Some experts suggest that as many as 15 to 20 countries are candidates for sovereign debt defaults in the near term.

An additional issue is that China has become the world’s largest official creditor, particularly for emerging-market countries. This has already caused some difficulties for debt restructurings.

This article explores lessons learned from the past crises and the role of international investment agreements and arbitration in resolving such disputes.

Foreign investors stand a better chance of weathering any debt crisis by understanding the available options.

Warning Signs

The COVID-19 pandemic has greatly lengthened the list of developing and emerging market economies in debt distress. Default rates are rising, and the need for debt restructuring is growing. For some, a crisis is imminent. For many more, only exceptionally low global interest rates may be delaying a reckoning.

The COVID-19 pandemic has exposed gaps in the sovereign debt restructuring architecture that could lead to a sovereign debt crisis unprecedented in size and complexity.          

A debt restructuring legal framework for sovereign borrowers has yet to be found. The G20 countries committed earlier this year to extend their “debt service suspension initiative” to halt debt-service payments through the end of 2021. However, there have been problems with this initiative, in part because the private sector has not joined in.

A number of nations are facing potential defaults as a result of unprecedented amounts of borrowing driven by the COVID-19 pandemic. Many of these nations were arguably on the brink before onset of the pandemic. In February 2020, the IMF published a paper called Evolution of Public Debt Vulnerabilities in Lower Income Economies that found half of low income countries (36/70) were at high risk of debt distress or already in distress. Private international capital stopped flowing to emerging market countries after the COVID lockdowns started in March 2020.

A debt crisis is likely to be hard to avoid, especially among the world’s poorest countries and those with continuing high rates of COVID-19 infections.

In November 2020, Zambia defaulted on its external debt payments — the first African nation to default since the pandemic started. Zambia’s bondholders refused to consider offering interim relief without full disclosure of the nation’s agreements with its largest creditor, China. A study published in March 2021 by the Peterson Institute for International Economics noted that China’s lending contracts contain confidentiality clauses that bar borrowers from revealing the terms or even existence of the debt and that “Chinese lenders seek advantage over other creditors, using collateral arrangements such as lender-controlled revenue accounts and promises to keep the debt out of collective restructuring.”

Investment Treaties

Foreign investors may be able to fall back on protections in international investment treaties or “IIAs”.

IIAs are agreements between states in which they mutually agree to certain minimum standards of protection for investments made in their territories by foreign investors from other states that are parties to IIAs. Among the thousands of IIAs currently in force worldwide, many are bilateral investment treaties between a developed and a developing state.

IIAs offer qualifying foreign investors — including creditors — a framework of protections against adverse state action, whether the action is inspired by a debt restructuring program or some other objective.

IIAs typically set out the criteria that must be satisfied in order for a claimant to benefit from such protections. For example, IIAs define who is an “investor” and what is a protected “investment”.

IIAs vary in the substantive and procedural protections that they offer. Investors who satisfy the criteria typically have access to protections in the form of prohibitions against direct and indirect expropriation absent certain minimum conduct standards, such as observing due process and the principle of non-discrimination, as well as rights to fair and equitable treatment or the minimum standard of treatment in customary international law, full protection and security, national treatment and most-favored-nation treatment, among other protections.

Some IIAs contain carveouts for taxation measures and particular industry sectors that may affect an investor’s entitlements, as well as “umbrella” clauses that elevate contractual breaches to treaty breaches.

Critically, these substantive protections have teeth because IIAs afford qualifying foreign investors with standing to bring claims direct access to dispute resolution in a neutral forum, usually international arbitration, before impartial arbitrators and in accordance with neutral, transparent rules.

Claims under IIAs tend to follow capital flows, and unsurprisingly claims most often arise between qualifying foreign investors from developed states as claimant and the developing state hosting the investment as respondent. However, increasingly IIA claims are also against and among investors and states from developed countries.

Past is Prologue?

Parallels with the looming sovereign debt crisis can be drawn with previous sovereign debt crises, such as the 1980 Latin American debt crisis, the 1998-to-2002 Argentina debt crisis, and the 2009 Eurozone crisis. Following each of these crises, investors brought IIA claims against defaulting states.

In the early 1990s, Argentina defaulted on US$93 billion in sovereign debt. Argentina’s subsequent debt restructuring process led to a number of IIA claims by Italian bondholders against Argentina under the Argentina-Italy bilateral investment treaty.

Three cases arose from Argentina’s default: Abaclat v. Argentina, Ambiente Ufficio S.p.A v. Argentina and Alemanni v. Argentina. In each case, Argentina challenged the jurisdiction of the tribunal, asserting that its consent to ICSID arbitration in the bilateral investment treaty did not include consent to multiparty proceedings and that its bonds were not protected investments under the ICSID convention. Argentina also challenged the admissibility of mass claims.

In all three cases, Argentina’s jurisdictional objections were dismissed. The tribunal in Abaclat held that the claimants’ purchase of security entitlements in Argentinean bonds constituted a contribution that qualified as an investment under article 25 of the ICSID convention. On the issue of admissibility, the tribunal determined that the ICSID procedural framework could be adapted to render the claims by the Italian bondholders admissible. The majority found that the only relevant question was whether there was sufficient homogeneity among the bondholders’ claims, a question that the majority answered in the affirmative. The Ambiente and Alemanni arbitrations were discontinued before the issue of admissibility was adjudicated. All three cases settled before they progressed to a merits phase.

In the late 2000s, several European countries faced debt distress on the heels of the global financial crisis. Greece’s default on its debt was followed by a restructuring process that gave rise to a claim under the Cyprus-Greece and Slovakia-Greece bilateral investment treaties in a case called Postova Bank v. Greece. The claimants, a Slovak bank and its former Cypriot shareholder, alleged that the Greek debt restructuring was a breach of the investors’ rights under the bilateral investment treaties. In contrast to the Argentine cases, the tribunal refused jurisdiction over the claim, holding that the bank’s Greek government bonds were not protected investments under the Slovakia-Greece treaty.

More recently, in the case of Adamakopoulos v. Cyprus, the tribunal held (by majority) that it had jurisdiction to hear a mass claim of a group of almost 1,000 claimants holding financial assets in Cypriot banks. The claimants alleged that the actions by two Cypriot banks to merge in response to suffering losses due to their exposure to the Greek financial crisis had caused significant devaluation to the assets held by them. Cyprus, like Argentina before it, argued that the mass claim arbitration was outside the tribunal’s jurisdiction and was inadmissible. The majority followed the reasoning in Alemanni in determining that the claims were admissible and could be considered together as a “single” dispute within the meaning of the Greek-Cyprus and Luxembourg-Cyprus bilateral investment treaties.

Implications for Today

This decade’s sovereign debt crisis threatens to unfold on a wider and deeper scale than we have seen in recent past.

Even if progress is made on an enhanced multilateral debt restructuring framework that includes the private sector, many foreign investors will probably fall outside the tent. They will therefore need to consider other alternatives.

IIAs are an important potential tool. As past cases reveal, while some IIAs expressly include debt instruments among protected investments, not all IIAs are so clear. IIA protections, where available, have real teeth because IIAs allow investors to bring claims directly against the state through international arbitration. They can also add weight to settlement discussions and negotiations.

For more on this topic, including the experience of companies that have won foreign investment disputes when trying to collect on judgments, see “Experience with Foreign Investment Disputes” in the February 2003 NewsWire and “Tactics When Caught in an Expropriation” in the April 2007 NewsWire.