Pari passu clauses were deliberately crafted to gain an upper hand in sovereign bankruptcy disputes brought to the London stock exchange’s jurisdiction
Few persons, even legal scholars, realize that sovereign bankruptcy has a long history. Far from a pie-in-the-sky scheme conceived in the 1980s by international lawyers such as Christopher Oeschli and economists such as Jeffrey Sachs that later inspired the failed IMF Krueger proposal for a sovereign debt restructuring mechanism, the concept of sovereign debt bankruptcy and discharge (write-off) has an ancient and little known history. My new INET working paper sets out this history for the first time.
“Pari Passu Lost and Found: The Origins of Sovereign Bankruptcy, 1798-1873” uses the modern debate on pari passu clauses in sovereign debt contracts as the entry point to reconstruct the historical origins of sovereign bankruptcy. Pari passu literally means “in equal steps” and pari passu clauses which are ubiquitous in modern sovereign debt contracts pledge equitable treatment to creditors holding bonds exhibiting such provisions. But the precise meaning of “equal steps” is unclear and has been hotly contested in disputes among creditors in the midst of debt restructurings.
In the past 20 years, so-called vulture funds have successfully promoted a reading of pari passu clauses that prevents defaulting countries from going ahead with payments to bond holders who accept their terms while others reject them. This interpretation, which gives the holdout creditors great power in the negotiations, was most famously upheld in the influential Griesa ruling in a 2014 dispute that pitted the Argentine Republic against Elliott, a hedge fund. The verdict promoted what came to be known as the ratable interpretation of pari passu clauses: That under the penalty of being intercepted by a court or justice, payments to creditors have always to be ratable or proportional to all creditors whether or not they accepted the defaulting government’s terms.
Because no one likes vulture funds and their actions were perceived as threats to the very precarious balance upon which IMF-supported debt restructuring rested, there was a general outcry against the Elliott verdict and more generally against the ratable interpretation of pari passu clauses. In particular, a group of critical scholars styling themselves as “contract originalists” suggested on the basis of a series of historical forays that pari passu clauses in sovereign debt covenants were initially (in the late 19th century) a misguided transplant from corporate law where equal treatment is warranted with respect to collateral or security. The language was then introduced to the sphere of sovereign debt, where it is a problematic concept because under sovereign immunity attachment of assets is difficult.
A variant of this line of thought asserts that pari passu clauses emerged in sovereign debt contracts either randomly or in anticipation of gunboat enforcement. In yet another incarnation of the argument, actual contracts, such as a Bolivian loan contract dating to 1872, which was at one point considered to be patient zero, were examined, with originalists concluding that they could not make sense of the clauses. On the basis of such historical evidence, originalists have attacked the broad ratable interpretation of pari passu clauses. In the language of one supporter of this view: “[The idea that pari passu clauses grant] each bondholder a unilateral right to block payments to bondholders who assent to a government’s restructuring proposal [would] have no historical precedent whatsoever.”
My research shows that this is not true. On the basis of novel archival work, I show that the interpretation of pari passu clauses as giving obstruction rights in debt restructurings has very precise historical precedents. In the early Victorian era, a full-fledged sovereign bankruptcy regime evolved, supported by a court of arbitration which developed its own jurisprudence. This court consisted of the Committee of the London Stock Exchange, then by far the most important market for sovereign debt. The Stock Exchange Committee developed initially as a tribunal dedicated to stockbroker bankruptcies because stockbrokers who dealt extensively in illegal derivative products sought to avoid getting the Lord Chancellor’s court of bankruptcy involved in their failures. And in 1827, on the heels of what has been described as the first international sovereign debt crisis, the Stock Exchange Committee took advantage of the bankruptcy expertise it had accumulated and became a venue to adjudicate sovereign default and sanction debt discharges.
This finding is in itself important because in conventional interpretations, as for example, in the recent series of articles by the New York Times on Haïti’s debt to France, the 19th century is conventionally seen as an age of imperial violence, with debt enforcement secured by dispatching a man-of-war. But my research shows that until very late in the nineteenth century, mainly lesser powers – France in the first half of the 19th century, or the United States in the age of the so-called “dollar diplomacy” – cloaked their imperial desires behind the letter of Vattel’s Law of Nations which indeed gave a blank check to the sovereign of the creditor’s power to shell the ports of defaulting borrowers. By contrast, Britain made less extensive use of violence and coercion to secure debt enforcement, usually intervening because it saw another power (France) taking action and was compelled to tag along (as in the case of Mexico) or act pre-emptively (as in the case of Egypt).
The reason for Britain’s more limited use of gunboats, I argue, is that sovereign debt contracted under the laws of the London stock exchange could rely on a full-fledged debt restructuring mechanism. What is more, to secure creditor cooperation, the law of the stock exchange ensured it would deliver fair debt write-offs, i.e. governed by pari passu logic. In fact, pari passu treatment of creditors was a pre-condition for any discharge: A creditor who failed to receive a ratable payment could litigate the country’s discharge and have the stock exchange pronounce it a defaulter. At bottom, this was an early form of what is known today as Fair and Equitable Treatment (FET) clauses. They were implicit in any sovereign loan issued under the law of the London stock exchange.
In practice, creditors in a default were ranked according to the rights set down in the respective covenants and these rights were then mapped proportionately into payments. Against this backdrop, a departure from proportional payment gave the right to individual bondholders to litigate: In case a bankruptcy workout would not result in ratable distributions, aggrieved creditors could ask the court to strike down the discharge. In other words, the ratable interpretation of creditor equality of treatment was the cornerstone and foundation of sovereign bankruptcy and in turn, of the London sovereign debt market. Indeed, loans issued in this market gave creditors convenient instruments to address distress: I suggest that this was one reason why the London stock exchange was such a successful market. To creditors, it ensured that they would be fairly treated in a debt restructuring. To debtors, it ensured that they would have a way to negotiate a proper write-off, and what is more, they would be protected afterward. But this also means that, sadly for contract originalists, pari passu verdicts have very ancient and high-profile roots. They were the cornerstone of a system that enabled proper discharges to be extended.
To deliver this message, the working paper first discusses the reasons why the modern literature has overlooked the existence of the stock exchange tribunal as a court of sovereign bankruptcy. The oversight is traced to interwar American scholars. These scholars noted that under the rules of the stock exchange, a defaulter could not borrow. But they failed to grasp that, first, this mechanism ensured the equitable treatment of creditors, and second, that it provided countries with the attractive prospect of a debt write-off. Superficial research and. as I show, theoretical hostility to the concept of sovereign bankruptcy, which these interwar scholars inherited from 19th century British Law Officers, did lead them to erase from the record the role of the London stock exchange tribunal.
Next, drawing extensively on unexploited archives, the paper details the rise of the stock exchange sovereign bankruptcy tribunal from its roots in Early Modern Lex Mercatoria. The Stock Exchange Committee was a sui generis merchant court created in 1798 to deal with “illegal” stockbroker bankruptcy. Remarkably, the first verdict it ever returned, consisted in interpreting creditor equitability as ratable payment. The jurisprudence was later encapsulated in the statutes – or Rules and Regulations – of the stock exchange. When, in the aftermath of the 1825-6 sovereign debt crash, the committee of the London stock exchange was turned into a sovereign bankruptcy tribunal and equipped with the authority to govern debt discharges, it inherited the logic.
The article then unpacks the mechanics of discharge litigation and illuminates, in so doing, the “real” function fulfilled by the equal treatment assumption. By providing grounds for individual creditors to litigate non-ratable payments, the clauses served to strike down exploitive discharges. In so doing, they secured creditor cooperation. A striking finding is that because of its promotion of creditor cooperation, sovereign bankruptcy became, in English law, a field of bankruptcy experimentation, in fact, an avant-garde movement of then conservative corporate bankruptcy: Modern economists and lawyers may believe that causality runs from corporate to sovereign, but historical research suggests that in reality, the opposite occurred.
Finally, the paper studies closely the first instances of pari passu provisions found in actual sovereign debt contracts of the 19th century. It shows that they emerged as lenders and borrowers and the lawyers who assisted them availed themselves of the law of the stock exchange in clever ways. Far from being inspired by a misguided transplant from corporate debt law, as contract originalists suggest, pari passu clauses were deliberately crafted to gain an upper hand in sovereign bankruptcy disputes brought to the London stock exchange’s jurisdiction. Drafters – the ancestors and sometimes actual predecessors of modern English law firms – admitted the agency of the stock exchange tribunal and harbored a keen sense of the possibilities afforded by the stock exchange’s sovereign bankruptcy court. Examining the way they crafted the clauses speaks volumes about their warranted expectation that the stock exchange tribunal would enforce the clauses as it did.
In the light of history, therefore, it does not appear absurd at all to say that modern pari passu clauses were introduced with an eye to secure ratable distributions as the vulture funds have charged. Under the early regime where they first appeared, pari passu provisions were introduced indeed precisely with this intention – in anticipation that departure from ratable distributions would be punished under the discharge statute of the London stock exchange. Of course, modern contract drafters could not have had in mind the precise machinery of the now-deceased London stock exchange’s jurisdiction as I unpack it here, since until this paper was written, its substance was unknown – as the good faith errors committed by contract originalists demonstrate. But the early drafters had in view the possibility that some court, someday, would hear them and perhaps an understanding of the role which equitable treatment can play, under the right circumstances, in promoting creditor cooperation. They may also have had in mind that, if sovereign bankruptcy is ever to be implemented, then it will have to begin with ratable distributions. Against this backdrop, and considering that many sovereign debts are long-term instruments, the clauses became a way to secure protection preemptively, “just in case;” a barnacle expecting to find its whale. Maybe, in their own opportunistic and mercurial way, the vultures are clamoring for the creation of a sovereign bankruptcy court?
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