Contract hope and sovereign redemption

Abstract

Sovereign immunity has served as a partial substitute for bankruptcy protection, but it has encouraged a minority of creditors to pursue unorthodox legal remedies with spillover effects far beyond the debtor-creditor relationship. The attempt to enforce Argentina’s pari passu clause in New York is an example of such a remedy, which relies primarily on collateral damage to other creditors and market infrastructure to obtain settlement from a debtor that would not pay. The District Court decision, now on appeal before the Second Circuit, may not make holding out more attractive in future restructurings – but it would make participation less attractive for creditors, and create uncertainty for trustees, clearing and payments systems. Contractual innovations that support debt restructuring, such as collective action clauses (CACs), will not diminish the impact of the remedy for the foreseeable future, among other reasons because they are not designed to work across the debt stock. The Greek debt restructuring, where over half of the foreign-law issues with CACs failed to clear the voting threshold, is a case in point. The latest pari passu episode illustrates the challenge of a purely contractual framework for debt restructuring: interpretation uncertainty, institutional barriers to contract change, and a well-resourced constituency with every incentive to take advantage of the combination, make for an irreducible risk. Options going forward range from contract reform to reviving treaty-based sovereign bankruptcy. The former will be slow and incomplete; the latter has dim political prospects. If the District Court decision stands, it strengthens the hand of sovereign bankruptcy proponents. This article suggests a mix of contractual and institutional reform focusing on financial markt infrastructure, as an interim fix for what remains a deeply dysfunctional regime.