Treating sovereign defaults like a plane crash

Regular Alphaville readers (going back to the pari passu glory days) will know that restructuring government debt has always been a messy process, and it has become much messier in recent years.

Two of the field’s leading thinkers (Mitu Gulati and Lee Buchheit) have suggested a new legal doctrine to help break the logjam: treat sovereign creditors like victims of a plane crash, nuclear plant meltdown or a dud drug.

To rewind a little, here is a quick summary of what Buchheit and Gulati reckon are the three main impediments to (somewhat) smoother sovereign debt restructurings:

The first is a creditor coordination issue. Before 2010 a sovereign debtor had to deal with two groups of creditors — commercial lenders (commercial banks before about 1995; bondholders thereafter) and official bilateral creditors that were members of the Paris Club. There is now a third group: non-Paris Club bilateral creditors such as China, India and South Africa. Indeed, in the last decade this third category has come to dominate bilateral lending to low income countries.

The second reason is the increasingly diverse nature of sovereign debt stocks. In addition to the conventional list of commercial banks, bondholders and official bilateral creditors, many countries must now also deal with arbitration award holders, unpaid suppliers, holders of derivative contracts, tort claimants and various other categories. Many of these are not “creditors” in the strict sense of parties from whom money has been borrowed. They are rather better described as “claimants”: persons or entities with claims against the financial resources of the state. A process that deals with a country’s conventional obligations for borrowed money but which does not resolve sizable claims of other kinds is obviously fragmentary and insufficient.

The third major flaw in the current architecture for the restructuring of sovereign debt is the near-total absence of any mechanism that will permit the supermajority of similarly-situated creditors to agree on the terms of a financial settlement and have that decision bind any dissenting minority. “Class voting” of this kind is a central pillar of most statutory regimes governing corporate insolvencies but the prospect of replicating it in the context of sovereign debt workouts remains vanishingly remote.

Zambia is a good example. As former Alphavillain (and pari passu supremo) Joseph Cotterill reported last week, the country is still struggling to get all its creditors to agree to a debt workout three years after it first defaulted. That impasse is impeding the country’s recovery, at a very real human cost.

The paper by Buchheit and Gulati mostly discusses restructuring challenges. But at the end, the lawyers suggest that perhaps one solution could be to treat a sovereign bankruptcy like a mass tort.

Some people in the vicinity of the exploding chemical plant may have been there by unhappy accident. Others may live there. Some may work at the plant while others were in a bus driving by, and so forth. The explosion and resulting injuries, however, instantly transform all of these disparate individuals into a single class — victims. They will be united by this common circumstance: the tortfeasor’s assets and insurance will probably be insufficient to pay in full all claims of all victims.

Accordingly, while each victim may have a legal entitlement to be paid in full, a disproportionate recovery by any one of the them will work an injury on all the rest by depleting the tortfeasor’s limited pool of financial resources. The law has devised various procedural devices such as class actions and bankruptcy to ensure that victims of a mass tort will be treated in an even-handed manner.

Claimants against an insolvent sovereign are in a very similar situation. Regardless of how their claim arose, a preferential financial recovery by any one of them will proportionally injure all the rest. difference is that there are no statutes, civil procedure devices or bankruptcy codes that will ensure the ratable treatment of all creditors. The most that the sovereign debtor can do is to commit, morally or contractually, to some version of the principle of “comparable treatment.”

The prospects for a transnational statutory embodiment of this principle (like the IMF’s 2002 proposed Sovereign Debt Restructuring Mechanism) seem slim. The best hope might therefore be for the development of judicial doctrines that will discourage efforts by more aggressive claimants to extract disproportionate recoveries in cases of sovereign insolvency.

This is an intriguing idea, but it’s hard to see how such a judicial doctrine could develop absent any international statutory underpinning. Otherwise it would presumably have to be built brick-by-brick, in legal rulings by judges around the world. Which, even if it were to happen, would take too long to help the almost 60 per cent of low-income countries that are either in “debt distress” or close to it right now.

We emailed Gulati and Buchheit to put our scepticism to them over the weekend. They saw several ways to move in this direction, such as legislation, new contractual loan clauses to make inter-creditor duties explicit, or simply court decisions to interpret implied “good faith and fair dealing” covenants more aggressively.

But Buchheit reckons this is the unavoidable direction of the sovereign bankruptcy field:

I see this as a necessary — and frankly inevitable — evolutionary step in sovereign debt. I just can’t predict when. It may come gradually as academics/judges/investors come to acknowledge intercreditor responsibilities in the sovereign context. Or it may come in a Great Leap Forward manner similar to collective action clauses.

Further reading:

Why the coming emerging markets debt crisis will be messy.

Breaking the sovereign debt impasse.

In the world of sovereign debt, bad ideas can never die.

How to restructure sovereign debt.