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Contracting with a foreign sovereign: capacity and authority

 

02 October 2018

Ukraine v The Law Debenture Trust Corporation PLC [2018] EWCA Civ 2026 

The second round of the legal battle between Russia and Ukraine over repayment of Eurobonds issued by Ukraine has ended with a victory for Ukraine: it can defend Russia’s claim for repayment on the grounds it entered into the Eurobond under unlawful duress exerted by Russia.  The Court of Appeal unanimously found that foreign sovereign states have unlimited capacity to contract which cannot be constrained by domestic law restrictions (constitutional or otherwise).  Any lack of compliance with internal restrictions is properly characterised as a question of authority, rather than capacity: counterparties will need to continue to be careful to ensure that they do not, and should not, have known of any lack of authority. The court also refused to imply terms into the Eurobonds on the basis that they were transferable financial instruments.  

Ukraine issues USD3bn Eurobonds

In late 2013, Ukraine was on the verge of signing an Association Agreement with the European Union.  It did not ultimately do so: Ukraine contended that Russia applied "massive, unlawful and illegitimate" economic and political pressure to force the Ukraine administration into accepting Russian financial support instead.   The financial support was structured as a standard Eurobond note issue by the State of Ukraine for USD 3bn with Russia as the sole subscriber.  The transaction documentation was otherwise as usual for Eurobonds: documents governed by English law, with the Law Debenture Trust Corporation (the Trustee) appointed as trustee.  The notes were listed on the Irish stock exchange and fully tradeable instruments, although Russia never in fact sold them. 

Ukraine defaults on bonds

In early 2014, Russia invaded the Crimea, impeding Ukraine's ability to meet its obligations under the notes due to adverse effects on tax revenues.  Following Ukraine's failure to repay the Eurobond at maturity, the Trustee (acting on the direction of Russia) brought proceedings against Ukraine in England.  Ukraine's defence was threefold: 

• Capacity and authority: The Eurobond transaction is void because, as a matter of Ukrainian law, Ukraine had no capacity to enter into it due to restrictions in its Constitution and Budget laws, and the Minister of Finance had no authority to sign the agreements and issue the bonds. 
• Breach of implied terms: Russia, by invading the Crimea, was in breach of implied terms not to demand repayment if it (a) deliberately interfered with Ukraine's capacity to repay, or (b) breached its obligations to Ukraine under public international law.  
• Duress: Wrongful and illegitimate acts by Russia constitute duress under English law, such that the transaction documents were voidable. 

At first instance before Blair J, all of Ukraine's arguments were unsuccessful.   Ukraine appealed.  

Unlimited capacity of a sovereign state to contract 

The Court of Appeal ruled that, despite a lack of compliance with its own domestic law, Ukraine did not lack the capacity to issue the Eurobonds, although the court’s reasoning differed from Blair J’s. 

The Court of Appeal found that a sovereign state derives legal personality, as a matter of English common law, from its recognition as a state by the British government.  Its legal personality is sui generis: it is neither a person, nor a corporation, but rather a third category, a sovereign state.  There is no analogy to be drawn to foreign corporations, whose capacity to contract is determined as a matter of local law.

Capacity flows from legal personality.  The consequence of possessing legal personality in English law is that the person can do any of the things for which legal personality is required: owning property, becoming subject to liabilities and entering into contracts.  English law imposes no restriction on the capacity of those who have legal personality except as imposed by statute. There is no prerogative or statutory authority for limiting the capacity of a foreign state, and there are no restrictions under common law, so a foreign sovereign state enjoys unlimited capacity as a matter of English law. 

Authority to contract: Did the Minister of Finance have authority to bind Ukraine by executing the documents?

The Court of Appeal agreed with Blair J that the Minister did have ostensible authority, although for different reasons. 

Actual authority is determined by local law (in this case, Ukrainian law).  The parties agreed for summary judgment purpose that the Minister of Finance had no actual authority under Ukrainian law to sign the various agreements and issue the Eurobonds.  However, the question of ostensible authority is governed by English law, as the governing law of the agreements.  Ostensible authority arises where there has been some direct representation as to the authority of the person acting. 

The Court of Appeal agreed that the Minister and cabinet had ostensible authority to issue the Eurobonds.  This ostensible authority of the Minister and cabinet (who purported to authorise the Minister) to borrow on behalf of Ukraine was derived from their powers set out in the publicly available Ukrainian legislation.   

However, an agent could not have ostensible authority where it conflicted with the express terms of the actual authority granted to the agent, of which the counterparty has notice (that is, in this case, the Ukrainian budget code and constitution).  So if the Minister took steps to issue loan notes where it was known (or should have been known) to the Trustee as counterparty that the necessary steps to comply with the Ukrainian budget code (being the document which effectively authorised the Minister) had not been satisfied, the Trustee would have knowledge or notice that the Minister acted beyond his authority, and could not have relied on the Minister's ostensible authority. 

The budget legislation was publicly available, and anyone lending to Ukraine was taken to know of its effect, albeit they would have required assistance from local Ukrainian counsel.  There was evidence that Ukraine's external borrowings, if aggregated with the Eurobonds, would have exceeded its external borrowing limit for 2013.  However, Ukraine could point to nothing contemporaneous which informed, or could be reasonably taken as informing, the Trustee that the external borrowing limit would be breached by the issue of the Notes.  In fact, Ukraine had issued a public statement prior to the Eurobond issue stating that all state debt indicators were within the budgetary limits.  

The Court of Appeal concluded that it was impossible to find that the Trustee knew of or should have known, prior to the Eurobond issuance, that Ukraine’s external borrowing limit would be exceeded. Ukraine did not therefore have an arguable defence that the Minister and cabinet lacked ostensible authority to issue the notes. 

Unusual / suspicious circumstances

The Court said that a third party (in this case, the Trustee) cannot rely on ostensible authority if the terms of the transaction are unusual, or there are suspicious circumstances or abnormalities.  The third party should make reasonable enquiries to ensure the agent's authority is sufficient to bind the principal.  In this case, there were no terms that self-evidently stood out as abnormal.

Cabinet had no actual authority to make representation as to Minister’s authority

The Court of Appeal disagreed with Blair J's supplementary finding that the Ukrainian Cabinet had usual authority to hold out the Minister of Finance as Ukraine's authorised representative in the transaction, such that the Minister also had ostensible authority to enter into it.  This is because the person who holds out another as agent (so as to bestow them with ostensible authority) must have actual authority to do so on behalf of the principal, or ostensible authority derived from someone with actual authority.  

No implied terms in transferable financial instruments 

The Court of Appeal agreed that terms could not be implied into the Eurobonds. Although courts have been willing to imply terms that one party would not seek to prevent a counterparty's performance of a contract (as the Crimea invasion may be said to have done), there is no general rule that such a term will be implied, and it will depend on the relevant contract, particularly its express terms. 

The implied terms contended for by Ukraine were not necessary in the context of the overall transaction and its express terms.  They were not necessary for the operation of the agreement, which otherwise functioned clearly, they were not so obvious as to go without saying (particularly to subsequent purchasers of the Eurobond), and were not capable of clear expression. 

Most importantly, the structure of Ukraine's debt obligation took the form of a tradeable financial instrument listed on the Irish stock exchange.  This gave rise to strong arguments against the implication of terms: 

 

Any implied term would need to be derived from the contractual documentation available to subsequent holders of the Eurobonds (not just the initial subscriber).  It could not be derived from the background or matrix of facts in which the initial subscriber had purchased the Eurobonds, in particular the state of Russia/Ukraine relations at the time of initial issuance. 

Although the initial subscriber, Russia, was not a counterparty to the relevant contractual documentation, it was contrary to principle and common sense to imply terms relevant to the relationship between Russia and Ukraine into a contract between Ukraine and the Trustee. 

The implication of Ukraine's suggested terms would effectively render the Eurobond unworkable and untradeable and therefore conflict with their express terms, as it would mean that future purchasers of the Eurobonds would have to agree to accept that Ukraine's payment obligations were contingent on the conduct of Russia vis-à-vis Ukraine. This was incompatible with the commercial purpose of the agreements. 

Duress applied by a foreign state  

The Court of Appeal found that the defence of duress was available to Ukraine.  Unlike the trial judge, the Court of Appeal concluded that although the acts allegedly constituting the duress were foreign acts of state involving violations of norms of international law, they were justiciable before an English court as a matter of public policy. This was because the loan relationship between the parties had been structured in the form of a Eurobond, governed by English law with choice of English court as the forum. Russia therefore accepted the risk that an English court would apply the English law of duress.

As such, overall, Ukraine succeeded on its appeal. The claim will proceed to trial on the issue of duress although the Trustee was granted leave to appeal to the Supreme Court. 

Implications for dealings with sovereigns 

The unanimous Court of Appeal support for the conclusions (if not the reasoning) of the trial judge on sovereign capacity and authority provides welcome clarity given the lack of prior case law on this topic.  It confirms that a foreign state recognised in the UK has unlimited capacity to contract as a matter of English law, irrespective of any foreign domestic law provisions to the contrary.  Consideration of questions of capacity remain important in the context of assessing the commercial risk of a transaction, particularly in emerging markets.  

Given a foreign sovereign's status as a sui generis creature, it should be noted that the ruling does not change the position on capacity of a foreign public body (rather than the state itself): it will remain the law of the jurisdiction of the public body which determines capacity.  

Instead, any restrictions on a foreign state's ability to contract under domestic law go to the question of whether those purporting to bind the state had authority to do so.  Even if there is clearly no express actual authority under local law, there may still be ostensible authority established as a matter of English law where transaction documents are governed by English law.  

Parties contracting with states must carefully consider the authority of the individual (or individuals) purporting to bind the state before transacting.  The Court of Appeal was clearly of the view that a state representative's ostensible authority could be defeated in circumstances where a counterparty knew, or should have known, that the representative lacked authority to bind the state (including by acting in breach of relevant publicly available domestic legislation).  Obtaining robust legal opinions as to authority will therefore remain the best protection for counterparties hoping to satisfy themselves of the enforceability of their transactions.  

Finally, the court was firmly against implying terms into transferable financial instruments. Its reasoning resonates beyond Eurobonds into a wider field of instruments, and it is reassuring to see the regard given to the position of potential subsequent investors in such products.  

This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication.  If you wish to receive this publication, please contact Amy Edwards, amy.edwards@allenovery.com


​Update, April 2019: Law Debenture’s application for permission to appeal has been refused by the Supreme Court because the application does not raise an arguable point of law of general public importance which ought to be considered at this time bearing in mind that the case has already been the subject of judicial decision and reviewed on appeal.​​

 

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