Ukraine Has 1 Month to Avoid Default

Ukrainian ideas for defaulting on its debt to Russia cannot be justified on legal grounds. With talks with creditors in deadlock and the economy in a tailspin, default now looks certain. 

Tue, Apr 21, 2015 | 2,818 Comments
Ukrainian Finance Minister Jaresko leads negotiations with the IMF and Ukraine's creditors
Ukrainian Finance Minister Jaresko leads negotiations with the IMF and Ukraine's creditors

Legal discussions about how Ukraine can “legally” default on its $3 billion loan from Russia are becoming increasingly convoluted. 

I thought it might help if I set out what the various proposed schemes are and why none of them look at all convincing.

In doing so I will also say something about the latest stage of Ukraine’s negotiations with its creditors and why these are now in deadlock, causing all interested outside observers to conclude that a default is now just weeks away.

Before doing so I should explain that the $3 billion loan Russia made to Ukraine takes the form of a  purchase of a Eurobond Ukraine issued in Ireland, which is governed by British law as administered by the High Court in London.

In summary, the various suggestions made as to how Ukraine can “legally” default on its debt to Russia are these:

The UK Parliament Passes a Law Cancelling the Loan

This was proposed early last year.  

This proposal admits the debt. There would be no point passing a law to cancel a debt if the debt did not exist.

The problems involved in using the national parliament of one country to cancel a debt owed by another country to a third country are legion.  The problems of using legislation to cancel a Eurobond, which is a form of property, are also legion. On the face of it, it looks like an act of outright confiscation.  So far as I know, nothing like it has ever been done before.

The British government has shown no interest in this proposal, which would call into question London’s reliability as an international legal and financial centre, even if doing it was legal, which as it is probably contrary to European Union law it probably isn’t.   

This idea looks like a non-starter and has been dropped.

A set-off for the loss of Crimea

This proposal also admits the debt.  A debt cannot be extinguished by a set-off if it is not valid.  Asking for a set-off admits the debt.

Extinguishing the debt by setting off against the debt compensation Russia supposedly owes Ukraine for the loss of Crimea is politically speaking a non-starter since it would require Ukraine to admit Crimea is indeed lost to Russia.  That is something the present Ukrainian government is not going to do.

Some people have tried to get round this by proposing the debt be extinguished by setting it off against compensation Russia supposedly owes Ukraine not for the loss of Crimea but for the economic cost to Ukraine caused by Russia’s “occupation” of Crimea.  

There are two obvious problems:

(1) Even if it accepted that Russia’s “occupation” of Crimea was illegal (which since this is the view of the British government it might well do) the High Court would almost certainly refuse to assess the amount of the cost of this "occupation" to Ukraine. It would probably say this was not something it was competent to do and that this was a matter for the International Court of Justice in the Hague and not for the High Court in London. 

In the absence of any figure for the cost of the "occupation" to Ukraine, the High Court would almost certainly refuse to make a set-off. This is quite apart from the fact that it would anyway probably say that it cannot set-off compensation arising from a political conflict against a commercial debt.

(2) The plaintiff seeking recovery of the debt would anyway not be the Russian government, which had “occupied” Crimea, but Russia’s National Welfare Fund.   It is not clear that Russia’s National Welfare Fund is liable for the actions of Russia’s government. The High Court would almost certainly decide that it isn’t. 

This idea also looks like a non-starter and the Ukrainians are not proceeding with it.

Ukraine demands “disclosure” about Crimea

The idea is that Ukraine uses the British legal procedure known as “disclosure” to force Russia to release confidential information about the events leading up to Crimea’s unification with Russia.  The idea seems to be that in order to avoid being put in this position Russia would write off the debt.

This makes no sense.  Why would the Russians agree to cancel the debt simply because Ukraine had obtained an order from a British court for disclosure?  Such an order would be unenforceable and the Russians would simply refuse to comply with it.  The High Court would not cancel the debt simply because Russia had not complied with the order.  The two issues are completely unrelated.  As a matter of fact it is most unlikely the British courts would make such an order at all.

The debt is unenforceable because Russia knew when it made the loan Ukraine was bankrupt and could not repay it so that the real beneficiary of the loan was Yanukovych rather than Ukraine

This argues that despite all outward appearances it was not a loan at all but rather a kind of bribe paid by Russia to Yanukovych to keep him afloat and onside.

This argument suffers from the fundamental difficulty that exactly the same argument can be used to challenge the validity of the various loans Western governments and financial institutions have made to Ukraine since Yanukovych fell.

The terms of the loan anyway refute the argument.  It was clearly intended to be repaid. The loan contains a provision that it becomes automatically repayable if Ukraine’s debt to GDP ratio exceeds 60%.  It is impossible to see the point of this provision if the loan was not intended to be repaid.

In reality the loan was part of a larger financial package or action plan intended to put Ukraine back on its feet. This included a substantial discount for natural gas supplied to Ukraine by Russia. In view of this the argument that it was intended to benefit Yanukovych personally rather than Ukraine falls on its face.  

The debt should not be repaid because Russia has undermined a key provision by reducing the size of Ukraine’s GDP by taking over Crimea

This argument turns on the provision that the loan becomes repayable if Ukraine’s debt to GDP ratio exceeds 60%.

Russia however has not enforced this provision. Russia has not demanded repayment of the loan despite the fact that Ukraine’s debt to GDP ratio some months ago passed 60%.

The High Court would anyway be most unlikely to say the whole loan should be simply cancelled because of this provision.

The debt is not repayable because Russia has made its repayment impossible by committing military aggression against Ukraine

Russia categorically denies it is committing aggression against Ukraine.  

The Russians would undoubtedly argue that the question of whether or not Russia is committing aggression against Ukraine has been answered in their favour by Ukraine’s signature to the Minsk Memorandum. This treats the Ukrainian conflict as a civil war and commits Ukraine to a process for its settlement.  

The High Court would anyway almost certainly refuse to look at this question.  It would probably again say this a matter for the International Court of Justice. It is anyway doubtful even if Ukraine could persuade the High Court that Russia had committed aggression against Ukraine that this cancels Ukraine’s whole debt.  

I have tried to highlight the obvious problems with each of the arguments that have been made to justify Ukraine defaulting on its debt to Russia. To someone unfamiliar with the law in this area and with the practice of the British High Court, some of these arguments might appear attractive. This is not in fact so. On the contrary each has so many problems that they all look frankly farfetched.

A Eurobond, which is the form this loan takes, is a negotiable instrument, in this case one Ukraine itself has itself issued. Defaulting on a Eurobond would be akin to a government bouncing a cheque. If only for that reason the High Court would be almost certain to reject any of the arguments put forward as valid reasons to justify doing it.

The Ukrainians seem, very grudgingly, to have come round to this view themselves. They have not pushed any one of these arguments. They have not disputed the debt. Rather they claim that it is a “private” debt as opposed to a “public” one.

“Private” debt or “public” debt

This argument surfaced in recent weeks as a result of something I warned might happen several weeks ago.

Back in January, when it was becoming increasingly obvious that the previous IMF package was falling apart, I made this point:

“Since neither the Ukrainians nor the Western powers want to talk to the Russians about a formal debt restructuring of Ukraine’s debts, they seem to be trying to get around this by adopting Soros’s plan of increasing the amount of IMF lending to Ukraine whilst getting Ukraine’s private western creditors to take a bigger hit than they would otherwise have done.

The …. point about this plan is that if the Russians are not party to it then the amount Ukraine owes the Russians is unchanged and the Ukrainians must pay the Russians the same amount they pay now, as the loans say.  

It will be interesting to see whether Ukraine’s private creditors agree to the sort of voluntary haircut they are being asked to make. Many of them may not be happy to agree to a haircut so that Ukraine and its Western supporters don’t have to talk to the Russians.

They may very well balk at a plan whose effect would be to privilege loans Ukraine owes Russia over loans Ukraine owes them. No doubt there will be a lot of arms twisting to get them to agree but it is likely the negotiations will be tough.”

What has in fact happened is that since the Ukrainians and the West do not want to talk to the Russians about a restructuring, the Russians have refused to be part of one. My guess that the Ukraine’s private creditors would in that case “balk at a plan whose effect would be to privilege loans Ukraine owes Russia over loans Ukraine owes them” has turned out to be completely correct. Not only have the negotiations proved tough. By all accounts they are in complete deadlock.

In order to break the deadlock there has now been a creative reinterpretation of the IMF’s rules regarding bailouts.  

Supposedly, if a debt owed by a state is a “private” debt, i.e. a commercial debt owed to a private creditor, the private creditor can be forced into a restructuring whether the creditor wants to be part of that restructuring or not. In that case both the restructuring and the IMF bailout can go ahead regardless of the creditor's wishes.

However, if the debt is a “public” debt,  i.e., a debt owed by one state to another, then the state to which the debt is owed cannot be forced into a restructuring against its will. In that case, if it refuses to be part of a restructuring, and the state which owes the debt defaults on the loan, then the planned IMF bailout cannot go ahead.

Some readers who have read articles about the Ukrainian debt negotiations may have come across references to the "London Club" and the "Paris Club".  The "London Club" refers to Ukraine's "private" creditors.  The "Paris Club" to its "public" ones.

Over the last few weeks the Ukrainian government has argued that the debt Ukraine owes Russia is a “private” debt, that Russia is a member of the so called "London Club" and is subject to its rules and that Russia must therefore accept whatever restructuring Ukraine agrees with its other creditors who are also members with Russia of the "London Club".

The Russians of course disagree. Russian Finance Minister Siluanov has said the debt Ukraine owes Russia is a “public” debt and, since Russia refuses to be part of any restructuring, if Ukraine defaults on the debt Russia will take legal action to enforce it and to declare Ukraine in default.

The Ukrainian claim that the debt Ukraine owes Russia is a “private” debt is based on the fact that the debt takes the form of a Eurobond. The Ukrainians argue this means that it is not properly speaking a loan between two states at all, since what the Russians actually did was buy into Ukrainian Eurobonds. The Ukrainians say the Russians are trying to have it both ways, taking the advantage of being holders of a Eurobond (which makes default more difficult) while at the same time resisting calls for a restructuring by claiming it is a “public” debt.

The problem the Ukrainians have is that the legal community and the IMF bureaucracy, by and large, don’t agree with them.

The loan was negotiated in December 2013 by Putin and Yanukovych, who was President of Ukraine. It formed part of a package intended to support Ukraine;s economy. The money comes from Russia’s National Welfare Fund.

To argue therefore that the debt is a “private” debt rather than a "public" debt is farfetched to say the least.   

As for the argument that Russia is trying to have it both ways, that sounds like an argument that Russia should have made the debt easier for Ukraine to default on. An argument that a creditor owes it to the debtor to make it easier for the debtor to renege on a debt is not one that would persuade most people.

Some say that despite the flimsy nature of this argument it puts Ukraine in a strong position because there is no court or tribunal competent to decide whether or not the debt is “public” or not.  

That is almost certainly wrong. If Ukraine tried to impose a restructuring upon Russia, the Russians would treat Ukraine as being in default and would enforce the debt in London's High Court.  Ukraine would then have to argue in its defence that the debt is a “private” one.  At that point the High Court would have to decide the question. 

The IMF could come to Ukraine’s rescue by giving evidence the debt is indeed a “private” debt. That however would require Lagarde and the IMF Board to override the IMF’s own bureaucracy who quite clearly think differently. It would also involve the IMF in court proceedings in London. That might be embarrassing, exposing the IMF to questions about whether, given that Ukraine is insolvent and in the middle of a civil war, it should be getting IMF funding at all. The IMF would probably be very unwilling to be put in this position.

Some commentators on threads of previous articles I have written for Russia Insider in which I have discussed this question have expressed the view that all these legal considerations are in the end unimportant. Politics supposedly overrides everything. The West’s need at the moment is to back Ukraine and that is what it is going to do. The law is not going to be allowed to stand in the way. IMF funding will be railroaded through no matter what and if Ukraine defaults on its debt to Russia it will be allowed to do so.

This is a valid view. In recent years the Western powers - the US especially - have shown that they will ignore the law when it suits them and when they think they can get away with it. The very fact discussions are underway about how Ukraine can “legally” default on its loan to Russia shows this.

The difficulties however should not be underestimated. 

Commercial law is the foundation underpinning world trade, which is the lifeblood of the world economy. If the US and its allies play fast and loose with it they risk unravelling the very same trade system upon which they ultimately depend. At a time when they face an increasing challenge from China the risks of doing this are high.  

Frankly, it looks simpler and less risky for the West simply to give Ukraine more money than go down this road. That of course is precisely what they are not prepared to do, which is why these intricate discussions about how Ukraine can "legally" default on the debt it owes Russia are taking place.

Regardless, until this issue is resolved, the negotiations with Ukraine’s private creditors will likely remain deadlocked. From their point of view it probably makes more sense to let Ukraine default than agree to a restructuring on unfavourable terms, which the Russians might be able to set aside through court action. If the creditors agree to a restructuring they might find themselves in future up against an argument that they are stuck with whatever reduction in the amount Ukraine owes them that they agreed even if the Russians eventually get the restructuring set aside. By contrast if Ukraine simply defaults, they can come back and demand all their money later when Ukraine recovers, perhaps under a new government.  

The IMF says the issue has to be resolved at the latest by the end of May. If it is not resolved by then, IMF support will be withdrawn. Ukraine will at that point be left with no choice but to default.

As of now that looks like the likeliest prospect.  Certainly, judging by their latest assessments, the international credit rating agencies think so.

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