Second Circuit Gives Successor States a Blank Slate on Credit Obligations

Last month the Second Circuit issued a remarkable ruling that threatens to upend the longstanding rule of successor state liability for the credit obligations of predecessor states. It did so by ruling that the automatic assumption of liability of sovereign debt of the predecessor state under international law is not a “commercial activity” within the meaning of the FSIA. In so holding, the Second Circuit ruled that without some affirmative action by the successor state, it is immune from liability for the commercial obligations of the predecessor state. In other words, each new state starts with a blank financial slate.

The case of Mortimer v. Germany, is complex, involving 1928 local public debt owed by the state of Prussia, a Länder within the German Republic. Following the Second World War, the German Republic was divided into West Germany and East Germany, and then united again in 1990. Thus, since the time the public debt was guaranteed, the government went through two state successions, one in 1949 and a second in 1990. Approximately one-third of the bonds were issued by obligor banks in West Germany, and the remaining two-thirds by obligor banks in East Germany. The current market value of the bonds alleged exceeded $400 million.

The bondholder sought to enforce the bonds against Germany, but to no avail. The Second Circuit ruled that with respect to the West Germany bonds the express assumption of liability for those bonds through enactment of “validation laws” constituted a “commercial activity” within the meaning of § 1605(a)(2), as affirmed in Republic of Argentina v. Weltover. But because the bondholders never validated the bonds the plaintiff, under the Iqbal pleading standard, “failed to plausibly allege that it either met the statutory validation requirements … or was not required to do so.”

The more significant holding is with respect to the East German bonds. East Germany never expressly assumed liability for the Prussian bonds. The question therefore, was whether the plaintiff could identify any “commercial activity” that would satisfy the FSIA standard. The Second Circuit concluded that the plaintiff could not.

“We hold that automatic assumption of liability by a successor state, even if established, would not meet the requirements of the FSIA’s commercial activity exception…. Accession to liability by the rules of customary international law entails no action by the successor state with respect to the commercial activity at issue—the assumption of liability. The state performs no action when it automatically assumes liability. This stands in sharp contrast to a country’s assumption of liability through an explicit act, such as West Germany did here. Because no “action” within the meaning of § 1605(a)(2) occurs when a successor state accedes to liability, the requirements of FSIA’s commercial activity exception are not met in that context and jurisdiction under the FSIA based on such an accession will not lie.”

The problem with this reading, of course, is that it completely ignores the original commercial activity of the predecessor state of Prussia in 1928. When Prussia guaranteed the obligations of the banks, that was a commercial activity under then-existing international law. The Second Circuit makes no mention whatsoever of this activity, nor does it recognize the retroactive application of the FSIA as affirmed by the Supreme Court in Austria v. Altmann.

The result of the Second Circuit’s holding is to render claims against the commercial debt of a predecessor state unenforceable, absent express assumption of liability by the successor state. It effectively transforms the customary international law rule of automatic successor liability for public debt into one of conditional successor liability. The effect of this ruling is to preclude creditors from enforcing all predecessor public debt against state successors, at least in the financial headquarters of the United States.

(Disclaimer: Tai-Heng Cheng and I wrote an amicus brief on the issue of successor liability in support of the plaintiff).