Sovereign Debt: the Rise of the Secondary Market and Its Implications for Future Restructurings

Fordham Law Review Volume 64 Issue 6 Article 9 1996 Sovereign Debt: The Rise of the Secondary Market and its Implications for Future Restructurings Philip J. Power Follow this and additional works at: https://ir.lawnet.fordham.edu/flr Part of the Law Commons Recommended Citation Philip J. Power, Sovereign Debt: The Rise of the Secondary Market and its Implications for Future Restructurings, 64 Fordham L. Rev. 2701 (1996). Available at: https://ir.lawnet.fordham.edu/flr/vol64/iss6/9 This Article is brought to you for free and open access by FLASH: The Fordham Law Archive of Scholarship and History. It has been accepted for inclusion in Fordham Law Review by an authorized editor of FLASH: The Fordham Law Archive of Scholarship and History. For more information, please contact [email protected]. SOVEREIGN DEBT: THE RISE OF THE SECONDARY MARKET AND ITS IMPLICATIONS FOR FUTURE RESTRUCTURINGS Philip J. Power Small debts are like small shot; they are rattling on every side, and can scarcely be escaped without a wound; great debts are like can- non; of loud noise, but little danger.' TABLE OF CONTENTS INTRODUCTION ................................................. 2702 I. THE LAST SOVEREIGN DEBT CRISIS ....................... 2706 A. Origins of the Debt Crisis ........................... 2707 B. The Commercial Banks' Response ................... 2709 C. The Baker Plan...................................... 2714 D. The Secondary Market .............................. 2715 E. The Brady Plan ..................................... 2719 I. SUING THE SOVEREIGN: THE ROAD NOT TAKEN ......... 2723 A. Article VIII, Section 2(b) of the IMF Articles of Agreement ........................................... 2723 B. Sovereign Immunity ................................. 2727 C. The Act of State Doctrine............................ 2732 D. International Comity ............ ............... 2738 E. Averting the Nightmare Scenario..................... 2742 IlH. SUING THE SOVEREIGN: THE WAY OF THE FUTURE? ..... 2745 A. CIBC Bank and Trust Co. (Cayman) Ltd. v. Banco Central do Brasil .................................... 2745 B. Pravin Banker Assocs. Ltd. v. Banco Popular del Peru ................................................. 2754 IV. THE NEXT SOVEREIGN DEBT CRISIS ...................... 2763 A. The Effect of the New Creditor Class ................ 2763 B. Averting the (New) Nightmare Scenario .............. 2764 1. An International Bankruptcy Court? ............ 2765 2. An Automatic Stay .............................. 2767 3. Binding Dissenters ............................... 2768 CONCLUSION ................................................... 2771 1. Letter from Samuel Johnson to Joseph Simpson, Esq. (1759), in James Bos- well, The Life of Samuel Johnson 218 (Everyman's Library ed., Alfred A. Knopf, Inc. 1992) (1791). 2701 2702 FORDHAM LAW REVIEW [Vol. 64 INTRODUCTION By all accounts, the sovereign debt crisis2 of the 1980s has passed into history.3 The event, which hobbled the development of Latin America for more than a decade and threatened the stability of the international financial system, is over. In the years after the crisis erupted, U.S. commercial banks averted financial ruin by steadily in- creasing their loan loss reserves, writing off nonperforming loans, and selling their sovereign loan assets in a growing secondary market for sovereign debt.4 In addition, since the announcement of the Brady Plan in 1989,1 banks have converted most of their outstanding sovereign loans to bonds, writing down a large percentage of the loans as part of the conversion process, and spreading the risk of future sovereign defaults among a larger class of creditors. Thus, over the course of more than a decade, banks have taken the bad loans off their books and the sovereign debtors have been afforded a measure of debt relief. The economic challenges facing the debtor countries have not been eliminated, however. Indeed, Latin America's ratio of aggregate ex- ternal debt to export earnings remains close to the ratio prevailing at the onset of the debt crisis.6 Although no one is predicting an immi- nent Latin American sovereign default,7 the transformation of the creditor class from a relatively small number of commercial banks to a 2. A sovereign debt crisis occurs when a country's foreign exchange reserves are insufficient to meet its foreign exchange payment obligations over an extended period of time. See Lee C. Buchheit, The Capitalizationof Sovereign Debt: An Introduction, 1988 U. Ill. L. Rev. 401, 401. 3. See, e.g., Hobart Rowen, Third World Debt Crisis Has Come to an End, Wash. Post, May 3, 1992, at HI; Bill Orr, After a Decade, Bankers Say "Adios" to Latin Debt Crisis,A.B.A. Banking J., July 1992, at 36 (noting that Argentina, Brazil, Chile, Mex- ico, and Venezuela, which collectively owed approximately 90% of the $41 billion that Latin American countries owed to U.S. commercial banks in 1992, had all either converted, or were in the process of converting, their bank loans to bonds). 4. See infra part I.D. 5. See infra part I.E. 6. Rory MacMillan, The Next Sovereign Debt Crisis, 31 Stan. J. Int'l L. 305, 307- 08 & n.21 (1995). 7. Indeed, recent budget confrontations between Congress and the executive branch briefly shifted concern to the hitherto unthinkable possibility, however re- mote, of a U.S. sovereign default. See Charles Jaffe, U.S. Credit Rating at Risk of Downgrade, Firm Says, The Boston Globe, Jan. 25, 1996, at 4; Isabelle Clary, U.S. Treasury Has Talked About Default With Wall Street, Reuters, Nov. 10, 1995. If history is of predictive value, however, the possibility of another Latin American debt crisis is too real to ignore. The first debt crisis involving the United States and Latin America occurred in September of 1873 after several Latin American nations de- clared themselves bankrupt and suspended payments on their debts to foreign creditors, triggering a crash of the New York stock market. See Carlos Marichal, A Century of Debt Crises in Latin America 99 (1989). Widespread Latin American sovereign defaults occurred again in the 1890s, see Barry Eichengreen & Richard Portes, Settling Defaults in the Era of Bond Finance, 3 The World Bank Econ. Rev. 211, 212 (1989), and in the 1930s. See Barry Eichengreen & Richard Portes, Debt and Default in the 1930s: Causes and Consequences, 30 Eur. Econ. Rev. 599, 621 (1986). 1996] SOVEREIGN DEBT & THE SECONDARY MARKET 2703 larger group of bondholders suggests that the complexity of sovereign debt restructuring in the event of another debt crisis will cause the last crisis to pale in comparison. That transformation calls for a reap- praisal of both the creditor rights established in the wake of the debt crisis and the methods employed during the crisis for restructuring sovereign debt. Consider the case of Debtor Republic, a hypothetical Latin Ameri- can country. In the late 1970s, Debtor Republic borrowed $50 billion from U.S. commercial banks to finance infrastructure development projects. In 1982, Debtor Republic experienced a shortage of U.S. dollar reserves and announced that it was unable to repay its debts to the banks. Believing that Debtor Republic was experiencing only a temporary liquidity crisis, the banks agreed to extend by one year the maturity dates of their loans to the country. Moreover, because Debtor Republic was unable to pay interest on the loans, the banks agreed collectively to extend new loans in an amount sufficient to enable Debtor Republic to make its interest payments. When the rescheduled loans matured in 1983, Debtor Republic again announced it was unable to repay them. Again the banks rescheduled the old loans and made new loans to cover the accrued interest, this time with the reluctant recognition that Debtor Republic would never be able to repay its debts in full. By 1988, the banks had rescheduled their loans to Debtor Republic four times. Collection suits were not an option; Debtor Republic had only $500 million of attachable assets in the United States. Even worse, the banks could not afford to write off their loans to Debtor Republic because they did not have sufficient reserves to cover the loss. By 1989, however, the banks had increased their loan-loss reserves sufficiently to enable them to write off eighty percent of their loans to Debtor Republic. Many of the banks began selling Debtor Republic's loan obligations to intrepid investors at twenty percent of face value and charging the remaining eighty percent against loan-loss reserves. In 1990, Vulture Venture Fund, Inc., a small investment firm spe- cializing in emerging markets, purchased from a large commercial bank a portfolio of rescheduled loans to Debtor Republic having a face value of $100 million and due to mature in 1994. Vulture Venture paid $20 million for the portfolio. Although Vulture Venture did not expect that Debtor Republic would be able to repay the full $100 million of principal in 1994, Vulture Venture was confident that Debtor Republic would eventually repay at least $20 million of principal. Moreover, the interest payments Debtor Republic was continuing to pay on the loans ensured that Vulture Venture would earn the high rate of return promised to its investors. When its loans became due in 1994, however, Debtor Republic once again announced that it was unable to repay them. Determined to solve its debt problems once and for all, Debtor Republic requested 2704 FORDHAM LAW REVIEW [Vol. 64 that all its foreign creditors participate in a bold new debt conversion

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