Sovereigns in Distress: Do They Need Bankruptcy?

Should there be a sovereign bankruptcy procedure for countries in financial distress? This paper explores the use of U.S. bankruptcy law as a model for a sovereign bankruptcy procedure and asks whether adoption of such a procedure would lead to a more orderly process of sovereign debt restructuring. It assumes that a quick and orderly debt restructuring process is more efficient than a prolonged and disorderly one, because a lengthy process of debt restructuring takes a high toll on debtor countries' economies as well as harming creditors in general. I concentrate on three goals for a sovereign bankruptcy procedure: preventing individual creditors or groups of creditors from suing the debtor for repayment, preventing groups of creditors from strategically delaying negotiations or acting as holdouts, and increasing the likelihood that private creditors will provide new loans to sovereign debtors in financial distress, thus reducing the pressure on the International Monetary Fund (IMF) to fund bailouts. I conclude that nonbankruptcy alternatives are less likely to accomplish these goals than a sovereign bankruptcy procedure.

U.S. Bankruptcy Law and Important Trade-Offs in Bankruptcy

Three sections of the U.S. Bankruptcy Code are of possible relevance for a future international bankruptcy procedure: Chapter 7 (bankruptcy liquidation), Chapter 11 (corporate reorganization), and Chapter 9 (municipal bankruptcy).

Chapter 7

Chapter 7 is the U.S. bankruptcy liquidation procedure for both corporations and individuals. When a corporation files under Chapter 7, its operations are shut down and the corporation ceases to exist. Its assets are liquidated and the proceeds distributed among creditors according to the absolute priority rule (APR, described below). When an individual files under Chapter 7, his or her assets are divided into exempt and nonexempt categories. Nonexempt assets are liquidated and the proceeds distributed among creditors according to the APR. The individual's postbankruptcy earnings are completely exempt from the obligation to repay prebankruptcy debt. For both individuals and corporations, any debt not repaid by the liquidation procedure is discharged.¹

Under the APR the administrative expenses of bankruptcy are paid first, unsecured creditors second, and anything left goes to equity holders.² Each class of creditors must be paid in full before lower-ranking classes receive anything. Unsecured creditors' claims may be divided into subclasses if their contracts with the firm contain subordination agreements, but otherwise all of their claims are treated equally. Claims due in the future (such as long-term bonds) are accelerated to the present. Thus bankruptcy liquidation is a collective procedure aimed at resolving all claims against the debtor.

An important advantage of a bankruptcy procedure, whether it involves liquidation or reorganization, is that it reduces creditors' incentives to engage in a race to seize the debtor's assets. As in a bank run, when individual creditors perceive that the debtor's assets are insufficient to repay all of its debts, they have an incentive to race to be repaid before the debtor's funds run out. Such a grab race is destructive, because it results in particular assets of the debtor being liquidated in order to satisfy the winners' claims, even though the debtor's assets may be more valuable if they remain together. For example, a firm may be unable to continue producing goods if a creditor seizes its main computer, even though it still has all of its other equipment. In the sovereign debt context, a debtor country's manufacturing sector may suffer because it cannot import fuel if a creditor attaches the country's external bank account. The point of the bankruptcy procedure is to reduce creditors' incentive to race for payment by resolving all of the firm's debts at once. If creditors know that winning a grab race will cause the firm to file for bankruptcy, they will have little incentive to enter the race at all, because doing so will not increase their reward unless they win early enough to collect without tipping the debtor into bankruptcy.³

The race by creditors to be first to collect from a failing firm is an example of a prisoners' dilemma. To illustrate, suppose a firm has...