macroeconomics, sovereign debt, new bankruptcy arrangements, New Bankruptcy Regime

Hal S. Scott

English

Research Papers in Economics

334
Hal S. Scott How Would a New Bankruptcy
Regime Help?
A key issue in THE debate over reform of the international ﬁnancial sys-
tem is whether to adopt a new international bankruptcy regime for sover-
eign debt, and an important aspect of that debate is the lack of consensus
about the problems that such a regime would be designed to solve and
whether it would solve them. My remarks are focused on a new bank-
ruptcy regime rather than a new court, because the former does not neces-
sarily entail the latter. The authors of the three papers in this symposium
all have quite different conceptions of the problems, as do other important
protagonists. 
Bulow’s paper, like his past articles on this subject, is focused on the
need to reduce bailouts of developing-country debt by international ﬁnan-
cial institutions (IFIs) and governments in the industrial countries, so as to
achieve more optimal ﬂows of private capital to emerging markets.
Sachs’ paper sees two different roles for the bankruptcy process: avoiding
a creditor grab race for the sovereign debtor’s assets, and giving the sov-
ereign debtor a new start by substantially reducing its debt. White’s paper
mainly addresses two objectives that differ from both Bulow’s and
Sachs’: preventing rogue creditors from upsetting private debt reorder-
ings and making sure defaulting countries have adequate sources of
funds, through granting seniority to creditors who lend in the wake of a
default. The U.S. Treasury, in the form of John Taylor’s statement during
the same week as this conference,1 has yet a different objective. He wants
to reduce the uncertainty of the current process by providing a more
orderly structure for resolving crises when they occur. Finally, the pur-
pose of the IMF proposal offered by Anne Krueger is more encompass-
ing. In her proposal last November she said the IMF’s aim is “to create a
catalyst that will encourage debtors and creditors to come together to
restructure unsustainable debts in a timely and efﬁcient manner.”2
Krueger’s latest proposal for a sovereign debt restructuring mechanism
(SDRM) contains the following elements: a stay for some ﬁxed duration
1. Taylor (2002).
2. Krueger (2001).
0675-09 BPEA/Scott  7/22/02  1:11 PM  Page 334Hal S. Scott 335
on creditors’ seizure of a troubled debtor’s assets, reform of the debtor’s
economic policies as part of the bankruptcy plan, seniority for creditors
who lend after the petition for a stay, and a mechanism enabling a super-
majority of creditors to bind other creditors to a plan. How does this pro-
posal relate to the objectives identiﬁed by Krueger herself, Taylor, and the
others? 
The relationship between Krueger’s SDRM and reducing bailouts is
not clear. One could argue that this objective could be achieved more
directly than through adoption of an SDRM, by placing restraints on crisis
lending by the IFIs. This could be done in a variety of ways. Under the
proposal by Adam Lerrick and Allan Meltzer,3 IMF support would be
limited to a commitment to buy the debt of defaulting sovereigns at some
discount from the price being offered by the sovereign. Under a proposal
offered jointly by the Bank of Canada and the Bank of England,4 there
would be procedures like those adopted in the United States in 1991 under
the Federal Deposit Insurance Corporation Improvement Act for ofﬁcial
lending to failed banks. Lending would be permitted only when there is a
threat to the stability of the international monetary system and only after
approval by a supermajority of the IMF’s executive board. 
Krueger’s proposal for an SDRM addresses the bailout problem more
indirectly. The idea is that pressure for IMF lending would be lessened if
the SDRM offered a mechanism by which a troubled sovereign debtor
and its creditors could reach an agreement to reduce the sovereign’s debt.
One reason that IMF lending has been so prevalent is that there is no
workable mechanism for reducing debt. Indeed, the argument would be
that the IMF could not risk the chaos, economic and political, that might
ensue in the absence of its lending unless an alternative debt reduction
process were in place. Of course, in the short term, this is proving wrong
in Argentina. One can just say no, without an SDRM. One wonders how
long such a policy would be sustainable, however. 
Even if an SDRM existed, nothing would ensure its use, at least under
the current versions of the proposal. A country would choose to use the
procedure, and then would be permitted to do so only if it met some
threshold test of insolvency, in the sense that it was unable to service its
debt. A country could well choose not to use the procedure even though to
3. Lerrick and Meltzer (2001).
4. Haldane and Kruger (2001).
0675-09 BPEA/Scott  7/22/02  1:11 PM  Page 335336 Brookings Papers on Economic Activity, 1:2002
do so offered the prospect of cutting its debt burden. It might fear being
cut off from market access in the future and prefer to solve the problem
through a bailout. And, as the Argentine case currently illustrates, as do
the examples of Ecuador and Russia in the 1990s as well as the Latin
American crises in the early 1980s, a country does not need an SDRM to
default and restructure its debt. Thus the proposed SDRM will lead to
increased debt reduction and fewer bailouts only if sovereigns prefer that
outcome. Most heavily indebted poor countries will, but what about coun-
tries like Brazil, Korea, or Turkey? 
Is a bankruptcy procedure necessary to avoid the rush to seize a sover-
eign’s assets when the sovereign defaults, as Sachs has contended? This
depends at the outset on how exposed the sovereign’s assets are to such
seizure. There is little empirical evidence that this is a serious problem.
Sovereign default should not put at risk the assets of state enterprises,
such as state-owned airlines, because these are separate entities from the
sovereign. It is unlikely that these assets would be collapsible into those
of the sovereign as a matter of course. Certain assets, like those of the
central bank, enjoy absolute immunity, that is, immunity that cannot be
waived. Nonetheless, the creditor grab race remains a concern. A stay, if
binding on all countries, would prevent the seizure of sovereign assets
once a default occurred. 
Is a bankruptcy procedure necessary to bind rogue creditors? White
does not think so. She, like Taylor, thinks this could be done through the
use of U.K.-style collective action clauses in which a supermajority of
creditors could bind all others. The problem is that such clauses have not
been adopted, probably because of the increased cost of issuing bonds
that have them.5 As Taylor has suggested, this problem could be over-
come by requiring such clauses as a condition for IMF programs or by
subsidizing such clauses through lower IMF charges for borrowing. But
this would not solve the problem of outstanding bonds without such
clauses. 
Some have argued that majority action clauses are really not necessary
given the alternative possibility of using exit consents.6 Under this tech-
nique, as used in conjunction with an exchange offer as in Ecuador, those
5. Eichengreen and Mody (2000).
6. Buchheit and Gulati (2000). 
0675-09 BPEA/Scott  7/22/02  1:11 PM  Page 336Hal S. Scott 337
tendering the old bonds vote to poison them by changing all of their non-
payment terms (payment terms themselves on bonds issued under New
York law cannot be changed without unanimous consent). For example,
the tendering creditors could vote to retract any waivers of sovereign
immunity or to prohibit the bonds from being listed, thus making them
much less attractive to hold. But although this might increase the tender
rate, the vulture creditor looking to realize the face value of the old bond
would still hold the bond and sue. And the prospect of ﬁnding sovereign
assets to attach to satisfy such judgments is signiﬁcant. This is the lesson
of the case involving Elliott Associates and Peru, where vulture creditors
refused to tender old bonds for new Brady bonds, and then, in an action in
a Brussels court, attached interest payments that were to be made on the
Brady bonds through the Euroclear system. Peru’s decision to settle this
claim makes future actions of this kind more likely. 
Bulow thinks the problem could be addressed by the United States
repealing the Foreign Sovereign Immunities Act of 1976 (FSIA), and that
other countries should similarly repeal their foreign sovereign immunity
acts. The idea is that the FSIA is bad because it permits creditors to seize
sovereign assets in the United States in satisfaction of their claims. This is
far from clear. The FSIA does permit creditors to seize nonexempt assets
in connection with commercial activity of the sovereign, and the Supreme
Court has held, in Republic of Argentina v. Weltover, Inc.,7 that issuance
of a bond constitutes a commercial activity. But it does not follow that
creditors would have no remedies in the absence of the FSIA. In its
absence, the jurisdiction of U.S. courts would be determined by interna-
tional law, which generally itself provides a commercial activity excep-
tion to sovereign immunity. This exception could be eliminated only by
international agreement. So neither exit consents nor repeals of sovereign
immunity provisions are likely to solve the problem of rogue creditors. 
We are therefore back to majority action clauses, but the problem
remains that today’s outstanding bonds do not have these clauses. Fur-
thermore, as Krueger points out, even if these clauses existed in all bonds,
“a country with an unsustainable debt burden will require a comprehen-
sive restructuring across a broad range of indebtedness, potentially
including different bonds issued under different jurisdictions, bank loans,
7. 504 U.S. 607 (1992).
0675-09 BPEA/Scott  7/22/02  1:11 PM  Page 337338 Brookings Papers on Economic Activity, 1:2002
trade credits, and some ofﬁcial claims.”8 This is a fundamental point. The
very existence of corporate bankruptcy laws responds to the collective
action problem in trying to provide such a process through private con-
tract. Although Alan Schwartz has argued that the state should permit par-
ties to contract for the corporate bankruptcy system they prefer,9 such
contracting would take place against a default system of law, in the
shadow of the law. Such a default is missing in Taylor’s exclusive
reliance on private contract. 
Is a bankruptcy procedure necessary to ensure the continued ﬂow of
funds to defaulting debtors, as White contends? Not if the lender provid-
ing new ﬁnancing enjoys seniority, as the IMF clearly does, and as do all
ofﬁcial creditors to a degree. But if we are seeking to minimize assistance
from governmental institutions, it is necessary to ensure seniority for pri-
vate postdefault creditors. This would be impossible to achieve through
subordination agreements, because preexisting creditors are unlikely to
agree to subordination without substantial compensation, and the transac-
tions costs of subordination negotiations would be high. Thus seniority
for new money could be ensured only through some international agree-
ment, which could be part of a new SDRM. 
To conclude, I believe it is relatively clear that private contracting
alone will not be able to achieve the various objectives I have examined,
although it can play an important role, particularly in the shadow of a
default rule. I think we should focus in the future on issues of implemen-
tation of an SDRM, such as who will administer this procedure, what
types of debt should be covered, whether any creditors should enjoy
seniority, and how the “plan” of reorganization with respect to the sover-
eign’s future economic policies should be handled. Whatever procedure is
adopted must, however, be ﬂexible and responsive to the political and for-
eign policy concerns of creditor governments. In a pinch, and perhaps
more often, one must be able to override the SDRM. This counsels
against entrusting authority to any independent court, as Krueger’s latest
proposal suggests, at least if the jurisdiction of the court cannot be
restrained where necessary. 
The black hole in the SDRM proposal is, What happens to the debt if,
even with majority voting rules, the sovereign and its creditors cannot
8. Krueger (2002).
9. Schwartz (1998).
0675-09 BPEA/Scott  7/22/02  1:11 PM  Page 338Hal S. Scott 339
agree on a plan? Liquidation is not a practical alternative. Corporate
cramdown, as White points out, is judged against a liquidation benchmark—
all classes of creditors must get what they would have received in liquida-
tion. Like liquidation itself, this benchmark is unavailable for sovereign
bankruptcies. 
One solution might be to require that bankruptcy creditors get no less
in bankruptcy than the debt would be worth absent bankruptcy. The mar-
ket would be able to value newly issued debt. One could probably not rely
on the actual market value of the old debt to make a determination of what
creditors would receive absent bankruptcy (assuming there was a market
in the instrument), because that value might be heavily inﬂuenced by
expectations of what would happen in bankruptcy. One might look, how-
ever, to valuation models to determine what the debt was worth. 
Finally, it is unlikely that politics would permit private creditors to
impose an economic plan on the debtor, as in a corporate bankruptcy.
This suggests that the debtor’s interlocutor about future economic plans
be the IMF, with input, as at present, from the private creditors.
References
Buchheit, Lee C., and G. Mitu Gulati. 2000. “Exit Consents in Sovereign Bond
Exchanges.” UCLA Law Review 48(October): 59–84.
Eichengreen, Barry, and Ashoka Mody. 2000. “Would Collective Action Clauses
Raise Borrowing Costs?” Working Paper 7458. Cambridge, Mass.: National
Bureau of Economic Research (January).
Haldane, Andy, and Mark Kruger. 2001. “The Resolution of International Finan-
cial Crises: Private Finance and Public Funds.” Bank of Canada Working Paper
2001-20. Ottawa: Bank of Canada (November).
Krueger, Anne. 2001. “International Financial Architecture for 2002: A New
Approach to Sovereign Debt Restructuring.” Address given at the National
Economists’ Club, November 26. (www.imf.org/external/np/speeches/2001/
112601.htm, accessed on May 6, 2002.)
———. 2002. “New Approaches to Sovereign Debt Restructuring: An Update
on Our Thinking.” Speech given at a conference on “Sovereign Debt Work-
outs: Hopes and Hazards,” Institute for International Economics, Washington,
April 1. (www.imf.org/external/np/speeches/2002/040102.htm, accessed on
May 6, 2002.)
Lerrick, Adam, and Allan H. Meltzer. 1991. “Blueprint for an International Lender
of Last Resort.” Working paper. Carnegie Mellon University (October).
0675-09 BPEA/Scott  7/22/02  1:11 PM  Page 339340 Brookings Papers on Economic Activity, 1:2002
Schwartz, Alan. 1998. “A Contract Theory Approach to Business Bankruptcy.”
Yale Law Journal 107(5): 1807–51.
Taylor, John. 2002. “Sovereign Debt Restructuring: A U.S. Perspective.” Paper
presented at a conference on “Sovereign Debt Workouts: Hopes and Hazards,”
Institute for International Economics, Washington, April 2. (www.ustreas.gov/
press/releases/po2056.htm, accessed on May 6, 2002.)
0675-09 BPEA/Scott  7/22/02  1:11 PM  Page 340

International Financial Architecture for 2002: A New Approach to Sovereign Debt Restructuring.” Address given at the National Economists’ Club,

Sovereign Debt Restructuring: A U.S. Perspective.” Paper presented at a conference on “Sovereign Debt Workouts: Hopes and Hazards,”

The Resolution of International Financial Crises: Private Finance and Public Funds.” Bank of Canada Working Paper 2001-20.

Would Collective Action Clauses Raise Borrowing Costs?” Working Paper 7458.

How Would a New Bankruptcy Regime Help?

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How Would a New Bankruptcy Regime Help?

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