Bad Latin: Lex Monetae, Pari Passu, and Other Italy Exit Irritants
Abandoning the euro is a weighty economic and political decision that would not and should not be driven by the finer points of contract law. The latter is decidedly a matter of “how,” not “whether” an exit might take place. With this in mind, my column continues to map legal issues attending a hypothetical Italian exit.
First, as Hal Scott and others have pointed out, redenomination is the big money item, and can be accomplished in a relatively straightforward way for domestic-law contracts among Italian residents. However, it could get sticky once foreign residents or foreign law are involved. Second, if a substantial portion of private or public debt escapes redenomination, the effective debt burden would go up for the Italian economy, raising the specter of debt restructuring. Third and related, policymakers should look for hidden mismatches on the balance sheets of financial intermediaries. For example, if banks’ Italian law assets are successfully converted into lire while their foreign-law liabilities remain in euros, redenomination could leave the banking sector with a bigger capital shortfall and simultaneously subordinate unsuspecting domestic creditors. More government debt is the likely result.
Redenomination of euro contracts into lire would normally be a matter for lex monetae, the legal principle that vests the sovereign issuing a currency with control over the value of that currency. Ruritania issuing debt denominated in Rur is free to replace it with the New Rur worth half the old; creditors would normally have no choice but accept the New Rur in payment of the old debt, suffering a fifty percent haircut. Unfortunately for Italy, lex monetae would not help its case very much, since the prevailing contract currency is issued by the European Central Bank, and would continue to exist even after the lira’s return as legal tender. For this reason, redenomination is more likely to succeed if supported by legislation in Italy, throughout the euro area, and in major financial jurisdictions around the world, recognizing that euro-denominated contracts could now be paid in lire.
A redenomination statute should trump local-law contractual commitments, such as Collective Action Clauses (CACs) in euro area sovereign bonds, which have required creditor majorities to approve changes in contract currency since 2013. While it is exiting its other European treaty commitments, Italy would be prudent to shed its promise to adopt CACs under the European Stability Mechanism (ESM) treaty. This is best accomplished before enacting the redenomination law or launching a debt restructuring, which means that both speed and secrecy would be essential. Even then, some creditor holding domestic-law bonds with CACs is bound to challenge redenomination as both a contract and a treaty violation. While she would probably lose in the end, litigation would drain precious resources.
What of the debt governed by foreign law, which would be hard to redenominate? Depending on the relative size of the foreign currency debt stock and on who holds it at exit time, this debt may need to be restructured. Contrary to some of the market analyst reports, the bigger the stock of inflexible foreign debt, the less likely it is to avoid losses under the principle known as “pig to hog” among bankruptcy aficionados. For private debtors, national bankruptcy and bank resolution procedures should take care of the debt overhang. Italy’s bank resolution regime has been in flux since the introduction of the Single Resolution Mechanism at the EU level; it is hard to tell what it would look like after the exit shock.
The sovereign cannot file for bankruptcy or resolution. In an optimistic scenario, only debt that specifies foreign law in the contract would escape redenomination. This would leave five percent or so of Italian government debt denominated in foreign currencies, including the euro, but also the pound, the US dollar, and the Swiss franc (non-euro currencies are a small fraction of the total in Italy). The economic case for restructuring this debt is iffy—I would not bet on it. In the unlikely case that everyone else restructures while foreign law bonds escape, market participants would have powerful incentives to demand foreign currency and foreign law in subsequent Italian issues. This may weigh on financing for recovery and would make the Italian debt stock more rigid and volatile at the same time.
Restructuring Italy’s foreign-law sovereign bonds would present another challenge. All of these bonds were issued before the introduction of euro area CACs in January 2013, and include some remarkably creditor-friendly terms. For example, bonds issued in New York before 2003 have no CACs of any kind, and require each creditor to consent to restructuring. Bonds issued between 2003 and 2013 have CACs that require a two-thirds supermajority of the creditors under each series to vote in favor of a restructuring. Italy’s bonds issued before 2013 also include a clause that promises to pay the bondholders equally and in proportion with all other obligations due from the Italian treasury, not limited to foreign bonds. A far less pointed formulation of this so-called pari passu (equal footing) clause in Argentinian bonds, which did not expressly promise equal and ratable payment, served as the basis for a US federal court in 2012 to block Argentina’s government from paying interest on restructured debt until creditors who held out from its 2005 and 2010 restructurings got paid in full.
From the holdout creditor’s perspective, the pari passu clause is valuable because it allows the smallest minority creditor armed with the promise of equal payment to aim it as an offensive weapon at the rest of the sovereign’s debt stock. Ideally, if all other creditors restructure, the holdout demanding payment on pari passu grounds would try to block payments to everyone else until he is paid. A $2 billion bond issue in the hands of a holdout could, in theory, block payments on trillions of dollars in debt and other obligations. It remains to be seen whether a court in New York or London would be willing to invoke such a dramatic sanction absent egregiously aggressive conduct by Italy towards its creditors.
Finally, redenomination and restructuring can create new mismatches in the financial system. For example, if people, firms, and governments have their debt redenominated into lire, but banks still owe euro, dollars, pounds, and yen, banks could become insolvent overnight. Estimates from 2012 indicate that Italian financial firms have issued a far higher percentage of their tradable bonds under foreign law than the government itself or nonfinancial firms (61 percent compared to 6 and 40 percent, respectively). Loans and derivatives exposure would add to the stock of foreign-law debt. On the asset side, Italian banks have a heavy concentration of Italian sovereign bonds and other domestic assets. This reflects a contingent currency mismatch, which could, in case of redenomination, become a capital hole and a contingent sovereign liability. Sovereign backstop for the banks would become even more likely if redenomination threatened effectively to subordinate Italian-law bonds held by unsuspecting retail investors and maybe even deposits.
The dearth of current information to help predict the magnitude of such balance sheet shocks, along with uncertainties surrounding the bank resolution process highlight just how much work would have to be done for a minimally disruptive exit.
1. “When a pig becomes a hog, it is slaughtered.”
2. Post-2013 bonds with euro-CACs have even lower per-series amendment thresholds of 50-55 percent in the event two or more series use aggregated voting; however, these are all governed by domestic law. Post-2013 Italian bonds also have a much less vulnerable version of the pari passu clause.