Get the latest updates as we post them — right on your browser

. Last Updated: 07/27/2016

BUSINESS AND THE LAW: GKO Default Still Legal Enigma

More than two months have passed since the Kiriyenko government announced its plan to restructure the government's debts on treasury bills, or GKOs. But the legal consequences of this move still remain unclear and open to speculation.

Generally speaking, there are four types of GKO holders affected by the conversion, each in a different way: Major foreign banks, other foreign corporate GKO holders, Russian banks and Russian companies.

In order to resurrect the banking system, the new government purchased a number of Russian banks' GKOs by exchanging them for new short-term Central Bank securities. This exchange wascriticized by Western banks, which accused the government of giving Russian banks preferential treatment.

But the exchange could, however, also be viewed as discrimination against the Russian banks: It could be considered as a forced waiver of their right to sue the government for a greater recovery. These banks badly needed liquidity and, having accepted this exchange, could not go on to sue the government. Therefore, the lawsuit brought by the Association of Russian Banks is not getting as much press attention as it had previously.

Foreign GKO holders have been affected mainly by two events: the conversion itself and the sudden fall of the ruble. Most of the foreign holders were covered for a better part of the currency losses by forwards, but many of those forward contracts have not been fulfilled.

For example, an argument had been accepted by Russian courts before that non-deliverable forwards are not enforceable under Russian law. This was given further weight by a Moscow arbitration court which decided in favor of Tokobank, sued by Western banks for failing to meet its liabilities with regard to more than $50 million in forward ruble-dollar contracts.

However, a decision by the highest arbitration court, which had been lobbied by the Central Bank to accept certain forwards, does not yet exist, leaving the problem unsolved for the time being.

While there is no doubt that the forced conversion of the GKOs is illegal, losses due to the nonfulfillment of forward contracts and changes in the exchange rate are clearly not subject to any possible legal argument. The new government clearly does not intend to simply declare the forwards void but, rather, is keen to offer investors a deal.

The government is currently in negotiations with a group of foreign banks, known as the "Moscow Club", to decide how to proceed with their GKOs, but whatever the result of these negotiations, it will in no way be binding on all GKO holders. The State Duma has failed to even consider the legislation which is needed to make the conversion comply with the Civil Code, let alone the necessary amendment to other legislative acts like the Securities Law. More importantly, the Russian Constitution, wary of Stalinist practices, clearly forbids forced loans, which is exactly what the conversion is.

Finally, the government, by negotiating with the major foreign holders of GKOs, has implicitly acknowledged that a forced conversion is illegal.

For foreign holders of GKOs who are not Moscow Club members, the question is whether they are willing to accept any of the Russian government's proposals or risk filing a lawsuit.

In many senses, developments favor a lawsuit. There may be arguments made in favor of the sovereign immunity of Russian state assets. However, the Russian Federation has a number of offshore assets which are definitely not subject to sovereign immunity.

Further, the courts are obviously resisting the temptation to vest the state with extraordinary powers. The recent decision of the Supreme Court, which declares invalid the Decree dated July 17, 1998, on the payment of value-added taxes proves that judges in Russia still put the rule of law above the short term needs of the budget. In that sense, the conversion may be the real test of strength for the rule of law in Russia.

A consequence of the conversion which has so far gone unnoticed, however, is likely to be the behavior of the corporate Russian GKO holders. They are the group most likely to bring a lawsuit against the Russian government, and they can hardly be expected to invest in governments securities again anytime soon. The money available in Russia in the future is therefore more likely to be used for commercial loans, and to contribute to the growth of the country.

Max Gutbrod is an international partner at Baker & McKenzie, Moscow.