If, as some fear, the current European sovereign debt crisis does come to a tragic conclusion then one of the many issues the resulting chaos may potentially throw-up is the ability of investors to enforce or attempt to enforce debt securities which have been issued by a defaulting sovereign state.

Sovereign immunity

Unlike with a conventional, publicly listed, issuer the first hurdle is whether a defaulting sovereign state can actually be sued at all or whether it is protected by sovereign immunity.  Then, separately, whether any judgment obtained against the defaulting state can be enforced and, if so, against what assets.

In the last couple of months there have been two high profile court decisions in the UK1 and Hong Kong2 highlighting the difference between the doctrine of:

  • absolute immunity” recognised in the PRC (and now confirmed as applying in Hong Kong) - under which a foreign state is immune from proceedings and its assets are immune from execution unless it waives its immunity.  Waiver by means of a clause in a contract is not sufficient it must be by international treaty or “in the face of the court” by the foreign state making an unequivocal submission to the court when the proceedings are commenced; and
  • restricted immunity” recognised in Australia and the UK - where a foreign state is not immune from proceedings concerning a “commercial transaction” and its assets are not immune from execution if they are “commercial assets” and in each case a provision in a contract can be sufficient for the foreign state to submit to jurisdiction or waive immunity from action.  

Commercial transactions:  NML v Republic of Argentina

Section 11(3) of the Foreign States Immunities Act 1985 (Cwlth) clarifies that a commercial transaction includes “an agreement for a loan or some other transaction for or in respect of the provision of finance” and therefore includes a bond or other debt security.  The UK State Immunity Act 1978 contains almost identical provisions.  What was in question in the NML case in the UK was whether proceedings to enforce a New York judgment in relation to a bond issued by the Republic of Argentina (rather than direct proceedings under the bond itself) were proceedings “relating to a commercial transaction”.  The majority of the UK Supreme Court held that they were not but the Court was unanimous in its view that the Republic of Argentina was not immune for other reasons, in particular:

  • as a result of the UK Civil Jurisdiction and Judgments Act 1982 which regulates the enforcement of foreign judgments; and
  • as Argentina had submitted to the jurisdiction of the English courts under the terms of the bonds.  

While judgments of the superior courts of certain European countries including the UK, France and Germany are each enforceable simply by registration in Australia under the Foreign Judgments Act 1991 (Cwlth) (“FJA”) it is an interesting question whether a similar issue as to sovereign immunity could arise in Australia if the original judgment was obtained in a jurisdiction which is not covered by the FJA, such indeed as the US or Greece.  Ultimately on exactly the same facts the decision is likely to be the same because of the terms of the bonds themselves.  As Lords Phillips stated in the NML case:

“The reality is that Argentina agreed that the bonds should bear words that provided for the widest possible submission to jurisdiction for the purposes of enforcement, short of conferring on any country whose domestic laws would not, absent any question of immunity, permit an action to enforce a New York judgment.  No doubt those responsible were anxious to make the bonds as attractive as possible.”

Times change

As for any bankrupt European state, it too may have wanted to make any bonds as attractive as possible at the time they were issued.  This would most likely have been at a time when it was no doubt thought that enforcement would never become an issue.  However if the house of cards begins to fall then a defaulting state will not feel so benevolent and may take a number of actions in an attempt to circumvent or limit its obligations, such as:

  • declaring a moratorium;
  • providing that the bonds will be settled only in a new currency it has then sponsored; or
  • if the bonds are issued by its central bank, providing that those debts are assumed by some new entity.  

In these circumstances the location of the Courts in which any action is brought will be critical.  This together with the original choice of governing law (as expressed in the bond terms) and whether it is the law of the defaulting state or the law of a third country (such as New York law) will determine the effectiveness of any such measures.3

Effect of subsequent foreign legislation

If a defaulting state was to attempt to limit its obligations this would normally be through new legislation passed by that sovereign state.  Under English common law, where the governing law of the bonds is English law, the debtor/obligor cannot be discharged for the purposes of proceedings in English courts from that liability by subsequent legislation of the defaulting state.  It is likely that an Australian Court would take a similar view.

This principle was established following two cases4 arising from Greek legislation initially passed in 1949 which attempted to suspend payments and impose a moratorium on all bonds issued by Greek banks which were payable in a foreign currency.  The bonds which were the subject of the litigation were sterling mortgage bonds, governed by English law and guaranteed by the National Bank of Greece.  The National Bank of Greece was subsequently amalgamated by Greek legislation with the Bank of Athens to form a new bank, the National Bank of Greece and Athens Co (the “New Bank”), which became the universal successor to the rights and liabilities of the predecessor banks.  When litigation was first commenced in the English courts Greece passed further legislation to attempt to retrospectively exclude any foreign currency bonds from the obligations which the New Bank had succeeded to. 

The first proceedings5 concluded that as the governing law of the bonds and the guarantee was English law, the National Bank of Greece (if sued in the English courts) could not have relied on the moratorium imposed by Greek law and therefore neither could the New Bank.  In what was described as the sequel to those proceedings,6 the Court again held that as the governing law of the bonds and guarantee was English law, then once the New Bank had become liable under the guarantee that liability could not then be discharged by subsequent Greek legislation.

The fact that, since these principles were established, both the UK and Greece have joined the EU is unlikely to affect the outcome if similar circumstances were to arise again today.  Arguably certain actions a defaulting state may wish to take are today more likely to be notionally prohibited under European law and therefore provide possible further grounds for the English Courts refusing to recognise any such measures.  What would make a difference, however, is if instead of the defaulting state adopting its own measures any debt relief legislation was passed by the European Council and European Parliament.  While previously any such legislation may have been both unthinkable and unconstitutional Is it possible some could take a different view if it is argued that the entire future of the EU is at stake?  Desperate times could potentially be used to argue for desperate measures.  While the comment was aimed at other potential concerns the UK Deputy Prime Minister did warn at the EU Eastern Partnership Summit at the end of last month that “we cannot accept arrangements that would privilege the Eurozone7 as a decision making body over the European Council.  It would not be right for the Eurozone to take decisions that bind the rest of the EU.  Above all, it cannot act against the interests of those who are not members”.


Separately, if the bonds are denominated in Euros the original choice of governing law and the Courts in which any action is brought may also be influential in determining the currency in which the bonds are repaid. 

During the course of the current difficulties there have been various discussions in the media as to whether certain states should leave the Eurozone.  If a Eurozone state was to default then this would presumably become reality.  The defaulting state would need to pass legislation creating a new currency.  The question would then arise as to what currency the bonds are repayable in - Euros or the new currency of the defaulting state?

A Court in the defaulting state would apply the legislation creating the new currency.  However a Court in any other jurisdiction would have to decide what law determines the identification of the relevant currency.  If the currency is unique to one country, such as the Australian dollar, then this is easy.  Regardless of the law of the contract/bond, only the law of Australia can define an Australian dollar.  In the case of the Euro this is more difficult.  Are the laws of the defaulting state used to identify the relevant currency, in which case they would specify the new currency, or the laws of one of the other 16 states which continue to use the Euro?

One approach would be to consider the original intention of the parties.  The fact that the bonds were marketed and issued in an international market where the Euro represents the currency of numerous states would suggest that the parties did not necessarily intend the currency to be determined exclusively in accordance with the laws of the defaulting state.  This is why the governing law of the bonds may well be relevant as it is any guiding principles which exist under this law which will be used to infer what the intention of the parties was.  For example under English and Australian law a potential but not decisive factor to be taken into account when inferring the intention of the parties in the context of government debt is the place of payment.8 

Means of withdrawal

An additional and unprecedented factor which may influence these outcomes is the means by which any defaulting state withdraws from the Eurozone and/or the EU.  There is no formal mechanism for leaving the Eurozone, adopting a new currency, but still remaining a member of the European Union.  There is only a mechanism for withdrawing from the European Union.  This requires the EU to negotiate and conclude an agreement with the state setting out the arrangements for its withdrawal, taking into account of the framework for its future relations with the EU.9  These are obviously unchartered waters and it would need to be considered what the affect of any such agreement would be if it:

  • in any way recognises that the withdrawing state will adopt a new currency and implicitly sanctions this action; or
  • goes further, and attempts to explicitly provide that any Euro denominated debts owed by the sovereign state will only be payable in the new currency?  

Conversely if a defaulting state withdraws unilaterally from the Eurozone or the EU in breach of the EU treaties, then this may also influence these outcomes.  A Court which would otherwise have found that the laws of the defaulting state should determine the relevant currency may as a matter of public policy refuse to recognise the new currency of the defaulting state as it was introduced in breach of the relevant treaties.  Whether there would be any difference in approach between an English Court (as a member of the EU) and an Australian Court (where Australia is not a member) is difficult to say.

The unknown

If any sovereign state was to default as a result of the current debt crisis it clearly would not be the first sovereign state in history to do so.  There have unfortunately been many previous examples around the world.  Part of the uncertainty here is that none of these have been of a country which shares a collective currency with so many other countries and is so closely bound by treaties and laws with its neighbours as those countries in the Eurozone.

Clearly most of the current speculation focuses on Greece.  It is believed from reports that the majority of debt currently on issue by Greece is denominated in Euros and governed by Greek law.  If a doomsday scenario was to occur this may well help Greece in any attempt to restructure its debt but may not assist an investor if several years down the track they were to find themselves attempting to recoup their money.