A Desert Parable. – You have decided to join 25 other people, all strangers to each other, on a bus tour of the broiling Mojave Desert. The ages of your fellow passengers range from 17 to 78.
50 miles into the desert and long out of cell phone range the bus breaks down.
Behind the driver's seat is a single two-liter bottle of water. It is the only potable liquid on the bus.
Immediately after the bus lurches to a halt, the 17 year old passenger wearing a varsity wrestling tee shirt grabs the bottle, drinks as much of its contents as he can hold and pours the rest over his sandaled feet (which had been uncomfortably heated by a stroll in the scorching sand).
Confronted with the prospect of many hours or even days on the stranded bus, your primary emotional reaction is:
a) Admiration, for the young lad's demonstration of decisiveness and initiative in seizing the water bottle. He was, after all, as much entitled to it as anyone else on the bus.
b) Gratitude, for the boy's having demonstrated to the tour bus company how dangerous it can be to send a bus into the desert without adequate drinking water. His action delivered a sharp and salutary reprimand to the management of the bus company that will benefit all future passengers on all future tour buses.
c) Regret, for not having signed up for the wrestling team when you were in high school.
Lenders are perfectly free to decide for themselves whether, when, how, to whom and on what terms they will extend credit to a sovereign borrower. But all such loans will involve risks and those risks occasionally materialize. When they do, is a creditor obliged to cooperate with its fellow lenders in the sovereign debt workout process? We don’t ask this question in the context of lending to corporate or individual debtors for the simple reason that insolvency statutes mandate such cooperation. Every lender to a corporate borrower knowingly extends credit in the shadow of a bankruptcy code that will, in the event of the borrower’s financial distress, subject the loan to a workout process in which the collective decisions of a supermajority of lenders will control.
Not so for loans to sovereign borrowers. Sovereigns are not subject to bankruptcy codes, not their own, not anyone else’s. In the absence of a statutory compulsion through a bankruptcy code, are lenders to sovereign debtors obliged to cooperate with each other in a debt workout process? Or are they altogether free, morally and legally, to disregard the wishes of their colleagues and, at their pleasure, use the judicial process to free ride on the debt relief being provided to the sovereign by those other creditors?
In response to aggressive uses of the litigation process by ‘holdout’ creditors in a number of recent sovereign workouts, and especially so in the aftermath of Argentina’s default in 2001, the international community debated whether to put in place a bankruptcy system for sovereigns. Various proposals for establishing a statutory scheme to facilitate sovereign debt workouts were made, including one from the IMF, but none prospered. The time may have come, however, to ask whether at least one feature of these proposals—the duty of creditors to cooperate with each other and refrain from behavior that effectively exploits debt relief given by other similarly-situated lenders—has become so accepted in the international financial markets that it can now be seen as a responsibility implied by ownership of a sovereign debt instrument. Were there a bankruptcy code applicable to sovereigns, this duty would be lodged in that code. The absence of a formal insolvency regime for sovereigns, however, does not mean that the duty is wholly nonexistent.
By acquiring a sovereign debt instrument a creditor knowingly places itself in a relationship of financial interdependence with all other lenders to that borrower. The relationship is largely imperceptible and inconsequential unless and until the sovereign debtor encounters severe financial distress. Unsustainable sovereign debt is another way of saying that the borrower has insufficient resources to meet all of its contractual obligations on their existing terms. It follows that while each of those creditors is legally entitled to insist on strict performance of its contract with the sovereign debtor, any attempt to do so will inevitably disadvantage all of the other lenders to that borrower. It is the financial equivalent of the Desert Parable with which we began, with the sovereign borrower’s limited debt servicing capacity substituting for the two liter bottle of water on the bus.
The law is familiar with situations in which individual actors and their financial interests are unexpectedly connected by an external event. A mass tort is a good example: hundreds or thousands of completely unrelated people affected by a toxic chemical spill, or the misleading marketing of a pharmaceutical product or a Madoff-style Ponzi scheme. In these situations, each of the victims may have a perfectly valid cause of action against the tortfeasor. What unites them is the fact that the resources of the tortfeasor and/or its insurer are insufficient to pay the claims of all the victims. The options? Allow that limited fund of financial resources to be drained by those who sue first or importune the tortfeasor most aggressively, and devil take the hindmost, or marshal all of the available resources and distribute them ratably across the universe of similarly-situated claimants. Justice usually requires the latter. In most situations of this kind the law has evolved procedural mechanisms for ensuring the ratable distribution of assets whether through a bankruptcy proceeding of the tortfeasor or a class action or similar device.
Creditors of an insolvent sovereign debtor are in much the same position as the victims of a mass tort. The sovereign will have a limited capacity to service its foreign currency-denominated obligations. The IMF will usually attest to this. Each creditor, however, has an unquestioned legal right to insist on the full payment of its claim. But full payment of the claims of some creditors inevitably means a lower, or no, recovery for all the others.
This analogy between the victims of a mass tort and external creditors of a sovereign debtor breaks down in two respects. First, unlike tort victims, lenders to the same borrower know at the time they acquire a debt instrument of the sovereign that they may potentially find themselves in this position if the sovereign experiences severe debt distress. The assembly of creditors is therefore not nearly as random as that of tort victims. Second, unlike the victims of a corporate or individual tortfeasor, there are no institutional or procedural mechanisms that can enforce a ratable treatment of similarly-situated creditors.
In our article, The Duty of Creditors to Cooperate in Sovereign Debt Workouts, we ask whether the time has come for courts to apply good faith duties (that already exist in all contracts under New York law) to the obligation of creditors to cooperate with each other in sovereign workouts. Better still, to save courts from having to search for implicit duties, parties could include such terms explicitly in their contracts.
Lee C. Buchheit is a Fellow at the Center for Contract and Economic Organization at Columbia University Law School and a Honorary Professor at the University of Edinburgh.
Mitu Gulati is a Professor at the University of Virginia Law School.
Together, they teach a course on Sovereign Debt at the European University Institute.