Russian Debt Default and Deficiency in Providing Enough Protection for Its Creditors

by | Jun 24, 2022

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About Charles Mak

Charles Ho Wang Mak is a PhD Candidate in law and a Graduate Teaching Assistant at the University of Glasgow, a Fellow of the Centre for Chinese and Comparative Law at the City University of Hong Kong, an Honorary Fellow of the Asian Institute of International Financial Law at the University of Hong Kong, a Research Affiliate at SovereigNET at The Fletcher School, Tufts University, and a Research Associate at China, Law and Development Project at the University of Oxford.

Image description: graphs showing price changes

Almost half of Russia’s foreign reserves are frozen since the implementation of western sanctions against the country. That said, the exception granted by the United States has enabled Russia to continue paying its sovereign debt to American investors in U.S. dollar from sources approved by the U.S. Treasury on a case-by-case basis. However, the U.S. Treasury recently stated that the sanction waiver for American investors has expired.

The Right to Enjoy Possessions Peacefully and Without Discrimination

In response to sanctions, Russia’s finance minister, Anton Siluanov suggested that the government will make all of its sovereign debt payments in roubles if the U.S. blocks other alternatives. The alternative payment currency clause under the sovereign debt contracts signed by Russia with other stakeholders supports such a payment arrangement. Such a circumstance indicates that powerful sovereign debtors may impose their own terms on foreign private creditors. As a sovereign debtor, Russia would jeopardise the interests of its private creditors (especially individual investors) if the currency continued to decline after the implementation of Western sanctions.

The potential debt default in Russia demonstrates that the current approach to sovereign debt is insufficient for providing adequate protection for its creditors. The solutions to the problems of sovereign debt are likely to continue to rely on contractual techniques in the absence of an international treaty dealing specifically with sovereign default and restructuring. Accordingly, private creditors seeking protection against Russian default can only depend on the contractual provisions under sovereign debt contracts. However, the terms of the Russia debt contracts are designed by Russia. Private creditors have effectively no say in the contract drafting because of the inequality in bargaining power.

Aside from contractual provisions, the current rules protecting private creditors are non-binding. A notable example of the voluntary guidelines developed by the private sector is the Institute of International Finance’s Principles for Stable Capital Flows and Fair Debt Restructuring (“Principles”). The Principles support a consensual, predictable, and orderly debt restructuring process based on good faith acts and fair treatment of all parties involved. Russia is not bound by the Principles or other voluntarily guidelines meaning that the interests of private creditors are not adequately safeguarded.

Even though private creditors may take legal action against Russia for defaulting on its debt, the associated costs are extraordinarily high. This is because the jurisdictional threshold for creditors to pursue legal action against Russia is getting higher. For instance, it might be challenging for the creditors to prove that they have jurisdiction against Russia under the current contract between them. It requires more court proceedings. Even where a claim succeeds, Russia would only pay what the original sovereign debt contract stated. Hence, concerns related to assess to justice emerge.

Problem of Vulture Funds

On the other hand, large private-sector creditors, particularly vulture funds (hedge funds, private equity funds, and distressed debt funds that invest in distressed securities, which are debt that is deemed to be particularly weak or in default), may benefit from Russia’s default, which might harm the interest of other creditors. Large private-sector creditors can even take legal action against Russia in the designated forum set out in their sovereign debt contract This is most often  English and New York courts which might negatively affect the public interest. Even if the large private-sector creditors do not succeed in their claim, their holdout conduct still poses a significant challenge for other creditors. Restructuring efforts may be scuppered by those large private-sector creditors. However, the existing regulatory regime does not completely prohibit vulture funds from exploiting defaulted or defaulting sovereign debtors.

Moving Forward

The ideal international legal system dealing with sovereign default should allow sovereign debtors, creditors, and other stakeholders to be treated fairly throughout the debt restructuring process. The existing system is inadequate to provide private creditors with adequate protections. In order to adequately safeguard private creditors from unfair treatment, it is necessary to establish a more comprehensive international framework. The international legal community could take some practical steps to improve such a situation. For instance, the IMF could revisit and start to renegotiate its failed sovereign debt restructuring mechanism.

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