Sovereigns and Safety Valves in the Legal Theory of Finance

Katharina Pistor’s ‘Legal Theory of Finance’ (LTF) is an important contribution to our evolved understanding of international finance following the most recent (and in the case of Europe, ongoing) international financial crises. By probing the implications for international finance of that fundamental or irreducible uncertainty about the future that both Keynes and Knight described in 1921 – but which has all too damagingly been forgotten or suppressed for most of the time since – Pistor helps us better understand both the positive and negative relationships between law and financial crises. This post begins by singling out a key point made by Kathryn Judge in her comment on LTF, then explores some applications of LTF to the special context of sovereigns and sovereign debt markets.

Kathryn Judge’s comment on Pistor’s theory sheds light on a number of aspects of LTF. Most useful for the purpose of this post is how Judge calls attention to Pistor’s implicit argument that in a crisis, “liquidity support can function as a substitute for treating law as elastic.” This allows the satisfaction of private market participants’ claims and thus avoids the need for a government-sanctioned alteration of otherwise binding contractual commitments (through bankruptcy proceedings or otherwise). It follows, Judge notes, that “the more aggressive and creative central banks are willing to be in the provision of liquidity, the easier it may be to maintain the façade that legal obligations are fixed rather than inherently contingent and elastic.”

What I think is significant about this is that it suggests that the key choice for the role of law in international financial crises can be seen not as a binary one between inelastic or elastic enforcement of legal obligations, but effectively ternary: (1) inelastic enforcement, (2) elastic enforcement, or (3) the extralegal (in the sense that it is not legally required[1]) provision of extraordinary liquidity. (This will typically be provided by one or more official sector actors that have direct or indirect access to central banks capable of creating theoretically unlimited liquidity.) For convenience, I will refer to this third alternative as the official bailout option.

Thus far my discussion has focused chiefly on the possible courses of action when private market participants encounter distress during a major financial crisis. In the remainder of this post, I want to focus on the application of LTF to sovereign market participants – most importantly as sovereign debtors – during financial crises. I will suggest that although some of the four elements of LTF look somewhat different in the sovereign context, the core substantive points of LTF remain valid and useful.

Pistor’s first element of LTF is that modern financial markets are rule-bound systems. “There is … no financial system of substantial scale that is not backed by a formal legal system with the capacity to authoritatively vindicate the rights and obligations of contractual parties or to lend its coercive powers to the enforcement of such claims.”

As Pistor notes elsewhere, however, the sovereign debt market is famous for the practical limitations on the ability of creditors to enforce their contractual claims against assets of a sovereign in the event that the sovereign defaults. While all sovereign debt is issued under the governing law of some jurisdiction (foreign or domestic), and, in the event of a default, a creditor can usually win a judgment confirming the claim (even from a domestic court of the issuing sovereign), successful enforcement of such claims against actual sovereign assets when the sovereign is resistant is generally the exception rather than the rule. As Professor Anna Gelpern (a participant in the LTF research program) once noted in another context, “The base asset [of the sovereign debt market] is probably the most bizarre one out there. It’s an unenforceable obligation.”[2]

Nonetheless, as Pistor notes, “most states pay most of their debt most of the time, if not out of fear of being sued, in order to secure future access to capital markets.” Furthermore, as Gelpern and Gulati describe in detail in their account of the nearly two decade-long policy drama over the inclusion of Collective Action Clauses (CACs) in sovereign debt instruments of both developing and developed countries, sovereign debt issuers go to great lengths to portray their promises to pay as rock-solid, and typically have expressed significant reservations about any measures (such as the inclusion of CACs) that could be read as suggesting that there might be any ‘flex’ to the claim. With respect to sovereign debt markets, LTF’s first element might thus be stated more broadly that despite the ability to qualify legal commitments that is a defining feature of sovereignty (and which distinguishes sovereigns from non-sovereign market participants that cannot define the law), sovereigns typically do their utmost to act as if the market for their sovereign debt is very much a rule-bound system.

The second element of LTF, financial markets’ essential hybridity – involving both public (i.e., state) and private (i.e., market) elements – is obviously the case in the sovereign debt context in which state debtors borrow from private creditors. Even when sovereigns borrow from other sovereigns (or international financial institutions), such borrowing almost always coexists with and has important financial implications for private borrowing.

The third element of LTF, which I think is in many ways the most profound contribution of LTF, is also where the sovereign context is most distinctive. This is what Pistor calls the law-finance paradox: “Law lends credibility to financial instruments by casting the shadow of coercive enforceability over them. But the actual enforcement of all legal commitments made in the past irrespective of changes in circumstances would inevitably bring down the financial system.”

Initially, the application of LTF to the scenario of a sovereign debtor in distress during a financial crisis does not look that dissimilar to its application to a systemically important private financial institution in distress. If we return to Judge’s refinement of Pistor’s point discussed at the outset, there are three options: (1) inelastic enforcement of the debt claims against the sovereign, (2) elastic enforcement of the claims (e.g., a restructuring/reprofiling of the claims), or (3) the extralegal provision of extraordinary liquidity, i.e., an official bailout.

The premise of the law-finance paradox is that in at least certain kinds of financial crises, sticking to the first option of inelastic enforcement – normally the most intuitively attractive course of action – will exacerbate the systemic crisis and risk blowing up the financial system. That leaves us with options two and three: elastic enforcement or official bailout.

It is at this point that the distinctiveness of the sovereign context comes squarely into view. For non-sovereign (i.e., private) market participants in distress, there are legally established national institutions and procedures for ensuring that the losses from the elastic enforcement of claims (e.g., haircuts to debt claims) are shared in what is regarded as an equitable manner – namely, bankruptcy regimes. Among the functions of such regimes is to prevent some similarly situated market participants from pursuing the inelastic enforcement of their claims while everyone else has to accept elasticity. This makes it possible for there to be a collective and consistently followed decision to elect the elasticity route. In the international context of sovereign debtors, however, there is no such universal legal institution (whether an international bankruptcy regime or some kind of universal convention for contracts). Consequently, in the sovereign context there is what looks like – in comparison to the more explicit regimes for non-sovereigns – a greater degree of risk with respect to whether it will be possible to collectively and consistently pursue the second option of elasticity.[3]

Traditionally, the result of this appearance of greater risk in the sovereign context has been to push policymakers towards the third option, official bailout. (By contrast, adequate confidence in the feasibility of option two often – although not always – leads the official sector to take option three off the table). For the sovereign’s creditors, the official bailout option also has the not insignificant advantage that they escape having to suffer the losses of the elasticity option. In sum, this account of how the law-finance paradox of Pistor’s LTF plays out in the sovereign context helps to explain why in sovereign financial crisis the tendency has often been neither inelastic nor elastic enforcement of claims but option three, official bailout.

However, from the perspective of the official contributors to the bailout (other sovereigns and their taxpayers), option three is suboptimal, because the risk of losing the bailout funds now lies with them. (They may also be concerned about encouraging moral hazard on the part of bailed-out creditors.) Bailout contributor concern about financial risk to their contribution in turn often leads to an insistence on austerity conditions for the sovereign debtor, which sometimes encourages beneficial fiscal reforms but is often regarded as suboptimal by the officials and citizens of the sovereign debtor as well.

Of course, five years into the Eurozone financial crisis, the observation that official bailouts are seen as suboptimal by both the contributors to sovereign bailouts (e.g., Germany) and the debtor governments and citizens who receive the funds conditioned on painful austerity measures no longer qualifies as news.[4] I therefore conclude with the question of whether Pistor’s LTF helps illuminate any alternative path towards a better resolution of sovereign financial crises.

Pistor’s most detailed description of LTF concludes with the statement that “One of the major lessons LTF holds is that we need more safety valves …  – not only at the apex where law tends to be relatively more elastic, but also on the periphery of the system.” I agree wholeheartedly with Pistor that “safety valves” are necessary in order to escape what she has with great insight described as the law-finance paradox posed by international financial crises. A dogmatic insistence that pacta sunt servanda will not save us (and could well doom us).

Nonetheless, I think the frontier of this important discussion now needs to shift to a rigorous discussion about the advantages and disadvantages of different kinds of safety valves. On this I offer three brief (and necessarily preliminary) thoughts in closing.

First, to reiterate the point made by Kate Judge with which I started, crisis liquidity support – or what I’ve called in the sovereign context official bailouts – can function as a substitute for treating law as elastic. Because it doesn’t require explicitly acknowledging that we are departing from classic inelasticity (and, not insignificantly, because creditors do not have to take losses) this approach has often been the safety valve of first resort.  However, as we’ve gradually been learning (and have learned repeatedly before), bailouts are not without costs, including (among others): moral hazard for bailed-out creditors; tension with the democratic norms that normally govern taking risks with public money; international insistence that debtor sovereigns subject themselves to excessive austerity (perhaps as a conscious or unconscious reflection of contributing governments’ defensiveness about this ‘democratic deficit’ in the ‘court of public opinion’); and last but not least, actual fiscal limitations on the resources prudently available for this social use. I think this is more than just a matter of insisting on accompanying ‘private sector involvement’ or ‘bail-in’ transactions (although that too is important).

Second, regarding non-bailout safety valves or institutional mechanisms for elasticity, the two that have received the most attention are contractual Collective Action Clauses and some kind of statutory sovereign bankruptcy regime. Like bailouts, neither of these is without limitations. For CACs, the limitations are technical (in the sense that their reach is limited), and as Gelpern and Gulati have shown in their LTF article, political (in the sense that they have arguably distracted the attention of Eurozone policymakers from matters that might have made a bigger contribution to the resolution of the Eurozone financial crisis). For a sovereign bankruptcy regime, the limitation is political in a different sense. Given international politics, few informed observers believe that an international agreement to transfer sufficient sovereignty to establishing anything approaching a fully functioning regime is very likely. While it might be possible to reach agreement on a very modest start toward some such international regime, which might develop over time and someday end up as  a more substantive body, it will be worth asking the same kind of question Gelpern and Gulati have asked in retrospect of the emerging market and Eurozone CAC initiatives: is this possibly quixotic venture the most effective use of international policymakers’ and lawyers’ finite time?

Finally, Keynes’ and Knight’s emphasis on the phenomenon of inherent uncertainty, and Pistor’s and LTF’s important point about the relationship between this systematically underappreciated quality and the need for elasticity and adaptability in contracts – particularly, I would argue, in international debt contracts with sovereigns –  raises a more basic question about both law and policy in international finance. If the irreducibility of uncertainty about the future means that some kinds of international financial crises are inevitable, and if (for the time being at least) there is no supranational regime with the authority to enforce elasticity regarding international contracts such as sovereign debt instruments, shouldn’t the common law of responsible sovereigns (that possess common law systems) more explicitly recognize the need for elasticity in the event of international financial crises? U.S. law regarding elasticity in U.S. law-governed sovereign debt contracts has been inconsistent on this question over the years, in part because our judicial doctrine calls for deference to the executive branch in foreign affairs and executive branch policy has been inconsistent.  In the end, one of the major implications of Pistor’s Legal Theory of Finance (with Gelpern and Gulati’s cautionary tale about CACs as a somewhat over-hyped “wonder-clause” just one illustration) might be the advantages of an approach that relies neither on explicit contractual language nor on international statutory authority, but is simultaneously more flexible and potentially more universal: the acknowledgement in common law doctrine of the irreducibility of uncertainty in international affairs, and the concomitant recognition of the value of prudently exercised safety valves for sovereign debt contracts in the event of sovereign financial crises.

[1] This is, incidentally, how Pistor defines power in the context of the fourth element of LTF, which holds that “law is more elastic at the apex than on the periphery of the financial system, and where law is elastic power becomes salient.” Pistor, “Law in Finance,” J Comp Econ 41 (2013), p. 312.
[2] Quoted in The Economist, “Sovereign debt markets: An illusory haven,” April 20, 2013.
[3] Note that my argument here is about the perception of (relative) risk; in fact, I think that the history of contemporary sovereign debt restructurings (from the late-1990s to present) shows that this risk can usually be adequately controlled in a well-managed debt restructuring.
[4] For some recent soul-searching by the IMF about lessons to be learned from recent sovereign debt restructuring experience in general and key elements of the Eurozone crisis in particular, see IMF, Sovereign Debt Restructuring – Recent Developments and Implications for the Fund’s Legal and Policy Framework, April 26, 2013, at; and IMF, Greece: Ex Post Evaluation of Exceptional Access Under the 2010 Stand-By Arrangement, May 20, 2013, at