Do sovereign debtors need a bankruptcy law?

• Author: Schwartz, Anna J.

The idea that there is a "gaping hole" in the architecture of the international financial system that should be filled by a universal bankruptcy tribunal is not credible. For centuries, sovereign debt defaults have been resolved without the benefit of bankruptcy laws. When a financial crisis exposes a sovereign debtor's bankruptcy, it seems wrongheaded to focus on resolving its dishonored obligations rather than expanding efforts on preventing debtors from accumulating excessive obligations.

Implicit in the bankruptcy approach is an assumption that the financial crises that have taken place in emerging markets have been made worse by the difficulties debtor governments have faced when trying to attenuate the commitments they had made to their creditors. But in each of the crises following the Mexican devaluation of 1994, the International Monetary Fund has bailed out creditors, and, to the extent that debt restructuring was involved, that restructuring was not stymied. There has been so much criticism of the moral hazard created by that policy that in the future the IMF may restrain its penchant for bailouts. But even if it does so, its continued sponsorship of a universal bankruptcy law should be questioned. Why would such a law be a higher priority for the IMF than more effective oversight of the economic policies of emerging markets?

The case for setting up an elaborate mechanism for sovereign debt restructuring is weakened to begin with by the IMF's acknowledgment that such an instrument would not be activated often because many countries do not need debt restructuring. Moreover, it is not clear that the absence of a bankruptcy law has produced chaotic conditions in the few countries that have had to settle differences with their creditors. Finally, it is not at all obvious how a sovereign debt bankruptcy law, for which there is no precedent, would work or whose benefit it would serve. If the legislation was intended to serve both debtor nations and their creditors, it is remarkable that the IMF did not consult with representatives of either of the parties to learn their wishes before issuing its proposals. (1)

In this paper, I begin by discussing two recent versions of the proposal for bankruptcy arrangements for sovereign debtors, and the status of the proposal in 2003. I then ask if there is extensive demand for such arrangements from debtor countries, private investors, and disinterested observers and find it lacking. Next, I review the alternatives proposed by various opponents of sovereign bankruptcy legislation, the majority of whom prefer a market solution to bureaucratic management of debt-related problems. I conclude with some observations about the IMF's role in the elusive quest for the development of emerging market countries by means of indebtedness.

Proposals for a Bankruptcy Law for Sovereign Debtors

In an address to a Washington audience in November 2001, Anne Krueger--the first deputy managing director of the IMF--presented a proposal for bankruptcy procedures for sovereign debtors to facilitate the orderly restructuring of their debt as if that were the holy grail long sought for the salvation of emerging market countries (Krueger 2001a). The proposal would enable governments to seek legal protection from their creditors by declaring bankruptcy, similar to the way in which Chapter 11 works for companies and Chapter 9 for municipalities under the U.S. Bankruptcy Code. (2)

The objectives of sovereign bankruptcy proceedings would be to (1) prevent creditors from disrupting negotiations by seeking repayment through domestic courts, (3) (2) require debtors to negotiate with creditors in good faith and to reform the policies that led to their bankruptcy, (3) encourage lenders to provide new money (known as debtor-in-possession financing) by guaranteeing that their claims would come before the claims of existing private creditors, and (4) persuade minority creditors to participate in restructuring arrangements. (4)

Krueger outlined the proposal again in a speech in Delhi, India, on December 20, 2001, and responded to objections that had been raised (Krueger 2001b). The IMF's executive board gave preliminary approval to the proposal, but at a two-day meeting in March 2002 there was no unanimity among the directors on how to proceed (Krueger 2002a). The subject was not formally on the agenda at the spring meeting. On April 1, 2002, Krueger answered questions at a press conference before giving another speech modifying the proposal (Krueger 2002b).

The November 2001 Proposal

The November proposal would have authorized the IMF to grant a government, in response to its application for a temporary standstill on the repayment of its debt, the right to declare bankruptcy. The government would then negotiate a restructuring of its debt with its creditors, a majority of whom would decide the terms for all of them (a feature modeled on British bankruptcy laws). To prevent an outflow of private funds during the negotiations, the IMF would allow governments to impose temporary foreign exchange controls.

To restrict the ability of creditors to enforce their claims in national courts, it would be necessary to establish bankruptcy laws for sovereign debtors in each of the 183 member countries of the IMF. Otherwise creditors could attempt to enforce their claims in jurisdictions without such laws. Alternatively, an amendment to the Fund's articles--which requires the consent of 85 percent of the shareholders--could create an international law binding all nations and altering terms of all existing and future financial instruments. The IMF would then become the international bankruptcy tribunal, whose job would be to mimic bankruptcy proceedings in domestic corporate workouts. It would give sovereign debtors the benefit of a freeze on creditor lawsuits and the "cram-down" features (meaning compulsory acceptance of a restructuring plan by dissident creditors) of a domestic bankruptcy proceeding. Disputes between a debtor government and its creditors would be adjudicated by an independent tribunal. A majority vote by creditors would bind dissident creditors just as if their bonds included collective action clauses.

The April 2002 Proposal

In April 2002, Krueger modified the original proposal, mainly in response to criticism that the original version aggrandized the IMF's authority to resolve a debtor's negotiations with its creditors. The revised proposal removed the Fund from the restructuring process, leaving decisions on the matter to the debtor and a supermajority of the creditors. As before, an amendment to the IMF's articles would be required, this time to achieve a uniform legal arrangement for collective action. The definition of a supermajority was to be determined at a later date.

A second change from the original proposal was that the validation of the need for a stay or a standstill would be declared by the IMF only at the start of the process but would then be revalidated by a creditors' committee on its formation. A third change required a single supermajority for different creditor claims (bank loans, bonds, trade credits, interbank loans, and other claims), rather than each creditor class, to approve prolonging a stay beyond three months and a final restructuring agreement. If that agreement did not accord with the Fund's view of how much the debt burden needed to be reduced to be sustainable, the IMF could withhold further financing and additional restructuring would be expected.

Current Status of the Proposal

As of spring 2003, no final version of the proposal existed. A 75-page staff memorandum (International Monetary Fund 2002) detailing the status of the proposal...