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State insolvency: bankruptcy without a bankruptcy law

19 January 2009

This is the second in a series of articles written by Philip Wood, Allen & Overy's Special Global Counsel, on the financial crisis and the global slowdown from a legal perspective.

States are just like everybody else. They can and do become bankrupt. Here is a map showing state insolvencies in the period 1980 to 2005. About 40 per cent of states were insolvent in this period.

For the people who live there, the insolvency of their country is a national humiliation. Some vent their sense of helplessness in rancour towards the foreign moneylender and the Washington Consensus. The banking system collapses so that people lose their savings. Inflation and interest rocket. Hopes of happiness are dashed. Bankruptcy is a destroyer.

Foreign banks lending in foreign currency are effectively expropriated by a rule of law. This is because, as is almost universally the case, corporate liquidation law converts foreign currency into the local currency at the commencement rate of exchange. If the local currency is depreciating rapidly, as it always is, the claim becomes worthless in nominal terms, even if there were a dividend. So local creditors are incentivised to liquidate, foreign banks are not.

So what does the law do about the situation generally?

A state is insolvent when it is unable to pay its foreign currency debts as they fall due. Some states are serial insolvents.

The medieval history of state insolvencies was one of wars, kings, more wars and ruined Italian bankers. In the 19th century, most insolvencies involved defaults on international bond issues. Some were hardly surprising. The romantic Greek independence loan of 1825 of £2,000,000 (maybe half a billion now) was issued at 56.5%. After deductions of this and that, £245,000 eventually reached Greece, £60,000 in stores. The loan remained in default until 1879. So Byron died for this.

The 20th century was bad. Belligerents defaulted after World War I, drawing President Coolidge's remark: "They hired the money, didn't they". There followed the Great Depression defaults of the 1930s. Everywhere there was misery. In the 1980s most emerging countries defaulted. Botswana did not. The Asian collapses of 1998 spread to Russia.

The 21st century started with a swagger with the biggest collapse of all, the land of the pampas. Since then, state insolvencies have been running at about two a year, e.g. recently Dominica and Grenada. The latter was caused by the hurricane of 7 September 2004 which destroyed 90% of the houses on the island. Iraq was a special case.

Nowadays, the usual pattern is that the debtor state declares a standstill and offers to exchange old bonds and bank debt for new rescheduled bonds. Some bank debt may simply be rescheduled as a syndication rather than an exchange into bonds. Inter-government debt is rescheduled by the Paris Club of creditor governments on agreed common terms. A Paris Club comparability clause with the debtor effectively forces the debtor - and hence its other creditors - to reschedule on comparable terms. As with corporate work-outs, trade and small debt are not rescheduled. IMF and multilateral debt are not rescheduled: the lender of last resort always comes out first.

So who is next? One only has to read the newspapers. If the 20th century was bad, will this century be worse?

The extraordinary aspect of state insolvency is that it operates in a legal vacuum without a bankruptcy law. Compare bank insolvencies which spark off overpowering state dirigisme. This legal statism is so intense that in some countries the insolvency of banks is run solely by a government agency without any judicial or creditor involvement, e.g. the United States. There are others. Bankruptcy law is nationalised. The UK Government is currently thinking along these lines with protections. The piper calls the tune. The piper does not always have the best tunes.

Contrast state insolvency when the IMF suggested a few years ago that there should be a stay on creditor attachments if 75% of relevant creditors voted in favour, the market rejected the idea. They preferred to carry on in a legal vacuum. According to the markets, this worked well. They pointed to high rates of acceptance by bondholders in recent years by voluntary agreement, such as Pakistan 1999 (99%), Ukraine 1999 (99%), Ecuador 2000 (97%). Only Argentina failed to get more than 76%, not unexpected in view of a write-down of 70%.

The differences between corporate and state insolvency are massive. In the case of states, people live there. There is no realisation of the assets. Creditors can't sell Karachi. There are no creditor controls on management except via IMF conditionality in standbys. This company doctor function is one of the main roles of the IMF now – creditors will not reschedule without an IMF programme. There are no freezes on creditor actions so that foreign assets are exposed (although states can and do employ strategies to insulate their assets, as the Central Bank of Cuba litigation testifies).

There is no forced disclosure except via voluntary statistics, no set aside of fraudulent preferences, no bankruptcy ladder of priorities, no equality clause, no discharge of the debtor, no stopping of interest and no retribution for delinquents. Set-off runs on. Theoretically debt-equity conversions are not possible, although the equivalent has been tried by swaps of debt into local companies. Everything has to be achieved by agreement.

State entities can be insulated by the veil of incorporation, e.g. the central bank. The 1970s practice of bank loans to the central bank guaranteed by the state itself was dropped from the 1990s forward in bond issues so that the reserves escaped. The former protection of states, sovereign immunity, has been swept away by contract practice and legal developments.

One of the big debates in state insolvency is whether there should be a stay on creditors. Back in 1944 the British economist, John Maynard Keynes and the American far-left-winger Harry Dexter White attempted to draft a Chapter 11-style stay for sovereign states in the IMF Agreement. Article VIII 2(b) of the IMF Agreement states that the courts of member states (practically the whole world now) will recognise eligible exchange controls of other member states. In effect any IMF member could initiate its own bankruptcy proceedings which would be universally recognised in virtually all of the world's countries. Faced by this, the courts in leading countries, including in England and New York, neutered the article by interpretation. A few other important states did not, so that jurisdiction for foreign creditors in a court which overturns Keynes and White is worth considering.

After the IMF proposal for a softish bankruptcy law was stood down in 2002, the market determined to introduce their own versions of a stay. This was to be achieved by collective action clauses in bond issues. There are three features of these clauses: (1) no action by individual bondholders unless a trustee or, say, 25% of the bondholders agree; (2) voting provisions whereby the majority can override the minority (and therefore reschedule); and (3) a pro rata payment clause (which necessitates a trustee). They roughly replicated bankruptcy law, but without a sale, without all the frills.

The background was that English law bonds always had voting. But there was a view in some markets elsewhere that the best way for bondholders to get paid was to have no method of organising them, so that, unless they were paid or offered acceptable terms, they would forever be a marauding band. There is legislation preventing majority bondholders from binding the minority to a change of payments in the US, Canada, Germany and elsewhere - mainly for corporates.

That view is on the wane. A brief review of recent offering circulars for debt issues by around a dozen emerging countries shows that nearly all of them had a 50% to 66% vote, that most of them had a 25% threshold for accelerations (but no stays on individual bondholder action) and that a couple had a trustee.

All of these debt issues had an external governing law (English, New York or Swiss) so as to immunise the bonds from legal changes by the borrowing states. They had waivers of sovereign immunity, although about half of them had exemptions for official property. They all had a standard pari passu clause a chest-thumping provision which has attracted much recent litigation by hedge funds arguing that the pari passu clause actually meant something. They all had weak negative pledges, mostly useless, but so what? Most had a cross-default with a threshold of between $25 million and $50 million.

So there things stand – bankruptcy without a bankruptcy law. Just contract and consensus. The question is whether this is a situation which can or should continue.

This issue has a parallel in the sphere of corporate insolvency law . In some countries, such as the US and France, the rescue statute contemplates high legal intervention via micromanaged rules, via involvement of the court with a big fist. Other countries, such as Australia, leave the rescue statute open and free, minimalist. Who is right?

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Further information

If you have any queries relating to this article, please email Philip Wood or tel: +44 20 3088 2552.

Read more on Allen & Overy's Sovereign Debt Restructuring Group.