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Era of the Holdout Is Raising the Cost of Sovereign Default

Updated on
  • Study finds that 50% of restructurings result in litigation
  • Vulture funds getting more confident about reaping returns

Going broke just ain’t what it used to be.

In defaults of yesteryear, countries could bank on immunity as they reneged their obligations in peace. These days they’re ending up in costly legal quagmire like never before, according to a working paper published by the European Central Bank on Wednesday.

The trend is strengthening the power of creditors, especially hedge funds, and significantly raising the cost of default for debtors, the paper found. Argentina’s decade-long debacle with hedge-fund holdouts is a case in point, showing how court disputes can bind the hand of an issuer for years.

“In recent decades, the legal standards of sovereign immunity have gradually eroded in global financial centers,” wrote Julian Schumacher, Christoph Trebesch, and Henrik Enderlein, who authored the paper. “Sovereign debt lawsuits have become larger, less likely to be settled early on, and more likely to involve attempts to attach sovereign assets abroad.”

Half of debt restructurings have resulted in litigation in recent years, according to the study, up from just 5 percent in the 1980s. The value of such obligations has climbed and it takes longer to resolve disputes as distressed debt funds get more confident about reaping returns.

Unlike private corporations that undergo insolvency procedures, defaulting governments can’t be liquidated and to this day there is no supranational legal authority to enforce repayment, the report said.

One silver lining is that steps are already being taken to reverse the trend through clauses in bond prospectuses that discourage creditors from trying to litigate, the researchers wrote. Law firms representing sovereign defaulters are also getting smarter as they accumulate experience in similar cases, they said.

The study analyzed 158 litigation cases against 34 defaulting sovereigns between 1976 and 2010 initiated in the U.S. and U.K.

(Adds sixth paragraph on insolvency procedures.)
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