The legal risks for defaulting sovereigns have multiplied in recent decades. Since the mid-2000s, one in two defaults was accompanied by litigation, compared to less than 10 percent in the 1980s and early 1990s. The claims under dispute have grown from close to zero to an average of 3 percent of re-structured debt. As a result, it is now increasingly difficult to resolve debt crises and negotiate debt relief.
Those are findings of an empirical study co-produced by the Kiel Institute and published as a Kiel Working Paper (Sovereign Defaults in Court) and abridged in German in the Kiel Institute series Kiel Focus (Staatsbankrotte und die rechtlichen Folgen: Wie Anlegerklagen den Markt für Staatsanleihen verändern). The study is based on court documents relating to 158 litigation cases against 34 defaulting sovereigns filed by private creditors in the US or UK between 1976 and 2010. “The data illustrates a major shift in the legal framework of sovereign debt markets since the early 1990s, as specialized hedge funds have become increasingly active,” said co-author Christoph Trebesch, Head of International Finance and Global Governance at the Kiel Institute.
“These investors buy government debt at a discount in the secondary market and then sue for full repayment.” Hedge funds now account for two-thirds of all new lawsuits, which are typically larger and more protracted than those of other creditors. “Hedge funds are more aggressive and more likely to attach sovereign assets abroad or use other enforcement mechanisms,” added Trebesch.
Argentina is perhaps the most prominent example. After a 15-year legal battle, the most tenacious of its creditors prevailed before a New York court, forcing the Argentine government into a settle-ment of more than 10 billion US-Dollar.
Big profits for a few creditors
According to the study, creditor litigation and holdout creditors can often have serious negative consequences for the defaulting state. Legal disputes can lead to a financial embargo, with credi-tors gaining the right to effectively block the defaulting sovereign’s access to international capital markets. Based on recent case law, this could also affect debt and interest payments on existing bonds that are processed through US banks.
“Creditor litigation can lead to attachment of assets and loss of access to international capital mar-kets,” said Trebesch. This view is supported by the empirical data. Often, defaulting governments cease placing sovereign bonds in London or New York for a number of years. The governments in question include major issuers who normally borrow foreign capital on a regular basis, e.g., Argentina, Brazil, and Peru.
“As a result, debt crises are more difficult to resolve as creditor litigation can prevent an orderly restructuring and the associated fresh financial start,” said Trebesch. “Most of the cost is borne by the population of the defaulting country, which is hit by a financial embargo and has to repay the debt while a small number of creditors make substantial profits.”
A sovereign insolvency framework is required
A number of case studies indicate that the growing risk of litigation can increase the willingness of defaulting sovereigns to repay their debts to private creditors. Greece, for example, which had its debt restructured in 2012, decided to repay the holdouts in these bonds in full, allowing them to escape the haircut imposed on all other creditors and avoid having to go to court. The resulting transfers amounted to more than 2 percent of Greek GDP.
Venezuela continued to service all bonds issued in the United States in full until the end of 2017—despite several years of humanitarian crisis and having defaulted on most of its other creditors. “Venezuela prioritized its foreign debt bonds, as it feared that lawsuits in New York would lead to the seizure of oil shipments and refineries abroad,” commented Trebesch.
Looking ahead, there are few reasons to assume that the legal risk on sovereign debt will decrease soon, according to the authors. Recent hedge fund successes in Argentina and Greece have drawn attention to the distressed sovereign debt market. Moreover, the introduction of sovereign debt restructuring clauses in their current form is unlikely to resolve the problem in the foreseeable future. The authors recommend moving toward a more orderly framework for sovereign insolvency and new collective action clauses (CACs) with a simplified, one limb voting rule, as currently being discussed in Europe. These measures could significantly reduce the macroeconomic costs of sovereign debt crises and protracted litigation.