Stopping a Russian bond invasion

All it took was 11 days — and one schtum Kremlin spokesman — to make people wonder recently just how strong and secure a ruler Vladimir Putin really is.

They might want to look inside his Ukrainian bonds next.

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If Ukraine was to default this year on the $3bn in bonds it owes to the Russian government, nearly everyone expects the Kremlin’s response would be as assertive and fierce as ever. It would demand full payment and disrupt Kiev’s highly fragile IMF programme and broader debt restructuring at its leisure.

Russia’s claims are two-year bonds issued in December 2013 and governed under English law, not fuzzier official loans. Their terms could be pressed in an English court — and those terms are, as we’ve noted in the past, unusually restrictive for a sovereign bond contract.

The intimidation is, apparently, enough to overpower simple arithmetic. Ukraine wants $15.3bn of debt relief (versus just under $25bn of official loans). The IMF thinks the “debt operation” will therefore save $5.2bn on $7.7bn of bond payments which come due this year. As Anna Gelpern pointed out, that doesn’t leave the full $3bn for Russia in December.

Aleksei Mokshin must have noticed it: as Russia’s representative on the IMF’s executive board, he voted to approve the Ukraine programme this month. But Russia’s finance ministry still says it’s expecting every dollar back. Ukraine’s other private bondholders must also have noticed: but they’re clearly nervous Ukraine will pay Russia’s bond out in full and take the difference out of a bigger haircut for them. Ukraine’s 2017 bond is currently changing hands (no doubt rather tremulous hands) in the market for about 40 cents per dollar of face value.

Beyond the courthouse, Russia also has an enforcement device the others do not: 4,500km of Brotherhood gas pipeline.

The IMF, meanwhile, does not want a disorderly default in a programme where it’s already very nervous about its own exposure: it expects Ukraine back on the market in two years.

Хорошо. Vladimir’s in control.

And yet…

What if Russia actually can’t use those terms to enforce its bond effectively? What if Ukraine could combine defending its debt restructuring with putting the Kremlin on the spot about the causes of the country’s crisis — in court?

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1) A carefully drafted bond

It’s still striking just how preternaturally clever and careful Russia appears to have been when arranging the terms of its Ukrainian bond. (Ukraine’s other bondholders, meanwhile, have “quite classical” means of enforcing their claim, Allen & Overy judged last year.)

Foresight and attention to detail would be all the more remarkable given many sovereign bond contracts are copy and paste boilerplate. Also, the $3bn bond was the first bit of a $15bn bailout Russia planned for a friendly government in Kiev, the Yanukovich regime. Months before Maidan, Russia appears to have figured that it might have to find ways to protect its investment against political hostility. It’s the bond equivalent of assiduously distributing guards divisions around Moscow to forestall coup attempts. (A subject that may be on Mr Putin’s mind of late.)

Anyway, one piece of contract Russia could exploit is the bond’s by now notorious debt to GDP clause.

If Ukraine’s public debt (plus guarantees) goes above 60 per cent, Russia could declare an event of default. This month’s IMF programme frankly acknowledged that the ratio will hit 94 per cent this year, and the debt operation is itself meant to get it down to 71 per cent by 2020, so this looks like a slam dunk for Russia’s lawyers.

But there’s another seemingly clever clause in the bond, right below the debt ratio one…

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2) The set-off provision

Joseph Blocher and Mitu Gulati point to the existence of this clause in a recent, fascinating paper.

It’s a set-off provision. Ukraine can’t avoid full payment by subtracting something which Russia owes to it. These provisions tend not to appear in sovereign bonds: the point of them wouldn’t be very clear if the debt is held by thousands of investors. Russia, however, might well rack up obligations to Ukraine – gas, military bases, arms purchases – over time.

There would also be the small matter of the chunk of Ukraine it stole last year.

One way Ukraine might actually seek to justify not paying Russia back in full is that its creditor owes damages for having annexed Crimea in 2014. This is a version of a set-off argument. It’s also important to note that employing it in court wouldn’t legitimise the Russian annexation, which remains internationally unrecognised.

As Blocher and Gulati note, in English law, Ukraine could argue from the doctrines of ‘clean hands’ and ‘prevention’. Russia arguably caused the country’s inability to pay its debt after the annexation triggered a broader crisis in the country’s east. If Russia sued for payment, Ukraine’s lawyers could contend that it actually prevented its debtor from fulfilling its obligation.

We think this is interesting because Ukraine wouldn’t necessarily have to win the claim. It would just need to raise it long enough in court to achieve the following, suggested in Blocher and Gulati’s paper (emphasis ours):

Russia may have been a bit too clever in including this provision in its December 2013 bond though because the attempt to use it will open the door to Ukraine arguing that the fact that the clause was put in place so close to the annexation of Crimea shows that Russia knew in December 2013 that there was a plan to annex Crimea (this provision is not present in the April 15, 2013 Ukrainian bond). That in turn will allow for Ukraine to ask for discovery into what Russia knew or had planned in the months leading up to the annexation – something that Russia surely does not want. Ukraine though will have to have the courage to at least suggest to the Russians it is contemplating making a set off claim.

Of course, while he wasn’t seen for days on end this month, Mr Putin did appear on a Russian state TV documentary that ‘explained’ events leading to the annexation of Crimea (and let slip that the Kremlin had planned it weeks before a supposed referendum on the matter).

This disclosure was very much on the Kremlin’s terms, as part of an all-consuming media cult around Mr Putin. (Which is why the regime quickly seems so listless when the president retires from public view, and out comes canned Putin.)

The Russian government is much less comfortable whenever its dirty linen is washed elsewhere. That includes in an English courthouse. Witness the Litvinenko Inquiry’s extensive documents and transcripts; witness also the Tu-95 Bear aircraft that appeared in airspace not far from Bournemouth, the day after the inquiry began.

Ukraine could then bring Crimea, plus an examination of the inner workings of both the Putin regime and its relations with the Yanukovich government, into a legal defence against any lawsuit over the $3bn bond – forcing daylight on them through the very English court jurisdiction Russia wanted in its contract.

The effect would be explosive. Russia’s response might be aggravated and hard to predict. But this might also be the best tool available to persuade the Kremlin that pressing for full payment is more trouble than it’s worth.

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3) The sovereign wealth fund

There’s one potential Russian response to think about, of course: insisting that it doesn’t actually own the bond.

When an absolutely thrilled-looking Mr Putin announced his bailout for the Yanukovich government in December 2013, he said that “the Russian Government has decided to invest $15 billion in reserves from the Russian National Wealth Fund in Ukrainian government securities”.

He also said “this does not come with any conditions attached” — which, 15 months on, is a little ironic. But the NWF, the longer-term of Russia’s two sovereign wealth funds and probably where the $3bn in bonds remain warehoused, presents a problem for discovery directed at the Russian government. It could simply argue that it’s an entirely different entity. That would require Ukraine’s lawyers to make a case for piercing the veil to establish the fund’s ultimate controller. This isn’t something English judges usually like doing: it overturns corporate law.

On the other hand, how the NWF came to be holding Ukrainian bonds is rather interesting.

As GeoEconomica, the political risk consultancy, pointed out:

As the power battle on the streets of Kiev escalated, Putin’s move is a striking example of how politics interferes with sound and prudent sovereign wealth management practices, an accusation that SWFs at large have long sought to fend off. The Russian commitment also appears to break the Fund’s own investment guidelines…

Those guidelines restrict the NWF’s sovereign bond holdings to highly-rated Western European and North American issuers. Ukraine doesn’t quite fit. Buying all of the December 2013 bond issue — for $3bn compared to the NWF’s then assets of $88bn (now $74bn) — also seems like an unusual concentration of risk.

Russia’s SWFs have borne the brunt of the Ukraine misadventure’s economic blowback. Lawyers picking over in a courtroom how the Kremlin may have pushed the NWF into politicised investments might make for interesting reading for ordinary Russians — and investors.

It’s thus another reason Ukraine may be able to challenge its supposedly most fearsome creditor after all.