Lawyers pick up the pieces as states go bust - Jonathan Watson

Human rather than legal failings caused the global financial crisis. The bankruptcy of Iceland in October 2008 was a clear sign that the global fi nancial crisis had entered a new and disturbing phase. In November, the International Monetary Fund (IMF) approved a US$2.1 billion loan for the country, making it the first Western European nation to receive an IMF loan since the United Kingdom in 1976. And when widespread popular protests took hold in early 2009 over the way the crisis had been handled, the government had little choice but to resign. Elections that were originally due in 2011 were brought forward to the spring. For Iceland, these were unprecedented events. But state insolvency is not a new phenomenon. ‘Since 1980, nearly 45 per cent of the world’s countries have been insolvent in the sense that they have not been able to pay their foreign currency debts’, says Philip Wood, partner at Allen & Overy and a member of the IBA’s Task Force on the Financial Crisis. ‘That includes virtually all developing countries – the whole of central and eastern Europe, Russia, the whole of Latin America with a few exceptions, the whole of Africa except for Botswana and many countries in the Caribbean. That’s pretty much everyone except the developed world.’

It was still a shock to see a developed country such as Iceland fall prey to insolvency. ‘We are not used to state insolvencies in Western Europe’, says Odd Swarting, a partner at Setterwalls in Sweden and a member of the IBA’s Section on Insolvency, Restructuring and Creditors’ Rights (SIRC). However, he says that the warning signs were there for those who cared to see them. ‘Many people wondered how such a small economy could have such big banks with so much business’, he says. ‘When you looked at the complex nature of the Icelandic banking system, it was a very worrying picture.’

Carsten Ceutz, a partner with Bech-Bruun in Copenhagen, is SIRC Co-Chair. He wonders if Iceland’s small size contributed to the problems in its banking sector. ‘If statutory law had been followed to the letter, Iceland would not be in the financial distress it is in now’, he says. ‘But the population of the country is so small that the civil servants hired by the financial regulators are to some extent family with the bank directors and hedge fund managers. This means that you do not have checks and balances that you would have in a normal system.’

Lessons learned

As the crisis deepens, efforts to understand what can be learned from it are intensifying. According to Ceutz, the crisis of Iceland and others offers few legal lessons. ‘From a legal point of view, we haven’t learned anything’, he says. ‘If statutory law had been followed to the letter, we would not be in this mess. What could have been written into the statutory law of Iceland that would have prevented this situation? What we really needed were some courageous governments to say that we could not carry on living like this.’

However, the crisis has served to highlight the strange fact that there is no international legal framework for dealing with state insolvency. It operates in a legal vacuum, without a bankruptcy law. ‘Compare bank insolvencies, which spark off overpowering state dirigisme’, says Wood. ‘Banks are regulated from cradle to grave, and when they go insolvent, the state is extremely closely engaged. In some countries, the insolvency of banks is run solely by a government agency without any judicial or creditor involvement.’ This is not the case for state insolvencies, where everything has to be achieved by agreement.

‘Since 1980, nearly 45 per cent of the world’s countries have been insolvent’ Philip Wood Allen & Overy

Six years ago, the IMF tried to change this by proposing a new Sovereign Debt Restructuring Mechanism (SDRM). The SDRM would have created a new international legal framework for state insolvencies, similar to bankruptcy proceedings in the private sector. A new judicial group within the IMF was to oversee the framework, and it would have been implemented through international treaties.

The IMF’s approach was a ‘twin-track’ one. The first, a statutory approach, was to create a legal framework that would allow a qualified majority of a country’s creditors to approve a restructuring agreement that would be binding on all. The second approach was to incorporate comprehensive restructuring clauses, so-called ‘collective action clauses’, in debt instruments. Collective action clauses, found in sovereign bond contracts, limit the ability of dissident creditors to block a widely supported restructuring on a  individual bond issue.

The SDRM failed to gain enough support and fell by the wayside. Wood says this is because it came too soon after the bankruptcy of Argentina, which had just made history with what was then the largest ever sovereign debt default. It ended up offering investors 30 cents on the dollar. ‘Argentina had behaved badly and not really engaged with its creditors’, says Wood. ‘People felt that the IMF proposal would encourage others to follow suit.’

Call for bankruptcy court

The current crisis has brought the idea of an international bankruptcy framework back to the top of the agenda. Christoph Paulus, professor of law at Berlin’s Humboldt University, believes that this should start with an international bankruptcy court. ‘There is an urgent need to develop a transparent system for coping with overindebtedness and insolvency’, he says. ‘The bailouts are not the best solution. As a first step, I would propose that we set up some kind of worldwide bankruptcy court. It could be a special chamber of the International Association of Judges, it could be something independent or it could be something like the Iran–United States Claims Tribunal. This would be expensive, of course.’

Manfred Balz drafted the German bankruptcy law reform of 1994 and chaired the EuropeanCouncil Committee on bankruptcy, which negotiated the 1995 European Convention on Insolvency Proceedings. He suggests that the US Chapter 9 bankruptcy rules could provide useful guidance for state insolvency proceedings. Chapter 9 is only available to US municipalities and assists them in the restructuring of debts. The best-known example of this came in 1994, when Orange County, California, filed for Chapter 9 bankruptcy protection after losing US$1.6 billion in bad investments. Vallejo City Council, also in California, took the same route last year after its finances were shattered by spiralling public employee salaries and the plummeting housing market. ‘One could consider this as a model for countries’, Balz says. ‘It would mean a process could be installed without the need for an enforcement agency.’

Uncertain future

The problem with developing international state insolvency law is the number of countries involved. ‘It’s very difficult to get almost 200 countries to agree on a statute for a stay on creditors’, says Wood. ‘The idea with the SDRM was to do it via the IMF articles of agreement, because you can amend those if 85 per cent vote in favour. All the member states would then have to implement it, because the articles of agreement would oblige them to import it into domestic legislation. But the US holds 17 per cent of IMF votes, so it could block the SDRM.’

‘We have to help those countries in trouble to find out what went wrong’ Carsten Ceutz Bech-Bruun

The high degree of state interventionism that is flourishing in the wake of the crisis may now be enough to see such reforms through. We might live to see a full bankruptcy regime, including an international bankruptcy court, or the introduction of a modest stay on creditors. But it’s important to remember that the financial crisis should be explained in terms of human failings, not legal ones. ‘If you were an Icelandic regulator, for example, and you were asked to approve a major loan or transfer of amounts between Iceland and abroad, an amount that was twice the size of the UK’s GNP, then you should have asked: is this proper? Is this the right way of doing things? It is the role of the national authorities to ask such questions. They must have not done so.’

Wood believes that the whole of society was implicated in a gigantic conspiracy to inflate the bubble. ‘Everyone loved it and got something out of it’, he says. ‘People sat at home and got rich by not doing anything. They didn’t have to work, their houses doubled in value and everyone was very happy. No one questioned it. But what if we had said in 2006 that we must stop lending to poor people? That would not have gone down very well. The whole crisis is extremely simple and it’s to do with ordinary human hope, fallibility and general credulity – thinking things are great when they are not.’

Ceutz agrees. ‘Should we have done anything else? Yes, we should have waited for our financial success to come at a rate of 1.5 per cent and two per cent per year rather than 15 per cent. We needed a different way of thinking.’

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Jonathan Watson is a journalist specialising in european business, legal and regulatory developments. He can be contacted by e-mail at watsonjonathan@yahoo.co.uk

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