THE SANCTITY OF SOVEREIGN LOAN CONTRACTS AND ITS ORIGINS IN ENFORCEMENT LITIGATION

"While the Costa Rican Banks make light of 'sanctity of contracts' and argue that litigation is but a theoretical right which disappears when a 'friendly' country defaults on its debt obligations, that is simply not the law."1

"Whenever a Court has felt what it believed to be the pangs of justice

I. INTRODUCTION

This Article examines sovereign debt enforcement litigation from a new perspective. It makes the case that while there is a burgeoning academic interest surrounding sovereign debt, there is little or no examination of the sanctity of contracts doctrine which, since the mid-1980s, became the reigning paradigm underlying sovereign debt enforcement litigation. Consistent with this doctrine, an especially strong rule of creditor rights was established under which the baseline for acceleration of creditor rights became simple default. This contrasts with the prior rule which provided that renunciation or repudiation of a debt by a sovereign borrower was a precondition for accelerating payment. Under thenew "hair-trigger rule" of enforcement or acceleration, courts refrain from intervening on behalf of sovereign borrowers on the premise that such non-intervention is required to maintain judicial neutrality in the face of a freely negotiated contract. Sovereign debt litigation is therefore rooted in a contractual model where judicial inaction in the face of an otherwise excusable default is treated as neutral and legally unobjectionable.

The sanctity of contracts doctrine was first definitively pronounced by the United States Court of Appeals for the Second Circuit (Second Circuit) in Allied Bank International v. Banco Credito Agricola de Cartago (Allied II). Under this doctrine, a system of cooperative debt adjustment in which indebted sovereigns readjust their debts to enable them to meet their repayment schedule is treated as an impermissible unilateral abrogation of the contractual rights of sovereign creditors. In addition, granting debt restructuring common law protection as a species of bankruptcy is regarded as an impermissible intrusion on the contractual rights of sovereign lenders. Since Allied II, equitable,3 statutory,4 and affirmative defenses5 to sovereign default were virtually extinguished as every sovereign debt default became susceptible to being construed as a unilateral restructuring of sovereign debt contracts, a repudiation, or a taking that violated the sanctity of the underlying contractual obligation to repay under the loan contract.6

By shifting the baseline for enforcement to simple default, an all too common and foreseeable contingency, the court in Allied II departed from prior cases and established international practice in several respects. First, by adopting simple default as the triggering event for enforcement, the second Circuit departed from the accepted laws and practices in the United States and other countries, as well as international commercial law.7 Under English law, for example, an inadvertent default unaccompanied by a country's desire to disavow or repudiate its debt does not automatically rise to an event triggering enforcement under international commercial law.8

Second, in Allied II the Second Circuit declined to give judicial acknowledgment of the policy of cooperative debt adjustment that had been designed precisely on the premise that defaults of sovereign debt would occur and as such provided a framework under which creditor and sovereign debtor interests would be balanced.9 Under this framework, defaults would lead to cooperative readjustment or refinancing of sovereign debt between both public and private lenders, on the one hand and borrower countries on the other, with the blessing and support of the International Monetary Fund (IMF) and the richest countries in the world. Under this arrangement, private banks would continue lending new money; the IMF would bail out the indebted countries; the indebted countries would, at the direction of the IMF and on a case by case basis, renegotiate and refinance their loans with the voluntary participation of the commercial lenders; and indebted countries would commit to undertake stringent macroeconomic stabilization programs as a pre-condition to qualifying for new money.10

Third, though the Allied II court held that its abstention or inaction was a neutral response to a freely negotiated contract, the court effectively legitimized hell-or-high-water clauses in sovereign debt contracts requiring performance irrespective of default.11 Such clauses serve as an assurance of payment for banks lending to sovereigns and for purchasers of sovereign bonds. Hell-or-high-water clauses undermine the application of equitable relief to delay or excuse default where the default is inadvertent and even if the defaulting party makes an effort to immediately cure the default because such clauses make payment irrevocable and independent of any excuses.12 Thus, as the sanctity of sovereign loan contracts became the reigning paradigm in sovereign debt litigation in the mid-1980s, the defenses to default and balancing considerations such as comity that once were traditionally available to sovereign debtors simultaneously withered away in subsequent litigation.13

This Article argues that the sanctity of contracts doctrine underlying Allied II undid the flexibility available under New York law and the U.S. policy of supporting cooperative adjustment of debt in a manner that balances the interests of debtor and creditor sovereigns. Allied II was thus decisive in tilting sovereign debt litigation favorably towards creditors and against sovereign debtors particularly in the enforcement litigation in New York courts. The sanctity of contract view adopted in Allied II produced a doctrine of legal necessity which ignores the interests of sovereign debtors by discarding any mechanism for safeguarding sovereign interests in private contractual relationships such as through the principle of comity, the act of state doctrine, or other defenses traditionally available under domestic contract law. This outcome results from the politics of the private realm of contracts and property law, the interventionist role of the Department of Justice, and the interests of creditors who organized as amici seeking a reversal of the case at the trial-court level (Allied I).

The Article proceeds as follows: In Part II, it traces the origins of current developing world debt crises emphasizing the role of indebted sovereigns, the external shocks arising from the oil crises as well as over-lending by commercial banks. This Part shows that the rise of cooperative debt adjustment through restructuring and refinancing was mutually beneficial to both sovereign as well as private creditors and indebted sovereigns as well. Part III traces the effect of enforcement litigation of sovereign debt to the emergent principle of cooperative debt adjustment. It further discusses how the decision in Allied I was an impetus for private creditors to overcome collective action problems and to organize in an attempt to change the baseline in enforcement litigation towards simple default and away from renunciation or repudiation. This Part also tracks shifts in judicial constructions of the act of state and comity doctrines. Part IV presents the shortcomings of the sanctity of contracts doctrine endorsed in Allied II and its progeny, and also discusses the issues surrounding the interpretation of pari passu clauses. Finally, Part V presents proposals for overcoming the strong rule of enforcement adopted in Allied II. The overriding proposal favors resorting to forums other than New York or federal courts in enforcement litigation to ensure a better balance of the rights and equities between creditors and borrowers. The Article also emphasizes reliance on international commercial law because it balances the rights and equities between borrowers consistent with prevailing commercial norms unlike the creditor-friendly state courts of New York and the Second Circuit.

II. THE DEBT CRISIS AND THE ROAD TOWARDS INTERNATIONAL FINANCIAI, LIBERALISM

A. The Origins of the 1980s Sovereign Debt Crises

A variety of factors contributed to the debt crises of the 1980s. Three of the most important factors include: (1) the domestic policy failures of developing countries; (2) the external shocks of the oil crises of 1973-74 and 1978-79; and (3) the over-lending by commercial banks, particularly those based in the United States.14

In the 1970s, oil-exporting countries enjoyed huge windfalls following crude oil price hikes. These countries exported surplus capital to private Western banks, which in turn recycled it to developing countries in the form of loans. This phenomenon was known as the recycling of petrodollars and Eurodollars.15 During this period, the flow of capital to developing countries reached unprecedented levels.16 These transfers were "widely proclaimed as a triumph of the virtues of the free market."17 Undoubtedly, the interest the banks were paying on deposits was significantly lower than the rates on which they loaned the money out, allowing them to reap impressive profits.18

Early in 1980, a debt crisis hit low and medium income developing countries around the world.19 The debt crisis resulted in enormous cutoffs in lending levels by the private sector. Lending by the IMF and the World Bank was henceforth attached to strict macroeconomic structural adjustment conditions that required cutoffs in social spending (for example in health, education, and wages) with a view to channeling these resources towards debt repayment. A new type of lending thus emerged, referred to as policy-based lending, which required developing countries to change their economic policies in line with those required by the World Bank, the IMF, and northern industrial countries.

The immediate causes of the debt crisis were attributed to the economic policies of developing countries20 which hindered economic performance and exacerbated the debt crisis when combined with macro-economic 'shocks' in the international economy and decreases in commodity prices and the high borrowing levels of developing countries between 1979 and 1981 which was a period of low interest rates coupled with a belief in North American private banking circles that countries do not go bankrupt.21

B. The Admixture of Public and Private Debt in Addressing the Crisis

The debt crisis of the 1980s hobbled indebted economies and endangered the ability of creditor banks to continue lending. The response of the IMF under the leadership of the United States was viewed as an attempt to address both of these problems simultaneously.

The policy conditions attached to IMF and World Bank lending programs for developing countries became a litmus test for the lending programs of other public and private lenders.22 In fact, initiatives designed to deal with the oil and debt crises throughout the 1970s and 1980s demonstrated that the interests of commercial banks largely coincided with those of the U.S. government. Because the U.S. government and commercial banks agreed on how to deal with sovereign debt, similar approaches to private debt (money borrowed from private lenders) and public sovereign debt (money borrowed from bilateral lenders) were pursued.23 As will be demonstrated below, however, the sovereign debt litigation which followed the debt crisis made very clear the differences in the effect of the efforts to restructure sovereign debts as between private debt, on the one hand, and public debt on the other.

In an attempt to manage the debt crisis, the IMF conditioned loans on severe restrictions of central bank flexibility.24 This policy was pursued to help indebted countries reform their economies so as to eventually be in a position to repay their debts. The cost of ensuring these banks were repaid was to be borne not only by tax payers in northern industrialized countries-through contributions by their countries to the IMF-but also by the tax payers in the indebted countries, where the IMF's restructuring policies required implementation of measures such as cuts to food subsidies and civil servant wages.25

Multinational banks headquartered in the United States had loaned so much of their money to developing countries, especially those in Latin America. According to a 1982 estimate, "the nine largest U.S. banks have loans amounting to multiples of their capital base to six countries: Brazil, Mexico, Korea, Argentina, the Philippines and Taiwan. Some of the biggest have lent the equivalent to one country, Mexico."20 In theory therefore, these banks "could be wiped out if a few of the big Latin American debtors defaulted."27 Such default had the potential to force the closure of the banks, since if default occurred and depositors panicked, they might have made a run on the bank. The survival of these banks was thus a significant motivating factor in the efforts of the IMF and the United States to curb the debt crisis.28 Indeed, as Jeffrey Sachs notes:

Although it is sometimes asserted that official creditors and bank creditors have been treated equally in the management of the debt crisis, in the past five years the commercial banks have received large net transfers from the debtor countries, while the official creditors, including the creditor governments and the multilateral institutions, have made large net transfers to the debtor countries. Operationally, it can be argued that the official creditors are indeed 'bailing out the banks.'29

C. The Secuntization of Sovereign Debts

In this Part, three IMF and U.S.-sponsored initiatives with a view to reorganizing and renegotiating sovereign debts are outlined.

1. The Baker Plan

The Baker Plan was launched on October 9, 1985, at the annual meeting of the World Bank and the IMF.30 The plan, spawned by then Secretary of the Treasury James A. Baker, singled out fifteen of the most highly indebted less-developed countries and called on commercial banks to provide these countries with $20 billion in new loans over a three-year period.31 An additional $9 billion in loans was to be made by the World Bank, the IMF, and other multilateral lending institutions.32 The developing countries involved in the Baker Plan were in turn required to implement structural adjustment programs under the supervision of the IMF.33 The key features of the Baker Plan involved: (1) a commitment to resolve the debt crisis with more private lending;34 (2) a requirement that multilateral institutions be part of the overall solution, requiring borrowers to satisfy the conditions including liberalizing trade and foreign investment, and reforming state enterprises;35 (3) voluntary participation;36 and (4) maintenance of a rescheduling process37 while lending new money to keep interest payments current.

The Baker Plan failed primarily because rescheduling between the banks and the sovereign debtors became a more complex issue than was anticipated. The banks became increasingly weary of what they perceived to be an endless cycle of rescheduling and bridge loans.38 At the same time, debtor countries also began to tire of the rescheduling process, realizing that by incurring new debt to keep current their interest payments on old loans they were merely increasing their debt burden for benefit of the banks.39 In addition, the fact that the Baker Plan was voluntary meant that the banks and debtor nations could deviate from the plan's guidelines. This inevitably resulted in debtor countries being unwilling to enact the requested reforms. As a result, the banks' willingness to provide additional loans declined.40 The success of the Baker Plan was further hindered by the fact that progress made in the securitization of debt effectively reduced new borrowing. Instead, refinancing of old securitized loans on the secondary market became the primary source of sovereign commercial lending.41

2. The Brady Plan

Following the breakdown of the Baker Plan, the next major development was the Brady Plan of March 1989, proposed by then secretary of the Treasury Nicholas Brady.42 Like the Baker Plan, it was designed to "encourage banks to voluntarily reduce the debt burdens of LDC debtors"43 with a view to making their economies more creditworthy and, as such, able to attract more capital for growth.44 The Brady Plan is perhaps best known for its innovation of securitizing "sovereign loans by converting loan obligations into bonds, now known as Brady Bonds."45 Securitization involves pooling together loans from single banks and repackaging them as bonds, which are the offered to the public in the secondary market.46 The proceeds of these sales are used to settle a country's bank-loan indebtedness and the country is then left to make cyclic payments to a trustee for distribution to the bondholders.47 The most common types of bonds issued in the Brady Plan are par bonds and discount bonds. Par bonds "are issued in a principal amount equal to the face value of the loans from which they are converted, but carry a reduced, fixed interest rate."48 Discount bonds "carry a floating interest rate but are issued at a discount in principal from the face value of the loans from which they are converted."49

The trustee in a Brady Bond situation is often referred to as a fiscal agent and is governed by a Fiscal Agency Agreement (Agreement).50 Allied Bank International in the Allied v. Banco Credito case discussed below is an example of such an agent. The Agreement also controls the relationship between a debtor nation and the bank that issues the bonds to the creditors.51 Under the Agreement, the fiscal agent acts solely as the agent for the bond issuer and not for the bondholders.52 "If the debtor fails to deposit sufficient funds to pay the interest due; if . . . a bondholder claims that an 'event of default' or 'default' has occurred; or if the bonds have been accelerated," however, then the fiscal agent is obligated to provide notice to the bondholders.53

In addition to providing bondholders with notice of certain events, a fiscal agent must convene a bondholders meeting if requested by ten percent of the bondholders and must also appoint a chairperson for such a meeting.54 Other than the appointment of a chairperson to bondholders meetings, the fiscal agent has virtually no leadership role in the Brady Bond program.55

The securitization that occurs with Brady Bonds has several benefits for both the debtors and the banks. Specifically, banks have the option of ridding themselves of troubling sovereign loans. In addition, since Brady Bonds are offered at a discount rate from the original loan, the debtor nation is provided with a reduced service obligation.56 Another feature of Brady Bonds is the collateral and protective covenants that help provide some security and stability for both the bondholders and the sovereign.57

3. Loan Loss and SEC Intervention

An issue of tremendous significance involving the implementation of the Brady Plan was how to deal with losses that would be shouldered by commercial creditors. This problem arose because securitization involved commercial creditors receiving a fair value for the loan originally advanced that was less than the recorded value of the debt.58 The difference between the fair value of the securitized loan and its recorded value would have forced these banks to record the transaction as a loss. This in turn would have severely damaged the banks recorded earnings and overall financial situation.

In 1997, the Financial Accounting Standards Board (FASB), a privately funded nongovernmental agency that establishes general accounting principles, provided a set of standards known as Financial Accounting Standards No. 15 (FAS 15) to govern the issue of troubled debt restructuring.59 Under FAS 15, a debt restructuring loss would not have to be recorded as a loss "if future payments equal or exceed the recorded book value" of the original debt.60 The U.S. Securities and Exchange Commission (SEC) endorsed this interpretation of FAS 15 in a July 14, 1989 letter to David Mulford, then Under Secretary of the Treasury and the architect of the Brady Plan.61 This letter specifically states that recording a loss would be unnecessary "if the total future undiscounted cash receipts specified by the new terms of the loan, including receipts designated as both principal and interest, equaled or exceed the book value of the loan."62 By allowing banks to avoid recording losses in their books, the SEC made the securitization of loans a much more favorable endeavor for the creditor banks.63

D. The Emergence of the Era of International Financial Liberalism

The debt crisis contributed towards the establishment of a new world order of economic and financial liberalism and the breakdown of the restrictive international financial framework established at the Bretton Woods conference after the Second World War. My goal in briefly tracing the emergence of an open financial order is to suggest that the sanctity of contract doctrine emerged as the restrictive international financial framework envisaged of the post-war period began to crumble and break down.

The international economic system established by the Bretton Woods framework after World War II was committed to a restrictive international financial order. It was restrictive in large part because it was designed to give monetary policy autonomy to the new interventionist welfare state and to protect it from "speculative and dis-equilibrating international capital flows."64 In the period immediately after World War II, a return to the open financial order of the pre-1931 period in the Western world was opposed as it was also believed to be incompatible with a stable system of exchange rates and a liberal trading order. "This belief stemmed from the experience of the interwar period, when speculative capital movements had severely disrupted exchange rates and trade relations."65 The goal of this restrictive international financial system was therefore to establish a system of stable exchange rates. Stability in exchange rates was achieved through the gold standard which meant that the U.S. dollar served as a store of value as each dollar was pegged to a fixed price of gold.66 Some founding members of the IMF regarded its creation as a way of replacing private money-lenders charging exorbitant rates of interest in international capital markets. According to one of its founders, Henry Morgenthau, the creation of the IMF would "drive the usurious moneylenders from the temple of international finance."67

The Bretton Woods framework was also thought of as a balance between post Second World War national economies that had increasingly sought to assert "direct social power"68 over market forces on the one hand, and "the emergence of deliberate management of international economic transactions by means of collaboration among governments,"69 on the other.70 The fixed system of exchange rates anchored by a gold standard, together with balance of payments support from the IMF, were the primary devices used to facilitate this balance.71

The Nixon administration's announcement in August of 1971 that the U.S. dollar would no longer be pegged to the gold standard set in motion the dissolution of this restrictive financial order.72 This order also came under heavy attack primarily from financial forces seeking to escape regulatory restrictions (e.g. to price competition and market entry) in the oil crisis climate of the 1970s.73 These forces, spurred by the demise of the gold standard and the floating exchange rate regime, challenged the post Second World War restrictive Financial order with a new orthodoxy, a hands-off, laissez faire approach to regulatory policy. As Susan Strange observed, the speculative international financial system that was quickly displacing the Bretton Woods vision resembles a casino in which assets are traded almost entirely for speculative profit rather than for beneficial productive purposes.74 The recycling of euro- and petro dollars that contributed to the emergence of the debt crisis of the early 1980s evidenced the emergence of this new financial system characterized by the unencumbered free flow of capital across national boundaries. The inhibitions of the restrictive post Second World War era aimed at protecting the welfare state from the disequilibrating effects of the speculative flow of capital as in the pre-1930 era seemed to have disappeared.

The transformation of the post-second World War Bretton Woods restrictive financial vision was further reflected in the IMF's response to the East Asian financial crisis of the mid-1990's. Rather than treating massive flows of capital to these economies as injurious to national economic policy, the IMF regarded them as offering unprecedented opportunities for investment, trade and growth. According to a former Managing Director of the IMF, the East Asian financial crisis was not a problem of the flow of unregulated capital flows, but rather of the inability of economies without sound economic policy to tap on these private capital flows.75 The crisis was therefore argued to be a well-deserved "punishment" for what the market perceives as market weakness.76

III. SOVEREIGN DEBT ENFORCEMENT LITIGATION

A. Background to Enforcement Litigation

The process of restructuring debt involves moving from sovereign debt to bonded debt. This often involves a large number of creditors with divergent interests. Large banking institutions, for example, are often interested in ensuring that indebted countries commit to implementing IMF approved economic policies as a condition of proceeding with refinancing. Unlike hedge funds and smaller investors involved in refinancing of sovereign debt, big banks are also unlikely to declare default on bonded debts because it reflects poorly on their balance sheets and charters. In addition, large banking institutions often have close ties to foreign governments and are unwilling to jeopardize their relationships by declaring default. Further, the use of cross-default, sharing, and negative pledge clauses in sovereign debt contracts also discourages such creditors from independently declaring a sovereign loan as defaulted.

Smaller creditors, or creditors who would rather be paid sooner rather than later,77 by contrast, often find it more beneficial to break away from the crowd of large institutions and seek default from the debtor country in a restructuring. This arises in part from a dissatisfaction of these investors over the nature of the secondary debt market created by the implementation of the Brady Plan and the securitization that accompanies it. In addition, in this secondary market sovereign creditors do not have the same concerns as smaller banking institutions because sovereign loans are secured through policy-based lending as well as foreign policy considerations that do not apply to contracts with private lenders. In the absence of a commitment to cooperative debt adjustment, small private creditors face little or no pressure to refrain from declaring indebted countries in default. This is particularly so since these creditors are often not repeat players of the international debt scene and have no incentive to do what is best for the entire international creditor community, such as participating in the process of cooperative adjustment of sovereign debt. In addition, small private creditors, unlike big creditors such as large multinational banks, lack any regulatory pressure viz-a-viz sovereign debtors to guide them in their handling of sovereign debt. Another significant reason for the likelihood that private creditors would declare default is that the debt they are owed is typically much smaller than that of the larger lending institutions. This increases the likelihood that these smaller amounts can be immediately recovered.78 To compound this problem, bonds are so heavily traded that it is difficult for indebted countries to have contact with private creditors holding bonds in the same way that they have with large lending institutions.

These advantages give smaller creditors the power to either accept or decline new bonds when a refinancing or restructuring of the debt takes place. Where such a refinancing involves a reduction in the amount of the debt, the likelihood that some creditors may decide to withhold old bonds and accelerate them to full payment increases. For such creditors, a hold-out is likely to be more profitable than accepting new bonds in the restructuring plan since payment of the existing bond would be higher than for the restructured debt. This creates a collective action problem within syndicates of creditors to the extent that as self-interested actors, members of the syndicate will not voluntarily sacrifice or organize themselves in order to promote the interests of all the members of the syndicate.79 Private creditors become hold-outs by holding onto bonds and seeking payment through litigation even after the indebted country has offered to restructure such bonds. If each creditor were to follow the lead of such defectors or hold-outs, the restructuring of the sovereign debt involved would be sacrificed with gains only accruing to a minority of the defecting creditors and at the expense of the indebted country.

B. Judicial Response to the Hold-Out Problem: The Allied Case at the District Court

Since the Second Circuit's decision in Allied II, courts80 have largely adopted as a rule the sanctity of sovereign debt contracts when confronted with claims brought by holdout creditors. In effect, the judiciary has endorsed the practice of holding out as a legitimate exercise of creditors' contractual rights rather than viewing the practice as destabilizing the cooperative adjustment of sovereign debt through restructuring.81 This judicial response is analogous to the jurisprudence of classical legal thought of the late nineteenth and early twentieth centuries, the period of early capitalism in the United States. Like classical legal thought, the judicial response to hold-cuts has been to understand freedom of contract as embodying freely made choices that should not be interfered with by either the lenders or borrowers or even the courts.82 This attitude towards sovereign loan or bond contracts therefore departed from the efforts to deal with the 1980s debt crisis involving governments, private banks and the IMF working together, as noted in Part I above, without making sharp distinctions between how to treat public or private debt. Under the argument advanced by the Second Circuit in Allied II, a governmental default on a sovereign loan or bond is regarded as a breach of contractual obligations and, to that extent, courts ought to regard it as "a unilateral attempt to repudiate private commercial obligations."83 To illustrate this judicial response, a detailed discussion of some of Allied, Allied I and Allied II and its progeny follows.

C. The Factual Background

Allied Bank International (Allied), a U.S. chartered bank with its principal place of business in New York, was an agent of a syndicate of thirty-nine creditor banks84 that had advanced credit to Costa Rica in 1979. In 1982, Allied brought suit against three banks owned by the government of Costa Rica.85 The purpose of the suit was to recover on promissory notes issued by the Costa Rican banks payable to the syndicate banks.86 Under the terms of the indenture on the promissory notes, they were to be payable in New York City in U.S. dollars every six months, beginning July 1, 1978, up to July 1983.87 Although the Costa Rican banks made payments on schedule through 1981, they defaulted on the note payments after the Costa Rican Central Bank suspended all external debt payments in 1981 in response to the mounting economic problems in the country.88 This suspension involved a two-step process. First, on August 27, 1981, the Central Bank issued regulations limiting state owned institutions from paying principal and interest on external debt to foreign creditors in foreign currency.89 Second, the Costa Rican President and Minister of Finance issued decrees forbidding the three Costa Rican banks from paying any principal or interest on external debt in foreign currency without prior approval of the Central Bank in consultation with the Ministry of Finance because Costa Rica was in the process of renegotiating its foreign debt and, as such, was seeking a "harmony of decisions and centralization in the decision making process" concerning the carrying out of the service of the external debt."90 Allied sued and brought a summary judgment motion arguing in part that the regulations and decrees were issued "without notice to or consultation with" the syndicate.91

In its summary judgment motion, Allied sought to accelerate payment with a view to recovering the unpaid balances, including both principle and accrued interest, owed by all three banks.92 The Costa Rican banks defended by asserting sovereign immunity and the act of state doctrine, as well as by claiming that the court lacked jurisdiction and that service of process was insufficient.93 The district court declined to enter summary judgment for Allied on the reasoning that a judicial determination contrary to the Costa Rican directives could embarrass the U.S. government because it was the public, as opposed to the commercial, conduct of the Costa Rican government that prevented payment.94 The district court applied the act of state doctrine to dismiss Allied's summary judgment motion."95

D. The District Court's Application of the Act of State Doctrine

According to Judge Griesa, the three conditions necessary to apply the act of state doctrine when a court has been invited "to judge a foreign government's conduct under ambiguous principles of international law" were present in Allied.96 First, the actions that led to the prevention of payment by the Costa Rican government were public in nature rather than commercial.97 Second, what made them public rather than commercial was that their purpose was to serve an integral governmental function "in response to a serious national economic crisis" of the type governments perform in such circumstances.98 Third, "the executive branch of the United States Government has stated its view regarding the propriety of applying the act of state doctrine or regarding the validity of the foreign governmental act in question,"99 and, as such, the act of state defense "dictate [d]" the denial of Allied's summary judgment motion.100 It is important to note that Judge Griesa observed that the defendant banks were raising the act of state doctrine as a shield in Allied's summary judgment motion and not as a sword in a motion seeking to dismiss Allied's claims.101 Judge Greisa ruled that the act of state doctrine may have prevented Allied from recovering102 because the purpose of the doctrine was to "avoid judicial action which would impinge upon the foreign relations of the United States."103 Indeed, the Supreme Court noted in a prior case that the purpose of the doctrine was in part to ensure respect for the independence of every sovereign state by judicial abstention when the acts of foreign states were at issue.104

Judge Greisa was squarely within the weight of authority on the proper application of the act of state doctrine. Under this doctrine, judges exercise restraint in cases challenging the conduct of a foreign sovereign's public functions.105 Judge Griesa cited Hunt v. Mobil oil Corp,106 a case from the Second Circuit that the Supreme Court declined to review.107 In Mobil, the Second Circuit refrained from inquiring into the validity and motivation of Libyan confiscations of an American corporation's oil concessions despite the fact that Libya was not a party to the suit and the validity of its confiscations was not at issue.108 The objections to upholding the act of state doctrine in Mobil were very similar to the objections made against Judge Griesa's reliance on the doctrine in Allied.109 The Plaintiff-Appellants in Mobil objected to the application of the act of state doctrine for at least three reasons. First, they argued the doctrine's prohibition of inquiring into the validity of the acts of a recognized foreign sovereign where such a sovereign had confiscated the property of a U.S. citizen was a far reaching jurisdictional bar on the ability of such U.S. citizens to access federal courts.110 The Court in Mobil rejected this argument and held that "the fact that the court has jurisdiction does not make the issue justiciable."111 Second, the Plaintiff-Appellants in Mobil argued that the act of state doctrine ought to be redefined to apply only where what is at issue was the legality of a foreign sovereign's action since this did not involve sitting in judgment over the acts of a foreign sovereign.112 The court also rejected this effort to redefine the act of state doctrine. The Mobil court noted the doctrine had survived "unscathed"113 in a long line of cases and that in any event, it could not, as a lower court, depart from precedent.114 Third, the Plaintiff-Appellants contended that where a foreign sovereign had violated international law such as by confiscating the property of aliens, such acts by virtue of their discriminatory and arbitrary nature were contrary to international law and ought not to receive recognition by other states.115 The court rejected this argument holding that it was being invited to inquire into the motivation of the actions of a foreign sovereign, a "subtle and delicate" foreign policy issue which was barred both by the act of state doctrine and the constraints of fact finding that the judicial branch would have to engage in to make a determination one way or another.116

These objections of the Plaintiff-Appellants in Mobil and in Allied to the application of the act of state doctrine were not new.117 They had been raised more than decades earlier injustice White's dissent in Banco National de Cuba v. Sabbatino (Sabbatino) where he opined:

I am dismayed that the court has, with one broad stroke, declared the ascertainment and application of international law beyond the competence of the courts of the United States in a large and important category of cases. I am also disappointed in the Court's declaration that the acts of a sovereign state with regard to the property of aliens within its borders are beyond the reach of international law in the courts of this country. . . . I do not believe that the act of state doctrine, as judicially fashioned in this Court, and the reasons underlying it, require American courts to decide cases in disregard of international law and of the rights of litigants to a full determination on the merits. . . . The reasons for non-review, based as they are on traditional concepts of territorial sovereignty, lose much of their force when the foreign act of state is shown to be a violation of international law.118

These concerns would become key to the arguments for reversal in Allied II. Suffice it to say these concerns were not new and had already received congressional imprimatur in 1965 through the Second Hickenlooper Amendment to the Foreign Assistance Act,119 which effectively reversed the Supreme Court's application of the act of state doctrine to preclude judicial inquiry into the Cuban government's confiscation of American owned property in Cuba. However, while it was clear by the time Allied was decided that the act of state doctrine did not preclude judicial inquiry into confiscations of American property abroad, it was not clear whether such territorial limitations applied with equal force in cases where the confiscated property was intangible,120 such as in Allied's claim that its promissory notes has been confiscated by Costa Rica. It is my contention in this Article, that though the question of whether the territorial limitations of the act of state doctrine applied to intangible property was not directly at issue in Allied, Allied I, and Allied II,121 that the Allied II decision upholding Allied I fell in line with a definitive line of second Circuit decisions unambiguously holding that constraints such as the intangibility of confiscated property would not disable a court from inquiring into a foreign sovereign's "unilateral" efforts to abrogate contractual obligations with a U.S. citizen.122

What I hope will become clear as I proceed to examine the critique of the reliance on the act of state doctrine in Allied, is how the distinction between the basis for establishing jurisdiction, on the hand, and for establishing justiciability under the act of state doctrine on the other, disappeared, thereby virtually sounding the death knell of the act of state doctrine in cases where the allegation was the confiscation of intangible property.123

E. Re-characterizing the Act of State Doctrine-The DOJ's Critique of the District Court's Application of the Act of State Doctrine on Appeal

In the briefs seeking a rehearing of Allied I, the U.S. Department of Justice (DOJ) made a three point attack on Judge Griesa's application of the act of state doctrine. In doing so, the DOJ was effectively inviting the Second Circuit to re-characterize the act of state doctrine in at least three ways. First, that it was available only where a taking or confiscation took place exclusively within the territory of the foreign state.124 This is a strictly territorialist requirement in light of the globalized nature of international financial lending. Situs analysis, the DOJ argued, demonstrated that the promissory notes were payable in New York and in U.S. dollars.125 As such, the Costa Rican decrees affecting the contract rights outside Costa Rica's territory could not benefit from the protection of judicial abstention under the act of state doctrine.126

Thus unlike in Sabbatino where the Supreme Court found that the act of state doctrine was available where the foreign state had territorial jurisdiction,127 the DOJ and Fidelity's amici argued that if any part of the transaction took place within the United States, or if the place of performance, enforcement, or collection was the located in the United States, the doctrine was unavailable.128 The DOJ's brief in support of a re-hearing was therefore misleading to the extent that it made the case that Sabbatino had decided that all aspects of a transaction had to take place within the territory of foreign state for the act of state doctrine to be applied.

Although Sabbatino has not been reversed, there are now numerous Second Circuit decisions upholding the contrary view that "a debt is not 'located' within a foreign state unless that state has the power to enforce or collect it,"129 or that a debt can only have its situs in a foreign country where the debt transaction comes to complete fruition within the dominion of that country.130 Thus, under the analysis preferred by the DOJ, the location or situs of contractual obligations would be determined by the place of performance, which would be where the principal and interest on the loan would be payable, the country whose currency would be used, and the country whose law would apply or govern the contract.131

Second, the DOJ argued that the act of state doctrine was inapplicable in Allied under New York conflict of law rules.132 According to the DOJ, where a foreign sovereign's conduct is in the remotest way connected to New York, such conduct could be evaluated for its consistency with New York law and policy.133 Where such conduct was inconsistent with either New York law or policy or both, the act of state doctrine could not protect the act of a foreign state from judicial review.134 The DOJ claimed that since Costa Rica by defaulting on the loan seized assets belonging to persons outside its territory,135 such confiscation or seizure was contrary to the law and public policy of New York and therefore could not be protected by the act of state doctrine.136

By characterizing the act of state doctrine this way, the distinction between reasons precluding justic lability (to avoid embarrassing foreign sovereigns) and conditions for obtaining jurisdiction in federal courts collapsed.

F. Application of Comity in the Second Circuit's First Decision-Allied I and the DOJ's Response

To understand why the Second Circuit applied the comity doctrine in Allied I and the reaction it caused in private lenders, it is necessary to retrace the developments in the case prior to the district court's decision in Allied. While Allied was pending in the district court, a consent to dismiss the case was reached after the parties stipulated no issues of fact remained with respect to the issue of the act of state doctrine.137 Pursuant to this consent agreement, the Costa Rican Central Bank and the Republic of Costa Rica signed a refinancing agreement with Allied, the agent of Costa Rica's thirty-nine external creditors.138 However, when the restructuring plan was drawn up in September 1983, Fidelity Union Trust Company, one of Costa Rica's thirty-nine creditors, refused to participate in the restructuring.139 Costa Rica then began making payments to all its creditors.140 Allied therefore revived the case against the Costa Rican banks on Fidelity's behalf. The refinancing agreement with respect to the other thirty-eight creditors proceeded and Costa Rica began making payments to them.141 Given the Second Circuit's consideration of these developments following the district court dismissal of the case by applying the act of state doctrine, Allied I was arguably decided on the premise that the rescheduling agreement entered between Costa Rica and the thirty-eight banks would be jeopardized by a ruling in favor of Fidelity.142

In its Allied I decision, the Second Circuit affirmed the district court's dismissal not on the basis of the act of state doctrine, but rather on the premise that the principles of comity required that U.S. courts give recognition to the validity of the Costa Rican directives which had set in motion the default.143 The Second Circuit found it unnecessary to rule on the applicability of the act of state doctrine because it found that the actions of the Costa Rican government accounting for the default were consistent with the law and policy of the United States.144

The rationale of Allied I was that the conduct of the Costa Rican government that led to the prohibition of payments was consistent with the law and policy of the United States with regard to cooperative debt adjustment.145 The consistency of this conduct with U.S. policy, according to the court, also necessitated giving effect to the Costa Rican government's conduct even if the situs of the debt was found to be within the United States.146 The court also asserted that the Costa Rican government was acting as a sovereign preventing a "national fiscal disaster" and therefore rejected the claim that these actions constituted a commercial activity that could not be given recognition by U.S. courts.147

In addition to finding that the actions of the Costa Rican government were valid under the doctrine of comity, the Second Circuit also arrived at another controversial conclusion. The Allied I court began by noting that in Canada Southern Railway Co. v. Gebhard148 (Canada Southern) the Supreme Court held that bondholders of government owned bonds can be bound by a government reorganization of debt.149 Relying on this Supreme Court precedent, the Allied I court analogized the Costa Rican prohibition of external debt payments "to the reorganization of a business pursuant to Chapter 11 of [the] Bankruptcy Code."150 Thus, the Costa Rican government's actions leading to a default were likened to an automatic stay such as that given to a corporation to buy it time to reorganize its debt to repay its creditors while preventing a scramble for its assets.151 The Second Circuit's Allied I decision therefore found unequivocally that Costa Rica's non-payment of its debt prior to the restructuring was not a repudiation, but rather "merely a deferral of payments while it attempted in good faith to renegotiate its obligations."152

After the Allied I decision was handed down, the DOJ immediately filed two amicus briefs, one urging rehearing153 and the other urging reversal on rehearing.154 The DOJ argued that the Allied I court had misconstrued U.S. foreign policy on debt adjustment for at least three reasons. First, it argued that the United States' leadership and involvement in the cooperative rescheduling of debt through the Paris Club and through federal assistance under the Foreign Assistance Act only applied to and affected sovereign defaults on debt borrowed from other sovereign lenders rather than debt borrowed from private lenders.155 As such, Allied I was argued to have applied the notion of cooperative debt adjustment to debt borrowed on the private market while it was only designed to apply to borrowing between sovereigns. Second, the DOJ argued that Allied I misconstrued U.S. support for cooperative debt adjustment as a basis to undermine the rights of private creditors to obtain effective remedies, including due process safeguards against expropriation of their property through enforcement litigation.156 This in turn left creditors with the undesirable remedy of collective rescheduling wholly at the mercy of indebted sovereigns and international organizations and without any avenues for judicial redress.157 Third, it was argued that cooperative debt adjustment was just one of several policies of the U.S. government and that the Allied I court wrongly presumed that Costa Rica's unilateral restructuring of its debt was excusable as a result.158

Thus, as advocated by the United States, cooperative adjustment offered indebted countries only de facto protection since the participation of commercial creditors was voluntary. Effectively, this meant that the United States supported creditor actions accelerating payment of debt obligations through judicial enforcement,159 a position which stands somewhat at odds with its support of cooperative debt adjustment and its encouragement of creditors to voluntarily participate.

G. Reliance on Canada Southern Railway Co. v. Debhard: The Bankruptcy Analogy to Cooperative Debt Restructuring

Just as the DOJ, Allied and its amici criticized the Allied I decision for applying the comity doctrine, they criticized the decision for Costa Rica's reorganization of its debt to a reorganization of a business pursuant to Chapter 11 of the Bankruptcy Cocie.160 In Allied I, the court relied on Canada Southern161 to find that a sovereign reorganization of its debt was similar to the reorganization of debt by a corporation.162 A primary reason mobilized in opposing the bankruptcy analogy was that Costa Rica's debt reorganization plan did not fulfill the criteria for obtaining bankruptcy protection afforded to creditors under section 304 of the Bankruptcy Code.163 The Allied I court held that using the bankruptcy analogy to allow Costa Rica to formulate plans for repayment through deferral of payments as a way of preventing the "mad scramble of creditors" for its assets was a "good faith" supported by the U.S. government.164

The primary charge made against reliance on Canada Southern was that the Costa Rican decrees suspending payment under the promissory notes with Allied could not be equated to a commercial bankruptcy such as that at issue in Canada Southern.165 Further, it was argued that, unlike in Canada Southern, in the Costa Rican situation no notice was given to creditors, nor was the consent of creditors sought.166 Indeed, that the Costa Rican decrees were an indefinite prohibition of payment that bore no resemblance to either Canadian or U.S. bankruptcy legislation.167 In addition, Allied argued that Canada Southern had been distinguished in Central Hanover Bank & Trust Co. v. Siemens (Central Hanover)168 where legislation that discriminated against non-resident creditors in relation to domestic creditors was denied recognition under the comity doctrine.169

In my view, characterizing the Costa Rican default and its attendant reorganization as indefinite prohibitions of payments was crucial to Allied and its amici in making the claim that Costa Rica violated the sanctity of its sovereign debt contract with Fidelity. Thus, Allied and its amici downplayed the importance of Costa Rica reorganizing its national economy in the face of a national economic crisis. Allied understated the restructuring perhaps to prevent a result similar to that in Canada Southern where the Supreme Court had ordered balancing the equities in favor of Canada reorganizing its economy in relation to the New York bondholder's efforts to enforce their rights.170 In fact, it seemed that Allied and its amici were especially critical of any judicial outcome that would have recognized the validity of the Costa Rican decrees that suspended payments under the promissory notes executed between Allied and Costa Rica.

Allied and its amici made three additional attacks on the decrees. First, although they sought to distinguish Canada Southern by invoking Central Hanover, they also relied on Justice Harlan's dissent in Canada Southern where he made arguments very similar to those that Allied and its amici were making in favor of reviewing Allied I (particularly to the extent no notice or opportunity to be heard was given by the Canadian government for the restructuring).171 Allied's selective reading of Canada Southern, a case in which the Supreme Court extended the protection of comity to the Canadian government's legislative scheme reorganizing a corporation, illustrates the overriding significance of the sanctity of contracts doctrine to their argument. Justice Harlan's dissent in Canada Southern was mainly premised on the sanctity of contracts view-that a foreign state (Canada) could not legislatively deprive U.S. citizens or corporations of their property without due process of the law or without compensation, very much the same way a U.S. state is prohibited from doing so under U.S. law because it would constitute an unconstitutional impairment of contract.172 Thus, in one of the amicus briefs, the United States rather misleadingly argued that the "normal expectation" of New York lenders was that foreign bankruptcy proceedings would be subordinated to a right of enforcement in New York.173

Second, Allied and its amici sought to portray Costa Rica as having confiscated assets of U.S. citizens as had Hitler era moratorium laws decades earlier.174 They did so by invoking Central Hanover and its progeny. In these cases, moratorium laws were consistently denied recognition for being intentionally discriminatory against non-Germans.175 These cases reflect an appropriate aversion to enforcing Nazi legislation.176 By relying on these cases, Allied and its amici were effectively depicting Costa Rica in the gaze of the Hitler era. Yet, there is in fact a world of difference between German moratorium laws of the Hitler era and Costa Rica's effort to reorganize its economy in the face of a national economic crisis.177 Notably, while Allied and its amici argued the non-payments under the contracts Costa Rica had with Fidelity constituted a unilateral confiscation of its assets, the president certified to Congress that Costa Rica was eligible to continue receiving federal assistance.178 This indicated that the executive branch did not treat the Costa Rican default as an expropriation. Had the executive branch found that the default constituted an expropriation, this would have triggered a suspension of assistance as well as the imposition of economic sanctions rather than a certification for federal assistance.179 Similarly, the concurrent resolution of the House of Representatives indicating sympathy and support for the Costa Rica restructuring far from indicated that Costa Rica's default was understood as a unilateral restructuring of its sovereign debt obligations consistent with the takings concerns of the Hickenlooper amendment variety.180 As the Canada Southern majority held, bankruptcy compositions agreed to by a majority of creditors did not unjustly deprive a non-assenting creditor of their property without due process of the law. Rather, "[t]hey simply require each individual to so conduct himself for the general good as not unnecessarily to injure another."181 In the golden era of federal equity jurisdiction, courts in the United States developed analogous receiverships for distressed railroads and it has been credibly argued that the bankruptcy analogy is worth considering today to deal with sovereign indebtedness.182 In fact, the policy of cooperative debt restructuring is based on the assumption that both private and governmental lenders to defaulting sovereigns would collectively but voluntarily cooperate in restructuring, so that each lender's individual interest is checked by its interest in not suffering the "opprobrium" of the other creditors.183 Unsurprisingly, the IMF's proposed sovereign debt restructuring mechanism borrows from the bankruptcy analogy used by the court in Allied I.184

H. The Campaign Against Allied I by Wall Street Investors and Organizations

As soon as Allied I was handed down, uproar from Wall Street Financial institutions and investor organizations ensued.185 Allied I was interpreted to endanger the entire portfolio of sovereign debt owed by developing countries to Wall Street, thereby setting the stage for a concerted campaign for its reversal. This campaign was led by creditor banks, the business press, and organizations such as the National Foreign Trade Council, the Rule of Law Committee and the New York Clearing House.186

The primary claim made by the organizers of the campaign was that Allied I legitimized unilateral repudiation of sovereign loan contracts without any remedies for U.S. financial institutions and that this lack of creditor protection under New York law (as interpreted by the Second Circuit) made all loans to developing countries susceptible to similar repudiation.187 As a result, sovereign creditors, and the U.S. economy in general,188 faced a major financial meltdown. Many were worried that the Second Circuit's decision would encourage creditors to migrate to other countries, where the law provided better protection.189 The first line of an editorial in the Financial Times captured the essence of the campaign's apocalyptic message: "IT'S MONSTROUS, it's a scandal, nothing like this has happened before! From now, no-one in his right mind will specify New York law and New York as a place of litigation in a loan agreement."190

The National Law Journal wrote that Allied I gave "debtor nations virtually unlimited power to repudiate their loans,"191 while the briefs of the New York Clearing House, the Foreign Trade Council and the Rule of Law Committee predicted "doom and disaster" if Allied I was left to stand.192 Costa Rica, by contrast, argued that predictions of doom and disaster were trotted out in similar circumstances before and rejected by courts as being "speculative and remote."193

Barely a week after the decision in Allied I, it was the subject of discussion in a Senate hearing on U.S. involvement in Argentina's debt crisis. Senator Riegle sought to understand the effect Allied I's extension of Chapter 11 bankruptcy to sovereign lenders would have on the legal recourse available to lenders where a sovereign borrower stopped loan payments.194 It is instructive that Anthony M. Solomon, the president of the Federal Bank of New York, answered the question in part by noting that the decision would "limit the ability of banks to bring. . . successful litigation against a unilateral imposition of terms by a sovereign debtor government."195 Solomon seemed to have been carrying the clarion cry for the campaign to reverse Allied I by asserting that the decision legitimated an indebted government's ability to unilaterally alter sovereign debt contracts to the disadvantage of sovereign creditors.

The hearings on Argentina's debt problems which were also heard concurrently in the House Subcommittee on International Trade, Investment and Monetary Policy196 were especially critical of the administration's support of an IMF rescue package. The thrust of the critique was that the rescue package was primarily aimed at bailing out U.S. private commercial banks rather than Argentina, and that the package would lead to reduced availability of credit in the U.S. domestic market and would result in increased interest rates for domestic loans.197 Several members of Congress pointed out that these consequences would have the effect of transferring the risk of imprudent commercial loans to sovereign debtors such as Argentina from the lenders to American tax payers.198 Some critics pointed out that the high interest rescheduling supported by the IMF had the effect of papering over rather than resolving the "ticking debt bomb" among hard-pressed donor nations199 and that rather than seeking to ensure commercial banks made their quarterly profits, the IMF and the Treasury ought to be in the business of ensuring the long term sustainability of the international financial system.200

Thus, it is against this background of a Congress generally skeptical of using tax-payer dollars to effectively bail out commercial banks, and a preexisting executive branch policy favoring cooperative debt restructuring, that the campaign against Allied I was taking place.

I. Characterizing Default as Repudiation to Justify Acceleration

Allied's motion for rehearing was supported by the Justice Department which intervened as amicus curiae.201 A subsequent amicus brief of the Justice Department was supported by advisors, attorneys, counselors and general counsels of the Department of State, the Department of the Treasury, and the Board of Governors of the Federal Reserve System.202 Significantly, Allied argued that the participation of all these governmental agencies in the amicus brief squarely contravened Costa Rica's assertions that Allied I's abstention from adjudicating on its acts was consistent with U.S. foreign policy.203

Consistent with the clarion cry of the public campaign to reverse Allied I, the primary argument asserted by the United States in seeking a rehearing and reversal was that Costa Rica had unilaterally attempted to repudiate payment obligations under private contracts and that this repudiation was inconsistent with the U.S.'s policy favoring the orderly resolution of international debt problems.204 A central part of these claims was that Allied I introduced uncertainty and confusion regarding the circumstances under which U.S. courts would give effect to acts of foreign sovereigns to limit payment obligations under sovereign loan contracts.205 Thus, the DOJ brief argued that presidential certification under the Foreign Assistance Act in favor of assisting Costa Rica's debt restructuring efforts that were also supported by Congress did not extend to private commercial debt and that, in any event, the participation of commercial banks in debt restructuring was voluntary and was thus neither required by U.S. policy nor the Paris Club Agreed Minute relied on by the court in Allied I to preclude the enforcement of private commercial debt.206 The DOJ further argued that if Allied I was not reversed, the willingness of commercial banks to participate in providing new sovereign debt financing to make debt restructuring successful would be "seriously jeopardized."207

According to the DOJ, "while [private] parties may agree to renegotiate conditions of payment, the underlying obligations to pay nevertheless remain valid and enforceable."208 The DOJ also argued that the Costa Rican Central Bank's declaration that payment would not be made in U.S. dollars was an "attempted unilateral restructuring of private obligations . . . inconsistent with this system of international cooperation and negotiation and thus inconsistent with United States policy."209

J. Creditor Unity on Default Rule Overcomes Collective Action Problems Among Them

Later DOJ amicus briefs would reiterate the view that Allied I endorsed the unilateral repudiation of sovereign loan contracts. These claims were initially made, however, with much force and clarity in the amicus briefs of the New York Clearing House, the National Foreign Trade Council, and the Rule of Law Committee.210 The participation of these organizations as amici at the rehearing greatly enhanced the position of Fidelity Trust viz-a-viz the Costa Rican banks. For example, Costa Rica argued that Fidelity was a rogue bank for defecting and was instituting nuisance litigation, thereby threatening a restructuring accepted by thirty-eight other creditors.211 Ten of the members of the New York Clearing House who accepted the restructuring now supported Fidelity's effort to collect based on the view that while they disagreed with Fidelity's enforcement action, they nevertheless "believe[d] it to be of overriding importance to the conduct of their business-[the NYCH banks] and to the interests of New York and the United States-that Fidelity's legal right to have such a judgment be recognized and upheld in unequivocal terms."212 In addition, Bank of America, which was the coordinating agent for the restructuring and is a member of the Rule of Law Committee that filed an amicus brief, also supported Fidelity's case for a rehearing and thus for an early if not preferential payout through litigation.213 Thus, while holdouts potentially jeopardize restructuring agreements agreed to by bigger financial institutions like those comprising the New York Clearing House, larger financial institutions nevertheless joined with Fidelity to argue that it was best to have dissenting creditors paid out rather than jeopardize debt restructuring.214 Clearly, the organized efforts of these organisations in Allied I and II overcame the collective action problems that would otherwise have confronted Fidelity if it were seeking a rehearing by itself. The concerted move by amici for a rehearing in this case was a key factor in the reversal of Allied I.215

K. Re-Characterizing Comity: Extra-Territorial Effect of Costa Rican Decrees in the United States Precluded

According to Allied and the amici who supported Fidelity's defection from the Costa Rican restructuring, for a U.S. court to give controlling effect to the Costa Rican decrees was precluded by comity considerations because of the selective and discriminatory nature of the decrees.216 In particular, Allied and the amici argued that the decrees precluded payment of debt to foreigners without subjecting domestic creditors and international institutional creditors to similar treatment.217 The claim here was that by upholding Allied I the court would be endorsing Costa Rican decrees that were inconsistent with the law and public policy of New York, the forum state.218 Allied and the amici therefore construed the doctrine of comity to require foreign laws and decrees inconsistent with the policy of the forum be denied recognition.

The public policy and law of New York were predicated on a disparate set of justifications. First, it was argued that it was the law and policy of New York to promote "certainty and predictability of result in international transactions" and that upholding of Allied I would destroy validly contracted loans.219 Second, this law and public policy was traced to a requirement of comity that a forum court not overlook the rights of citizens.220 Third, the law and policy of New York was argued to originate in Restatement (Second) of Conflicts' requirement that the application of foreign law was barred where its effect would be to defeat the justified expectations of the parties even if the foreign law was consistent with U.S. foreign policy.221 Fourth, as a matter of the law and public policy of New York and of the United States, comity does not protect foreign exchange control regulations,222 debt renegotiations, confiscatory moratorium legislation or other analogous defenses, such as impossibility, that would have the effect of defeating the contractual rights of U.S. citizens.223 Fifth, even if ordinary choice of law rules permitted judicial deference to the Costa Rican decrees, comity proscribed a forum court from endorsing the extinction of the rights of its citizens simply because of conduct within the territory of a foreign sovereign.224 Sixth, foreign decrees inconsistent with the sanctity of the contractual rights of U.S. citizens enshrined in the U.S. Constitution and other U.S. laws could not be given effect in the U.S. as a matter of comity.225 Seventh, as a matter of comity, courts must have regard to New York's preeminent position as an international financial capital whose law and public policy is that payments of sovereign loan contracts governed by its laws are protected from default, repudiation or unilateral modification without the consent of creditors.226 Eighth, the Costa Rican decrees were discriminatory because they treated U.S. commercial banks differently than other creditors, including domestic ones and, as such, the decrees were inimical to the law and policy of the United States and New York.227

By contrast, it should be noted that Costa Rica's arguments were predicated on an alternative public policy view: that its Central Bank's regulations limiting foreign exchange authorization for repayment of external debt as well as the decrees of the Costa Rican president and minister of finance to the same effect were necessitated by an economic crisis that it was addressing by seeking a "harmony of decisions and centralization in the decision making process" concerning the carrying out of the service of the external debt."228 Costa Rica was effectively making the case that its efforts to restructure its foreign loans ought to be read as a good faith renegotiation effort rather than arbitrary and unilateral suspension of its contractual obligations leaving no remedy for its creditors. In any event, Costa Rica claimed that not all of its creditors were similarly situated and as such it did not discriminate against Fidelity by applying its decrees only to foreign creditors and not to international institutional or domestic creditors.229

In addition, while Allied argued that comity requires non-recognition of foreign acts of state which in any way violate the rights of citizens of the forum state, it is unclear if such a broad prohibition is the standard for non-enforcement of foreign acts of state under the comity doctrine and U.S. and New York law. For example, Justice Benjamin Cardozo, in a view echoed in the Restatement (Second) of the Conflicts of Laws, argued that such non-enforcement was required where it "would violate some fundamental principle of justice, some prevalent conception of morals, some deep-rooted tradition of the common-weal."230 It would be hard to argue that the sanctity of contracts doctrine advanced by Allied and its amici represented such a fundamental principal of justice and, even if it did, that Costa Rica's efforts to restructure its debts constituted a violation.

Finally, the comity arguments advanced by Allied and its amici were predicated on the misleading premise that the comity doctrine was a species of the choice of law doctrine.231 The factors advanced by Allied and its amici as relevant in addition to the comity doctrine were principles of contract law borrowed directly from New York commercial and conflicts law.232 It is important to bear in mind that treating the comity doctrine as a conflict of laws rule is problematic for several reasons.233 First, comity is not understood to be a subset of conflict of laws rules where an act of a foreign sovereign is implicated.234 Rather, comity calls upon a court to give deference to foreign law, as a rule of decision under principles of its own law, with a view to minimizing potential conflict between two sovereigns and to attaining a balancing of the interests in the particular.235 Second, where the act of a foreign state is implicated, that necessarily is a foreign policy issue and the doctrine of comity is regarded as a matter of federal236 rather than state law in light of the executive's preeminent role in directing foreign affairs.237 Thus, because non-recognition of the Costa Rican decrees in the United States would be illegal under the Costa Rican laws that had temporarily suspended payment in U.S. dollars, a judgment in favor of Fidelity raised the prospect that Fidelity would in effect be required to violate Costa Rican law. Such a violation of Costa Rican law under the comity doctrine would be contrary to the requirement of respecting a foreign sovereign's laws even though there were differences between the legal and economic philosophy of the foreign state and of the United States.238 In light of the comity requirements of avoiding such conflicts and the judiciary's role in weighing the competing interests to achieve this purpose, it can hardly be argued that state choice of law rules override the federal interest. In fact, in Sabbatino the Supreme Court, in analogous circumstances, declined to apply both New York's conflicts rules and the act of state doctrine, arguing that where there was a federal interest at stake, matters "should be not be left to the divergent and perhaps parochial state interpretations."239 Third, the New York conflict of law rules relied upon by Allied and the amici for the proposition that the law of the place of performance, or where a particular event occurred, necessarily governed the transaction was superceded by the development of modern choice of law analysis, which focuses on interests and contacts.a40 The fact that under both contacts jurisprudence and the sovereign loan contracts at issue both Costa Rican and New York law was applicable significantly reduced the pvirchase of the overriding significance of New York law. The fact that either Costa Rican or New York law could apply at minimum called for a balancing of the interests of both New York and Costa Rican law.241

L. Refection of Impossibility of Performance, Sovereign Debt Restructunng or Financial Difficulty as Defenses to Sovereign Loan Default

Allied and its amici argued that under New York law, impossibility of performance,242 sovereign debt restructuring243 and financial difficulty were not defenses to an enforcement action pursuant to non-payment of debt. Further, they argued that defenses such as force majeure and the consistency of Costa Rica's decrees with Article VIII, Sec. 2(b) of the Articles of Agreement of the International Monetary Fund244 were similarly unavailable to vary their unconditional obligation to repay.245

However, the view that these remedies were unavailable was not especially tenable. For example, in one of the cases relied on by Allied for the proposition that impossibility of performance was unavailable, the New York State Supreme Court, Bronx County, observed the following:

It is true that the law does intervene to discharge the obligations of contracts in certain well-established circumstances such as those resulting from impossibility of performance. These are cases where subsequent to the making of a contract difficulties arise so substantial in nature as to render impossible the fulfillment of the duties that had been undertaken. These are cases dealing with the destruction of the subject matter, the death or physical incapacity of a person who had undertaken the responsibility of performing the designated circumstances, etc.246

Thus, it is not as clear as Allied and its amici argued that New York courts could not under any circumstances give relief to a defaulting party who made immediate efforts to cure the default.247 Indeed, the U.S. Supreme Court has held that equitable relief in cases of contractual breach is within "the sound discretion of the court"248 and the New York State Supreme Court, New York County, has held that a slight delay in making a quarterly payment was "out of proportion" to an enforcement action.249 Thus, contrary to the assertions of the unavailability of defenses for Costa Rica, there is authority for the proposition that a state can adjust the debt of a municipality for bonds and interest coupons and that such modification of creditor claims was not struck down for its inconsistency with sanctity of contracts doctrine as Allied and amici sought with regard to Costa Rica.250

IV. A CRITICAL APPRAISAL OF THE ALLIED II DECISION

A. The Decision: The Sanctity of Contracts Underlies all Sovereign Loan Contracts

Upon rehearing its Allied I decision, a three judge panel of the Second Circuit reversed, this time agreeing with the arguments put forward by Allied, the DOJ, and the various amici. In Allied II, the Second Circuit completely ignored the comity doctrine that underpinned its Allied I decision and held that its reliance on the U.S. policy of cooperative debt adjustment was mistaken.251 The Second Circuit further held that the act of state doctrine was inapplicable.252

The Second Circuit agreed with the Justice Department that the Allied I court was wrong to interpret U.S. policy as consistent with "the actions of the Costa Rican government which precipitated the default of the Costa Rican banks."253 As noted above, in Allied I the Second Circuit held that the conduct of the Costa Rican government leading to the prohibition of payments was consistent with the policy of the United States of encouraging cooperative debt adjustment.254 It was on this basis that the Second Circuit necessitated giving effect to this conduct of the Costa Rican government even if the situs of the debt was within the United States.255 Further, in Allied I the Second Circuit asserted that the Costa Rican government was acting to prevent a "national fiscal disaster" rather than engaging in commercial activity.256

In Allied II the Second Circuit restated, in all essential respects, the DOJ's articulation of U.S. policy as "grounded in the understanding that, while parties may agree to renegotiate conditions of payment, the underlying obligations to pay nevertheless remain valid and enforceable."257 Thus, in Allied II the Second Circuit upheld this policy and its logical outcome: that the Central Bank and presidential orders of the Costa Rica government constituted "unilateral restructuring of private obligations" and that this was inconsistent with the U.S. policy of "international cooperation and negotiation" in debt restructuring.258 The court further noted that where acts of foreign states have an extraterritorial effect within the United States, they fall outside the scope the act of state doctrine.259

The Second Circuit then proceeded to consider whether the act of suite doctrine would render the actions of the Costa Rican Central Bank non-justiciable.260 The issue at stake here was whether the doctrine precluded justiciability on Costa Rica's stoppage of the payments of the Costa Rican bank's foreign debt obligations.261 Such conduct would only be non-justiciable if Costa Rica could show that the conduct took place exclusively within its own territory.262 Citing Sabbatino, the court noted the rationale of judicial abstention when determining the legality of extraterritorial conduct such as a taking by a foreign state exclusively within the foreign territory.263

Proceeding from the premise that the doctrine was a flexible one rather than all encompassing, the court observed that applying the doctrine to preclude judicial review was only possible if the "situs of the debts was in Costa Rica."264 The applicable test for determining the situs of the debt was whether the act came "to complete fruition within the dominion of the [foreign] government."265 The court found that the situs of the debts was not in Costa Rica and as such there was no "complete fruition" within Costa Rica.266 In addition, the Second Circuit found that because the debt was repayable in the United States and in U.S. dollars, and because Costa Rica dealt with the creditors agents, who were based in New York City where most of the negotiations on the refinancing took place, the act of state doctrine did not apply.267

Most significantly for the discussion in this paper, the Second Circuit added another layer of justifications predicated on the view that only under the "most extraordinary circumstances" could rights of creditors within the jurisdiction of the United States be determined other than "in accordance with recognized principles of contract law."268 The Court further observed that U.S. banks lend foreign debtors billions of dollars each year and that the "unilateral attempt to repudiate private, commercial obligations [was] inconsistent with the orderly resolution of international debt problems . . . .[and was] similarly contrary to the interests of the United States."269

According to the Second Circuit, the U.S. government has procedures for resolving intergovernmental financial difficulties under the Foreign Assistance Act and U.S. policy on private debt restructuring consists of supporting the strategy of the IMF in so far as IMF policy is consistent with "the policy aims and best interests of the United States."270 Thus, the Allied II court drew a distinction between what it termed Costa Rica's attempt to unilaterally repudiate private debt on the one hand, and Costa Rica's financial difficulties that led to the refinancing of the loan on the other.271 Based on this distinction, the court held that "while Costa Rica ha[d] a legitimate concern in overseeing the debt situation of state owned banks and in maintaining a stable economy, its interests in the contracts at issue [wa]s essentially limited to the extent to which it c[ould] unilaterally alter the payment terms."272 The Allied II court further served that the inability of the Costa Rican banks to pay the debts due and owing in U.S. dollars was a question of enforcement and it could "not determine whether judgment should enter."273

Under this finding, it is clear that under New York law, as construed by the Second Circuit, an emergency could not cure the impairment of bond obligations to meet a public exigency.274 Treating the Costa Rican decrees as exceptional exercises of sovereign authority to address a crisis would, according to the Second Circuit, "be counter to the principles of contract law."275 As such, this would undermine the very promises by which the Costa Rican banks had bound themselves, and a judicial decision to the contrary "would vitiate an express provision of the contracts between the parties."276 Because the express terms of the contract did not explicitly excuse default on the part of the Costa Rican banks arising from the inability of the Costa Rican Central Bank to provide U.S. dollars, the court found the directives were the "precise cause of the default."277

B. A Critical Appraisal of Allied II

1. Allied II Sounded the Death-Knell for Cooperative Debt Adjustment

Since Allied II, courts have tended to treat the contractual rights of holdouts as incapable of being disturbed by the goals of cooperative debt adjustment.278 This judicial attitude comports with the executive branch's reluctance to resort to cooperative, transnational solutions where the interests of the United States are balanced against competing considerations of non-U.S. litigants and foreign sovereigns.279 Rather than treating defectors from cooperative debt adjustment processes as distorting or supplanting the adjustment process supported by the IMF and the U.S. government, since Allied II courts have upheld the rights of defectors without regard to the consequences for sovereign debtors. In A.I. Credit Corp. v. The Government of Jamaica (A.I. Credit)280 for example, the Southern District Court of New York (SDNY) rejected Jamaica's argument that by industry custom a debt restructuring process precluded a commercial creditor from accelerating payment and that such acceleration would have a devastating impact on its economy.281 The court held that industry custom could not vary agreements between creditors and sovereign debtors and that it was not within the court's competence to evaluate the consequences of Jamaica's inability to pay or weigh the foreign policy implications involved.282

In National Union Fire Insurance Co. of Pittsburgh v. Peoples Republic of Congo (National Union Fire Insurance)283 a case involving a sole holdout in a rescheduling, the court rejected Congo's argument that participation in the Brady Plan process could be used to "unilaterally restructure" loan contracts.284 Both in A.I. Credit and National Union Fire Insurance the courts' rejection of the claim that international debt rescheduling was voluntary and could not unilaterally be imposed upon unwilling private creditors was eerily similar to the reasoning of the Second Circuit in Allied II.

In Commercial Bank of Kuwait v. Rifidian Bank and Central Bank of Iraq, the Second Circuit went even further than Allied II in holding that a default occasioned by war, economic sanctions, and the freezing of its assets, thus making it impossible to obtain foreign currency to repay its debts, did not preclude the finding that Iraq had willfully defaulted.285 Finally, in Elliot Associates v. Banco de Nacional,286 the Second Circuit, citing Allied II, A.I. Credit and Prawn Banker v. Banco Popular Del Peru (Pravin Banker),287 held that it was now established that creditors could opt out of rescheduling agreements and sue on the debt.288

This line of reasoning adopted by courts since Allied II has therefore routinely been to preclude countervailing considerations such as maintaining Financial stability in indebted developing countries. This is particularly so since the sanctity of contracts view announced in Allied II effectively prevented indebted sovereigns who had defaulted an opportunity to reorganize its house to enable it to continue making its debt payments. By upholding the rights of holdouts such as Fidelity, this sanctity of contracts view may also jeopardize a national plan of economic development, not to mention the disruption of provisioning of basic services like education and health that might have to be sacrificed to meet the demands of a holdout.

Thus, the sanctity of contracts view embraced in Allied II reinterpreted cooperative debt adjustment not as a flexible doctrine to be applied pragmatically on a case by case basis and balancing different considerations, but as a trump card in one direction only.

2. Allied II's Rejection of Good Faith Efforts to Remedy Defaults

It is striking how the Second Circuit's Allied II decision selectively used Costa Rica's default as the source of a contractual breach without acknowledging Costa Rica's willingness to refinance the debt.289 Rather than viewing the sovereign debt contracts that Costa Rica had with the thirty-nine other creditors as establishing relations within which the interests of both sovereign debtors and creditors converge, the court subscribed to an especially atomistic and individualist outlook of their contractual relations.290 From this individualistic perspective, the fact that thirty-eight of the thirty-nine creditors agreed to proceed with refinancing rather than to seek enforcement does not feature even tangentially in the analysis of Costa Rica's contractual breach. More significantly, the court failed to take into account Costa Rica's argument that Fidelity's defection from the refinancing was itself inconsistent with the policy of a coordinated system of cooperative adjustment under the auspices of the IMF.291 Instead, the Court seemed to presuppose that cooperative adjustment is a one-way street-that holdouts exercising certain contractual rights cannot be regarded as destabilizing cooperative adjustment of debt.

3. Allied II Shifted the Risks of Sovereign Lending

Holdouts such as Fidelity in the secondary market for sovereign bonds are sophisticated enough to investigate the creditworthiness of the sovereigns whose bonds they buy. These holdouts are not in the position of involuntary lenders unaware of the fact that sovereign borrowers are often unable to bare the risk of borrowed monies. Rather, holdouts carefully select their borrowers and are fully aware of their financial problems. In addition, holdouts cannot plead lack of bargaining power in relation to indebted sovereign borrowers. In fact, as the IMF and the British Chancellor of the Exchequer have long argued, these holdouts are rogue investors taking advantage of the indebtedness of sovereigns.292 From this point of view, it would therefore be reasonable to assume that these holdouts are often aware of the financial handicaps of sovereign debtors and by buying bonds underwritten by such indebted sovereigns they are assuming the risk of non-payment. Indeed, in similar commercial contexts, lenders are not automatically entitled to judgment upon default.293

4. Judicial Abdication: Did the Allied II Court Give the Executive Branch Un-Reviewable Power to Construe Sovereign Debt Contracts?

By showing overwhelming deference to the Department of Justice's amicus curiae intervention seeking to have the case decided consistently with a newly announced policy on cooperative debt adjustment, the Second Circuit's Allied II decision effectively surrendered its judicial authority to the executive branch.294 As a result a strong case can be made that the surprising deference given to the Department of Justice in Allied II does not reflect a proper distribution of functions between the judicial and political branches, because the Second Circuit, in reversing itself, simply adopted the Department's construction of the rights of holdouts in enforcement litigation. In so doing, the Allied II court effectively gave the executive branch an un-reviewable right that requires judicial deference to the executive's view of the foreign policy goals of the United States.295 Yet, the controversy in the Allied case was not a question within the traditional domain of the foreign affairs power of the federal government. It is only under the preemption doctrine, which provides that states are preempted from interfering with the executive branch's foreign affairs prerogatives, that a result dictated by the executive branch might have been warranted. The Allied controversy presented no such foreign policy question and yet precisely because of such intervention the traditional tools of judicial decision making involving foreign sovereigns such as the act of state doctrine and the doctrine of comity which guide judicial deference to the foreign sovereign and its laws were upended by executive interpretation of contractual rights under a loan contract. Ultimately even if it could be argued that the U.S. policy interest in ensuring the sanctity of sovereign debt contracts was so strong, not all foreign policy decisions adverse to the United States ought to compel a judicial result in favor of the United States.296

5. Judicial Non-intervention of Allied II as an Affirmation of Creditor Rights at the Expense of Debtor Concerns

While the Allied II court argues that it ought not to interfere with the contractual obligations entered into between Fidelity and the Costa Rican banks,297 the court effectively upheld the arguments in favor of Fidelity while rejecting those in favor of the banks. This is far from non-interventionism. Judicial abstention is indistinguishable from judicial action.298 Thus, by refraining from sitting in judgment or examining the validity of arguments put forward by the Costa Rican banks, the court effectively foreclosed the flexibility and balancing considerations inherent in the cooperative adjustment of debt policy of the IMF. This result was also possible because the court construed the need for cooperative adjustment of debt solely from the perspective of the rights of creditors without taking into account those of debtors.299

There is another reason to be skeptical of the claim that Allied II and its progeny are neutral applications of freely made choices between contracting parties. To make this point, it is important to first acknowledge the imperative that contracts as written cannot be contradicted, qualified or enlarged by any contemporaneous or antecedent understanding or agreement. This strict requirement of abstention from qualifying contracts, however, is not always reflected in practice and, more importantly, in the doctrines of contract law. There are a number of contract doctrines that question such a stringent intention-based notion of contracts. For example, New York courts have admitted testimony that an apparently unconditional option was subject to a condition.300 It cannot therefore be assumed that courts are involved in a neutral role facilitating the intentions of the contracting parties without much else going on. The point ultimately is that while courts in the sovereign debt context have rejected the doctrines such as impossibility of performance in holdout cases, they are merely exercising the power of the state of New York over the power of a foreign state to favor in-state multinationals banking interests. Contracts here are therefore no more than the result of public decisions about what agreements to enforce or not to enforce.301

6. Allied II Collapsed the Distinction Between Sovereign Functions and Commercial Acts of Sovereigns

While the erosion of comity and the act of state doctrine comports with the modern trend to make states accountable, especially when they act as traders or commercial actors,w'2 the extinction of any regard for the sovereign or regulatory functions of sovereigns in managing public functions such as refinancing sovereign debt results in an unbalanced projection of the authority of the United States over coequal sovereigns. While English and Canadian courts have been reluctant to undermine or interfere with the sovereign functions of a state,303 the U.S. Supreme Court has endorsed the view that once a sovereign participates in the bond market as a private party under the Foreign Sovereign Immunities Act the purpose of the participation is irrelevant because the commercial nature of the transaction rather than its purpose is controlling in determining commerciality.304 Under New York law, as interpreted by New York courts and the second Circuit, a breach of a contractual agreement arising from the exercise of powers peculiar to sovereigns and not exercisable by private citizens does not immunize a foreign sovereign's conduct because its nature, rather than its purpose, is controlling for purposes of whether or not immunity would be granted.305 Similarly in Republic of Argentina v. Weltover, the Supreme Court found that it was irrelevant that the immediate reasons accounting for Argentina's default under the "bonds" at issue in that case arose from its efforts to meet a critical shortage of foreign exchange arising from a domestic credit crisis.306 The practice of U.S. courts relying on the commercial nature of transactions as opposed to the purpose of such transactions where sovereigns are involved departs from English decisions which have been far more circumspect of relying too much on either a purpose or nature test in establishing commerciality in the context of sovereign immunity.307

The exercise of such judicial authority over the foreign sovereign prerogatives by U.S. courts is further exacerbated by the virtue of the fact that U.S. creditors are guaranteed relief in sovereign debt litigation since under New York law all the defenses otherwise available to sovereign debtors have been eroded.(TM)" This erosion has been so complete that there is no room under New York law to make the point that a state has an inherent authority as a sovereign to act to safeguard vital interests even though such acts may modify or abrogate the rights of creditors under existing contracts.30" This is the principle of the Faitoute case and a widely recognized right inherent in the authority of a sovereign state.310 The Supreme Court recently affirmed a similar power in KeIo v. City of New London.311 Allied II is indeed all the more surprising since in domestic U.S. jurisprudence the contract clause upon which the sanctity of contracts view is drawn is widely regarded as having a very narrow scope.312 Yet even under New York law, such predictable outcomes against sovereign debtors are not preordained for a number of reasons. First, the act of state doctrine could be argued, as in Allied I, to preclude U.S. courts from inquiring into the exercise of a regulatory power of a foreign sovereign over the functioning of both its financial markets and, more importantly, of its authority over domestic fiscal policy.313 second, following on the analysis of giving deference to the exercise of a domestic regulatory power in fiscal policy are arguments made in Sabbatino to the effect that judicial abstention would be wise in order to refrain from impeding or embarrassing the executive from discharging its constitutional responsibilities in the realm of foreign affairs.HH Indeed, it is precisely to prevent the embarrassment of the People's Republic of China that then secretary of State George Schultz signed a Statement of Interest (Statement) and forwarded it to the Eleventh Circuit via the DOJ in a bond default case, Russell Jackson v. The Peoftles Republic of China.315 In the Statement, the secretary urged the court to refrain from deciding the case, arguing in part that China's refusal to participate in the case was based on its understanding that it had absolute immunity in U.S. courts.316 Schultz also highlighted China's ability to retaliate economically against the United States should the court proceed to rule against China.317 As such, he argued, the court should refrain from deciding the case on the merits.318 By making this intervention on behalf of China in 1983, only a year before it made contrary arguments in Allied II, the DOJ effectively contradicted the central thesis of its position in Allied II that the contractual rights of the U.S. bondholders prevail over any countervailing considerations of a foreign sovereign.

7. Allied II Encourages Inefficient Allocation of Resources

The recycling of developing world debt through rescheduling promises developing countries sources of capital for their growth and development needs. Debt servicing, however, makes it extremely difficult for these countries to afford imports to generate growth or development. Investment in highly indebted countries is particularly risky as reflected by its highly speculative nature making it hard for indebted economies to benefit from it.319 In addition, increased flows of recycled capital and aid to Africa have acted as perverse incentives supporting regimes and economic policies that did not contribute either to growth or poverty reduction.Ha" Holdouts in sovereign debt litigation only exacerbate these inefficiencies in the capital needs of developing countries.

Recent statistics on foreign direct investment in Africa demonstrate that although economies that are strong and open attract more foreign investment, some of the leading direct investment destinations in Africa are not the politically stable and growing economies on the Continent but rather are countries like Angola and Mozambique.8al Certainly, these countries have undergone some macroeconomic reforms supported by the Bretton Woods institutions but not nearly as well as countries such as Botswana, which have had a longer record of political stability and relatively liberal economic policies.3^ Capital flows to politically unstable countries, though important, may be inefficiently utilized thereby fueling the cycle of indebtedness.

To overcome muddling through the debt crisis through repeated recycling of capital as well as to address the opportunistic tendencies of holdouts in debt restructuring requires making it possible for indebted sovereigns to wipe out large portions of their debts held by commercial banks. Indebted sovereigns would also have to commit themselves to starting afresh by maximizing the use of any new capital and adopting economic reforms that would create new wealth and development opportunities. Stich a vision of reform would also count on the willingness of commercial banks to share in "a certain rough justice," in the words of the Wall Street Journal, since they too bear part of the responsibility for creating the debt crisis.323 In Part IV, I make a more modest reform proposal addressing only part of the larger problem-that of holdouts in sovereign debt litigation.

8. The Extinction of the Champerty Defense: The Ghost of Allied II?

In theory, the champerty defense under New York law might help an indebted country faced with a holdout. Here the country would argue that the acquisition of a debt for the primary purpose of enforcing it by resorting to litigation would be champertous and a violation of New York law. New York courts have, however, held that a violation of the champerty law is only possible where the primary purpose of the purchase is to bring an enforcement suitthus the champerty defense does not apply in a case where some other purpose induced the purchase and the intent to sue was merely incidental or contingent.^1 Hence, just as New York courts have moved the enforcement baseline from repudiation to simple default, they have extinguished the champerty defense. In Turkmani v. Republic of Bolivia (Turkmani)325 for example, the second Circuit held that the purchase of bonds as an investment was a legitimate business purpose and suing for failure to pay on the bonds was only incidental and not harassing litigation since it only involved the collection of a debt owed under a contract.326 The court made the distinction between suing, which is prohibited under the champerty law, and collection, which is not.327 Such a construction of New York champerty law is not necessary or even inevitable. The equities in Turkmani would have been weighed consistently with New York law to find in favor of the foreign sovereign if the Court gave the champerty law its intended meaning of prohibiting the purchase of debt for the purpose of suing on it.

In Elliott Assocs., L.P. v. Banco De La Nacion,(Elliott) the plaintiffs appealed two judgments of the SDNY dismissing plaintiffs' complaints to collect certain debt purchased from international banks.328 The defendants, a foreign bank and a foreign government, asserted that Elliot was assigned the debt for the primary purpose of enforcing it through legal action, which violated New York's champerty law.329 In particular, the defendants argued that Elliot awaited the outcome of the Pravin Banker case, especially on the question of assignment, before bringing their enforcement action.330 This, according to the defendants, demonstrated a calculated goal of purchasing the debt with an intent to sue.331 The district court found that plaintiff was the lawful assignee of the debt and that the defendant foreign government guaranteed the debt and both defendants were liable on the instruments.332 Recovery was therefore denied.333

The question on appeal therefore was whether the plaintiff's acquisition of the debt for the primary purpose of enforcing it by resorting to litigation in violation of New York's champerty law.334 The Third Circuit held in the negative on the basis that the intent to litigate was incidental and contingent and did not violate the champerty law.335 Hence, although the plaintiff knew that the defendant government would not pay in full, this did not make plaintiffs intent to file suit any less contingent. Further, the fact that enforcement of the assigned debt awaited the outcome in Pravin Banker did not undermine the Plaintiffs contractual right to enforce.

The Third Circuit therefore construed the champerty law to be "violated only if the primary purpose of the purchase or taking by assignment of the thing in action is to enable the attorney to commence a suit thereon."336; "The statute does not embrace a case where some other purpose induced the purchase, and the intent to sue was merely incidental and contingent."337 According to the court, the critical factor in determining whether or not the champerty law should be applied is whether there is an "absence of any purpose for the assignment except bringing legal action and the non-discretionary obligation to bring suit."338

In my view, the Elliot decision goes to fortify the rights of holdouts even further since the test the court developed to establish whether there is an intent to resort to litigation with a view to enforcing an assigned debt is invariably considered incidental and contingent. In other words, any motive for a debt assignment other than an intent to litigate in enforcing the assigned debt can pass muster. The threshold it sets is far too low-anything goes.

The Elliot court further cites Pravin Ranker in asserting that the policy considerations of the United States would be undermined through a broad interpretation of the champerty law. In particular, the court observes that a different construction of the champerty law would "undermin[e] the voluntary nature of Brady Plan participation [thereby] rendering otherwise valid debts unenforceable."339 In effect, the court's finding can be construed as being consistent with the view that that a creditor should not be penali/,ed for failing to follow the crowd. In other words, a creditor who prefers not to participate in cooperative debt adjustment is within their rights to do so and should suffer no consequences for exercising such rights.340

Ultimately, courts construing sovereign debt contracts have been especially reluctant to give defaulting sovereigns any healing benediction. Litigation in U.S. courts is especially unfavorable to these sovereigns and particularly generous to lenders.

9. Enforcement Dilemmas: The Pan Passu Controversy

Throughout this paper, I have shown how easy it is for sovereign creditors to obtain judgment against a defaulting sovereign. However, enforcing a judgment poses a variety of hurdles. First, some indebted sovereigns have few attachable assets located outside their territories.341 Second, where a sovereign debtor has attachable assets outside their territory, there are legal hurdles that could bar attachment. For example, in the United States, the property of a foreign Central Bank is immune from attachment or execution in the absence of a waiver of immunity.342 Further, under the commercial activity exception to execution immunity, property sought to be attached for enforcement in the United States must be "used for the commercial activity upon which the claim is based."343 However, in a recent case, the Fifth Circuit found that since Congo had used a substantial portion of tax and royalties revenues it earned from oil and gas exploration to repay another judgment creditor, this revenue was not immune from execution under the Foreign Sovereign Immunities Act.344

Judgment creditors have sought to overcome the limitations of enforcing their judgments in a variety of ways. For example, in 2004, following Argentina's historic default in 2001,345 the Southern District of New York granted summary judgment in several cases to plaintiffs seeking to collect on the defaulted bonds.346 After initially refusing to certify a class of U.S. bondholders seeking to enforce their judgments, the court certified the class347 and expanded it to include Argentine bond holders.*48 These class certifications unified a varied group of judgment creditors who had held a variety of instruments in an almost unprecedented manner.349 Prior to certification, the Southern District of New York had already granted summary judgment and allowed bond holders to collect on the defaulted Argentine bonds.350 These certifications then laid the basis of novel enforcement claims.

One such claim revolves around the pari passu clause in sovereign debt instruments. Pari passu clauses appear in standard form in most sovereign bond indentures. The pari passu clause in the Argentine indentures in Macrotecnic Int'l Corp v. Republic of Argentina (Microtecnic)351 for example provided that:

The Securities will constitute. . .direct, unconditional, unsecured, and unsubordinated obligations of the Republic and shall at all times rank pari passu and without preference among themselves. The payment obligations of the Republic under the securities shall at all times rank at least equally with all its other present and future unsecured and unsubordinated External Indebtedness (as defined in this Agreement).352

Several judgment creditors relied on this clause in seeking attachment orders in a number of cases before the Southern Distict of New York. In NML Capital Ltd v. The Republic of Argentina (NML Capital), for example, the Southern District of New York had ordered an attachment of $7 billion worth of Argentine bonds. The judgment creditors argued that, under this clause, Argentina could not decide against paying on their judgment while simultaneously continuing to pay other bondholders.353 Specifically, they argued that they could attach Argentina's bonds that had been surrendered to Argentina by security holders in anticipation of receiving new bonds at the time of closing of a restructuring of the bonds.354 According to the judgment creditors, Argentina's receipt of the bonds constituted an attachable property right in the bonds or that at a minimum that Argentina had a contractual right to receive the bonds and that this contractual right was also attachable.355

In support of this entitlement to attachment of Argentina's bonds or the contractual right to receive them, the judgment creditors relied on two Belgium cases in which Peru was held to have violated the pari passu clause by treating one class of unsecured creditors better off than another class.356 Under this argument, the judgment creditors argued the pari passu clause required Argentina to make a payment to them before they could make payments to any other creditors whose indentures had a pari passu clause.357 Remarkably, the Belgian court cited no authorities in its novel interpretation of the pari passu clause that the judgment creditors in the Southern District of New York were now relying on.358 Unlike in the Allied litigation extensively discussed in the earlier parts of this Article, the New York Clearing House (NYCH) weighed in on behalf of Argentina and against the judgment creditors. The NYCH argued that "long standing understanding of these clauses in the market" prohibited a "debtor from creating unsecured debt that ranks senior in legal right of payment to the payment obligations the debtor has to creditors for whose benefit the covenant was made."359 The NYCH further argued that such a broad reading of the clause would disrupt cross border flow of finance and therefore drive up costs of making international payments.360 With regard to the judgment creditors' alternative argument that the clause required Argentina to make ratable payments to all its creditors without discrimination, the NYCH argued that this was 'an absurd and counterproductive proposition."361 Clearly, the judgment creditors were making rather broad interpretations of the clause unsupported by any prior New York interpretation.362

In its decision, the Southern District of New York held against the judgment creditors and vacated its attachment orders.363 The Southern District of New York did not reach the issue of the interpretation of the pari passu clause. Instead, the ratio of its decision was that, if the attachments were allowed to stand, they would jeopardize Argentina's ability to restructure about $60 billion worth of debt.364 In upholding the SDNY, the Second Circuit held it was within the lower court's jurisdiction to vacate the enforcement orders because doing so would avoid "a substantial risk to Argentina's debt restructuring."365 Quite importantly, the court held that restructuring was "obviously of critical importance to the economic health of a nation."366 Thus the Southern District of New York and the Second Circuit agreed with Argentina and the United States that allowing the attachments to proceed would have undermined the well established "consensual, good-faith process leading to a restructuring of debt" and would "do damage to settled market expectations."367 As important an endorsement of cooperative debt restructuring as this statement is, it must be borne in mind that it was made in striking down an effort to expand the rights of bondholders who bought their securities with a view to suing on them while making extremely expansive claims of their rights under sovereign debt contracts.368

V. POSSIBLE SOLUTIONS TO THE ENFORCEMENT LITIGATION STATUS Quo

For all the reasons identified above New York law has a particularly strong pro-creditor bias in enforcement litigation, especially as construed by the Second Circuit. New York creditors strongly object to being subject to foreign law with which they may be unfamiliar and which does not provide the reliability of New York law. The resulting status quo is highly undesirable from a fairness and efficiency perspective, especially for sovereign debtors. This Part proposes some solutions to overcome this status quo which can supplement and perhaps inform proposals such as the Sovereign Debt Restructuring Mechanism,369 the adoption of Collective Action Clauses,370 or the adoption of a rescue and rehabilitation regime akin to the cooperative debt adjustment model.

As noted, New York law is too favorable to creditors. While in Allied II it was clear that when a sovereign borrows from a private lender the sovereign will be treated as a trader,"371 under norms of international commercial law372 there is no guaranteed relief available to a creditor upon default of a commercial loan because, in some circumstances, the government's reason for default can immunize the act, even if the original transaction is commercial.

Under international commercial law, a default is not necessarily "an international delinquency which the state of the creditor is called upon to vindicate."373 In fact, under international commercial law, states engage in protecting their nationals only in the cases where there is a denial of justice, expropriation without compensation or unjustifiable discrimination.374 Under these principles, the considerations before the court in Allied II would have had to balance the contractual rights of the creditor against the national interests of the sovereign debtor. While it is not to be suggested that under such an analysis the second Circuit would necessarily have decided in favor of the Costa Rican banks and against Fidelity, the point is that international commercial law offers a balanced consideration of the law and equities on both sides since it does not have such an obvious pro-creditor bias as New York law does.

Another attractive reason to resort to international commercial law is that unlike under New York law,375 which reads promissory or contractual agreements literally,376 under international commercial law repudiation rather than default is the standard that triggers the right to enforce payment.377 Further, international commercial law does not treat a simple default as a repudiation or confiscation but rather as a declaration of insolvency.378 A repudiation "constitutes a refusal to admit the binding character of an obligation" while a default "admits the binding character of the debt, but pleads inability to meet its terms."379 A default is either good faith inability to pay or bad faith when unwilling.380 A state unwilling to pay may also cite "disability" as a defense.381

Repudiations often occur after a revolution, when a new government refuses to fulfill the obligations of the previous government.382 Under such circumstances, the loan contract is argued to be defective because the previous government did not have legal authority to incur the debt.383 Repudiations are considered a willful breach under international law and they confer on a creditor the benefit of their government's assistance in remedying the breach.384

One way of dealing with the overwhelming pro-creditor bias in New York courts in order to establish a jurisprudence of balancing the equities between creditors and sovereign debtors would be to change the venues of enforcement litigation from New York courts to venues such as international arbitral forums which would apply a hybrid of international commercial legal principles and New York law. This option might be particularly attractive when bond commitments are restructured so that future sovereign bonds would enable sovereigns and creditors to resolve disputes through arbitral forums. This would be in keeping with a general principle of international commercial law, accepted under U.S. law, under which contractual parties ought to have the autonomy to select not only the governing law, but the forum as well.385 In The Bremen v. Zapata Offshore Co., (Bremen)386 the Supreme Court, in upholding such a forum selection and choice of law clause, noted that "[t]he expansion of American business and industry will hardly be encouraged if, notwithstanding solemn contracts, we insist on a parochial concept that all disputes must be resolved under our laws and in our courts."387

A good example of how such a forum might apply the relevant legal regime is Kuwait and American Independent oil Company (Aminoil),388 where the arbitral tribunal argued that the law of the Kuwait also incorporated international law. Instead of declaring that the applicable law was international law, however, the tribunal concluded that the three sources of law-municipal law of the state concerned, general principles, and international public law-should be considered as a common body of law.389 Similarly in Texaco Overseas Petroleum Co., Award of January 19, 1977,390 the arbitral tribunal made reference to principles of law common to the national legal systems of countries involved and to general principle's of international law, bringing the agreement within the domain of international law:391 and requiring reference to rules of international law and, in particular, to rules of the international law of contracts. Such a choice of law rule applied in an arbitral context would overcome the deficiencies of the laws of the foreign (indebted) state and of New York which do not balance the equities between creditors and borrowers particularly well.392

The distillation of international contractual rules from several diverse legal systems has long been favored, particularly in the international arbitral context.393 In addition to the potential of addressing the pro-creditor bias of New York's governing law by turning to principles of international commercial law, arbitration would also reintroduce equitable jurisdiction, particularly because it has ebbed away in the U.S. federal judiciary394 and certainly in New York courts where a sovereign borrower has defaulted. Thus, in the international arbitral context, equity has been invoked as a basis for a general principle of law and in some cases as a ground for departing from law to avoid unjust enrichment.395 Sometimes the invocation of defenses such as force majeure or impossibility of performance, though permissible, has failed in international judicial forums.396 Since arbitral tribunals and international judicial forums are not likely to defeat creditor rights willy-nilly, creditors may be persuaded to accept them as alternative forums. Acceptance would of course be a hard sell from the point of view of the creditors because New York and U.S. courts give them tremendous pro-plaintiff advantages when they sue defaulting sovereigns.397

In contrast to New York courts, arbitrators are also much more likely to take into account all the circumstances of a specific situation and are wary that a contrary approach would be illogical and inequitable.398 Further, arbitral tribunals, unlike New York courts in sovereign debt litigation, have been far more willing to address questions such as whether there is ground to apply contra legem as a basis for departing from strict contractual law on grounds of equity in particular cases.399

Besides the promise of a more balanced choice of law regime, international commercial law and arbitration may be more favorable to developing countries because they lack the financial strength of Wall Street financial institutions. These countries also generally lack the organizational ability to coordinate as an interest group and lack the information gathering abilities of large financial institutions. In addition, foreign states are without the ability to mobilize the democratic process to alter the direction of legal reform in legislatures such as those of New York.400

VI. CONCLUSION

This Article traces the rise of the sanctity of contract doctrine in enforcement litigation. It does so by closely tracking the role of creditor groups in litigation, particularly in the Allied case. I have shown that the second Circuit has adopted a view that favors the interests of creditors at the expense of those of sovereign borrowers. A critical aspect of this view is the virtual elimination of balancing considerations-such as comity and the act of state doctrine-in enforcement litigation. Instead, the adoption of New York law operates to the exclusion of balancing doctrines traditionally applied in litigation involving foreign sovereigns. These courts have also moved the enforcement baseline towards the hair-trigger requirement of a simple default as opposed to repudiation. This Article refers to the type of legal necessity generated by Allied II and its progeny as the doctrine of the sanctity of contracts. This view of sovereign debt contracts ignores the interests of sovereign debtors by displacing any room for safeguarding sovereign interests in private contractual relationships. The outcome of the Allied II decision cannot be understood solely from the perspective that legal doctrine necessarily determined the dispute. Rather, the outcome in Allied II was the result of a very particular legal construction of New York law that favors New York creditors by denying foreign sovereigns defenses traditionally available. Thus, rather than treating the outcome in Allied II as an inevitable result of the doctrines of the law of contracts and the institutional role of New York and federal courts it is as much a result of the politics in the private realm of contracts and property law as well as the outcome of the concerted actions of creditor groups.

In effect Allied II holds, contrary to international commercial law that any default on a sovereign loan contract constitutes a proscribed unilateral modification of the contract.401 While commentators and courts have cited Allied II for this legal proposition, there has been no effort to trace the emergence of this rule to the concerted interest group actions up to now. This Article demonstrates how creditors as an interest group used litigation to shift the baseline of enforcement of sovereign loan contract obligations to simple default and away from the much higher threshold of repudiation or renunciation. Allied II shifted almost all the risks of sovereign lending to borrowers inconsistently with the then emergent principle of cooperative debt restructuring under which the risks and benefits of sovereign lending were determined between lenders and borrowers in conjunction with the IMF.402 Allied II is, in this sense, a crucial decision because it gave creditors enormous bargaining leverage over indebted borrowers by establishing simple default as the enforcement baseline.403 Allied Ifs doctrine of judicial abstention in the face of such "freely" negotiated contracts simply ratified whatever allocations of risks and benefits were reflected in the contracts.

As a reform proposal, I favor the use of international arbitration and international commercial law in sovereign loan default cases. In contrast to the second Circuit in particular, international arbitral forums have shown more willingness to adopt widely recognized principles of international commercial law. The use of international commercial law would help in overcoming the procreditor bias of New York law and the objections to application of the laws of foreign sovereign debtors in enforcement litigation. In addition, these forums are arguably less likely to adopt a doctrine of sanctity of contracts on a per se basis against foreign sovereign debtors in the event of an inadvertent default. This proposal is at best futuristic. By that I mean, that if accepted, these proposals are likely to be included in future lending contracts rather than finding acceptance with respect to preexisting loan contracts. The Supreme Court's view in Bremen that the United States cannot expect to trade with other countries exclusively on its own terms and its laws in this era of global commerce reminds us that where parties choose international arbitral forums and international commercial law to decide and govern their contracts, domestic courts should respect their wishes.404