How Sri Lanka can uncover its mysterious legal adversary

Receive free Sovereign debt updates

We’ll send you a myFT Daily Digest email rounding up the latest Sovereign debt news every morning.

Ruth Mason and Mitu Gulati both teach at the University of Virginia Law School.

There have been a lot of intriguing developments in the Hamilton Reserve Bank vs Sri Lanka litigation lately, not least mounting questions around who is really behind the lawsuit, as Alphaville explored earlier this month.

This movie has run before. Dig into the archives on the evolution of modern holdout creditor litigation and one will find reference to Water Street Bank and Trust. In the early 1990s, Water Street brought cases against Ecuador, Ivory Coast, Poland, Panama and Congo for unpaid debt claims (for the history, see the opinion in Elliott vs. Peru, here). 

However, the litigation against Panama hit a bump when Panama’s lawyers found a clever hook in their champerty defence — an old common law doctrine prohibiting litigation driven by the goal of obtaining a financial gain — by asking for the revelation of the real parties in interest in the case.

After some back and forth, Water Street’s unwillingness to disclose who was actually behind its holding companies and limited partnerships resulted in a dismissal. The judge expressed his frustration thus:

In response to each of my orders, plaintiff grudgingly revealed another link in an elaborate chain of 100% holding companies. It should have been crystal clear to plaintiff that I had ordered it to reveal the identities of the human beings who ultimately owned plaintiff. If this was not clear from my December 1 Order, it should have become evident from my subsequent orders and, at the very latest, during oral argument on the sanctions motion. In response to a direct question, plaintiff’s counsel could not articulate any cognizable prejudice to his client from revealing who really owned his client. Plaintiff’s disobedience and evasive compliance with this Court’s orders has lasted far too long.

Sovereign debt geeks know that some of the dramatis personae at Water Street subsequently moved to Elliott Associates — and that’s when the real game of sovereign debt litigation began. Panama eventually lost to Elliott, and the champerty defence got killed in New York via legislation in 2004 (although some are currently trying to resuscitate it).

Maybe the backers of Hamilton Reserve Bank have therefore forgotten the lesson of Water Street vs. Panama. Or perhaps they didn’t think that Panama’s strategy of asking for the identities of the real humans behind the money would work again?

Sri Lanka might have another arrow in its quiver though; one that it might want to use before the bond gets converted into a judgment. Buried in its tax clauses is a weapon we’ve rarely seen in a sovereign bond (with the caveat that reading the tax clause is not something we jump to when we open a bond document). 

First, some basics about this creature.

Referred to as the “tax gross up clause”, the standard version of the provision promises that the sovereign borrower will make all payments of principal and interest free of any withholding or other taxes. In the event that there is some legal change that results in a tax by the sovereign, the country will pay the bondholder these “additional amounts”. 

Every version of the tax clause we have seen will then list a handful of exceptions to the foregoing. Key among these, as Lebanon’s 2015 prospectus shows, is the following:

[N]o such additional amounts shall be payable . . . [to a bondholder] who is liable for such taxes . . . by reason of his having some connection with the Republic other than the mere holding of such Note, Receipt or Coupon.

In other words, domestic residents do not get to escape their income taxes by purchasing a foreign currency sovereign bond.

Some sovereigns put the matter differently than Lebanon. For example, in a 2017 issuance South Africa says that reimbursement of additional amounts will not be made if the holder does not make an explicit declaration of non residence. But the basic idea is the same.

And then there is the Sri Lankan clause. It phrases the matter differently:

[The Issuer shall not pay additional amounts if] upon reasonable request by the Issuer . . . [the] beneficial owner failed to comply with . . . any identification . . . requirement concerning the . . . beneficial owner’s nationality, residence, identity or connection with Sri Lanka, if compliance with such requirement is required by any statute or regulation of Sri Lanka as a precondition to exemption from withholding or deduction of Taxes.

This is delicious. 

Unlike the South African clause that says that the bondholder has to make a declaration as to residence, this one says that Sri Lanka, at any stage of the life of the bond, can request the true owner of the bond to reveal “nationality, residence, identity or connection with Sri Lanka.” 

Assuming that there are interest payments owed as part of Hamilton Reserve Bank’s claim (there are), Sri Lanka can withhold payments on the grounds that it suspects that there might domestic residents among the owners of these claims, and it needs full disclosure of all identities to make its tax determinations.   

Now, Hamilton Bank might be willing to say: “Forget the interest payments; just pay us the principal amounts you owe.” But the longer the default drags on, the more unpaid interest there is to withhold on. 

Plus, if Sri Lanka suspects that some of these folks are domestic residents who have been skipping out on taxes for a while, it can assess those back taxes (until the holders reveal their identities and show otherwise). 

As one of our tax professors in law school would sometimes say: “For the government, it is never too late to tax!”