependency, an ascendant position, or capacity to influence so as to place a fiduciary duty on the lender.¹⁶ In light of these principles, in so far as the scholars claim abusive lending acts to shield or reduce the liability of the sovereign debtor, shifting the burden for overborrowing onto the financial markets amounts to avoiding one’s own responsibility for imprudent borrowing.¹⁷

6.20  Second, it is a commonsensical principle that the sovereign debtor may not raise the argument of abusive lending against the claimant who might have purchased the bonds on the secondary market and in no way contributed to the abusive lending. Should, for argument’s sake, the claimant be the original bondholder, having lent in excess and without due diligence of the State’s financial health, it cannot be held liable for the aggregate overborrowing ensured by the mass of lenders who collectively contributed to the over-indebtedness of the debtor.

6.21  Third, the lending to a debtor with high levels of debt is perhaps better conceptualised not as abusive lending, but as high-risk and high-yield investment which bets on the financial recovery of the State. By providing the funds to an over-indebted State, the creditor expects that the State has a chance of recovery and will be able to fully repay the debt.

6.22  At a policy level, an argument can be made that overzealous lending presents a systematic issue and should be treated as such. Valid as that may be, it is hardly an issue for the judicial development of law.

6.23  This argument will not carry the day in English law since the debtor will struggle to pinpoint any unjust factor, such as lack of consideration, undue influence, and so on. The question of unjust enrichment may only arise when the loan is invalid and the lender claims that the debtor is unjustly enriched by the money provided without a valid loan agreement.¹⁸ Schreuer goes further and suggests that crisis-like situations may in themselves be grounds for a claim of unjust enrichment and cites either (p. 177) the outbreak of war or change of territorial sovereignty.¹⁹ He then, however, continues:

[W]ith international law in its present state of development, restitution for unjustified enrichment can be considered hardly more than a decision-technique to be applied once the basic policy decisions have been made, and not a normative principle or general rule from which specific ‘correct’ decisions can be logically derived.²⁰

6.24  Waibel claims that awarding the fair market value would ensure intercreditor equity: it is nothing but fair to award a comparable level of damages to creditors, both holdout and consenting.²¹ In Salah Turkmani v Republic of Bolivia,²² the defendant claimed that the damages of a private creditor are necessarily constrained to the level of damages accorded in the Paris Club Agreement. The court correctly confirmed the voluntary character of debt restructurings and derived from it that the agreement of the Paris Club would not bind a private creditor litigating before domestic courts.²³ The case is very much to the point: a creditor may not be forced into accepting the haircut that other creditors have consented to (absent, of course, a triggered majority action clause). Holding all the groups of creditors to the same level of repayment of the debt might wreak havoc on the secondary market of sovereign bonds. Predicting the broader repercussions of such an outcome on the practice and pricing of sovereign debt is difficult, and testing it in real life does not seem to be a well-thought-through step.

6.25  In National Fire Insurance v Congo,²⁴ the claimant attempted to enforce an English judgment arising out of a loan agreement in the courts of the United States. Among other arguments, Congo claimed that the recognition of the judgment would fly in the face of the principles of equity and international law. Congo argued that recognising and enforcing a judgment would be against the restructuring agreement that Congo had entered into with all but one of its commercial creditors, namely the holdout creditor in those proceedings. The court strongly rebutted the argument on the ground that participation in the restructuring ought to be voluntary. The mere fact that the enforcement of contractual rights might (p. 178) have adverse effects upon the Congo was not sufficient to render the exercise of contractual rights illegitimate. The court added that it was not the appropriate institution to make a policy judgment, namely to weigh the potential harm to the sovereign debtor against the harm to the claimant if the court refused to enforce the judgment.

6.26  A precedent does exist for less than full compensation. Under the UK Debt Relief (Developing Countries) Act (2010),²⁵ in actions against heavily indebted poor countries (HIPC), the creditors are able to recover only the debt as reduced in accordance with the HIPC Initiative. The statute is, however, by definition limited to HIPC only—the countries which the international community has agreed to treat in a beneficial manner. In Belgium, under the Loi relative à la lutte contre les activités des fonds vauteurs, adopted on 12 July 2015, if a Belgian judge determines that a fund is acting as a ‘vulture’, the fund may only recover the discounted price paid for the bonds, and not their full value. Importantly, this provision applies irrespective of the governing law of bonds (Art 1).

6.27  There is a more general point to be made in respect of the Debt Relief (Developing Countries) Act (2010). The Act was expressly constrained to HIPC. Should the legislature have wished to let other sovereign debtors benefit from such reduction, it could have specified such in the Act. The courts might prefer not to embark on an innovative interpretation of English contract law where the legislature has chosen to remain silent on the contracts of all debtors, other than HIPC.

6.28  Two further counterarguments can be invoked. First, from a policy perspective, too blunt a limitation of the rights of ‘vulture’ funds might come at the expense of damaging the secondary market of the sovereign debt and the free assignability of sovereign debt. Even more so, damaging the secondary market would have direct negative repercussions on the primary sovereign market. The whole raison d’être of the secondary market is to counteract the weak enforcement mechanisms in the primary markets.²⁶ Trading on the secondary market is not necessarily a speculation in that it has a social function, namely, to provide money to bondholders who exchange their non-performing loans for liquidity.

(p. 179) 6.29  More generally, the proposed overhaul of the payment system in the sovereign debt litigation might have negative spillovers to the markets of sovereign bonds and thus make the litigation of sovereign debt disputes, already an adventurous exercise, the pursuit of very few. This would undermine the whole business model of hedge funds specialising in the purchase and litigation of sovereign debt on the secondary market. The whole point of providing liquidity to the holders of sovereign bonds and preserving the often coveted secondary market of bonds might disappear for the hedge funds should the only remedy that a secondary market purchaser receive be the market value or less.

6.30  The arguments that propose to reduce the full compensation arising out of sovereign default are all the more pronounced and have a higher likelihood of being upheld in investment treaty arbitration.²⁷ There is a trend advanced by a number of international investment tribunals not to afford full compensation to the investors engaged in speculative trading who acquired the debt after the investment declined in value.²⁸

6.31  In international investment law, the fact that the claimant bought the securities in the secondary market at a heavy discount could be a relevant consideration in deciding whether he was treated in a fair and equitable way at the time of default and/or restructuring. In investment arbitration this is captured by the mitigation of damages rule. By contrast, in English contract law, an action for an agreed sum of money is not subject to the requirement of mitigation.

6.32  Lienau, in her lucid historical analysis of the doctrine of odious debt, contends that the principle of consistent repayment of sovereign (illegitimate) debt in all circumstances is historically charged. It is based on the assumptions of political neutrality, reputational stability, and creditor uniformity, as well as the conception of sovereignty and the model of ‘agency’ between the government and the people. Drawing on the historical examples of Costa Rica and the USSR, she highlights that ‘the degree to which creditor interactions are competitive or consolidated … may affect the degree to which the rule of continuous debt repayment is stable’.²⁹ At the expense (p. 180) of oversimplification, her argument is that in a system where creditors are competitive, some of them might forgo the requirement of consistent repayment of sovereign debt, thus affecting the stability of such a rule.

6.33  The principle of full and consistent repayment of the debt is not modified just because at some points in history in Costa Rica and the USSR the lenders decided to waive their entitlement to consistent repayment. The principle of debt repayment remains valid, yet whether it will be applied in the current economic or political environment is an altogether different question.

6.34  Although ostensibly limited to the issue of odious debt, one should warn against extending this type of extralegal, historically charged argument to the principle of consistent repayment in general. By entering into sovereign debt obligations, and absent any contentions of odiousness (quaere whether this doctrine is good law), the sovereign debtor is bound to its contractual obligations and the courts should resist calls for undermining the commercial basis of sovereign debt issuance.

6.35  It is usual for a bondholder to move for a summary judgment upon the bonds. In English litigation, the claimant can obtain a summary judgment if the defendant has no real prospect of successfully defending the claim or issue (CPR 24.2). In the US, the court will grant summary judgment if the movant (either claimant or defendant) shows that there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law (Rule 56, Federal Rules of Civil Procedure).

6.36  In most cases, the sovereign debtor, who defaulted on the bonds, will have no real prospect of succeeding on the claim. The fact of default will rarely be contested and most legal defences raised by the State in financial litigation will receive short shrift from the English and New York courts. Nevertheless, some defences have prospects of success in sovereign debt litigation.

6.37  The discussion below examines the defences under English and New York laws and is not concerned with defences available in international law, specifically the defence of necessity.³⁰

6.38  Before proceeding with the discussion of defences, a preliminary point needs to be raised. It is at least arguable that the Events of Default Clause ubiquitously found in sovereign bond documentation may colour the defences that a State can raise. Often, sovereign bonds provide that an Event of Default (which has the effect of accelerating the payment of the principal) will arise if:

1. (5)  Validity:

   1. (a)  the Republic, or any governmental body with the legal power and authority to declare such series of debt securities and the related Fiscal Agency Agreement invalid or unenforceable, challenges the validity of such series of debt securities or the related Fiscal Agency Agreement;

   2. (b)  the Republic denies any of its obligations under such series of debt securities or the related Fiscal Agency Agreement; or

   3. (c)  any legislative, executive or constitutional measure or final judicial decision renders any material provision of such series of debt securities or the related Fiscal Agency Agreement invalid or unenforceable or prevents or delays the performance of the Republic’s obligations under such series of debt securities or the related Fiscal Agency Agreement;

2. (6)  Failure of Authorisations: any legislative, executive or constitutional authorisation necessary for the Republic to perform its material obligations under the series of debt securities or the related Fiscal Agency Agreement ceases to be in full force and effect or is modified in a manner materially prejudicial to the holders of the debt securities.³¹

6.39  Pursuant to this provision, challenges to the validity and even denial of obligations are treated as Events of Default. In a similar vein, some bonds (by El Salvador³² and Trinidad and Tobago)³³ contain a clause which provides for payment in a certain currency irrespective of any laws or regulations:

Judgment Currency. All payments required to be made hereunder by the Republic shall be in U.S. dollars, regardless of any law, rule, regulation or statute, whether (p. 182) now or hereafter in existence or in effect in any jurisdiction, which affects or purports to affect such obligations.

6.40  The question is whether these provisions can act as a barrier to the raising of legal defences in court proceedings. The issue arose in Elliott Associates v Banco de la Nacion and Republic of Peru,³⁴ where Peru agreed to pay the amounts due ‘regardless of any law, regulation or order’. The District Court first established that under New York law, a sovereign may waive a statutory or even a constitutional provision enacted for his benefit or protection, assuming a private right is involved and the public interest is not. On the facts, the Court held that a champerty statute involved public interest and could not be waived.

6.41  It stands to reason that these types of clauses are not treated as capable of genuinely insulating the bonds from genuine defences, mandatory rules, or valid legislative changes adopted by the sovereign debtor. Most of these will in one way or another involve public interest. If the State adopts a legislative act recognised by English courts or relies on a defence under English law to challenge the validity of a bond, the Event of Defaults clause cannot prevent such reliance. Upon an event of default, the bondholder will only be able to accelerate the debt, merely to find the terms and conditions of bonds it possesses already altered by unilateral modifications of the sovereign debtor (if applicable).³⁵

6.42  Further, bonds may often contain warranties or be accompanied by legal opinions regarding the validity of the bonds, including their compliance with the constitutional principles of the sovereign debtors. Properly understood, the legal effect of any warranties or legal opinions is a matter to be determined by the governing law. Thus, if, for instance, the State raises an issue of legal capacity, the relevance of warranties is a matter for the law governing capacity.³⁶

6.43  In the recent Belhaj v Straw, Lord Neuberger, in the majority, set the boundaries of the Act of State doctrine. For him, the doctrine is composed of three rules. First, English courts will recognise, and will not question, the effect of a foreign State’s legislation or other laws in relation to any acts which take place or take effect within the territory of that State. Second, English courts will recognise, and will not question, the effect of an act of a foreign (p. 183) State’s executive in relation to any acts which take place or take effect within the territory of that State. The third rule is the non-justiciability or abstention, or in the terminology of Lord Sumption, international act of a State.³⁷ To cite an example, in Law Debenture Trust Corporation plc v Ukraine, Blair J held that the allegations of duress and threat of force made by Ukraine against Russia were non-justiciable.³⁸ Importantly, it was earlier confirmed that while sovereign immunity may be waived, the doctrine of Act of State or non-justiciability may not.³⁹

6.44  The doctrine of Act of State may feature prominently in the litigation of various disputes involving sovereign defendants. However, it shall have no application to sovereign defaults given that the doctrine does not in principle extend to commercial transactions.⁴⁰ In commercial cases, if a State adopts laws and regulations to govern or modify its own debt, then their application will be determined by the conflict of laws principles canvassed in this book. If the court reaches the conclusion that the governing law of sovereign bonds is English or New York law, or indeed any legal system other than that of the sovereign debtor, those regulations will have no application.⁴¹ If, by contrast, the bonds are subject to the laws of the foreign State, the claimants may need to challenge the legality of such laws, perhaps by arguing that they are inconsistent with English public policy.⁴² The challenge of foreign legislation will have the result of triggering the Act of State doctrine, but so long as the challenge is based on the doctrine of public policy, the English court will not be precluded from reviewing its consistency with public policy.⁴³

6.45  The Act of State doctrine may apply when the State acts in its public capacity by regulating the foreign debt of local entities. In 1981, following a severe economic crisis, the Costa Rican government passed a decree prohibiting all external debt payments without the consent of its Central Bank, to ensure the uniformity of the renegotiation of the Costa Rican external debt. Soon thereafter, the Costa Rican Central Bank deferred the release of foreign currency intended for the repayment of external debt, which caused three Costa Rican State-owned banks to default on their (p. 184) external debt obligations. Here, the Costa Rican government intervened to cater for the illiquidity of a State-owned bank—the dispute was not thus concerned with the sovereign debt sensu stricto; Costa Rica was acting in the capacity of public regulator.

6.46  A disgruntled creditor, Allied, sued in the US courts to recover on promissory notes issued by the three Costa Rican banks. The District Court held that the Act of State doctrine barred the review of the Costa Rican decrees, which prevented any further consideration of the matter (Allied I).⁴⁴ Allied appealed before the Second Circuit. The Second Circuit, relying on the doctrine of comity, decided that the US courts should recognise the decrees and resolutions of Costa Rica because they were consistent with US bankruptcy law, as well as US foreign policy in support of the renegotiation of foreign debts (Allied II).⁴⁵ Applying the authority in Canada Southern Railway Co v Gebhard—a case on the recognition of foreign schemes of arrangement⁴⁶—the Second Circuit analogised sovereign debt default with the bankruptcy of a company. It held that Costa Rica’s attempts at restructuring/reorganisation should be given effect and, relatedly, pending actions should be stayed to allow for the orderly reorganisation of the Costa Rican external debt. Further, the court considered that ‘Costa Rica’s prohibition of payment of debt was not a repudiation of the debt but rather was merely a deferral of payments while it attempted in good faith to renegotiate its obligations.’⁴⁷

6.47  Following the decision of the Second Circuit, the US government submitted an amicus brief in which the US government expressed its support for granting priority to the enforceability of loan agreements over the comity to external debt restructurings. The US brief contained two reasons for not extending comity to the Costa Rican restructuring: (1) permitting Costa Rica to deny its private creditors their contractual rights would discourage grants of future loans; (2) allowing Costa Rica to alleviate its debt in that fashion would disincentivise sovereign debtors from undertaking necessary economic reforms.⁴⁸ Giving effect to the Costa Rican restructuring would be at odds with pivotal US interests, particularly that of the effective functioning of the international financial infrastructure.⁴⁹

(p. 185) 6.48  In the light of the newly emerged expression of the official policy of the US government, the Second Circuit in Allied III reheard the case en banc, being advised that it had misconstrued the US government policy, and eventually reversed itself.⁵⁰

6.49  The Second Circuit discarded the application of the Act of State doctrine since the situs of the debt was not in Costa Rica, but in New York. This was so for two main reasons: (1) US courts had jurisdiction over the defendants; (2) the payment was to be made in New York in US dollars. As for the acts of foreign governments purporting to have extraterritorial effect, they fall outside the scope of the act of State doctrine and should be recognised by the courts only if they are consistent with US law and policy. The Second Circuit affirmed that the unilateral modification of debts was not so consistent.⁵¹ (In 1982, Congress adopted the so-called Second Hickenlooper Amendment,⁵² whereby the court cannot refuse to decide on an expropriation claim on the grounds of the Act of State.⁵³)

6.50  The court also found that Costa Rica’s debt restructuring was inconsistent with the US policy of voluntary negotiations as it purported to unilaterally repudiate the debt owed to Costa Rica’s private creditors. Costa Rica’s unilateral restructuring also contravened the established IMF procedures of restructuring the debt which were based on the cooperative adjustment of international debt problems. The Second Circuit reinforced its conclusions by relying on the text of the loan contract. The text provided that the default would not be excused if the Central Bank failed to provide the currency necessary for repayment. In the same spirit, the Second Circuit did not reiterate the bankruptcy analogy and reversed the decision on the doctrine of Act of State.

6.51  The Second Circuit in Allied III followed the US governmental policy on sovereign debt restructurings, as expressed in the amicus curiae, as if it were bound by the latter.⁵⁴ This interrelation between judicial and (p. 186) executive branches is a particularity of the doctrine of separation of powers in the United States. It is redolent of the governmental interests doctrine commonly used in the US conflict of laws analysis, particularly in the weighing of the factors present in the application of the doctrine of forum non conveniens.⁵⁵

6.52  It is doubtful that the English courts will defer to the UK’s official governmental policy in the same way that the US courts have.⁵⁶ It is indicative that Lord Collins, commenting extrajudicially upon the Allied case, affirmed that the US courts could have taken an alternative route to weighing US governmental interests against the interests of Costa Rica, and instead held that US law governed the loan transactions and therefore Costa Rican decrees were not applicable in casu.⁵⁷ Applying the governing law to questions of discharge is the well-established position in English law.⁵⁸ The House of Lords in a case about personal injuries of South African workers incurred as the result of exposure to asbestos stressed that public interest considerations not related to the private interests of the parties and the ends of justice would have no bearing on its decision.⁵⁹ Lord Hope expressly refused ‘to follow those judges in the United States who would decide issues as to where a case ought to be tried on broad grounds of public policy’.⁶⁰

6.53  A tale of caution for all bondholders, especially those active on secondary markets, is well illustrated by the recent developments in the Argentine saga. In 2016, Argentina, following a change of government, announced its intention to settle its outstanding claims with the holdout bondholders. However, later on, it reserved its right not to pay those bondholders whose claims are barred under the Argentine statute of limitations.⁶¹ The very same issue is bound to arise in the recovery of other historic debts.

6.54  The expiry of the limitation period is a ground for striking out the claim of holdout litigants. The expiry of a limitation period bars any judicial (p. 187) remedies, with the overriding aim of ensuring predictability and putting an end to legal controversies. Limitation periods pursue the policy of protecting people from being perpetually at risk of litigation and preventing situations where evidence is lost or witness memories have been contaminated over time.

6.55  It is well established that limitation periods apply both to actions on the merits to recover the debt and to the enforcement of the ensuing judgment.⁶² In both cases, as a matter of English law, the limitation period is set at six years. In setting the limitation period for the enforcement of judgments, English law (and, for that matter other, jurisdictions) draws a distinction between suing for recognition and enforcement of a judgment (obtaining an exequatur) to which the limitation period applies, and actually executing the judgment.⁶³ The latter is a procedural matter on which the limitation period should have no bearing.⁶⁴ What this means in practice is that once the bondholder brings an action to recognise and enforce the judgment against the judgment debtor, the limitation period stops. Once this first step is completed, the creditor may take as much time as necessary to execute the judgment against the assets of the sovereign debtor.⁶⁵

6.56  The limitation period in New York is similar. New York’s CPLR §213 stipulates a six-year statute of limitations for ‘an action upon a contractual obligation or liability, express or implied’. An exception is set out in CPLR §211(a) which extends the limitation period to twenty years for claims on certain bonds. The exception is engaged when the bonds (i) are ‘indebtedness of the State of New York or of any person, association or public or private corporation’; (ii) were ‘originally sold by the issuer after publication of an advertisement for bids for the issue in a newspaper of general circulation’; and (iii) were ‘secured only by a pledge of faith and credit of the issuer’. However, the District Court found that the exception does not apply to foreign States because they are not ‘persons’ within the meaning of CPLR §211(a).⁶⁶

6.57  Another preliminary point that needs to be clarified at the outset is that limitation periods are determined by the governing law of the contract.⁶⁷ It is up to the governing law of sovereign bonds to determine how long (p. 188) the limitation period is and in what circumstances, if at all, it applies. In principle, in so far as limitation periods are a function of the governing law of the contract, they should not vary depending on the jurisdiction where the action is brought.

6.58  Although the limitation period is a question of substance and thus falls to be determined by the governing law of bonds, it may not be stopped by bringing proceedings in a single jurisdiction with universal effect across other jurisdictions. An action, either on the merits or on a judgment, is required in any jurisdiction where execution will be sought.

6.59  In English law, limitation periods are regulated by the Limitation Act of 1980. The Act consolidates previous law, and the case law decided prior to 1980 is not overridden. For defaults preceding the entry into force of the Limitation Act of 1980, the parties would be required to consult the precursor statutes. These statutes go back as early as 1623 and the transitional provisions in respective statutes would delineate the temporal scope of application of each of these statutes.

6.60  Some relevant key limitation periods, as articulated in the 1980 Act, are set out below:

• •  simple contract—six years from the date of breach;⁶⁸

• •  specialty actions/contracts executed as a deed—twelve years from the date of breach;⁶⁹

• •  tort—six years from the date of damage,⁷⁰ or

  • •  three years from the date of discovery of the damage;

  • •  specific torts such as personal injury, and defamation have their own time limits;

• •  breach of trust—six years;⁷¹

• •  fraudulent breach of trust—unlimited;⁷²

• •  recovery of money secured by mortgage— twelve years;⁷³

• •  equitable remedies—inapplicable.⁷⁴

6.61  The most relevant provision in the context of sovereign debt disputes is s 5 of the 1980 Act, which stipulates that for simple contracts (including loans), the limitation period is six years since the date of breach of the (p. 189) contract.⁷⁵ The limitation period runs from the day following the day on which the cause of action arose, ie, breach of contract.⁷⁶ When the State has defaulted both on the principal and interest, the analysis of both needs to be disentangled. In other words, the limitation periods run separately for each of the claims, and different rules may apply to the repayment of the principal and interest payments. The limitation period for the payment of the principal starts from the maturity date or when the repayment becomes due following an event of default. Gulati suggests that, in addition to the default on sovereign bonds, each breach of the pari passu clause is a fresh violation of a financial covenant and the statute of limitations should be reset each time a breach of the pari passu clause occurs.⁷⁷ Under this regime, the prospects of recovering historic claims against sovereign debtors seem rather bleak if the action for one reason or another has not been brought within six years since the date of default or maturity. A number of doctrines can be advanced to circumvent the short limitation periods.

6.62  Limitation periods can be reset in a number of ways. The first means of resetting is through acknowledgement and part payments (s 29 of the 1980 Act). Section 30 of the 1980 Act requires the acknowledgement to be in writing and signed by the person liable or his agent.⁷⁸

6.63  The peculiarity of these two methods of extending the prescription period is that if the six-year limitation period has expired, acknowledgements/part payments are not capable of reviving the limitation period. They only act before the limitation period has expired (s 29(7)).

6.64  The part payment of a debt acknowledges the existence of the debt and thus extends the limitation period. Under s 29(6) of the Limitation Act of 1980, the payment of interest sets the limitation period for the recovery of the principal afresh. In International Finance Corporation v Utexafrica Sprl, the recovery of debt should have been time-barred by 15 December 1994, however the part payment of interest on 29 July 1992 sought to reset the (p. 190) limitation period for the principal afresh.⁷⁹ The utility of this provision, when applied in the context of historic debts, should not be underestimated since as long as the sovereign debtor continues to repay interest, it resets the limitation period for the principal (but not for the remainder of interest payments then due).

6.65  The Limitation Act of 1980 sets out an exception from the general rule of limitation period for loans of a rather peculiar character. This section only applies to ‘certain loans’ which:

• •  do not provide for repayment of debt on or before a fixed or determinable date;

• •  do not effectively (whether or not it purports to do so) make the obligation to repay the debt conditional on demand for repayment made by or on behalf of the creditor or on any other matter.⁸⁰

6.66  Principally, when the loan does not provide for repayment of the debt on or before a fixed or determinable date, the limitation period begins its course only after the demand to repay the debt has been made (s 6(3)). However, s 6, as interpreted by the courts, applies primarily to loans of informal character where the loan is silent on the date of repayment (eg, loans extended within the family).⁸¹ Sovereign bonds would ubiquitously provide a fixed or a determinable date of repayment, either through the maturity (repayment date) or upon an event of default.

6.67  Further, the sovereign bondholder may argue that limitation periods start anew each time the bonds pass hands, ie, when the bond is sold to a new bondholder. This is especially so since in sovereign debt markets, the bonds pass hands without the old and new owners knowing each other. Should we wipe the slate clean for each new bondholder? The rather convincing riposte to this would be that the assignee of sovereign bonds steps into the shoes of the previous bondholder and cannot benefit from an extended limitation period.

6.68  There are no common law rules on limitation beyond the Limitation Act of 1980.⁸² The implication is that if a certain cause of action is not regulated in the Limitation Act of 1980, the statutory regime of limitation periods does not apply to it. It is often the case that behind the non-payment of sovereign debt stands the expropriation of the rights of private bondholders. The sovereign may take actions which are tantamount to expropriation of the entitlements of private bondholders. Potentially, such an action might be couched in terms different from a contractual claim for repayment (eg, infringement of property rights), and fall outside the ambit of the Limitation Act of 1980.

6.69  English law recognises the capacity of parties to contract out of the statutory limitation periods. The parties may either extend or decrease the limitation periods. Parties may also agree to a standstill or denounce their right to bring a claim entirely.

6.70  What distinguishes prescription clauses from limitation periods is that the failure to bring the action within the period provided within the prescription clause renders the claims extinguished or void,⁸³ whereas the limitation period, as set out in the 1980 Act, simply seeks to bar judicial remedies.

6.71  The implications arising from this distinction are twofold: first, the expiry of a limitation period is a procedural defence, which needs to be specified in the defence,⁸⁴ ie the court will not apply limitation periods of its own motion. The defendant has to raise the limitation period so as to bar the remedy, and may decide not to do so.

6.72  And, second, limitation periods seek to bar judicial remedies, which means the extrajudicial methods of enforcing contractual rights remain open to the creditor.⁸⁵ An example of such an extrajudicial remedy is set-off. By contrast, if the bonds are void following the failure to comply with (p. 192) the prescription clause, the claims of the creditor will be extinguished and that will prevent the use of extrajudicial methods.

6.73  A quick perusal of sovereign bond documentation demonstrates that prescription clauses are common in sovereign bonds. As an illustration, the Austrian Medium-Term Note Programme, subject to English law, provides for the prescription of the principal after thirty years and the prescription of the interest after three years:

Claims against the Republic for payment in respect of the Notes, Receipts and Coupons (which, for this purpose shall not include Talons) shall be prescribed and become void unless made within 30 years (in the case of principal) and 3 years (in the case of interest) from the appropriate Relevant Date in respect thereof.⁸⁶

6.74  Similarly, English law governed Greek bonds provide the prescription for the payment of principal after ten years:

Claims for payment of principal in respect of the Notes shall be prescribed upon the expiry of ten years, and claims for payment of interest in respect of the Notes shall be prescribed upon the expiry of five years.⁸⁷

6.75  Other bonds provide for a shorter prescription:

Claims for principal and interest on the bonds shall become void unless made within the period of five years from the Relevant Date.⁸⁸

6.76  The rules on prescription and limitation periods are strict. One way to circumvent the rather stringent rules on limitation periods is to seek redress before an international investment tribunal. International investment law sets out a much more lax regime, if any, of prescription (limitation periods) at the international level. Bilateral investment treaties are commonly silent on limitation periods and the limitation periods at municipal level are inapposite at the international level.⁸⁹

6.77  Two caveats need to be mentioned. First, international law may recognise the doctrine of equitable prescription. That said, investment tribunals are divided as to the existence of the doctrine and its actual content.⁹⁰(p. 193) Second, if the bonds contain a prescription clause, with the effect of voiding claims, it may well be arguable that no claim will lie under a bilateral investment treaty.

6.78  In principle, sovereign debt is assignable, both in the form of bonds and in the form of judgments and awards upon such bonds.⁹¹ In the market of syndicated loans, no-assignability clauses were commonplace. Under these clauses, the creditor might not assign its rights under the contract to third parties without the debtor’s prior consent. If the creditor failed to comply with said clauses, no rights would pass to him and he would have no right to sue under the loan agreements.⁹²

6.79  The right to litigate to enforce assigned obligations was historically precluded by the champerty defence. Under the law of New York, the champerty defence is, however, no longer a real threat to the distressed debt purchasers. In Elliott v Peru, the District Court found that Elliott purchased Peru’s debt with the intention to bring a suit thereon, thus infringing NY Judiciary Law §489, and denied recovery on that basis. The Second Circuit reversed the finding and held that buying debt with the purpose of collecting it did not infringe §489, even though litigation might be a necessary step in the process; §489 would only be engaged when litigation is the ‘primary’ purpose, which was not Elliott’s intent.⁹³

6.80  The originally harsh position of English law with respect to champerty has also undergone dramatic changes. The Court of Appeal in Camdex International Ltd v Bank of Zambia, relying upon section 136 of the Law of Property Act 1925 and earlier cases, ruled that, like other species of property, debts may be transferred to another. And the legal rights which are incidents of that property may be exercised by the new owner of the property.⁹⁴ When trading on the secondary markets, one bondholder is selling his bonds to another person, with the concomitant right to sue on (p. 194) the bonds. The doctrine of champerty may engage only in the exceptional cases when the claim only is assigned.⁹⁵

6.81  The doctrine of odious debt is more a creature of academic literature than positive law. The doctrine refers to the funds borrowed by illegitimate governments or for illegitimate purposes (war, apartheid, etc). Given their parochial nature, such funds, it is said, do not bind the new government which succeeds the illegitimate government.

6.82  The leading authority on odious debt is the award in Tinoco (1928).⁹⁶ There, the Costa Rican dictator Tinoco borrowed funds from the Royal Bank of Canada. Although Tinoco was an illegitimate ruler, the arbitrator Taft found that he was the de facto government at the time in Costa Rica and a State is bound by the obligations of its previous governments. More importantly, it was established that payments, fraught with irregularities, were paid for the use of the then president Tinoco for his personal support after he had taken refuge in a foreign country. The other part of the funds was paid to his brother as a salary for four years in advance. The borrowed funds were thus not for ‘legitimate government purposes’. In both instances, the arbitrator Taft was convinced that the bank knew or must have known about the final destination of the funds provided.⁹⁷ Waibel notes:

But the holding is narrow. The reason why Costa Rica did not need to repay the loans was not the illegitimacy of Tinoco’s government under international law. Rather, it was because of the lending bank’s knowledge that the sole purpose of the loans was personal. Without such knowledge, Costa Rica would have been under an obligation to service the loans.⁹⁸

6.83  Wider interpretations of the doctrine of odious debt may not find support in current international law. The Iran–US Claims Tribunal held that whatever the merits of the doctrine in cases of State succession, at least in cases of government continuity the doctrine of odious debt has no merit.⁹⁹

(p. 195) 6.84  In this sense, the doctrine of odious debt may better be treated as an ‘umbrella’ doctrine, which unifies various legal justifications for challenging what may seem as odious debt. Gulati, Buchheit, and Thompson seek to unfold the meaning of odious debt by reference to and by analogy with a cluster of national doctrines: considerations of public policy, unclean hands, agency, disregarding entity separateness in corporate law.¹⁰⁰ Other legal rules may provide substance to the doctrine of odious debt. Thus, if the facts permit, the State may argue that the bonds were ultra vires in so far as they were issued in breach of its constitution and statutes.¹⁰¹ If the place of payment of bonds is in the territory of the State, the State may also seek to rely on its mandatory provisions relating to the ruling of the illegitimate government.¹⁰²

6.85  It is possible to dispense with the doctrine of usury summarily since it has no application to sovereign debt. English law does not recognise a separate doctrine of usury.¹⁰³ The court enjoys a general discretion under ss 19–22 of the Consumer Credit Act 2006 to strike down a consumer credit if it is unfair. However, this power applies only to credit agreements entered into by an individual. In New York, the statutory provisions on usury do not apply to loans in excess of $2.5 million (NY Gen Oblig Law para 5-526(6)(a)).

6.86  Nonetheless, the doctrine may persist in other jurisdictions—perhaps the jurisdiction of the sovereign debtor. This may in itself incite the sovereign debtor to engage in ‘forum shopping’ in the jurisdiction which may strike down the interest rate as usurious.

6.87  States may also argue that the contractual provisions, including the interest rate, are penal and therefore should not be enforced. In Donegal International v Republic of Zambia,¹⁰⁴ Romania assigned to a distressed debt investor, Donegal, the debt owed to it by Zambia. Following the assignment, Donegal entered into a settlement agreement with Zambia. When (p. 196) Zambia failed to pay, Donegal initiated proceedings in England. Among other things, Zambia contended that Donegal bribed two former Zambian officials to obtain more information on the validity of the debt and that the Minister of Finance who signed the settlement agreement did not have authority to do so. Smith J rejected these allegations.

6.88  Zambia further contended that the interest rate provisions in the settlement agreement were penal since the sum payable on breach was not a genuine pre-estimate of the loss that the innocent party was likely to suffer as a result of the breach. The settlement agreement provided that on default, Zambia will pay a higher and compounded interest rate. Smith J considered, on a summary judgment application, that Zambia had a real prospect of defending the claim on the ground that the interest rate was penal and invited further submissions on the precise relief.¹⁰⁵ The case never proceeded to full trial. In any case, this decision in respect of penal interest rate may not stand in light of the recalibration of the law on penalties by the Supreme Court in Cavendish Square Holdings BV v Makdessi.¹⁰⁶

6.89  The issue of the capacity of the State to enter into loan agreements or issue bonds is truly a legal minefield. A State’s constitutional law may contain various requirements of form, authorisation and substance that need to be fulfilled to issue valid debt.¹⁰⁷ The consequences for non-compliance with these provisions are uncertain.

6.90  The issue of capacity to issue bonds was canvassed in great detail in Law Debenture Trust Corporation plc v Ukraine,¹⁰⁸ which arose on the footing of and as a corollary to the Russian–Ukrainian conflict. In late 2013, Ukraine borrowed $3bn from the Russian Federation through an issuance of bonds. The sole subscriber of the bonds was the Russian Federation. When the revolution in Ukraine unfolded in 2014, Mr Yanukovich fled the country and the next Ukrainian government issued a moratorium and refused to pay the debt upon maturation, although they paid some of the interest payments in the meantime. Instructed by the Russian government, the Law Debenture Trust Corporation brought an action against the (p. 197) Ukrainian government pursuant to an English choice of court agreement in the bonds.

6.91  The Trustee alleged that the debt was ‘a simple English law debt obligation’ and any claims based on political aggression or breaches of international law had no part to play in considering the creation of obligations or their repayment. Ukraine contended that the claim was part of a broader strategy of unlawful and illegitimate economic, political, and military aggression by Russia against Ukraine and should be treated thus. Ukraine also contested that the bonds were not a private arrangement but rather a bilateral loan in disguise, however, it did not ask for legal recharacterisation of the bonds as a bilateral loan. Nor did it seek to rely on the law on the moratorium given that the governing law was English.

6.92  Among other things, Ukraine raised a defence that because it was acting through its CMU (Cabinet of Ministers of Ukraine), it lacked capacity to issue the Notes.¹⁰⁹ Ukraine’s capacity defence was based on two strands: (a) the bonds breached the limit set out in the Budget Law and accordingly the CMU could not authorise any borrowing beyond that limit; and (b) the decree authorising the issuance breached constitutional principles, namely, the CMU did not receive an expert opinion on the Decree and it was not aware of the terms of the bonds.

6.93  In the absence of legal authority on the capacity of States to enter into transactions, there were two alternative routes pursued by the parties: (1) either to treat the capacity of States in a manner analogous to the capacity of individuals which is unlimited; (2) or to approximate the State’s capacity to the capacity of corporations which is subject to limitations (mostly under the local law of the corporation). Arguing for the former proposition, the Trustee claimed that Ukraine had unlimited capacity and hence could not rely on its internal law to invalidate the bonds. The Trustee contended that at most, this could be an issue of authority in so far as the CMU did not exercise its powers correctly.

6.94  Blair J first confirmed the general understanding that unlike issues of capacity, issues of authority can be mitigated by the doctrines of usual or ostensible authority. If treated as an issue of authority, the questions of usual or ostensible authority are governed by English law, the putative governing law of the contracts, rather than by Ukrainian law. If, by contrast, this matter were treated as an issue of capacity, Ukrainian law would be the governing law.

(p. 198) 6.95  Blair J first distinguished Haugesund Kommune v DEPFA ACS Bank, where the Court of Appeal found that the contracts entered into by Norwegian local authorities in defiance of their capacity were void.¹¹⁰Haugesund was concerned with local authorities and drew analogies from the law on the capacity of corporations. Blair J considered that the analogy with the capacity of corporations did not apply to States, not least because the State might change its own law (which governs issues of capacity) unilaterally. Blair J then discarded the analogy with individuals proffered by the Trustee.

6.96  Instead, Blair J adopted the Trustee’s argument based on the Lotus principle, set out in the landmark S.S. Lotus case,¹¹¹ namely that States have unlimited capacity and, in this context, unlimited capacity to borrow. In light of this, the State’s internal laws as to borrowing cannot operate to restrict the unlimited capacity of the State.

6.97  Taking the matter to its logical conclusion, Blair J considered that compliance with Ukrainian law was a question of authority and not capacity. The Minister of Finance enjoyed the requisite power but that power was not exercised as required by the law. Given that this was an issue of authority, the court considered whether the Minister had usual or ostensible authority. Applying English law to this issue, Blair J found that the Minister of Finance had usual and even ostensible authority to sign the bonds on behalf of Ukraine.

6.98  A number of points can be raised. First, the court refused to approximate State capacity with the capacity of corporations since the State could change its capacity unilaterally. On the facts, the issue of capacity existed at the time of issuance of bonds. There is no reason why separate rules could not be designed for unilateral changes of capacity introduced after the contract had been concluded.¹¹²

6.99  Second, the Lotus principle was concerned with the powers of the State exercised at the international level. The Lotus principle may not be entirely apposite in the context of the capacity of a State to enter into a commercial transaction governed by English law and the treatment thereof by English conflict of laws.

(p. 199) 6.100  Third, an alternative interpretation of the Lotus principles might cautiously be suggested. First, the Lotus principle is in no sense absolute and many reservations have been expressed in respect of the principle. Judges Higgins, Kooijmans, and Buergenthal in the Arrest Warrant Case stated that ‘the dictum [in the S.S. Lotus case] represents the high water mark of laissez-faire in international relations, and an era that has been significantly overtaken by other tendencies’.¹¹³

6.101  Further, and more importantly, the S.S. Lotus case could have led to the opposite conclusion. The Permanent Court of International Justice held in S.S. Lotus that:

6.102  What the famous obiter from S.S. Lotus thus stands for is the freedom of the State to apply its own law without incurring international responsibility, unless prohibited from doing so. The implication of the decision of Blair J was to limit the power of the State in holding that it could not rely on its internal law as a question of capacity. On the contrary, the Lotus principle allows for the application of the rules on the capacity to borrow unless prohibited to do so by international law. The Lotus principle stands for empowering the State and not for constraining it.

6.103  Furthermore, international tribunals never recognised full and unlimited capacity of States. Thus, in the Aboilard Case (France v Haiti), the concessions entered into by Haiti were in breach of its constitutional requirements since, under the constitution of Haiti, the transactions had to receive the authorisation of the Haitian parliament. The interstate arbitral tribunal confirmed that the transactions were ‘null and without effect’.¹¹⁵

6.104  Of course, the Tribunal then went on to find Haiti liable under international law for frustrating the expectations of the investor. Other tribunals have also found States liable for entering into ultra vires transactions.¹¹⁶ Article 7 (p. 200) of the ILC Articles on the Responsibility of States for Internationally Wrongful Acts stipulates that the conduct of an organ of a State or of a person or entity empowered to exercise elements of the governmental authority shall be considered an act of the State under international law if the organ, person or entity acts in that capacity, even if it exceeds its authority or contravenes instructions.¹¹⁷ Further, in cases when the State has relied on its local law to avoid an arguably ultra vires choice of forum agreement, international tribunals have found ways to give effect to such agreements.¹¹⁸

6.105  However, the tribunals in Aboilard and other cases were competent under international law to find the State in breach of international law. English courts cannot so easily sit in judgment of a foreign State’s acts allegedly in breach of international law and hold a State liable for a breach of international law. Article 7 of the ILC Articles only deals with issues of attribution and therefore a separate finding of breach of international law is necessary.

6.106  If one thus recognises the possibility that a State may lack capacity, it may be appropriate to draw a line between lack of capacity properly speaking and mere procedural defects. The lack of parliamentary approval of the acts of the executive or States (provinces) is a valid example of the lack of capacity, however, the failure to obtain an expert opinion may be better treated as a procedural defect.

6.107  Other examples may be less straightforward. In Dexia Crediop SPA v Comune di Prato, the Italian municipality of Prato raised two arguments to substantiate its claim that it lacked capacity to enter into swap agreements. The first was based on Art 119 of the Italian Constitution, which provided that municipalities may resort to ‘indebtedness only as a means of funding investments’. It was common ground that this was an issue of capacity and any indebtedness in breach of the provision would be null and void. The second argument was grounded in Art 41 of Law 448/2001, which imposed the financial advantage test (convenienza economica) (p. 201) of restructuring transactions, namely whether the transaction allows for ‘a reduction of the financial value of the total liabilities’. Both arguments failed and on that ground, the court did not determine whether the second ground—financial advantage—constituted a case of lack of capacity.¹¹⁹ In all likelihood, it would, or at least should, have been treated as an issue of lack of capacity since the financial advantage test, if found applicable, was a condition antecedent to entering into the transaction.

6.108  In any case, if the court came to the conclusion that the contract was null and void on the ground of the lack of capacity, the funds could be subject to an order of restitution back to the bondholder. According to the majority in Haugesund, the consequences of lack of capacity are to be determined by reference to English law.¹²⁰ Under English law, the restitution will be ‘unaffected by any of the contractual terms governing the borrowing’. However, it will be subject to any applicable restitutionary defences,¹²¹ including the doctrine of clean hands.

6.109  A theoretically distinct, but practically interconnected question, is how should the court address the defence of debt ‘overhang’ that a State may raise in commercial litigation. As a general rule, the State in default is in financial distress and in a legal action, relies on the unsustainably high level of its debt. Economists suggest that when the debt burden of a sovereign reaches a certain level, the State is locked in a self-fuelling debt trap. Locked in such a trap, the sovereign debtor may no longer repay its debt in full, unless it resorts to a debt restructuring (debt ‘overhang’).

6.110  By diverting the available revenues to the service of the debt, the excessive level of debt impedes the economic growth of the sovereign State and undermines the incentives to invest in such an economy. Further borrowing may only exacerbate the situation by crowding out private spending and investment. Often only substantial debt reduction will lead to the revival of the national economy.¹²² Once the debt has reached the unsustainable level, austerity measures and additional borrowing—commonly available at prohibitive interest rates—will not realistically offer the debtor the chance (p. 202) to escape the vicious circle of unsustainable debt. Putting aside the cases of opportunistic default, one may sympathise with the sovereign debtors who lack the wherewithal to pay the excessive debt they have incurred—taking a pound of flesh would also shed drops of blood.

6.111  The preliminary question that a court would be confronted with is whether the courts have the power to assess the payment capacity of the State. The issue, albeit rare, may arise in sovereign debt litigation.¹²³ The Second Circuit in NML v Argentina positively affirmed that:

6.112  In those cases where the determination of the payment capacity is at stake, the courts (and parties) are well advised to seek expert opinions. The concept of debt ‘overhang’ does not have the requisite legal precision to be susceptible to straightforward application in judicial proceedings. The level of debt sustainability is on its terms an arbitrary concept and is generally defined rather randomly.¹²⁵ To this, one might retort that the IMF and rating agencies routinely conduct debt sustainability studies. However, as one distinguished economist correctly points out, the reliability of their methodologies is often far from perfect and they failed on numerous occasions.¹²⁶

6.113  The conventional thinking is that the debt sustainability may be measured as the ratio of the government debt to the GDP of the country or goods exported,¹²⁷ although other financial ratios are also used, such as debt (p. 203) service to government revenue and debt service to GDP.¹²⁸ The orthodoxy posits that the higher the debt/GDP ratio is, the more likely it is that the sovereign debt is unsustainable. Among the variations of ratios, it seems that the ratio of government revenues/total debt service is able to catch the payment capacity more aptly. It shifts the focus to the cash-flow capacity of the State, measured through its income, to service the debt falling due in a definite year.

6.114  The use of financial ratios for determining the debt unsustainability is, however, imperfect.¹²⁹ Financial ratios of the sort described are too simplistic a measure and do not account for a whole range of various factors conditioning the State’s capacity to pay, especially in the long run. Such factors are: culture, record of previous debt restructurings, contingent liabilities, currency or maturity mismatches, the nature of the investor base, macroeconomic stability, market sentiment, professionalism of the State’s institutions, the level of development, the amount of government revenues, and so forth, which are not always susceptible to easy quantification in advance.¹³⁰ So, too, the internal political situation of the State and its internal political support will be hugely relevant in determining the acceptable size of taxes and austerity measures.¹³¹

6.115  To make matters worse, the insolvency of a State depends to a large extent upon the saturation of financial markets and the markets’ perceptions of the State’s capacity to repay.¹³² The Japanese governmental debt is very much a case in point. With a debt/GDP ratio of 224%—a higher ratio than that of Greece at the peak of its recent debt crisis—Japan’s debt is prima facie extremely high. Yet its debt portfolio is manageable, mainly due to the ‘home bias’ of local investors.¹³³ Additional factors reflecting the market confidence in the financial sanity of the debtor should be considered, such as the pricing of sovereign bonds on the primary and secondary (p. 204) markets, ratings of the sovereign debtor by rating agencies,¹³⁴ and credit default swaps (CDS) prices.

6.116  A more holistic analysis of the sustainability of the sovereign’s debt is called for. In light of this, the court should invite expert evidence (akin to valuers in corporate reorganisations) for assistance. It is worth stressing that the use of experts will only be necessary when the applicable legal rules require assessment of the payment capacity of the State.¹³⁵ In such cases, the court may well find on the facts of the case before it that the sovereign debtor is not afflicted by severe financial plight and decide accordingly.¹³⁶ This will act as a check upon opportunistic defaults by financially healthy States. Of course, there are rare instances in practice where the State would default out of mere unwillingness to pay and regardless of financial capacity to pay (so-called opportunistic defaults). A 1993 Salomon Brothers report found only 11% of sovereign defaults were opportunistic.¹³⁷ That said, in rare cases where the court is called to decide on the sustainability of the debt level and the payment capacity of the State, it will not shy away from the conclusion that the sovereign debtor has sufficient funds to make good on its debts in spite of its claims to the contrary.¹³⁸ Of course, the court may also come to the conclusion that the sovereign debtor lacks the wherewithal to meet its contractual obligations.¹³⁹

6.117  Without prejudice to those cases where legal rules require an enquiry into the payment capacity of the sovereign debtor, a finding that the State is incapable of paying will not, at least under English (and New York) law, be dispositive of the dispute. The court may face a State that is clearly overburdened by unsustainable debt under any conceivable benchmark of debt sustainability (heavily indebted poor countries are a pertinent example). Even in such clear-cut situations, the debt ‘overhang’ cannot be used as a catch-all argument in the litigation of sovereign debt disputes. (p. 205) In sovereign debt litigation, courts simply are called to confirm the debt due through the issuance of binding judgments: the serious financial predicament of the sovereign debtor was judged on many occasions not to constitute a bar to obtaining a judgment.¹⁴⁰

6.118  In any event, if that is of any conciliation, creditors will most likely face serious obstacles to full recovery of money at the stage of enforcement of the judgment. The strong shield of State immunity from enforcement affords the necessary protection to those States with excessive debt levels. If the debt ‘overhang’ argument were to be used to prevent issuance of a judgment, it would prevent any recovery whatsoever and any disciplining effect that sovereign debt litigation might have upon the sovereign debtor.

6.119  In this context, Scott, questioning the mainstream approach, argues that:

The root of the sovereign debt problem is that sovereigns overborrow. … Overborrowing results from the fact that sovereigns face few consequences as a result of default. … The default does not impede their access to future credit because creditors have short memories. The only effective remedy against sovereign overborrowing is to allow creditors to enforce their contract rights effectively against sovereigns in default.¹⁴¹

6.120  Irrespective of the stance one takes on who is to blame for the unsustainability of sovereign debt,¹⁴² the sovereign debtor in financial distress does not have carte blanche to restructure the debt or refuse to pay those who did not partake in the reduction of the sovereign debt burden. Of course, the sovereign debtor may take whatever legal measures it has at hand to bring its debt to a sustainable path, but it cannot flex legal rules by reliance on the unsustainable level of its debt. The unsustainability of the debt is (p. 206) already catered for by the contractual provisions,¹⁴³ considerations of payment incapacity in the context of challenges to the conduct of sovereign debt restructurings built into English law¹⁴⁴ and wide-ranging restructuring practices at the service of States (whether such practices are efficacious and cost-effective is a question in its own right). Stretching the debt unsustainability argument further to defend abusive practices or ignore valid contractual claims is not a valid extension of the debt ‘overhang’ defence.

6.121  This defence does not require much examination. English courts have discarded financial crises as a ground for frustration of a commercial contract.¹⁴⁵ English courts held in the aftermath of the 2008 financial crisis that ‘a change in economic/market circumstances, affecting the profitability of a contract or the ease with which the parties’ obligations can be performed, is not regarded as being a force majeure event’.¹⁴⁶

6.122  Rarely, sovereign bonds may contain language to prohibit the use of set-off¹⁴⁷ or even set-off and counterclaims.¹⁴⁸ More commonly, the sovereign debtor will recognise the possibility of set-off by waiving immunity against set-off.¹⁴⁹

6.123  In Law Debenture Trust Corporation plc v Ukraine, Ukraine argued a term was to be implied into the Trust Deed whereby Russia would be prohibited from: (i) deliberately interfering with or hindering Ukraine’s ability to repay; or (ii) demanding repayment if it was in breach of its obligations towards Ukraine under public international law. Blair J, while accepting the general proposition that a term may readily be implied into a contract (p. 207) whereby a party will not seek to prevent contractual performance, refused to imply it on the facts. He substantiated the refusal to imply by saying that in so far as the bonds were transferable, potential transferees, who had to be able to ascertain the nature of the obligation they were acquiring, could not do so through implied terms. The implication of such terms would make the bonds ‘unworkable and untransferable’. It could perhaps be suggested that any reasonable person should anticipate implied obligations which, by definition, go without saying, including the terms put forward by Ukraine.

6.124  The last defence that Ukraine raised was that it was entitled to decline to make payments to Russia as a ‘countermeasure’ under public international law. The judge held that this matter was non-justiciable.(p. 208)