April 20, 2022
Mark Weidemaier, University of North Carolina at Chapel Hill, and Mitu Gulati, University of Virginia School of Law
Even before the Russian invasion of Ukraine, sovereign debt markets were poised for a period of instability and uncertainty from the pandemic, climate-related risks, and the unwinding of stimulus programs in rich countries. The global economic fallout from the invasion will make matters worse. As ever at such times, there are calls to consider whether the international financial architecture is adequate to manage the potential sovereign debt crises. One of the key institutions in this architecture is the institution of contract, and that is our focus here.
More specifically, we are interested in the international bonds issued by the Russian Federation. At the time of this writing, because of the U.S.-led sanctions regime, the Russian government has sought to pay some of its foreign-currency debt in rubles, and is expected to keep trying to do so. Somewhat surprisingly, it is not clear that paying dollar- and euro-denominated debt in rubles will constitute a default, at least for a subset of the debt. The reason is that the Russian bond contracts include the strangest and most perplexing set of clauses we have seen in some time. It is hard to tell whether these unusual clauses represent drafting goofs, clever exploitation by Russia and its advisors of investors’ penchant for not reading the contracts they buy, or some combination of the two. But one thing is clear: if these contracts are any guide, the contract architecture of sovereign debt markets has a long way to go before it can hope to provide predictable rules for handling sovereign defaults.
The clauses we discuss below appear in only a subset of Russia’s sovereign bonds. For simplicity, we will quote from the November 18, 2020 prospectus for euro bonds due 2027 and 2032.
The Alternative Payment Currency Clause
This clause appears in a subset of the Russian Federation international bonds. It lets the government pay in another currency if, “for reasons beyond its control,” it cannot come up with any of the foreign currencies specified for repayment. In a euro bond, for example, the alternative currencies are U.S. dollars, pounds sterling or Swiss francs. If one of these currencies is not available—again, “for reasons beyond its control”—the Russian Federation can pay in rubles.
We have not seen a clause like this in other sovereign bonds. And we do not know what makes a reason “beyond the control” of the Russian Federation in case it finds itself “unable to pay” in the specified currency. Presumably the fact that Vladimir Putin has forbidden something—such as paying dollars directly out of the Russian treasury—does not make it beyond the control of the government; he can choose not to forbid it. But could Russia plausibly argue that it is unable to pay because of western sanctions, which are beyond its control? A creditor might assume that courts in New York or London would be skeptical of this argument, at least if those courts take jurisdiction over the dispute (a subject we address below). After all, the Russian government’s invasion of Ukraine prompted the sanctions, and it seems reasonable to assume that the Russian government can also get the sanctions lifted if it turns its tanks around. More to the point, it is extremely unusual for investors in international bonds to assume currency risk in this fashion. As we have written elsewhere, the contracts imply that investors have agreed to assume the risk of sanctions that deny the Russian government access to foreign exchange—in other words, that investors have implicitly agreed to finance Russian actions against the policies of the investors’ own governments.
The Bizarre Pari Passu Clause
Most sovereign bonds include a clause providing that the bonds will “rank equally” with other, defined kinds of indebtedness. This pari passu clause has been the subject of much discussion and litigation, notably involving Argentina. Famously, the district judge overseeing that litigation entered an injunction forbidding Argentina to pay holders of its restructured debt unless it also paid holdout creditors in full. These decisions were upheld by the appeals court in 2012 and 2013.
Russia’s pari passu clause has some provisions that are remarkably favorable to investors. Most notably, the clause (quoted below) provides that the bonds will rank pari passu with essentially any unsecured and unsubordinated obligation of the government. The typical clause extends protection only to obligations denominated in foreign currency. The Russian clause includes no such limitation. Payments in local currency to local creditors—say, wages paid to Russian soldiers—might violate the clause, at least in some cases. Moreover, in the wake of the injunction against Argentina, most countries amended their bond contracts to incorporate protective language disclaiming the interpretation adopted by the courts in New York (e.g., “this provision shall not be construed so as to require the Issuer to make payments under the Bonds ratably with payments being made under any other External Indebtedness”). The Russian Federation did not incorporate such protective language.
However, around 2012 or 2013, the Russian Federation did introduce a bizarre modification to its pari passu clause. Below, we reprint the clause in a way that depicts these changes. We depict new text in bold, underlined typeface and strike out text that had appeared in prior versions of the clause but was deleted in the new version:
The Bonds constitute direct, unconditional, unsecured and unsubordinated obligations of the Russian Federation and the full faith and credit of the Russian Federation is pledged for the due and punctual payment of principal of, and interest on, the Bonds and for the performance of all other obligations of the Russian Federation pursuant to the Bonds. As at their date of issue, the Bonds
shall at all timesrank pari passu without any preference among themselves and at leastpari passu in all respectswith all other present and futureunsecured and unsubordinated obligations of the Russian Federation.
Again, the clause is bizarre. The typical pari passu clause is both a representation and a covenant. That is, a statement of fact about how the bonds presently rank and a commitment to maintain that ranking in the future. The new clause arguably makes a representation only. It deletes verb conjugations in the future tense (“shall … rank”) as well as the reference to “future” obligations. The implication is that the government is free to subordinate investors later.
It is not certain that the clause will be construed as only a representation. Among other reasons, the Russian bonds make it an event of default if the “bonds do not rank pari passu… and any such failure to rank pari passu continues for” 60 days. The fact that the violation must be a continuing one implies that the obligation to maintain the bonds’ pari passu ranking is also a continuing one. But the pari passu clause has attracted more attention from drafters and readers of sovereign bond contracts than almost any other clause. It is extraordinary to find that such a heavily-examined clause can still leave such basic questions unanswered.
Payments Subject to Fiscal Laws. But Which Ones?
Another clause in the Russian bonds provides, “All payments of principal and interest in respect of the Bonds are subject in all cases to (i) any applicable fiscal or other laws and regulations…” This “payments subject to fiscal laws” clause is a bit less unusual; we have seen it in bonds by other sovereign issuers. (Amusingly, one of them is the $3 billion bond issued by Ukraine and held by Russia.) But it is still perplexing. The bonds issued by the Russian Federation provide for the application of English law. But “applicable” fiscal law cannot refer only to English law. Among other reasons, the payments subject to fiscal laws clause specifically references U.S. tax law in a part not quoted above. Perhaps “applicable” law is the law where the investor is located? Who knows. Here, the risk is that the clause might be interpreted to make payments subject to fiscal laws enacted by Russia itself. By failing to limit the “applicable” law to foreign law, the clause potentially lets the issuer enact legislation that keeps money away from bondholders.
In theory, bondholders are protected by another clause, the taxation clause, which provides that:
If at any time any Taxes are withheld or deducted from such a payment [of principal and interest] by the Russian Federation, the Russian Federation shall increase the payment of principal or interest, as the case may be, to such amount as will result in the receipt by the Bondholders of such amounts as would have been received by them had no such withholding or deduction been required . . .
This provision would seem to negate any attempt to tax away payments to bondholders by requiring the issuer to gross up the payment to account for the tax. However, the clause has an exception for bondholders “having some connection with the Russian Federation other than the mere holding of a Bond,” and this exception might eliminate the tax gross-up protection for some bondholders. Moreover, not all fiscal laws are tax laws: a law intended to protect the public fisc, or to regulate the government’s spending of public resources, might impede payments to bondholders without requiring a tax gross up.
Where to Adjudicate
We have been discussing these clauses as if disputes over their meaning will be resolved in the usual fashion for a sovereign bond—litigation in the courts of New York or London. But unlike most international sovereign bonds, the Russian Federation bonds contain neither a waiver of sovereign immunity nor a clause submitting the issuer to the jurisdiction of any foreign court. Nor do the bonds appoint an agent to receive service of process, making even that preliminary step to filing suit more expensive and cumbersome than that which investors face in the usual context. Assuming an investor wanted to sue to enforce its rights, where would it go?
We have discussed this question in other contexts (here and here). The short answer is that investors will likely be able to persuade courts in London, and perhaps New York, to take jurisdiction over a lawsuit—but it would take time, likely many months, which investors in a typical international sovereign bond save by securing a boilerplate submission to jurisdiction and a clause appointing an agent to receive judicial process. Moreover, the Russian bonds also do not waive the country’s sovereign immunity from execution on its assets. As a result, investors will face even greater trouble than usual enforcing any judgment they might receive. We do not think these barriers are total. Indeed, by blocking movement of many assets, the sanctions imposed by the U.S., U.K., and other countries may create opportunities for enforcement that would not otherwise be present. As a rule, however, investors are likely to find it much easier to obtain a judgment than to enforce it. (Indeed, once a court decides to take jurisdiction over the dispute, it is possible that the Russian government will not appear to contest the merits.) A few lucky investors may find a way to quickly convert a court judgment into a recovery. Most will be in for a long wait.
In sum, the Russian bonds leave key provisions ambiguous, do nothing to mitigate the delay and risk of enforcement, and potentially require investors to insure the Russian government against the cost of sanctions. If contracts are to remain a key feature of sovereign debt architecture, these do not give much reason for optimism. Reformers have long pushed for better contracts, with more detailed provisions (mousetraps, our friend Anna would say), as a solution for sovereign debt crises. Yet, these contracts often do not perform as hoped. Does that mean that we should move away from contracts to some kind of statutory mechanism, or maybe just a reliance on simple background implied duties? Not clear. The alternatives have significant flaws, too. But contracts, in this crisis, sure don’t seem to be doing well.
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