Sovereign bonds’ loose ends
di Hal S.Scott
5' di lettura
A key purpose of an Italian withdrawal from the euro area would, of course, be currency redenomination: providing that contracts and instruments (including sovereign bonds) in euros could be repaid in a new, devalued national currency. The stark reality is that Italy could not successfully do so without the agreement of the EU and other major markets around the world (1).
The process of making redenomination effective within a withdrawing Member State, between Italian debtor and creditors, is relatively straightforward. Italy simply would pass legislation providing that in Italy all contracts specifying payment in euros — from government bonds to commercial loans to home mortgages — were to be satisfied in the new lira. Italy and the other Member States within the euro area are intimately familiar with this process, since they had to pass similar enabling legislation to adopt the euro when they first joined the monetary union. This would mean, for example, that mortgages between Italian residents and Italian banks could easily and effectively be redenominated from euros to new lira.
There are collective action clauses (CACs) in Italian bonds, recently issued under Italian law, requiring a super-majority of creditors (in principal amount) to approve changes in currency in order to bind all bondholders. But Italy could easily nullify these clauses by just canceling the requirement as part of its new redenomination law. This would be the reverse of what Greece did in 2012 when it inserted new CACs into outstanding sovereign bonds to allow a majority of creditors to block attempts of holdouts to resist bond restructuring. Anything issued under local law can be changed by local law.
In theory, one might question whether redenomination would be subject to attack as a matter of constitutional law. But this is unlikely to be a problem in Italy since past devaluations of the lira were not challenged, and the basis for doing so seems weak. Italy still might confront challenges based on protections enshrined in binding international human rights law, notably the European Convention on Human Rights, but these treaties allow deviation in cases of emergency.
While making redenomination effective within a Member State would thus be relatively easy, effecting redenomination outside of the country's jurisdiction (between foreign creditors and Italian debtors) would be substantially more difficult.
Unlike the courts of the withdrawing Member State, which would be bound to apply its national redenomination law, foreign courts (both within and beyond the E.U.), where contracts would undoubtedly be challenged, would have a choice of which jurisdiction's law to apply. Depending on the law they selected, they might well find redenomination illegal. This would be very bad news for Italian debtors who would still have to pay in Euros, while their assets and revenue in Italy would be devalued.
In the ordinary case of a single country moving from one currency to another, the choice-of-law question is relatively straightforward and likely to result in a finding that redenomination is effective. Courts generally apply the lex monetae, the law of the currency issuer. For example, when the hyperinflation of the 1920s forced Weimar Germany to replace the Mark with the emergency Rentenmark and eventually the permanent Reichsmark, foreign courts enforced redenomination because it was legal under the lex monetae — German law.
In the case of withdrawal from a currency union, however, there is no clear lex monetae. Thus, if Italy withdrew from the euro area and mandated that euro contracts were to be redenominated in new lira, Italy would be the issuer of the replacement currency, but the Member States of the euro area would remain the joint issuers of the replaced currency.
F.A. Mann, the most important scholar on such matters, years ago proposed a solution to this dilemma: courts should apply the law specified in the legal instrument at issue — the “law of the contract” (2). If applied, this solution would help Italy on the public side since most public debt is issued under Italian law, about 94% as of 2012. However, private obligations often specify that they are governed by the law of another jurisdiction, respectively 61% and 40% of financial and nonfinancial bonds, again as of 2012 (3). For non-bond contracts, there is no data but one could expect foreign law contracts to be quite substantial.
Although the legality of redenomination would vary, in principle, with the foreign law applied, some jurisdictions plainly would be quite hostile to an assertion that a contract made in euros could be repaid in anything other than euros, especially when substantial losses were imposed on creditors. This might lead them to reject redenomination for foreign creditors even where Italian law was provided in the contract, e.g. Italian government bonds. Anticipating how courts might actually rule in foreign jurisdictions is difficult; no judicial opinions have addressed the withdrawal of a country from a surviving monetary union. Regardless of the outcome in any particular court, however, there would be protracted litigation and severe uncertainty.
The best way for Italy to protect itself from such a future would be for the EU and other major economic powers to pass their own laws addressing Italy's adoption of a new currency. Such laws would mirror those passed when the euro itself was adopted. In 1997, the EU enacted the 235 Council Regulation that specified that the “introduction of the euro shall not have the effect of altering any term of a legal instrument or of discharging or excusing performance under any legal instrument, nor give a party the right unilaterally to alter or terminate such an instrument.” Other jurisdictions followed the EU's lead. The state of New York, for example, passed a similar law providing that if “a subject or medium of payment of a contract, security or instruments is a currency that has been substituted or replaced by the euro, the euro will be a commercially reasonable substitute and substantial equivalent.”
As part of establishing a framework for a Member State's withdrawal from the euro area, the E.U. could adopt a “reverse-235 Regulation,” providing that Member States were bound to honor redenomination, subject to the agreed-upon terms for withdrawal. And other jurisdictions could follow suit. But would the EU really agree to a euro withdrawal, and if so, to what extent would the terms imposed on Italy erode some of the anticipated gains? Given the uncertainty and potential nullification of redenomination through litigation, the leverage the EU would have over the terms of an Italian departure from the euro area would greatly exceed the leverage the EU now has on the terms of the U.K.'s departure from the EU itself.
1. Hal S. Scott, When the Euro Falls Apart, 1 International Finance 207 (1998) and When the Euro Falls Apart - A Sequel (2012), Harvard Public Law Working Paper No. 12-16, available at SSRN: https://ssrn.com/abstract=1998356.
2. F.A. Mann, Money in Public International Law: Hague Academy of International Law (1960).
3. Percentages from Jean Nordvig and Dr. Nick Firoozye, Nomura Securities, Rethinking the European Monetary Union (2012), Appendix II.