October 14, 2013

Has the Second Circuit (Unwittingly) Breathed

Life Into the Nostrils of
Imperial Chinese Government Bonds?
Mitu Gulati
Abstract
The attached letter from one Horatio D. Gadfly will form
the basis of the term project for my class at the Duke Law School in the
spring semester of 2014. The course is entitled International Debt
Transactions.
Holders of long-defaulted bonds issued by the Chinese
Imperial Government and Tsarist Russian Government have faced two
insurmountable obstacles to the enforcement of those instruments in U.S.
courts:
(i) Federal courts had previously ruled that the
absolute theory of sovereign immunity which
prevailed in the United States until 1952 applied
to debt obligations issued by foreign
governments prior to that time. (Under the
absolute theory of sovereign immunity, foreign
states could not be sued in U.S. courts without
their consent.)
(ii) The statute of limitations (six years for contract
cases in New York) will have long since expired
on those old bonds.
A Supreme Court case decided in 2004 (Austria v.
Altmann) reversed the old rule about applying absolute sovereign
immunity to claims arising prior to 1952. Under the Supreme Courts new
approach, a federal judge should apply the U.S. sovereign immunity rules
prevailing at the time an action is commenced, not the rules that existed
when the debt was issued.
As for the statute of limitations, the Second Circuit Court of
Appeals ruled in 2012 that a debt instrument containing a financial
covenant (in that case, a promise to maintain the equal ranking of bonds)
is breached each time the issuer makes a payment to other creditors in

violation of the covenant. The decision may imply that the statute of
limitations is commenced afresh for the enforcement (by specific
performance or injunction) of the financial covenant in the old bonds each
time a payment under new instruments is made in violation of the
covenant. See NML v. Argentina.
Taken together, these two decisions could possibly, just
possibly, breathe life into the nostrils of some sovereign bonds that have
for 60 years been esteemed principally for their aesthetic, as opposed to
their financial, characteristics. At the very least, magnifying glasses will
be trained on framed sovereign bonds hanging in foyers, physician
waiting rooms and bathrooms around the country.

Horatio D. Gadfly
12 Never Street
Elmira, New York

December 31, 2013

Honorable John F. Kerry
Secretary of State
United States of America
Washington, D.C.
Re: Peoples Republic of China
Dear Mr. Secretary:
I am taking the liberty of writing to you on a matter of
considerable importance both to me and to the foreign relations of the United
States.
Background
My name is Horatio D. Gadfly. I am a lifelong resident of
Elmira, New York.
I am the sole remainderman on a trust established by my great
uncle Waldo Z. Gadfly who died in 1975. Uncle Waldo was also a lifelong
resident of Elmira, except for the several years he spent in China (described
below). By the terms of the trust, I received clean title to all of the assets in
the trust earlier this year.
In one of the boxes that was delivered to me by the trustee, I
found a manila folder bearing the cryptic legend The last camel died at
noon. This, I seem to recall, was Uncle Waldos favorite expression for
describing a situation or occurrence that was imminently to ripen into a fullyfledged catastrophe. All his life, Uncle Waldo had a keen -- some said
clairvoyant -- instinct for sensing imminent catastrophes.
Inside this folder I found fifty bonds issued by the Chinese
Imperial Government in 1898.
The bonds are captioned 4% Gold Loan of 1898. The
bonds are denominated in Great Britain Pounds Sterling. I am attaching to
this letter a copy of one of the bonds.
Clipped to this stack of bonds was a note written in Uncle
Waldos distinctive spidery scrawl. It reads as follows:
3

My dear Horatio,
As you know, in my younger days I was a civil engineer
and went out to China in 1895 to make my fortune. The Chinese
Government of the day quickly retained my services pursuant to a
three-year contract to build railroads in various places in the
country. Although my efforts were greatly esteemed by the
Government, when my contract ended in 1898 the Government
pleaded a temporary embarrassment of liquidity (thats a free
translation from the Mandarin). In other words, they didnt pay
me. Instead, the Government promised to send the money due to
me by not later than midnight on December 31, 1899.
I returned to Elmira, as the saying goes, poorer but wiser.
But to much my surprise, at 11:45 p.m. on December 31,
1899, just as I was waiting to welcome in a new century, I heard a
knock on the door of my little house in Elmira. I opened the door
to see a young fellow, covered in snow, clutching an envelope. He
handed me a business card saying Third Deputy Financial
Attach, Embassy of the Imperial Government of China. This
fellow uttered only one sentence: Honorable Waldo, the Imperial
Government of China always pays its debts. And with that he
shoved an envelope into my paw and disappeared again into the
snowy night.
The envelope contained the bonds you now are holding. It
also contained instructions that I was to present the coupons to the
offices of the Hong Kong and Shanghai Banking Corporation in
New York City where the Government had apparently made
arrangements for payment.
And indeed they had. Every year between 1900 and 1939,
I presented a coupon across the counters of the HSBC in New
York City and was paid in full. The coupon I presented in 1940,
however, was dishonored. No explanation was given.
Naturally, I consulted a lawyer but was told that a foreign
Government like China was absolutely immune from suit in a U.S.
court and I was advised to forget the whole incident.
Well my lad, who knows. By the time you read this, things
may have changed. Good luck and good hunting.
Affectionately,
Uncle Waldo.
4

And, bless his heart, Uncle Waldo actually had that

handwritten note notarized.
The Current Situation
Mr. Secretary, I direct your attention to the fifth paragraph of
the Extracts from the Agreement referred to in the Bond which appears on
the reverse of the attached bond.
It reads as follows:
This entire loan of sixteen million pounds sterling
shall have priority both as regards principal and interest
over all future loans . . . so long as this loan or any part
thereof shall be unredeemed.
I shall refer to this as the Absolute Priority Undertaking.
In other words, the Chinese Government solemnly promised
that until the bonds were paid in full, amounts due under these instruments
would enjoy a priority over any other Chinese Government debts contracted
after the issue date of these bonds. My research has confirmed that the
current Chinese Government has indeed issued new debt securities to
investors in the United States, and that those instruments are being paid
currently. Specifically, the PRC issued a New York-law governed bond
(Euro 1 billion; 4.5%) in 2009. All coupons on that bond have been
punctually paid in full; the final payment is due on October 28, 2014. It is
obvious that each such payment on those subsequently-issued Chinese bonds
violates the Absolute Priority Covenant.
Legal Analysis
I have consulted legal counsel skilled in sovereign debt
matters and, once again, Uncle Waldos premonitions have proven accurate -things have changed (dramatically) since his day. Set out below is a
summary of the legal advice I have received on issues relevant to my Chinese
Government bonds.
1.
Responsibility of the PRC. Although the Government
of the PRC has disclaimed responsibility for the debts of its predecessor
governments, these disclaimers are not binding in a U.S. court. The law of
the United States provides that successor administrations in a country must
honor the debts incurred by their predecessors. See Restatement (Third) of
the Foreign Relations Law of the United States 209(2) (1987).
2.
Odious Debts. The PRC has labeled the debts of the
Imperial Chinese Government as odious. There is some discussion in the
academic literature about the possibility that a doctrine of odious debts may
5

have evolved in recent years. My counsel, however, is of the view that this
doctrine (if doctrine it be) is not recognized in U.S. jurisprudence. See
Buchheit and Gulati, The Dilemma of Odious Debts, 56 Duke Law Journal
1201, 1228-1230 (2007).
3.
Sovereign Immunity. Although Uncle Waldo was
correct that in his day a suit could not be brought against a foreign sovereign
in a U.S. court without the sovereigns consent, all of that changed starting in
1952. U.S. law today holds foreign sovereigns accountable at law for their
commercial contracts like bonds and loans. See Foreign Sovereign
Immunities Act of 1976 (FSIA). The PRC takes the view that it has never
acquiesced to the evolution of international law from an absolute theory of
sovereign immunity to a more restrictive theory. See Qi, State Immunity,
China, and Its Shifting Position, 7 Chinese Journal of International Law 307,
315-323 (2008); see also Jackson v. Peoples Republic of China, 794 F.2d
1490, 1494 (11th Cir. 1986). However, even assuming that the PRC qualifies
as a persistent objector for purposes of customary international law (a
questionable assumption), a U.S. domestic court is not going to read an
exception for one nation into the FSIA.
4.
Applicable Law. For many years, however, U.S.
courts applied the old rule of absolute sovereign immunity to debt obligations
issued before 1952. See Jackson v. Peoples Republic of China, 794 F.2d at
1497-98. This was expressly altered by the U.S. Supreme Court in 2004.
See Republic of Austria v. Altmann, 541 U.S. 677. As a result of the
Altmann decision, it is now clear that the PRC would not enjoy immunity in a
U.S. court for its obligations under these bonds.
5. Statute of Limitations. I recognize that it may be too late
now to obtain a judgment for the unpaid principal and interest on the bonds
because they went into default so long ago. See Morris v. Peoples Republic
of China, 478 F.Supp.2d 561, 571-73 (2007). However, the expiry of the
statute of limitations does not extinguish the vitality or validity of a debt
instrument. Rather, it just limits the judicial remedies available to enforce
the instrument. In the matter at hand, a fresh violation of the Absolute
Priority Undertaking occurs each time the PRC makes a payment on one of
its new bonds without paying me. The Second Circuit Court of Appeals has
recently interpreted a very similar financial covenant in a sovereign bond to
require ratable payments on the issuers long-defaulted obligations. See
NML v. Argentina, 699 F.2d 246 (2d Cir. 2012).
6.
Rights Against Third Parties. Quite apart from my
claim against the PRC, I am also advised that one implication of the Second
Circuits decision in NML v. Argentina is that I may have a right to require
the holders of all new Chinese bonds -- once I inform them of the existence
of the Absolute Priority Undertaking -- to disgorge to me any payment that

they may receive under those new bonds. See Coast Bank v. Minderhout,
392 P.2d 265 (Cal. 1964) (Traynor, J.).
7.
The Uniquely Recalcitrant Debtor. The Second Circuit
Court of Appeals has demonstrated that the federal judiciary will stretch to
give the aggrieved creditors of uniquely recalcitrant sovereign debtors an
equitable remedy to redress their grievances. See NML v. Argentina, 2013
WL 4487563 at n.13. Surely, the actions of the Chinese Government in
explicitly disavowing predecessor government debts and paying only more
recent creditors put it into the uniquely recalcitrant category.
*

Mr. Secretary, I am certain you will concur that my case in

this matter, were I to resort to my legal remedies, is invincible. But such a
step would undoubtedly create diplomatic friction between the United States
and the Peoples Republic of China. I have no wish to stir up that trouble.
Accordingly, I would be grateful if you could use the influence of the State
Department to cause the Government of the PRC to honor the debt that it
once owed to dear Uncle Waldo, and that it now owes to me.
Regretfully submitted,

Horatio D. Gadfly
Enclosure

Citation:
Gulati, G. Mitu, Has the Second Circuit (Unwittingly) Breathed Life into the
Nostrils of Imperial Chinese Government Bonds? (October 14, 2013). Available at
SSRN: http://ssrn.com/abstract=2340299 or
http://dx.doi.org/10.2139/ssrn.2340299

ft.com > Comment > Blogs > FT Alphaville

Back to the future with pari passu

Joseph Cotterill
| Nov 05 2013 12:45 | 15 comments | Share
Wait a minute, Doc. Ah Are you telling me that you built a time machine out of a sovereign
bond contract?
Marty McFly (paraphrased)
Imagine the next place to come under the new era of enforcing sovereign debt isnt Argentina, or
in the Caribbean, or even a future eurozone crisis. Imagine something older. Much older.
For when historians come to study the Great Calamity of 2014 in international relations between
the United States and China, they shall surely whisper one name, in trembling tones.
Horatio D. Gadfly.*
And they shall doubtless point an equally trembling finger at such ornate and frilly bond
contracts as this one.

Thats a 4 per cent gold loan issued by the Imperial Chinese government in 1898 the year
the Hundred Days Reform failed and the Empress Dowager led a coup against her nephew, the
Guangxu Emperor.
And yes, this is related to Argentinas pari passu saga, particularly now that its turned into a
huge headache for third-party creditors. Weve also been thinking about what the case implies
about the practicality of courts granting injunctions against bad sovereign debtors, when the only
realistic place to enforce is on third parties.
Even if the following does sound completely insane, do please at least consider the argument
Concerning these old Chinese bonds. They have an interesting history. Backed by internal tariffs
introduced during the Taiping rebellion the likin tax, a symbol of the fiscal disintegration of
the Qing dynasty they paid out their coupons until September 1940. Not bad going,

considering events between 1898 and then. But they have not paid according to their terms since.
Such mouldering paper vestiges of a dead empire as they are, you can often find the bonds on
Ebay for a few quid.
The Imperial bond might seem a long way away from even the weirder sovereign debt curios of
the 2010s like Argentinas defaulted debts, or for that matter, the handful of bonds which the
modern Peoples Republic of China has issued under New York law.
Holders of the PRCs October 2014 bond, for instance, have happily collected payments on it for
almost ten years now, without threat of interruption by third parties. Holders of Argentinas
restructured debt havent been quite so confident lately. Thats the power of ratable payment for
you especially when ordered as equitable relief by a US federal court. Pay all together, or pay
all nothing.
Although that is where Horatio D. Gadfly comes in.
FT Alphaville recently came across an astonishing letter penned by Mr Gadfly to John Kerry,
regarding ownership of these very Imperial bonds
In it, the US Secretary of State is alerted to something in the bonds which isnt quite a pari passu
clause. But it would arguably be even more slam-dunk as basis for an injunction of ratable
payment, enforceable on third-party bondholders.
That is, if Mr Gadfly was to sue the current Chinese government for relief.
Its a provision for priority over all future loans:

Whereas pari passu is just a promise of equal treatment.

Imperialist bond clauses
Funnily enough late-nineteenth-century contracts (like the 4 per cent Imperial Chinese issue)
could well be the primeval soup from which the sovereign version of pari passu emerged, along
with its close cousin, negative pledge. No wonder studying them has been called legal
paleontology. How these clauses became genuine boilerplate in the twentieth century
crammed into increasingly unsecured sovereign debt contracts everywhere is a story for
another time.
They probably made some kind of sense in an era where it was still acceptable for governments
to dedicate a specific stream of tax revenue to specific bonds, but where they could increasingly
sell ever more pieces of debt (using the same collateral) to ever more gullible distant investors.
The latter would therefore increasingly demand equality of treatment (or maybe just direct
priority).

An era when the first age of globalisation rubbed shoulders with financial imperialism, basically.
It is no accident that a bond which handed over railway rights to foreigners helped start Chinas
1911 revolution.
So, you might regard the grant of absolute priority to one bond as among the last decadent
insanities of a decrepit dynasty. No modern government would fetishise even general debt
service so ludicrously. (Would they?)
A sovereign bond Delorean?
But we are getting lost from Mr Gadfly. Heres his take on the absolutely priority clauses
relevance in 2013, as relayed to (a doubtless alarmed) John Kerry:
In other words, the Chinese Government solemnly promised that until the bonds were paid in
full, amounts due under these instruments would enjoy a priority over any other Chinese
Government debts contracted after the issue date of these bonds. My research has confirmed that
the current Chinese Government has indeed issued new debt securities to investors in the United
States, and that those instruments are being paid currently. Specifically, the PRC issued a New
York-law governed bond (Euro 1 billion; 4.5%) in 2009. All coupons on that bond have been
punctually paid in full; the final payment is due on October 28, 2014. It is obvious that each
such payment on those subsequently-issued Chinese bonds violates the Absolute Priority
Covenant
In which you may detect a rather familiar modus operandi.

But before we note how familiar, there are two big objections to note first, all to do with the
procedure of suing a sovereign, before the substance of whether its been a bad debtor.
1) China could argue that it doesnt have any responsibility for bonds contracted by the
Qing empire. It might even insist that these debts are odious. In fact the Chinese government
argued some 30 years ago, in an aide-memoire to one of these bondholder cases (yes, Horatio
wouldnt be the first), that it recognizes no external debts incurred by the defunct Chinese
Governments and has no obligation to repay them.
On the other hand, US law on state succession isnt so clear, and thats the forum where Mr
Gadflys proposing to bring his case. In particular, odious debt has few judicial fans.
2) Similarly, the Peoples Republic has long maintained that it still adheres to the absolute
theory of sovereign immunity. Much of the rest of the world moved on to restrictive
immunity after the Second World War. If states are engaged in the same kind of activity as
anyone else like commercial transactions they could be sued in the courts of other states
over that activity. China has always objected, in international law, to this shift. Which might
sound like a dead end for Mr Gadfly.
But the US gradually codified restrictive immunity in its own law from 1952 to 1976, the date of
the Foreign Sovereign Immunities Act. Probably just as well, because modern sovereign bond
litigation could never have got off the ground without it (or its UK equivalent). In any case,
Gadfly has argued that the only relevant law for his suit is US law.

(Holders of the PRCs modern New York law bonds, meanwhile, were warned on buying that
China has not waived its sovereign immunity in connection with any action arising out of or
based on United States federal or state securities laws)
Now, in US law as of 2004, the courts are supposed to apply the regime of sovereign immunity
that applied when a case was brought, not when a debt was first issued. The FSIA is retroactive.
Assuming that opens the door to Mr Gadflys pre-1952 bonds, they still have a problem. New
York contract cases limit claims that are older than six years.
But that (finally) is where NML Capital v Argentina might come in. It could have provided some
guidance to old Chinese bondholders on two other key bits of bringing an injunction against the
PRC. As Mr Gadfly puts it himself:
Statute of Limitations. I recognize that it may be too late now to obtain a judgment for the
unpaid principal and interest on the bonds because they went into default so long ago. See
Morris v. Peoples Republic of China, 478 F.Supp.2d 561, 571-73 (2007). However, the expiry
of the statute of limitations does not extinguish the vitality or validity of a debt instrument.
Rather, it just limits the judicial remedies available to enforce the instrument. In the matter at
hand, a fresh violation of the Absolute Priority Undertaking occurs each time the PRC
makes a payment on one of its new bonds without paying me. The Second Circuit Court of
Appeals has recently interpreted a very similar financial covenant in a sovereign bond to require
ratable payments on the issuers long-defaulted obligations. See NML v. Argentina
Rights Against Third Parties. Quite apart from my claim against the PRC, I am also advised
that one implication of the Second Circuits decision in NML v. Argentina is that I may have a

right to require the holders of all new Chinese bonds once I inform them of the existence of
the Absolute Priority Undertaking to disgorge to me any payment that they may receive under
those new bonds. See Coast Bank v. Minderhout, 392 P.2d 265 (Cal. 1964) (Traynor, J.).
The Uniquely Recalcitrant Debtor. The Second Circuit Court of Appeals has demonstrated that
the federal judiciary will stretch to give the aggrieved creditors of uniquely recalcitrant
sovereign debtors an equitable remedy to redress their grievances. See NML v. Argentina, 2013
WL 4487563 at n.13. Surely, the actions of the Chinese Government in explicitly disavowing
predecessor government debts and paying only more recent creditors put it into the uniquely
recalcitrant category
Ingenious crazy isnt it?
The focus on payments to other bondholders isnt just to breathe life into the redress of a seven
decade-old default. It might also allow suing them directly. Argentinas restructured holders
might end up volunteering to disgorge some payments in order to get holdouts to settle so
maybe the logic isnt so crazy.
But also interesting, because youd hardly expect the Peoples Republic of China, rising global
power and guardian of absolute sovereignty, to take being enjoined by US courts lightly. Third
parties would have to be the route to getting the PRC itself to comply. It would probably see
holdouts not as vultures but as annoying gnats (or, well, gadflies). So it would be like testing out
the state of play post-Argentina in extremis.
After all, the mechanism the Second Circuit has used to try and control the consequences of the
pari passu ruling is to say that Argentina has been not just recalcitrant to holdouts but uniquely

recalcitrant. This is interesting in itself: the remedy to be derived from a contract is not just about
contractual terms but bad behaviour of one of the counterparties. And sure, its been very bad.
But then look at the PRC: its directly repudiated Gadflys bonds. How recalcitrant is that?
And actually, looking further afield what about those Tsarist bonds that modern Russia has
never fully repaid? Old-style pari passu clauses were put in this debt too before the Bolsheviks
repudiated it.
So we might be getting a host of Gadflies.
Or perhaps (more seriously) we should be asking whether holes in the law on injunctions and
sovereign immunity and not holes in pari passu clauses have been the problem all along
__________________
*NB Horatio Gadfly is not actually real. Hes a figment of the imagination of Mitu Gulati of
Duke Law School. Mitu prepared Gadflys arguments to test on students of his International
Debt Transactions course next year. But those Imperial Chinese bonds are real. People do sue
over them. No ones used the pari passu template or teased out its full implications yet.
This entry was posted by Joseph Cotterill on Tuesday November 5th, 2013 12:45. Tagged with
Argentina, China, Sovereign Debt.