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Global Law Working Paper 04/09 Juan Pablo Bohoslavsky Sovereign Insolvency, Abusive Lending, and Distribution of Losses
NYUSchoolofLawNewYork,NY10012

Allrightsreserved. Nopartofthispapermaybereproducedinanyform withoutpermissionoftheauthor. ISSN 1553-1724 JUANPABLOBOHOSLAVSKY NewYorkUniversitySchoolofLaw NewYork,NY10012 USA

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 SovereignInsolvency,AbusiveLending,and DistributionofLosses
JuanPabloBohoslavsky
DirectoroftheLLMinGlobalAdministrativeLaw,UniversidadNacionaldeRioNegro

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Sovereign Insolvency, Abusive Lending, and Distribution of Losses Juan Pablo Bohoslavsky1

Abstract
This article argues that there are legal and economic justifications for converting the responsibility for granting abusive loans into a general principle of international law and, as such, that it can and should be applied to matters of sovereign insolvency. It develops concrete legal and economic reasoning and mechanisms by which the financial losses that any sovereign insolvency imposes on creditors should be distributed among them. Loans granted to states not following even the most elemental precautionary guidelines with regard to the analysis of credit risk, and with the intention of diluting or taking unfair advantage at the expense of the other creditors, should be totally or partially subordinated to those not classified as abusive in the case of sovereign bankruptcy.

Key Words

Sovereign Insolvency. Lending. Creditors. Abusive. Losses. Finance. Comparative Law.

Introduction This paper examines some legal aspects of sovereign insolvency, focusing in general on the lack of rules applied to this realm and, particularly, on the stage at which the financial losses (reduction of the debt) of sovereign bankruptcy have to be distributed among creditors. It argues that a general principle that is widely accepted in private lawthe so-called responsibility for granting abusive loansshould have an influence on the credit ranking system of sovereign insolvencies, and therefore on the amount of money that each class of creditors collects in these collective procedures. The first section describes the main flaws of the legal framework of sovereign insolvency. In this context, it describes the poor, insufficient legal rules that govern the credit priority ranking that applies to creditors when trying to collect from an insolvent state, and how this situation leads to inefficiencies and abuses on the part of creditors and debtors. It also analyzes the relationship between the pari passu clause inserted in public bonds and the parity of treatment principle that applies in bankruptcy law. The international financial institutions preferences are critically analyzed. Exposing actual concrete sovereign insolvency cases, the first section also explains how these legal deficits have negatively impacted on particular creditors allowing, on the one hand, sovereign debtors to impose excessively painful haircuts and, on the other hand, abusive creditors to take advantage of this at the expense of the bona fide ones. It also points out how the latest official and nongovernmental proposals in the field of sovereign insolvency law ignore the collective action problems that are related to the seniority of the credits and to the very behaviour of the creditors. The second section of the paper begins by introducing the basis of responsibility for granting abusive loansemphasizing the way that the credit risk was assessed and the dishonesty of the lender as a new principle to promote fair and efficient allocation of financial losses in the sovereign insolvency realm. It briefly explains the methodological features of recognizing these general principles in
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Director of the LLM in Global Administrative Law, Universidad Nacional de Rio Negro, Patagonia, Argentina. This paper was produced during the postdoctoral fellowship at New York University School of Law during 2008-09. The author wishes to extend his gratitude to the Hauser programs academic and administrative staff for their phenomenal support. Special thanks also go to New York University Professors Lee Buchheit, Richard Hulbert, Andreas Lowenfeld, Harvey Miller, Kunibert Raffer and Gerald Rosenfeld for their helpful suggestions and insights, particularly in reshaping early drafts of this paper. I also want to thanks all the participants at the April 1st, 2009 Hauser forum at NYU where this paper was presented and discussed. The views and conclusions reflected in this paper are solely mine and are in no way intended to reflect the views of the aforementioned people.

international law before launching into a comparative survey of how the American, Argentinean, Belgian, English, French, German, Italian, and Spanish legal systemsand their case lawstreat this principle of responsibility for granting abusive loans. This comparative analysis brings into view a crucial common denominator: across the board, the bankruptcy laws of the countries studied stipulate that in a bankruptcy procedure abusive creditors deserve to receive less money than prudent and honest ones. The final section applies this general principle to the sovereign insolvency field. Abusive loans are visibleas a representation of a collective action problem that comes with the insolvency of the borrowerwhen lenders grant excessive loans to the already insolvent sovereign trying to get unfair benefits at the expense of aggravating the borrowers situation and diluting the other creditors. Departing from the analysis of the practical difficulties inherent in implementing this idea, the paper then proposes a viable way to introduce the new principle into real sovereign insolvency procedures. It also puts the socalled first-in-time rule next to the legal principle presented in this paper, to articulate the economic rationale of both legal rules in an interactive manner. The application of the principle proposed here to the position of international financial institutions (IFI) is separately analyzed. 1. Distributing the financial losses of sovereign insolvency among creditors 1.1. Institutional and legal framework of the problem The idea developed in this work addresses one of the collective action problems related to creditor behaviour in sovereign insolvencies:2 when creditors realize that the debtor will go bankrupt some of them try to take unfair advantage at the expense of others, aggravating the borrowers situation and dissipating both its assets and its ability to reorganize. Even so, this paper does not ignore the problems of so-called debt intolerance; unproductive (inefficient and corrupt) use of loans by the borrowing government; opportunistic default; and the relationship that can exist between the coerciveness of the state as an insolvent borrower and the extent of the reduction of the debt. Since they represent serious problems of sovereign over-indebtedness, they require diverse institutional and economic tools. Institutional changes on the debtor side, as well as changes in the legal regulatory systems of creditors, are two necessary and supplementary mechanisms to limit borrowing to a more cautious extent.3 There is some consensus among economic and legal scholars that the international financial architecture still needs to perform an important task: namely, to develop a functional sovereign insolvency procedure.4 This should be one which, while balancing the interests of all parties, fulfils, at least to some extent, the following goals: maximize creditor wealth; solve inter-creditor collective action problems before, during, and after the default of states; discourage opportunistic defaults; protect the debtor; and allow the debtor to fully recover. A balancing approach would thus coordinate debt collection, while organizing and rationalizing the decision-making process.5 There have been several academic proposals aimed at tackling these challenges,6 but only few of them have received official attention. The Sovereign Debt Restructuring Mechanism (SDRM) elaborated by the International Monetary Fund (IMF)7 and the Collective Action Clauses (CACs) proposed by the
2 SACHS, Jeffrey, Do We Need an International Lender of Last Resort?, Frank Graham Lecture, Princeton University, 1995, www2.harvard.edu/cidpapers/intllr.pdf; SCHWARCZ, Steven, Sovereign Debt Restructuring: A Bankruptcy Reorganization Approach, Cornell Law Review, Vol. 85, 1999-2000, pp. 956-7. 3 REINHART, Carmen, ROGOFF, Kenneth & SAVASTANO, Miguel, Debt Intolerance, Brooking Papers on Economic Activity, 1, 2003, p. 5. 4 SCOTT, Hal, A Bankruptcy Procedure for Sovereign Debtors? The International Lawyer, 37, 2003, pp. 103-135. 5 FLESSNER, Axel, Philosophies of Business Bankruptcy Law: An International Overview, in ZIEGEL, Jacob (ed.), Current Developments in International and Comparative Corporate Insolvency Law, Oxford, 1994, p. 24; SCHIER, Holger, Towards a Reorganization System for Sovereign Debt, Martinus Nijhoff, 2007, pp. 118. 6 ROGOFF, Kenneth & ZETTELMEYER, Jeromin, Bankruptcy Procedures for Sovereigns: A History of Ideas, 1976-2001, IMF Staff Papers, 2002. 7 KRUEGER, Anne, New Approaches to Sovereign Debt Restructuring: An Update on Our Thinking, April 1 2002, 2

U.S. government8 are the two main official approaches in the sovereign insolvency debate, representing both statutory and contractual proposals. Both models have received harsh criticism9. Regarding the SDRM, the most important obstacle is that the IMF itself would be the (non)neutral authority which would administer the insolvency procedure, being creditor and judge at the same time. For the contractual approach, problems might arise from the majorities required to approve the modification of the contract terms since even cross- majorities clauses risk being exposed to abuse through vote manipulating (buying) by hold-out creditors and bad-faith debtors; furthermore, CACs do not include bank, multilateral or bilateral debt, so debt restructuring would not be complete. Surprisingly, both of these approaches fail to address one important aspect of insolvency procedures: efficient criterion or criteria to distribute the burden of the reduction of the debt (haircut) among creditors. 1.2. Credit-ranking in sovereign insolvency: an insufficient and difficult-to-enforce rule In international law there is basically one theoretical guidelinecredit-ranking at the time of paymentthat relates to the distribution of financial losses derived from sovereign insolvencies, and it does not tackle the collective action problem with which this article is concerned. This deficit in the legal framework of sovereign insolvency also produces a notable void that market forces, sovereign interests, and experts try to fill. The main rule that governs this field is the principle of parity of treatment of creditors in relation to comparable debt.10 This is a rule that comes from the very basis of most domestic bankruptcy laws.11 Because of practical borrower discretion when applying this principlebasically allowing them to decide how to use their assets to pay their debtscreditors try to enforce this rule through specific clauses such as the negative pledge, pari passu and sharing clauses,12 which minimize (but do not eliminate) ex ante the impact of the power of the state.13 Reflecting this idea of parity, we can find some informal rules related to credit-ranking if we look at the practice of the Paris Club, which works on the basis of equitable burden-sharing as follows: each sovereign creditor has to extend debt relief in proportion to its exposure to the debtor country and the debtor is expected to seek comparable relief from the private sector.14
http://www.imf.org/external/np/speeches/2002/040102.htm<; ibid., International Financial Architecture for 2002: A New Approach to Sovereign Debt Restructuring, November 26 2001, http://www.imf.org/external/np/speeches/2001/112601.htm. 8 TAYLOR, John, Using Clauses to Reform the Process for Sovereign Debt Workouts: Progress and Next Steps, EMTA Meeting, December 5 2002, http://www.treas.gov/press/releases/po3672.htm; ibid., "Sovereign Debt Restructuring: a U.S. Perspective, Conference "Sovereign Debt Workouts: Hopes and Hazards?," Institute for International Economics, Washington, D.C., April 26 2002, http://www.ustreas.gov/press/releases/po2056.htm. 9 MAKIPAA, Arttu, Bankruptcy Procedures for Sovereign Debtors, Wirtschaftswissenschaftlichen Fakultt der Universitt Heidelberg, 2003, p. 50 (mimeo); PETTIFOR, Ann & RAFFER, Kunibert, Report of the IMF's conference on the Sovereign Debt Restructuring Mechanism, January 22 2003, Washington, D.C., Jubilee Research at the New Economics Foundation, http://www.jubileeresearch.org/latest/sdr220103.htm; WHITE, Michele, Sovereigns in Distress: Do they Need Bankruptcy?, Brookings Papers on Economic Activity, N 1, 2002, pp. 300. 10 CLARK, Keith, Sovereign Debt restructurings: Parity of Treatment between Equivalent Creditors in Relation to Comparable Debts, The International Lawyer, 20, 1986, pp. 857. 11 For more on this principle in European law see, MCBRYDE, William & FLESSNER, Axel, Principles of European Insolvency Law and General Commentary, in MCBRYDE, FLESSNER & KORMANN (eds.), Principles of European Insolvency Law, Kluwer Legal Publishers, Deventer, 2003, pp. 81-2. 12 BUCHHEIT, Lee, The Search for Intercreditors Parity, Law and Business Review of the Americas, Winter-Spring, 2002, pp. 73. 13 HYDE, Charles, The Negotiation of External Loans with Foreign Governments, The American Journal of International Law, 1922, No. 16, pp. 523. 14 VITALE, Giovanni, Multilateral Sovereign Debt Restructuring: The Paris Club and the London Club, in EICHENGREEN & PORTES (eds.), Crisis? What Crisis? Orderly Workouts for Sovereign Debtors, London, Center for Economic Policy Research, 1995, p. 123. 3

The enforcement of this basic legal guidelinewhich rules the ranking of payments that an insolvent sovereign should followis limited mainly by two factual circumstances. First, given that sovereigns cannot be subjected to norms like chapter 7 (liquidation) of the US bankruptcy code, and that they usually do not have assets abroad, they enjoy wide discretion in paying their creditors, often violating informal or customary rules. Second, even these informal criteria applied by insolvent states are not clear nor unanimously accepted by all the creditors, as they evolve and are constantly challenged.15 For example, if the traditionally excluded creditors (from restructurings) form part of a large portion of the debt stock, it is should be expected that these preferred categories would be subject to question.16 The parity of treatment is altered in practice by the use of preferred treatment, given, for example, to IFI credits, secured debts, trade debts, new credits, collateralized loans, and inter-bank deposit debts, among others. Each is grounded in political and economic reasons that would suggest the recognition of its seniority. Given the nature of these reasons, this ranking evolves continuously, without paying much attention to legal principles, as we will see bellow. 1.3. General system of priorities, realpolitik, and disorder Apart from the weak parity treatment rule we just examined, there are no fixed formal rules regulating credit preference ranking in cases of sovereign insolvency. Going back in history, if we observe the debt settlements reached during the thirties, there was no uniformity there either. In most cases the agreements were not grounded in legal principles but in practical solutions to meet immediate needs.17 The same phenomenon can be observed in the debt settlements reached in the last two decades. Insolvent sovereigns do a cost-benefit analysis when deciding which debts to exclude from restructuring. This is the main reason why, for example, sovereigns try to take care of short-term trade: they are dealing with the countrys ability to participate in the international market.18 The same reasoning explains why some countries, in particular instances (such as Mexico in 1982), decide to exclude capital market instruments from restructuring, because these markets are thought to have very long memories.19 We already saw that the main principle governing the system of priorities is equal treatment of creditors. Thus, discriminating among creditors would not only be incompatible with international financial tradition and justice,20 but also with the so-called pars conditio creditorum rule present in most domestic bankruptcy laws, and even in bilateral investment treaties.21
15 When in 1999 Ecuador defaulted its debt, it was logical to assume that the collateralized Brady bonds were going to have priority over uncollateralized bonds. However, Ecuador opened the restructuring negotiations with the Brady bondholders first, apparently because these bonds gave the country a thirty-day grace period for not being in default, see EICHENGREEN, Barry & RUEHL, Christof, The Bail-In Problem: Systematic Goals, Ad Hoc Means, National Bureau of Economic Research, Working Paper No. W7653, April 2000. 16 BUCHHEIT, Lee, Of Creditors, Preferred and Otherwise, International Financial Law Review, June 1991, p. 13. This probably can occur with the domestic debt, since countries are now issuing more of this kind of debt, see GELPERN, Anna, Building a Better Seating Chart for Sovereign Restructuring, Emory Law Journal, Vol. 53, 2004, p. 1136. 17 FEILCHENFELD, Ernst, DE MAURY ELRICK, Earle & JUDD, Orrin, Priority Problems in Public Debt Settlements, Columbia Law Review, 30, 1930, pp. 1115. 18 CLARK, op. cit., pp. 857; ibid., Trade Debt in Sovereign Restructuring, International Financial Law Review, 3, 1984, pp. 33. 19 BUCHHEIT, op. cit. (1991), p. 12. 20 FEILCHENFELD, op. cit., p. 215. 21 For the fair and equitable treatment in foreign investment law see LOWENFELD, Andreas, International Economic Law, Oxford University Press, 2008, pp. 556; MUCHLINSKI, Peter, Multinational Enterprises & The Law, Oxford University Press, 2007, pp. 635. This field of law is now particularly important in sovereign debt restructuring since thousands of financial creditors of Argentina sued it through the ICSID in order to collect their bonds. The cases are Giovanni Alemanni and others v. Argentine Republic, ICSID Case No. ARB/07/08 (claiming E 14.3) and Giovanna A. Beccara and others v. Argentine Republic, ICSID Case No. ARB/07/05 (170.000 bondholders claiming US$ 3.5 billion). Analyzing whether it is legally possible to use the BIT framework to invoke financial credits, see WAIBEL, Michael, Opening Pandoras Box: Sovereign Bonds in International Arbitration, American Journal of International Law, 2007, Vol. 101, No. 4, pp. 711. 4

Despite the defective treatment of this principle by the IMF in its institutional proposal for a Sovereign Debt Restructuring Mechanism (SDRM), even this institution appears to recognize the importance of this rule. The SDRM has explicitly prohibited unjustified discrimination of creditor groups when the insolvent sovereign presents the classification of debts in order to negotiate and approve a restructuring.22 The restructuring process involves the allocation of payments over a long period rather than the liquidation and distribution of a debtors present assets. This is why prioritization (and discrimination) can emerge in the form of at least three different kinds of acts: by paying a certain creditor or creditors first; by reducing their principal and interests less than that of others; and by applying an amortization schedule providing for complete liquidation before others.23 These kinds of decisions are taken at the early stages in restructuring procedures when the debtor decides, for example, which debts are going to be restructured and which are not.24 This dynamic is not a fixed practice, since creditors included in restructuring will try to ensure that even categories of debt that are formally excluded be subjected to informal roll-over agreements.25 In any case, after deciding which credits are to be restructured, the debtor, negotiating26 with its creditors, determines the terms of the haircut. Looking at different financial crises that have occurred over the past fifteen years, we can easily confirm that many sovereign borrowers have used their discretion to discriminate against creditors or groups of creditors when dealing with the problem of inter-creditor equity.27 The most recent sovereign defaults show that, within the same restructuring, the extent of the haircut varied greatly among different classes of creditors, without following any legal guide when doing so.28 In the current legal and institutional framework, sovereigns can enjoy wide discretionary faculties to negotiate, reach agreement with their creditors, or just decide the terms of the restructuring and how it affects each of them in terms of their place in the credit priority ranking. This prerogative is usually associated with not only legal disorder in preference terms but also the idea of sovereignty itself. Even respecting the very core of this notion of sovereignty, it is desirable for each party to develop a minimal set of rules to govern the credit ranking process in a sovereign insolvency. There are several negative consequences of not having a clear and enforceable priority system.29 First, some creditors may gamble on subordinating other creditors. Lenders may attempt to obtain de facto priorities by issuing debts that involve a very high credit risk through short maturities and dispersed bondholders, provoking higher costs for the borrower, higher risk of default, and higher transaction costs in the event of restructuring. Second, because creditors do not know whether they are going to be involuntarily subordinated, they can charge this risk to the price of loans. Third, the borrower itself, trying to delay default, may be tempted to take excessive new debts and dilute earlier creditors. Fourth, a creditor may try to lend, but only backed by collateral. Fifth, because priorities and even collateral are difficult to enforce, creditors can try to shelter themselves with faster repayment schedules, provoking a roll-over crisis. Sixth, once financial distress emerges, creditors will compete to catch the cash flows of the debtor, complicating and delaying
IMF, The Design of the Sovereign Debt Restructuring Mechanism Further Considerations, 2002, available at http://www.imf.org/external/np/pdr/sdrm/2002/112702.pdf . 23 FEILCHENFELD, DE MAURY ELRICK, & JUDD, op. cit., p. 1144. 24 BRATTON, William, Pari passu and a Distressed Sovereigns Rational Choices, Emory Law Journal, 53, 2004, ps. 843-4; BUCCHEIT, op. cit., (2002), pp. 74. 25 BUCHHEIT, op. cit., (1991), p. 12. 26 To read about the aggressive style of the Argentinean government in negotiating the terms of its last default, see PORZECANSKI, Arturo, From Rogue Creditors to Rogue Debtors: Implications of Argentinas Default, Chicago Journal of International Law, Vol. 6 No. 1, 2005, pp. 311. 27 GELPERN, op. cit., p. 1116. 28 ROGOFF & ZETTELMEYER, op. cit., pp. 792. 29 BOLTON, Patrick & SKEEL, David, Inside the Black Box: How Should a Sovereign Bankruptcy Framework be Restructured?, Emory Law Journal, 53, 2004, pp. 788; GELPERN, op. cit., pp. 1116,1140; ZETTELMEYER, Jeromin, The Case for an Explicit Seniority Structure in Sovereign Debt, IMF, Research Department, Working paper, September 29, 2003. 5
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the restructuring and, thus, the borrowers recovery. Finally, it has been pointed out that violating absolute priority in bankruptcy increases the bias of equity holders and managers in favour of riskier investments, because they know they will receive the benefits while creditors will bear the negative outcomes of this business.30 1.4. Equivalent treatment of creditors and the pari passu clause battle Creditors have tried to limit the arbitrarinessor at least the impactof sovereign borrowers when jeopardizing the payment of principal or interest. To this end (which fits in with others, such as discouraging rogue creditors) they have developed different contractual devices.31 The first one is the sharing-of-payment clause that ensures that if a lender receives a payment disproportional in comparison with the amount that other lenders receive from the common borrower, the latter can ask to have the excess payment shared with them. The second clause is the so-called negative pledge that prohibits the lender from pledging its assets in favour of other creditors, precluding the preferential allocation of assets.32 The third contractual device is the pari passu clause, which has provoked broad discussion in both scholarly and judicial realms over the past few years, in terms of the extent of its interpretation. On the one hand, a narrow reading of this clause supports the idea that it is basically a promise that the financial obligation will always rank equally in preference of payment with all the other unsubordinated debts of the borrower.33 The borrower cannot modify (worsen) the legal status of the creditor in terms of ranking. This narrow reading of the pari passu clause has a historical explanation. The clause as we know it today originated in the early seventies, when lenders were first becoming aware of the fact that the Spanish, Philippine, and Argentine legal systems explicitly permitted actions that had the effect of formally subordinating existing debt to other debtor obligations. This would support this restrictive interpretation.34 On the other hand, some judicial cases have broadened this reading, holding that this clause also compels equal treatment. The most famous case among them is Elliot (2000),35 in which the court recognized the ratable payment criterion as implicit in the pari passu clause, implying that creditors cannot be discriminated against by the debtor through paying some but not others who enjoy the same status. This is precisely what happened in Elliot: a creditor opposed the payment that the debtor wanted to make to other creditors without paying him at the same time. If one admits that sovereign borrowers are not allowed to formally subordinate debts but can do so in practice (paying A but not B), it seems that the pari passu clause does not tackleand cannot effectively respond tothe challenge of protecting creditors from arbitrariness in the framework of collective action problems and abuse of debtors or even other creditors. We have to bear in mind that in corporate bankruptcy procedure legal priorities affect the status of debts (U.S.C. Section 1129.b) long before any money crosses the table, whereas in sovereign bankruptcy the priorities only take effect at the final step, that is, when it comes to payment.36 Even when a broad reading of the clause could aggravate coordination problemssince hold-out creditors could oppose any payment that the borrower intended to make to other creditors, thus
BEBCHUK, Lucian, Ex Ante Costs of Violating Absolute Priority in Bankruptcy, National Bureau of Economic Research, Working Paper 8388, July 2001. 31 HYDE, op.cit., pp. 531-2. 32 BUCCHEIT, Lee, How to Negotiate Eurocurrency Loan Agreements, International Financial Law Review, London, 2006, pp. 86. 33 BUCCHEIT, Lee & PAM, Jeremiah, The Pari Passu Clause in Sovereign Debt Instruments, Emory Law Journal, 53, 2004, pp. 869. 34 See BUCCHEIT & PAM, op. cit., pp. 871, 903. 35 Elliot Associates, L.P., General Docket No. 2000/QR/92, Court of Appeals of Brussels, 8th Chamber, 26 September 2000. 36 BRATTON, op. cit., p. 846. 6
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complicating the restructuring problem37 the arbitrary discrimination of payments to creditors, not grounded in legal reasons would not be accepted. It is true that rogue creditors can undermine restructuring procedures through their claims against the debtor. However, this is not primarily provoked by the interpretation of the pari passu clause but, rather, by the lack of an institutional framework that allows supermajorities to impose their agreement on dissident creditors. In fact, the Elliot case was the formal trigger for the IMF to develop and propose the SDRM.38 Good proof that this clause would not be the main cause of hold- out creditor problems is that these creditors can oppose agreements even when approved by overwhelming majorities of creditors, whether or not a pari passu clause exists, as shown by re Allied in 1985.39 In any case, the current judicial struggle brought about by the pari passu clause highlights not only the abuse of some hold-out, hyper-speculative creditors and the frustration of bondholders discriminated against by sovereign debtors, but also the insufficiency of such contractual devices in preventing abuses by these same debtors. However, the judicial evolution of this clause shows it to be an unpredictable and inadequate tool for enforcing inter-creditor equity.40 The underlying legal issue in this problem is the way in which the financial losses of a sovereign have to be ordered in the event of insolvency. As explained above, there is a general principle in domestic bankruptcy law that supports equal treatment of creditors (including payments) except for those legally or contractually subordinated or preferred. Although there are several political variables that a government considers when deciding how to distribute the losses that a haircut necessary implies among creditors, theoretically they must be paid equally, except if legal reasons exist to do otherwiseas claimed by the principle proposed in this paper. Some scholars question why so many creditors use share clauses (which indeed embrace a broad reading of the pari passu clause), when supposedly41 pari passu clauses already contemplate this rule.42 At the same time, one might also ask why many creditors, even without enjoying the protection of share clauses, successfully challenge the borrowers decisions for violating one of the cardinal principles of bankruptcy law: pars conditio creditorum. Perhaps the answer is that the principle of equal treatmentas tantamount to prorated paymentshas its legal roots not only in contractual sources but also, particularly, in general legal principles. In any case, the pars conditio creditorum, as a manifestation of distributive justice, is complementary to, rather than mutually exclusive of the incentive upon which the principle builds and the responsibility for granting abusive loans. The equal treatment principlewhich assures that all creditors have the same rightis limited by legal or contractual preferences for some creditors and also by certain moralizing rules that, through subordinating credits, penalize abusive and fraudulent conducts. 1.4. IFI preferences In practice, one of the factors that affects the way in which creditors suffer the haircut is manifested in the preference of IFIs, although reality shows that it is not an absolute preference since, for example, in some cases the IMF will roll over its loans when the sovereign is unable or unwilling to pay. Far from being strictly theoretical, with the onset and evolution of the current financial crisis and the renewed role of the IMF in international sovereign finance, this issue is crucial to sovereign insolvency law.

Ibid., pp. 823, 836. KRUEGER, op. cit. 39 Allied Bank International v. Banco Credito Agricola de Cartago, 1985, 757 F.2d 516 (2d cir. 1985). 40 GELPERN, op. cit., p. 1136. 41 It has been explained, in any event, that both clauses have different extents and goals, see BRATTON, op. cit., pp. 857-8. 42 OLIVARES-CAMINAL, Rodrigo, Rethinking Sovereign Debt Restructuring: Lessons From the Argentine Case, doctoral thesis, Queen Mary University of London, August 2007, p. 74. 7
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There is serious doubt on whether this preference has legal grounding. Some scholars have argued that this preference is only de facto.43 For example, when we survey the statutes of the World Bank (WB) and the IMF, we do not find any rule that explicitly or implicitly states a preferential status. The IMF has itself recognized that no legal seniority status exists but this forbearance is exercised by creditors for policy reasons and creditors have not legally subordinated their claims to those of the Fund.44 This preference would also be important in order to avoid arrears and efficiency troubles in this cooperative IFI.45 Going even further, the IMF argues that preferred creditor status has been recognized as benefiting not just Fund members but official and private creditors alike by allowing the Fund to assist member countries in regaining a sustainable financial path and helping to promote orderly resolutions to debt problems, when needed () The concept of the Funds preferred creditor status is confirmed by the Paris Club, where official bilateral creditors exclude the multilateral financial organizations from the rescheduling process.46 It is problematic to state that there is a legal preference grounded in this confirmation by the Paris Club, or in borrowers practices when paying the IFIs more generously than other creditors. As the IMF itself explains, these behaviours correspond to matters of economic convenience rather than to any conviction that they should behave in such a manner because of a legal obligation. Even so, there is no consensus among economists about the financial effects of IFI loans and, consequently, the need for preferential status of their credits. Indeed, it has been said that if one accepts that some of the loans and bail-outs implemented particularly by the IMF were not economically sound, the suggestion would indeed be to treat its credits as junior in order to discourage multilateral founds from just subsidizing private creditors and deferring reforms when sovereign borrowers have very serious financial troubles.47 It seems clear that the arguments for supporting this preferential status work in the economic field and are related to the special role that these institutions play in the global system. In any case, the SDRM proposes that this preference be formally incorporated into international law, which might mean that this status does not have enough grounding in the current legal framework. We will retirn back again to the matter of IFI seniority once we have incorporated the main principles being proposed in this paper into our analysis. 1.5. What the latest defaults have taught us Beyond the basic rules described above, since the thirtieswhich were characterized by tension among private sectors and huge financial losses48there have not been major official efforts to develop legal guidelines to promote an efficient, fair allocation of financial losses in sovereign insolvencies. One probable, yet partial, explanation for this is the fact is that with only a few exceptionsnamely, the Latin American debt reduction that took place between the two World Wars;49 the London Agreement in 1953, which implemented a meaningful reduction of the German debt; and the a similar agreement reached
43 RAFFER, Kunibert, Preferred or Not Preferred: Thoughts on Priority Structures of Creditors, paper prepared for discussions at the 2nd Meeting of the ILA Soverign Insolvency Study Group, 16 October 2009, IMF; RUTSEL SILVESTRE, J. Martha, Preferred Creditor Status under International Law: The Case of the International Monetary Fund, International and Comparative Law Quarterly, Vol. 39, N 4, 1990, pp. 813-4. 44 IMF, Financial Risk in the Fund and the Level of Precautionary Balances, prepared by the Finance Department, approved by Eduard Brau, February 3, 2004. 45 See Communiqu of the Interim Committee of the Board of Governors of the IMF, Press Releases N 88/33 (September 26 1988) and N 89/83 (April 4 1989). 46 Ibid. 47 SCOTT, op. cit. 48 See FEILCHENFELD, DE MAURY ELRICK & JUDD, op. cit., pp. 1115-44; QUINDRY, Silvester, Bonds & Bondholders. Rights & Remedies, With Forms, Burdette Smith Co, Vernon Law Book, 1934, Chicago & Kansas City. 49 The haircut obtained by these countries ranged from 15% - 48% of effective debt reduction, see JORGENSEN, Erika & SACHS, Jeffrey, Default and Renegotiation of Latin American Foreign Bonds in the Interwar Period, in EICHENGREEN & LINDERT, The International Debt Crisis in Historical Perspective, Mit Press Cambridge, 1989, pp. 57. 8

between Indonesia and its largest creditors in 1970-7150and except for the Highly Indebted Poor Countries Initiative of the IMF (which did not mainly affect private creditors), there has been no significant sovereign debt restructuring that involving major losses for private creditors. Historically, except for the aforementioned cases, most restructuring procedures have not entailed overly painful haircuts for creditors, while the Brady plan, multilateral bail-outs, and restructuring plans still significantly reduced the extent of the negative effects of sovereign defaults. It is therefore understandable that the criteria according to which losses are shared did not receive much attention among creditors. This inertia was challenged by the Argentinean case of 2001-2005, when a haircut that exceeded 75% of the face value of the bonds was accepted by more than 76% of its creditors. Although the Argentinean haircut was the harshest, the most recent defaults (Russia, Ukraine, Pakistan, and Ecuador) led to restructuring agreements that implied haircuts clustered in a range of from 25% to 60%.51 If the current sovereign insolvency framework allowed a debtor to implement such radical haircuts,52 then it is possible that other debtors would consider taking similar steps. As the Argentinean case shows, when the haircut is substantial (and painful), creditors are more willing to discuss loss distribution. Leaving aside internal and social debt issues,53 financial creditors have fought fiercely to reduce their own losses in many ways: the full repayment Argentina made to the IMF was criticized by other creditors;54 holdout creditors are still trying to benefit from Argentinas improved economic situation55 (which is partially a consequence of the sacrifice that the majority of the creditors made when accepting the restructuring plan);56 Italian and German bondholders sued the banks which had sold them the so-called tango bonds;57 Italian bondholders demanded and received some compensation from the Italian government58 for not supervising those banks;59 German bondholders argued that the German representative on the IMF board did not fulfil his duties to the German people, but rather prioritized international financial interests and that this justified compensation; and the Paris Club is still
PAZARTZIS, Photini, La rengociation des dettes: les exemples allemand (1953) et indonsien (1970), in CARREAU, Dominique & SHAW, Malcom N. (eds.), La dette extrieure The external debt, The Hague Academy of International Law, Martinus Nijhoss Publishers, 1995, pp. 57-77; MORALES, Rafael, The German Debt Settlement of 1953: Some Guidelines for the Current Debt Crisis, ibid., pp. 79-107. 51 STURZENEGGER, Federico & ZETTELMEYER, Jeromin, Haircuts : Estimating Investor Losses in Sovereign Debt Restructurings, 1998-2005, Journal of International Money and Finance, 27, 2008, pp. 780. 52 The pending judicial and arbitrated claims against Argentina are related to holdout creditors, not to the majority of creditors that in fact accepted the restructuring agreement. 53 MICHALOWSKI, Sabine, Sovereign Debt and Social Rights Legal Reflections on a Difficult Relationship, Human Rights Law Review, 2008, 8, 1, pp. 35-68. 54 EM Ltd. V. Republic of Argentina, 473 F.3d 463 (2d Cir 2007). At this time the Report on the Evaluation of the Role of the IMF in Argentina, 19912001, made by the Independent Evaluation Office about the co-responsibility of the IMF in the collapse of Argentina, had been released (June 30 2004). http://www.imf.org/EXTERNAL/NP/IEO/2004/ARG/ENG/INDEX.HTM 55 For more about the litigation of creditors against Argentina in German and American courts, see LOWENFELD, op. cit., pp. 740. 56 This argument was recently used by an Argentinean court to dismiss a claim filed by a creditor (Juzgado Nacional en lo Contencioso Administrativo Federal N 1, October 12 2006). For comments about this sentence see MICHALOWSKI, Sabine, El estado de necesidad como defensa contra el pago de la deuda externa, Jurisprudencia Argentina, 2007, IV, Fasc. IX, November 28 2007, pp. 3. 57 SEB-Bank wegen falscher Beratung zu Argentinien-Anleihen verurteilt, Sddeutsche Zeitung, November 7 2003 (Frankurts Court, 2003); En Alemania, un fallo judicial apunta a un banco por los bonos, Clarn, October 29 2003 (Mnsters Regional Court, 2003); Deuda: otro fallo contra un banco, Clarn, November 8 2003 (Mnsters Regional Court, 2003); Banca, Borsa e Titoli di Credito, 2004, II (Mantovas Court, 2004); Sezione II, I Contratti, N 1, 2005 (Venezias Court, 2004); Judge Angelo Pezzuti, March 21 2005 and May 31 2005 (mimeo, Firenzes Court, 2005). 58 Act 266 December 23 2005, sections 343 to 345, GU N 302 December 29 2005, Suppl. Ordinario N 211. 59 See FRANZONI, Massimo, La responsabilit civile delle authorities per omissione di vigilanza, in GALGANO & VISINTINI, Mercato finanziario e tutela del risparmio, CEDAM, Padova, 2006, pp. 267-279; SCOGNAMIGLIO, Giuliana, La responsabilit civille della CONSOB, ibid., pp. 281-311. 9
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claiming that it should not suffer any reduction of its credits.60 This case shows several things very clearly: that the impact of the haircut among creditors can be a zero sum game;61 that there is not a stable and predictable priority credit ranking; that creditors do not enjoy an institutional framework within which to have an orderly discussion about how to allocate financial losses among them, which delays and complicates the restructuring process;62 and, that if the borrower feels that it has enough room to expand its discretionary (and arbitrary) power, it will do so.63 Thus, there is a need for a more orderly and efficient process for distributing financial losses among creditor groups. This implies that some minimum ex ante and enforceable ex post guidelines regarding credit ranking should exist in the realm of sovereign insolvency. 1.6. Seniority ranking in sovereign insolvency proposals (SDRM, CAC, and FATP) The SDRM formalizes the continuity of the status quo in this particular issue. IFIs have absolute priority and are therefore excluded from the restructuring process, resulting in the fact that only the private sector is asked to make sacrifices. Regarding the status of bilateral debt, this official proposal is not yet clear. The latest version suggests that these debts should form a different class of credits in order for the agreement to be approved. Domestic debt (trade debt, claims against the central bank, and so on) are in principle excluded, given that it is the debtor who has to decide whether to include them in the agreement.64 Since it is necessary to obtain acceptance by at least 75% of the creditors to approve priority financing, creditor votes would be difficult to obtain in a timely fashion. In terms of the CACs, they only involve bondholders, which leaves aside the rest of the creditors that also need to be qualified as senior or junior. It has no provisions capable of solving the debt dilution problem either.65 The priority of new lending is not the main concern of this contractual approach66 and the only possibility for bondholders is to agree to the subordination of their own credits, but there is no guarantee that this decision will be affirmative. The social movement Jubilee 200067 developed and presented a proposal of Fair and Transparent Arbitration Procedure (FTAP),68 which would provide (regarding the seniority ranking) that all unsecured creditors would have to receive symmetrical treatment in terms of bearing losses. IFIs and Paris Club debts are qualified as unsecured.

On September 2, 2008 the Argentinean government announced its intention of fully repaying these loans, but the extent and execution itself of these payments were delayed due to the onset of the current financial crisis. 61 BUCHHEIT, op. cit. (2002), p. 74. 62 Recent empirical studies have shown that creditor coordination problems, political shocks, and governmental behaviour of the borrower lead to messy restructurings, TREBESCH, Christoph, Delays in Sovereign Debt Restructurings. Should we Really Blame the Creditors, Free University of Berlin and Hertie School of Governance, 2008 (mimeo). 63 Since 1987, the coerciveness of the average sovereign borrower has increased, due basically to changes in creditor composition and the international legal environment, cfr. ENDERLEIN, Henrik, MULLER, Laura & TREBESCH, Christoph, Debt Disputes. Measuring Government Coerciveness in Sovereign Debt Crises, paper presented at the Annual Conference of the International Studies Association, San Francisco, CA, March 26-28 2008. 64 IMF, op. cit. (2002). 65 BOLTON, Patrick & SKEEL, David Redesigning the International Lender of Last Resort, Chicago Journal of International Law, Vol. 6 No. 1, 20005-6,pp. 182. 66 KRUEGER, Anne & HAGAN, Sean, Sovereign Workouts: An IMF Perspective, Chicago Journal of International Law, 2005, 6, pp. 214. 67PETTIFOR, Ann, "Arbitration, Insolvency and Limited Liability: Their Relevance to Debtor Nations, 2001, http://www.jubileeplus.org/analysis/analysis.htm; ibid., Resolving international debt crises the Jubilee Framework for international insolvency, 2002, http://www.jubilee2000uk.org/analysis/reports/jubilee_framework.html; ibid., Captulo 9-11 para resolver las crisis de la deuda internacional: la Jubilee Framework, estructura para la insolvencia internacional, New Economics Foundation report, 2002, http://www.jubileeplus.org/analysis/reports/jubilee_framework_sp.pdf. 68 AMBROSE, Soren, Social Movements and the Politics of Debt Cancellation, Chicago Journal of International Law, 2005, 6, pp. 272. 10
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None of these three proposals establishes seniority rules relating directly to the creditor behaviour and the collective action problem with which this paper tries to deal, such as responsibility for granting abusive loans. Even instituting a perfect symmetry among all creditorsor setting up creditor categories that completely ignore the actual behaviour of the lenders and the situation of the sovereign when borrowing moneyimpedes creating efficient ex ante incentives to promote prudence in future loans.

2. Responsibility for granting abusive loans 2.1. A sound guide for distributing losses among creditors: Looking at the lenders behaviour and its consequences We now turn to the problem of how financial insolvency losses should be distributed among a sovereigns creditors, and here we must pay closer attention to domestic bankruptcy laws. Although equal treatment of creditors is the main rule, it is limited from two sides: priority credit ranking and the subordination of certain credits. We will focus on one specific category of this last type of credits. Most legal systems establish that if creditor A engages in some kind of fraudulent lending practice and grants excessive loans, it does not deserve the same treatment as creditor B which has not violated pars conditio creditorum, has carefully evaluated its credit risk, and has acted according to the economic situation of the debtor. This rule has a clear economic rationale: it provides incentives for creditors to be prudent and diligent in assessing risk, encourages efficient allocation of financial resources, helps creditors act in good faith, prevents collective action problems in insolvency contexts, and helps to prevent the aggravation of the situation of the debtor and, thus, of the creditors as a whole. Even when responsibility for granting abusive loans is broader in domestic law, we will see that from an international perspective reckless conduct alone is not enough to create liability and subsequently lead to being subordinated in a sovereign bankruptcy procedure. This general principle, as this section aims to verify, requires the establishment of fraudulent intent, which differentiates this rule from the so-called deepening insolvency doctrine. When a lender tries to obtain extra (unfair) advantages at the expense of other creditors in the context of insolvency, it can do so by attempting to grant loans which assume an excessive risk that can only be understood if we integrate the extra advantages to the cost-benefit analysis conducted by the lender. This is the way that excessive risk assumed by an abusive lender and unfair advantage can go hand-in-hand Regarding the factual consequences of abusive loans, it is important to mention, first, that they can impede the debtors asymptomatic insolvency from revealing itself, precisely because the new credits keep the debtor afloat and functioning in the market for more time, concealing the real (insolvent) situation of the debtor.69 Second, during the extra time in the borrowers commercial life its debt usually increases considerably dueon the one handto the moral risk problems that appear in the administrators and shareholders behaviour during the final period of the company andon the other handto the gradually worsening conditions in which the company is dealing with other economic players. The assets of the debtor are also dramatically reduced during this period because of the same moral risk problems and the claims that other creditors are starting to make against the debtor, that erode its wealth. Finally, the disguising of the debtors situation can inhibit creditors from using their contractual and legal self-protection tools in order to collect their credits and defend the borrowers wealth. All these types of equity deterioration affect the guarantee of the creditors: they will receive less than they could have collected if the debtor had filed a restructuring procedure earlier. Since the economic
69

DI MARZIO, Abuso nella concessione del credito, Edizioni Scientifiche Italiane, Napoli, 2004, pp. 39, 170-1, 186-9, 220. 11

situation of a debtor that leads a loan to be qualified as abusive is characterized by irreversible distress (no rational financial aid would avoid the collapse), this kind of loan does not eliminate insolvency, but rather hides it and possibly aggravates it, prolonging the interval between asymptomatic and symptomatic insolvency. For all the reasons mentioned above, domestic bankruptcy laws have tried to discourage abusive loans by allowing these creditors to collect less money in insolvency procedures than those who are not abusive. This is effected through the principle of responsibility for granting abusive loans. 2.2. A general legal principle The insufficiency of legal guidance regulating, in general, the problems that sovereign insolvency comes with and, in particular, the consequences of abusive loans, cannot be an excuse non liquet for the legal questions that this economic, social, and political phenomenon raises. If we were to ask which legal norms apply to the behaviour of speculative creditors, at first glance international law does not provide clear responses. International finance needs answers and this gap can be filled by general principles of law.70 Art. 38 of the Statute of the International Court of Justice (ICJ) recognizes general principles as a legal source of international law. Therefore, when necessary, it is worth resorting to legal principles in order to solve disputes and make the legal framework more predictable. Particularly in sovereign insolvency law, domestic principles have been doing a very important job, as the official proposals of SRDM and CACs actually show. There are basically two methods for identifying general principles: the quantitative and the qualitative. The first one is ponderous, too mathematical, and does not reflect the view of the aforementioned Art. 38, since it alludes to general principles recognized by (the colonialist expression) civilized nations not all the civilized nations.71 Having discarded the quantitative method, the problem requiring solution must be individualised. An analytical approach has to be implemented, taking into account the rationale behind the way domestic law responds to a particular problem. This requires an intrinsic evaluation of the principles founded in domestic systems that provide the best solution for the case, rather than a mechanical or statistical search of predominant rules.72 Using this telos-oriented approachwhich has been openly adopted by the European Court of Justice73it is apparent that a synthesis of domestic rules and concepts is necessary. The selection of the relevant system is largely dependent on the purpose of the comparative analysis.74 As an example, the Iran-U.S. arbitral claim tribunal focused on what Iranian and American law established to determine whether general principles could be applied to this procedure. For the case this paper addresses, it is useful to focus on creditor and debtor legal systems. Apart from the similarities between private and state insolvencies,75 there is a growing and broadening tendency to systematize principles distilled from domestic legal systems (especially taking Chapters 9 and 11 of the U.S. Bankruptcy Code as models) in order to build a new sovereign insolvency architecture. The notable similarities in domestic bankruptcy laws facilitated the work to create the SDRM proposed by the IMF, since, for instance, the standstill and approval of the reorganization plan are
BASSIOUNI, M.Cherif, A Functional Approach to General Principles of International Law, Michigan Journal of International Law, 11, 1990, p. 776; OLUFEMI, Elias & CHIM, Lim General Principles of Law, Soft Law and the Identification of International Law, Netherlands Yearbook of International Law, 28, 1997, p. 4. 71 FORD, Christopher, Judicial Discretion in International Jurisprudence: Art. 38 (1) (c) and General Principles of Law, Duke Journal of Comparative & International Law, 1994, 5, p. 76. 72 TRIDIMAS, Takis, The General Principles of EU Law, Oxford Univ. Press, Oxford, 1999, p. 38. 73 SCHIER, op. cit., pp. 105. 74 Ibid., pp. 94. 75 CARREAU, Dominique, Bilan de recherches de la Section de langue franaise du Centre dtude et de Recherche de lAcadmie, in La dette extrieure. The external debt, Centre dtude et de Recherche de Droit International et de Relations Internationales, Acadmie de Droit International de La Haye, Martinus Nijhoff Publishers, 1992, pp. 20. 12
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deeply-rooted institutions in domestic law. In other cases, the distilling of general principles in order to develop a new institutional design for sovereign insolvencies has been even more explicit.76 The idea is simple: legal lacunae cannot be a valid argument for not applying the rule of law to the sovereign insolvency problem, and the general principles coming from domestic bankruptcy laws offer a goldmine of sound, consolidated rules to deal with this economic phenomenon. We have to bear in mind that the common characteristics a rule may have in different legal systems does not necessarily give rise to a common principle of quality at the international level.77 Also, apart from verifying the basis of the rule itself, we have to appropriately synthesize and adapt it to the level at which we plan to explore its application. Resorting to the comparative law method in order to detect and shape responsibility for abusive loans as a principle to be applied in international law stems from the idea that general legal problems exist and comparative law allows us to incorporate a variety of solutions and their adequate evaluations.78 Abusive loans are one of these general problems79 as both domestic reality and global finances quite often dramatically shows us. 2.3. The content of this particular responsibility 2.3.1. General theory in domestic law The commercial and bankruptcy laws of several legal systems recognize the validity of the so-called liability for granting abusive loans.80 This liability stems from the understanding that a creditor that grants a loan without following the most elementary precautionary guidelines with regard to the analysis of credit risk can cause negative externalities in the market.81 The market absorbs the information generated by a credit institutions activity because it theoretically helps in terms of transaction costs and, thus, with efficiency. These institutions are important producers of social capital,82 and they basically help to reduce or cushion the negative effects of asymmetric information in markets.83 While leaving room for broad discretion appropriate to the risk implicit in this activity, financial rules impose minimal standards of professional diligence in relation to the evaluation of credit risk of loan transactions.84 That means that lenders are not completely unaffected by the consequences that their loans may have on borrowers and third parties. The externalities generated in the market by such behaviour are not minor, and have led to the acceptance of this special ethic in the banking and financial professions. When we say that too much credit was given we implicitly recognize that a false image can be generated and this information can in turn become part of the market. The law seeks to prevent this

Ibid. See PISTOR, Katharina, The Standardization of Law and its Effect on Developing Countries, The American Journal of Comparative Law, 50, 2002, pp. 97 ss. 78 LARENZ, Karl, Methodenlehre der Rechtswissenschaft, Springer-Verlag, Berlin, New York, 1969. 79 Development of legal doctrine regarding protection of expectations is transnational and fundamental, independent of the particularities and variables that each positive law presents, see DE CASTRO PORTUGAL CARNEIRO DA FRADA, Manuel, Teoria da Confiana e responsabilidade civil, Almedina, Coimbra, 2004, pp. 33-7. 80 For a comparative analysis of the American, Argentinean, Belgium, English, French, German, Italian and Spanish legal systems specifically in terms of this kind of responsibility, see BOHOSLAVSKY, Juan Pablo, Crditos abusivos. Sobreendeudamiento de Estados, empresas y consumidores, Abaco Ed., Buenos Aires, 2009, (Ph.D. dissertation); SIMONT, Lucien & BRUYNEEL, Andr, La responsabilit extra-contractuelle du donneur de crdit en Droit Compar, Feduci, Siena, 1984. 81 On externalities and how one persons decision can affect another person who was not part of the first one, see COASE, R.H., The Firm, the Market, and the Law, University of Chicago Press, Chicago, 1988, pp. 23-4. 82 For more on the social capital concept see COLEMAN, James, Social capital in the creation of human capital, American Journal of Sociology, Vol. 94, 1988, pp. 95-120. 83 BEBCZUK, Ricardo, Informacin asimtrica en mercados financieros, Cambridge University Press, Madrid, 2000, pp. 19. 84 J. STOUFFLET, Devoirs et responsabilites du banquier a loccasion de la distribution du credit, in GAVALDA, Responsabilit professionnelle du banquier: contribution la protection des clientes de Banque, Economica, Pars, 1978, pp. 23. 13
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situation by assuming the existence of a general principle based on protection of legitimate expectations.85 Abusive loans are not proportionate to the borrowers repayment prospects and are granted in an irreversibly distressed economic situation of this same borrower.86 The extent of this lack of proportionality is economically intrinsic to the situation of the borrower. The economic circumstance that characterizes an abusive loan is the fact that the situation of the borrower limits any hope that it its situation will improve and its loans be paid,87 allowing and facilitating the aggravation of its situation and, thus, affecting other creditors.88 In fact, when the abusive lender realizes that the end is coming, it changes its behaviour and tries to protect its interests by granting loans that go directly against the main objectives of any bankruptcy law. We already described the specific consequences of abusive loans: they conceal insolvency, give the debtor an extra lease on life during which its situation worsens,89 and operate under a contractual freedom that impedes creditors from appropriately reacting and defending their credits. Inappropriate loans imply the assumption of unreasonable risk in providing financial support that only delays the inevitable bankruptcy, further eroding the net worth of debtor assets. More specifically, the so-called previous (that is, to the abusive loan) creditors suffer financial losses as a result of the economic deterioration of the common debtor that the abusive loans facilitated, allowing the debtor to continue eroding its net worth since there was no possible escape to the bankruptcy. The later creditors are victims of the appearance that the abusive loans generated,90 and thus they acted based on the trust artificially provoked by the economic cautionnement.91 If the creditors had known the real situation they would surely have behaved differently, for example not signing the contract or taking other defensive and/or preventive measures.92 The abusive loan may be granted negligently or wilfully, seeking unfair advantage. The legal reactionas we will see in the comparative analysisis not unanimous in the first case, where the level of state intervention in the economy and the general open or closed nature of the tort liability system that each country has adopted seem to determine the extent of this liability.93 Owing to the purpose of this paper, we will concentrate on the case of wilfully abusive loans since this is the point where the minimal similarities that international law requires for internationalising general principles are found. This restrictive technique has been used since the famous Haute-Silsie polonaise (1926) case.94 We are now interested in focusing on the behaviour of creditors who, through granting abusive loans, wilfully violate par condictio creditorum. For example, thanks to these loans a creditor can delay default and thus consolidate his collateral, seek repayment in advance, or convert old loans into new ones and, thus, reduce bank exposure.95 Blatant violation of the legal and financial rules that establish how credit
DE CASTRO PORTUGAL CARNEIRO DA FRADA, op. cit., esp. pp. 474-9. BONNEAU, Thierry, Droit Bancarie, Montchrestien, Paris, 1994, p. 426. 87 BAUMBACH, Adolf & HOPT, Klaus, Handelsgesetzbuch, Beck'scher Kurz-Kommentar, Beck, Mnchen, 2005 (mimeo). 88 VEZIAN, Jack, La responsabilit du baquier en droit priv franais, Litec, Paris, 1983, pp. 144. 89 According to the definition of damage in the famous French case Laroche (Cour de Cassation Ch. Com., January 7 1976, Recueil Dalloz Sirey, 1976, I, pp. 277; Revue des Socits, 1976, Jurisp. Gnrale Dalloz, Pars, pp. 126 ; Revue Trimestrielle de Droit Commercial, 1976, I, pp. 171) the assets of the debtor are also dramatically reduced during this period because of the same moral hazard problems and the claims that some creditors start making against the debtor, which erode the debtors wealth. 90 VEZIAN, op. cit., p. 156. 91 LIKILLIMBA, Guy-Auguste, Le soutien abusif dune entreprise en difficult, 2nd Ed., Litec, Paris, 2001, p. 69. 92 VISCUSI, Amalita Concessione abusiva di credito e legittimazione del curatore fallimentare allesercizio dellazione di responsabilit, Banca, Borsa e Titoli di Credito, 2004, p. 662. 93 VV.AA., Responsabilit du banquier: aspects nouveaux, Association Henri Capitant, T. XXXV., Ed. Economica, 1984, p. 10; LIKILLIMBA, op. cit., p. 158; SIMONT & BRUYNEEL, op. cit., pp. 205. 94 Recueil des Arrts of the Permanent Court of International Justice, A, N 7, 1926. 95 DI MARZIO, op. cit., p. 172; ZENNER, Alain, Responsabilits du donneur de crdit, Revue de la Banque, 1974, pp. 723. 14
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risk must be assessed and other circumstantial evidence, such as the potential benefit to the creditor from granting the abusive loans, help to prove whether the lender was wilfully abusive. We have already said that a debtors economic situation that leads loans to be qualified as abusive is characterized by irreversible distress. This kind of loan does not eliminate insolvency, but rather hides it and may aggravate it, prolonging the interval between asymptomatic and symptomatic insolvency. The point here is that this doctrine does not affect the banks right to make mistakes.96 A borrower can go bankrupt after a loan and the lender will not be liable. The situation that this doctrine isolates is the following: the lender, applying minimal diligence, should have known that the effect of the loan would only delay the inevitable bankruptcy of the client; plus, he tried to acquire unfair advantage over other creditors, thereby violating the equal treatment principle. All creditorsbanks and othersmust fulfil their own obligations of assessing the credit risk of any transaction in which they want to participate. Liability for granting abusive loans does not affect these duties. If a creditor claims that it was a victim of an abusive credit and such creditor behaved without following the rules attributable to it, the harm will have been the result of its own fault and nemo auditor quid propria turpitudinem allegans.97 Each creditors duty to take due care depends on a variety of factors, including the nature, profession, and economic size of the lender, the volume of the loan, etc. 2.3.2. Comparative analysis Although a broader survey including other countries would be ideal, if we look at the domestic legal systems of most of the major creditor countries (in terms of developing country external debt), we find common denominators among them relating to this specific kind of responsibility. The strong presence of creditor countries in this survey is important since most of the bonds and financial contracts to which developing countries are party stipulate that the legal jurisdiction and applicable law are, precisely, of those countries. In other words, the selection of legal systems from which to develop the comparative analysis is consistent with the goal of this survey.98 The French, Belgian, Italian, German, English, American, Spanish andas a good example of a debtor countrythe Argentinean legal systems all recognize, to differing degrees and with varying effect, the obligation to rebuild net worth after harm has occurred through abusive credit lending. Depending on the legal system involved, this can be channelled through civil liability or solutions that are typically bankruptcy procedural tools, with subordination being the most important among them. This specific kind of responsibility is usually seen as a response to a collective action problem that arises in time of insolvency when some creditors try to take unfair advantage at the expense of others. This is the reason why the abusive loan issue is usually thought of, made visible, and addressed in contexts of bankruptcy. The contractual freedom of financial institutions operates within the limits imposed by law, fundamentally through the guidelines that have been established by case law. Each legal system imposes different limits, but they coincide in certain circumstances, as we will see in the following paragraphs. This legal theory was born in France more than 120 years ago,99 and has developed vigorously since the early sixties.100 The so-called open French tort law system (sections 1382 and 1383, civ. code) allowed an offended person to register a claim even when he was negligently harmed.101 Liability for granting
CA de Pau, February 22 1990, (mimeo). Blanc c/ Socit gnrale, Cass. Com. Paris, February 21 1995, N 374 DF, RJDA, July 1995, N 868, p. 702. 98 SCHIER, op. cit., pp. 94. 99 Cass. Civ., August 1 1876, S 1876, I, p. 457; Req. July 27 1897, D. 1897, I, p. 607. 100 STOUFFLET, Jean, Louverture de crdit peut-elle tre source de responsabilit envers les tiers?, JCP, 1965, I, 1882; ibid., Devoirs et responsabilits du banquier loccasion de la distribution du crdit, Rapport au colloque de droit bancaire, Universit de Paris I, February 10-11 1977, Economica, 1978, pp. 21. An ample and contemporary study of the scholar and judicial evolution of this issue in France, LIKILLIMBA, op. cit. 101 GAVALDA, Christian & STOUFFLET, Jean, Droit bancaire. Institutions. Comptes. Oprations. Services, Litec, Paris, 1992, pp. 415; RIVES LANGE, Jean & VEZIAN, Jack, Banquiers, JCP Annexes, Fas 8, 11, 1970, pp. 28. 15
96 97

abusive loans has been treated as any other tort, requiring the typical elements of civil liability,102 particularly focusing on the causal link between the loan, the aggravation of the borrowers situation, and the affectation of other creditors.103 The recent Act of July 25, 2005modifying section 650 of the French code de commercelimited this specific type of liability to cases of fraud. The legislative technique, however, was defective and there is confusion about the real extension of this legal reform.104 The Belgian legal system followed the same path as the French. The courts started to implement it a relatively long time ago105 and it has grown strongly over the past thirty years.106 The most important difference between the French and Belgian systems is that the latter did not institute a legislative reform in order to limit liability for negligence.107 In Italy the development of this type of liability has been directly linked to the evolving interpretation of the element of injustice that Art. 2043 Civ. Code requires in order to find a tort.108 Once the open system was consolidatedit does not require a specific tort or duty of care to hold a tort feasor liable anymore109the doctrine quickly moved forward to deal with the fundamentals and details of liability for granting abusive loans.110 If a bank violates the general dovere di correteza by granting loans to an already insolvent client behaviour that can be aimed at taking some advantage of other creditors, or disregarding negligently the most basic rules of assessing the credit riskthe jurisprudence is very clear on condemning the lender to compensate the damages equivalent to the aggravation of the borrowers situation that he facilitated, even in case of negligence.111 Nowadays, the toughest discussions are related to a procedural issue: whether the trustee or the creditors have the right to sue the abusive lenders.112
102 Cass. Com., January 7 2004, J.C.P., 2004, IV, 1399; Cass. Com., March 17 2004, Juris-Data, n2004-023168; Cass. com., March 22 2005, Banque et droit, 2005, N 102, p. 71. 103 Cass. Com. Ass. pln., July 9 1993, Societ Gnrale c. Guiraud, es qualit syndic SA Astre et Cie., et a., JCP, 1993, d. E, II, 22122. 104 BONHOMME, Rgine, La responsabilidad por concesin abusiva de crdito conforme a la ley 2005-845, de 26 de julio de 2005, Revista de Derecho Concursal y Paraconcursal, N 5, 2006; DAIGRE, Jean-Jacques, Crances bancaires et crances ordinaires dans la faillite du client: vers deux poids et deux mesures ?, Rev. Dr. Banc., July-August 2005; LEGEAIS, Dominique, Les concours consentis une entreprise en difficult (C. com. Art. 650-1), J.C.P. E, 2005, N 1510. 105 Brussels , April 13 1914, Pas., 1914, II, p. 226, in ZENNER, Alain, Responsabilits du donneur de crdit, Revue de la Banque, 1974, p. 707. 106 Lige, April 29 2004, 7e chambre; Bruxelles, Septembre 6 1999, R.D.C., 2000; Comm. Bruxelles, Septembre 12 2000, R.D.C., 2001, p.787; Civ. Anvers, Novembre 28 2000, R.W., 2001-2002, p. 1072. In the legal literature see CATTARUZZA, Jean, Le banque et lentreprise en difficult, Revue de la Facult de Droit de Lige, 1997, pp. 602-3. DEMONTY, Bernard, Derniers dveloppements en matire de responsabilit du banquier dispensateur de crdit, in LINSMEAU, Jacqueline (coord.), Droits bancaire, cambiaire et financer, Formation Permanent (CUP), Vol. XXIV, Lige, 1998, pp. 75; VAN OMMESLAGHE, Pierre, La responsabilit du banquier dispensateur de crdit en droit belge, Socit Anonyme Suisse, 49, 1977, pp. 110. 107 CUIGNET, Roger, Responsabilit juridique du banquier donner de crdit, Revue de la Banque, 1976, 1, p. 15. 108 ANELLI, Franco, La responsabilit risarcitoria delle banche per illeciti commessi nellerogazione del credito, Diritto della Banca e del Mercato Finanziario, 1998, pp. 142. 109 FRANZONI, Massimo, Fatti iliciti. La lesione dellinteresse legittimo , dunque, risarcibile, Contratto e Impresa, 1999, N 3, pp. 1039. 110 See CASTIELLO DANTONIO, Antonio, La banca tra concessione abusiva e interruzione brutale del credito, Il Diritto Fallimentare, 2005, N 5; ibid., Responsabilit della banca per concessione abusiva di credito, Il Diritto Fallimentare, 2002, N 5; DI MARZIO, op. cit.; GALGANO, Francesco, Civile e penale nella responsabilit del banchiere, Contratto e Impresa, 1987, I; INZITARI, Bruno, Irregolarit del fido e responsabilit della banca per concessione abusiva del credito, en AA.VV., Scritti in onore di Luigi Mengoni, T II, Giuffr Ed., Miln, 1995; TERRANOVA, Giuseppe, Profili dellattivit bancaria, Giuffr, Miln, 1989. 111 The two first cases in which a bank was held liable to another bank were Corte di Cassazione, January 13 1993, Cassa di Risparmio di Livorno c. Cassa di Risparmio di Modena e altri, Sent. N 343, Banca, Borsa e Titoli di Credito, 1994, II, pp. 258-266, with notes of Nicoletta MARZONA & Andrea PERRONE, pp. 266-283; Rivista Diritto della Banca e del Mercato Finanziario, N 1, 1993, pp. 399-411, with note of Bruno INZITARI, pp. 412-423; the second case was Corte di Cass., January 8 1997, Banca di Roma s.p.a. c. Banca Popolare di Ancona soc. coop. a r.l., Sent. N 72, 16

In Germany, since section 823 of the Brgerliches Gesetzbuch (BGB, Civil Code) requires a creditor to violate an absolute (erga omnes) right or commit a breach of a statute that specifically protects a person or interest (rule of Schutzgesetz),113 and the financial damages that are of interest to this paper are not among such categories of illicit acts, the liability under analysis cannot be based on this norm. The case is different when there was an intention of causing harm, in which case the action falls in Section 826 BGB, which reacts by defending bona fide creditors in instances where some creditors tried to create undue privilege over the debtors assets.114 This can happen, for example, when a bank postpones its clients bankruptcy petition in order to collect its loans through collateral that it is able to obtain during this period or goods that still remain in the debtor possession (Konkursverschleppung).115 Regarding the economic situation of the borrower, if the credit-granting entity seriously evaluated the financial perspectives of the debtor company and its attempts to remedy its troubles, and they indicated that the company could be recovered, the lender cannot be held liable.116 The so-called cooperation duties (Kooperationspflichten) that creditors should observe toward other creditors,117 and the fundamentals of new Articles 241 and 311 BGB that consolidated protective effects for third parties, can also play a role in configuring the illegality of the abusive loans.118 In the United States there is no specific tort aimed at preventing abusive loans, basically because there is a certain aversion to recognizing compensation in such cases of indirect (non-contractual) economic loss.119 It is not absolutely clear if this requirementnamely of establishing a contractual link between the victim and the tort feasorhas formal legal support in the American system.120 In any case, special statutes relating to insolvency have provisions that apply to the facts this paper seeks to explore. On the one hand, with the exception of a situation involving control by a bank, which generates special stewardship duties,121 a trustee can only attempt to obtain a declaration of nullity of certain transactions if it is able to demonstrate that the creditor attempted to hinder, delay, or defraud the interests of the remaining creditors (Bankruptcy Code Sec. 548). The Uniform Fraudulent Transfer Act (Sec. 4.b) provides some circumstantial evidence of the existence of dolus, such as when the debtor received less than reasonably equivalent value in exchange for a transfer or obligation, the debtor was insolvent, or there was a notable growth of the debt after transfer.

Banca, Borsa e Titoli di Credito, 1997, N 6, with note of Claudio SCOGNAMIGLIO, pp. 653-8. More recently, broadly developing the legal requirements for the responsibility for granting abusive loans, Tribunale di Foggia, May 7 2002, Il Fallimento, 2002, pp. 1166. 112 Corte Cassazzione, Sezioni Unite, March 28 2006, N 7030, Il Diritto Fallimentare, 2006, N 5, pp. 615-642, with notes of RUSSO, Libertino, Legitimazione del curatore allazione per abusiva concessione di credito, pp. 615-629, and NARDECCHIA, Giovanni, Labusiva concessione del credito allesame delle sezioni unite, pp. 616-642. 113 Jurisprudence has required these elements, for more see BGHZ 10, 228; WM 1972, p. 441. 114 BHNER, Reinhard, La lutte contre la criminilat economique en Allemagne, in GAVALDA, C. (director), Responsabilit professionelle du banquier: contribution la protection des clientes de banque, Recherches Pantheon-Sorbonne Universit de Paris I, Srie Sciences Juridiques Droit des Affaires, Ed. Economica, Paris, 1978, pp. 94 ss. 115 MERTENS, Hans-Joachim, Zur Bankenhaftung wegen Glubigerbenachteiligung, ZHR, N 143, 1979, pp. 177; RMKER, Dietrich, Glubigerbenachteiligung durch Gewhrung und Belassung von Krediten, ZHR, N 143, 1979, p. 204. 116 BAUMBACH & HOPT, op. cit. 117 EIDENMLLER, Horst, Die Banken im Gefangenendilemma: Kooperationspflichten and Akkordstrunsverbot im Sanierungsrecht, ZHR, 160, 1996, pp. 343-373. 118 COESTER, Michael & BASIL, Markesinis, Liability of Financial Experts in German and American Law: An Exercise in Comparative Methodology, The American Journal of Comparative Law, Vol. 51, 2003, pp. 290. 119 COOGAN, Peter in BRUYNEEL & SIMONT, ob.cit., p. 161. 120 PERRY, Ronen, The Unsolved Mystery of Tort Law, New York University School of Law, working paper, 2008. 121 BLUMBERG, Phillip, The Law of Corporate Groups. Problems in the Bankruptcy or Reorganization of Parent and Subsidiary Corporations, Including the Law of Corporate Guaranties, Little, Brown & Company, Boston and Toronto, 1985, pp. 165-8. See cases Process-Manz Press, Inc., 236 F. Supp 333 (N.D. III 1964); 369 F. 2d 513 (7th Cir. 1966); 386 U.S. 597 (1967). 17

On the other hand, the equitable subordinationaimed also at sanctioning fraud122 of the loan can be claimed, among other reasons, if inequitable behaviour resulted in harm to remaining creditors or in unfair advantage detrimental to the interests of the rest (Bankruptcy Code Section 510 (c)).123 The insiders (shareholders, directors) logically bear more stewardship duties, but the outsiders (such as the creditors) can also assume some fiduciary duties vis-a-vis other creditors in extreme cases, such as de facto control of the borrower and lending money in a unconscionable way, which can justify that their credits be subordinated.124 The constructive fraud contemplated by Section 548 establishes that there is no need to demonstrate the intent to defraud the remaining creditors. What is required is a lack of proportion between the performance and the occurrence of a situation in which the debtor is collapsing, or, more specifically, an awareness of the lack of repayment capacity of the borrower. All of this indicates the implicit dolus of the lender.125 In England there are no specific torts focusing on abusive loans. This means that under general rules there is no area for this kind of responsibility. This idea is even clearer if one considers that there are no fiduciary duties between the lender and the creditors of his borrower.126 However, some specific bankruptcy rules allow for sanctioning behaviour under particular circumstances. When there was an intention to defraud the remaining creditorsand thus to take unfair advantage of them (fraudulent trading, Insolvency Act 1986, Section 213)this creditor can be held liable. Moreover, according to Section 214 (3) of the same act (wrongful trading), when the company is insolvent and its directors knew or should have known that this condition was irreversible and yet in spite of that they contracted new, unfair, inappropriate debts,127 such directors can be held liable.128 The connecting point with the abusive loans is that these directors can be creditors when they act in the shadow, unfairly controlling the debtor, and when the abusive loans were tools used by the de facto directorcreditor. The loans of those who engaged in this behaviour can be subordinated by the court.129 In Spain the academic debate has not paid much attention to this special kind of liability,130 although after the most recent reforms in its bankruptcy laws (Ley concursal, 2003) this particular statute has been seen as the specific rule that should guide the abusive credit discussion.131
BAIRD, Douglas & JACKSON, Thomas, Cases, Problems, and Material on Bankruptcy, Little, Brown & Company, Boston and Toronto, 1985, pp. 254-7. 123 HERBERT, Michael, Understanding Bankruptcy, Matthew Bender Irwin, US, 1995, p. 176. 124 COWANS, Daniel, Cowans Bankruptcy Law and Practice, Vol. III, 6th edition, West Publishing Co., St. Paul (Minn), 1994, p. 126. Applying this principle, the Bankruptcy Court for the District of Montana recently subordinated a banks credit because of its lack of financial due diligence and inattention to borrowers abilities to repay the loans, see In re Yellowstone Mountain Club, LLC, Case No. 08-61570 (Bankr. D. Mont. May 13, 2009). 125 COOGAN, op. cit., p. 167. In one case the banks credit was subordinated because it had induced other creditors of the common debtor to keep on granting loans to this borrower in order to avoid its bankruptcy (which eventually happened), knowing its distressed situation, see Frank S. Osborne and Doris Arlene Osborne, Debtors. Bank of New Richmond, New Richmond Farmer's Union Co-Op Oil Company and General Feeds, Inc., v. Production Credit Association of River Falls, Wisconsin, United States District Court, W.D. Wisconsin, No. 84-C-43-C, Sept. 18, 1984, 42 B.R. 988, 11 Collier Bankr.Cas.2d 1349, Bankr. L. Rep., p. 70. 126 MEGRAH, Maurice, in SIMONT, Lucien & BRUYNEEL, op. cit., 1984, pp. 157-160. 127 The jurisprudence is not unanimous regarding whether the director had to have shown a particular intention towards the damages, see PFTZM (in liquidation),2 AII ER 365, 1995 (CA) and Secretary of State for Trade and Industry v. Deverell, CA (Civ. Div.), 2000, All England Law Reports, 365 (CA). 128 HAMMERSON, Marc, What is a Shadow Director? New Law Journal, Vol. 151, N 7008, 2001, p. 1704. 129 STEVENS, Robert, National Report for England, in MCBRYDE, FLESSNER & KORMANN (eds.), Principles of European Insolvency Law, Kluwer Legal Publishers, Deventer, 2003, pp. 216. 130 See the Spanish chapter of Jos GIRON TENA in SIMONT & BRUYNEEL, ob. cit., pp. 73-91; FERNNDEZARMESTO, Juan & DE CARLOS BERTRN, Luis, El Derecho del Mercado Financiero, Civitas, 1992, Madrid, pp. 195, 202-4; SANCHEZ MIGUEL, Mara C., La responsabilidad de las entidades de crdito en su actuacin profesional, Revista de Derecho Bancario y Burstil, N 37, 1990, pp. 319-342. 131 RUBIO VICENTE, Pedro, Concesin abusiva de crdito y concurso, Revista de Derecho Concursal y Paraconcursal, No. 8, 2009, pp. 247-274. 18
122

Applying the general alterum non laedere principle contemplated in Art. 1902 Civil Code, the damage effectively provoked by negligent behaviour must be compensated.132 The free market constitutional framework (Art. 78, Spanish Constitution) protects banks from the consequences of mistakes, but not from violation of their own professional duties of stewardship caused by serious imprudence (culpa lata). In this case, the victims own negligence operates as a defence for avoiding liability.133 As pointed out above, the new Ley concursal added new procedural tools for channelling judicial claims related to abusive loans. Seeking reconstruction of the economic active mass and reinforcement of the equal treatment rule, fraudulent and/or harmful acts performed by insolvent debtors before default can be challenged by the actions established under the new act (Art. 71).134 These credits can be subordinated (Art. 92) or a trustee can also file to protect the active mass related to the complicity of third parties with the debtor, who helped him to simulate the real economic state of the debtor (Arts. 164-166). The important consequence here is that the loan of the abusive lender is considered void and the lender is compelled to pay compensation.135 Finally, we look at the Argentinean system, which is another example of an open tort model, strongly influenced by the Italian and French systems. The general principle in tort law (Arts. 1109, 1113 Civil Code) indicates that any damage caused by negligent or wilful behaviour must be repaired,136 facilitating the recognition of liability for granting abusive loans. Specifically focusing on responsibility for abusive loans, the lenders behaviour is considered wrongful when it violates the duties of the banking profession, its internal guidelines, and/or the rules established by the central bank.137 With regard to which aspect of the borrowers situation renders the lenders decision to grant a loan unlawful, this occurs when the economic distress is definite and irreversible and there is no option other than to default.138 The trustee will have to prove that the lender knew or should have known this situation and that this loan provoked, at least partially, the alleged damages. The plaintiff must prove that the abusive loan provoked the aggravation of the borrowers situation or induced him to contract with this common debtor. The collective damages (inflicted on the creditors as a group) must be claimed by the trustee, as a bankruptcy inefficacy action and/or as a compensation claim,139 while so-called particular damages must be claimed by the creditors individually
LACRUZ BERDEJO, J.L., LUNA SERRANO, A., DELGADO ECHEVERRA, J. & RIVERO HERNNDEZ, F., Elementos de Derecho Civil. Derecho de Obligaciones, Vol. II, Bosch, Barcelona, 1987, p. 584. 133 GIRON TENA, op.cit., pp. 88. 134 The bad faith of the creditor can be represented by his intention of harming--or his knowledge that his behavior had or could have had a damaging effect over--the other creditors, Tribunal Supremo de Espaa, December 16 1997, FALCN FERR, Juan, Los crditos subordinados, Civitas, Aranzadi, Cizur Menor, 2006, 308 pp. 135 GARCA-CRUCES, Jos, in ROJO & BELTRN (director), Comentario de la ley concursal, T II, Civitas, Madrid, 2004, p. 2577; FERRER BARRIENDOS, Agustn, in SAGREGA TIZN, SALA REIXACHS & FERRER BARRIENDOS (coord.), Comentarios a la ley concursal, T II, Bosch, Barcelona, 2004, p. 1715. GIRON TENA, op.cit., pp. 88. 136 Corte Suprema de Justicia de la Nacin, Santa Coloma, Luis F. y otros c. Empresa Ferrocarriles Argentinos, August 6 1986, La Ley, 1987-A, p. 442. 137 CHIAVASSA, Eduardo & RICHARD, Efran, Responsabilidad por abuso crediticio, paper presented at the I Congreso Argentino e Iberoamericano de Derecho Bancario y V Congreso de Aspectos Legales de las Entidades Financieras, Lomas de Zamora (Buenos Aires), June 28- 29 2007. 138 In Argentina, insolvency is tantamount to cessation of payment and therefore the bankruptcy solution is unavoidable (arts. 1 and 78, ley de concursos y quiebras), see RIVERA, Julio Csar, Instituciones de Derecho Concursal, Rubinzal-Culzoni, Sante Fe, 1996, p. 119. 139 3rd Juzgado Proc. Concursal de Mendoza,Fernndez Darder, Juan J. s/ quiebra, February 7 1996, Revista Foro de Cuyo, February 1996, pp. 122. The trustee petitioned the bankruptcy judge to reject the credit that a bank was trying to verify in the procedure, alleging it was abusive. After describing the general elements of this specific kind of responsibility, which basically coincide with the framework explained above, the judge had to reject the claim because the trustee was not able to prove them empirically. For comments about this case see RIBERA, Carlos, Una sentencia ejemplar del juez Mosso respecto a la concesin abusiva del crdito y los concursos, Derecho y Empresa, Universidad Austral, September 2004. 19
132

affected.140 Abusive credits can also provoke the nullification of collateral that a lender can otherwise obtain through these kinds of loans.141

2.4. Checking the general theory: Some final remarks to determine and contextualize common denominators After reviewing eight different legal systems it is possible to state that the theory of responsibility for granting abusive loans is generally confirmed by all of them. Indeed, these laws affirm that lenders cannot lend money with impunity, disconnecting themselves from certain consequences that these contracts can bring about in foreseeable victims. Recognizing that there is ample room for discretion, a fact intrinsic to financial activity, financial ethics imposes a minimal standard of professional due diligence when assessing the credit risk of loans. When violating this duty and granting loans to a borrower that it is definitely in an irreversible situation of insolvency, if this creditor unfairly tries to establish an advantage over the rest of the creditors, violating the pars conditio creditorum, it has to repair the negative consequences of such behaviour. This fraudulent conduct requirement assures the uniformity of the principle referred to in this paper. More specifically, regarding the mental state of the lender, we have already verified that some legal systems sanction negligent conduct; for example, those of Belgium (Art. 1382, Civil Code), Italy (Art. 2043, Civil Code), to some extent Spain (Art. 1902, Civil Code), and Argentina (Arts 1109 and 1113, Civil Code). Other systems are more restrictive and admit such liability to a lesser extent, such as the United States (Section 548, Bankruptcy Code), Germany (Section 526, BGB), and England (Sections 213 and 214, Insolvency Act 1986), where this liability only applies under certain limited circumstances characterized by dolus. Recently, France explicitly limited this liability to the case of fraud (Sec. 650 Code de Commerce), but the extent of this particular legal reform remains uncertain. The lack of absolute consensus on the matter of liability for negligently granting loans is only of relative importance, not only because they react uniformly in case of fraudwhich is the criterion adopted in this paperbut also because of the fact that all of the legal systems that were analyzed allow proof of intent to be shown using circumstantial evidence, such as proximity of the date of bankruptcy, performance of irregular activities, setting up of excessive collateral, and very high rates of interest required. What is relevant is that it is possible to infer iuris tantum from certain determined events that the grantor of the excessive credit intendedbreaching the equal treatment principleto gain unfair advantage with its loans or to cause harm to the remaining creditors. There is also a general agreement that the receiver or trustee in the bankruptcy procedure is the legitimate party to demand compensation for the collective harm caused by the erosion of the net worth of the insolvent party due to the excessive credit granted by the lending entity (damage to pre-existing creditors). On the other hand, the so-called latter creditors can also independently and autonomously claim compensation for having been seduced by the apocryphal solvency generated by the abusive credits, since the damage is individual and specific in each case. As indicated above, the remedies used to correct the situation arising from abusive credit vary
Cmara Nacional de Apelaciones en los Comercial, Sala D, Vigna, Juan J.A. v. Lloyds Bank (BLSA) Ltd., June 30 2008, La Ley, September 29 2008, a guarantor sued the bank because he alleged that this lender granted abusive loans to the guaranteed, and that this impaired his right to recover his payments made as a guarantor. In spite of the fact that the court did not find the loans abusive, it developed a doctrinal theory recognizing that if a bank abusively lends money to a guaranteed entity, it loses its contractual right against the guarantor. See BOHOSLAVSKY, Juan Pablo, Los crditos abusivos y la fianza, La Ley, Revista Doctrina Judicial, February 25 2009, pp. 426-443. 141 Cmara Nacional Comercial., Sala C, Selaco, S.A. s/ quiebra c. Banco de Italia y Ro de la Plata, S.A., November 29 1984, El Derecho, 115, p. 552; Cmara Nacional Comercial., Sala D, Establecimiento Metalrgico Pec, S.A. s/ quiebra c. Permanente, S.A. Ca. Financiera, April 28 1988, El Derecho, 132, p. 305. 20
140

according to each legal system, with the existence of two basic mechanisms: claims for compensation through bringing legal action for extra-contractual liability (France, Belgium, Italy, Germany, and Argentina) and subordination of credits (England, the United States, and Spain). This latter country is unusual as it contemplates the possibility of subordinating abusive credits (Articles 73, 92, Ley concursal), but at the same time, subsequent creditors are able to file claims in accordance with the rules on tort liability (Article 1902, Civil Code). The common denominator can be found in the intention to undo the effects of credits qualified as abusive on the companys net worth, and therefore on the rest of the creditors. Since the central idea of such claims is based on the notion of economic compensation, it is plausible to seek distribution of blame and causal links among the various interested parties within this injurious structure (even to the victim), and consequently, to assign portions of joint responsibility. To summarize, several common denominators have been found within the sophisticated legal techniques applied to the problem of abusive granting of credit. Depending on the domestic legal system under examination, this principle is admitted to varying degreessubstantive and proceduralby the respective tort or bankruptcy law. However, they basically concur that lenders or creditors who behaved in bad faithby deliberately violating the equal treatment of creditors requirement, granting loans to an already over-indebted borrower, and to those who do not stand a chance of surviving without seeking formal reliefare neither legally nor economically treated in the same way as creditors who acted prudently and in good faith. Differences in the economic structures (stronger influence of the banking system or capital markets) of countries with respect to lending institutions appear to have some influence on the development and scope of the theory of liability for abusive credit. However, this tends to become diluted in the case of international state financing, because in this field the uniformity of globalized financial activity is greater than in the domestic private realm, thereby promoting the drafting of universal rules in the field of sovereign loans. 3. Applying liability for granting abusive loan to the realm of sovereign insolvency

3.1. Abusive loans in sovereign finances When lenders lend to a sovereign, a comparable situation as that which occurs in the private realm (described above) can develop. A lender may realize the economic situation of a borrower who faces inevitable default. The outlook may be such that resorting to a moratorium or insolvency procedure may be the only way to reduce debt to a sustainable level. At this point, the lender might speculate about the possibility of gaining unfair advantage or reducing its losses at the expense of other creditors, violating the pars conditio creditorum. This can occur when a creditor speculates with rising interest rates, as this will create more liabilities for the common debtor. A creditor can also seek to obtain or improve securities or pledges. In this case, it is clear that these assets are subtracted from the general economic guarantee of the debtor to benefit only this creditor. Granting larger loans or postponing the moratorium can also be an instrument to accelerate credit collection, which implies fewer assets for other creditors and aggravates the situation. Another type of advantage or benefit can be identified in the case of multilateral lenders, whose credits enjoy a de facto preference status, which means they also benefit objectively from more loans without assuming the same major risks. By increasing loan volumes, they strengthen their bureaucratic structures and political leverage, no matter what the countrys economic repayment capacity may be.142 It is perfectly legal and understandable that a creditor will try to contain and minimize its financial losses. However, when insolvency is the only possible fate for the common debtor, this creditor must not protect itself by harming other creditors through violation of the equal treatment principle. This is
142

For details about the economic relationship between the IMF and Argentina during the 1990s and its default, see LOWENFELD, quoted, pp. 719. 21

precisely one of the collective action problems that bankruptcy law tries, or should try, to prevent. These legal norms seek to protect and maximize the value of the debtors assets, in the interest of all creditors and the debtor itself. If we translate the damages from the private abusive credit realm to the sovereign insolvency phenomenon it should be noted that the loans that only postpone the agony of the country will also aggravate its situation, as experienced by Belize in 2005-06.143 In these contexts, debts will increase dramaticallyas usually happens in the last stage before a defaultbecause of the high interest rates these lenders usually require. Also, the sovereign tends to ruinously consume its hard currency reserves during this time, while also increasing rates to avoid suspending debt payments.144 The effectscapital flight and weakening of the banking systemare costs that increase during, after, and also before the default.145 Moreover, sometimes countries issue excessive amounts of short-term debt while trying to avoid defaulting on their existing debt,146 provoking liquidity problems and forcing higher adjustment costs, which the debtor will have to implement.147 All of these problems are aggravated by one of the main reasons that sovereign governments are reluctant to accept insolvency and face restructuring procedures: they quite simply fear the political, financial, and economic consequences of the default.148 From the insolvency game perspective, when one lends money to an over-indebted sovereign, some creditors can gamble on diluting and subordinating other creditors.149 In that case, when the country has already reached its repayment capacity, new loans are not aimed at paying off the old ones, but rather for paying off the new debt: the old creditors are thus diluted in their claims, having to share the debtors lower repayment capacity with new creditors.150 This involuntary subordination can also contribute to harming old creditors since the borrowerdesperate for new fundspromises new creditors they will be the first to collect in times of trouble. If we look closer, we might say that non-abusive creditors could indeed benefit from abusive loans. If these loans postpone the default and the reduction of the debt, during the borrowers extra lease on life, the creditors will continue receiving regular interest payments, putting off the inevitable restructuring. However, this postponement will also provoke a more painful haircut, precisely because the situation of the country has become worse than it was before this deferral process. From a practical standpoint, it can be difficult to demonstrate in formal procedural terms that a lender had the intention of damaging or obtaining unfair advantage, but indirect evidence can help in approaching the facts. Among the indicators that the lender knew (or must have known) about the situation of the borrowerfactors which the loan could only aggravate, causing distress and therefore harming others by trying to take unfair advantageare the following: the date on which the transaction was made; the execution date of the contract; the interest rate of the loan; public availability of information related to the debtors situation; the human and physical resources that the lender used in order to evaluate the risk; the loan amount; the legal nature of the contract; the request and constitution of strong collateral; and, acceleration of payments requested from the borrower, among others. The rule proposed here suggests that creditors who behaved in good faith (which implies the
143 BUCCHEIT, Lee & KARPINSKI, Elizabeth, Belizes Innovations, Butterworths Journal of International Banking and Financial Law, Vol. 22 No. 5, May 2007, pp. 278. 144 EICHENGREEN, Barry, Restructuring Sovereign Debt, Journal of Economic Perspective, N 17, 4, 2003, pp. 75. 145 STURZENEGGER, Federico & ZETTELMEYER, Jeromin, Debt Defaults and Lessons from a Decade of Crises, The MIT Press, Cambridge, USA, 2007, pp. 49-52. 146 BULOW, Jeremy, First World Governments and The World Debt, Brookings Papers on Economic Activity, N 1, 2002. 147 IBD, Living with Debt. How to Limit the Risks of Sovereign Finance, Economic and Social Progress in Latin America, 2007 Report, IBD, Washington, 2006, pp. 225. 148 DICKERSON, Michele, A Politically Viable Approach to Sovereign Debt Restructuring, Emory Law Journal, 53, 2004, pp. 1006. 149 GELPERN, op.cit., pp. 1117, 1140. 150 Ibid. pp. 1140. 22

fulfilment of minimum due diligence standards when negotiating and signing contracts) in relation to the debtor and the other creditors, should receive different (read better) economic and legal treatment during the restructuring process than creditors who did not follow this standard of conduct and violated the equal treatment principle, as described in the last few paragraphs. These abusive credits should be totally or partially subordinated to the constructive ones. In the world of international finance there are different kinds of lenders: official and private. The first category includes bilateral and multilateral lenders; the second, commercial banks, institutional investors, and bondholders. A detailed examination of each of these categories will generate other subcategories (e.g., mutual funds and insurance companies among institutional lenders), but for the sake of this argument, this is useful to make the point that each kind of lender has special skills, goals, availability of financial resources, and most importantly, different regulations under which to lend money, which define their precautionary responsibility regarding diligent evaluation of the credit risks of loans. Hence, the special features of each class of creditor and each type of transaction determine, with regard to each concrete insolvent debtor, the prerequisites for a defining responsible lending. Creditors with the most human and material resources to assess credit riskand those having the largest volume of financing availabilityare more likely to be subjected to stricter due diligence obligations (and are probably more regulated). Lender liability has to be proportional to their actual power and resources.151 We must undertake the same task of individualizing lender obligations when looking at the nature and goal of each. Banks and other private financial investors must be presumed to be economically rational: they prioritize their profit, which means that they have to appropriately evaluate transaction risk,152 and cannot allege extra economic motivations in their decisions. Bondholders are less homogenous than banks, and their due diligence obligations also differ. On the one hand, noninstitutional investors have more freedom to take risks; on the other hand, institutional investors are more regulated and controlled because of their characteristics, goals, structures and role in the economy. The regulation of what they can do (pension funds, insurance companies, sovereign funds, etc.) tends to match such characteristics.153 Regarding bilateral loans (or political debts154) other factors enter into play because of the possibility of political gain. The main problem here is that these loans do not usually make these political motivations explicit. If a loan says nothing about political considerations it can be presumed that the lender tried to make money with the loan, meaning its acceptance of minimal due diligence when assessing credit risk.155 Finally, although the goal of IFIs is not to make profits from their lending activities, they make money and they aim to do so. Their respective charters require them to ensure that the loans granted to member countries will be repaid, which presumes undertaking proper evaluation of the sovereign states capacity to repay. In fact, IFIs usually possess sophisticated risk assessment manuals. Specifically, international development banks must do a serious and reasoned analysis of project viability.156 IFIs, however, also have broader room for discretion since they fulfil, at least theoretically, counter-cyclical functions. The idea of applying certain sanctions to lenders who granted loans that involved excessive or

Principle broadly applied in the banking activity, see GAVALDA & STOUFFLET, ob cit.,pp. 186; VEZIAN, La responsabilit du banquier..., ob. cit., p. 138. 152 HERMAN, Barry, The Players and the Game of Sovereign Deb,t, in BARRY, HERMAN & TOMITOVA, (eds.), Dealing Fairly with Developing Country Debt, Wiley-Blackwell, Malden & Oxford, 2007, pp. 15. 153 IBD, ob. cit., p. 152. 154 WB & IMF, External Debt, Definition, Statistical Coverage and Methodology, Washington, D.C., 1988; BPI, Commonwealth Secretariat, Eurostat, FMI, OCDE, Paris Club, UNCTAD & WB, External Debt Statistics. Guide for Compilers and Users, IMF, Washington, 2003. 155 See http://www.odin.dep.no/ud/english/news/news/032171-070886/dok-bn.html 156 RIGO SUREDA, Andres, The Law Applicable to the Activities of International Development Banks, Recueil des Cours, 2004, pp. 87-8, 106. 23
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unreasonable risk is not new. As Kremer & Jayachandran have proposed,157 once an IFI declares that a country is pursuing an unsustainable economic path, the loans granted after this announcement should be labelled as bad risk credit and thus excluded from future bail-outs. 3.2. Applying the legal principle and some practical problems While different countries have different domestic bankruptcy laws, it is clear that all of them postulate that some decisions must be taken by neutral authorities (judges). Creditors can negotiate the restructuring plan with the debtor, but they cannot decide, for example, regarding credit validityand nor can the debtor. Neither can they modify certain rules regarding credit seniority. It is up to a judgenot the creditors nor the debtorto decide when a credit must be subordinated because its holder granted abusive loans. The neutral judge principle is well accepted at the domestic legal level, as well as in international arbitration and under U.S. municipality insolvency law (Chapter 9, US Bankruptcy Code). Thus, it is no surprise that many scholars have also pointed out the importance of a neutral authority for settling disputes in sovereign insolvency issues.158 However, bargaining power and a failure to coordinate the parties involved in the sovereign insolvency problem have evidently not yet permitted the implementation of this basic principle. Even so, it seems that private financial creditors are starting to realize that impartial arbitration could be beneficial for them,159 and at the same time it is difficult to predict if this tendency will continue and what the position of the IFIs and the US will be regarding the trend toward a third-party impartial authority. To make the issue even more complex, due to social movements and NGOs concerned with the debt problems of many developing countries, the idea of a neutral authority settling financial creditor-debtor disputes is slowly gaining acceptance at the international political level.160 All in all, the recent political experience of the SDRM showed that the statutory model met with fierce resistance from key players, among other reasons because it does not respect the basic rule of a neutral authority. Despite having been proposed by the IMF, the centralized sovereign insolvency model has not, to date, succeeded. Collective action clauses, at least in the form in which they have already been implemented, do not seem to allow creditors as a group to distribute the burden of the haircut efficiently and fairly among them. Why would a creditor vote against itself by accepting that it did not grant a loan in a prudent way? Since there is a capitalist basis in the political system upon which to decide what to do with the sovereign debt, and being a pareto optimum (the creditors would discuss how to distribute the reduction of the debt previously agreed with the debtor), it is not easy to imagine how creditors themselves could find and implement a sound criterion for sharing losses. In other words, in the absence of incentives from a legal or contractual framework, this collective action problem would not be able to be solved spontaneously by its protagonists. This collective action limitation will be tested, to some extent, when bondholders are asked to subordinate their credits in order to grant priority to new lending. Theoretically, there are other possibilities we can explore before simply accepting that we are at a stalemate where some players are too strong to accept a neutral authority to assure a fair insolvency procedure, and where the U.S. administration is too convinced that the statutory approach is not
Odious debt Conference on Macroeconomic Policies and Poverty Reduction, IMF, Washington, March 14-15 2002, The American Economic Review, 96, 2006. 158 PAULUS, Christoph, Thoughts on an Insolvency Procedure for Countries, The American Journal of Comparative Law, Vol. 50, No. 3, 2002, pp. 541-2. 159 In 2007, almost 20% of the claims filed by private creditors challenging the HIPC were in arbitration, IDA & IMF, Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI)Status of Implementation, August 28, 2007. 160 PETTIFOR, Ann, The Jubilee 2000 Campaign: A Brief Overview, in JOCHNICK & PRESTON (eds.), Sovereign Debt at the Crossroads, Oxford University Press, New York, 2006, pp. 297-317. 24
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consistent with its vision of how international financial markets should work. One option would be to include some basic guidelines in bond collective action clauses. They could come into force once insolvency erupted, establishing a gradual system whereby creditorsor categories of creditorswho lent money after a certain (high) grade of country credit risk was announced by the most well known credit ranking agencies and IFIs, would have to assume more losses than others (subordination of the debt). One of the problems with this proposal would be its partial approach. Even if bondholders voluntarily accepted instruments with such clauses, IFIs, banks, other sovereigns, and commercial and domestic creditors would not be contemplated in this seniority ranking scheme. Most importantly, why would creditors buy a bond that already says that it is going to be subordinated? The price of this bond would be very low. Recently it has been said that the recognition of a broad ex ante priority hierarchy would be politically hard to envision, and that for this reason it would be advisable for each sovereign borrower to unilaterally decide its own priority policy. In this scenario, the only requirement would be that the debtor has to disclose the ranking at the time of borrowing.161 This proposal falls short in that it does not explain what guarantees would be in effect in case of financial distressnor if the sovereign would respect the priority policy announced in tranquil times. In this way, it would likely lack enforceability. Finally, the first-in-time-priority rule has been suggested as a criterion to complement the SDRM.162 The priority is based on the time that the loan was granted, with debt of any given year taking priority over loans granted in subsequent years. This rule would tackle the problem of debt dilution through overborrowing because, in the event of financial crisis, the sovereign would not be able to turn to new lenders because they would be junior and their indebtedness would thus be limited. To some extent, this rule is already applied by the Paris Club to agreements under the pre-cutoff debt principle, which means that the loans granted before an agreed date will be incorporated into restructuring, facilitating a situation in which new lending has priority.

3.3. The first-in-time rule, abusive loan liability and their economic rationale Behind the first-in-time priority rule there is a presumption that the closer the loan was to the moment of final default, the less constructive and more speculative it was. Connecting this idea to the abusive loan theory, both must stem from the fact that the situation of the borrowerat the moment the loan is grantedcannot be fixed through adjustments and that it needs to undergo debt restructuring to pay off its debts. In this context, any adjustment would either worsen the situation or improve it to an insufficient extent, striving to raise enough hard currency to pay the debts or violating the minimum standard of life that should be assured any debtor.163 This criterion allows differentiating between the hero that showed trust in the country in tough times and helped it avoid a crash, and others that just speculated and tried to dilute other creditors. If the default was clearly unavoidable and the lender tried to take unfair advantage of the rest, the conditions required by the abusive loan theory could be encountered. On the other hand, if the country could have reasonably implemented adjustments or changes in order to avoid disaster and new loans could have helped in this directionbeyond what eventually happened to the borrowers economythis lender then
See GELPERN, op. cit., pp. 1143. In 1992, California implemented a system of disclosure like this one, see details in ibid., p. 1152. 162 BOLTON & SKEEL, op. cit., (2004, 2005-6). These authors propose a two-step voting process. In the first one, creditors have to assess the haircut proposal sent by the insolvent borrower. If they accept it, the next step is to discuss the restructuring plan. 163 Vital interests of the contractual debtor according to the terminoly used by DIEZ-PICAZO Y PONCE DE LEON, Luis, Libertad, responsabilidad contractuales e intereses vitales del deudor, in SCHIPANI, Sandro (director), Debito internazionale. Principi generali del Diritto, CEDAM, Padova, 1995, pp. 195-201. See also International Law Association, Committee on International Monetary Law, "Committee Report, Warsaw Conference, 63, 1988, p. 9, paragr. 21. 25
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behaved constructively. The possibility of recovery in this case quashes the idea of fraud on part of the lender. Some criticism164 against the first-in-time rule has been voiced regarding the proposal of Bolton & Skeel, which departs from (and modifies) the SDRM model. This criticism also applies to the principle proposed in this paper and is why it is worth analysing here. First, implementing this rule could provoke pro-cyclical effects, shortening the time before the day on which insolvency is recognized. Lenders would perceive the possibility of default and would likely shorten maturities and raise interest rates in order to compensate for their junior status. If the over-indebted state has no remedy other than to face a restructuring procedure, its postponement can only provoke the harm that the abusive loan theory describes.165 Thus, it does not seem particularly wrong to force the sovereign to openly recognize and deal with its problem and implement the bankruptcy remedies necessary for overcoming the difficulties and minimizing creditor damages. However, a country could be having liquidity problems and new loans could genuinely help the debtor avoid the painful consequences of default. The first-in-time rule could then discourage refinancing which could be useful for solving liquidity troubles. This is precisely why the first-time priority rule should distinguish between debtor insolvency and liquidity problems, not an easy task. Here, again, we must pay attention to the technical development exhibited by bankruptcy law in this field. When it regulates the goal of promoting prudent credit risk assessment by punishing financial recklessness in some way, it adopts a retrospectiveprospective approach. Whoever judges this has to isolate the actual possibilities of recovery presented by the debtor when the loan was granted.166 This analysis requires distinguishing between liquidity problems (which allows one to think new loans will offer hopes of resolving the situation) and solvency problems (which require a haircut and/or debt restructuring because they lack a way out). The key is to determine whether, when the loan was granted, real possibilities for recovery existed. If they did, they were probably encouraged by the new set of loans,167 which is why whoever analyzes the situation has to perform an economic evaluation that is both retrospective and prospective.168 This analyst must consider whether, at a certain time in the past, it was easy to forecast that the debtor was not going to be capable of avoiding default. Beyond the important nuances and limitations to which the first-in-time rule can give rise, it is necessary to remember again that it was proposed in the context of an improved version of the SDRM. This means that it required amending the IMFs statutes, which involves enormous political energy169 being devoted to enforcing this system. Suggesting the use of Section VIII (2b)170 of the IMF Agreement in order to implement some of the new institutional ideas would seem to put too much strain on the text and spirit of this Section, and could bring about political troubles among member states.

GELPERN, op. cit., pp. 1143. In the absence of enforceable priorities, when a debtor country approaches financial distress any new debt it issues is partly at the expense of existing creditors who face a greater risk of default and will have to accept a greater haircut (or debt reduction) in the event of default, since the total resources the debtor can muster towards repayment of its stock of debt will have to be divided pro rata among its creditors, old and new, BOLTON & SKEEL, op. cit. (20005-6), p. 185. 166 V. C.A. Lyon, April 29 1983, Rev. Banque, 1983, p. 1198. 167 BUTHURIEUX, Andr, Responsabilit du banquier. Entreprises en difficult. Crdit fautif. Expertise, Litec, Paris, 1999, pp. 78 ss. VAN OMMESLAGHE, Pierre, La responsabilit du banquier dispensateur de credit en droit belge, Socit Anonyme Suisse, 49, 1977, pp. 128. 168 LIKILLIMBA, op. cit., p. 134. 169 BEATTIE, Alan, US Set to Block Sovereign Chapter 11 Proposal, Financial Times, March 31, 2003. 170 EULISS, Richard, The Feasibility of the IMFs Sovereign Debt Restructuring Mechanism: An Alternative Statutory Approach to Mollify American Reservations, American University International Law Review, 19, 2003-4, pp. 108; POWER, Philip, Sovereign Debt: The rise of the Secondary Market and its Implications for future restructurings, Fordham Law Review, 64, 1995-6, pp. 2723. 26
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3.4. The legal principle already exists: now it must be applied The principle proposed in this paper must be added to the priority ranking system, which does not require any statutory change, as it is a lege lata rule. This idea that the treatment of abusive and nonabusive lenders must be different in terms of bearing the financial consequences of the haircut already exists and is strongly evident in the similarities among domestic laws of different countriesas analyzed in the second section of this paperwhich contain a general legal principle. This principle applies to a problem that does not recognize any other legal source as directly addressing it. Regarding the practical features of this proposal, since the states assets are mostly in its territory, it cannot be ignored that sovereign power is at the very core of the sovereign insolvency priority system. The state will try to do what is in its best interest (even trespassing contractual and legal limits); therefore, trying to force the sovereign to renounce ex ante use of its discretion, especially in tough times, would seem to be a futile effort that, in any case, would require costly statutory changes. Hence, control should be ex post, which, once applied, would exemplarily work ex ante as well. When a creditor challenges the restructuring agreement that an insolvent sovereign reached with a majority of its creditors, it can argue different points. For example, if it is a rogue creditor, having made a very high risk bet by buying instruments at their lowest price and then seeking to collect full face value, it could attempt merely to argue that the majority cannot modify the monetary terms of its contract. Depending on the political winds and the global effects of the threat of frustration of sovereign debt restructuring, the court will decide whether this holds credit or if the agreement is legally superior. Sometimes the sanctity of contracts is really sacred, 171 sometimes it is not.172 This points to a different, specific problem, which is conceptually subsequent to the haircut: when the distribution of the financial losses (debt reduction) among creditors is legally unfair. Of course, arbitrary discrimination implies violation of the pars conditio creditorum. However, sometimes it is also unfair to treat all creditors in the same way. For example, it is legally and economically difficult to argue in favour of forcing creditors that bought ten-year-instruments nine years before the default to bear the same financial losses as those that bought them only a few months before the moratorium with a huge interest rate, at a very low price, and reaching some collateral. There is a viable manner for applying this liability for granting an abusive loan rule to the current institutional and legal sovereign insolvency framework. When a creditor challenges the legal effects that sovereign debt restructuring has on it, the court has to analyze whether the agreement fulfils basic legal rules, such as the principle that gives rise to liability for granting abusive loans. The court does not have the authority to decide how much money the agreement has to assign to each creditor, but deciding in a particular case that the sovereigneven when ratified by a majority of creditorsengaged in arbitrary discrimination of some creditors and/or in violation of the rationale underlying the rule proposed here, the borrower (and the creditors who could have ratified it) would absorb this judicial decision and react in consequence. If both sovereigns and creditors want to legally shield restructuring, they should meet the principle studied in this paper. As empirical studies have recently shown,173 the correlation between creditor losses and government coerciveness is rather weak. That is why it is also necessary to pay attention to cases in which creditor majorities voluntarily accompany large haircuts (like the Russian case174), which can also implement a discriminatory distribution of losses. The will of the majority should not punish non-abusive creditors by making them bear more loss than what the credit ranking system establishes for themincluding the
See Allied Bank International v. Banco Credito Agricola de Cartago, U.S. Court of Appeals, 2d Cir., March 18, 1985 (757 F.2d 516); Pravin Banker Associates v. Banco Popular del Peru, 109 F. 3d 850, 854 (2d Cir. 1997); Elliot Associates v. Banco de la Nacion and the Republic of Peru, 12 F.Supp. 2d 328 (S.D.N.Y. 1998). 172 CIBC Bank and Trust Co. (Cayman) Ltd. v. Banco Central do Brasil, 1995, 886 F. Supp. 1105 (S.D.N.Y. 1995); EM Ltd. V. Republic of Argentina, (S.D.N.Y January 12, 2004, No. 03 CV 2507). 173 ENDERLEIN, MULLER & TREBESCH, op. cit. 174 With the international promissory notes (Prins/Ians) it presented a moderate degree of coerciveness but a haircut of over 50%. 27
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criterion arising from the new rule proposed here. It bears repeating here that the logic previously put forth in explaining the reasons for the rationale of $1=1 vote behind the Collective Actions Clauses cannot be used to decide how to distribute the financial losses among creditors. In fact, creditors that feel they were victims of abusive treatment from the debtor or other creditorsand who are not receiving the financial consideration they deserve in the restructuringwill simply not accept this agreement. This is precisely how some small creditors reacted in Argentina, when they felt that the IMF and the big investment banks should have borne heavier losses owing to their behaviour toward the common debtor. The logical effect would be that sovereigns financially treat creditors respecting the equal treatment principle, not in an automatic or egalitarian way, but by focusing on the creditors behaviour itself. And by the same token, creditors would be constrained to respect this rule when agreeing the terms of restructuring. When implementing the right credit ranking system in a concrete case, different treatments must be given to different categories of credits, which are previously defined by the sovereign under objective and well-founded criteria that must reflect the rationale of the abusive loan theory according to the parameters sketched out in this paper. In this case, restructuring must partially or totally subordinate the abusive credits and benefit other creditor categories. And, beyond the freedom that creditors have to decide on the extent of the haircut by freely negotiating with the debtor, creditors have to take lawful decisions when allocating financial losses among them. 3.5. What is the place of IFI credits in this proposal? Since not only private lenders but also IFIs can grant abusive loans, their unchanging preference disconnects loan quality from losses caused by borrower insolvency. The reason behind this idea promoted by the IFIswhich also shields them from the principles of the free marketis very clear: The rationale for this is to insulate multilateral financial organizations from the risk of nonpayment and restructuring so that they can provide financing, without risk premia or collateral, when other creditors would not be willing to do so.175 The preference of IFIs ignores the effect of such loans in terms of efficiency, since it disconnects decisions from their consequences. While the anti-cyclical functions of these institutions deserve to some extent a different (read better) treatment than that which private creditors receive, IFIs should be incorporated into the general scheme of sharing some losses and promoting efficient and prudent loans. This idea could be translated, in practice, into a partial preference which would recognize the public interest element of these institutions functions and, at the same time, force them to act diligently, demonstrating that even development banks have to assess the viability of their projects176 and some losses with the private sector. In procedural terms this means that the borrowerand the judge who examines the restructuring should provide some preferential status to IFI credits, but when their behaviour isaccording to the abusive loans theoryreproachable and their consequences are cyclical rather than anti-cyclical, the sovereign has to limit its preferences through partial subordination regarding other groups of creditors that did not exhibit reprehensible or abusive behaviour. This idea in part reflects a certain call for asking that multilateral and even bilateral bailouts be supplemented by a partial private sector bail in. The involvement of institutions like the IMF in financial crises should be conditionedwhen the problem is one of insolvency rather than one of liquidityon debt reduction or restructuring by private lenders.177 In legal terms this view means, generally, that both multilateral and private lenders should assume some costs of debt restructuring.
IMF, Financial Risk, op. cit. , 2004, p. 6. RIGO SUREDA, Andrs, The Law Applicable to the Activities of International Development Banks, Recueil des Cours, 2004, pp. 87-8, 106. 177 BOLTON & SKEEL, (2005-6), op. cit., pp. 177. See also ROUBINI, Nouriel & SETSER, Brad, Bailouts or Bail-Ins?. Responding to Financial Crises in Emerging Economies, Viva Books, New Delhi, 2006. 28
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The judicial immunity of IFIs, even if only acknowledged in a strict and restrictive sense,178 does not prevent them from having the principle developed in this paper applied to them. The sovereign debtor must respect the equal treatment of creditors principle and treat them differentially only when legally warranted: when they are preferred creditors, pay them back first; when they are abusive creditors, subordinate them partially. If a creditor considers that this principle was violated by the debtor and/or other creditors it can ask a judge for remedy. Since the demand would be against the debtor in order to force it to respect the pars conditio creditorum, the case would not formally (judicially) involve any IFI creditor. Final considerations The theory of abusive credit, in both private and sovereign spheres, is based on there being a failure of the market. Abusive credit is a manifestation of imperfect and asymmetrical information, generating a negative externality for other markets participants. This phenomenon exacerbates the collective action problems that usually arise when the insolvency is approaching. Assigning legal liability for abusive credit-granting, and thus protecting confidence as an ethical and legal principle, is a corrective remedy for this market failure. This is the point where the persuasive and reparatory mechanism of liability for abusive credit intersects, promoting a constructive attitude among all creditors. In the context of unavoidable sovereign bankruptcy, some lenders try to unfairly benefit at the expense of other creditors, aggravating the debtors situation and diluting other creditors, which explain why they grant loans under circumstances when financial ethics would recommend otherwise. This conduct must have some financial impact at the time the credit-ranking is conceived, agreed and implemented in the sovereign restructuring. Applying the general principle to abusive loans, this rationale is translated into a subordination mechanism, which gives total or partial priority to good-faith creditors while correlatively subordinating abusive ones. This principle is complementary to the main pillar of bankruptcy lawequal treatment of creditorswhich applies except when a fair and justified differentiation must be made among creditors. This system not only protects bona fide creditors from abusive creditors, but also from the arbitrariness of the sovereign debtor, who can be tempted to treat different groups of creditors in accordance only to its own convenience, unfairly discriminating against them and/or rewarding abusive behaviour, even when a majority of creditors ratifies this illegal discrimination. Since the proposed principle demands greater rigour from market agents in obtaining, processing, and transmitting information, and discourages non-cooperative behaviour among creditors, it would presumably impose higher standards of best practices on the participating partiesboth public and privatein international finance, and would therefore provide for a more efficient functioning of market economies. Liability for granting abusive loans is not a revolutionary act; it is a matter of applying sound rules of risk management that presume the need to be informed about the client and its situation.179 Critics of this liability principle warn that this theory could dampenor even precludeefforts to restructure distressed entities, by precipitating potentially premature bankruptcy cases. Beyond this warning, however, no empirical data exists to confirm this premonition.180 Because this liability only applies when all other
178 ANGHIE, Antony, Time Present and Time Past: Globalization, International Financial Institutions, and The Third World, New York University Journal of International Law and Politics, 2000, 32, pp. 271-2; BROCHES, Aaron, Selected Essays. World Bank, ICSID, and Other Subjects of Public and Private International Law, Matinus Nijhoff Publishers, Dordrecht, Boston, London, 1995, p. 9; HOLDER, William E., Can International Organizations be Controlled?. Accountability and Responsibility, American Society of International Law Proceedings, April 2-5, 2003, 97, pp. 233; SINGER, Michael, Jurisdictional Immunity of International Organizations: Human Rights and Functional Necessity Concerns, Virginia Journal of International Law, 1995, pp. 109-165. 179 LIKILLIMBA, op. cit., p. 144. 180 In 2005, when the French National Assembly was discussing the reform of Article L. 650 code de commerce reducing significantly the scope of this type of bank liability Representative Arnaud said (without being 29

financial efforts are in vain and the loans can only deepen the insolvency and facilitate asset dissipation, the extent of the liability proposed here discourages only abusive loans, not those that can be dramatically helpful in situations of distress. This is how constructive risk and diligence can be promoted among lenders181 and the distressed entities forced to turn to formal relief before assets are dissipated and the ability to reorganise exists. It is true that a form of flexible borrowing can be a way to face cataclysmic events and economic crisis and avoid the intrinsic costs involved in any default. In that case, the criteria for assessing whether a loan was abusive must be adjusted to this environment of extreme and generalized financial need. Regardless, bad faith lending is not justifiableand should not be rewardedin any context.

contradicted) that the new act would protect the banking industry from a ghost since in 2004 convictions for abusive loans had only amounted to 14 Euro million. 181 Mmoire de Barsy, Revue de la Banque, 1977, I, pp. 331; BRUYNEL, Andr, Le Memoire de Barsy sur la responsabilit du donneur de crdit, ibid., pp. 314-7. 30