Sovereign Bankruptcy Hydraulics

By Stephen Lubben (Seton Hall University School of Law)

The frequent suggestion that the world needs a sovereign bankruptcy mechanism is puzzling.   What precisely would be gained?

The core of any insolvency system consists of a stay against creditor action, an ability to recover preferential payments, and an ability to revamp the debtor’s operations by rejecting burdensome contracts and selling assets. These features, however, are largely irrelevant to sovereign debtors.

In the event of insolvency – or, more simply an inability to pay – sovereign debtors have four tools at their disposal. First, the sovereign might hide behind its immunity, by refusing to be sued. Or the sovereign might change its own law applicable to the debt. That might violate norms, but the sovereign who does this probably also controls the remedy for violations of such norms. Third, the sovereign might manipulate the currency in which its debts are paid. There are economic consequences to doing this, but they might be preferable to a formal default.

These first three tools comprise the modern concept of “sovereign immunity.” But a discussion of sovereign debtors must include a fourth, related issue: the ability to shield assets from collection. That is, even if the debtor can be sued somewhere, in some court, a judgment might be worthless.

If a government issuer can employ some or all of these mechanisms, it has little need of a bankruptcy mechanism because it can refuse to pay its debts, or it can negotiate with creditors to restructure the debt on its own. Kings and queens of old had no need for a bankruptcy mechanism because they could use all four of these tools. They would pay when they felt that paying was worth it, such as when they needed more funds from lenders.

Of course, there are differing forms of “sovereign immunity.” Few sovereigns retain full, old-fashioned sovereign immunity. Today, many emerging market borrowers and all American municipalities lack access to the first three tools. Their ability to avoid paying turns on the fourth tool, which they can deploy with varying ability.

In short, sovereignty and sovereign immunity occur along a continuum, and the need for a bankruptcy system to address financial distress varies inversely with a sovereign’s place on the continuum.

My short paper, Sovereign Bankruptcy Hydraulics, forthcoming in NYU’s Annual Survey of American Law, examines this basic dynamic and its implications for the insolvency of sovereigns and semi-sovereigns.