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Capacity of state to contract

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30 May 2017

​A political battle between Russia and Ukraine has ended up before the English courts, in the context of a dispute over repayment of Eurobonds issued by Ukraine. The decision in The Law Debenture Trust Corporation plc v Ukraine [2017] EWHC 655, 29 March 2017 is the first English law authority on the capacity of a state to contract.  Blair J held that once a state is recognised as such, it has unlimited capacity to borrow and cannot be constrained by domestic law restrictions (constitutional or otherwise) on the state.  Any lack of compliance with internal restrictions is properly characterised as a question of authority, rather than capacity. The judge also held that terms should not be implied into transferable financial instruments.


Russia sole subscriber to Ukraine 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 transaction was structured as a USD 3 billion Eurobond note issue by the state of Ukraine, with Russia as the sole subscriber. 

The documentation was standard for Eurobonds: the documents were governed by English law, with the Law Debenture Trust Corporation appointed as trustee (to represent the interests of the sole noteholder, Russia).  In early 2014, Russia invaded Crimea, severely 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 in the English Commercial Court for summary judgment for non-payment, contending that the debt was a simple English law obligation. Ukraine's defence was threefold:

  1. 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 actual authority to sign the various agreements and issue the Eurobonds.
  2. Breach of implied terms: Russia, through its acts in invading Crimea, was in breach of implied terms, including a term not to demand repayment if it unlawfully deprived Ukraine of the benefit of the loan, deliberately interfered with Ukraine's capacity to repay, or breached its obligations towards Ukraine under public international law. 
  3. Duress: Wrongful and illegitimate acts by Russia constitute duress under English law, such that the transaction documents were voidable.

Capacity of a sovereign state to contract

No prior case law has considered the question of the capacity of a foreign state to borrow, or indeed to enter into other forms of contract, as a matter of English law. For the purpose of the summary judgment application, it was assumed, as a matter of Ukrainian law, that Ukraine lacked capacity to enter into the Eurobonds due to the breaches of its constitution and budget laws.

The judge found that the question of a state’s capacity to contract should be determined as a matter of English law (rather than the law of the relevant state). Lacking prior English authority on how the capacity of a state is determined, Blair J considered how the English court would approach the question in cases involving natural persons, public authorities and foreign corporations but found those analogies to be inexact, and reasoned instead from principles of public international law.  He held that a state's capacity to borrow resides in its sovereignty. So once a state is recognised as such, as a matter of English and international law, it has unlimited capacity to borrow, which cannot be restricted by the state's domestic rules on borrowing. Ukraine did not therefore lack the capacity to borrow notwithstanding any provision to the contrary in its domestic law. 

Authority to contract

The court then considered whether the Minister of Finance, as a matter of authority, had bound the state in executing the documents. 

Actual authority is determined by local law (in this case, Ukrainian law).  The parties agreed that the Minister of Finance had no actual authority under Ukrainian law to sign the various agreements and issue the Eurobonds. 

On the other hand, the question of whether there was usual or ostensible authority was governed by English law, as the governing law of the agreements. The term "usual authority" is associated with the type of authority usually held by a person in the position of the person acting, whereas ostensible authority arises where there has been some more direct representation as to the authority of the person acting.

Blair J found that a Finance Minister would not always have usual authority for state borrowing by reason of his/her office: it would depend on the role of the Finance Minister in the particular state, and the particular borrowing. 

However, on the facts, there was usual authority, as the Minister had been the signatory of all 31 previous debt issuances (on which the Trustee had also acted) and there was no suggestion that the Trustee was on notice of any lack of authority in this instance. 

Blair J also found 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. The 'holding out' appears to arise from the existence of a Cabinet Decree, and the issuance of the Prospectus by Ukraine. 

No implied terms in transferable financial instruments

Blair J recognised, as a general principle, that a term would be readily implied that one party would not seek to prevent a counterparty's performance of a contract (and that it was powerfully contended that the Crimea invasion had this effect). However, where the subject matter of a contract is a transferable financial instrument, he found there should be no implied terms. There is a need for certainty on the part of transferees who must be able to ascertain the nature of the obligation they are acquiring from the relevant contract. 

Duress applied by a foreign state

Ukraine argued that the contractual arrangements were procured by duress, namely unlawful and illegitimate threats and pressure exerted by Russia in the form of threats of trade sanctions and use of force in Crimea.  While the English law defence of duress was available to Ukraine, the judge found that it had no real prospects of success because the acts allegedly constituting the duress, being foreign acts of state, were inherently non-justiciable and the court would refrain from adjudicating upon them. 

As such, overall, distinguishing the "deeply troubling" political background from the strict legal arguments, Blair J held against Ukraine and granted summary judgment. Ukraine has stated its intention to appeal the judgment. 

Implications for dealings with sovereigns

For any party contracting with a sovereign, particularly in debt financings, the judgment provides welcome clarity in this surprisingly underdeveloped area of English law. The ruling establishes that a foreign state recognised in the UK has unlimited capacity to contract as a matter of English law, irrespective of any domestic law provisions to the contrary. 

Instead, any domestic law limits are likely to go to the question of whether the actor binding the state had authority, rather than capacity, to contract. And even if there is clearly no actual authority under local law, there may still be usual or ostensible authority established under English law. 

Parties contracting with states must therefore continue to carefully consider the state actor's authority in all transactions. The saving grace in this particular case was a long course of prior dealings with the Trustee, a representation from a body (the Ukrainian Cabinet) with usual authority to hold out an authorised representative of the state, and a lack of notice of any deficiencies in the Minister's authority. 

It will remain important to consider questions of capacity in the context of assessing the commercial risk of a transaction, particularly in emerging markets.  A non-payment or other default by a state counterparty triggered by domestic legal or political imperatives will be commercially problematic even if the agreement proves to be legally enforceable. Litigation against states tends to be particularly hard fought, and the difficulties in enforcing against state assets can often significantly delay or even thwart any remedy. 

The separate finding of an absolute prohibition on the implication of terms into transferable financial instruments is a wide-ranging one, going beyond previous case law (and therefore potentially vulnerable to appeal).  The ruling provides increased certainty in dealings in, or restructurings of, such instruments. 

Finally, this does not change the position on capacity of a foreign public body (rather than the state itself): it is the law of the jurisdiction of the public body which determines capacity. However, if it relates to an English law contract, it remains English law that determines the consequences of any such incapacity.


Further information

This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication.  For more information please contact Amy Edwards at ​​