Gone broke: sovereign debt, personal bankruptcy, and a comprehensive contractual solution.

• Author: Brenneman, Adam

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.

1. 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.

   1. 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 in order to close the "poverty gap. (10) However, with a few exceptions, developing countries are unable to finance these investments using domestic funds, just as Fred is unable to pay for college out of his own pocket. Savings rates are often low in such countries, and export revenue is usually insufficient to meet financing needs. (11) Often, tax receipts do not cover budgetary outlays. (12) While "official development assistance" from the World Bank and other bilateral and multilateral entities cover some of these needs, "this source of resources has been shrinking for many years" (13) As a result, developing countries often look to the private sector to finance budget support and new programs. (14)

      Creditors are likely to lend to Fred because he is a good investment; that is, he is likely to pay the loan back. Fred generally has a sense of obligation to repay his debts, and he is unlikely to stray from this conviction. As such, default on a loan is likely to be a traumatic emotional experience for Fred and will probably do serious injury to his reputation. (15) Furthermore, defaulting on his loan is likely to impair Fred's credit rating and his ability to borrow in the future. (16) Accordingly, he is unlikely to default on the loan unless necessary. Likewise, sovereigns "try hard" to repay their debt obligations. (17) A government is also likely to consider reputational risk and the attendant consequences when deciding whether to comply with its financial obligations. (18) Outright repudiations of debt are rare, if for no other reason than sovereigns need continual access to credit markets, access that a default is likely to eliminate. (19) Furthermore, defaulting on debt may cause other problems for a sovereign and its economy, particularly with respect to international trade. (20) Regardless of whether one believes in the reputation theory of sovereign debt (21) or the enforcement theory of sovereign debt, (22) the sanctions imposed on a defaulting nation are usually sufficiently severe to deter defaults that are entirely opportunistic. (23)

      Now imagine that Fred's 25% risk comes to fruition and something goes wrong with his plan. Perhaps Fred gets sick, and is unable to work for a few months. Maybe Fred misunderstood the job advertisements and needed to study something different for the job he seeks. It could be that the jobs Fred seeks do not pay the rate Fred expected or that they materialize and disappear after a few months. Conceivably, Fred could spend his book money on beer and fail to graduate, becoming ineligible for a higher paying job. Perhaps the other students in Fred's class use their loans improperly and creditors think that Fred poses a similar risk, in which case creditors raise interest rates to cover the losses. In any of these situations, one can imagine that Fred will no longer be able to make his loan payments in full.

      Fred's potential personal crisis parallels the financial crises endured by developing countries. Just as Fred may have chosen to study the wrong subject to obtain a new job, a financial crisis might occur in the sovereign context because a country has implemented the wrong economic policies to increase growth. (24) For example, overvalued exchange rates, unsustainable budgets, anti-export trade regimes, and other domestic policies may have led to the defaults of Latin American governments on bank loans during the 1980s. (25) Modern devaluations in exchange rates have also led to problems with servicing sovereign debt. (26) Much like Fred's job might not pay the wage he previously believed it would pay, ill-conceived projects in which developing countries invest the proceeds of external financing often fail to produce the increased revenue expected of them. (27) Just as Fred might misdirect part of his loan proceeds towards non-educational expenses, developing countries may face problems with corrupt leaders and the misdirection of loan proceeds. (28) The literature on domestic policies that may lead to the creation of economic crisis is far too broad to explore in this Comment, but it suffices to say that an economic crisis may be a country's own doing.

      Other times, exogenous circumstances may cause a crisis. Just as Fred might get sick, developing countries may endure natural disasters that dampen economic output. (29) Just as a financial crisis might prevent a future employer from hiring Fred, a sovereign's policies may meet some initial success, but external circumstances can lead to poor results. (30) Still other times, debtor countries suffer from contagion of crises from other countries. Just as Fred's classmates' malfeasance might lead to higher interest rates for Fred, investor panic resulting from economic crises in neighboring countries might lead to regional capital flight, regardless of an individual country's policies. Such "herd behavior" on the part of investors is thought to result from a combination of high trading volatility and information...