In the legal dispute over Ukraine's $3 billion debt to Russia, it is Russia that has the advantage
This post first appeared on Russia Insider
As had become inevitable, Ukraine at the end of the year defaulted on the $3 billion bond held by Russia.
As discussed previously, the Ukrainian default became inevitable following Ukraine’s failure to achieve better terms from its private creditors.
Without a default on the Russian debt the numbers of Ukraine’s IMF bailout simply don’t add up.
When it became clear that neither the IMF nor Western governments were prepared to provide Ukraine with the extra money or the guarantees needed to pay the debt and cover the shortfall on Ukraine’s IMF programme, a default became inevitable.
As was also inevitable, Russia has responded to Ukraine’s default by bringing legal proceedings against Ukraine in London.
In this article I will discuss briefly the legal claim Russia is bringing against Ukraine, before turning to an article on the subject by the US economist Michael Hudson, which has attracted a lot of attention.
Russia’s legal claim against Ukraine
The claim has not been brought in London’s High Court - the court that decides the law for this sort of debt - but in the London Court of International Arbitration.
As its name implies, the London Court of International Arbitration is not properly speaking a court at all, but is an arbitration tribunal set up in the City of London in the nineteenth century to deal with international commercial disputes.
The reason the Russians have brought their claim to the London Court of International Arbitration rather than the High Court is almost certainly because the terms of the Eurobond contract between Ukraine and Russia require it.
It is now almost routine for commercial contracts to contain a clause requiring the parties to seek to resolve their disputes by arbitration, and it is quite often the case that the relevant arbitration panel - in this case the London Court of International Arbitration - is named in the contract.
The reason for choosing arbitration in preference to litigation in the High Court is that the procedures are generally faster and simpler.
The law is however the same, and the lawyers and arbitrators involved in cases in the London Court of International Arbitration are the same people who conduct cases in the High Court.
Though decisions of the London Court of International Arbitration do not have the force of law that Judgments of the High Court do, there is no practical difference since decisions of the London Court of International Arbitration can be converted into High Court Judgments without difficulty.
Once converted, they can be enforced in the same way that British High Court Judgments can be, including in other jurisdictions, such as those of the European Economic Area - which includes Switzerland - and in the British Commonwealth, where British High Court Judgments are recognised.
Reciprocal arrangements also mean that decisions of the London Court of International Arbitration can also generally be converted and enforced by the courts in the US.
Some reports of the claim the Russians are bringing talk about the legal proceedings lasting a long time.
Since it is difficult to see what defence to the claim the Ukrainians have (no lawyer I know of thinks they have one) this may not actually be true.
Needless to say, the London Court of International Arbitration - as an arbitration tribunal - is even less likely to accept the various political arguments made in Ukraine’s defence by some of its supporters than the High Court would be.
As an arbitration panel it would be almost certain to say that consideration of such arguments lay outside its jurisdiction and competence.
What is probably more true is that whilst the Russians may find it relatively easy to obtain a Judgment in their favour, they may find it more difficult to enforce that Judgment.
However saying it might be difficult is not the same as saying it would be impossible.
I am not an expert in this area, but one possibility might be for the Russians to enforce their Judgment against any money held in any commercial bank or financial institution which that bank or lending institution might be lending to Ukraine.
If so then a Judgment in Russia’s favour would effectively lock Ukraine out of Western financial markets, since it beggars belief any compliance officer in any Western financial institution would authorise a loan to Ukraine in those circumstances.
A more incendiary possibility is that the Russians might enforce the Judgment against any of Ukraine’s IMF bailout funds that passed through the European Economic Area - which is to say most of them.
I do not know whether that is legally possible - it would depend on whether IMF funding has sovereign protection (my guess is it doesn’t) - but I am sure there are armies of lawyers currently studying that possibility.
Needless to say either of these developments - should they ever happen - would be a disaster for Ukraine, and potentially a major embarrassment for the IMF.
Ukraine has up to now point-blank refused to negotiate about this loan with Russia. Instead it has made Russia a take it or leave it offer, demanding that Russia accept repayment on the same terms as Ukraine’s commercial lenders.
Given the high risks for Ukraine - and the IMF - arising from the court case, I suspect Ukraine will now come under mounting pressure from the IMF to come to a settlement with Russia. It is by no means impossible the IMF could threaten to withhold funding if Ukraine does not do so.
The IMF, China and the “Paris Club”
This brings me to a recent article by the US economist Michael Hudson in which - quite rightly - he excoriates the IMF’s decision to continue lending to Ukraine despite its default on the debt to Russia.
In this article Michael Hudson sees in the recent IMF rule change a US plot ultimately targeted at China.
According to this view the recent change in the IMF’s rules - allowing the IMF to continue lending to states that default on debts they owe other states - is intended to make it impossible for China to obtain payment of the debts other countries owe it.
China has become a major lender in the last few years - a fact that has alarmed the US.
What Michael Hudson is saying is that the US - by getting the IMF to change its rules - is intending to short-circuit Chinese lending by making Chinese loans irrecoverable.
Michael Hudson’s article has attracted a lot of attention and deservedly so because overall it is a fine article that rightly condemns the way the IMF is being used as an instrument of Western - or rather US -geopolitical interests - a fact just illustrated by the role it has played in the Ukrainian crisis.
Michael Hudson is however an economist rather than a lawyer and in one or two places he misunderstands the law. That is hardly surprising since this is a pretty arcane subject.
Having said that, the situation - though bad - is not quite as bad as Michael Hudson thinks.
Unfortunately this requires a rather technical explanation of the legal difference between the two ways states borrow money.
Briefly, there are two ways states borrow money.
One is the straightforward way of borrowing money from other states.
That generally involves an agreement between the state that is lending the money and the state that is borrowing the money.
The agreement involves a straight transfer of money from the treasury of the state that is lending the money to the treasury of the state that is borrowing it.
The important point to understand about this sort of loan is that it is made pursuant to an interstate agreement between two sovereign states.
As such, because of the doctrine of sovereign immunity - which means states cannot be sued in the civil or commercial courts of other states - there is no court in any state other than (sometimes) the courts of the state that has borrowed the money that can enforce this sort of loan.
Since states that default on loans invariably impose moratoriums on their repayment - which are binding on their courts - that means that in practice there are no courts that will enforce this sort of loan.
The second way for a state to borrow money is by issuing a bond.
A bond - like a cheque - is a sort of IOU.
It is a form of private property bondholders can - and do - buy and sell to each other.
A bond is subject to the law of the place where it is issued. Mostly in the West that is the capital of the state that has issued it.
In the case of some other states - Ukraine being one - it is the law of one of the major financial centres where it is issued. In Europe the City of London and Frankfurt normally fulfil this role.
Bondholders - unlike states that make loans to each other - can sue in the courts of the place where the bonds are issued against a state that defaults on them.
It is because of the difference between these two types of debt - one legally enforceable through the courts, one not - that the IMF has created the distinction between “public” and “private” debt.
Since no court will enforce debts made purely through inter state agreements, that role falls upon the IMF.
If the IMF recognises such a loan - calling it a “public” debt - then its practice until just a few weeks ago was to refuse to lend money to a state in default on it until a restructuring had been agreed or the loan was paid.
Since no mainstream private lender will lend to a state to which the IMF refuses to lend money, that would in effect close a state in default on a “public” debt from the international money markets.
That is a powerful sanction, which effectively cut a state off from external funding. Since no state wants to be put in this position, most states will do almost anything to avoid it.
It is important to say however that contrary to what Michael Hudson appears to think, the IMF has never at any time in its history recognised all debts states owe to each other as “public” debts, nor has it ever said that it would do so.
By way of example, during the Cold War the USSR regularly made large loans to many states - China, Egypt, Vietnam and Cuba being some of the better known examples.
The USSR however stood entirely outside the system operated by the IMF. As a result, the IMF never recognised any of its loans as “public” debts, and never said it would.
The result was that countries that borrowed from the USSR could default on their Soviet loans without facing sanctions from the IMF, and without being barred from borrowing from the IMF or from the international money markets.
Many in fact did so, Egypt being perhaps the most famous - or notorious - example.
The loans the IMF recognises as “public” debts tend in practise to be principally those made by states that are members of the so-called Paris Club.
This is a semi-formal body in which the IMF itself participates.
It provides a venue and mechanisms that enable a state that owes money to a Paris Club member to negotiate restructuring of the debt, with the IMF itself usually directly involved.
The Paris Club also sets out guidelines on how such debts should be treated, and what sort of rescheduling arrangements are appropriate.
Russia is a member of the Paris Club. That fact alone made it effectively impossible for the IMF to deny the $3 billion Ukraine owes Russia is a “public” debt.
China however is not a member of the Paris Club.
China operates in an intermediate position. Unlike the USSR it is an active member of the IMF, with a representative on the IMF’s Executive Board and with its currency recognised by the IMF as suitable for use in international transactions. However it does all these things without being a member of the Paris Club.
Given China’s position - inside the IMF but outside the Paris Club - it is understandable that there has been some uncertainty over how the IMF should treat the loans it makes, and that the IMF should want to clarify this.
The discussions around this issue that Michael Hudson talks about in his article are not therefore quite as sinister as he appears to think.
That the IMF should say it will not always insist on repayment of loans to China as a condition for its own lending is not quite as great a departure from previous IMF practice as Michael Hudson thinks it is.
That does not mean that states that default on their loans to China face no sanction. The sanction they face is that they cannot borrow further from China.
Since China - unlike the USSR - is a major hard currency lender, whose currency is increasingly being used in international transactions, that is a heavy sanction regardless of what position the IMF takes on defaults of Chinese loans.
In reality China has - to US alarm - been steadily gaining ground in the IMF.
Recently it managed to get the IMF to recognise its currency as one suitable for use in international transactions.
Despite US opposition the day when China will join the Paris Club cannot be far off, at which point the anomalies caused by China’s present position will end.
The IMF and Russia’s loan to Ukraine
It is quite a different matter however when the IMF takes the approach that it will continue lending to a country that has defaulted on a loan owed to Russia - a Paris Club member - which is indisputably “public” debt.
That is a major departure, yet in relation to the $3 billion debt Ukraine owes Russia it is one the IMF has now made.
What makes the situation very complicated is that the Russians did not simply rely on the fact the debt is “public” debt in order to secure it.
Instead they took the precaution of securing their interest by making the loan through the purchase of a Ukrainian Eurobond that is protected by English law.
The Ukrainians actually tried to use the fact that the Russians had doubly insured the loan in this way in order to argue that it was not “public” debt at all, but was “private” debt.
Their argument was that the Russians should not be allowed to call the debt “public” (thereby rendering it enforceable by the IMF), whilst having the advantages of a bond that is legally enforceable through the English courts - something the Ukrainians say is more typical of “private” debt.
As I have said previously, the fact a creditor has taken added precautions against the debtor’s default, is not usually considered a reason to make a debt easier to default on. Unsurprisingly, the IMF has rejected the Ukrainian argument and confirmed that the debt Ukraine owes Russia is indeed “public” debt.
What that means in practice is that the IMF has admitted that the Russians are not bound by the terms of the restructuring agreement Ukraine concluded in August with its private creditors.
However the fact that the debt takes the form of a Eurobond does mean that the Russians can enforce the debt by taking legal action in London, which is what they are now doing. Moreover, since they are not bound by the restructuring agreement Ukraine has concluded with its private creditors, they are free to enforce any Judgment they obtain in any way they can.
As I discussed above, that potentially puts the IMF in a very awkward position, and it is not at the moment obvious what its way out is.
For that reason, as I said previously, I expect the IMF to do everything it can to force the Ukrainians to settle, and it is not impossible that the IMF could threaten to withhold funding unless the Ukrainians do so.
If so then the IMF’s rule change may turn out to be of less benefit to Ukraine than appears to be the case at the moment.
Prospect of Western Courts Refusing to Enforce Loans Owed to China and Russia
In his article Michael Hudson worries that before long no Western court will recognise a loan owed to China or Russia, allowing states to default on loans to those countries with impunity.
One day it may indeed come to that. However for the moment the situation is not quite as bad as Michael Hudson thinks.
Western courts already do not enforce loans made directly between states as a result of inter state agreements because of the doctrine of sovereign immunity I discussed above.
That already covers the majority of loans made by China and Russia to non-Western countries like Argentina or Venezuela.
As I said previously, the sanction for these countries if they default on their debts to China is that the Chinese will not lend to them in future.
In the case of the (far fewer and smaller) debts these countries owe Russia, since these are indisputably “public” debts, the IMF - despite its recent rule change - would probably enforce them.
By contrast barring Western courts from enforcing debts that take the form of government bonds - like the $3 billion Ukrainian Eurobond - simply because China or Russia are the bondholders, would be a radically new departure and a very extreme step.
Given that government bonds have been around since the seventeenth century (some say the sixteenth century) that would be a fundamental change in the law, with huge implications, striking at the very root of modern international commercial and banking law.
It would in fact be at one and the same time a legalised form of mass default and a declaration of economic war against two of the world’s most powerful economies.
Given that China and Russia are major holders of US treasury bonds the financial implications of doing something like that would be nothing short of momentous, and the sort of crisis it would give rise to hardly bears thinking about.
Whilst it may one day happen, things will indeed be very bad if it ever comes to that.
Certainly it is not going to happen soon enough to help Ukraine.
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