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Box 3.4 Sovereign debt restructuring and domestic bankruptcy law
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more debtor friendly. In France, maintaining employment is a stated goal.
Balancing the interests of creditors and debtors A key goal of domestic bankruptcy law is to maintain an appropriate balance between the interests of debtors (becoming free from unpayable debts) and the interests of creditors (maximizing the value of the firm after bankruptcy and ensuring that the incentives to repay debt are maintained). Considerable differences exist among legal systems in the balance between creditor and debtor interests. Bankruptcy codes have changed over time; no approach to bankruptcy law is clearly superior to all others. In the United States, the treatment of bankrupt railroads in the 19th century evolved from a liquidation procedure to debt reorganization, which preserved the value of the railroad as a going concern. During the 1930s, Chapter 10 of the Chandler Act mandated an administrative model for bankrupt firms, augmenting the power of an independent trustee at the expense of both debtors and creditors, and frequently leading to liquidation. Firms tended to avoid Chapter 10 in favor of Chapter 11, which provided greater potential for maintaining the firm as a going concern. The 1978 Bankruptcy Act, which facilitated the use of the more debtor-friendly provisions of Chapter 11, may have contributed to the boom in the corporate bond market in the 1980s. By contrast, the administrative process under the U.K. bankruptcy law provides more leverage to creditors, who appoint a receiver to take control of the firm. In France and Germany, where the court appoints an administrator to run the firm, bankruptcy institutions tend to be
Sovereign governments are not firms Differences in the nature of sovereign governments versus firms have important implications for the balance of creditor versus debtor interests. Sovereigns cannot be liquidated and the ability to seize their assets is limited. Thus there is no lower limit to the return to creditors (the liquidation value of the firm in corporate bankruptcy), and creditors’ leverage in defining the reorganization agreement and ensuring a speedy resolution is less than in corporate bankruptcies. Moreover, sovereigns cannot be taken over by creditor-imposed management. Thus, creditors cannot ensure that the government’s policies are consistent with maximizing their return. The absence of these safeguards for creditor rights is a major reason why many creditors believe that the SDRM would provide excessive leverage to debtors, as compared with the position of firms under domestic bankruptcy legislation. Other differences between sovereigns and firms provide greater leverage to creditors than in corporate bankruptcy. Sovereigns are ultimately accountable to their people for domestic economic activity. Suspensions of debt service can be met by a flight from domestic assets, resulting in a massive exchange rate devaluation, a banking crisis, and perhaps widespread corporate bankruptcy. Capital controls and bank holidays may be inadequate means of addressing such shocks to the financial system. These economic costs often lead to the replacement of political leadership following a result of a crisis. Thus, sovereigns may face sufficient incentives to repay debt, even if a sovereign bankruptcy system improved their leverage vis-à-vis creditors. Municipal bankruptcy may provide a closer analogy than corporate bankruptcy to the issues facing the SDRM. Like sovereign nations, municipalities also cannot be liquidated. In the United States the court cannot interfere in a municipality’s political or governmental powers. Modeling a sovereign bankruptcy framework on U.S. municipal bankruptcy laws would tend to improve the leverage of debtors. For example, stakeholders such as citizens’ groups and labor unions (who are unlikely to have creditor interests at heart) can be represented in bankruptcy procedures, and their interests may be taken into account by the court. Adopting this approach to sovereign bankruptcy would likely tilt the balance too far in the direction of debtor interests. In the U.S. context, creditor rights can be
acilitating coordination among creditors is an important goal of bankruptcy law. Bankruptcy legislation typically provides for: (a) a stay on legal actions against the debtor to avoid a grab race for assets that lowers the return to creditors as a whole; (b) liquidation or maintenance of the firm as a going concern, depending on which course provides the greatest return to creditors; (c) seniority for new finance, where the firm continues to operate; (d) imposition of a majority-agreed reorganization on potential holdouts, which facilitates a speedy resolution; and (e) monitoring or replacement of management, to safeguard creditor interests against asset stripping and insider payments. At the same time, these steps to protect creditor interests provide debtors with the potential to undertake strategic defaults: a debtor may seek protection from its creditors through bankruptcy, even though the debtor has the resources to pay.
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