Are we facing a sovereign debt crisis?

Introduction

The COVID-19 pandemic has greatly lengthened the list of developing and emerging market economies in debt distress. For some, a crisis is imminent. For many more, only exceptionally low global interest rates may be delaying a reckoning. Past sovereign debt crises have given rise to creditor and other foreign investor claims under international investment agreements (IIAs). This article explores lessons learned from the past crises and the role of investment arbitration in resolving such disputes. Understanding the nature and scope of protections available is critical for foreign investors to weather the looming debt crisis.

Deepening debt trouble for developing countries

Default rates are rising, and the need for debt restructuring is growing. Yet new challenges may hamper debt workouts unless governments and multilateral lenders provide better tools to navigate a wave of restructuring. A debt restructuring legal framework for sovereigns is yet to be found. Earlier this year, the G20 committed to extend their Debt Service Suspension Initiative (DSSI) to halt debtservice payments through the end of 2021. But there have been problems with this initiative, in part because the private sector has not fully participated.

Many of the poorest or developing countries were already in debt trouble before March 2020. The COVID-19 pandemic has exposed gaps in the sovereign debt restructuring architecture that could lead to a sovereign debt crisis unprecedented in size and complexity. There are a number of nations that are facing potential defaults as a result of unprecedented amounts of borrowing driven by the COVID-19 pandemic. Many of these nations and others were arguably on the brink prior to the onset of the pandemic. In February 2020, the IMF published a paper ‘Evolution of Public Debt Vulnerabilities in Lower Income Economies’ which found that half of low income countries (36/70) were at high risk of debt distress or already in distress. In March 2020, private international capital stopped flowing to emerging market countries. Once the measures, which allowed distressed nations access to easy money, expire, the number of developing countries with sovereign debt vulnerabilities will only increase.

A debt crisis is likely to be hard to avoid, especially among the world’s poorest countries and those with continuing high rates of COVID-19 infections. Some experts suggest it could be as many as 15-20 nations. An additional issue is that China has become the world’s largest official creditor, particularly for emerging countries. This has already caused some difficulties for restructuring the debt of some nations.

In November 2020, Zambia defaulted on its external debt payments – the first African nation to default since the pandemic started. Zambia’s bondholders refused to consider offering interim relief without full disclosure of the nation’s agreements with its largest creditor, China. A study published in March 2021 by the Peterson Institute for International Economics noted that China’s lending contracts contain confidentiality clauses that bar borrowers from revealing the terms or even existence of the debt and that “Chinese lenders seek advantage over other creditors, using collateral arrangements such as lender-controlled revenue accounts and promises to keep the debt out of collective restructuring.”

A debt crisis is likely to be hard to avoid, especially among the world’s poorest countries and those with continuing high rates of COVID-19 infections.

The role of international investment agreements (IIAs)

As the sovereign debt crisis unfolds and states implement strategies to manage the crisis, investors will need to carefully consider their positions and the legal options and claims routes that may be open to them, including the important protections that may be available to them under IIAs.

IIAs are agreements between states in which they mutually agree to certain minimum standards of protection for investments made in their territory by foreign investors from other states that are party to the IIA. Among the thousands of IIAs currently in force worldwide, many are bilateral investment treaties (BITs) between a developed and a developing state.

IIAs offer qualifying foreign investors – including creditors – a framework of protections against adverse state action, whether such action is inspired by a debt restructuring program or some other objective.

IIAs typically set out the criteria that must be satisfied in order for a claimant to benefit from such protections. For example, IIAs define who is an “investor” and what is a protected “investment”.

IIAs vary in the substantive and procedural protections that they offer. But investors who satisfy the criteria typically have access to protections in the form of prohibitions against direct and indirect expropriation absent certain minimum conduct standards, such as observing due process and the principle of nondiscrimination, as well as rights to fair and equitable treatment or the minimum standard of treatment at customary international law, full protection and security, national treatment and most favoured nation treatment, among other protections. Some IIAs contain carveouts for taxation measures and particular industry sectors that may impact on an investor’s entitlements, as well as ‘umbrella’ clauses that raise contractual breaches to treaty breaches.

Critically, these substantive protections have teeth because IIAs afford qualifying foreign investors with standing to bring and thus have claims direct access to dispute resolution in a neutral forum, usually international arbitration, before impartial arbitrators, and in accordance with neutral, transparent rules.

Critically, these substantive protections have teeth because IIAs afford qualifying foreign investors with standing to bring claims and thus have direct access to dispute resolution

Claims under IIAs tend to follow capital flows, and unsurprisingly claims most often arise between qualifying foreign investors from developed states as claimant and the developing state party hosting the investment as respondent. Though increasingly IIA claims are also against and between investors and states from developed countries.

(See also our article on investor-state claims in the era of COVID-19, in the June 2020 edition of the International Arbitration Report).

What’s past is prologue?

Parallels with the looming sovereign debt crisis can be drawn with previous sovereign debt crises, such as the 1980 Latin American debt crisis, the 1998- 2002 Argentina debt crisis, and the 2009 Eurozone crisis. Following each of these crises, investors brought IIA claims against defaulting states.

In the early nineties, Argentina defaulted on US $93 billion in sovereign debt. Argentina’s subsequent debt restructuring process led to a number of IIA claims by Italian bondholders against Argentina under the Argentina-Italy BIT. Three cases arose from Argentina’s default: Abaclat v Argentina; Ambiente Ufficio S.p.A v Argentina; and Alemanni v Argentina. In each case, Argentina challenged the jurisdiction of the tribunal, asserting that its consent to ICSID arbitration in the BIT did not include consent to multiparty proceedings and that its bonds were not protected investments under the ICSID Convention. Argentina also challenged the admissibility of mass claims.

In all three cases, Argentina’s jurisdictional objections were dismissed. The tribunal in Abaclat held that the claimants’ purchase of security entitlements in Argentinean bonds constituted a contribution which qualified as an investment under Article 25 ICSID Convention. On the issue of admissibility, the tribunal determined that the ICSID procedural framework could be adapted to render the claims by the Italian bondholders admissible. The majority found that the only relevant question was whether there was sufficient homogeneity between the bondholders claims, a question that the majority answered in the affirmative. The Ambiente and Alemanni arbitrations were discontinued before the issue of admissibility was adjudicated. All three cases settled before they progressed to a merits phase.

In the late 2000s, several European countries faced debt distress on the heels of the global financial crisis. Greece’s default on its debt was followed by a restructuring process that gave rise to a claim under the Cyprus-Greece and Slovakia-Greece BITs: Postova bank v Greece. The claimants, a Slovak bank and its former Cypriot shareholder, alleged that the Greek debt restructuring was a breach of the investors’ rights under the BITs. In contrast to the Argentine cases, the tribunal refused jurisdiction over the claim, holding that the bank’s Greek government bonds were not protected investments under the Slovakia-Greece BIT.

More recently, in the case of Adamakopoulos v Cyprus, the tribunal held (by majority) that it had jurisdiction to hear a mass claim of a group of almost 1000 claimants holding financial assets in Cypriot banks. The claimants alleged that the actions by two Cypriot banks to merge in response to suffering losses due to their exposure to the Greek financial crisis had caused significant devaluation to the assets held by them. Similar to Argentina’s objections in the aforementioned cases, Cyprus argued, amongst other things, that the mass claim arbitration was outside the Tribunal’s jurisdiction and was inadmissible. The majority followed the reasoning in Alemanni in determining that the claims were admissible and could be considered together as a ‘single’ dispute within the meaning of the Greek-Cyprus and Luxembourg-Cyprus BITs.

IIAs provide protections for qualifying foreign investors and qualifying investments against adverse state action

The implications for today

This decade’s sovereign debt crisis threatens to unfold on a wider and deeper scale than we have seen in recent past. Even if progress is made on an enhanced multilateral debt restructuring framework that includes the private sector, many foreign investors will likely fall ‘outside the tent’. They will therefore need to consider available avenues to pursue remedies and recourse for loss and damage incurred.

IIAs are an important potential tool available to foreign investors.

IIAs provide protections for qualifying foreign investors and qualifying investments against adverse state action, including where such action is inspired by a debt restructuring program or related objective. Though as past cases reveal, while some IIAs expressly include debt instruments among protected investments, not all IIAs are so clear. These protections have real teeth because IIAs allow investors to bring claims directly against the state through international arbitration. They can also add weight to settlement discussions and negotiations.

As the sovereign debt crisis unfolds and states implement strategies to manage these crises, investors will need to watch those developments close and carefully consider their positions under IIAs and the legal options and claims routes that may be open to them.