Guest post: Mr Putin’s clever bond issue

Guest writer | Mar 10 10:30 | 20 comments | Share

What to do when your creditor invades? Beyond its occupation of Crimea, Russia remains a lender to Ukraine — even as IMF teams ponder the Kiev government’s financial sustainability. Mitu Gulati, a law professor at Duke University, considers both sovereigns’ options.

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In December 2013, Russia lent Ukraine $3bn as the first part of a $15bn assistance package. At the time, few paid attention to either the form that the lending took (a Eurobond) or to a small contractual innovation in the bond issue. Things have changed.

The Yanukovich government is gone, Crimea is trying to secede with the help of the Russians, and Ukraine is on the brink of defaulting on its debt payments unless a substantial EU bailout package is forthcoming. It is in this context that the new contract term and the form of the Russian lending might be important.

Having cut ties with Russia, Ukraine needs a substantial debt relief package from the EU and is likely to receive it (along with some IMF assistance). The question though is how much of that relief will come from an EU taxpayer bailout and how much will come from haircuts to the claims of private creditors. The answer to the question will depend, as it always does, on who the creditors are. The more unpalatable the creditors, the less willing taxpayers are going to be to subsidise them.

In this case, thanks to that new contractual provision that was placed in the bond in December 2013, Russian President Vladimir Putin is likely to have a big claim coming due soon.

The provision in the bond contract, 4(b), titled, “Debt Ratio” reads:

So long as the Notes remain outstanding the Issuer shall ensure that the volume of the total state debt and state guaranteed debt should not at any time exceed an amount equal to 60 per cent of the annual nominal gross domestic product of Ukraine.

For a sovereign bond, this is an unusual provision. As part of my research, I have been reading sovereign bond contracts for years and have never seen one of these. That is, where the creditor is essentially allowed to declare his debt due and payable immediately if the 60 per cent ratio of debt to GDP is crossed. Understanding how this provision is likely to play out might tell us why Mr Putin may have demanded this provision a few months ago.

When Russia lent Ukraine the $3bn in December, the debt-to-GDP ratio, as reported by the Ukraine Ministry of Finance, was just north of 40 per cent. Sixty percent was a long way away. But if one factors in the loss of Crimea, the inevitable economic consequences of the unrest throughout the country and — lest we forget — the inevitable drop in GDP that follows IMF-prescribed austerity, that ratio is probably going to clear the 60 per cent threshold. And when it does, Mr. Putin can declare the entire $3bn due and payable immediately. Put differently, the Russian loan that, on its face, had a duration of two years is, thanks to the combination of the Debt Ratio covenant and Russian activities in Crimea, effectively a demand note (subject to the typical 30 day grace period).

At this point, anyone familiar with the world of sovereign debt restructurings will likely ask two questions.

(1) So what if Russia has a contractual right to accelerate? Russia is not an ordinary commercial creditor. It is a member of the Paris Club; the exclusive club of rich creditor countries that gets together periodically in Paris to renegotiate debts that its members have with distressed debtor nations. Surely, as a member of the Paris Club, the rules that will govern Russia’s debt renegotiation with Ukraine will be those of the Paris Club rather than those of the contract (including acceleration provisions).

(2) In any event, doesn’t Ukraine have a defence that these are Odious Debts and, therefore, void under international law? After all, this is a case of a lender (Russia) who surely knew (or should have known) that the regime it was lending to could have been systematically looting the funds coming in from the borrowing.

Both are good questions. And the answer to both may well be yes. But this is where Mr Putin’s clever structuring of the December 2013 lending as a tradable and liquid Eurobond, as opposed to the typical illiquid country-to-country Paris Club lending, comes into play.

If Mr Putin senses that the Ukraine is planning to skip out on payments to him, all he needs to do is to quietly sell his bonds to some private enterprise that can then plead complete innocence regarding any kleptomaniacal tendencies of the prior Ukrainian regime. Indeed, he may not even need to sell the bonds; warehousing them with a Russian bank will probably be enough. The success that holdout creditors have had with English law governed bonds (the same law of the Ukrainian December 2013 issue) in the 2012 Greek restructuring might produce a large set of willing and eager secondary market purchasers for these bonds.

Game, set and match to Uncle Vlad?

Perhaps not. He may have been clever in his structuring of the lending in Eurobond form and in the insertion of the Debt Ratio covenant. But the Ukrainians, should they choose to, can be equally clever. All they need to do is read a few provisions down from 4(b) and they will find, in 6(b), the Payments provision, a potent weapon with which to counter Mr. Putin. This is essentially the same provision that Cyprus had in its foreign-law bonds, which it could have used in order to restructure them last year. They ultimately chose to use bailout funds to pay their private creditors in full and on time. Ukraine may not do the same. Suffice it to say, things are going to play out in an interesting fashion.

Related links:
Ukraine $1,984,838,000 5.00 per cent Notes due 2015 — and the burning tyres therein – FT Alphaville
So long, Ukraine $1,984,838,000 5.00 per cent Notes due 2015 – FT Alphaville

http://ftalphaville.ft.com/2014/03/10/1793702/guest-post-mr-putins-clever-bond-issue/#