Sovereign Debt

Terms of Borrowing

Sovereigns are generally immune from enforcement in foreign courts. There are no effective solvency mechanisms against states.  There is no process by which their assets may be realized and distributed to creditors.

Solvent states have an inherent power to borrow subject to the terms of their own constitution.  Some Constitutions may impose debt breaks and limitations.

States may pass legislation to enable particular borrowings for particular purposes either directly or by state entities.  In the case of bodies established under law, specific statutory power and authority will be given to allow the borrowing for purposes which may be specified..

The broad terms of state borrowing are similar to those for corporate borrowing.  There are a number of significant differences.  States control their own taxation.  States undertake to pay gross, unaffected by changes in their own taxation system.  The state’s right to redeem would be restricted if it changes its domestic tax regime to require withholding.

State Covenants

States do not provide financial statements in accordance with standard financial conditions.  State financial reporting tends to have its own format.

No warranties are given in relation to litigation or formal insolvency.  Warranties may be given in relation to the accuracy of the underlying information, memorandum or prospectus.  The warranty will confirm the disclaimer of the state’s immunity.

Undertakings and restrictions will not apply to solvent borrowers in view of their prerogatives and powers.  They will not accept fetters on their freedom of action.  Accordingly, state debt transactions will not generally include financial covenants.  There may be a requirement to maintain good standing with the IMF.

There may be a negative pledge giving preference to particular creditors to the prejudice of all creditors.  Generally, it may be limited to foreign currency borrowing. It is standard for sovereigns to undertake that the debt ranks pari passu and equally with other unsecured creditors.

Events of default will normally include failure to pay, breach of terms, misrepresentation for cross-default, perhaps limited to foreign borrowing, debt rescheduling, and other creditor enforcement. Maintenance of good standing membership of IMF may be included.

Governing Law

A governing law will be a foreign law, and enforcement will be in a foreign jurisdiction.  This will almost invariably be required for obvious reasons.  The state could otherwise propose a moratorium on payments by its own law or require payments to be made in some other form.

Restriction of Immunity

The modern concept of sovereignty has tended to remove immunity in respect of certain state activities.  Trade and commerce are not core sovereign activities.

Most states removed complete immunity by legislation in the 20th century.  It was removed in Ireland by constitutional interpretation.

The Crown Proceedings Act, 1947 in the UK, permitted a range of claims against a state.  Sovereign Immunity Act 1978 provides for the general principle of immunity from jurisdiction for foreign states subject to certain exceptions.  Similar exemptions exist in Australia and the US based on the nature of the activity.

A sovereign state may submit to jurisdiction by prior written agreement.  In commercial transactions, states are not immune.  This may include the supply of goods or services, transactions for finance or guarantee, and other transactions entered by states other than in the exercise of sovereign authority.

State entities have immunity only if the proceedings relate to matters that are an exercise of sovereign authority and if a state would, in the same circumstances, have been entitled to immunity.

Coventnats & Disclosure

The state will be obliged to give extensive information.  A negative pledge may be required from the central bank and state entities.  The negative pledge may be limited to external debt.  External debt may be that other than in the state’s currency.

A negative pledge may prevent the grant of security and collateral with limited exceptions, including liens by operation of law, a collateral grant which committee approval, purchase money mortgages in the ordinary course of trade, collateral over title documents, insurance policy, sales contracts in relation to consumer goods in the ordinary course of business.

Default

Events of default are likely to include

• non-payment,
• breach of obligations,
• cross-default,
•  enforcement,
• repudiation,
• windup of state entities.
• breach of pari passu,
• breach of IMF obligations,
• suspension from IMF.

Loan management will take place on a syndicated basis with a committee of the banks.  Majority approval will suffice or a specified percentage may be prescribed.

Enforcement

Generally, states are immune from enforcement.  Enforcement is permissible if they consent and the asset is commercial in nature and not used in the administration of the state. Generally, remedies of injunction, specific performance, delivery of assets, arrest, and detention on sale are not available against states.

If a state fails to meet its obligations, it may, in effect, be insolvent.  This may arise through poor financial management, external circumstances, fraud, war, change in interest rate, collapse in prices etc.

There is no mechanism for taking over of the management of a state’s affairs.  The IMF may put in place a stabilization program.

There are no mechanisms whereby creditors of states may be necessarily treated equally.  Some creditors may take proceedings in foreign courts.

Rescheduling

In default, states may reach scheduled debts in order to resolve financial crises in an orderly manner.  Different creditors may be treated differently.  Reorganization may only occur by consent.  It cannot generally be imposed, and there is no mechanism for imposition on a dissenting minority.  There is no mechanism to write down the debt other than by agreement.

Restructuring of state debt commonly takes place on a so-called short-leash basis.  It seeks to incentivize the state to undertake economic austerity to maintain creditors’ bargaining power to enable monitoring.

Certain liabilities, including interest, trade debt and short term debt, may be restructured in certain circumstances if possible. Certain categories of debt, such as public bonds, which are widely held, may not be rescheduled in some cases. Generally, the amount rescheduled will be up to four-fifths or nine-tenths of the total with the balance repaid as a condition of restructuring.

Supranational creditors, including IMF, World Bank, regional development banks and the EIB, do not generally accept rescheduling.  Intergovernmental debt is rescheduled in accordance with Paris Club principles set out below.

Commercial banks are generally organized to join in rescheduling.  Public bond debt is only restructured in highly exceptional circumstances where the position of the state is badly impaired.  Trade debt is not generally restructured.

Paris Club

The Paris club is an informal intergovernmental association coordinating the actions of major creditor countries.  It is not binding.  There is no formal association rules or offices.

The club’s principles require the debtor to disclose its economic position.  The principles require that default on external payments will arise in the absence of rescheduling.  This will generally be apparent from arrears.

The state must accept an economic adjustment program with the IMF to reschedule and contributes to the stabilization of economic conditions. Creditors should agree to accept the burden arising from debt rescheduling equitably and fairly.  Grace periods on the scheduled payments may be equalized. The state enters bilateral agreements with each creditor country that accepts the rescheduling program.

Commercial Debt

Commercial bank debt may be restructured through negotiation with a committee of its principal bank creditors. The committee may make proposals.  A rescheduling agreement may be entered equivalent to a syndicated loan agreement. Appropriate state entities may join in the obligations under the agreement.

Participation by a high percentage of participants may be a practical requirement.  Non-rescheduled debt may require to be repaid.  Third-party governing law and forum will be required.

Where there are multiple currency exposures, credits may be required under the agreement to convert it into one or a small number of major currencies. There may be a common basis for interest rates for ease of administration and transparency.

The Pari Passu principle requires proportionate payments of all debt obligations. The most favoured principle provides that arrangements with other debtors outside the agreement should not be on more favourable terms.  If so, they are to be applied under the rescheduling agreement if they later arise.

There may be an incentivisation which provides that debt maturing beyond a cut-off date may not be rescheduled if economic progress is not satisfactory.

Succession

The issue of recognition and succession arises in the context of state debt.

International recognition of the state will be important.  Recognition is a matter of fact.  It may be formal through treaties or by implication.

Recognition may arise when a new state comes into being, or a new government takes control by some unconstitutional mechanism such as a coup.  This raises questions about the entitlement of the state to borrow, and its recognition in its own and other courts.

There is an international convention on the succession of states in respect of state property, the 1983 Vienna Convention.  It is not universally accepted.

Partition and Decolonisation

Third-party creditors will not be bound by partition or devolution.  A successor state of the devolved entity may agree to take responsibility for the predecessor’s obligations.

The Vienna Convention provides that where there is a partial transfer of territory, the debt should be apportioned in the absence of a specific agreement.  Localized debt, which is debt incurred in connection with the development of expenditure in a particular area, will go with the area which is partitioned.

In the case of the colonization of a new state, the new state does not succeed to the colonizer’s debt. Where states unify, the obligation passes to the successor.  The successor may apportion the debt over its territory.

An equitable proportion of the debts of the apportioned and passed to the successor. Where states cease to exist, successors should take on an equitable proportion.