Extract
Gone broke: sovereign debt, personal bankruptcy, and a comprehensive contractual solution.
To the extent that bankruptcy theory attempts to justify bankruptcy law from any point in time after a party becomes a creditor of a firm, it begins the inquiry in the wrong place. (1)
Both sovereign debt and defaults have appeared frequently in the news over the past few years. (2) However, the issue of sovereign debt restructuring is far from new. Restructurings have occurred as far back as the sixteenth century. Between 1557 and 1647, six debt crises in Spain were resolved using two of the same techniques discussed in modern restructurings: rescheduling principal payments and reducing interest rates. (3) Proposals of mechanisms to help sovereigns deal with defaults have been made as early as 1976. (4) Throughout the long discussion on how to help countries restructure their debt, most commentators have analyzed corporations undergoing bankruptcy and have compared them to countries in default to provide the basis of a model for sovereigns. (5) This Comment argues that the corporate analogy is incomplete. (6) The analogy between personal and sovereign bankruptcy may provide additional insight: a sovereign and its needs in default have, in many ways, more in common with a person who has fallen into bankruptcy than a corporation that has done so. Part I elaborates on the person-sovereign analogy to find that three common challenges face the insolvent person and sovereign in the absence of bankruptcy laws: creditor holdout, moral hazard, and lack of coordination. Part II examines existing proposals for sovereign debt restructuring--the International Monetary Fund's (IMF) Sovereign Debt Restructuring Mechanism (SDRM) and the inclusion of collective action clauses in bonds--to see if these challenges are addressed, and ultimately concludes that the existing proposals fall short. Part III proposes a contractual solution called a Designer Sovereign Debt Restructuring Mechanism (DSDRM), which would allow each debtor country to contract for its own insolvency and debt restructuring procedures. This Comment concludes by considering which options might be included in a DSDRM and how the DSDRM could be implemented. I. WHAT IS THE PROBLEM WITH SOVEREIGN DEBT? More often than not, commentators trying to find solutions to the problems associated with sovereign debt restructuring analogize a sovereign undergoing default to corporate bankruptcy. (7) The appeal of such an analogy is not entirely unexpected; both corporations and sovereigns are sophisticated, complex entities in terms of their ability to raise debt. (8) However, in many ways, the concept of personal bankruptcy bears a greater resemblance to a sovereign in the throes of default than corporate bankruptcy does. A comparison of sovereign insolvency to the bankruptcy of a hypothetical person may shine some light on the issue. A. Personal Bankruptcy and Sovereign Default: Some Similarities Between Fred and a Developing Country Imagine a hypothetical person, Fred Argent, living in a hypothetical state, Valeria, that enforces debt contracts. Fred is a widower and has five children. Fred rents a modest house and the children all share beds and have but one toy to share among them. The cost of supporting Fred's family's basic needs--heat, water, food, education, and clothing--is $20,000 per year. Fred works at a local restaurant as a waiter and is paid a salary of $23,500, just slightly more than his total expenses. Although he can pay his bills, Fred wants to provide a better life for his children (and for himself). He notices that there are many jobs in his community paying $30,000 for people with one-year college degrees, so Fred decides to study at a community college. Fred takes out a loan from the bank for $4500 to pay for tuition, charges $400 on his credit card to pay for books, and the school arranges for ten of his classmates to lend him $10 each ($100 total) for a bus pass. Thus, the total cost of his education is $5000. Assume that there is a 75% probability that he will repay all creditors in full, and there is a 25% probability that after one year, he will only have $3500 for his creditors. To account for the risk, his creditors charge him an interest rate of 10%. (9) All of the loans are due for repayment one year after he graduates. Thus, at repayment, Fred will owe $5500. However, since Fred expects to be earning $30,000 a year, his living costs ($20,000) plus repayment of the loan ($5500) will leave him with $4500 to buy toys, books, and beds for his kids. This situation can be analogized to the situation of a typical developing country. Developing countries often need to finance significant amounts of investment to foster the level of economic and social development they desire, just as Fred needs to finance his investment in education to earn a higher salary and provide a better life for his kids. According to the World Bank, significant investments in infrastructure, education, health, legal development, and other areas are needed...See the full content of this document
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