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D. A Free and Transparent Arbitration Procedure, aka International Chapter 9 Insolvency


1. Early Calls for International Insolvency

 A paper by an international lawyer, C.G. Oechsli, is apparently the first publication dealing with this matter in detail[59]. Interestingly, it was published shortly before the debt crisis "broke" in 1982. Soon afterwards a banker, D. Suratgar, proposed an international Chapter 11 to solve the debt problem.[60]Another banker, the late Alfred Herrhausen, was among the most vocal advocates of negotiated debt reduction. This solution was repeatedly advocated by economists in the 1980s, among them Nobel Laureate Lawrence Klein, as well as by UNCTAD in 1986,[61] J. Sachs, or Raffer[62]. In Germany Thomas Kampffmeyer,[63]who was the first to draw attention to the German example of a de facto insolvency, proposed the application of this solution to Southern debtors.

 While economically feasible, international reorganisation pursuant to Chapter 11 of US Title 11 (Bankruptcy) or similar laws in other countries fails to address the important problem of sovereignty. Although Kampffmeyer showed that this was no hindrance in the cases of Germany and Indonesia presented in more detail below, there is a formalistic counterargument against internationalising US Chapter that carries enough weight to destroy it. As insolvency procedures for firms do, of course, not tackle the problem of governmental powers, it was rightly argued that it cannot be applied to sovereign debtors. This argument is right as far as it goes, but there is an easy way out. Instead of internationalising Chapter 11, one can easily and immediately apply the US Chapter 9 to sovereign debtors. Designed and used for decades in the US to solve debt problems of municipalities, debtors vested with governmental powers, its essential points can be applied to sovereign borrowers without problems. Like all good insolvency laws it combines the need for a general framework with the flexibility necessary to deal fairly with individual debtors. Therefore internationalising Chapter 9 of Title 11 was proposed as a rejoinder.[64] It deals with the problem of sovereignty and can be adapted to the international problem with minor formal changes. There exists no more technical problem to heed Adam Smith's economically sound advice.

 Encouraged by a private consulting firm, Hungary recently introduced insolvency proceedings for municipalities - so far the only country following the US example. The international business community did not voice concerns. Understandably, the business community does not like insolvency but accepts it as a means of last resort to clear up an economic mess. As phantom debts prove they act quite reasonably. Commercial banks have quite often, though not always without "persuasion", granted debt reductions in various forms. If international insolvency recalling that countries can go bankrupt too had existed in the 1970s, loans would certainly have been given more cautiously. The debt crisis would most probably not have occurred. International insolvency is thus also an early warning and prevention mechanism, and thus in the interest of bona fide creditors.


2. The Essence of Insolvency

 Before describing insolvency procedures pursuant to the US Chapter 9 in detail a brief general point about the essence of all insolvency regulations seems advisable to clarify their very essence. As already shown above there is the need for an efficient procedure to solve cases of overindebtedness, as phantom debts otherwise continue to grow creating problems to anyone, including creditors. Historical evidence proves that even debt prisons cannot make unpayable debts paid. Once it is clear that creditors cannot get all payments to which they are entitled, it becomes obvious that a procedure to share losses is necessary and advisable. Such procedures were developed by all civilised legal systems.

 The basic function of any insolvency procedure is the resolution of a conflict between two fundamental legal principles. In a situation of overindebtedness the right of creditors to interest and repayments collides and the principle recognised generally (not only in the case of loans) by all civilised legal systems that no one must be forced to fulfil contracts if that leads to inhumane distress, endangers one’s life or health, or violates human dignity. Briefly put: debtors cannot be forced to starve themselves or starve their children to be able to pay. Although creditor claims are recognised as legitimate, insolvency exempts resources from being seized by bona fide creditors. Human rights and human dignity of debtors are given priority over inconditional repayment. It is important to emphasise that insolvency only deals with claims based on a solid and proper legal foundation. In the case of odious debts no insolvency is needed, as these debts are null and void. Demands for cancelling apartheid debts of the Republic of South Africa are therefore based on the odious debts doctrine.

 Debtor protection is one of the two essential features of insolvency. The other is the most fundamental principle of the Rule of Law: that one must not be judge in one's own cause. Civilised insolvency laws applicable to all debtors except SCs demand a neutral institution assuring fair settlements. Like all legal procedures insolvency must comply with the minimal demand that creditors must not decide on their own claims. Even at the time of debt prisons creditors were not allowed to do so - in contrast to present international practice violating this very minimum required by the Rule of Law most flagrantly. Creditors have been judge, jury, experts, bailiff, even the debtor's lawyers, all in one. This unrestricted creditor domination is not only an open breach of the Rule of Law, a principle presently preached to SCs by all OECD governments, but also inefficient from a purely economical perspective. Creditors tend to grant too small reductions too late, thus prolonging the crisis rather than solving it. Insolvency relief is not an act of mercy but of justice and economic reason. Substantial shares of present debts exist only because of prolonged, unsuccessful debt management by official creditors refusing necessary debt relief over years.

 The basic question is therefore whether a general solution that has been successfully applied over centuries to debtors in general can also be applied to a very special class of debtors - sovereign countries. If this is technically possible there exists no logic reason not to do so.

 3. Chapter 9 Insolvency within the US[65]

 Chapter 9, a procedure not well known outside the US, solves a problem unique to insolvent public borrowers: intrusion into the debtor's governmental power from without. The debtor, a municipality, is defined by section 101 (34), 11, USCA[66] as a "political subdivision or public agency or instrumentality of a State". In practice cities, irrigation districts, sewer operators, counties, even a hospital subject to control by public authority have been Chapter 9 debtors. Apart from being "authorised" to be a debtor - which apparently means minimal requirements of juridical independence of the entity - a municipality filing a petition must

- be insolvent or unable to meet its debts as they mature

- desire to effect a plan to adjust such debts

- have either obtained the agreement of the majority of each class of creditors affected, or have attempted to work out a plan without success, be unable to negotiate with creditors because this is impracticable, or reasonably believe that a creditor may attempt to gain preference.[67]

A petition filed results in an automatic stay of enforcements of claims against the debtor.

 The problem of governmental power is solved by §904, which limits jurisdiction and powers of the court. It makes clear that the court may not interfere with the choices of a municipality as to what services and benefits it will provide to its inhabitants. The jurisdiction of the court depends on the debtor's volition and cannot be extended beyond it. The composition plan can, of course, provide for interference into the political and governmental powers of the debtor. Also, the municipality may consent to interference by the court in such matters.

 During the Great Depression Chapter 9 procedures were introduced precisely to avoid prolonged and inefficient negotiations and reschedulings, allowing a quick, fair, and economically efficient solution for overindebted US municipalities. A first draft by municipalities that did not bar creditor intervention into the governmental sphere was rejected by lawmakers as unconstitutional[68]. Creditor interventions such as those usual in SCs nowadays were considered unacceptable. A new version containing §904 was allowed to pass. This demonstrates the appropriateness for sovereign debtors. Technically, Chapter 9 offers the legal possibility to implement an economically sensible solution. It became law for the very purpose to avoid that kind of "debt management" practised internationally for decades. The jurisdiction of the court depends on the municipality's volition, beyond which it cannot be extended, similar to the jurisdiction of international arbiters.

 The present version of §904 titled "Limitation on Jurisdiction and Powers of Court" formulates with greatest clarity:

 Notwithstanding any power of the court, unless the debtor consents or the plan so provides, the court may not, by any stay, order, or decree, in the case or otherwise, interfere with -

(1) any of the political and governmental powers of the debtor

(2) any of the property or revenues of the debtor; or

(3) the debtor's use or enjoyment of any income-producing property.


It should go without saying that this strong position precludes any form of receivership. Unlike in other bankruptcy procedures no trustee can be appointed, as §902(5) explicitly confirms: "'trustee', when used in a section that is made applicable in a case under this chapter ... means debtor". The only exception is §926, the very special and justified case if the debtor refuses to pursue avoiding powers. The text on the website of the House explains using Senate Report No.95-989:

 This section is necessary because a municipality might, by reason of political pressure or desire for future good relations with a particular creditor or class of creditors, make payments to such creditors in the days preceding the petition to the detriment of all other creditors. No change in the elected officials of such a city would automatically occur upon filing of the petition, and it might be very awkward for those same officials to turn around and demand the return of the payments following the filing of the petition. Hence, the need for a trustee for such purpose.

The general avoiding powers are incorporated by reference in section 901 and are broader than under current law. Preference, fraudulent conveyances, and other kinds of transfers will thus be voidable.

 A municipality's politicians - elected democratically - cannot be removed from office. In cases of fraud or conflicts of interest a trustee may be appointed for the special cases defined above. Understandably, elected officials will often even be glad not to have to deal with those creditors that gained preference themselves again. Rather than receivership §926 contains a rule to solve potential conflicts of interest and to avoid damage to bona fide creditors by fraud or other illegal activities. It is limited to such cases. It needs to be emphasised that a municipality cannot go into receivership and elected officials cannot be removed from office by the court - but, of course, by voters at the next elections. This makes Chapter 9 especially suited as a solution of sovereign debt overhangs.

 Surprisingly to anyone caring to thumb through the law, a frequent "counterargument" against an international Chapter 9 is that one cannot put a country into receivership or remove the government. Particularly in the German discussion it has surfaced with interesting regularity. Without discussing the compatibility of IMF conditionality with sovereignty - critics might see this as a form of receivership - it seems therefore be necessary to repeat in plain English that both are impossible in a Chapter 9 case, as a quick look at the law proves. Any form of BWI-type Structural Adjustment would clearly be impossible in any domestic US case. It would be seen as an unconstitutional infringement on the debtors governmental powers.

 In a more sophisticated way Kenneth Rogoff[69] sees lack "of enforcement clout in debtor countries" as the main problem with international bankruptcy, but comes to much more differentiated conclusion, conceding:

 it seems unlikely that an international court would have the right to enter a debtor country and seize physical assets, much less fire the "board of directors" - in this case the country's government. Advocates of international bankruptcy point out that similar problems arise in the case of bankrupt state and local governments, and that the obstacles have not proved insurmountable. For example, Chapter 9 of the U.S. bankruptcy code, which governs municipalities, has proven relatively effective (Raffer, 1990).

The analogy  to local government bankruptcies is certainly closer than to firm bankruptcies, but still far from perfect.

 The powerful position of the debtor might make people, especially non-economists, doubt whether this procedure actually works. Some 500 cases within the US so far show it does. As the debtor needs to reach a solution it must offer something that is acceptable to creditors. The composition plan should be fair, equitable, and feasible. Furthermore, to be confirmed the plan has to be reasonable and also in the best interest of creditors,[70] who must be provided the "going concern value" of their claims:

 The going concern value contemplates a "comparison of revenues and expenditures taking into account the taxing power and the extent to which tax in­creases are both necessary and feasible"... and is intended to provide more of a return to creditors than the liquidation value if the city's assets could be liquidated like those of a private corpo­ration.[71]

 A court decision further specified that a plan can only be confirmed by the court if it "embodies a fair and equitable bargain openly arrived at and devoid of overreaching, however subtle".[72]

 The openness and publicity of the bargaining process are of particular interest. People affected by the plan have the opportunity to voice their arguments. So-called "special taxpayers affected by the plan" may object to the confirmation of the plan. The legal term characterises a record owner or holder of title to real property against which a special assessment or tax has been levied, whose tax burden the plan proposes to increase. But also the municipality's employees have a right to be heard. Any record owner of title to real property included in the lists filed pursuant to Rule 1007e (formerly Rule 9-7b) shall have the right to be heard in all matters arising in a Chapter 9 case.

 Subsection (d) of Rule 2018[73] gives labour unions, employees' associations, and representatives of the debtor's employees the right to be heard on the economic soundness of a plan affecting their interests. Their right to appeal exists only if it is specifically permitted by law.

 The open process of elaborating the composition plan did not restrict the right to be heard to these two most directly affected groups, but Rule 2018(a) extended it, allowing the court to permitany interested entity to intervene generally or with respect to any specific matter.

 Fairness depends on "whether the amount to be received by bondholders is all they can reasonably expect in the circumstances".[74] In practice these amounts are similar to Chapter 11 cases. As the law explicitly prescribes the applicability of many sections of Chapter 11 to Chapter 9[75] this is no surprise. Approval of the plan is denied if the municipality has the means to honour all its obligations.In Fano v. Newport Heights Irrigation District this was done, because the district had assets greatly exceeding its liabilities and "there was no sufficient showing why District's tax rate should not have been increased sufficiently".[76]

 There are, however, legal limits to tax increases. In the 1930s, when some creditors insisted on higher payments by the City of Asbury Park - financed by tax increases - the US Supreme Court clearly stated:

 The notion that a city has unlimited taxing power is, of course, an illusion. A city cannot be taken over and operated for the benefit of its creditors, nor can its creditors take over the taxing po­wer.[77]

 A municipality is not expected to stop providing basic social services essential to the health, safety and welfare of its inhabitants in order to pay its creditors. Tax increases that would depress the standard of living of the municipality's population below the minimum guaranteed to private debtors are clearly illegal. Legally feasible tax increases have actually been much lower.

 In all OECD countries insolvency laws protect a certain minimum of basic needs, which is remarkably higher than the standards of most people in problem debtor countries. Interestingly, these insolvency laws are not considered uneconomic humanitarian sentiments, but, as for instance US jurisprudence states, a matter of "a public as well as a private interest".[78] The purpose of bankruptcy laws is defined as granting the debtor a new financial life, a fresh start, or, as prec. §101, note 63 formulates, "the opportunity to accumulate new wealth unhampered by pressure and discouragement of preexisting debts", to free the debtor from "oppressive debts, and to restore him to business activity", or to "discharge a debtor from obligations, which due to his particular circumstances, the bankruptcy court may find that he is unable to pay". Courts have regarded family needs and a reasonable protection of the family as of greater concern than payments of debts. In 1954 a US court explained the essence of bankruptcy laws as "founded on the principles of humanity, as well as justice, and [this title] confers on debtors privileges tending towards his [sic!] rehabilitation while protecting his creditors' substantial rights".[79] Generosity, a word so often heard in the case of bankrupt countries is not mentioned.

 In all cases of insolvency - be it a private or public debtor - the reduction of creditors' claims is one essential means of reaching a feasible composition plan. Feasibility is defined by whether the debtor emerges from reorganisation with reasonable prospects of financial stability and business success (or in Chapter 9 cases economic viability), including sufficiency of capital structures. The viability of the reorganised debtor is the touchstone, which includes the ability to service debts agreed on in the plan, and enough working capital to continue business. In short: the main characteristic of bankruptcy law is to give the debtor, private, corporate or municipal, a fresh start - a chance that is steadfastly denied to SCs.


4. The Framework of an International Chapter 9 or FTAP

 As the problem of governmental powers is solved by Chapter 9 it can easily be adapted to sovereign debts. Judging from the reasoning in a relevant US court case Chapter 9 could be instantly applied. In 1984 the US Court of Appeals for the Second Circuit in New York granted US insolvency protection to Costa Rica. The court recalled a Canadian precedent, drew analogies to US laws, quoted § 901(a), stating that Costa Rica's actions were "consistent with the law and the policy of the United States" and

 in entire harmony with the spirit of bankruptcy laws the binding force of which ... is recognised by all civilised nations ... Under these circum­stances the true spirit of international comity re­quires that schemes of this character, legalized at home, should be recognized in other countries .[80]

 After a rehearing in 1985, however, the court reversed itself. The executive branch had joined the litigation as amicus curiae making it clear that they supported the IMF rather than principles recognised by all civilised nations. Therefore a simple change in the administration's policy - accepting principles, which should be recognised by all civilised nations according to the Court - appears to be sufficient to allow the application of US law to sovereign debtors.

 Because impartiality of national courts, whether located in a creditor or a debtor country, cannot be guaranteed a neutral court of arbitration must be established to allow absolutely fair and equitable international Chapter 9 proceedings, devoid of overreaching, however subtle. The very essence of insolvency is an independent court, or - in the case of sovereign debtors - international arbitration. Proposing insolvency and proposing arbitration are therefore essentially equivalent as regards solving the debt problem. Therefore the acronym FTAP catches the essence of my Chapter 9 proposal. A fair and efficient decision on which part of a country's debts is unpayable can only be taken by a neutral entity, neither by creditors nor by debtors. Deman­ding the cancellation of unpayable debts means demanding an independent entity empowered to decide. Apparently, what creditors oppose is not so much debt reduction, which is seen as unavoidable anyway, but giving up control, even though creditor controlled debt management has failed and debts have accumulated further during and because of it. According to UNCTAD[81] two thirds of the increase in Sub-Saharan African debt since 1989 was due to ar­rears.

 The WTO's dispute settlement, state-investor arbitration as foreseen by NAFTA or proposed for the presently shelved MAI prove that arbitration is generally quite popular with OECD governments. The London Accord provided for neutral arbitration to settle disagreements between Germany and its creditors. By the way, arguing that neutral arbitration panels must replace bankruptcy courts, I used Germany’s London Accord as the illustrating example when proposing an international Chapter 9.[82] Arbitration is only shunned by OECD governments when it comes to sovereign Southern debts - when it comes to protecting the human dignity of the poorest.

 As is usual practice in international law each side should nominate the same number of persons, who, in turn, elect one further member to achieve an uneven number. One of the arbitrators is elected as chairperson by simple majority, or, if debtor and creditors should wish so, by qualified majority. Such a neutral body of arbitration was, by the way, also established by the London Accord, which reduced Germany's debt burden in the 1950s. Arbitration has been part of contracts between private creditors and some Southern debtors recently. The IBRD's Articles of Agreement explicitly foresee arbitration,[83]recognising default of countries as a fact of life. Article IV.6 demands a special reserve to cover what Article IV.7 calls "Methods of Meeting Liabilities of the Bank in Case of Defaults". As the Bank is only allowed to lend either to members or if member states fully guarantee repayment (Article III.4) the logical conclusion is that default of member states was definitely considered possible, maybe even an occasionally needed solution. Nevertheless the IBRD shies away from granting the Rule of Law to Southern debtors like official creditors by abiding to its own constitution.

 Naturally the number of arbitrators should not be excessively high. Since any case involves only one debtor but many creditors the number of arbitrators will most likely depend on creditors' demands. IFIs, such as the IMF or the IBRD, cannot be considered unbiased and neutral because they are both controlled by majorities of creditor States and creditors in their own right.

 It appears unlikely, though, that all creditors will feel well represented by any choice made by IFIs. It must not be forgotten that creditors themselves are not unbiased when making decisions affecting their own claims as well as those of other creditors. Emerging Markets this Week[84]published by the Commerzbank in Germany, expresses this concern very clearly: the BWIs "will be concerned with protecting their own balance sheets rather than with fair 'burden sharing'". Therefore the "IMF and World Bank are not suited either as arbitrators or as objective regulators of sovereign insolvency procedures."

 Under particularly exceptional circumstances both sides might agree on one single person. This happened when both Indonesia and its creditors asked the German banker Hermann Joseph Abs to solve Indonesia's debt problem in 1969. Although creditors eager to avoid a legal precedent stressed the singularity of the case, and Abs was not formally an arbitrator, Indonesia isa model solution. Economically it was doubtlessly a de facto international insolvency.[85]

 Like a court in a domestic Chapter 9 case arbitrators would have the task of mediating between debtors and creditors, chairing and supporting negotiations by advice, providing adequate possibilities to be heard for those affected by the plan, and - if necessary - deciding what should be done. Agreements between debtor and creditors would need their confirmation, in analogy to §943. They would have to take particular care that a minimum of human dignity of the poor is safeguarded - in analogy to the protection enjoyed by a municipality's inhabitants.

 Exactly like in domestic Chapter 9 cases employees of the debtor would be represented by trade unions or employees' associations. In contrast to "special taxpayers affected by the plan" the affected population would have to be represented by organisations speaking on their behalf. Grass-roots organisations of the poor, NGOs or international organisations such as UNICEF or the World Council of Churches could fulfil this task. The possibility of describing the expected impacts on the poor publicly would certainly have mitigating effects, contributing to a solution with a human face. Publicity of negotiations, in analogy to public sessions of domestic courts, would help guarantee a fair and equitable bargain, openly arrived at.

 As a first step towards elaborating the legal framework of an international Chapter 9 the following list of tasks and problems was presented:

  - Assessment of Debts : All claims have to be verified loan-by-loan at the beginning, as routinely done in any domestic insolvency. This has recently been demanded by Krueger[86] as well.

  - Socialised Debts : In many countries governments were forced by banks to assume retroactively losses from private lending initially done without any government involvement. Such increases in the debt burden of countries have never met audible protest by IFIs, although they made debt management much more difficult. These socialisations of private losses must be declared null and void.

  - Symmetrical Treatment of Creditors: An important distinction is made between commercial banks, bilateral governmental loans, and IFIs. The Brady Initiative only called on commercial banks to take losses by reducing their claims, while IFIs are still allowed to go on insisting adamantly on full and punctual repayment. This raises the question whether an objective reason exists for preferential treatment of this class of creditors. Considering all arguments the answer is no. The understandable self-interest of any creditor apart, there is no reason why IFIs should get a better deal. Considering that IFIs have been granted preferred treatment so far, the present discussion about bailing-in the private sector is particularly obfuscating. In the 1980s IFIs did bail-out commercial banks as long as the fiction - known as the "Baker Plan" - was maintained that temporarily illiquid SCs would eventually repay everything including newly incurred debts. But under Miyazawa/Brady schemes private creditors granted debt relief, e.g. 35 per cent in the case of Mexico or 45 per cent in the case of Ecuador. Although the percentages were quite generous, new official money increased debts again at the same time. With private creditors granting 45 per cent reduction of their claims Ecuador's first Miyazawa/Brady deal did not produce more than a very small blip downwards in the function describing the evolution of the country's debts over time. In 1999 finally, the country was unable to honour its "Brady bonds", the first undeniable example of failure of this Initiative. If all creditors had granted a reduction of only 30 per cent commercial banks would have saved 15 percentage points and the country would in all probability have been economically afloat again. Ecuador is thus a prime example of the necessity of equal treatment, as also demanded by the Commerzbank publication quoted above.

 Multilateral lenders may argue that they charge interests below the debtor's market rate. Even for normal IFI-lending which is too tough to qualify as Official Development Assistance according to the OECD definition - therefore it is called "development finance" - this is an objective difference between IFIs and private banks, generally (but not always) a valid point for preferential treatment.

 There is, however, another objective difference between these groups of lenders: commercial banks did lend aggressively but have usually not interfered with their clients' economic policy while multilaterals have strongly influenced the use of loans and exerted massive influence on their debtors' economies. This difference is well characterised by Svendsen's distinction between "debtor determined" and "creditor determined" debts.[87] In the case of the IMF the Group of 24 criticised the proliferation of performance criteria extending quite often down to microeconomic variables such as prices for specific products[88]. The IBRD has been proud of the detailed monitoring of its projects for decades. Only in the most recent past this pride has not been voiced as perceptibly, apparently for good reason. In 1983 the high ranking IBRD economist Ernest Stern presented Structural Adjustment Loans as an excellent means enabling "the Bank to address basic issues of economic management and of development strategy more directly and urgently", a "unique opportunity to achieve a comprehensive and timely approach to policy reform", and a tool for "detailed articulation of the precise modifications in policy necessary to adjust to a changed international environment". There is, of course, a need for a "firm understanding" of monitoring "in principle no different from the relationship involved in Bank sector or project lending."[89]

 In other words: IFIs take economic decisions but refuse to participate in the risks involved. IFIs insist on full repayment, even if damages negligently caused by their staffs occur, which have to be paid by the borrower. A new loan might be given to correct the damages done by the first, as e.g. in Brazil's Polonoreste case, leaving the debtor with more debts and the IFI with more interest income.[90] Or, to give one other example: the Republic of Trinidad and Tobago documented grave irregularities and deficiencies in the IMF's assessment of its economy, which created the impression of economic mismanagement. After the IMF became aware of these substantial errors this information was not published in spite of its importance for the country.[91]

 The IBRD argues that its own excellent rating as a borrower would suffer if not all their loans were repaid to the last cent. If that were true all commercial banks would have unbelievably low ratings as a certain amount of lost loans is part and parcel of normal banking activities. Also, one has to ask why debt reduction is enshrined in its own Articles of Agreement.

 Brady's policy of substituting IFI money for less strictly enforced commercial bank claims was bound to create problems. An increasing share of IFI debts which must be served at any costs to get the "seal of approval" or because of explicit links between a country's rating and IFIs, e.g. in the US International Lending Supervision Act, will eventually impair the service of private loans further. The fact that inverse transfers from debtor countries to IFIs have been observed, turning IFIs into net receivers rather than net funders, provides another strong argument for symmetric debt relief.[92] From the point of view of fairness it is hard to see why some creditors should contribute to a solution by reducing their claims, while others - more involved in producing the problem - are allowed to refuse this. Finally, the poorest countries with practically no debts to private banks but substantial shares of IFI-claims cannot benefit from debt reduction schemes excluding these important creditors.

 Summing up one must therefore say that a symmetrical treatment of all creditors is more than justified. The striking contrast between free-market recommendations given by IFIs and their own protection from market forces must be abolished. Like any other creditor they should carry the risk of losing part of their claims as the connexion between decisions and risks is the most basic condition for the functioning of the market mechanism. If this link is severed market efficiency is severely disturbed. After riskless decision making by bureaucrats was abolished in the East of Europe, there is no reason why it should be preserved in the West. Compensation for damages done within projects, where determining faults and errors is much easier is an issue in its own right.[93] It would reduce the debt burden further.

  - Capital Flight : Both creditor and debtor countries should take measures against capital flight, as proposed by W. Nölling.[94] In analogy to domestic laws the international Chapter 9 should provide the possibility of overruling banking secrecy if justified suspicion exists that money was obtained in the first place by certain criminal activities, such as corruption, theft or embezzlement. The act of screening accounts could be done at the request of arbitrators in the way of judicial assistance rendered by domestic courts in the country where the pertinent bank is located. Legal details would have to elaborated by jurists.

A particularly interesting and innovative idea by Jean-Loup Dherse was reported in the journal The Banker of May 1999 on p.14. Debtor countries should formally transfer to the Paris Club or its members title to any funds illegally spirited abroad by former regimes. These creditors have the means to track down and sequester this money. Debt reductions would thus be at least partly self-financing. The concern that debt relief would mainly benefit corrupt élites could be thoroughly dispelled. Of course, OECD governments could also choose to let former dictators have that money as a reward for whatever services rendered to creditor governments, as long as the country and the poor would not have to pick up the bill.

  - Economic Adjustment : Economic reform in problem debtor countries is doubtlessly necessary, but the burden of adjusting should not be shifted entirely on them. In analogy to domestic insolvency debt service must be geared to the debtor's capacity to pay, restoring economic viability while protecting minimum standards for the poor. In contrast to present practice there must be a trade off between payments and protectionism. The more protectionism creditor countries wish to maintain the more relief must be granted.

 A realistic policy would drop the present predilection for one-sided liberalisation by those countries that are at the mercy of IFIs. Trying to export more while export possibilities are destroyed by increasing protectionism is no sensible strategy. If all coffee producers are advised to produce more coffee, simple microeconomics suggests that oversupply will lead to falling prices, as has actually happened and is known as the "fallacy of composition" argument. Import substitution on a substantial scale is necessary, while existing export possibilities should be used. Economic diversification must be part and parcel of this kind of adjustment. A policy mix between intervention and market forces is necessary. It would be a task of the arbitrators to prevent protection necessary to establish infant industries from petrifying. The board of arbitrators would have the power to suspend or revoke Chapter 9 benefits if the debtor tries to abuse the system by not complying with the agreed plan.

  - Protecting the Poor: It is mandatory that schemes to protect a minimum standard of living be part and parcel of every international composition plan. In analogy to the protection granted to the population of an indebted municipality by domestic Chapter 9 the money to service a country's debts must not be raised by destroying basic social services. Subsidies and transfers necessary to guarantee humane minimum standards to the poor must be maintained. Funds necessary for sustainable economic recovery must be set aside.

 Examining domestic orders for general principles of law in search of international law rules the ILA's Committee on International Monetary Law concluded:

 On the municipal level, bankruptcy laws and norms protecting debtors from enforcement measures affec­ting the right to a basic living standard would be relevant. As a State is involved, the special rights and obligations of the State on the national level have to be taken into account. An integrated per­spective of these rules may suggest that obligations of a State cannot generally be enforced if basic rights of the population would be affected. Such considerations could be supplemented by refe­rence to modern recognition of human rights in ge­neral, and of basic rights of the human person in particular.[95]

 Protecting the poor can be done by targeting social expenditures on those needing support. Considerable knowledge how to do so exists[96]. Present anti-poverty strategies under HIPC II meanwhile also demand protection of the poor. Redirecting expenditures in favour of basic services, using less expensive yet efficient drugs, employing basic health workers or "barefoot doctors" are possibilities. Good results can be achieved with limited financial resources. These resources, however, must be exempted from debt service. In addition some percentage of the country's foreign debt could be transferred to a counterpart fund financing social expenditures in domestic currency. This has already been practised by some commercial banks donating parts of their claims to NGOs for environmental (debt for nature swaps) and, more recently, for social purposes. The Austrian Creditanstalt, e.g., was the first bank to conclude a debt for charity swap of some Mexican debt with FAPRODE to finance social projects and housing for the poor.

 The principle of debtor protection demands exempting resources necessary to finance minimum standards of basic health services, primary education etc. This exemption can only be justified if that money is demonstrably used for its declared purpose. Not without reason creditors as well as NGOs are concerned that this might not be the case.

 The solution is quite simple - a transparently managed fund financed by the debtor in domestic currency. In a discussion with public servants of the G7 and representatives of the BWIs Ann Pettifor[97] proposed a Poverty Action Fund as a means to guarantee that the money is actually used for the poor and for expenditures necessary for a fresh start of the debtor economy. The management of such a fund could be monitored by an international board or advisory council consisting of members from the debtor country as well as members from creditor countries. They could be nominated by NGOs and by governments (including the debtor government). As this fund is a legal entity of its own, checks and discussions of its projects would not concern the government’s budget, which is an important part of a country's sovereignty. Aid could also be channelled through the fund, changing its character of money just set apart from the ordinary budget towards a normal fund for the poor.

  - The Problems of Commercial Banks: Contractual constraints for individual bargains between debtors and banks, such as negative pledge and sharing clauses, exist. The former forbids separate deals with individual banks, keeping the debtor from working the case-by-case approach on the banks. In the latter clause members of bank consortia forswear making separate deals with the debtor. Consent by all banks involved is necessary to waive these clauses. To accelerate the pace of debt reductions Brady had initially proposed a general waiver of these clauses. Commercial banks opposed strongly and successfully. These clauses serve the same purpose as the automatic stay triggered by a Chapter 9 petition: to prevent unfair preferential treatment of one or some creditors. Whatever can be received from the debtor must be shared.

 In an international Chapter 9 these clauses would no longer be necessary because all creditors would have to be treated fairly and equally. This solves the free rider problem too. Any bank is reluctant to reduce its claims and consequently its interest earnings if some banks refusing to go along remain entitled to full repayments and interest on initial face values. If relief measures are successful, viz. the debtor economy becomes again able to service (remaining) debts correctly, these free riders would be rewarded for letting others make concessions. A deadlock where all banks refuse debt reductions may result. Insolvency procedures covering all creditors can avoid this outcome. The free rider argument also strengthens the case for symmetrical treatment of all creditors.

 Debt reductions should be fixed in percentages of present values. Within national regulations legal and accounting details should be arranged in the way most favourable to creditors. Regulatory relief, if needed, should be made available when Chapter 9 is applied internationally for the first time.

 The introduction of international insolvency should also be used by national legislators to change national laws and regulations creating unnecessary complications and "legal risks". The US is a prime example: crises reported at quarters' ends during the 1980s were often triggered by awkward and economically debatable regulatory constraints, such as the 90 days clause, the impossibility of capitalising interest arrears, or unpredictable and allegedly discriminatory decisions of regulators. Inflexible and antiquated US regulations even brought about the only working "debtors' cartel" so far when debtors such as Mexico, Brazil or Venezuela joined to help Argentina pay in time to save US banks from having to classify loans as non-performing.[98] On one occasion the hands of the clock were reportedly held back to book payments "in time".

  Finally a clarifying remark on tax deductible loan loss provisions seems necessary, because they have often been misunderstood as a taxpayers' subsidy to banks. The costs to the taxpayer, and hence the benefits to banks, have always been strongly exaggerated.[99] Tax authorities in countries restricting tax deductibility are at least implicitly of the opinion that losses occur when the respective entry correcting a loan's nominal value is made in the creditor's books. According to this perception a loan would be granted by the Treasury over the period between the year in which reserves are establis­hed and the year in which the loan is finally written down or off, or reserves are finally dissolved and taxed. Tax deductible provisions only shift losses (or taxes) over time. Assuming reserves of $100, a tax rate t, and an interest rate ig at which the government itself can borrow, the annual costs to the taxpayer are


 $ 100tig    (2).

 Or verbally, these costs are the additional amount which would have been paid to tax authorities if no provisions had been made or these provisions would have been fully subjected to taxation multiplied by the interest rate the government has to pay as a borrower. In continental Europe this loan carries no interest - not only in the case of banks, but for all enterprises. At a tax rate of 50%, and an interest rate of 6% at which the government itself borrows, reserves of $100 cost taxpayers $ 3 annually. Clearly, tig is the upper limit for any estimate of costs. If one sees tax deductability this way the conclusion logically follows: the longer it takes to solve the crisis (= to realise losses) the higher will costs to the taxpayer become. Delaying a solution to the debt crisis - as our governments have done - has negative financial effects on taxpayers according to this view.

 But the assumption that the time lag is the span between the year in which reserves are set aside and the year when they are used is not unassailable. A loan still kept at 100 per cent in the books will have a lower factual or real value once the creditworthiness and economic stan­ding of a debtor has become doubtful, as the existence of secondary markets proves. From an economic and factual point of view money is actually lost before nominal claims are finally adjusted downwards in the books. Recognising diminished values of claims is just another way of stating that the sum of net assets, and thus the tax base, have declined.

 To the extent that provisions reflect actual losses in the values of loans already suffered but not yet booked, they do not economically constitute taxable income. This would be the case if loan loss reserves set aside during one year are equivalent to the change in factual values during that year. In­creasing reserves continuously in line with declining factual va­lues would thus not really cost the taxpayer a single cent. Should the economic outlook of the debtor change to the better these re­serves would, of course, have to be reduced accordingly to keep provisions in line with actual values. A tax régime without tax deductibility of reserves thus taxes illusory pro­fits, which only exist due to accounting practices. Looking at the matter this way, it might be argued that banks grant an interest free loan to the Treasury by shifting losses to the future.

 Because the real world is not an economist's comfortable black­board, uncertainty will not allow a precise estimate of probabili­ties (and thus factual values) in practice, and one might discuss whether reserves actually match losses already suffered. If reserves are larger than these losses banks get a loan by tax authorities equivalent to this dif­ference between reserves and changes in the values of loans; if reserves are smaller this difference is taxed as illusory income. In contrast to the first one-period example above the costs of the tax-loan are not $100tig for reserves of $100, but only tig times this difference if reserves are greater than actual losses. Or, more formally,


$[100(1 - p) - reserves]tig    (3)

 where p is the probability of repayment, and 100p hence the ex­pected value. The first term in square brackets expresses actual losses. If set aside reserves are smaller than actual losses the term in square brackets is simply illusory income taxed. Assuming that supervisory authorities keep loan loss reserves roughly in line with the decline in value of dubious loans one can say that both costs to taxpayers and taxation of illusory profits will be very low or negligible. A substantial stabilising effect can be obtained at no or minimal real costs to the taxpayer.

 Economically, provisions have the important function of spreading losses over some years, which might ruin a creditor if they had to be absorbed in one year. Whether to have a tax system that encourages more prudential provisioning this way is a political question, which should not be decided without considering the alternatives. Continental Illinois or the case of the US S&L institutions may suffice to show that extremely limited tax deductibility does not necessarily mean no costs to the taxpayer.


[59] C.G. Oechsli, C.G. Procedural Guidelines for Renegotiating LSC Debts: An Analogy to Chapter 11 of the US Bankruptcy Reform Act. Virginia Journal of International Law 21 (1981), pp. 305ff.; for a survey cf. A. N. Malagardis.Ein "Konkursrecht" für Staaten? Zur Regelung von Insolvenzen souveräner Schuldner in Vergangenheit und Gegenwart. Baden-Baden: Nomos 1990

[60] Suratgar's proposal was published in 1984. Cf. Malagardis, op.cit., p. 181, who also quotes similar deliberations by German colleagues during 1982 and 1983.

[61] UNCTAD. Trade and Development Report 1986. Geneva: UNCTAD 1986

[62]Raffer, Kunibert. Die Verschuldung Lateinamerikas als Mechanismus des Ungleichen Tausches. Zeitschrift für Lateinamerika (Wien) No.30/31 (1986), pp.67ff

[63] Kampffmeyer,Thomas. Towards a Solution to the Debt Crisis: Appyling the Concept of Corporate Composition with Creditors. Berlin: German Development Institute (DIE)1987

[64]Raffer, Kunibert. International Debts: A Crisis for Whom? op. cit.  

[65] The description of domestic (US) Chapter 9 procedures draws on Raffer, Kunibert. Internationalising US Chapter 9 Insolvency: Economic Problems in Need of Legal Conceptualisation. In: S.R. Chowdhury, E. Denters &P.J.I.M. de Waart (eds) The Right to Development in International Law. Dordrecht: Kluwer Academic Press/ Martinus Nijhoff Publishers 1992, pp.397-410, as well as Raffer, Kunibert. Applying Chapter 9 Insolvency ..., op.cit. The current version of US bankruptcy laws can be found at, the Congress website posting all presently valid laws plus their history and explanations. As this publication focusses on the basic elements of Chapter 9 it does not go into minor details or differences of formulations between current and past formulations, as these do not affect the thrust of the argument. It quotes those formulations that convey the meaning of this procedure best, even if they are not from the current version.

[66]United States Code Annotated, Title 11(Bankruptcy), including 1988 Cumulative Annual Pocket Part; Rules of Bankruptcy Procedures (pre-1984), and Bankruptcy Rules and OfficialForms, 1984 edition, West Publishing Co., 1988.

[67] §109(c), 11, USCA

[68]Spiotto, James E. Municipal Bankruptcy. Municipal Finance Journal 14, 1993, pp.1ff

[69] Rogoff, Kenneth. International Institutions for Reducing Global Financial Instability. The Journal of Economic Perspectives 13(4), Fall 1999, p.30

[70] This condition is presently found in §943(b),7

[71] Quoted from Note to §943, 11, USCA

[72] Rule 9-27, note 1, Rules of Bankruptcy Procedures, USCA

[73]Bankruptcy Rules and Official Forms, USCA

[74] Rule 9-27, note 1, Rules of Bankruptcy Procedures, USCA

[75] cf. especially §§901 and 902, 11, USCA

[76] Quoted from §943, note 3, 11, USCA

[77] Quoted from Malagardis,op.cit., p. 68

[78] §101, 11, USCA, note 63

[79] prec.§101, 11, USCA, note 61

[80] quoted from UNCTAD . Trade and Development Report 1986, Geneva: UN 1986, p.142, emphasis mine

[81] UNCTAD. Trade and Development Report 1998, Geneva: UN 1998, p.127

[82]  Raffer 1989, p.60

[83]  cf. Raffer, Kunibert. Introducing Financial Accountability at the IBRD: An Overdue and Necessary Reform. Paper presented at the Conference Reinventing the World Bank, 14 - 16 May 1999, North­western University, Evanston, Ill.; available from  or via my homepage. Forthcoming in the conference volume at Cornell University Press, ed. by Jonathan Pincus & Jeffrey Winters

[84] no. 26/1999 of October 15, 1999, stress in orig.

[85] v. Raffer,1990, op.cit.

[86]Krueger, Anne. International Financial Architecture for 2002 ....., op. cit., p.7

[87] Svendsen, K.E. The Failure of the International Debt Strategy, CDR-Report n.13, Copenhagen: Centre for Development Research 1987, p.27. As early as 1984 the IBRD (Toward Sustained Development in Sub-Saharan Africa - A Joint Program of Action,  Washington DC: IBRD 1984, p. 24) wrote that "external financial agencies have shared responsibility" for investments qualified as "genuine mistakes and misfortunes" without, however, calling for financial consequences.

[88] cf. IMF Survey , August 10, 1987, Supplement on the Group of 24 Deputies' Report, para 58.

[89] Stern, E. World Bank Financing and Structural Adjustment. In: J. Williamson (ed) IMF Conditionality, Washington DC: Institute for International Economics/ MIT Press 1983, pp. 91ff.

[90] cf. Raffer , Kunibert. International Financial Institutions and Accountability ..., op.cit., pp.156f; Brazil's IBRD debts increased by 440 million $: the first 240 million $ resulted in considerable environmental damage - Bank officials admitted that they had erred - then 200 million $ were lent to control the damage done by the first loan.

[91] Republic of Trinidad & Tobago, Ministry of Finance and the Economy. Trinidad and Tobago Government's Relationship with the International Monetary Fund 1988, January 1989 (mimeo). Because of the government's need for the IMF's "seal of approval" to reschedule their debts Trinidad's own expert (K. Levitt) advised them not to "pick a fight" with the IMF (ibid.).

[92]cf. e.g. Feinberg , R.E. Defunding Latin America: Reverse Transfers by the Multilateral Lending Agencies, Third World Quarterly, vol. 11/ 3, 1989, pp.71ff.

[93] Raffer, Kunibert. International financial institutions and accountability...., or K. Raffer & H.W. Singer. The Economic North-South Divide ....pp.246f

[94]Nölling, W. Combating Capital Flight from Developing Countries, Intereconomics, vol.21/3 1986, pp.117ff.

[95] ILA (International Law Association) Warsaw Conference (1988), Committee on International Monetary Law. Committee Report, p. 9, para 21.

[96] v. Raffer, 1990, op.cit. pp.305f. and the literature quoted there.

[97] Pettifor, Ann. Concordats for debt cancellation, a contribution to the debate. Jubilee2000 Coalition UK, 18 March 1999 (mimeo)

[98] v. Raffer, 1989, op.cit., pp.54ff; a more detailed study of legal risk can be found in Bransilver, E. & E.T. Patrikis, Lending limits and regulatory constraints under US law. In: M.Gruson & R. Reissner (eds) Sovereign Lending: Managing Legal Risk. London: Euromoney Publications 1984, pp. 1ff.

[99] The argument is presented in greater detail in Raffer, Kunibert. Tax-Deductible Loan Loss Reserves and International Banking: An Economist's Unbiased Analysis, Working Pa­pers in Commerce WPC 91/ 19, Birmingham University, Department of Commerce, The Birmingham Business School 1991