Sovereign debt restructuring: statutory reform or contractual solution?

• Author: Sedlak, Jonathan

INTRODUCTION

During the last twenty years, as the global financial markets have become increasingly interdependent, the problem of sovereign debt has become more pronounced. Simultaneously, irresponsible lending practices and unwise investment strategies have led to several well-publicized financial "crises." A solution is needed to improve the efficiency of the international financial market, to encourage wiser investment, and to offer a method of market stabilization when events reduce the likelihood of sovereign debt repayment. This Comment addresses whether that solution can be provided through private negotiation or whether a new, intergovernmental structure must be effected.

The problem of sovereign debt has been the subject of significant academic debate. (1) Indeed, two competing proposals for dealing with the restructuring of sovereign debt recently have come to the fore. One proposal, advocated by the U.S. Treasury Department, encourages lenders to include collective action clauses in their debt instruments as a method of dealing with potential debt restructuring. (2) The other position, advocated by some at the International Monetary Fund (IMF) (particularly fund director, Anne Krueger), suggests that market participants adopt a statutory scheme to deal with the problem. (3) This statutory scheme has been labeled the sovereign debt restructuring mechanism (SDRM). (4)

While both proposals had their share of supporters and detractors, the IMF's SDRM received a substantial blow during the fund's spring meeting of 2003. During this meeting, Treasury Secretary John Snow cited market moves toward collective action clauses and concluded that it was "neither necessary nor feasible to continue working on SDRM." (5) Such a position by the United States, the largest contributor to the IMF, makes it difficult, if not impossible, to implement anything like the SDRM. (6) In fact, this pronouncement by Secretary Snow has caused at least one source to declare that the SDRM is "officially dead." (7) Although these developments significantly impair the likelihood of implementing anything that resembles the SDRM in the near future, the inherent flaws of a market-based approach coupled with the growing recognition of the need for a more systematic process indicate that we are at the beginning, not at the end, of this debate.

This Comment focuses the debate over these two proposed solutions to the sovereign debt crisis. Its purpose is to identify the theory underlying these competing solutions. Bankruptcy law is not a monolithic legal theory. Rather, it encompasses societal values concerning who should bear the financial loss that inevitably results from insolvency. The ensuing discussion rests on the premise that a better evaluation of the competing proposals for dealing with sovereign debt can be achieved by examining them in the context of bankruptcy theory.

This Comment addresses the problem as follows: Part I gives an overview of sovereign debt and examines the historical methods for dealing with financial crises when a sovereign defaults on its loans. Part II explores a recent statutory proposal advanced by the IMF, which is designed to create the functional equivalent of an international bankruptcy court. Part III examines an alternative, market-based approach to dealing with sovereign debt that is currently advocated by the U.S. Treasury Department. Part IV considers the competing axioms present in bankruptcy law generally while Part V analyzes both the statutory and market-based approaches for evidence of the tensions present in modern bankruptcy theory. Part VI concludes by recommending a traditionalist-based approach to solving the sovereign debt crisis. This conclusion results from the unique nature of sovereign debt explored in some detail here and in the concerns addressed by the SDRM, but ignored by the Treasury Department proposal.

1. RESTRUCTURING SOVEREIGN DEBT

   1. History of Sovereign Debt

      Sovereign debt can be defined as the "debt incurred by governments, typically those of developing countries, to foreign investors seeking a competitive return." (8) Notably, this definition excludes several other types of financing available in the international financial market such as government debt to public institutions, private borrowing in international capital markets, and direct foreign investment. (9)

      A good starting point for the analysis of sovereign debt is an inquiry into why an independent country, with internal sources of financing, would need to borrow money from foreigners. First, no country has an inexhaustible supply of resources available for investment. Countries face the same economic choices confronting individuals and corporations in a world of scarcity. A country must decide how much of its resource supply to consume and how much of its resource supply to invest in the hope of increasing future consumption. At the same time, the level of current consumption necessarily constrains the resources available for investment. Borrowing, therefore, allows a country to increase the resources available for investment without having to forgo current consumption. A country can borrow capital for investment, and as long as the value of the goods produced by that capital exceeds the cost of acquiring external capital, it is in the country's long-term economic interest to do so. (10)

      Mirroring the incentives for countries to borrow are the incentives for creditors to lend. These incentives are typically divided into factors that are external and those that are internal or specific to the borrowing country. (11) External factors include lower average interest rates, economic slowdowns in more developed countries (a factor that limits investment opportunities in those markets), and a growing trend among all investors toward diversification of investments through international markets. (12) Internal factors include the adoption of sound monetary and fiscal policies by some developing countries and active promotion of improved debtor/creditor relationships. (13) The incentives for creditors to lend and for debtors to borrow together create the market for sovereign debt.

   2. The Unique Aspects of Sovereign Debt

      With the above understanding of sovereign debt in mind, I now consider the unique problems that arise when a country is unable or refuses to pay its debts. A vast literature (comprised of mostly economists' contributions) devotes itself to the deceptively simple question of why a country repays its debts. (14) An examination of all the proposed conclusions in that literature is beyond the scope of this Comment. However, the inquiry highlights major distinctions between sovereign debt and corporate debt. Ultimately, three characteristics distinguish the two types of debt.

      First, at least in an abstract sense, a country can always service its debt, which makes it difficult to determine if a country is ever "insolvent." A company repays its debts because it must. If a company fails to repay its debts, the business can be dismantled by the unpaid creditors. (15) However, no parallel mechanism exists to force repayment by sovereign nations since no creditor has the ability to dismantle or liquidate a country. As a result, collection remedies against countries remain extraordinarily complex and difficult to execute.

      Furthermore, a corporation's ability to service its debt (16) is undoubtedly a methodical question, based primarily on the value of the firm's assets and the burden of its obligations. (17) While a sovereign's ability to service its debt initially invokes a similar inquiry, it also involves political, social, and even moral questions. (18) Rarely, if ever, though, is a country unable to meet its obligations in the same way a corporation is unable to meet its obligations. (19) In almost all cases, a government can repay its loans as scheduled by diverting funds from other projects or by increasing taxes. (20) The problem with this conclusion is that a country will always reach a point beyond which the costs of servicing its debts exceed the costs of defaulting on its obligations. (21) Because of the elusive character of this calculation, it seems impossible to predict when this point will be reached. Furthermore, each change in political leadership presents a potentially different calculus for determining the costs of defaulting on sovereign debt.

      The second difference between corporate and sovereign debt, therefore, is that a country can use little (if anything) to secure debt in the traditional sense. As a consequence, most sovereign debt remains "unsecured," which further frustrates collection remedies. In the corporate financing context, one of the major justifications for secured debt "is the desire to increase the likelihood of payment in the event of bankruptcy." (22) Although there has been an ongoing debate over the value of secured debt generally, (23) secured debt plays a major role in corporate bankruptcies. The absence of secured debt in the sovereign debt context limits the suitability of using domestic bankruptcy law as a model for sovereign debt restructuring.

      Third, "the ability of a court to force a sovereign entity to comply with its wishes is extremely limited." (24) As just explained, the traditional state law methods of debt collection (25) are not applicable to sovereign debt. Further, no intergovernmental agency currently exists to adjudicate disputes between creditors and sovereign states. (26) The absence of this structure is a major obstacle to any reorganization plan seeking implementation of domestic bankruptcy rules in the sovereign debt context.

   3. Historical Approaches to Dealing with Default

      In the last twenty years, there have been several periods of "crisis" during which numerous countries have simultaneously defaulted or have been in danger of defaulting. These crises have occurred in Latin America, Mexico, and most recently, Southeast Asia, (27) and...