A Sensible Step to Mitigate Sovereign Bond Dysfunction
Lingering fallout from the debt crises in Argentina and Greece exposed serious flaws in the sovereign debt restructuring process: Small groups of creditors were able to extract preferential treatment and cause serious disruptions for everyone else. On August 29, 2014, the International Capital Market Association (ICMA) released a new set of model clauses for foreign sovereign bond contracts to address some of these flaws. The initiative was hashed out in an informal working group convened by the US Treasury, comprising market participants, officials from wealthy and emerging market countries and multilateral institutions, and academics (including myself). The group in turn got its impetus from the Greek debt restructuring and Argentina's court battles of the past two years. The ICMA's clauses went through multiple rounds of consultation with its members, which include capital market investors and issuers, as well as market service-providers like clearinghouses. With such broad-based support, ICMA's model clauses will no doubt boost the case for reform [pdf] being made by the staff at the International Monetary Fund (IMF) [pdf].
What's New: If they are widely adopted, the new clauses would allow a crisis-stricken government to restructure its foreign bonds using three alternative procedures.
First, it could poll the holders of each bond series. If three-quarters of a series agree to the new terms, the remaining minority would be bound to go along. However, if a creditor buys up slightly more than a quarter of any series, it could block that series from restructuring, and demand full payment from the debtor—as NML Capital and colleagues are demanding from Argentina and as many of Greece's foreign-law bondholders demanded from Greece. Series-by-series amendment clauses have been standard in English-law bonds for a long time and in New York since 2003.
Second, it could poll holders of multiple series at once. If at least half of each series polled, and two-thirds of all outstanding debt polled, agree to the new terms, the remaining creditors would be bound. However, any series that fails to get a 50 percent vote can drop out of the restructuring and, again, demand full payment. Four countries have used a similar mechanism in New York and English-law bonds. Euro area governments have adopted this mechanism in all their long-term bonds issued since the start of 2013; these are mostly governed by local law, which gives the government additional tools against holdout creditors.
Third—here is the big innovation—the government could poll holders of multiple series at once but take only a single vote across all affected series. If three-quarters of the total approve the new terms, the remainder would be bound. No creditor, and no series, can drop out. The restructuring either goes ahead for everyone polled or fails for everyone polled. To ensure that such an aggregated vote is not used to discriminate against creditor minorities, the model requires that all affected creditors be offered the same restructuring terms. Greece used a similar mechanism, enacted by statute [pdf], to restructure its local-law bonds with no holdouts.
In addition, ICMA has proposed clarifying and standardizing the pari passu ("equal step") clause in sovereign bonds to preclude courts from ordering debtors to pay holdout creditors whenever they pay restructured creditors. US federal court decisions invoking this clause in Argentina's contracts required it to pay holdout creditors in full when it paid interest on restructured debt, leading the country to default on billions of dollars in new debt on July 30, 2014, and triggering fresh lawsuits around the world.
What to Make of It: The world of sovereign debt is deeply dysfunctional. On the one hand, debt contracts are very difficult to enforce against immune governments, which leads some creditors to unorthodox and disruptive collection tactics, as in Argentina. On the other hand, sovereign governments cannot file for bankruptcy protection, which means among other things that there is no judge or body of law to oversee the restructuring so that debts that cannot be paid would be wiped away, and all creditors would be treated equally. Although the IMF tried to introduce a treaty to mimic some elements of bankruptcy between 2001 and in 2003, its Sovereign Debt Restructuring Mechanism failed for lack of political support. Instead, governments adopted majority amendment clauses in their contracts—but these clauses allowed some creditors to buy blocking positions, and forced individual debt series out of a comprehensive restructuring. More than €6 billion of Greece's foreign-law bonds did just that, and are getting paid in full, while approximately €200 billion of the rest had to give up more than half of their claims [pdf].
Greece did not have the same holdout problem in its domestic bonds because it passed a law to let all its creditors vote as a group, so that no creditor could get a blocking position to gain advantage over the rest. The IMF pointed to the success of this tactic in its recent papers [pdf] on reforming sovereign debt restructuring. The ICMA's new model follows through with a specific proposal—the third option described above. Recognizing that a single aggregated vote can also be used to discriminate against creditor minorities, the model includes additional safeguards to ensure that all creditors get the same terms, protections against vote manipulation, and additional information disclosure obligations for the government debtor concerning its financial condition, economic recovery program, and debt restructuring plans for different creditor groups.
The initiative represents incremental change—a far cry from a comprehensive treaty-based bankruptcy favored by debt relief advocates and some in the official community. However, since sovereign bankruptcy remains politically infeasible, the ICMA's model clauses mark major progress. If adopted, the new clauses would make sovereign debt restructurings much more predictable and fair for all creditors, as well as the debtor.
Of course there are caveats. It would be a mistake to expect the proposed clauses to fix all or even most of the dysfunctions of sovereign debt. The big attraction of contract reform over bankruptcy is its voluntary nature. Debtors and creditors are not compelled to adopt ICMA clauses in new bonds, even if they are endorsed by the IMF and its biggest shareholders. Although the ICMA's endorsement means a lot, past experience suggests that market participants rarely if ever copy and paste its models into their contracts. It is likely that many will adopt some version of the clauses in due time, but neither the content nor the timing is guaranteed. Change may well be partial and fragmented.
Contract change also takes time. The new terms would only be included in new bonds; they are not retroactive. Hundreds of billions of dollars in bonds without the recommended clauses will remain outstanding for years, even decades. Series-by-series modification clauses were introduced on a large scale in New York over a decade ago. Even though nearly all new bonds since 2003 have had majority modification terms, the IMF estimates that there is still a large stock of bonds without them. This means that the danger of holdouts in sovereign bond restructurings will remain for the foreseeable future.
Finally, contract reform is essentially a private response to a very public problem—government debt crises. Unlike statutes and treaties, no one votes on sovereign debt contracts, or on the debt restructuring terms they produce, as a matter of course. This may make for faster change and more efficient negotiations, but the price is attenuated accountability. Bankruptcy and contract reform are quite different in this respect.
Nevertheless, this is a promising effort for three reasons. First, it comes out of an intense collaboration between public officials and private sector representatives who managed to agree on a problem, a solution, and a package of sensible trade-offs to make it happen. A lot of people have a stake in its success. Second, the initiative takes place against the background of expanding default and proliferating lawsuits by all against all in the case of Argentina. The experience has been sobering for many; it may prompt faster and wider adoption of new contract terms to minimize the impact on other debt restructurings. Third, this round of reforms builds on those that came before and benefits from several decades of intense market, policy, and academic focus on sovereign debt contracts. The new terms are designed to reduce the number of holdouts in a debt restructuring quite dramatically and, for the first time, would limit holdout enforcement tools in the form of the pari passu clause.
Like all contract reform, this one is not a fast fix for the fundamental dysfunctions of sovereign debt—but by contract reform standards, it is a big step forward.