International Insolvency and Finance Law

Legal Constants in Times of Crises

Daniele D'Alvia

• Publisher: Routledge
• Year: 2022
• Print ISBN:
  9781032243795
• eBook ISBN:
  9781000610901
• Topic: Law
• Subtopic: Finance
• Index: Law

Focusing on the Global Financial Crisis 2007-2010 and the new emerging Covid-19 crisis in 2020, this book examines the discourse on risk and uncertainty in the markets through the lens of financial crises. Such crises represent a failure of the law to regulate, and constitute the basis through which a new theory of legal constants can be introduced in comparative law. Crisis impose a dramatic reformulation of the law, the Covid-19 confirms this trend, and new out-of-law instances are appearing beyond a paternalistic approach of direct State regulation. Restructuring procedures are playing a vital role in businesses' survival, and new out-of-law mechanisms such as moratorium agreements and private workouts have become essential to preserve businesses. It is clear that the role of the law has completely changed, and this book argues that constants outside of the law are new ways to promote an "uncodified-codification" of the law. The case for uncodified uncertainty in the Covid-19 crisis is a primary example of how no codification process can ignore the importance of out-of-law instances in the act of making law. This book explores how this approach influences the harmonisation process of international economic law between national insolvency regimes and international agreed frameworks, demonstrating the role of comparative law in formulating legal constants using Covid-19 and the complexity of modern financial markets as the criterion to introduce the reader to this new theory, which claims a new role for comparative law in policy making processes within the framework of international economic law.

1 The Times of Crisis between Insolvency and Financial Law

DOI: 10.4324/9781003278320-2

1.1 The Legal Theory of Finance

In 2013, Katharina Pistor wrote a working paper at Columbia Law School titled “A Legal Theory of Finance”.¹ In it, Pistor claims that finance is legally constructed; this means that finance does not stand outside the law. For example, Pistor makes the case that financial assets are disciplined by legal rules and regulators. Although this can vary from jurisdiction to jurisdiction, the legal enforcement of financial commitments is present in every jurisdiction and can influence the scope of the entire financial system. In other words, without legal enforcement, contractual promises cannot be honoured, and the capital outflows or inflows between jurisdictions cannot be effective. For this reason, market participants often design financial instruments that are not in conflict with the existing rules in different jurisdictions. It means that contract law plays a major role in contemporary financial markets, and contractual rules are able to provide financial operators as well as the financial industry with new contractual devices, which – according to Pistor – in turn, seek legal vindication.

1 Katharina Pistor, “A legal theory of finance” (2013) Paper Number 13-348 Columbia Law School – Public & Legal Theory Working Paper Group 13.

In claiming legal vindication, financial operators can try to mitigate uncertainty and prevent liquidity volatility. According to Pistor, liquidity is not a free asset, and when the future shows a liquidity scarcity, the refinance of financial commitments becomes more challenging. This is because every financial system is inherently unstable, and the exercise of discretionary power to enforce legal commitments can bring about a new theory of political economy of finance.

Pistor takes into account a conception of liquidity borrowed from Bernanke.² From this perspective, liquidity is connected to the ability to sell any asset for other assets or cash at will. For instance, in a business reorganisation procedure we might think of carve-out mergers and acquisitions transactions and the dismissal of business’ going concern (i.e. the selling of an asset for cash), and in respect of financial markets, we can imagine any secondary market where the investor is selling financial instruments, being they derivatives, bonds, or stocks, to second-hand investors. In sovereign debt restructuring practices: an exchange offer or debt-for-debt swap or through the use of an internal collective action mechanism³ (if included in the debt instrument).

3 Historically, collective action clauses (CACs) derive from the failure of the IMF’s proposal for a Sovereign Debt Restructuring Mechanism (SDRM), perhaps the best-known attempt to create a multilateral sovereign debt framework in the early 2000s. The private creditor community actively lobbied creditor-hosting governments and debtor states against the SDRM by presenting an alternative, more market-friendly approach to debt restructuring: CACs. CACs benefit private creditors by allowing them to remain in control of their loans to debtors during crises. In contrast, a multilateral sovereign debt framework would be capable of overriding debt financing contracts, imposing a stay on creditor litigation, and brokering debt restructuring under the auspices of a defined framework, to the detriment of private creditors. 2 Ben Bernanke, “The great moderation” (20 February 2004) Federal Reserve, available at www.federalreserve.gov/boarddocs/speeches/2004/20040220/defaul.htm, accessed on 10 December 2021.

To this end, Pistor defines liquidity shortage, namely the impossibility of finding second-hand investors willing to buy financial assets, as one of the main triggers of a financial crisis. Specifically, she claims that uncertainty, rather than underpinning money creation processes, undermines the possibility of obtaining new financing and, therefore, it qualifies liquidity shortage in terms of crisis. Consequently, if financial assets are legally constructed, the law directly contributes to finance’s instability. The main example that is brought to the attention of the reader is the case of sovereign debt. The law of the issuer, namely the national law of the country that is borrowing money from investors through a Eurobond, matters, because at the apex, the law is much more flexible in comparison with the periphery (the contractual terms and conditions of a bond prospectus or the offering memorandum or circular). Indeed, at the apex, the law is more elastic because the survival of the entire system is at stake, and the discretionary power can be limited to save the system. On the other hand, at the periphery, the law is less elastic, and default can result in an involuntary exit. Furthermore, if we agree with this vision, we must consequently admit that the survival of the system is determined at its apex.

Specifically, states or financial intermediaries are in greater proximity to the apex. Hence, they are also more likely to benefit from a relaxation of the rules or a suspension of the full force of the law. A direct example can be seen in sovereign debt contracts whose enforceability is doubtful, or elastic. States’ assets cannot be seized and liquidated, and only assets located overseas can be frozen (if ever). In other words, a state cannot be subject to liquidation as happens in the case of private distressed companies that might be liquidated if they do not find a viable alternative to restructure their finances. Furthermore, sovereign governments that owe debt to many foreign creditors can choose which creditors to favour when making payments by implementing a de facto seniority structure of sovereign debt.⁴ Essentially, the state issuing sovereign debt can “escape” legal obligation by changing the law or altering the order of priority of payments. However, financiers have been able to sue their own sovereigns for default. The Brady Plan of the 1980s was the turning point for sovereign debt litigation;⁵ today’s investors in sovereign debt markets differ from a handful of major syndicated commercial banks prior to the Brady Plan. The growth of secondary sovereign bond markets and the transferability of bonds have opened up access to a wide range of new investors, including professional sovereign debt litigants. These are distressed debt funds that have taken advantage of a business opportunity presented by the secondary market in the absence of a sovereign bankruptcy regime to operate a business model based on sovereign litigation. They have been labelled “vulture funds” as they acquire defaulted (or nearly defaulted) sovereign debt at a significant discount from their issue price on the secondary market, with a premeditated view to hold out⁶ from a restructuring and to litigate for the debt’s full face value with interest and delay penalties, and subsequently pursuing the debtor country’s assets to realise the full value of the claim.⁷ They sue sovereigns in multiple jurisdictions in order to seize sovereign assets to satisfy their court judgements.

7 Julian Schumacher and others, “Sovereign defaults in court” (2018) ECB Working Paper 2135, 17. 6 Holdout litigation has proliferated since courts have explicitly upheld the vulture funds’ business model of the late 1990s. In Elliot Associates v Republic of Peru (1998), the US Court of Appeals dismissed Peru’s champerty defence on the grounds that Elliot’s principal intent was to be paid in full and that Elliot’s litigation was incidental and contingent on Peru’s non-performance of obligations under the contract. Champerty prohibited the purchase of debt with the intent and for the purpose of bringing a lawsuit. The court rejected the champerty defence even though it was clear that at the time of buying Peru’s debt, Elliot, a vulture fund, would have known that Peru would not be able to pay in full. Vulture funds then lobbied in NY legislature in 2004 to amend the NY Judiciary Law 489 so as to prevent the defence of champerty from arising for any debt purchases above $500,000. 5 The Brady Plan involved exchanging outstanding commercial bank loans for bonds in order to relieve the emerging market debt crisis of the late 1980s and early 1990s. 4 Matthias Schlegl, Christoph Trebesch, Mark L. J. Wright, “The seniority structure of sovereign debt” (May 2019) Research Division Federal Reserve Bank of Minneapolis – Working Paper 759, 1.

Under the threat of potential litigation, states try to pay the majority of debt the majority of the time in the hope that this can more easily enable them to access further financing through capital markets and official sector intervention. On the other hand, the litigation risk has exponentially escalated due to the fact that sovereigns frequently issue debt to foreign investors. The latter have brought arbitration proceedings against the state once it defaults on its external debt.

Arbitration is also the field that allows us to make some preliminary reflections on soft law. Historically, the contractual right to choose soft law as the governing law has been narrowly restricted to arbitration. For instance, the Uniform Commercial Code provides the closest US non-arbitration precedent, allowing parties to vary their provisions by choosing soft law promulgated by intergovernmental authorities, such as the United Nations Commission on International Trade Law (UNCITRAL) or the International Institute for the Unification of Private Law (UNIDROIT), or to trade codes such as the Uniform Customs and Practice for Documentary Credits. The Hague Principles on Choice of Law in International Commercial Contracts also favour the right to parties to choose “rules of soft law” that “are generally accepted on an international, supranational or regional level as a neutral and balanced set of rules”. It seems that international commercial, financial, and other business transactions are increasingly conducted under “soft law” rules, which are non-state rules that may be aspirational or reflect best practices but are not yet legally enforceable. The attraction to soft law is focused on the fact that it does not need governmental validation or consent. Nonetheless, it is undeniable that the law still plays a vital role in shaping the enforcement of legal obligations. The law and the power that is exercised by the state can effectively change the level of enforcement and vindication. By contrast, soft law can be seen as a reliable methodology to provide parties with friendly regulatory frameworks that are seen as a non-mechanical form of regulation. Indeed, parties tend to spontaneously adhere to soft law frameworks rather than hard law, which is often perceived as a sort of external imposition. For this reason, it has sometimes been said that soft law is harder than hard law.⁸

8 Francis Snyder, “Soft law and governance: Aspects of the European Union experience” in Luo Haocai (ed) The European Union Experience (Peking University Press 2009).

This dynamic evolution of regulatory regimes has contributed to the exponential growth of hybrid models of regulation. For instance, a new hybrid model of the law has consented to the exponential growth of swaps and derivatives contracts. Indeed, the International Swaps and Derivatives Association (ISDA) has played a major role in the rise of derivatives by creating standard contracts and adapting them to different legal systems around the world. In other words, the ISDA was formed to develop templates for derivative instruments that would be enforceable in multiple jurisdictions. This is a direct example of the critical role that the law is playing in shaping the future, and indirectly in allowing private organisations discretionary power to determine market practices. This is, according to Pistor, the establishment of a central planner that can exercise its authority and power in order to influence the legal environment. The central planner can be a public entity such as the state or a private organisation such as the ISDA, whose objective is to ensure that critical pieces of legislation validate the contracts it sponsors.

The same example can be found in sovereign debt, with the International Capital Market Association (ICMA), which, in 2014, published a new standard of the pari passu clause for inclusion in the terms and conditions of sovereign debt securities, and an updated version of the aggregated collective action clauses for the terms and conditions of sovereign notes.⁹ A very good example of the application of those principles comes from the final restructuring deal that Argentina reached with its foreign bondholders in early August 2020 in the form of a bond exchange offer that was approved overwhelmingly by its foreign bondholders. The tortuous negotiating process lasted several months and came after Argentina had defaulted on its sovereign debt in late May 2020 for the ninth time in its history. On the issue of collective action clauses (CACs), prominent professors around the world wrote open letters to express their strong support for Argentina’s negotiating position.¹⁰ Specifically, those professors claimed that CACs based on aggregated voting across multiple series of bonds should be incorporated in the new bonds, as opposed to CACs that contained a requirement for series-by-series voting (a position that was favoured by certain bondholders). This is because aggregated CACs became the market standard as embodied in the model promulgated in 2014 by the ICMA and earlier-generation CACs based on series-by-series voting essentially only strengthened the hand of potential holdout creditors. Those are standard contractual terms to ensure the legal enforcement of financial obligations.

10 Joseph E. Stiglitz, Edmund S. Phelps, Carmen M. Reinhart, “Restructuring Argentina’s private debt is essential” (6 May 2020) available at www.project-syndicate.org/commentary/argentina-sovereign-debt-restructuring-private-creditors-by-joseph-e-stiglitz-et-al-2020-05, accessed on 13 June 2021. 9 International Capital Markets Association, “Standard collective action and pari passu clauses for the terms and conditions of sovereign notes” (2014) available at www.icmagroup.org/Regulatory-Policy-and-Market-Practice/Primary-Markets/primary-market-topics/collective-action-clauses/, accessed on 7 July 2021.

Pistor points out the cri...

Table of contents

• Cover
• Half-Title
• Series
• Title
• Copyright
• Dedication
• Contents
• Acknowledgements
• List of Abbreviations
• Introduction
• 1 The Times of Crisis between Insolvency and Financial Law
• 2 Legal Constants, and the Constant Outside of the Law
• 3 The Un(codified) Financial Systems in Times of Crisis
• 4 Cross-Border Insolvency Law: Venturing Beyond Structural Crisis
• Conclusions
• Index