How creditor lawsuits are reshaping sovereign debt markets

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[size=0.9em]The legal cost of default: How creditor lawsuits are reshaping sovereign debt markets

[size=0.9em]Julian Schumacher, Christoph Trebesch, Henrik Enderlein 16 July 2018

[size=0.9em]For centuries, sovereign debt was assumed to be ‘above the law’ and non-enforceable. This column shows that this is no longer the case. Building on a new dataset on sovereign debt lawsuits, it documents the erosion of sovereign immunity since the 1970s and argues that legal disputes can disrupt government access to international capital markets, as foreign courts impose a financial embargo on defaulting sovereigns. These legal developments have strengthened the hands of creditors and raised the cost of default for debtors, with far-reaching consequences for government willingness to pay and the resolution of debt crises.

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关键词：Sovereign Reshaping Lawsuits Markets Shaping

For much of history, sovereign debt was assumed to be ‘above the law’ and non-enforceable (e.g. Eaton and Gersovitz 1981, Grossman and van Huyck 1988). Defaulting governments were protected by the principle of sovereign immunity and there is no supranational legal authority to enforce repayment (Panizza et al. 2009). As a result, creditors had few options but to accept a sovereign default if it happened, and to hope for the best.

The Argentine debt crisis of 2001 and its aftermath, however, illustrates a major shift in the legal framework of international sovereign debt markets. Following the default, dozens of hedge funds filed suit against Argentina in New York and litigated for full repayment. Fifteen years later, these holdout creditors prevailed and a favourable court ruling forced the government into a settlement of more than $10 billion – a multiple of the debt’s face value (Cruces and Levy Yeyati 2016, Hébert and Schreger 2017).

As we show in this column and related research, the case of Argentina is not an exception but part of a general trend (Schumacher et al. 2015, 2018). Since at least the 1970s, sovereign immunity has eroded and banks and specialised hedge funds have been increasingly successful in suing defaulting countries in courts in the US and the UK. Legal risks in this market have increased – with significant economic consequences for distressed sovereigns. Most importantly, we find that litigation disrupts government access to international capital markets.

Our research relates to an ongoing policy debate on the international financial architecture and on euro area reform. Holdout and litigation risks are widely discussed, but evidence and hard data remains scarce. For example, several official actors recognise that creditor litigation can be a serious obstacle to resolving sovereign debt crises and for the functioning of international payment systems (e.g. US Government 2012, IMF 2013, United Nations 2014). For Europe, Buchheit et al. (2013) and Bénassy-Quéré et al. (2018) have proposed a sovereign debt restructuring framework, partly to deter holdouts and protracted legal battles. At the same time, private investors such as Elliott (Financial Times2013) or the rating agency Moody’s (2013) claim that the holdout problem is overdone and that litigation remains an exception. We inform this discussion by providing stylised facts on creditor litigation and its externalities across four decades.

The rise of creditor litigation and asset attachments – not just Argentina

Our research clearly shows that the holdout problem and litigation risks are not being exaggerated and should become part of our understanding of international capital markets.

The analysis builds on a comprehensive new dataset. We coded all events of sovereign debt litigation filed in the US and the UK between 1976 and 2010. The data show that since the mid-2000s, one in two defaults was accompanied by litigation, compared to less than 10% in the 1980s and early 1990s (see Figure 1). The claims under dispute have grown from close to nil to an average of 3% of restructured debt. Our case archive, based on direct coding from court documents, identifies 158 litigation cases against 34 defaulting sovereigns filed in the US or UK between 1976 and 2010. This is a lower bound since we focus on lawsuits by institutional investors and avoid double counting.

Figure 1 The rise of sovereign debt litigation: restructurings with and without litigation

Note: This figure shows the number of sovereign debt restructurings implemented in each year (left axis, light bars) and the subset of these restructurings that involved at least one creditor lawsuit in a US or UK court (dark bars). The black line shows the ratio of debt restructurings affected by litigation (in % of all restructurings, as five-year moving average, right axis).

Our case archive also shows that the market changed fundamentally in the early 1990s. A new type of plaintiff emerged: specialised distressed debt funds, which often buy debt at a discount and then sue for full repayment. Hedge funds now account for two-thirds of all new cases. The lawsuits they file are typically larger, less likely to be settled early on, and involve multiple attempts to attach sovereign assets abroad or interrupt the government’s capital market access.

Figure 2 Sovereign debt lawsuits with attachment attempts

Note: This figure shows pending sovereign debt lawsuits that involved enforcement proceedings by year, between 1975 and 2010, either as number of cases (bars, left axis) or as a share of all pending cases (line, right axis, as five-year moving average). Enforcement proceedings include both pre- and post-judgments actions. In recent years, more than 50% of creditors made at least one attempt to seize sovereign assets abroad.

Litigious creditors rarely wait for the satisfaction of their claims in court. Instead, they attempt to pressure the defaulting government into an out-of-court settlement at profitable terms. Since the 1980s, the most successful approach to achieve such settlements have been threats to disrupt international capital flows, meaning legal proceedings that enable creditors to interject cross-border financial transactions. Figure 2 shows that the share of lawsuits involving enforcement proceedings has increased from close to zero in the 1980s to 30-50% in the 2000s.

Litigation can block access to international capital markets

Creditor litigation needs to be taken seriously if it has economic consequences. Guided by the theoretical literature, our analysis focuses on the impact on international borrowing. We therefore combine our litigation dataset with micro-level data on sovereign external bond and loan placements since the 1980s. Our main finding is that legal disputes are a strong predictor of market exclusion, over and above the default effect per se. During years with attachment attempts by creditors, sovereign external issuance drops close to zero. Between 2000 and 2010, there is not a single instance in which a government facing a creditor lawsuit in the UK or US also placed a sovereign bond in these jurisdictions.

For illustration, consider Figure 3, which focuses on the case of Argentina. The country was among the most active emerging market issuers during the 1990s. After the default of 2001, however, the government did not place a single sovereign bond in international markets for 14 years. The private sector, in contrast, re-accessed foreign bond markets on a regular basis starting in late 2003, when economic conditions improved. The evidence suggests that sovereign litigation impairs sovereign market access, but not that of corporations.

Case studies provide further support for the channel at work: litigious hedge funds managed to block cross-border debt flows via legal means not only in Argentina but also in many other cases, such as in Costa Rica, Panama or Peru in the 1990s and 2000s, where debt issuances were delayed or cancelled due to creditor legal action.

Figure 3 Foreign borrowing in Argentina: Sovereign vs corporate bonds

Note: This figure shows the volume of bonds placed by the Argentine government (dark bars) and private Argentine companies (light grey bars) between 1997 and 2010 by quarter. Both the government and private firms were active borrowers in the 1990s. After the 2001 default, only the private sector returned to issuing bonds internationally. The loss of market access by the Argentine government coincides with 50 lawsuits filed by commercial investors over the past decade.

For much of history, sovereign debt was assumed to be ‘above the law’ and non-enforceable (e.g. Eaton and Gersovitz 1981, Grossman and van Huyck 1988). Defaulting governments were protected by the principle of sovereign immunity and there is no supranational legal authority to enforce repayment (Panizza et al. 2009). As a result, creditors had few options but to accept a sovereign default if it happened, and to hope for the best.

The Argentine debt crisis of 2001 and its aftermath, however, illustrates a major shift in the legal framework of international sovereign debt markets. Following the default, dozens of hedge funds filed suit against Argentina in New York and litigated for full repayment. Fifteen years later, these holdout creditors prevailed and a favourable court ruling forced the government into a settlement of more than $10 billion – a multiple of the debt’s face value (Cruces and Levy Yeyati 2016, Hébert and Schreger 2017).

As we show in this column and related research, the case of Argentina is not an exception but part of a general trend (Schumacher et al. 2015, 2018). Since at least the 1970s, sovereign immunity has eroded and banks and specialised hedge funds have been increasingly successful in suing defaulting countries in courts in the US and the UK. Legal risks in this market have increased – with significant economic consequences for distressed sovereigns. Most importantly, we find that litigation disrupts government access to international capital markets.

Our research relates to an ongoing policy debate on the international financial architecture and on euro area reform. Holdout and litigation risks are widely discussed, but evidence and hard data remains scarce. For example, several official actors recognise that creditor litigation can be a serious obstacle to resolving sovereign debt crises and for the functioning of international payment systems (e.g. US Government 2012, IMF 2013, United Nations 2014). For Europe, Buchheit et al. (2013) and Bénassy-Quéré et al. (2018) have proposed a sovereign debt restructuring framework, partly to deter holdouts and protracted legal battles. At the same time, private investors such as Elliott (Financial Times2013) or the rating agency Moody’s (2013) claim that the holdout problem is overdone and that litigation remains an exception. We inform this discussion by providing stylised facts on creditor litigation and its externalities across four decades.

The rise of creditor litigation and asset attachments – not just Argentina

Our research clearly shows that the holdout problem and litigation risks are not being exaggerated and should become part of our understanding of international capital markets.

The analysis builds on a comprehensive new dataset. We coded all events of sovereign debt litigation filed in the US and the UK between 1976 and 2010. The data show that since the mid-2000s, one in two defaults was accompanied by litigation, compared to less than 10% in the 1980s and early 1990s (see Figure 1). The claims under dispute have grown from close to nil to an average of 3% of restructured debt. Our case archive, based on direct coding from court documents, identifies 158 litigation cases against 34 defaulting sovereigns filed in the US or UK between 1976 and 2010. This is a lower bound since we focus on lawsuits by institutional investors and avoid double counting.

Figure 1 The rise of sovereign debt litigation: restructurings with and without litigation

Note: This figure shows the number of sovereign debt restructurings implemented in each year (left axis, light bars) and the subset of these restructurings that involved at least one creditor lawsuit in a US or UK court (dark bars). The black line shows the ratio of debt restructurings affected by litigation (in % of all restructurings, as five-year moving average, right axis).

Our case archive also shows that the market changed fundamentally in the early 1990s. A new type of plaintiff emerged: specialised distressed debt funds, which often buy debt at a discount and then sue for full repayment. Hedge funds now account for two-thirds of all new cases. The lawsuits they file are typically larger, less likely to be settled early on, and involve multiple attempts to attach sovereign assets abroad or interrupt the government’s capital market access.

Figure 2 Sovereign debt lawsuits with attachment attempts

Note: This figure shows pending sovereign debt lawsuits that involved enforcement proceedings by year, between 1975 and 2010, either as number of cases (bars, left axis) or as a share of all pending cases (line, right axis, as five-year moving average). Enforcement proceedings include both pre- and post-judgments actions. In recent years, more than 50% of creditors made at least one attempt to seize sovereign assets abroad.

Litigious creditors rarely wait for the satisfaction of their claims in court. Instead, they attempt to pressure the defaulting government into an out-of-court settlement at profitable terms. Since the 1980s, the most successful approach to achieve such settlements have been threats to disrupt international capital flows, meaning legal proceedings that enable creditors to interject cross-border financial transactions. Figure 2 shows that the share of lawsuits involving enforcement proceedings has increased from close to zero in the 1980s to 30-50% in the 2000s.

Litigation can block access to international capital markets

Creditor litigation needs to be taken seriously if it has economic consequences. Guided by the theoretical literature, our analysis focuses on the impact on international borrowing. We therefore combine our litigation dataset with micro-level data on sovereign external bond and loan placements since the 1980s. Our main finding is that legal disputes are a strong predictor of market exclusion, over and above the default effect per se. During years with attachment attempts by creditors, sovereign external issuance drops close to zero. Between 2000 and 2010, there is not a single instance in which a government facing a creditor lawsuit in the UK or US also placed a sovereign bond in these jurisdictions.

For illustration, consider Figure 3, which focuses on the case of Argentina. The country was among the most active emerging market issuers during the 1990s. After the default of 2001, however, the government did not place a single sovereign bond in international markets for 14 years. The private sector, in contrast, re-accessed foreign bond markets on a regular basis starting in late 2003, when economic conditions improved. The evidence suggests that sovereign litigation impairs sovereign market access, but not that of corporations.

Case studies provide further support for the channel at work: litigious hedge funds managed to block cross-border debt flows via legal means not only in Argentina but also in many other cases, such as in Costa Rica, Panama or Peru in the 1990s and 2000s, where debt issuances were delayed or cancelled due to creditor legal action.

Figure 3 Foreign borrowing in Argentina: Sovereign vs corporate bonds

Note: This figure shows the volume of bonds placed by the Argentine government (dark bars) and private Argentine companies (light grey bars) between 1997 and 2010 by quarter. Both the government and private firms were active borrowers in the 1990s. After the 2001 default, only the private sector returned to issuing bonds internationally. The loss of market access by the Argentine government coincides with 50 lawsuits filed by commercial investors over the past decade.

Holdout risks since 2010: A summary

Since Argentina’s default, the relevance of legal risks has only continued to increase. Governments in distress now frequently point to holdouts risks and litigation when explaining their policy choices, and the same is true for rating agencies justifying up- or downgrades. In line with this, our case studies confirm that holdouts and legal threats played a prominent role in many recent sovereign debt crises:

• Greece faced legal threats regarding its foreign-law bonds in 2012 and decided to repay the holdouts in these bonds in full, allowing them to escape the haircut imposed on all other creditors (the resulting transfers amounted to more than 2% of Greek GDP; Zettelmeyer et al. 2013).
• The Republic of Congo defaulted in August 2017, when a creditor convinced a New York court to freeze a bond coupon payment.
• Puerto Rico, a non-sovereign US territory, was confronted with large-scale creditor litigation in its ongoing debt crisis but was shielded from such legal action via the 2016 PROMESA legislation enacted by the US Congress. The law was intentionally designed “to remove the damaging uncertainty of protracted litigation that threatens to further destabilize the economy", according to former US Finance Minister Jacob Lew (2016).
• Ukraine is currently being sued by Russia over a defaulted bond in a London court. In 2015, Russia threatened to legally force all of Ukraine's international bonds into default.
• Venezuela has been in a humanitarian crisis for years and defaulted on most of its external and internal creditors. International bondholders, however, continued to be serviced fully until September 2017. Many observers see legal risks as the main reason why Venezuela treated its foreign bondholders so favourably (e.g. Economist 2017). In particular, the government feared that creditor lawsuits and attachment attempts might endanger oil exports – the country's main source of income.
  

Looking ahead: Legal risks are here to stay

We conclude that sovereign debt litigation is reshaping international sovereign debt markets in a fundamental way. Courts in foreign jurisdictions increasingly act as a third-party enforcement mechanism as they can explicitly or implicitly impose a financial embargo on defaulting sovereigns. The consequences are already starting to show, as legal risks have influenced the resolution of recent debt crises and governments' willingness to pay, in Argentina, Greece, Venezuela, and beyond.  

Looking ahead, there are few reasons to assume that the legal risk on sovereign debt will decrease soon. Recent hedge fund successes in Argentina and Greece have drawn attention to the distressed sovereign debt market. Moreover, the most widely discussed policy reforms – such as newly designed collective action clauses (CACs) – are unlikely to fully prevent holdout litigation in future debt crises. It may take more than a decade until newly added clauses will disseminate throughout the debt stock. Moreover, even with CACs, at least such as those introduced in euro area sovereign bonds after 2013, it will remain possible to buy blocking stakes in individual series in order to hold out and file suit.

Authors’ note: This column should not be reported as representing the views of the ECB. The views expressed are those of the authors and do not necessarily reflect those of the ECB.

References

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Eaton, J, and M Gersovitz (1981), “Debt with Potential Repudiation: Theoretical and Empirical Analysis”, Review of Economic Studies 48(2): 289-309.

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