Recent Proposals for Reform of Sovereign Debt Restructuring

the precise contingency clauses described above also do not yet exist. The US proposal envisages that debtors and creditors and their lawyers would work together and gradually come to a set of clauses that would become the standard clauses for contracts, building on existing ‘collective action clauses’ (discussed below) which are already used in some jurisdictions.7 Unlike the SDRM, the US Treasury approach would focus on separately restructuring different types of debt and different bond issues. However, there is flexibility in the proposal for it to use so-called ‘super collective action clauses’ whereby such clauses could be placed in all forms of debt, allowing restructuring by a qualified majority of all creditors. At a broader international level, the Group of Seven (G7) nations has also endorsed a contractual solution that shares many elements in common with the US Treasury model. However, G7 members have also suggested work should continue on developing the statutory-based approach, which could be pursued in a complementary fashion to the contractual approach. At a more specific level, the G7 has endorsed ongoing work on aggregation issues (e.g., how to bring together creditors in different instruments) and the treatment of new private lending. Private Sector Responses The views of different private sector groups towards proposed reforms to the international financial architecture have been evolving over time. The response of private sector market participants to reform was initially fairly negative, although it has recently evolved to support for a version of the Taylor proposal. The initial resistance to any change can be characterised as having four main points: 6. See JB Taylor, ‘Sovereign Debt Restructuring: A U.S. Perspective’, Remarks at the Institute for International Economics Conference on ‘Sovereign Debt Workouts: Hopes and Hazards’, Washington, 2 April 2002. 7. One creditor group has already proposed a set of model covenants, albeit with voting thresholds that appear excessively high. In addition, a G10 working group is developing model clauses. 8. See, e.g., MM Chamberlin, ‘Revisiting the IMF’s Sovereign Bankruptcy Proposal and the Quest for More Orderly Sovereign Work-Outs’, Remarks at the Institute for International Economics Conference on ‘Sovereign Debt Workouts: Hopes and Hazards’, Washington, 2 April 2002. August 2002 Reserve Bank of Australia Bulletin 65 • First, it has been argued that the current system is actually working quite well. In particular, many private sector market participants have noted that the current system has not prevented sovereigns restructuring their liabilities via exchange offers, in which bondholders voluntarily tender their existing securities for new securities that modify (and effectively reduce) the sovereign’s payments structure into a sustainable stream of payments. Pakistan, Ecuador, Ukraine and Russia have all managed to restructure their debts under such exchanges, even in circumstances where there were large numbers of diverse creditors in existence (see Box A). Ecuador, Pakistan, Russia and Ukraine provide recent examples of countries that have had debt servicing problems that resulted in the restructuring of external debt obligations. In each case they were able to do so via debt exchanges, whereby creditors agreed to exchange their existing bonds for new bonds that reduced debt service obligations. Although there were differences between the cases, they each provide examples of successful market-driven approaches to debt restructuring. In each exchange the market value of the debt had fallen to low levels at the time of negotiations, and the mark-to-market gains that resulted from each deal provided a ‘sweetener’ to investors that (in addition to cash payments in some cases) facilitated agreement. These gains presumably reflected the perception that the restructuring enabled the sovereign to return to a sustainable debt profile, and are an example of the gains that accrue to creditors from successful debt restructurings, as opposed to messy defaults where the creditors have little prospect of successful legal action to recover the value of their claims. There were some unique features in each exchange. In Pakistan’s case, the debtor had not yet defaulted on the Eurobond issues that were exchanged for longer maturity bonds. Furthermore, although the Eurobonds contained collective action clauses (CACs), these were not invoked to call a meeting of creditors to restructure the terms of the existing bond: creditors were instead persuaded to tender their bonds in a voluntary exchange, rather than risk default. Indeed, there is only one recent case – the exchange of Ukraine’s Eurobonds – where CACs have been used to facilitate a deal. In the case of Ecuador, the defaulted bonds that were involved did not have CACs and required unanimous consent for changes in the bonds’ payment terms. However, the US style bond contracts actually allowed a qualified majority of bondholders to change other terms of the contract. Creditors agreeing to the exchange were required to tender their bonds and agree to restructure the non-payment terms in such a way as to make the old bonds particularly unattractive for minority hold-out creditors. This was the first time such ‘exit amendments’ (or ‘exit consents’) had been used in a sovereign restructuring. Some commentators have, however, questioned whether this will be a reliable precedent for possible further use of exit amendments, since US courts might not allow such amendments if they were viewed as excessive. In the case of Russia, the defaulted US dollar securities were not obligations of the Russian Federation but were the obligations of the (quasi-sovereign) Vnesheconombank that had resulted from the London Club settlement of commercial payment obligations of the former Soviet Union. Box A: Recent Sovereign Debt Exchanges Recent Proposals for Reform of Sovereign Debt Restructuring August 2002 66 • Second, proponents of the status quo have argued that the perceived problems that have motivated recent calls for reforms are ‘non-problems’. Based on the experience in exchanges that have occurred so far, they argue that collective action problems have not been material and that the problems of hold-out or litigious creditors have not eventuated in practice. They also note that the suggestion that widely held bonded debt is far more difficult to restructure than narrowly held bank debt might not be confirmed by the 1980s debt crisis where banks took up to a decade to agree to debt restructurings. • Third, it has been argued that there are good reasons for not trying to replicate domestic bankruptcy frameworks in the international system. Behind much of the resistance to change is the notion that attempts to make defaults smoother are misguided, because default is not meant to be an easy process for debtors. Underlying these arguments is the premise from theoretical models that since sovereigns cannot be forced to repay, default must be made so costly (via output losses that result from loss of access to international financial markets) that those who can repay will indeed choose to repay rather than default. (The output losses imposed on those who indeed cannot repay are an unfortunate by-product that is implicitly ignored.) According to this line, sovereign debtors already have certain rights – sovereign immunity, the ability to determine domestic policies with no input from creditors, etc – that do not exist in domestic bankruptcy systems, so there are good reasons not to also give sovereigns some of the protections available to debtors in domestic systems. The proponents of this type of argument have suggested that if any changes are to be made to the international financial architecture, they should be in the direction of strengthening creditor rights, rather than making restructuring easier for debtors. Accordingly, one of the factors that helped the debt exchange was that creditors were given new Eurobonds that were true sovereign obligations. These four cases provide examples of how sovereign debtors have been able to work with their advisors and with creditors to come up with exchange offers that were acceptable to the vast majority of creditors. One interpretation would be that both sides have strong incentives to come to some form of agreement, regardless of the particular terms of the contract that governs their relationship. However, it should be noted that in all cases negotiations took many months and may well have resulted in greater costs to the debtor’s economy than might have occurred under an alternative framework. Furthermore, in each case there were a small number of different securities involved. It is unlikely that the favourable outcomes seen in these cases would be easily transferred to more complicated ones, for example the case of Argentina which had more than 80 different external bond issues outstanding at the time of its default in late 2001. R 9. Litigation was not a factor in the debt exchanges undertaken in recent years by Ecuador, Pakistan, Russia or Ukraine. However, an important exception is a court ruling in 2000 in Elliott Associates v Peru. In that case, a creditor held out from participating in an earlier restructuring of debt guaranteed by the government of Peru, and instead pursued litigation in order to enforce the original contractual obligations. While the matter was ultimately settled privately, a European court did issue a legal interpretation in favour of the hold-out creditor that argued that the sovereign was legally prevented from paying one group of creditors (those involved in the restructuring) ahead of others (the hold-out). While the implications of the case are unclear (as no legal precedent was set and the interpretation has been widely criticised), the decision has added an element of uncertainty to how future debt restructurings may evolve, by potentially strengthening the position of hold-out creditors. August 2002 Reserve Bank of Australia Bulletin 67 • Fourth, some market participants argue that changes to the current system could reduce the willingness of investors to provide financing to emerging market countries, with negative implications for economic growth in those countries. Despite these various reservations about proposed changes, a consensus has recently emerged among major private sector groups. In particular, groups representing investors, international banks and those involved in bond issuance and trading have endorsed a market-based solution along the lines of the US proposal. While endorsing the use of collective action clauses, they have opposed any contractual provisions that would allow for standstills, and have argued more generally for changes that would strengthen creditors’ rights. They have also endorsed greater transparency by borrowers and more frequent consultation between debtors and creditor representatives. A Statutory or a Contractual Approach? Although debt exchanges have been feasible in recent years, the problems identified by the IMF suggest that changes to the current system could improve the chances of smoother restructurings in future. However, the strong opposition of many in the private sector to the SDRM proposals has been noteworthy, given that the framework is intended to benefit creditors as well as debtors. This raises the question of whether a major change such as this might indeed upset the ‘delicate balance’ between the rights of debtors and creditors. Fortunately, many of the goals of the SDRM can also be achieved via a contractual approach. Given the choice between a contractual approach and the statutory alternative that would override contracts, it may be desirable to opt first for the contractual approach, particularly since a market-driven contractual approach might be less likely to have undesired impacts on the cost and availability of financing to emerging markets. If the contractual route proved difficult to implement it might then prove desirable or necessary to consider the alternative of a formal SDRM. Accordingly, work on the SDRM could proceed in parallel with the work on a contractual approach. The general principle guiding changes should be in giving creditors and debtors tools that will not restrict their rights (with the possible exception of ‘rogue’ creditors) but will facilitate agreements that are in both sides’ interests. Any changes should address the collective action problems that have been highlighted, yet not impede market incentives (e.g., that investors bear the risk of their investment decisions, and countries that can repay do so). Greater Use of Collective Action Clauses A core element in a contractual approach would be greater use of collective action clauses (CACs) to address the collective action problems discussed above. Such clauses are already used in many international bond issues in the Euromarket, and most emerging market sovereign borrowers have bonds outstanding both with and without CACs (see Box B). The most important clauses in this regard are those allowing for a qualified majority of bondholders (say 75 per cent) to modify payment terms, and for greater use of trustees to restrain individual bondholders from seeking repayment of their own claims at the expense of other bondholders. There has, however, been substantial opposition among the private sector in the 10. See the 3 June 2002 joint letter from representatives of the Emerging Markets Traders Association, the Institute of International Finance, the International Primary Market Association, the Bond Market Association, the Securities Industry Association, and the Emerging Markets Creditors Association to US Treasury Secretary O’Neill, available at . Recent Proposals for Reform of Sovereign Debt Restructuring August 2002 68 Collective action clauses (CACs) include clauses that allow for: • collective representation – procedures for bondholders to organise and designate a representative to negotiate on their behalf with the debtor; • qualified majority voting – which enables changes to be made in the terms of a bond contract without the unanimous consent of bondholders, and thus prevent a small number of dissenting bondholders from blocking an agreement beneficial to the majority; and • sharing among bondholders – which requires bondholders (generally through a trustee) to share the proceeds of litigation against a debtor with all other creditors, thus reducing the incentive for individual creditors to take independent legal action against the debtor. ‘British-style’ bonds issued in the Euromarket under English governing law almost invariably contain CACs. In particular, they allow a qualified majority (often 75 per cent) of bondholders to vote to make changes to the terms of the bond contract and make these changes binding on all bondholders. However, bonds issued into the US market typically do not contain CACs, nor do bonds targeted at the German market. Global bonds, which are issued simultaneously into several markets have also followed the US convention and excluded CACs. The contractual terms of ‘American-style’ international bonds typically require unanimous consent before the payment terms of bonds can be changed, and provide few limitations on the ability of individual bondholders to initiate and benefit from legal action on their claims. Table B1 shows the distribution of sovereign bond issuance over the period January 2001–April 2002. Box B: What Are Collective Action Clauses? Are they Costly for Borrowers?1 1. Some of the material in this Box is taken from T Becker, AJ Richards and Y Thaicharoen (2002), ‘Moral Hazard and Bond Restructuring: Are Collective Action Clauses Costly?’, forthcoming in the Journal of International Economics. An earlier version of this paper was published as IMF Working Paper WP/01/92. Table B1: Distribution of Sovereign Bond Issuance January 2001–April 2002, per cent Global bonds (without CACs) 45