Lee Buchheit is honorary professor of law at the University of Edinburgh; Mitu Gulati is professor of law at the University of Virginia. Together, they often teach a course on the law of sovereign debt.
At the commencement of a professional boxing match the referee will gently squeeze the boxing gloves of each pugilist to ensure that no one has inserted a piece of iron into the glove. The objective? A fair fight.
The US government seeks to perform a similar function in lawsuits commenced against foreign sovereigns in American courts by holdout creditors. In the oft-repeated phrase, the US wants to encourage an “orderly and consensual” debt restructuring process. In practice this means that the US will attempt to ensure that neither the holdout creditor nor the sovereign defendant can slip a piece of legal iron into its litigation glove.
We saw an example of this in the US government’s intervention in a creditor’s lawsuit against Sri Lanka last month. Regrettably, the US missed an opportunity to explain why holdout creditor litigation is actually so worrisome.
First, some background. Over the last 40 years the US has intervened a handful of times in holdout creditor lawsuits. In the 1980s, when it appeared that US federal courts might allow sovereign defendants to shield their actions behind legal doctrines like “act of state” and “comity”, the US quickly intervened to disabuse the federal judiciary of any suggestion that these defences comported with US law and policy.
The pendulum swung to the other extreme in this century. When Argentina’s holdout creditors began peddling a fallacious interpretation of the pari passu clause in sovereign debt instruments (claiming that it required ratable payments of all equally-ranking debts), the US again appeared to caution judges against entertaining “novel” (read, erroneous) interpretations of standard contractual provisions.
The US views the threat of legal remedies by creditors as a useful tool to keep sovereign debtors at the negotiating table with their lenders. But by the same token the US does not wish to see creditors forge an effective legal weapon that may compel sovereign debtors to reach preferential settlements with its most litigious lenders. This could dilute the incentive for the creditor class as a whole to remain at the negotiating table.
In short, the US government wants creditors to be able to threaten a resort to their legal remedies without allowing an actual resort to those remedies to become a quick and easy path to a preferential recovery.
The latest effort to dance on these egg shells appears in a “Statement of Interest” filed by the US on October 22, in Hamilton Reserve Bank Ltd. vs. The Democratic Socialist Republic of Sri Lanka. This followed a very unusual intervention in the case on August 31 by France and the UK as “friends of the court”.
The immediate issue prompting both interventions was Sri Lanka’s request for a six-month stay of the proceeding in order to permit the country to complete a debt restructuring with its bilateral and commercial creditors. But the difficulty faced by the US, France and the UK lay in explaining how a court judgment in the case would jeopardise the prospects for Sri Lanka’s ability to conclude its debt restructurings.
There’s a common belief that holdout creditors in sovereign debt workouts obtain leverage by threatening to gum up the country’s restructuring with its other creditors. They don’t. Moreover, they usually don’t want to delay a restructuring with more pliable creditors. Holdouts know that their chances of extracting a preferential recovery are greatly improved once the other lenders are out of the way and have left money on the table in the form of debt relief.
The only tactical risk that holdouts face is the possible use of a collective action clause to corral them into the main debt restructuring. But Hamilton Reserve Bank, claims to hold more than 25 per cent of the bond that is the subject of this lawsuit — a blocking stake in a CAC vote — and is therefore presumably not worried about being crammed down.
The US attempted to address this difficulty by hinting that HRB cannot know for sure whether it really wants to decline participating in the Sri Lankan debt restructuring until it knows the final terms of that debt restructuring.
The more concrete argument in both interventions, however, alludes to the principle of comparable treatment of creditors.
Countries that obtain debt relief from Paris Club creditor countries are obliged to promise that they will seek “comparable treatment” from all other creditors, bilateral and commercial. Sri Lanka has promised to respect this principle in its eventual debt restructurings.
The problem, of course, is that the principle of comparable treatment of creditors isn’t breached when a creditor reduces its claim to a court judgment; it is breached only if and when the sovereign borrower actually pays that judgment.
In urging the court to delay handing down a judgment for six months, the US, as well as France and the UK, suggest that Sri Lanka’s other creditors could abandon their pursuit of a consensual restructuring if one of their number succeeds in elevating itself to the status of a “judgment creditor” before the restructuring closes. They do not, however, attempt to explain why this would be more alarming to other lenders if the judgment is handed down before rather than after the restructuring closes.
This strikes us as a rather feeble explanation for why the US government has an interest in this case. The US might have justified its intervention on much more substantive grounds.
For example, it might have implored the judge not to put Sri Lanka in the odious position of either being forced to dishonour the court’s judgment (by not paying it) or breaching Sri Lanka’s solemn undertaking to all of its other lenders — including the US itself — that Sri Lanka will respect the principle of comparable treatment of creditors (by paying the judgment).
But there is an even more fundamental reason why the US (or for that matter any of Sri Lanka’s external creditors) has an immediate interest in this case: all sovereign debt restructurings ultimately come down to a zero-sum game.
The country will require a certain amount of debt relief in order to regain its financial footing. The staff of the IMF — in their Debt Sustainability Analysis — will prescribe the amount of debt relief that the Fund believes is needed to achieve this objective (and in Sri Lanka’s case it might not be enough). However, the IMF will not dictate how much of that relief must be extracted from any particular type of creditor.
It follows that if any one category of creditor, or even any one creditor, refuses to contribute its share of the needed debt relief, that shortfall must be covered by the other lenders bearing a disproportionate share of the required debt relief. A failure to do so places the entire debt restructuring in jeopardy with inevitable damage to everyone.
This is the hard financial logic behind the principle of comparable treatment of creditors. Lenders to a sovereign borrower don’t insist on the principle of comparable treatment as a matter of etiquette and good manners; they insist on it because if it is not respected, they will either have to increase their own financial sacrifices or let the debtor country go to ruin.
The US, France or Great Britain might have written to the court to assert a direct financial interest in the outcome of the case, not just a metaphysical desire to promote “orderly and consensual” sovereign debt restructurings.
“We are here to protect the interests of American/ French/ British taxpayers,” is a sentence that has the dual virtues of being both true and eye-catching. It was a missed opportunity.
Further reading:
— The mysterious ‘global financier’ suing Sri Lanka