The legal framework governing sovereign debt: challenges in contracting with states
States borrow money in similar ways as private individuals and corporations. They may borrow money from other states and international finance institutions but also from commercial banks and raise capital through the issuance of bonds in capital markets. This credit is regularly granted in the form of contracts, which confer rights and impose obligations to the respective parties. Similar to corporate debt instruments, sovereign debt instruments are normally governed not by international law but by domestic law. Governing law can be either the laws of the sovereign debtor (local law) or the laws of another jurisdiction. If well used, sovereign borrowing can contribute to economic and social development, helping achieve economic stability in a country. Almost all states borrow to promote development, invest in infrastructure, fund warfare or ensure that the government has sufficient cash reserves at all times.
Like any other debtor, states may default on their payment obligations. There are many reasons why countries default and end up in a debt crisis, including poor economic management, external economic shocks, civil wars and natural disasters. Despite several similarities, important differences exist between the legal framework for debt instruments issued by states and those issued by corporations. In contrast to corporate borrowers, there are no comprehensive frameworks under national or international law regulating sovereign borrowing and insolvency procedures. Because of this regulatory situation, sovereign borrowing regularly faces two profound challenges, which are discussed in the following two sections.
Bankruptcy procedure for states and collective action problems
In contrast to corporate debtors, sovereign debtors facing a debt crisis and solvency problems are not protected by any legally binding bankruptcy procedures because there are no legal insolvency frameworks for sovereign states in international or national law. This implies that there arc no mandatory standstills or stays on creditors, there is no mandatory ladder of priority, the state cannot be liquidated and its assets will not be realised and disbursed to creditors holding claims against the state.
For states, one available crisis resolution tool is restructuring the debt, which implies making the debt burden manageable through a renegotiation of outstanding debt agreements. Being that they are contractual renegotiations, restructurings depend on the voluntary acceptance of the creditors involved. This means that the economic losses that inherently come with a debt restructuring arc distributed among the creditors consenting to participate in the restructuring, while the creditors refusing to take part (‘holdout creditors’) retain their original claims.
Although an offer to restructure may be beneficial to the entire group of creditors, individual creditors may benefit from demanding a disproportionately greater payment than the amount received by the other creditors in a restructuring. In other words, holdout creditors can seek to take advantage of the financial concessions granted by fellow creditors to the debtor state during the restructuring process. Other creditors observing that holdout creditors can freeride on their losses might feel less inclined to participate in a restructuring. This leads to the risk that no restructuring agreement will be reached; this is often referred to as a ‘collective action problem’.
This ad-hoc system and reliance on voluntary renegotiations to implement a sovereign debt restructuring can make it challenging for the state to reach a sustainable debt level and solve a debt crisis. The IMF has stated that under the current legal framework governing sovereign borrowing, ‘debt restructurings have often been too little and too late, thus failing to re-establish debt sustainability and market access in a durable way’.
-  The Permanent Court of International Justice stated that: ‘[a]ny contract which is not a contract between States in their capacity as subjects of international law is based on the municipal law of some country’, see Case Concerning the Payment in Cold of the Serbian Federal Loans Issued in France (France v Kingdom of the Serbs, Croats and Slovenes), Judgment No 14 (1929) PCIJ Series A, para. 86. 2 Yuefen Li and Ugo Panizza, ‘The Economic Rationale for the Principles on Promoting Responsible Sovereign Lending and Borrowing’ in Carlos Esposito, Yufen Li and Juan Pablo Bohoslavsky (eds), Sovereign Financing and International Law: The UNCTAD Principles on Responsible Sovereign Lending and Borrowing (OUP 2013) 15. 3 For an introduction to sovereign insolvency, see Chapter 25 of Philip R Wood, Principles of International Insolvency (2nd edn, Thomson/ Sweet & Maxwell 2008).
-  See, in general, Lee Buchheit, Guillaume Chabert, Chanda DeLong and Jeromin Zettelmeyer, ‘How to Restructure Sovereign Debt: Lessons from Four Decades’ (2019) Peterson Institute for International Economics (PIIE) Working Paper May 2019. 2 Loan contracts and sovereign bonds may contain majority-voting clauses, enabling the majority of bondholders to bind minority creditors to a restructuring agreement, see the International Monetary Fund (IMF), ‘Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructuring’ (2014) IMF Staff Report. 3 Buchheit et al (n 13) 19. 4 IMF, ‘Sovereign Debt Restructuring: Recent Developments and Implications for the Fund’s Legal and Policy Framework’ (2013) IMF Paper, 7. 5 On sovereign immunity, see Hazel Fox and Philippa Webb, The Law of State Immunity (3rd edn, OUP 2015).