Opinion

Alison Frankel

If U.S. defaults, can debt holders sue for payment?

By Alison Frankel
October 9, 2013

To the long list of dire consequences if the United States defaults on debt obligations, here’s an addition you probably haven’t considered: litigation against the U.S. government for missed payments.

Let’s establish at the outset that if American owners of Treasury bills or U.S. bonds are counting on a suit against the U.S. government to recover any losses stemming from a default, their faith is misplaced. Litigation takes a long time in this country, especially when you’re talking about completely unprecedented claims arising from unique, unforeseeable circumstances. It’s just about unfathomable that the United States will fail to meet its obligations to bondholders for as long as it would take them to obtain a judgment, even assuming that bondholders somehow defied all reasonable expectations and managed to win their case. For that hypothetical to be realized, our economy would have to be so devastated that bondholder litigation would be a relatively small worry.

But what about a suit by foreigners who own U.S. debt? Or even foreign sovereigns? I talked Wednesday with several foreign debt and constitutional experts, both in academia and private practice. They outlined a set of hypotheticals under which foreign owners of U.S. debt could sue the U.S. government in their own courts and even attempt to enforce judgment against the United States by seizing U.S. assets. Granted, the scenario is based on speculation that’s incredibly unlikely to come to pass. In these strange days, though, a little mind-bending is good exercise.

The first thing to know is that T-bills and U.S. bonds don’t come with complicated purchase agreements. U.S. debt is sold under the full faith and credit of the government as a simple obligation to pay. That’s different from, say, the Argentine bonds that have occasioned so much litigation in federal district court in Manhattan and at the 2nd Circuit Court of Appeals. Argentina agreed in its bond offerings to submit to the jurisdiction of U.S. courts, which have acted as the interpreters of Argentina’s contracts with bondholders. T-bills and U.S. bonds do not specify any jurisdiction to oversee disputes in the event of default. The instruments don’t even contemplate the possibility of default, which is just another indication of the dilemma we’re in right now.

If the U.S. government misses a payment, American debt holders who wanted to litigate would presumably sue in either U.S. district court or the U.S. Court of Federal Claims, which oversees (among other things) disputes between the federal government and U.S. contractors. Jurisdiction would be a threshold question of first impression, in which the courts would have to determine whether there’s a contract between the government and debt holders.

Once that was decided, the United States would argue that it’s immune, as a sovereign, from bondholder claims. Law professor David Skeel of the University of Pennsylvania told me by email that U.S. debt instruments do not waive sovereign immunity, “so it would be tough to sue.” Professor Neil Buchanan of the George Washington University Law School said bondholders could surely “get through the courthouse door,” but he said federal judges would probably dismiss their suits under the Political Question Doctrine, which holds that courts should not oversee cases that interfere with the decision-making authority of elected officials.

Even if debt owners survived sovereign immunity and Political Question defenses and won a judgment against the government, how would they enforce it? Courts aren’t going to permit them to seize government assets, after all. As I said above, given the years of litigation American bondholders would have to endure and their infinitesimal odds of recovering anything from the courts, it’s just about impossible to imagine that they’d be made whole through litigation faster than they would be without suing. Never say never: Anyone with the cash to pay a filing fee can bring a lawsuit in federal court, and suing to recover a missed payment can make a public relations point. Just don’t expect more than a headline from the filing.

So why could the scenario be different for foreign debtholders? Because they can argue that their courts, and not U.S. courts, have jurisdiction over their claims. Remember, when you buy U.S. debt, there’s no contract provision specifying where disputes will be heard. That means there’s nothing to stop foreign citizens – or even foreign governments – from attempting to use their own court system to redress the U.S. government’s failure to make good on debt payments. Of course, such a suit would be subject to that country’s version of the U.S.’s Foreign Sovereign Immunities Act, which could preclude the litigation. There are also diplomatic and economic considerations for foreigners holding U.S. debt. A foreign sovereign like China would have to think very hard about the market and foreign relations impact of suing the United States over a default.

On the other hand, a foreign sovereign could point to the long-running Argentina bond litigation in U.S. courts to argue that if American judges can decide how Argentina must meet its obligations to bondholders, then their courts can decide the U.S. government’s obligations. (I should point out here that the Justice Department actually sided with Argentina on the interpretation of the equal-footing clause in its bond contracts. Also, unlike Argentina, the U.S. has never agreed to subject its agreements with debt holders to the jurisdiction of a foreign court.) If a foreign court were to claim jurisdiction and issue a judgment against the U.S. government, it’s probably more likely that foreign debt holders would actually be able to recover, via the seizure of U.S. assets abroad, than U.S. bondholders would be able to attempt to take control of government property within our borders.

Of course, that’s still an almost-impossible chain of events. Bondholder litigation against the United States is the longest of long shots, no matter where you’re suing. “It’s fun to speculate, but it’s hard to imagine that a lawsuit against the U.S. would be the most effective remedy or the fastest route to recovery in the U.S. or abroad,” said emerging-markets debt expert Bruce Wolfson of Bingham McCutchen. “Any suit like that would be more for political theater.”

Let’s hope we never get past the initial assumptions in my worst-case litigation hypothetical, namely that the United States will hit the debt ceiling and breach debt obligations. I’m just making a small contribution to the literature of looming default catastrophe, in case certain members of the executive or legislative branches need a bit of extra persuasion.

(Reporting by Alison Frankel)

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