Tough Love: Making It Hard to Restructure Sovereign Debt

The simplest solution of all would be to leave things more or less as they are, and several important commentators have called for precisely this.¹³ Advocates of the status quo acknowledge that the sovereign debt restructuring process is highly inefficient under current conditions, but they see the ex post inefficiency as a virtue rather than a problem. The key benefit of tough restructuring rules, in this view, comes from their ex ante effect. Because sovereign debtors know they cannot easily renegotiate their debt ex post, they will have a powerful incentive to repay the obligations. More flexible renegotiation rules, by contrast, would undermine the sovereign’s commitment to repay and would increase the sovereign’s ex ante costs of borrowing.

The observation that imposing high ex post renegotiation costs can impose valuable discipline on a borrower is well taken. But this insight assumes that borrowers will respond to these incentives by choosing a level of debt that optimally balances the debtor’s ex ante borrowing costs with its ex post costs of financial distress. Sovereign debtors, by contrast, often have built-in incentives to commit themselves to excessively high restructuring costs, rather than optimal ones.¹⁴ In part, these incentives are political. Political leaders are more concerned about short-term issues such as how much they can borrow rather than long-term ramifications such as the potential consequences of default since the current administration will usually be gone by the time any repayment difficulties arise. Somewhat similarly, current leaders may borrow to further their own goals even if the effect is to impose inordinate restructuring costs on the country as a whole. In addition to these political considerations, sovereign debtors who are good credit risks may agree to excessive restructuring costs for signaling purposes, to indicate that they are unlikely to default. The creditors of a sovereign debtor may be similarly anxious for the debtor to, like Ulysses, bind itself to the mast, because high restructuring costs can serve as a form of implicit priority vis-à-vis debt that is less difficult to restructure. Finally, the fact that excessive restructuring costs increase the likelihood of a bailout in the event of financial distress may give the parties another reason to gravitate toward debt that is too difficult to restructure.

Putting large barriers in the way of restructuring, as current sovereign debt practice does, has important downsides even before any default. Because it is difficult to establish enforceable priorities in sovereign debt, creditors adjust by insisting on priority substitutes such as a rapid repayment schedule.¹⁵ Inefficiently short maturities can create a rollover crisis when the debt comes due, and the crisis is likely to be exacerbated if there are significant impediments to restructuring.

In sum, although the prospect of high restructuring costs can have beneficial ex ante effects, it is not likely to work well in the sovereign debt context. Sovereign debtors have too great an incentive to include excessively stringent limitations on restructuring. A better approach must provide more flexibility to restructure the sovereign debtor’s obligations in the event of financial distress. It must consider the ex post costs of financial distress, such as the perverse effects of debt overhang in the event debt cannot be restructured, rather than just the ex ante costs.

Can Majority Voting Provisions Solve the Problem?

The other major alternative to sovereign bankruptcy assumes just this: that sovereign debtors need the flexibility to restructure their debt if they face a financial crisis. Rather than a full-blown SDRM, however, proponents of this view argue that existing bond contracts—perhaps with a few modifications—are fully adequate to the task. The silver bullet, in their view, is to use majority voting provisions (also known as CACs) to restructure troubled sovereign debt. These clauses provide that, if a specified majority, often 75 percent, of the bondholders vote to restructure the payment terms of the debt, all of the holders of the bonds in question are bound by the vote. Sovereign debtors already include majority voting provisions in debt they issue under U.K. law—roughly 40 percent of all sovereign debt¹⁶—and they already have been used in a few cases to restructure sovereign debt. Majority voting advocates argue that, if sovereigns included these provisions in all of their debt, CACs could provide most or all of the benefits of sovereign bankruptcy and sidestep the political and administrative obstacles to putting a bankruptcy framework in place.¹⁷

We should emphasize from the beginning that we share some of the enthusiasm for majority voting provisions. To the extent that CACs enhance the prospects for restructuring, they are an improvement over the unanimous action strictures that have traditionally characterized sovereign debt issued under U.S. law. Moreover, the most elegant defenders of the CAC approach have emphasized that its chief advantages over an SDRM are pragmatic rather than theoretical. CACs are a solution that is well within our grasp, they argue, whereas SDRMs are not.¹⁸ Even if every sovereign debt issue included a CAC,¹⁹ however, there are at least four serious limitations that make the majority voting strategy a poor substitute for sovereign bankruptcy.

The first limitation is that majority voting provisions do not provide for a sufficiently comprehensive restructuring. It is not accidental that the sovereign debtors that have used these provisions to restructure their debt have tended to be small countries with a relatively simple debt profile. Majority voting provisions can work fine if the sovereign has only issued a few different bonds, but the bond-by-bond restructuring strategy is much less effective if there are numerous different bonds, with different maturities and payout terms, to deal with. Moreover, this approach does not provide any mechanism for addressing the sovereign’s nonbond debt. In short, CACs are only adequate to the task if the sovereign’s borrowings are relatively simple; they are much less useful if the sovereign has a more complicated debt profile.

The historical antecedents of Chapter 11, the U.S. provisions for corporate restructuring, provide a useful illustration of this point. The early U.S. reorganizations known as “equity receiverships” involved the nation’s railroads, which had unusually convoluted capital structures. When the reorganizers restructured the railroads, they did not simply restructure the bonds one issue at a time. Rather, the bankers and lawyers formed committees for each class of public stock or debt, negotiated the terms of a restructuring not just for these claimants but for other debt holders as well, and then formed a single supercommittee to effect the reorganization.²⁰ The actions of individual committees alone would not have sufficed to sort out the financial chaos.²¹ Sovereign borrowers need a similarly comprehensive solution to financial distress.

The second problem with CACs is closely related: not only does majority voting fail to provide a comprehensive solution to financial distress, but it also will often leave the sovereign with too much debt.²² Creditors will trade off the efficiency benefits of debt reductions against the costs in terms of reduced expected debt repayments; as a result, a debt restructuring procedure that is too creditor-friendly may result in inefficiently low debt forgiveness.²³ By contrast, statutory bankruptcy regimes can be adjusted to be more debtor-friendly if this kind of inefficiency is a concern.

Less often recognized, but crucially important, is a third limitation of CACs: the danger that they will undermine absolute priority. Even under the best of conditions, establishing priority and achieving the efficiency benefits of this differentiation are quite difficult in the sovereign debt context. It is harder for sovereigns than for corporate debtors to offer collateral, for instance, and enforcement is quite tricky when the debt does purport to provide security. As a substitute for collateral, sovereigns have relied on differential repayment schedules and implicit priorities. If debt restructuring is left to the market, there is no clear way to guarantee that the parties’ agreed-on priorities will actually be respected if the sovereign encounters financial distress. As noted earlier, the restructuring of Ecuador’s debt in 1999 is a good illustration.²⁴ Although some of Ecuador’s Brady bonds were collateralized and thought to have priority, these bonds were actually restructured first, prior to Ecuador’s noncollateralized Brady bonds.²⁵ The restructuring thus turned the bonds’ ostensible priority scheme on its head.

A final shortcoming of majority voting is that it does not address the sovereign’s need for new financing. An essential part of U.S. corporate reorganization practice is the possibility of obtaining debtor-in-possession financing to preserve the going-concern value of the firm. If anything, DIP financing may be even more critical for sovereigns because of their vulnerability to capital flight and exchange rate crises. The IMF’s pattern of lending into arrears serves a similar function, but the IMF has not tied its lending to the negotiation of a restructuring agreement between the sovereign and its creditors. As a result, the IMF’s lending often has the perverse effect of encouraging creditors to drag their feet, delaying restructuring negotiations in the hope that the IMF will step in and provide new money.²⁶

Rather than relying on the IMF, majority voting advocates have argued that bondholders can coordinate among themselves to facilitate DIP financing. If new lending on a priority basis will solve the sovereign’s underinvestment problem, they argue, all of the creditors will be better off if they vote to subordinate their own interests in favor of the new lender.²⁷ But this strategy suffers from several of the same limitations that we have already seen. If the sovereign’s debt structure is at all complex, coordinating all of the bonds and holding a vote to pave the way for new financing would be complicated and often unworkable. Moreover, the financing would be further undermined by the difficulty of guaranteeing that the new lender’s priority would be honored if the sovereign experienced further financial difficulties down the road.

There are a variety of ways one could structure the DIP financing provisions in an SDRM, and we will explore the alternatives in detail later in the discussion. The important point for present purposes is that majority voting provisions do not provide a workable solution to the problem of securing financing during the restructuring process. We should emphasize that this does not mean that policymakers should discourage sovereigns from including CACs in their bonds. Even if an SDRM were adopted, some sovereigns could still use majority voting provisions to restructure their obligations outside of the SDRM, just as some corporations restructure their debt outside of Chapter 11 or other formal insolvency provisions. But, in many sovereign debt crises, CACs are not an adequate substitute for a full-blown SDRM.

The Choice Among Automatic, Conditional, or No Stay

An important function of bankruptcy is to solve creditors’ coordination problems. Indeed, this arguably is bankruptcy’s most important ex post function. (Protecting creditors’ priorities is, as we have emphasized, the most important ex ante objective.)⁴³ Bankruptcy enables the debtor’s creditors, who may be numerous and widely scattered, to come together and develop a collective response to the debtor’s financial distress.⁴⁴ With ordinary corporate debtors, lawmakers have long worried that creditors may try to sidestep the collective proceeding, and engage in a “race to the courthouse” or “grab race” in an effort to get their money back before anyone else gets paid. Although this strategy is rational for individual creditors, it can destroy value by, for instance, forcing the piecemeal liquidation of assets that would be worth more as a going concern.

U.S. bankruptcy law addresses the grab race concern by providing for an “automatic stay” of creditors’ collection activities.⁴⁵ From the moment a debtor (or its creditors) files for bankruptcy, creditors must cease and desist from all of their collection activities—no more litigation, no execution on liens, no more angry letters to the debtor’s managers. In other nations, the stay is more limited. In England, for instance, secured creditors are not stayed⁴⁶ and some bankruptcy systems omit the stay altogether.⁴⁷

The debate as to whether sovereign bankruptcy should include a U.S.-style stay, a lesser stay, or no stay has focused on a crucial distinction between sovereigns and ordinary corporate debtors: it is much harder for creditors to enforce their interests against sovereigns. The sovereign’s local assets usually cannot be seized, and most sovereign assets are within the country, which significantly limits a creditor’s enforcement options if the sovereign defaults. Some commentators have argued that the obstacles obviate the need for a stay altogether. The “State’s unilateral decision to suspend payments would produce virtually the same effect as a stay,” according to one commentator.⁴⁸ Not only are stays unnecessary, according to this view, but the stay would “likely generate significant litigation on issues including when the stay should apply, when it should end, and what exceptions should be allowed.”⁴⁹ Based on similar reasoning, as well as creditors’ opposition to the inclusion of the stay, the IMF does not call for a stay in its most recent SDRM proposal.⁵⁰

Although we agree that the stay is less critical for sovereign debtors than for ordinary corporations, it is important not to overstate the distinctions. Sovereign debtors may be vulnerable to asset seizures by determined creditors, for instance.⁵¹ Consider a sovereign that has a state-run airline, as many do. If the sovereign defaulted, creditors could seek to attach the sovereign’s airplanes after they landed in a country that permitted such actions. In recent years, the sovereign finance community has watched rogue creditors act precisely this way, pouncing on vulnerable assets.⁵² Given the amount of money on the table, there is every reason to believe that creditors will continue to devise strategies for collecting their debts if given the opportunity. These risks suggest that it may be important to have at least a limited stay as part of the SDRM.

Rather than eschewing the stay altogether, some commentators have called for an intermediate, scaled-down version of the stay.⁵³ Proponents of this view acknowledge the need for a stay in many cases, but they argue the stay should not be automatic; rather, it should be conditioned on a majority vote of the sovereign’s creditors.⁵⁴ Under this approach, if a sovereign defaults and initiates a restructuring effort under the SDRM, and one or more creditors continue to pursue litigation or other enforcement strategies, another creditor could propose that these enforcement activities be stayed. The request for a stay would trigger a referendum on the proposed stay. If a majority of the sovereign’s creditors voted in favor, the stay would go into effect; otherwise, creditors would remain free to attempt to collect the amounts owed to them. Either way, the creditors would negotiate with the sovereign over the terms of a restructuring plan that would then be put to a vote.

It is easy to see why proponents of the conditional stay might find this approach attractive. If the sovereign’s debt structure is quite simple, for instance, its creditors might see no need to impose a stay. (Ideally, in this view, no one would even propose a stay; but if they did, the remaining creditors would vote it down.) The prospect of eschewing stays in at least some cases would reduce the intrusiveness of the bankruptcy process. There would be no need to fight about the parameters of the stay, and the restructuring process could proceed in much the same way as it does in the absence of an SDRM.

Unfortunately, creditor votes are too cumbersome to ensure a timely stay if one were needed.⁵⁵ The vote on the stay would not take place immediately. To the contrary, it would take weeks and possibly several months to determine who all of the sovereign’s creditors are, provide notice, and collect votes on a proposed stay. There is a serious risk that delaying the stay this long would amount to closing the barn door after the horses escaped. During the weeks or months before the stay was finally issued, vigilant creditors could try to seize airplanes, or, as in the Elliott Associates case, attach funds in transit.⁵⁶

Rather than using a creditor vote, a better strategy would be to adopt a targeted stay, which would differentiate between ordinary litigation, on the one hand, and the actual seizure of assets on the other. Because ordinary litigation is unlikely to interfere with the restructuring process,⁵⁷ a targeted stay could apply solely to asset seizures. Efforts to obtain assets (whether tangible assets or financial assets such as bank accounts) could be stayed, while the litigation process (up to the point of enforcement through asset seizure) would be permitted to go forward. A targeted stay of this sort would be much less intrusive than a sweeping standstill, yet it would prevent the most troublesome interferences with an SDRM.

An important issue raised by this limited stay concerns the status of a creditor who litigates to enforce its claim and obtains a judgment, but is prevented from enforcing its judgment by the stay. Does this creditor have an enforceable property interest in some or all of the sovereign debtor’s attachable assets, such as airplanes located in the jurisdiction of the judgment? Our view is that any judgment obtained after the initiation of the SDRM should not give the creditor a property interest unless the restructuring effort later fails. A creditor that obtains a lien or other property interest prior to the initiation of the SDRM would be entitled to a priority interest in any assets covered by the lien, but creditors who obtained a lien during the restructuring process would continue to be treated as general unsecured creditors for the purposes of the restructuring process.⁵⁸ Only if the SDRM proceeding were later dismissed would a creditor be treated as a priority creditor and permitted to enforce its property interest. At least at the margin, preventing creditors from parlaying their postfiling collection efforts into an enforceable ownership interest would diminish their incentive to circumvent the bankruptcy proceeding in order to obtain full payment of what they are owed.

Let us suggest one additional alternative that could achieve many of the same benefits as our proposed limited stay. Rather than an automatic stay of asset seizures, the SDRM could include a right of appeal from judgments received by a creditor after the SDRM was underway. With judgments that threatened to undermine the restructuring process, the court could impose a stay; otherwise, the court would simply permit the creditor to pursue its remedies.

The most obvious concern with an appeal strategy is that creditor enforcement activities could interfere with the sovereign’s restructuring efforts during the period before the appeal. Even a temporary seizure of sovereign assets could have substantial untoward effects. A second, quite different concern is that the appellate process seems to put the court in the awkward position of passing judgment on the courts of the country where the assets are located. An important mitigating factor with respect to the sovereignty concern is that the SDRM court would not need to address the merits of the decision made by a nation’s judicial system. Rather than second-guessing the validity of the decision in question, the SDRM court would simply be determining whether a stay is necessary to protect the restructuring process.

Overall, we can imagine an SDRM working effectively even without a formal stay. The stay (with the exception of the need for some kind of capital controls, as we discuss briefly below) is not as essential as the other provisions we will be discussing, such as interim financing. Ideally, however, the SDRM would include at least a limited stay. A stay on asset seizures would prevent the kinds of interventions by rogue creditors that have interfered with several restructuring efforts in recent years. Providing for an appeal from judgments that threatened to interfere with the restructure might have a similar effect.

Throughout this discussion, we have focused on traditional collection activities by creditors. Before moving on, we should note that sovereign debtors face another, somewhat analogous threat as well: the risk of a run on the sovereign’s currency. In the face of a debt crisis, investors may withdraw their money from the troubled nation, which can then magnify the sovereign’s fiscal crisis. The threat of a currency crisis can sometimes be addressed by capital controls, which function somewhat like the more traditional stay we have described.⁵⁹ Capital controls, however, are also fraught with difficulties.

In the past, they have often been evaded, and it is very difficult to prevent currency runs from occurring as soon as the controls are lifted. Because capital controls are beyond the scope of our inquiry—which concerns the structure of an international bankruptcy framework—we do not take a position on whether or how capital controls could be used to protect against the risk of currency runs. But it is important to note both that capital controls are another significant issue when sovereigns face a debt crisis, and that capital controls could be implemented in tandem with the sovereign bankruptcy framework we propose.

A Note on Initiation: Should Involuntary Bankruptcy Be Permitted?

All of the existing sovereign bankruptcy proposals either assume or explicitly state that the sovereign debtor should be the one to initiate the restructuring process.⁶⁰ Like the most closely analogous regime, the U.S. provisions providing for municipal bankruptcy, and unlike the corporate bankruptcy laws of most nations, these proposals would not permit a sovereign debtor’s creditors to trigger the restructuring process involuntarily. This voluntary-only limitation is grounded in sovereignty concerns. Advocates of the voluntary-only approach point out that the private creditors’ ability to throw a sovereign debtor into bankruptcy could be seen as interfering with the sovereign’s autonomy.⁶¹ They also worry that the sovereign’s creditors might use involuntary bankruptcy strategically, invoking bankruptcy for political rather than economic reasons.

Notwithstanding these concerns, there is greater merit in recommending involuntary bankruptcy than is often appreciated. Under a voluntary-only regime, sovereigns may file for bankruptcy much later than the optimal time. This seems counterintuitive, because commentators often identify moral hazard—the concern that sovereigns will invoke the SDRM opportunistically—as an important downside of sovereign bankruptcy. In practice, however, sovereigns seem to default too late, not too early, due both to the reputational consequences of default, and to their ability to issue new debt, which dilutes the existing stock of outstanding debt and postpones the day of reckoning. Creditor initiation could serve as a corrective, counteracting both the reputational and the overborrowing concerns. Creditor initiation would alleviate the sovereign’s reputational concerns by suggesting that the filing really was necessary—that is, the sovereign was not trying to use bankruptcy opportunistically.⁶² With respect to overborrowing, involuntary initiation would provide a mechanism for creditors to block new debt issues that threaten to dilute their debt. In effect, involuntary initiation could serve as a substitute for dependable enforcement of priorities outside of the SDRM. Not only would this ensure a more timely initiation of the SDRM, but, by protecting creditors’ priorities, it also could significantly enhance the functioning of sovereign credit markets ex ante.

Now, an obvious concern with creditor initiation is that one or a small group of rogue creditors might initiate the SDRM opportunistically. The simplest solution is to require that a critical mass of creditors sign on to any involuntary SDRM petition. If the provision included a requirement that at least 5 percent of the sovereign’s creditors participate in any petition, the risk of frivolous filings would largely disappear.⁶³ The requirement could be further refined by excluding creditors whose debts are not yet in default from participating in the involuntary petition.

Whether sovereign debtors would agree to an SDRM that could be invoked involuntarily, by the sovereign’s creditors, is of course an open question. It is important to note, in this regard, that sovereigns are already subject to suit in foreign courts, and have been since they began waiving sovereign immunity in the 1970s.⁶⁴ Moreover, creditor initiation would help to offset the perception that sovereign bankruptcy is too lenient on sovereign debtors. In short, from the perspective of both creditors and sovereign debtors, involuntary bankruptcy makes much more sense than is generally thought.

Example: Debt Dilution and Overborrowing

Consider the following situation involving a sovereign borrower. The country borrows 100 to undertake an infrastructure investment in year t = 0. In normal circumstances this investment is expected to produce a yearly flow return of 20 in present-discounted (tax) revenues over a period of 10 years, starting in year t = 1. In other words, the cumulative present-discounted return over the 10 years is 200. But, in the event of a crisis, an adverse macroeconomic shock, a currency attack, or a political crisis, the maximum present-discounted yearly revenues that can be transferred to creditors are expected to drop to 5. We shall take it that this negative shock may occur in year t = 1. If it arises it reduces the sovereign’s revenues in year t = 1 and all remaining years. Moreover, we shall suppose that these revenues are obtained only if in the event of a crisis the debtor undertakes prompt corrective action by restructuring its outstanding debt obligations immediately. If the sovereign postpones restructuring, then the present-discounted yearly revenues will only be 4 over the next 10 periods.

The idea here is that if prompt restructuring is accompanied by immediate new infrastructure investments or more fiscal austerity measures, they will enhance the sovereign’s capacity to repay its debts. However, if restructuring is delayed, these measures or new investments will also be delayed, leading to lower potential repayments over a decade.

For simplicity we shall suppose that a negative shock is expected to hit the sovereign in year t = 1 with a 50 percent probability. Consider first the situation where the sovereign can borrow only from one source: a single large, risk-neutral lender issuing a single long-term debt claim. This lender is willing to lend as long as it expects to break even. Under prompt corrective action, this lender can expect to get a present-value return of 50 in the event of a negative shock, so that the minimum face value of the debt at which the lender can expect to break even at the time of issuance will be D₀ = 150, with a specified total yearly repayment of 15 over the 10-year period. Indeed, with probability 0.5 the sovereign will not be hit by an adverse shock, the lender will then receive a flow return of 15 over 10 periods amounting to a present-discounted value of 150. But with probability 0.5 a bad shock hits the sovereign, the debtor will be unable to meet the flow interest payments of 15.

What happens then? Since there is only one lender to whom the sovereign can turn, the sovereign is unable to raise new funds from other sources in an attempt to meet the outstanding debt obligations to the lender. The only option open to the sovereign then is to try to reschedule or roll over the lender’s debt obligation. But this is a decision for the lender to make. If the lender is unwilling to roll over the debt the sovereign will be forced to default. In other words, the sovereign will be in the hands of the lender and will be forced to restructure its fiscal position and outstanding debt promptly when an adverse macroeconomic shock occurs. The lender will agree to a debt reduction as long as the sovereign commits to undertaking the desired corrective actions and agrees to repay a yearly payment of 5 over the 10 periods.

These repayments add up to a total present-discounted repayment of 50. Thus, in expected terms the lender will get a total repayment of [0.5 × 150 + 0.5 × 50] = 100, just enough to cover the initial outlay of 100.

Thus, in the presence of a single lender the sovereign can raise 100 by issuing a total debt with face value of 150 and yearly repayments of 15. The sovereign faces a “hard budget constraint”⁶⁷ in the sense that it is unable to borrow itself out of a crisis and thereby delay the required restructuring. When a crisis occurs in year t = 1, the sovereign is forced either to default or to promptly restructure its debts.

But when the sovereign can raise new funds from other creditors and absolute priority is not enforced, it no longer faces a hard budget constraint. To see this, suppose that there is another creditor to which the sovereign can turn in year t = 1. Suppose in addition that the sovereign government always prefers to delay restructuring if it can. This may be the case, for example, if a new administration is taking office every year and there are net private costs involved for the administration in place in undertaking a major fiscal restructuring effort. Then each administration in office would prefer to have a later administration deal with the problem. Although incentives for procrastination are put in a very stark way in this example, this is hardly an unrealistic description of the behavior of many governments that have let their debt balloon rather than taking prompt corrective action in response to an adverse economic shock.

When there is a single potential lender available, it is not feasible to delay the restructuring, as we have explained above. It has to be dealt with immediately. In other words, the single lender acts as a commitment device for fiscal discipline. But when the sovereign can borrow from another source (at competitive terms) and priority is not enforced, then the sovereign may well be able to borrow itself out of the crisis and postpone restructuring. As a result, the low cost of borrowing under a single exclusive lending relationship is no longer obtainable.

To see this, suppose by contradiction that a naïve initial lender is willing to lend 100 in year t = 0 in exchange for a face value claim of 150, with a required flow repayment of 15 over 10 periods. Further, consider what the sovereign would do in response to an adverse shock in year t = 1 when no subordination priorities or other covenant protections are enforceable in international debt markets, as is currently the case. Then, in the event of a bad shock in year t = 1, the sovereign will be able to postpone corrective action for at least one period by issuing new debt, which dilutes the old outstanding debt.

To be able to meet the required debt repayment of 15 in year t = 1 following an adverse shock, the sovereign needs to raise 11 from another source. Indeed, if the sovereign fails to restructure and take prompt corrective action it will generate yearly revenues of at most 4.

What is the face value of this new debt? Put differently, how much is a new debt claim of D_N with flow repayment d_N over nine periods worth in the market? Under current pari passu rules the new debt will receive a fraction [d_N/(d_N + 15)] of the yearly flow revenue of 4 following restructuring in period t = 2. Therefore, the promised new repayment d_N is worth

The sovereign, therefore, only needs to set d_N at a level such that:

This figure is the amount of new funds the sovereign needs to raise to be able to meet its old debt obligations and postpone corrective action until the next period. In sum, any new debt with a promised yearly repayment of d_N = 33/5 = 6.6 will do the trick!

A central conclusion of this example is that this new debt issue involves a significant dilution of the value of the old debt claim. Instead of receiving a flow repayment of 5 over 10 periods in the event of a bad shock the initial lender now receives at most 15 in year t = 1 (as the sovereign fully meets the required debt repayment in an attempt to postpone the painful debt restructuring) plus 25 (that is, 9 × 4 − 11) in the subsequent nine years. That is a total of 40 instead of the previous 50 (when there was no dilution and prompt corrective action).

How much does this risk of dilution affect the cost of borrowing of the sovereign when dilution is anticipated at t = 0? To be able to answer this question one needs to determine the sovereign’s total capacity to raise new debt in the event of a negative shock. For any initial outstanding debt D₀ the sovereign will be able to raise at most 40 if the new lenders lend on fair terms, given that restructuring does not occur in year t = 1. In an attempt to avoid default and thus postpone restructuring as much as possible the sovereign will actually pay out this entire amount to the old lender.

Therefore, when overborrowing is expected in response to an adverse shock, which then dilutes outstanding debt, the face value of the original debt must increase from D₀ = 150 (with no dilution) to D₀ = 160. Indeed, by holding a debt claim of D₀ = 160, with total yearly repayments of 16 over a 10-year period, the initial lender can hope to get

Thus, when lending cannot be excluded, the sovereign faces a higher cost of capital and must promise a total present value of repayments of D₀ = 160 (instead of D₀ = 150) to be able to raise 100. The efficient outcome with no overborrowing would be attainable if absolute priority were enforced. Indeed, if the initial lender had priority over new lenders, then the sovereign could not turn to new lenders to raise more funds. These junior lenders would not be able to get any repayment following an adverse shock and would therefore be unwilling to lend.

This example starkly illustrates our main argument that the lack of enforcement of absolute priority results in a higher cost of borrowing for the sovereign. It also illustrates how this lack of enforcement of absolute priority may result in overborrowing and inefficiently delayed restructuring.

As bad as the outcome in the absence of absolute priority is in this example, it is still not the worst possible outcome. Indeed, we have only allowed for overborrowing in the event of a negative shock. But incentives to overborrow are present even when no negative shock occurs. Although in theory the sovereign would always want to issue new debt and dilute all outstanding debt, in our example it is not very plausible that sovereigns would pursue a systematic dilution policy with such guile. This is why we have only allowed for such lending in the event of a bad shock.

Under the current international financial architecture, the only lender that imposes discipline on sovereigns and induces them to undertake painful corrective measures to redress their financial health is the IMF. But the IMF is in a weak position to effectively fulfill this role, as has been argued in many places and is widely recognized.⁶⁸

Another important inefficiency that may result from the absence of legal enforcement of absolute priority is that lenders may attempt to obtain de facto priority repayment by issuing “dangerous” debt with short maturity and highly dispersed claimholders, which expose the sovereign to both a higher risk of a debt crisis and higher restructuring costs.⁶⁹ Thus, as has been widely recognized by legal scholars of corporate bankruptcy, enforcement of absolute priority is likely to provide a major benefit in sovereign debt markets,⁷⁰ and the introduction of the SDRM provides an ideal opportunity to lay the foundations of a new legal regime of sovereign debt priorities. The question, however, is how to achieve this.

Classification, Voting, and the First-in-Time Principle

To determine how best to protect creditors’ priorities in the sovereign debt context, it is natural to first briefly inquire how priority is enforced for corporate debt. An important and widely used way of guaranteeing priority for corporate debt in liquidation is to secure a loan with collateral and to perfect the security.⁷¹ In such a case, the secured creditor becomes the sole owner of the collateral in liquidation. Unfortunately, this option is generally unavailable for sovereign debt.

Another less commonly used option is to insert a subordination clause in the debt contract requiring all subsequent debt to be subordinated. The difficulty with this approach lies in the enforcement of this subordination clause, as it contractually binds only the creditor and debtor who sign the contract. Should the debtor issue future debt with higher or equal priority without the knowledge of the initial lender and should the debtor go bankrupt, the initial lender may be unable to enforce its priority claim. To be able to effectively enforce a subordination clause, the initial lender then needs to continuously monitor the debtor and stop the debtor from issuing new equal or higher priority debt by filing an injunction.

In Chapter 11, secured creditors’ actions to appropriate their collateralized assets are stayed.⁷² Although commentators have long suspected that secured creditors are not fully protected in Chapter 11, the bankruptcy laws provide a variety of protections designed to ensure that secured creditors’ priority is respected.⁷³ In the Chapter 11 plan confirmation process, absolute priority is enforced by a combination of three elements: (1) classification of secured and unsecured creditors in separate classes,⁷⁴ (2) veto power of each class over the proposed restructuring plan,⁷⁵ and (3) the “best interest” and “cram-down” rules.⁷⁶

Each of these elements is essential to enforce absolute priority. To see why classification by priority together with a unanimity requirement across classes is necessary to enforce absolute priority, consider the hypothetical rule under which only a (super) majority requirement across classes is needed to approve a plan. It is easy to see that in this case the debtor, who has agenda-setting power at least during the first 120 days of the bankruptcy case,⁷⁷ can single out one or several classes for special unfair treatment and hope to win approval from the other classes. By playing one class against another, the debtor may thus be able to secure approval by the required majority of classes of a plan that is very favorable to the debtor. But, worst of all, in the absence of any other protection the debtor can get a plan approved that does not respect the priority ranking of the claims in any systematic way. Thus, in the absence of a unanimity rule across classes, basic creditor protections would be undermined by classification, because any form of classification would permit deviations from equal treatment among all creditors and thus make it easier for a majority of creditors to expropriate a minority.

Under the unanimity requirement, each class, and in particular, each class of secured debt holders, has at least the basic protection given by their veto power. Note, however, that this protection by itself does not guarantee enforcement of absolute priority. Indeed, to the extent that junior classes also have a veto right they can block any restructuring agreement that is not to their liking, even if under a strict enforcement of absolute priority they should not be entitled to anything. In other words, junior creditor classes (and shareholders) also sit around the bargaining table and are as critical as any other class in securing an agreement. They are therefore able to extract some concessions in the restructuring negotiations and thereby may violate the priority ranking of claims.

This is why the third element of the cram-down option and best interest protection is essential. Under the cram down, the court can enforce a restructuring plan even if a junior class opposes it, if the court finds the plan to be “fair and equitable,” which includes a requirement that the plan satisfy the absolute priority rule with respect to any dissenting class.⁷⁸ That is, the court can approve the plan if it finds either that the dissenting junior class is paid in full, or that no lower priority class will receive anything under the plan. The best interest rule provides another protection. If the reorganization plan gives less to a class than it would get under liquidation, a unanimous agreement among the creditors in the class is required for the class to approve the plan.⁷⁹ The best interest protection and the threat of a cram down are essential for senior creditors to ensure that the restructuring agreement does not deviate too much from absolute priority. While courts have been reluctant to use a cram down in the past,⁸⁰ it has become a much more common practice in recent years. Accordingly, deviations from absolute priority are now significantly smaller.⁸¹

Interestingly, one could envision an extreme form of cram-down procedure, where the court determines by absolute priority the value of the reorganized firm and the allocation of claims on the reorganized firm to creditors. Under such a procedure, there would in principle be no need for a cumbersome classification of claims and a unanimity rule among classes. However, as one can easily imagine, such a procedure is likely to put too heavy a burden on the court’s ability to value a reorganized firm. The court is also likely to lack the information required to reliably classify claims by priority. The debtor is in a much better position to determine which claims should be classified together in a separate class. This is presumably why the law gives discretion to the debtor, within limits, to classify similar claims together.⁸²

Our proposal for enforcement of absolute priority under the SDRM mirrors some of the key elements of Chapter 11 by taking into account the specific practical difficulties related to sovereign debt. More so than for firms, judges are unlikely to have the expertise to make a reliable determination as to the sustainability of a sovereign’s debt. The judge might seek the expert opinion of the IMF, but the IMF’s evaluation of the level of debt that is likely to be sustainable may be seen as politically biased. Creditors and the debtor are likely to also retain experts and to produce widely differing estimates, which may not facilitate the judge’s task.

This is why we propose to leave the determination of what is a reasonable reduction of a sovereign’s overall indebtedness to the collective decision of the creditors in a two-step procedure. Once all debt claims have been identified and classified into priority classes or separate classes involving a distinctive common interest (like trade credit), we propose to have the following two steps:

(1) First, the sovereign puts an overall debt reduction proposal to a vote of all creditors in a single class, voting in proportion to their individual debt holdings. The majority rule would be specified in such a way as to fairly balance creditor and debtor interests. Although we will argue for a simple majority approach below, a two-thirds majority may seem reasonable, or even the 75 percent requirement used in most CACs for sovereign debt issue in London.⁸³

(2) Once a debt reduction has been agreed on, the sovereign would propose a reorganization plan specifying the treatment of each class of claims. Concretely, all creditor classes would vote on the proposed distribution of claims to the different classes. As under Chapter 11, each class would require a supermajority, say of two-thirds, of the face value of the total debt in the class, and unanimity among the classes would be required. Should one class vote against the proposed allocation of new claims then, as in Chapter 11, a cram down could be enforced by allocating claims directly in order of absolute priority.

The first step would serve the purpose of determining a sustainable level of debt for the sovereign and solve the collective action problem among creditors. The second step would be directed toward the enforcement of absolute priority. A number of obvious questions arise concerning this scheme. We discuss each one in detail below.

(a) How will creditors vote? A creditor’s vote will depend to a large extent on how high in the priority ranking the creditor’s claim is. If the claim is senior, then the creditor would be in favor of a significant haircut, since the cost of the haircut would fall primarily on the more junior debt classes and since the new claim is more likely to be repaid in full if the sovereign’s reorganized debt burden is lower. By the same logic, a junior claimholder would be opposed to significant haircuts. For junior claims, the incentive is to maintain the existing level of debt and “gamble for resurrection.” Thus, there will be a “pivotal” creditor or creditor class, which will decide the outcome.⁸⁴ Any proposed haircut that is higher than what the pivotal creditor wants will be defeated in a vote, and any haircut that is lower will be approved. The sovereign will then obviously propose the highest possible haircut that is acceptable to the pivotal creditor.

One potential concern with our proposed two-step procedure is that if a large fraction of creditors are junior claimholders they will be able to block any reasonable haircut. Our restructuring procedure would then result in too little debt reduction. The most extreme such situation would be one where all creditors are junior creditors and would therefore be required to give up some of their debt claims. In such a situation, the creditors would only agree to a haircut that is no greater than what they would agree to in a workout. Such a haircut might be too small for the reasons we have already evoked and it might be desirable to build an incentive for junior creditors to accept greater haircuts into the restructuring procedure. One way of building in such an incentive might be to give higher priority status and greater protection against default to the restructured junior debt. Alternatively, in situations where there are several different priority classes, it might be desirable to reduce the power of junior creditors by using a simple majority voting rule in the first round, rather than two-thirds or 75 percent.

(b) What happens when a proposed haircut is rejected in a vote of all creditors? In the event of a negative vote in the first round, it is reasonably straightforward to determine what should be done next. There are two options. One is to terminate the restructuring procedure and force the sovereign and creditors to find a restructuring agreement outside the SDRM through a workout. The other is to let the sovereign and/or creditors put a new haircut to a vote. The first option would serve as a threat to the sovereign to avoid excessively high haircuts. It would also offer added protection to creditors, who could always collectively guarantee that debt restructuring take place outside the SDRM by voting down any restructuring proposal. The second option is clearly more debtor-friendly. It would be justified if debt restructuring outside the SDRM is seen to result in too little debt forgiveness. Which of these two options is more desirable requires a careful balancing of creditor and debtor interests, which we are not in a position to do.

(c) What happens when a proposed allocation of new claims to creditors is rejected by one or more classes in the second round? Here again one could envision one or multiple new proposals by the debtor or creditors being put to a vote. As in Chapter 11, however, eventually this process has to end. We propose that the judges supervising the restructuring proceedings may decide at their own discretion or at the request of a creditor class to initiate a cram-down procedure, whereby the newly reduced stock of debt is allocated on an absolute priority basis.

(d) How is priority determined and how are claims classified? This is by far the most important and difficult issue, and it demands a somewhat more detailed discussion than the ones we have just covered. Two points require examination. The first one is how the contracting parties can define a priority claim. The second is how the different claims are classified. Who has the authority to classify and what should be the underlying principles?

Most lending to sovereigns can only be in the form of unsecured debt.⁸⁵ Thus, specifying a separate priority class for only secured debt and for debt issued by multilateral institutions would provide no more than a very limited form of priority enforcement. To enable enforcement of a more comprehensive form of absolute priority structure and to limit dilution of outstanding debt by new debt as much as possible, we would favor a first-in-time rule for unsecured debt. Such a rule would guarantee repayment of debt issued earlier over debt issued later and would come closest to the ideal of guaranteeing maximum protection against dilution through overborrowing, as has been recognized by legal and finance scholars.⁸⁶ Concretely, the way this rule would work is that when a sovereign files for debt restructuring under the SDRM, all unsecured debts would be classified by date of issue and earlier issues would have higher priority over later issues.

The priority scheme we envision would operate as a default rule that could be altered by contract. Subordination agreements between classes of creditors would be enforced. In theory, a sovereign that was concerned about the possibility of a subsequent liquidity crisis could include a provision giving it the right to issue a specific amount of priority debt in each of its contracts with current creditors.⁸⁷

If there are many different issues it may be impractical to have a separate class for every date at which an issue was made. To avoid the creation of too many classes, it may then be desirable to require that each class be of a minimum size in value relative to the total value of outstanding debt. Alternatively, another way of limiting the number of classes may be to lump issues within any given fiscal year together in a single class.

There are two other concerns with the first-in-time rule. First, it may impose substantial risk on new lenders, because they would inevitably be at the bottom of the queue unless they are able to obtain some form of security or other privilege. Of course, exposing new lenders to this risk is desirable to the extent that it forces new lenders to make the economically efficient lending decision: whether to lend the marginal dollar or cut the sovereign off from any new lending given that its existing stock of debt has grown too large. However, inefficiencies may arise if it is difficult for the new lenders to determine exactly how indebted the sovereign is. If the sovereign can easily hide or misrepresent its total indebtedness, new lenders may be excessively reluctant to extend a loan for fear of discovering after the fact that the sovereign’s stock of debt is much higher than anticipated. Such an inefficiency could be considerably reduced if a global clearinghouse was established to keep a public record of all outstanding sovereign debt, as was proposed at the Monterrey Summit in 2002 by Norway and the Ford Foundation.⁸⁸ With such a clearinghouse it would be a simple matter for a new lender to monitor a sovereign’s outstanding debt and to make an efficient lending decision under a first-in-time rule.

The other concern with the first-in-time rule is that new lenders may try to leapfrog the priority ranking by either insisting on a privileged claim or by shortening the maturity of their loan so as to be paid back before the other older debt. This is unlikely to be a major problem, because secured lending is generally difficult to obtain. Also, new short-maturity debt involves only a limited form of dilution of outstanding debt. Should creditors be concerned by this form of dilution, they could in principle get protection through covenants specifying lower limits on the maturity of new debt issues. With the exception of trade credit, which generally can only be of very short maturity, it may be desirable to enforce such covenants. Again, enforcement of such covenants would be considerably facilitated by the existence of a global clearinghouse.

This brings us to our second point on classification of claims into different classes. Classification of claims by priority is easy to understand in theory but difficult to implement in practice. What is worse, there are likely to be important additional considerations besides priority specific to sovereign debt. For example, it seems reasonable to think of Paris Club debt as a separate class. Similarly, multilateral debt and trade credit may belong to a separate class. One might also argue that bank loans ought to be classified separately from mark-to-market bond issues. Within the category of sovereign bonds a case could be made for classifying the bonds by the financial center where they were issued. Indeed, these centers may represent different clienteles with different economic interests.

To the extent that the treasury department of the sovereign government is likely to have the most detailed knowledge of the country’s debt structure and the inner working of the different credit markets they tap, it seems reasonable to leave the debtor discretion over classification, but to constrain the debtor’s freedom to classify by requiring that only similar claims can be classified within the same class. If there is sufficient ambiguity about how similar claims must be to belong to a given class and if creditors are concerned that the debtor is “gerrymandering,” then it should be possible for the creditors to prevent such classification, ex ante by including a covenant in the contract that precludes claims that are considered to be different from being classified with other types of debt, and ex post by appealing the debtor’s proposed classification.

(e) What should be the priority and maturity structure of the new claims? The discussion so far has been cast in terms of substituting a complex existing maturity and priority debt structure with a single new type of claim on the sovereign. While debt restructuring is often an opportunity to considerably simplify the existing debt structure, it is clearly overly simplistic to think of substituting a single new type of claim for all the different types of claims. Our proposal does not depend in any way on such a radical restructuring. Indeed, when it comes to the second stage of allocating new debt claims to the different classes it may be helpful to think of a swap of old claims for new claims of a similar type, with only possibly a reduced face value and an extended maturity.

Shortcomings of the IMF and Other International Institutions

The most obvious choice as overseer of a new SDRM is the IMF itself. In effect, the IMF already serves as a gatekeeper, since IMF approval is often a prerequisite to restructuring or otherwise addressing a sovereign debt crisis. The IMF’s close involvement also gives it much better information about a sovereign’s financial predicament than any outside decision maker would have. Given that the IMF is already intimately involved in these issues, and that SDRM oversight could be added to the IMF’s job description without altering its mission, one can easily imagine the IMF as the principal bankruptcy decision maker.¹⁰⁴

For all its benefits, however, IMF oversight has two major drawbacks: first, the IMF would have a significant conflict of interest. As lender of last resort, the IMF is likely to be a creditor of the sovereign debtor. As decision maker, on the other hand, its responsibility would be to mediate impartially among the various constituencies of the sovereign debtor. The second concern is political. IMF decision making has in some instances been driven more by political pressures by the United States or other G-7 members than by the economics of the crisis in question. As decision maker in a restructuring, its motives and impartiality may continually be questioned, making it ultimately an ineffective administrator of the restructuring process.

Once again, we do not have to look far to find a useful analogy to the dilemma posed by a regulator who acts both as an arbiter among creditors and as one of the creditors. In U.S. banking law, the Federal Deposit Insurance Corporation (FDIC) wears the same two hats. Because the FDIC guarantees the safety of bank deposits, it steps into the shoes of bank depositors if the bank runs into financial distress, which in essence makes the FDIC a bank’s largest unsecured creditor. At the same time, the FDIC decides how to dispose of a bank’s assets, and determines the treatment of the bank’s creditors. During the banking crisis of the 1990s, the FDIC’s dual role created or magnified conflicts in a variety of contexts.¹⁰⁵

The FDIC’s special concern with avoiding a costly bank run when a bank encounters financial distress is closely related to the IMF’s concern with avoiding currency runs and contagious debt crises. Because of the risk of a bank run, banks cannot be reorganized in the same way as other companies. When insolvent banks are small they are invariably liquidated rather than reorganized, usually through deposit transfers or sales to third parties, and the entire process is arranged by the FDIC in secret before it is announced. The need for speed, secrecy, and regulatory approval all point to the FDIC as the logical overseer.

Secrecy and speed may be just as important in the early stages of a sovereign debt restructuring, and the IMF is well positioned to keep things quiet. But, when it comes to large sovereign debt crises, the IMF may be reluctant to impose aggressive discipline, much as banking regulators are tempted to forbear when a troubled bank is viewed as “too big to fail.” Furthermore, the IMF cannot achieve the other benefits that justify FDIC control of bank insolvency proceedings. Unlike bank insolvencies, for instance, sovereign debt restructurings cannot be resolved by a single decisive transaction such as a liquidation or sale of assets. The process is more complicated and necessarily involves the input of other parties such as the sovereign’s major creditors. The IMF will of course play a central role in the restructuring process. But given the IMF’s conflicting interests, and its susceptibility to political pressures, it makes more sense to place oversight authority in a more disinterested decision maker.

In addition to the IMF, the other leading option for SDRM oversight is to vest this authority in a new international decision-making body or, in the alternative, to expand the scope of an existing organization. The IMF’s most recent approach is a hybrid between IMF oversight and establishing a new SDRM decision maker;¹⁰⁶ thus, we will focus on the possibility of a newly created decision maker in the discussion that follows. As should be evident, however, looking to an existing international organization would raise precisely the same concerns as those we identify above.

Under the IMF’s most recent proposal, an independent committee would select the members of a selection committee, and the selection committee would then pick the judges for the decision-making body, the SDDRF.¹⁰⁷ Unlike the IMF, the SDDRF would not have a financial stake in the decisions it makes, and all of its judges would be selected with their independence in mind. The most obvious selling point of the new body is this independence. Unfortunately, even the carefully structured nomination procedure in the IMF’s proposal provides no real guarantee of independence. Just reciting the layers of process (e.g., the committee that selects a committee) gives a sense of how susceptible to political pressure the selection process may be. When it comes to actual SDRM decisions, there is a real risk that the SDDRF would not be an impartial decision maker and that the new board’s deliberations, like the selection of its members, would be undermined by political considerations.

One could respond to these concerns by adding further guarantees of the tribunal’s independence,¹⁰⁸ but the suspicion of political interference is likely to remain. In short, with both the IMF’s proposals and those of others to rely on an international decision-making body, there is a serious risk that politics may influence the tribunal’s deliberations.

Another potential concern with the proposed SDDRF as currently envisioned is that it may not have sufficient powers to be able to administer the debt restructuring process efficiently. As currently contemplated, the court’s strongest sanction is that it may decide to avoid the process entirely and throw the parties back to the current status quo where they must renegotiate the debt without the help of a majority vote binding on a dissenting minority. But wielding such a strong weapon may often not be plausible, and in the absence of any other sanctions it may be difficult for the court to reprimand a sovereign or a creditor that deliberately attempts to slow down the process, submits false claims, or abuses the judicial process in other ways.

Tapping the Expertise of Existing Bankruptcy Courts

As we chronicle the flaws of existing proposals to vest authority over sovereign bankruptcy in the IMF or an international tribunal, we must be careful not to lapse into utopian despair. The fact that a proposal falls short of perfection does not necessarily mean it should be rejected. An imperfect decision maker may be the best option we have in the real world. In this case, however, there may be a better alternative.

We argue in the following paragraphs that authority over the SDRM process should be vested in existing corporate bankruptcy or insolvency courts. Existing courts are not perfect either, but they offer several striking advantages as compared to the IMF or an international organization. In the discussion that follows, we begin by briefly outlining the contours of our proposal. We then will address a series of potential objections to this strategy.

Our proposal is simple: rather than looking to a supranational decision maker, sovereign debtors should be permitted to file for bankruptcy in the courts of any foreign jurisdiction whose law governs a portion of the sovereign’s private debt. To avoid the problem of “home court” favoritism, sovereign debtors or creditors should not be allowed to file in the sovereign’s own courts, but the sovereign could select the bankruptcy arbiter of any jurisdiction where it issued bonds or bank debt. Under current practice, the majority of sovereign debt is issued in New York and is subject to New York law. The other major source of bond issues is London, with Tokyo or Frankfurt issuing much smaller shares.¹⁰⁹ This means that most sovereigns could choose from among one or more of these four jurisdictions. A sovereign that followed its New York debt would file in the bankruptcy court for the Southern District of New York; a London case would go to a judge with insolvency jurisdiction over administrative receiverships; and Frankfurt or Tokyo cases would be handled by the bankruptcy courts in those locations.

There is one small qualification. To ensure that sovereign debtors did not issue debt in a jurisdiction on the eve of default solely for the purpose of gaining access to the jurisdiction’s bankruptcy courts, a sovereign’s venue choice should be limited to jurisdictions where it had issued debt at least 18 months before bankruptcy.¹¹⁰ Other than this timing limitation, however, together with a minimum amount requirement, sovereigns could file wherever they issued their debt.

Perhaps the most important benefit of this approach, as compared to employing the IMF or an international body, is that it relies on an existing decision maker and legal community that already have the relevant expertise and authority to conduct the judicial process. In each of these courts, moreover, initial decisions are made by a single judge. As a result, courts would be well positioned to make immediate decisions on issues like interim financing; there would be no need to wait until, say, an arbitral panel was assembled to oversee the case. In addition, the bankruptcy or insolvency judge would be much less likely than the IMF or the SDDRF to be subject to political pressures. In short, the conflict-of-interest concerns that would bedevil each of the other proposed decision makers do not loom nearly as large for bankruptcy courts.

The first and most obvious objection to our proposal is that giving sovereign debtors a choice of filing locations will enable them to shop for the laxest forum and perhaps lead to a race to the bottom, with courts exacerbating debtors’ moral hazard by making it too easy for sovereigns to shed their debt.¹¹¹ This is the same kind of complaint that has been lodged against the U.S. corporate bankruptcy framework. In the United States, most corporate debtors have a variety of filing options, and several courts—most prominently Delaware and New York—have attracted a disproportionate number of the biggest cases.¹¹² Critics complain that the judges in these jurisdictions have undermined the bankruptcy process by rushing cases along, being too generous in paying attorneys’ and bankruptcy fees, or by favoring debtors and their managers—the allegations vary—in order to attract these reputation-enhancing cases.¹¹³

Rather than undermining the case for giving sovereign debtors a choice of bankruptcy court, the forum-shopping analysis actually proves on inspection to underscore its attractions. To see this, note first that even with corporate debtors, the venue-shopping complaints are largely misguided. Although critics complain that Delaware is too friendly to managers or their attorneys, for instance, this does not explain the fact that creditors often are the ones who insist that the case be filed in Delaware.¹¹⁴ Bankruptcy lawyers who have handled cases in Delaware usually attribute Delaware’s popularity to the speed of Delaware cases and the expertise of its bankruptcy judges. This is consistent with the existing empirical data, which suggests that Delaware cases were much faster than cases in other jurisdictions in the 1990s, and that debtors were most likely to file in Delaware rather than their “home court” (that is, the jurisdiction where the company’s headquarters or principal assets were located) if the home court was inexperienced or the case was especially complex.¹¹⁵

Sovereigns can be expected to take similar considerations into account when they select a filing location. A sovereign that wishes to restructure its obligations quickly and return to the capital markets will pay especial attention to the expertise of the respective bankruptcy courts, and the courts, in turn, have an incentive to demonstrate efficiency and expertise if they wish to attract important cases. It is also worth noting that tying the choice of courts to the location of the sovereign’s debt—New York, London, Frankfurt, or Tokyo for most sovereign debtors—assures that the case will be overseen by a jurisdiction that is likely to be sympathetic to the sovereign’s creditors. Requiring the case to be filed in a creditor jurisdiction provides a useful counterbalance to the sovereign debtor’s advantages—in particular, its rights to invoke the SDRM and to select the filing location. In short, jurisdiction shopping is a significant virtue of, not a problem for, the proposal.

A second possible concern is that ordinary courts cannot handle cases that have such large international implications as would a sovereign bankruptcy proceeding. Only an arbiter with international credentials, in this view, could oversee an SDRM.¹¹⁶ Before the late 1970s, when sovereigns first started routinely waiving their traditional immunity from litigation,¹¹⁷ this objection would have carried more weight. But we now have a much more extensive track record of domestic courts resolving issues involving sovereigns. Certainly, sovereign bankruptcy is a more elaborate proceeding than most legal issues, but the court’s oversight role is also quite constrained under the framework we have proposed, which leaves much of the process to be worked out by the parties. Nor should the magnitude of the cases be cause for alarm. New York and London courts already have experience handling huge bankruptcies. The bankruptcies of companies such as Maxwell, Polly Peck, WorldCom, and Global Crossing, for instance, involve larger amounts of outstanding debt than most sovereign debt restructuring cases. Particularly if the cases are brought in major economic centers like New York, London, or Tokyo, a commercial bankruptcy or insolvency judge will be equal to the oversight task.

A final, somewhat similar objection focuses on a court’s difficulty in implementing sovereign bankruptcy rules that differ markedly from the jurisdiction’s domestic bankruptcy or insolvency rules. Once again, there is much less to this objection than meets the eye. Given the similarities between the SDRM and U.S. Chapter 11, this objection would worry about judges in London or Tokyo, whose bankruptcy systems are much less oriented toward reorganization. But there is no reason to believe that London or Tokyo judges would find the SDRM disorienting, either. The framework is quite simple, and courts have managed to apply unfamiliar rules in other contexts.¹¹⁸ Moreover, London bankers and lawyers have been strong advocates of sovereign bankruptcy, and the SDRM is in many respects simply an elaboration of the collective action provisions that are already included in the sovereign debt governed by London law. It is hard to imagine that London judges will find sovereign bankruptcy, with its strong London influence, uncongenial.

To summarize, vesting SDRM authority in domestic bankruptcy judges avoids the politicization that would undermine international decision makers. Decisions would be made promptly, and the threat of political meddling or conflicts of interest would be much lower. Giving the sovereign debtor a choice to file in any jurisdiction where it has issued debt would reinforce these virtues by creating healthy interjurisdictional competition among bankruptcy courts. A court that wished to attract sovereign bankruptcy cases would need to establish a reputation for efficiency and expertise, and the competition to do so would enhance the quality of all of the courts where a sovereign debtor might file.

Indeed, the attractions of jurisdictional competition raise the question of whether we might want to go even further, and instruct sovereigns to specify their SDRM location ex ante. Under this ex ante (or pure jurisdictional choice) approach, each sovereign would pick a single jurisdiction as its filing location in the event it later invoked the SDRM. This ex ante choice strategy, which has been advocated in the international insolvency and corporate bankruptcy contexts,¹¹⁹ has significant theoretical attractions. Since sovereigns would pick a jurisdiction before they borrowed additional new funds—and their choice would be limited to a single court—their cost of credit would fully reflect the merits or demerits of the court they selected. Sovereigns that selected an inefficient (e.g., excessively pro-debtor) decision maker would (in theory) face higher credit costs. This would give the sovereign a strong incentive to seek, and courts an incentive to provide, efficient SDRM oversight.

While we recognize the virtues of a pure jurisdictional choice strategy, linking the SDRM decision maker to the sovereign’s issuance of debt is preferable for several reasons. Perhaps the most important problem with precommitting to a particular jurisdiction is the difficulty of making midstream corrections. Once a debtor has made its choice, it is very difficult to change its selection later if subsequent events make the original choice ill-advised.¹²⁰ The debtor is in a much better position to select a filing location at the time of filing than it is when there is no filing in prospect. Second, there may be sovereignty concerns about a sovereign’s precommitting to a particular nation’s bankruptcy or insolvency courts in the event of a future sovereign bankruptcy filing. Third, the prospect that a sovereign could choose any jurisdiction in the world as the filing location, even one with no ties to the debtor or any of its creditors, could provoke political resistance to the SDRM. As a practical matter, we suspect that most sovereigns would select New York, London, Tokyo, Zurich, or Frankfurt as their filing location, even if they had unbridled discretion ex ante, since sovereigns who chose a potential lax jurisdiction would pay the price for this choice in the credit markets. But, given the practical and political concerns we have just noted, the best way to structure the jurisdictional choice is to give sovereigns the ex post option to file for bankruptcy in any location where they have issued sovereign debt.