Russia's default on its foreign currency sovereign bonds is unprecedented and likely to lead to bondholder litigation as well as derivatives disputes. This article highlights the reasons for Russia's default and explores the scope of potential bondholder litigation, together with some of the obstacles which bondholders may face in bringing claims against Russia. The article then considers the ripple effect on the derivatives market, where it is possible that investors in products linked to Russian debt may seek to recover losses by bringing mis-selling claims.
Russia has defaulted on two series of foreign currency sovereign bonds (a US dollar denominated bond due to mature in 2026 and a euro denominated bond due to mature in 2036). The reason is unprecedented: it is able to pay bondholders but effectively prevented from doing so by Western sanctions. This article considers the Russian default from a disputes perspective and considers some of the litigation risks which may arise, both under the bonds themselves and in respect of a range of credit derivative products which reference the bonds.
As part of the sanctions imposed on Russia following its invasion of Ukraine in February this year, the US, UK, EU and others banned certain transactions with the Russian Central Bank (effectively freezing Russia's foreign currency reserves), designated multiple financial institutions, and implemented a range of other restrictive measures. In May this year restrictions were further tightened when the US decided not to extend a licence which had permitted the Russian Central Bank to service its sovereign dollar debts. Shortly afterwards, the EU sanctioned Russia's National Settlement Depository.
Interest payments of approximately $100m on the bonds fell due on 27 May 2022. It is reported that Russia has paid the sum into its Euroclear account at the National Settlement Depository, but Euroclear (the clearing house responsible for transferring coupon payments to bondholders) has not made any onward payment to bondholders due to the sanctions. The grace period expired 30 days later, with Moody's declaring on 27 June 2022 that the missed coupon payment constituted a default. This is the first (major) default on Russia's foreign debt since the Bolshevik revolution in 1918.
Russia denies that there has been a default. It is able to pay, reportedly receiving $1bn per day from oil and gas exports and appears committed to trying to do so. Russia has sought to put in place a workaround to allow bondholders to receive funds "outside of Western financial infrastructure". President Putin signed a decree in June under which payment in roubles will be made into Russian banks at which bondholders would need to open an account. Bondholders would be permitted to convert the roubles to forex and transfer the funds abroad. The decree states that Russia's obligations "will be considered properly fulfilled if they are executed in roubles in the amount equivalent to the value of obligations in foreign currency". It is not clear whether any foreign bondholders intend to (or will, compliantly with sanctions, be able to) accept these arrangements.
Around half of Russia's $40bn of foreign currency bonds is thought to be held by international investors, including asset managers, pension funds, insurers and other investment companies. Prior to the invasion of Ukraine the bonds were generally trading at above par. Since then, their price has dropped dramatically, into the region of 20-30 cents in the dollar or below. It is reported that hedge funds and distressed debt funds have been buying up the debt at discounted levels, and stand to make substantial gains if they can be repaid at par or anywhere near (bars on US investors buying Russian debt in the secondary market slowed such activity earlier in the year, but it is on the up since new guidelines were introduced in July to enable bondholders to wind down their positions).
This raises the prospect of bondholder litigation against Russia. The most highprofile example of this arising from an historic sovereign bond default, is the very long-running litigation brought by US hedge funds against Argentina following its default on $80bn of debt in 2001, in which the hedge funds ultimately succeeded in recovering sums which were many multiples of their original investment.
Any bondholders litigating against Russia will face a number of obstacles. The first is jurisdiction. The bonds are governed by English law but do not contain a jurisdiction clause and expressly state that Russia has not submitted to the jurisdiction of any court. Russia may well challenge jurisdiction in any proceedings brought in the courts of a Western state, for example on grounds of forum non conveniens. The second is sovereign immunity. Under the terms of the bonds Russia has not waived any of its rights to immunity from being sued or from its property being subject to any process of enforcement of a judgment. However, in the English courts at least, bondholders may well be able to rely on exceptions to immunity under the State Immunity Act 1978, if they can show that the bonds are "commercial transactions" and that any Russian assets they seek to enforce against are being used "for commercial purposes".
Third, Russia may raise a number of substantive defences. As discussed above, Russia says there has been no default and is seeking to put in place alternative arrangements under which payment would be made in roubles into Russian bank accounts. However, under the terms of the bonds, payment is to be made to accounts outside of Russia. Further, while both series of bonds provide that Russia may pay in certain alternative currencies if for reasons "beyond its control" it cannot pay in dollars or euros, roubles are only included as an alternative currency in the most recent series of bonds. Another defence Russia may run is that sanctions have rendered it impossible to pay bondholders and Russia is therefore discharged from its contractual obligations to do so under the doctrine of frustration. The bar to proving that a contract has been frustrated is high, due to the draconian consequences of the doctrine being invoked. It is not available if the party relying on the doctrine is itself to blame or at fault for the frustrating event, which the bondholders might argue is the case here, on the basis that Russia's invasion of Ukraine was the cause of the sanctions.
Finally, bondholders will also be considering the political situation. The bonds provide that any claims must be brought within three years. At present, it is understood that bondholders have not triggered acceleration, which they can do if the holders of at least 25% of the bonds agree. This would mean that all interest and principal would become immediately repayable. One possibility for bondholders is to wait until the war is over, when Western sanctions may be lifted and there may be a realistic prospect of engaging with Russia for a negotiated settlement. It is also possible that at some stage Western policymakers may change course, and decide that it is preferable to permit foreign creditors to be repaid rather than for the funds to remain with Russia, potentially available for use in the war against Ukraine.
An alternative route for bondholders could be a claim under a bilateral investment treaty, which are intended to protect foreign investors and creditors from adverse state action, and enable disputes to be referred to arbitration. Russia has bilateral investment treaties in place with many states, including the UK and the EU.
Bondholders are of course not the only investors exposed to Russian sovereign debt. There are a range of credit derivative products which reference Russia's foreign currency bonds, including CDS contracts, credit linked notes and credit indices. Holders of CDS contracts often buy them as protection for bonds or other Russian instruments they hold, and so there is a connection and symmetry between the two markets.
Significantly, Russia's sovereign bond default has triggered a "Failure to Pay Credit Event" under Russian CDS trades. The result is that holders of outstanding CDS on Russian debt (believed to total around $2.4bn) will receive a payout, although they are still also exposed to considerable uncertainty and risk. The usual process following default is for the payout on CDS contracts referencing the underlying debt to be determined through an auction arranged by the International Swaps and Derivatives Association (ISDA). The price paid for the bonds in the auction sets a market-wide recovery rate to be paid out on the CDS, to compensate CDS protection holders for losses incurred on the bonds. But because the auction process involves the purchase of bonds, there were concerns that it may have been illegal under the sanctions. In that case, there are various fallback mechanisms to set prices for CDS payouts. However, without a functioning market in the underlying bonds to allow for price discovery, any prices set would be likely to be controversial, with potential incentives for CDS holders who consider they have been disadvantaged to bring claims.
Recent developments have brought some more clarity. Following a waiver provided by the US Office of Foreign Assets Control (OFAC) in July, ISDA's Credit Derivatives Determination Committee (ISDA DC) has decided that an auction can take place in September, although it is continuing to consider the potential impact of the restrictions on how the auction will operate.
While many CDS contracts will be on the ISDA auction terms, there will be a significant minority that are not and are on bespoke terms. Most market participants are likely to follow the ISDA DC's final conclusion, but there is naturally more risk of uncertainty and disputes on CDS contracts which are on bespoke terms.
History suggests that a Russian default could prompt related derivatives disputes in this jurisdiction. When Russia defaulted on its domestic debt in the financial crisis of 1998, various claims were brought in the English courts by investors in derivatives linked to Russian debt. The most prominent was Springwell v JPMorgan Chase Bank & Ors, in which a Greek shipping group sued the bank for around $700m relating to investments in "GKO-linked notes", which were short-term structured (ie derivative) instruments issued by the bank and referenced to rouble-denominated bonds.
Springwell alleged negligent misrepresentation against the bank and breach of various contractual, tortious and fiduciary duties in advising it to invest in the notes. Springwell's claims were ultimately dismissed, but it became a landmark decision in financial services disputes. Part of Springwell's case was based on misrepresentations it alleged the bank had made about Russia, the state of the Russian economy, and the risk of Russia defaulting on its debt obligations.
While the reasons for the present Russian default are very different from those in 1998, it is possible that investors in products linked to Russian debt may seek to recover losses by bringing mis-selling claims of a similar type to those seen in Springwell. This risk may be impacted by the particular features of Russia's bonds, such as the ability to pay interest in alternative currencies, no submission by Russia to the jurisdiction of any court and no waiver of sovereign immunity.
Russia's default is driven by geopolitics rather than an inability to service its debts. This context means that many of the legal and commercial issues that arise are novel and may ultimately fall to be resolved through litigation.
Originally published in the September 2022 edition of JIBFL.
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