Pari Passu and a Distressed Sovereign's Rational Choices

Abstract

This Article interrogates the possibility that pari passu clauses in sovereign debt contracts legitimately can be read broadly so as to require pro rata payments to foreign creditors by sovereigns in default and forbid payments to favored classes of creditors. Many subscribe to a narrow interpretation, under which the clauses cover only contractual and legal priorities and do not regulate payments. The narrow interpretation makes sovereign debt compositions easier to conclude by depriving holdout creditors of a disruptive enforcement tool, arguably benefiting the bondholders as a group. This Article highlights benefits for the bondholders as a group under the broad reading, shifting to an ex ante time perspective and situating the clause in the economic context of sovereign lending. Debt contracts benefit sovereign bondholders in three ways when they create frictions that retard later compositions. First, the contracts diminish the likelihood of default by opportunistic sovereigns seeking to externalize the effects of economic reverses. Second, assuming severe financial distress, they make it less likely that the defaulting sovereign will attempt to impose the burden of restructuring on the particular class of bonds. Third, assuming a restructuring, they improve the bondholders' bargaining position. More generally, the pari passu clause, read broadly, constrains the distressed sovereign's range of choices, enhancing the enforcement power of the bonds, and arguably lowering the long run cost of sovereign debt capital. The Article depicts sovereign debt as a world of tradeoffs and contradictions, where a contract that makes the bondholders better off means one thing on the day it is executed and delivered and another thing in the event of severe distress later on. With private debt, such contradictions are surmounted through the intervention of the bankruptcy regime. With sovereign debt there is no bankruptcy, forcing the parties to paper over the tensions between ex ante and ex post by drafting vaguely. Intractable questions of interpretation arise in consequence. From this perspective, judicial attachment of the broad reading can be justified without being dictated and without the narrow reading being rendered implausible or illegitimate. The interpreting court must choose between the readings under uncertainty.