Thursday, September 10, 2020
The economic devastation caused by the Covid-19 pandemic is global, but the effects are magnified in poorer countries. There is an urgent need to divert resources away from debt service and towards pandemic mitigation. Countries that mostly owe money to official lenders—i.e., the poorest countries—can get some short-term relief courtesy of the Debt Service Suspension Initiative (although few have taken advantage of this opportunity). But countries with significant private-sector debts—especially the so-called emerging markets—are in a different kind of bind. Tourism revenue, remittances, tax collection… all are down sharply, while spending needs have increased. Even a small contraction in global liquidity will push many countries into unsustainable debt situations. Some are already there.
Unfortunately, no mechanism exists to coordinate the orderly restructuring of debts on this scale. Official creditors can coordinate their response to a debt crisis—not without friction, but with relative ease. Not so for dispersed private creditors. Here, the restructuring landscape consists of flawed contractual mechanisms that require each country to negotiate restructuring terms with creditors with diverse incentives, debt instruments, and legal rights. It is a recipe for disaster. Lawyers and financial advisors will do well; everyone else will suffer.
We start from the premise that, as in bankruptcy, a stay on creditor enforcement activity will reduce the chaos surrounding restructuring talks. More important, in the present context, a stay will allow countries to divert funding to deal with the combined economic and health crisis of the pandemic. A stay may not prove necessary; most private creditors would prefer not to be seen suing a country mired in a pandemic. But creditors are heterogeneous and, as time goes on, cohesion will break down. When this happens, is there a legal basis for imposing a stay?
One possibility is the doctrine of economic necessity. This is a doctrine of customary international law and might have purchase in jurisdictions that generally incorporate international law dictates into domestic law, such as the United States and United Kingdom. As a caution, sovereigns have occasionally raised economic necessity in prior debt cases, almost always without success. And to our knowledge, the doctrine has never been successfully asserted in a U.S. or U.K. municipal court (and the courts and law of New York and England are the ones that matter for almost all emerging market foreign borrowing). Indeed, because the defense evolved in the context of “international obligations,” it is not even clear that the doctrine excuses non-performance of private contractual obligations of the sort that concern us here. But there is reason to think these problems can be overcome and that the defense might be available in the present context (discussed in this paper).
Under Article 25 of the International Law Commission’s (“ILC”) draft Articles on Responsibility of States for Internationally Wrongful Acts, a state may invoke necessity to excuse its non-performance of an “international obligation” if non-performance is the only way to address “a grave and imminent peril,” as long as non-performance does not seriously impair an essential interest of the “State or States towards which the obligation exists.” As the wording suggests, the scope of the doctrine is narrow. The peril must be grave and must outweigh the risks to other states. Even then, a state may not invoke necessity to excuse the violation of an international obligation that “excludes the possibility of invoking necessity.” Nor, for that matter, may it invoke the defense if has contributed to the state of necessity. Finally, non-performance is excused only while the threat persists. The state must resume performance when the crisis ends, and it may have to pay compensation.
Local mismanagement has contributed to almost every sovereign debt crisis in our lifetimes—probably to every sovereign debt crisis there has ever been. So one might think that the necessity defense would never be available (in much the same way that borrowers are essentially never able to raise the contract law excuse of impracticability). This has mostly been the reaction of tribunals when a sovereign has raised necessity in the context of a debt default.
As we understand these decisions, they are primarily concerned with the difficulty of verifying the existence of a state of necessity. Tribunals understand that a doctrine that excuses nonperformance also creates room for opportunism. How can judges or arbitrators tell whether conditions in a debtor state are so bad that failure to ameliorate them will cause a humanitarian disaster? How can they tell whether the debtor state is blameless for the conditions? If tribunals cannot accurately answer these questions, their errors will disrupt the smooth functioning of debt markets. And in the cases thus far, the tribunals have not been confident of the answers, and the defense has failed.
But the Covid-19 pandemic may be the exception. It is hard to blame any emerging market nation for the economic and humanitarian fallout of the pandemic. To be sure, some have worsened the situation (as have some very rich countries). And there is always second guessing of government policies. But in most or all cases, the pandemic itself will swamp other contributing factors. Moreover, unlike in other settings, here there is reason to think that official sector actors can effectively certify that a state of necessity exists—this is the clear implication of the G-20’s Debt Service Suspension Initiative, and the official sector can take other steps to make clear that there is an international consensus to this effect. These steps should ease concerns about the verifiability of the present state of necessity. Likewise, their absence in future cases will provide an easy way for tribunals to limit the precedential value of recognizing the necessity defense in the context of Covid-19.
We do not mean to suggest that the defense will be available to every country. Nor will every country wish to make the argument. However, for those in dire need, who want to avoid a debt default, this could be an option. A related argument—although not the defense itself—has been raised in a U.S. sovereign debt case involving Venezuela, Casa Express v. Republic of Venezuela. Perhaps the case will shed some light on the applicability of the doctrine in the U.S. But if a sovereign state must choose between paying international creditors or paying for a vaccine, the case for a necessity defense strikes us as clear. In such cases, the sovereign’s non-payment should be excused during the period of necessity, and bondholders should not be allowed to use non-payment as a basis for accelerating the debt.
A week or so ago, we discussed the doctrine of economic necessity with Eric Posner on our Clauses and Controversies podcast. Rightly, we suspect, he cautioned that it will be a heavy lift to persuade a municipal court to apply the doctrine. As Eric pointed out, the doctrine is vague with undefined contours. And no judge in these two jurisdictions wants to take steps that might devalue their status as financial capitals. One implication is that judicial decisions may be heavily shaped by the views expressed by the U.S. and U.K. governments. (We suppose it would also help if government officials cared about the real domestic economy and about people in poorer countries. Also: we each want a pony.)
A final note: As others have pointed out, there are other legal techniques that judges have used to deal with related situations. Dave Hoffman and Cathy Hwang discuss a fascinating set of public health cases from the late 1800s and early 1900s (here and discussed in this previous post; and also listen to the Hoffman & Wilkinson-Ryan podcast on the Hanford baby exhibition here, discussed in this previous post). Jonathan Lipson looks to the equally interesting depression era cases, some of which directly deal with our favorite topic of sovereign debt contracts (here). And Emily Strauss has written about courts taking fairly radical steps in reforming certain contracts in the aftermath of the 2007-08 crisis (here).