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What Happens if a Sovereign Defaults

What Happens if a Sovereign Defaults

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Published by: ruthless_gravity on Jul 20, 2011
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 S  ov e ei   gnD e b W aH a p p en s S  ov e ei   gnD e a ul   s S  p e ci   al   C  omm en
July 2000
ContactPhone
New York 
Farisa Zarin1.212.553.1653Vincent TrugliaDavid LeveyChris Mahoney
Summary
For the first time in 50 years, the international bond market is confronted with sovereigndefaults. As each default, or near default, occurs, we at Moody’s are being asked a series of ques-tions that run common among the various situations.One area of growing interest is the extent of a creditor’s legal rights vis-à-vis the sovereignissuer. To put it simply: in case of a default or a restructuring, can a sovereign issuer be com-pelled to make good on its original debt obligations? This line of questioning is particularly ger-mane, as the threat of legal action could alter the underlying incentives of creditors and the sov-ereign debtor, which in turn could affect restructuring negotiations. Although the purpose of this comment is to try and shed some light on the relevant issues, itshould be noted at the very outset that Moody’s neither professes nor assumes expertise in inter-national law. The notions presented here are simply a restatement of the various sovereignimmunity statutes, relevant court cases, legal scholarship, and customary practice as it has devel-oped over the past years. This caveat notwithstanding, we will try to reply to five very specificquestions that have repeatedly been asked of us:
1)Can a holder of sovereign debt sue a sovereign in case of a default or a restructur-ing?
Quick and dirty answer:
 Yes. If the creditor was not party to the restructuring agree-ments and still retains full rights under the original terms of the debt, it can sue the sov-ereign.
continued on page 3
Sovereign Debt:What Happens If A Sovereign Defaults?
Special Comment 
 
2
Moody’s Special Comment 
 © Copyright 2000 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved.
ALL INFORMATION CONTAINED HEREIN ISCOPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISEREPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FORANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIORWRITTEN CONSENT.
All information contained herein is obtained by
MOODY’S
from sources believed by it to be accurate and reliable. Because of the possibility ofhuman or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and
MOODY’S
, in particular, makes norepresentation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information.Under no circumstances shall
MOODY’S
have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to,any error (negligent or otherwise) or other circumstance or contingency within or outside the control of
MOODY’S
or any of its directors, officers, employees or agents inconnection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct,indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if
MOODY’S
is advised in advance of thepossibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information containedherein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities.
NOWARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OFANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER.
Each rating or otheropinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user mustaccordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it mayconsider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933,
MOODY’S
hereby discloses that most issuers of debt securities (includingcorporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by
MOODY’S
have, prior to assignment of any rating, agreed to pay to
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for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.
Author
Farisa Zarin 
Editor
Susan Schwartz 
Senior Production Associate
Mark A. Lee 
 
Moody’s Special Comment 
3
2)Given the availability of legal recourse, can a holder of bonds (or bank loans) realisticallyexpect to get monetary compensation?
Quick and dirty answer:
It depends. Like most contractual obligations, many questions can beanswered through a close reading of the language of the instrument. But, on a very general level, aclaimant can recover through legal channels if: a) the sovereign has assets in the country whereinthe suit is brought; and, b) those assets are directly associated with the defaulting instrument.Needless to say, there are many factors that complicate the matter.
3)How does sovereign debt become more vulnerable to legal attack?
Quick and dirty answer:
Sovereign debt is generally governed by either New York State law orEnglish law. With very few exceptions, issuers of bonds will adopt the documentation practicesprevailing in the jurisdiction whose law is chosen to govern the bond and related documents.Generally speaking, New York law bonds do not permit debt rescheduling without the consent of all creditors. By contrast, English law bonds allow changes to payment terms when those changesare accepted by a supermajority of bondholders. Once the changes are approved, the restructuringterms are binding on all creditors. The absence of the supermajority clause in a debt instrumentleaves the sovereign more susceptible to legal attack, as the sovereign cannot “cram down” arestructuring agreement on stubborn creditors.
4)Who would sue a sovereign?
Quick and dirty answer:
 The most likely candidates are secondary purchasers of sovereign debtand small bond-holders. Generally referred to as the “free-rider problem,” legal claims against sov-ereigns are brought by creditors who do not participate in restructuring talks and who hold out onthe payment rescheduling decision of the majority of debt holders. If the particular instrument doesnot have a supermajority clause, which crams down the new terms on the dissenting minority,uncooperative creditors remain in possession of their legal rights to force the sovereign into com-plying with the original terms of the debt. They should be able to sue in most cases.
5)Could a proliferation of lawsuits alter the incentives of creditors and sovereigns to lend,borrow, and restructure?
Quick and dirty answer:
 As the bond market and the secondary debt market gain significance forsovereigns, the threat of suits increases. To date, claims against defaulting states have not madetheir way up through the US appellate system (i.e. the U.S. Supreme Court) because a binding judgment would ill serve the interests of either party. In fact, the standard course for legal actionseems to be settling out of court. Traditionally, major lenders, specifically London Club banks andthe IMF, have had long-term interests, which made rescheduling an attractive alternative to sover-eign default. However, the proliferation of small, speculative creditors, interested in quick-fixreturns, place debtor-sovereigns at greater risk of suits. The emphasis on the short-term, asopposed to the long-term, perspective may re-focus negotiation talks on the interests of all con-cerned parties, especially the small creditor.
I.WHAT IS SOVEREIGN IMMUNITY?
 A sovereign debtor is not the same as any other type of debtor. The same rules do not apply because his-torically sovereigns have had rights, which were, in essence, absolute in nature. Black’s Law Dictionary defines sovereignty as:“The supreme, absolute, and uncontrollable power by which any independent state is governed. … The power to do everything in a state without accountability, - to make laws, to execute and toapply them, to impose and collect taxes and levy contributions, to make war or peace, to formtreaties of alliance or of commerce with foreign nations, and the like.”
1
1Black’s Law Dictionary, Sixth Edition, pg. 1396 (1990).

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