Ukraine Versus the Vultures

Amid all of its other troubles, Ukraine cannot pay its creditors. The country needs more money, serious reform, and a rescheduling of its debt. Yet even the best efforts by the International Monetary Fund, the United States, and the European Union to achieve this will be hobbled by investment agreements that they themselves have pressed on Ukraine and many other emerging economies. Indeed, Ukraine could be left facing a string of complex and costly legal cases.

In recent years, shrewd creditor lawyers have argued that investment treaties give bondholders the same rights as foreign direct investors, and have smuggled sovereign-debt cases into international arbitration proceedings wherever they have found investment treaties with broad, open-ended definitions. The recent experiences of Argentina, Greece, and Cyprus highlight the “blowback” on sovereign-debt restructuring.

The first such case was Abaclat and Others v. Argentine Republic, which started in 2008. Thousands of Italian bondholders refused Argentina’s debt-restructuring deal, successfully arguing that the Italy-Argentina investment treaty gave them the right to pursue compensation through investor-state arbitration.

Resolving a sovereign-debt crisis requires a collective agreement by creditors, which can be achieved only by individual investors’ incentive to try to grab their money and run. That is why investment treaties that leave an opening for holdouts are counterproductive.

In national jurisdictions, a bankruptcy mechanism is used to corral creditors. But no such mechanism exists at the international level. The IMF proposed one in 2002; but, in the face of concerted lobbying by investors, the scheme was rebuffed and instead an agreement was reached to use collective action clauses (CACs) in debt contracts.

The Eurogroup, for example, has declared that all eurozone sovereign bonds issued after January 1, 2013, should include CACs, which render a government’s debt-restructuring proposal legally binding on all bondholders if a majority of bondholders accept the deal. When these clauses work, they streamline debt restructurings.

In the Greek case, CACs were retroactively inserted into all Greek-law debt. This allowed for a faster and more orderly restructuring than otherwise would have been possible. The troika – the IMF, the European Central Bank, and the European Commission – encouraged the Greek government to insert the collective action clauses. Yet now that very maneuver is being challenged as expropriation in international arbitration.

The same could easily happen to Ukraine, which has ratified more than 50 investment treaties. Their relevant clauses are similar – often identical – to those in Greece’s investment treaties, enshrining broad, open-ended definitions of investment that do not exclude sovereign debt. Moreover, many of the treaties provide investors with direct access to arbitration.

So what can be done? For starters, the countries that have investment treaties with Ukraine can add annexes making it explicitly clear that sovereign debt is excluded. Renegotiating more than 50 treaties would be unwieldy, but Ukraine would benefit enormously by renegotiating just one: the US-Ukraine investment treaty.

By some estimates, more than 20% of Ukrainian government debt was recently purchased by a single American investment fund, Franklin Templeton Investments, specializing in distressed debt. So, before the blowback begins, policymakers would do well to heed the strong precedent for excluding sovereign debt from a US investment treaty.

Although US investment treaties are uniform on most issues, they have remarkably diverse approaches to sovereign debt. Chapter 11 of the North American Free Trade Agreement explicitly excludes sovereign debt. Similarly, the US-Uruguay Bilateral Investment Treaty and the US-Peru Trade Promotion Agreement both have annexes that effectively exclude sovereign debt.

For US policymakers, the decision to add an annex excluding sovereign debt is a tough choice. On the one hand, US investment treaties are designed to secure the strongest possible protection for US investors overseas. To remove investment protection – at a time of instability and insecure property rights, no less – is antithetical to the purpose of such treaties.

Given the political and security imperatives of the crisis in Ukraine, however, the alternative is worse. Doing nothing means allowing US investment funds to pursue enormous compensation cases – likely in the billions of dollars – against a future Ukrainian administration, which, even in the best-case scenario, will be on weak domestic political footing and already saddled with an unpopular austerity program and loan-repayment schedule. This outcome would be more than a public-relations nightmare; with Russia beckoning, it might well hasten geostrategic disaster.

Ideally, the world would have a well-functioning international mechanism for sovereign-bond restructuring. We are far from that. Yet before the cameras turn away from Ukraine, officials and leaders can ensure that a future administration there is not left facing bondholders one by one in international arbitration proceedings.

The US and Western Europe have an overriding strategic interest in patching this hole in the international financial architecture, and preventing their private investment funds from aggressively seeking compensation from a future Ukrainian administration. To do otherwise risks far more than financial loss.


Professor Ngaire Woods is the Dean of the Blavatnik School of Government, University of Oxford. Taylor St. John is Senior Researcher in the Global Economic Governance Programme, Oxford University.

This piece first appeared in Project Syndicate, on 17 March 2014.

Image: National Bank of Ukraine by Xsandriel