Contracting With a Sovereign: Determining Capacity and Authority

Contracts with states are an omnipresent feature of the global financial system, underlying all sovereign debt obligations.  It may therefore come as a surprise that, until recently, the English courts had not considered certain basic questions: how does one determine a foreign sovereign state's capacity to enter a private law contract under English law? Is such capacity impugned if the sovereign breaches its domestic laws, or even its own constitution, in contracting?

The decision in The Law Debenture Trust Corporation plc v Ukraine [2017] EWHC 655 addresses these points (among others).  In 2013, the State of Ukraine issued a USD 3 billion Eurobond: a debt instrument, constituted by an English law governed trust deed, held by the Russian Federation.  Following Russia's invasion of Crimea, Ukraine refused to repay. 

Ukraine argued that the transaction was void as it lacked capacity to contract, because Ukraine's entry into the underlying contracts breached its constitution and domestic budget laws (as a matter of Ukrainian law).

No prior English case law had considered the capacity of a foreign state to contract, nor which conflict of laws rule would apply to determine this question. The court reasoned from principles of public international law to find that a state's capacity is not analogous to that of a public authority or foreign corporation, but rather "rests in its sovereignty". Once a state is recognised as such, as a matter of both English and international law, it is recognised as having unlimited capacity to contract which cannot be restricted by the state's domestic laws.

However, this power to contract must be exercised by a properly authorised individual. The Ukrainian Minister of Finance had no actual authority (under Ukrainian law) to bind Ukraine to the transaction when executing the documents. Under English law, the Minister could still possess either usual or ostensible authority to bind the state. Usual authority is held by virtue of a particular position (such as a company director), whereas ostensible authority arises with a direct representation as to authority. 

The court found that a Finance Minister would not always have usual authority to engage in state borrowing by reason of their office (which may have interesting implications for those contracting with Ministers more generally).  However, given prior dealings, usual authority was found in this case. Additionally, as the Ukrainian Cabinet possessed usual authority to hold out the Minister as Ukraine's authorised representative, the Minister also had ostensible authority following a representation from Cabinet.

The mischief being prevented is clear: Ukraine's breaches of domestic law were solely within its own cognizance. Allowing a state to evade its obligations through a plea of lack of capacity, when it is solely responsible for relevant deficiencies, would be remarkably harsh on counterparties, who may otherwise be forced to recover their loss on restitutionary grounds without the benefit of a contractual waiver of sovereign immunity. 

Litigation against states tends to be particularly hard fought. It will remain practically important to consider questions of domestic capacity in the context of assessing the commercial risk of a transaction. However, from a strict English law perspective, the focus should be on establishing authority: whether the actor purporting to bind the state has authority, rather than capacity, to contract will be the critical determinant of whether the contract is enforceable.

A longer version of this article appeared in the May 2017 issue of the Allen & Overy Litigation and Dispute Resolution Review.

Stacey McEvoy is an associate in the Banking, Finance and Regulatory Litigation Group of Allen & Overy, London.