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Moody's warns against debt repayment defaults

Our Bureau

CALCUTTA, Aug. 10

SOVEREIGN analysts at Moody's Investors Service have warned that countries that restructure their debts or miss payments on bonds or bank loans are increasingly at risk of being sued.

Secondary market creditors, who have proliferated, unlike their more traditional counterparts, were more likely to seek quick-fix settlement offers by threatening legal action. A precedent-setting decision in such a legal action would harm both the sove reign debtor and the speculative investors. Moody's, therefore, expected such legal issues to be settled out of court.

According to a report titled `Sovereign debt: What happens if a sovereign defaults?' (quoted in a credit risk commentary circulated by the rating agency), the increasing threat of legal action might influence the process of sovereign debt re-negotiation because it would focus more attention on the interest of the secondary market creditors.

The Moody's analysts also maintained that for the first time in 50 years, the international bond market was faced with the reality of sovereign defaults. The recent past had seen defaults by Russia, Ukraine and Pakistan in 1998; by Ecuador in 1999; and b y Ivory Coast in 2000.

``In these and other cases, traditional creditors such as the London Club, the Paris Club, and the IMF have had strong long-term interests to re-negotiate the debt package without resorting to legal action. It is the secondary purchaser of sovereign debt who resorts to the courts in case of defaults,'' the analysts stated.

Such speculative elements bought debt at sometimes substantially less than face value. However, the nations concerned were still liable for the face value of debt. Small creditors bought debt on the cheap with an eye on the potential upside.

A lot would depend on whether debt instruments contained the `collective action clause', and, in particular, the `supermajority clause'. Supermajority clauses make mandatory on all creditors to agree to the terms reached by the supermajority -- that is, two-thirds or more.

The absence of the supermajority clause in a debt instrument would leave the sovereign more susceptible to legal attack, it was observed. The creditor retained the right to sue under the terms of the original debt instrument. Both sides would tend to set tle out of court as it was in the best interest of all. Significantly, both creditor and debtor needed to avoid a precedent-setting appellate decision.

Sovereign defendants would not want to risk having an appeals court declare that these suits were proper as that would make the threat of legal recourse even more credible, which could lead to higher settlement offers.

``As the quasi-mythological stature of a sovereign entity diminishes, as secondary creditors become more courageous, and as their lawyers sharpen their legal arguments, the threat of suits in case of a default or an exchange offer will become dauntingly real,'' Moody's has concluded.