After Default to Putin, What’s Next for Ukraine-Russia Bond Row

International Monetary Fund Logo Over Ukraine Flag

(Bloomberg – – Natasha Doff and Marton Eder – December 20, 2015)

A two-year feud between Ukraine and Russia is on the verge of being played out in a London courtroom after the government in Kiev defaulted on $3 billion in bonds.

Ukrainian President Petro Poroshenko followed through on months of threats on Friday by reneging on the debt sold by his predecessor to Russian President Vladimir Putin in December 2013, two months before Viktor Yanukovych was toppled and the former Soviet republics went from allies to adversaries.

The bond has since become a focal point of the deteriorating ties.

As Putin’s annexation of Crimea and support of separatists in Ukraine’s easternmost regions battered the economy, the government in Kiev came to the brink of insolvency before securing aid from the International Monetary Fund. To qualify for the bailout, Ukraine negotiated a $15 billion debt restructuring with investors including Franklin Templeton.

Russia refused to take part.

While there are signs the two sides are willing to reach an out-of-court settlement, a legal battle in the U.K., either through the court system or arbitration, is a growing possibility. Just hours after the moratorium was imposed, Russian Deputy Finance Minister Sergey Storchak reiterated that Moscow will sue, saying Ukraine has “no chance of winning this case.” Prime Minister Dmitry Medvedev on Monday ordered the government to prepare a lawsuit.

* Where and how would legal action take place?

The Eurobonds were drafted under English Law, so any claim must be submitted to a court in London. The prospectus also allows parties to use the London Court of International Arbitration, a tribunal favored by former Soviet nations. Russia has said it will sue Ukraine for the $3 billion, plus an outstanding $75 million interest payment and all other interest that accumulates between now and a court verdict.

Russia may opt for the latter as arbitration is faster and more discrete. The country “probably has at least a reasonably strong case” of securing a ruling in its favor, according to Michael Waibel, a professor of international law at the University of Cambridge.

Getting its money back may prove challenging even if arbitrators order Ukraine to pay compensation, however. Russia may try to seize Ukrainian state assets abroad through legal processes in the countries where they’re located, Waibel said.

Andrew Wilkinson, a partner at law firm Weil Gotshal & Manges LLP who worked on drafting Ukraine’s restructuring documents, said: “legally, Russia’s options are very limited if it wants to get its money back.” He said lawyers took care to draft the debt deal to prevent holdouts getting the upper hand.

A defeat could cause “great embarrassment” for Putin if a judge determines that Russia already had plans to annex Crimea when the bond documents were drawn up, according to Mitu Gulati, a law professor at Duke University who specializes in sovereign debt.

* Could an out-of-court resolution still be reached?

Russia and Ukraine have indicated they’re willing to settle outside of court.

Finance Minister Natalie Jaresko on Friday said she was “hopeful” an agreement could be reached without resorting to a legal battle. On Dec. 15, she said the sides are in “everyday contact” through mediators from Germany, one of the key players in brokering a fragile cease-fire that’s taken hold in Ukraine’s easternmost regions since September.

Her counterpart in Moscow, Anton Siluanov, said the next day that Russia is open to cooperation, although the chances for an out-of-court settlement may be “impossible” due to time constraints. On Saturday, Siluanov said Russia still expects full payment and will wait until the new year to start litigation.

* What could a potential diplomatic deal look like?

To reach an accord, the two sides would probably have to agree to terms somewhere between the conditions of Ukraine’s broader restructuring and an offer made by Putin last month.

The restructuring imposed on Franklin Templeton and others involved a 20 percent writedown to principal, maturity extensions of at least four years and warrants tied to economic growth. Russia wouldn’t take part on the grounds that its debt should be treated as a sovereign loan. Moscow bought the note paying 5 percent interest, less than half the yield on Ukraine’s bonds at the time.

During the Group of 20 meeting in Ankara in November, Putin said he would let Ukraine settle the debt in three $1 billion instalments from 2016 to 2018, so long as Western governments or banks provided a repayment guarantee. The proposal fell through after the U.S. refused to offer the financial backing.

Even if a diplomatic solution is reached, Ukraine’s other bondholders must sign off since the debt deal barred the government from giving any holdout better terms. Franklin Templeton, Ukraine’s biggest investor, would therefore need to approve.

Any accord must also appease the IMF. Its aid package is contingent on Ukraine making savings of $15.3 billion in debt-servicing costs over four years.

* What does the default mean for Ukraine’s bondholders?

For investors in Ukrainian bonds, the moratorium will probably have little immediate effect. Before the restructuring, the missed payment on the Russian bond would have triggered defaults across other bonds. Now that the old securities have been exchanged for new securities, that can no longer happen.

* Is there any risk to Ukraine’s IMF rescue funding?

The IMF, which granted Ukraine a $17.5 billion lifeline over the next three years, probably won’t stop lending to Ukraine over the dispute. The Washington-based fund loosened its loan policies this month to allow it to keep disbursing aid to countries in arrears to sovereign creditors.

However, it also stressed that Ukraine must engage in substantive bilateral talks with Russia to try to resolve the dispute. Jaresko said Friday that Ukraine was acting in “good faith.”

The IMF executive board last week sided with Russia by branding the $3 billion bond as an official debt, undermining Ukraine’s argument that Moscow should accept the same terms as commercial creditors and nudging it toward reaching a separate resolution with its neighbor.

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