TY - JOUR AU - Buchheit, Lee C AB - In days of yore when men fought in sailing ships, a naval captain could only signal his intention to surrender his vessel by ‘striking the colours’—that is, by ordering the ship’s flag to be lowered. In the heat of a naval battle, however, the rope holding a ship’s flag could easily be shot away. The flag would then come fluttering down leading both the crew and the foe to conclude (wrongly) that the captain was surrendering. There was only one effective remedy—‘nail’ the flag to the mast before the shooting started. This ensured that no false signal of surrender could be made as long as the mast itself was still standing. Of course, it also meant that no signal of surrender, even an intentional one, could ever be made. The expression ‘nailing one’s flag to the mast’ has passed into modern usage as a way of saying that no surrender or compromise is possible. The technique was not limited to naval warfare. Both William the Conqueror (attacking England in 1066) and Hernán Cortés (attacking the Aztecs in the early 1500s) famously burnt their ships on the beach. This was a not-very-subtle way of announcing to the troops that retreat was simply not possible. Julius Caesar, prior to the battle of Bibracte in Gaul in 58 BC, is said to have ordered his soldiers to abandon their horses. The message? No Roman would be leaving the battlefield prematurely and none would be leaving at all if the Roman army was not victorious. The purpose of nailing a flag to the mast or burning boats on a beach is thus deliberately to foreclose options. In the jargon of modern game theorists, it is an overt method of reinforcing the ‘credibility’ of the only remaining option—victory. The game theorists refer to this as a ‘tying hands’ or ‘burning bridges’ strategy.1 1. Credibility and public debt Military engagements typically offer the participants a simple choice of outcomes—win or lose. Public debt obligations similarly involve binary outcomes. When due, debts are either paid or they are not paid. Lenders will accept a lower rate of interest if they can be persuaded that the borrower will in fact elect the ‘pay’ alternative when the loan matures. Much of the borrower’s marketing effort for a loan will be directed to effecting that persuasion. For example, the borrower may stress its stainless history of punctual debt service (if it has such a history); pledge assets or revenue streams as collateral security for its promise to pay; accept foreign law as the governing law of the debt instrument and submit to the jurisdiction of foreign courts; accept high penalties (such as stepped-up interest rates or broad cross-default consequences) for any failure to pay; or deliberately forswear any contractual ability to alter the terms of its debt instrument.2 Economic historians and political scientists have long debated whether a sovereign’s ‘credible commitment’ to implement sound fiscal policies can lower a sovereign’s borrowing costs or increase the country’s market access.3 Such commitments can take the form of balanced budget amendments, statutory ceilings on budget deficits, legal protections against expropriation or nationalization, constitutional or statutory impositions of government debt limits and general legal protections for property rights. One additional method of persuading prospective investors that a public sector debtor definitely intends to repay a loan is to promise that the obligation itself will enjoy a legal priority. In its extreme form, such an assurance promises not just a priority over the payment of other public debt but a priority over ‘all’ payment obligations of the sovereign of whatever kind—pensions, salaries, health and education, military expenditures and so forth. We shall refer to these assurances generically as promises of Debt ServiceÜber Alles. In the wake of the global financial crisis that began in 2008, some countries (such as Spain) have embraced Debt Service Über Alles assurances in the hopes of bolstering investor confidence.4 2. Methods A sovereign borrower intent on nailing its flag to the mast through a commitment to Debt Service Über Alles has several options for how to do it—constitutional, legislative and contractual. 3. Constitutional In most countries, the national constitution is the overarching legal document and the most difficult instrument to amend. Political subdivisions like the states of the USA may have their own constitutions. Incorporating a super-priority for public debt service in the constitution is thus the most visible, and probably the most durable, method of signalling a commitment to Debt Service Über Alles. Our survey of national and state constitutions reveals four methods by which prospective investors have been offered a constitutional assurance of a super-priority for public debt service: An automatic charge for debt service payments to the public budget (no need for prior legislative or executive authorization). An explicit priority for debt servicing over other state expenditures. General proclamations as to the sanctity of debt service. Special protections for specific categories of a state’s monetary obligations. No prior authorization/appropriation of funds In many countries, government expenditures, including debt service, require annual appropriations from the legislature. This can present a serious risk for investors in the sovereign’s debt obligations. The political composition of legislative bodies will change over time and some legislators may balk at being asked to appropriate funds to service debts incurred by prior administrations, particularly if they believe that the proceeds of those prior borrowings were squandered or stolen. To address this risk, the laws (usually constitutions) of roughly 50 countries provide that debt service payments shall be an ‘automatic’ charge to the state budget; no annual approval, authorization or appropriation by the legislature is required.5 For example, Spain—confronted in 2011 with skittish investors and rising yields on its sovereign paper—amended its constitution to add a new Article 135. Among other things, Article 135 provided that payments on Spain’s sovereign debt obligations would ‘always be deemed to be included in budget expenditures’6 (that is, would not require special parliamentary approval or appropriation). The new Article also stated that these obligations would enjoy an ‘absolute priority’ and ‘may not be subject to amendment or modification’.7 Provisions of this kind are often found in the constitutions of countries that had been colonies of Great Britain or otherwise had a close connection with Great Britain. They derive from an eighteenth-century change to Britain’s own public finance system. Prior to 1787, separate public revenue streams in Britain were often dedicated to the servicing of specific state debts. ‘Pitt’s Act’ of 1787 consolidated these various revenue streams into a single Consolidated Fund and provided that payments on government debts would henceforth be made out of a Consolidated Fund without the need for specific parliamentary authorization.8 The following excerpt from the Indian Constitution is typical of this Consolidated Fund approach: The following expenditure shall be expenditure charged on the Consolidated Fund of India – … (c) debt charges for which the Government of India is liable including interest, sinking fund charges and redemption charges, and other expenditure relating to the raising of loans and the service and redemption of debt; … (Section 112.3).9 Priority of debt service over other expenditures One of the boldest constitutional grants of a super-priority for debt service expenditures can be found in the Constitution of Puerto Rico (a territory of the United States). Article VI, section 8 contains this language designed to reassure investors in Puerto Rico’s General Obligation bonds: … in case the available revenues including surplus for any fiscal year are insufficient to meet the appropriations made for that year, interest on the public debt and amortization thereof shall first be paid, and other disbursements shall thereafter be made in accordance with the order of priorities established by law.10 In addition to promising this super-priority for Commonwealth of Puerto Rico debt obligations, the Puerto Rico Constitution also provides investors with a mandamus remedy should the super-priority not be respected.11 General proclamations A good example of a constitutional provision intended to reassure investors can be found in the 14th Amendment to the US Constitution. That provision reads in pertinent part: The validity of the public debt of the United States, authorized by law, … shall not be questioned. The 14th Amendment, enacted just after the end of the American Civil War in 1865, also expressly disavows any federal government responsibility for the debts incurred by the seceding Confederate states. Protection of specific categories of monetary obligations Some constitutions specify that certain types of monetary obligations will enjoy a super-priority. For example, a number of state constitutions in the USA provide (with varying formulations) that state pension benefits/obligations ‘shall not be diminished or impaired’. Such provisions appear in the state constitutions of Alaska, Arizona, Hawaii, Illinois, Michigan and New York. 4. Legislative The principal charm (from an investor’s standpoint) of enshrining a super-priority for debt service expenditures in a constitution is that constitutions are usually difficult to amend. The next best place to lodge a super-priority is in legislation, even accepting the reality that what the legislature giveth, a future legislature can taketh away. For example: Greece at the height of its debt crisis in 2012 adopted a legislative provision that characterized debt service ‘at a priority’ as one of the various principles governing fiscal regulations: For the maintenance and strengthening of the fiscal stability, the [following] general principles that govern the fiscal regulations are instituted, referring to: (a) The servicing of the public debt at a priority, in order to maintain and strengthen fiscal stability ….12 Liberia has a similar law: Debt service payments shall be adequately budgeted for in the National Budget and its subsequent Supplementary Budgets. The Minister shall ensure that debt service payments are among the first claims on resources in execution of the National Budget.13 Liberian Regulations have further clarified that debt service payments shall be among the first call on resources. Those regulations say that: The Comptroller General shall ensure this is done to the extent possible that the Government of Liberia does not default on debt obligations. Debt payments shall be made irrespective of whether they meet the general rules subject to reporting of any excess over appropriations, with full explanations of the circumstances, to the Legislature in the next quarterly reporting cycle.14 Cyprus in 2012 reinforced its constitutional super-priority for public debt service with an equivalent legislative provision: … [t]he debt of the Republic of Cyprus constitutes an absolute and unconditional financial obligation of the Republic and the obligations of the public debt constitutes one of the first claims on the Republic in accordance with article 166 of the Constitution of the Republic of Cyprus and its fulfillment does not depend on any other claim or counterclaim for payment.15 This Cypriot text is an imperfect example of a Debt Service Über Alles assurance. Note the manoeuvring room left by the saying that debt service is ‘one of the first claims on the Republic’. The reader is left to speculate about how many other ‘first claims’ there may be on the public purse. Similarly, Spain supplemented its newly adopted constitutional debt priority provision with Organic Law 2/2012: Budgetary appropriations for the payment of interest and principal of the Administrations’ public debt shall always be included on the expenditure statements of their Budgets and shall not be subject to amendments or modifications while complying with the conditions of the Law on the issue. The payment of interest and principal on the Public Administrations’ public debt shall have absolute priority over any other expenditure.16 5. Contractual Since the late 1970s sovereign borrowers have been in the habit of contractually promising that their foreign currency debt obligations will always rank equally (‘pari passu’) with the borrower’s other external indebtedness.17 These contractual pari passu provisions do not attempt to create a super-priority for the debt in question but they do seek to assuage any concerns an investor may have about being involuntarily subordinated to the sovereign’s other debt obligations. Very occasionally a pari passu clause will promise a legal ranking ‘senior’ to certain other types of public obligations. For example, the Japan Bank for International Cooperation (guaranteed by the Japanese state) promises its investors that: The bonds will be our direct, unsecured debt securities obligations and rank pari passu and be payable without any preference among themselves and at least equally with all of our other unsecured debt securities obligations from time to time outstanding, which rank senior to our unsecured general obligations not represented by debt securities, provided, however, that certain obligations in respect of national and local taxes and certain preferential rights granted by, among others, the Japanese Civil Code to certain specified types of creditors, such as preferential rights of employees to wages, will have preference.18 6. Effectiveness of Debt Service Über Alles assurances A cynic might conclude that promises of a super-priority for public debt—whether constitutional, legislative or contractual—are mere eyewash to lure gullible investors. They will be effective to enshrine the super-priority right up to the point that they cease to be effective. ‘Consolidated Fund’ structures that circumvent the need for annual legislative appropriations for debt service may indeed have some real value for the investors in those instruments. But promises to treat public debt service as a super-priority over every other use of government revenues are fatuous. In an emergency, a government would abdicate its most basic responsibilities to its citizens were it to honour such a promise literally.19 The idea that the government’s last dollar or euro would be spent on debt service rather than medicine (following an epidemic), bullets (following an invasion), oil imports (following chronic blackouts) or many other emergencies is silly. History shows that when confronted by severe financial crises, governments do what they must to address the situation, even if this means ignoring the promises made to entice investors into lending money. In the midst of the Great Depression, the US Congress, at the behest of the US government, passed a series of legislative measures that effectively obliged all Americans to sell their gold to the government, allowed the government to establish a new dollar value for gold, and abrogated the gold clauses in private debt and Treasury bonds. Gold clauses allowed the holder of a debt instrument to require payment of the underlying obligation in gold.20 The US Supreme Court, even though it found that the abrogation of the gold clauses in relation to US Treasury securities was unconstitutional, decided that bondholders were not entitled to any damages.21 The theory was that any gold paid out by the US Treasury in compliance with a gold clause must immediately be resold ‘to’ the US Treasury at precisely the same price. In Europe, the absence of positive market reaction to the Spanish constitutional amendment establishing the super-priority of debt further demonstrates the anaemic effect of such nailing-the-flag strategies.22 Spain’s constitutional amendment was ineffective to halt the upward pressure on yields for Spanish government debt.23 In fact, the constitutional amendments were largely ignored by the press and the credit rating agencies.24 Finally, governments may also sometimes rely on ‘state of emergency’ clauses to justify actions that would otherwise violate constitutional super-priority protections.25 Such ‘emergency’ clauses are found in many national constitutions and are intentionally crafted to leave ample room for interpretation.26 In conclusion, we think there is little justification for the contemporary enthusiasm for sovereign promises of Debt Service Über Alles. While these promises appear to provide little positive benefit in terms of lowering sovereign yields, they can impose costs. These include delays on the part of government officials (worried about constitutional constraints) in taking steps to quickly restructure a debt stock and they inevitably invite creditor litigation. Thanks to Ugo Panizza and Mark Weidemaier for comments. Footnotes 1 Avinash Dixit and Barry Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics and Everyday Life (WW Norton & Co 1991) 152. 2 Although official sector players like the IMF have strongly encouraged sovereign borrowers to incorporate clauses in their external debt instruments that will permit a modification of the terms of the instruments with the consent of only a supermajority of holders [IMF, Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructuring (October 2014)], some sovereign borrowers refuse to give themselves the flexibility conveyed by these clauses. By omitting any possible method for contractually modifying terms, the sovereign issuers hope to demonstrate to prospective investors that they never could, never would, seek such a modification. Prospectus Supplement to SEC Base Prospectus Dated 5 July 2012 of Japan Bank for International Development (23 July 2013) 44–5. 3 See, eg Douglass North and Barry Weingast, ‘Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England’ (1989) 49 J Econ Hist 803; John A Dove, ‘Credible Commitments and Constitutional Constraints: State Debt Repudiation and Default in Nineteenth Century America’ (2012) 23 Const Pol Econ 66; Gary W Cox, Marketing Sovereign Promises: Monopoly Brokerage and the Growth of the English State (Princeton University Press 2016). 4 Attempts along these lines have also periodically been made in the US Congress, but have not prospered. See, eg 2013 Cong US HR 807. Under this proposed legislation, the Treasury may issue new debt to pay principal and interest on the public debt, even if the statutory debt limit is reached (producing a form of priority). See also 159 Cong Rec H2539-03. 5 See Mitu Gulati, Ugo Panizza, Mark Weidemaier and Grace Willingham, ‘When Governments Promise to Prioritize Public Debt: Do the Markets Care?’ (2020) 6 J Fin Reg 41, Table 1 and Appendix 1. 6 Art 135.3, Spanish Constitution (as amended in September 2011). 7 Ibid. 8 John James Grellier, The History of the National Debt, from the Revolution in 1688 to the Beginning of the Year 1800; with a Preliminary Account of the Debts Contracted Previous to that Era 348 (Scholar Select 1810). With the passage of the 1968 National Loans Act, a separate fund was put in place (National Loans Fund) with respect to the UK government’s borrowing and lending. Consolidated Fund Account 2012–2013 of 19 July 2013, p 2 accessed 20 August 2021. 9 accessed 20 August 2021. 10 Puerto Rico Constitution , Article VI, General Provisions, Section 8. 11 The Commonwealth Constitution provides that ‘[t]he Secretary of the Treasury may be required to apply the available revenues including surplus to the payment of interest on the public debt and the amortization thereof in any case provided for by [section] 8 of this Article VI at the suit of any holder of bonds or notes issued in evidence thereof.’ Puerto Rico Constitution, art VI, s 2.3. The efficacy of this constitutional promise of priority was the subject of litigation in federal court recently, but the matter ended up being settled without any court decision. Relevant for our purposes is the fact that the general obligation bonds entitled to first priority did not in fact receive that and instead took significant haircuts. See, eg Deal Reached to Cut Puerto Rico Bond Debt, Yahoo Finance (23 February 2021) accessed 5 May 2021. 12 Law 2362/1995, art 1A, as amended. 13 Liberia, Public Finance Management Act 2009, art 22(3) accessed 20 August 2021. 14 E.1.(3), 2009 Liberian Public Finance Management Regulations, for Public Finance Management Act 2009 accessed 20 August 2021. 15 PDMA LAW 2012, art 19(1). 16 For a survey of all of the sovereigns with such promises, see Gulati and others (n 5) Appendix 1. 17 Lee C Buchheit and Jeremiah Pam, The Pari Passu Clause in Sovereign Debt Instruments. (2004) 53 Emory L J 869; Mitu Gulati and Robert E Scott, The Three and a Half Minute Transaction: Boilerplate and the Limits of Contract Design (University of Chicago Press 2013). 18 Prospectus Supplement to SEC Base Prospectus Dated 5 July 2012 of Japan Bank for International Cooperation (guaranteed by as to Payment of Principal and Interest by Japan, 23 July 2013) 44. 19 See art 25, International Law Commission Articles on State Responsibility accessed 20 August 2021. In the context of a sovereign debt crisis, the doctrine can be read to say that states should not be paying debts at the expense of providing essential govt services (and have a legal defence if they are sued for the repayment of debts in that circumstance). This doctrine is currently the subject of litigation in federal court in New York in the context of Venezuela’s debt crisis. See Mark Weidemaier and Mitu Gulati, ‘Venezuelan Debt Restructuring: Making Impossibility Possible’ (creditslips.org, 4 July 2019) accessed 20 August 2021. 20 See, eg Sebastian Edwards, American Default: The Untold Story of FDR, the Supreme Court and the Battle Over Gold (Princeton University Press 2018); Gerald Magliocca, ‘The Gold Clause Cases and Constitutional Necessity’ (2012) 64 Fla L Rev 1252. 21 Perry vUnited States (1935) 294 US 330, 357. 22 See Gulati and others (n 5). 23 The Amendment passed in September 2011 and rating agencies downgraded Spain shortly thereafter in October. For discussions of the Spanish legal reform, see Letitcia Diez Sanchez, ‘Spain: Dealing with the Economic Emergency through Constitutional Reform and Limited Parliamentary Intervention’ in Thomas Beukers, Bruno de Witte and Claire Kilpatrick (eds) Constitutional Change Through Euro-Crisis Law (Chapter 7, 2017), Center for European Policy Studies; José M Abad and Javier Hernández Galante, ‘Spanish Constitutional Reform: What is Seen and Not Seen’ (2011) CEPS Working Paper No 253 accessed 20 August 2021. 24 They focused entirely on a different constitutional amendment passed at the same time, that of instituting caps on annual deficits. See, eg Howard Schneider, ‘Spain Moves to Enshrine Spending Limits in Constitution’ (TheWashingtonPost, 30 August 2011) accessed 20 August 2021; see also Moody’s ‘Downgrades Spain’s Government Bond Ratings to A1, Negative Outlook’ (Moody’s 18 October 2011) accessed 20 August 2021. 25 For an empirical analysis of the impact of the passage of the priority promise on Spanish bond yields, that find the effect to have been negligible, see Gulati and others (n 5). 26 For instance, Greece’s Constitution (art 106.1) gives the state powers to plan and coordinate economic activity ‘in order to consolidate social peace and protect the general interest’. © The Author(s) (2021). Published by Oxford University Press. All rights reserved. For permissions, please email: journals.permissions@oup.com This article is published and distributed under the terms of the Oxford University Press, Standard Journals Publication Model (https://academic.oup.com/journals/pages/open_access/funder_policies/chorus/standard_publication_model) TI - Nailing the flag to the mast—promises of super-priority in public debt JF - Capital Markets Law Journal DO - 10.1093/cmlj/kmab028 DA - 2021-08-30 UR - https://www.deepdyve.com/lp/oxford-university-press/nailing-the-flag-to-the-mast-promises-of-super-priority-in-public-debt-tY8Rei0eeq SP - 1 EP - 1 VL - Advance Article IS - DP - DeepDyve ER -