Contracting with a sovereign state: determining capacity under English and U.S. law
Contracts with states are an omnipresent feature of the global financial system, underlying all sovereign debt obligations. It may therefore come as a surprise that, until recently, the English courts had not considered certain basic questions: how does one determine a foreign sovereign state’s capacity to enter a private law contract? Is such capacity impugned if the sovereign breaches its domestic laws, or even its own constitution, in contracting? In this article, we consider the answers to these questions both from an English and New York/U.S. law perspective, concluding with a reminder of the important factors that a party must consider before contracting with a state.
The position under English law
The decision in The Law Debenture Trust Corporation plc v Ukraine  EWHC 655 addresses these points (among others) in the context of the subscription by Russia to a Eurobond issued by the State of Ukraine.
Ukraine argued that the Eurobond transaction was 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 that the Minister of Finance had no actual authority to sign the various agreements and issue the Eurobonds.
A sovereign state has unlimited capacity to contract
No prior English case law had considered the capacity of a foreign state to contract, nor which conflict of laws rule would apply in determining this question. The court reasoned from principles of public international law to find that a state’s capacity is not analogous to that of a public authority or foreign corporation, but rather “rests in its sovereignty”. Once a state is recognised as such, as a matter of both English and international law, it is recognised as having unlimited capacity to contract, which cannot be restricted by the state’s domestic laws.
Finance ministers do not always have authority to bind the state
This power to contract must be exercised by a properly authorised individual.
The court in this case found that a Finance Minister would not always have “usual authority” (ie authority derived from holding a particular position) to engage in state borrowing by reason of their office (which may have interesting implications for those contracting with Ministers more generally). However, given prior dealings (the Minister had been the signatory of all 31 previous debt issuances, on which the claimant trustee had also acted), usual authority was found in this case. Additionally, as the Ukrainian Cabinet possessed usual authority to hold out the Minister as Ukraine’s authorised representative, the Minister also had ostensible authority following a representation from the Cabinet. The ‘holding out’ appears to have arisen from the existence of a Cabinet Decree, and the issuance of the Prospectus by Ukraine.
Domestic law breach not an excuse to evade contractual obligations
The mischief being prevented is clear: Ukraine’s breaches of domestic law were solely within its own cognisance. Allowing a state to evade its obligations through a plea of lack of capacity, when it is solely responsible for such deficiencies, would be remarkably harsh on counterparties.
New York/U.S. law approach
From a comparative law perspective, the primary alternative jurisdiction of choice for sovereign debt financings tends to be the law of the state of New York in the United States. Generally, U.S. courts have recognized that every state has the capacity to conclude an international agreement, which includes agreements between two or more states or international organizations, and agreements between a state and a commercial counterparty. It has been recognized that sovereigns can enter into commercial agreements such as credit agreements, debt restructuring agreements, promissory notes, bonds and loans, though courts generally have not considered the legal criteria for the state’s capacity to do so.
The question of authority to bind a sovereign state depends on choice of law and the law of agency.
As a preliminary matter, New York courts will typically undertake a choice of law analysis if the law of more than one jurisdiction is potentially applicable to a contract dispute by applying the law of the jurisdiction having the most significant relationship to the transaction and parties involved. Where a commercial transaction involves a foreign state and that state is found to have the most significant relationship to the transaction, New York law usually looks to the law of the foreign state to determine the actual authority of an agent of that state’s government through either express or implied conduct or words of the principal.
However, even if an individual lacks actual authority under that foreign state’s law, that individual may still be imbued with the authority to bind the state through the doctrine of apparent authority, which is generally assessed under New York state law. Under New York law, apparent authority authorizes an individual to bind its principal when the principal induces a third party reasonably to rely on a manifestation that the individual has been authorized to act on its behalf. Usually determinations of actual and apparent authority will be questions of fact, not questions of law, that require a factual inquiry and discovery into the principal’s manifestations to third parties.
As a result, apparent authority has been found to apply to acts of foreign states and their instrumentalities when entering commercial transactions on apparent behalf of their sovereign. We would note, however, that other U.S. courts outside of New York have taken varying positions on whether – and if so, when – a foreign government may be bound on a theory of apparent authority, though each court’s analysis of whether apparent authority may bind a sovereign state appears to turn on whether the specific legal commitment made by the government official on apparent behalf of the foreign government was a public act (which negates apparent authority) or a commercial private act (which permits apparent authority).
Litigation against states tends to be particularly hard fought. The English court’s judgment in the Ukraine case is very helpful indeed to parties transacting with sovereign borrowers, suggesting that the primary focus should be on establishing authority, as authority rather than capacity is likely to be the most critical determinant of whether the contract is enforceable. Having said that, this is a first instance decision and subject to appeal.
Further, even if the judge’s decision on capacity to borrow is confirmed, the question of domestic capacity may nevertheless feed into any assessment of authority and will certainly be relevant to an assessment of the commercial risks of the transaction. If a state lacks capacity domestically, the risk of default will inevitably be higher.
It is also more likely that a state lacking domestic capacity might seek to find other ways of extricating itself from the transaction (eg following a change of government) or conceivably that it might run capacity arguments with a view to prejudicing attempts to enforce any judgment.
Capacity will therefore continue to be a relevant consideration for commercial parties from an English law perspective when negotiating sovereign deals, notwithstanding this decision. Domestic capacity may also be relevant in a US context and indeed in other jurisdictions.
Further informationThis case summary is part of the Allen & Overy Legal & Regulatory Risk Note, a quarterly publication. For more information please contact Karen Birch – email@example.com, or tel +44 20 3088 3710.