Clipping wings: Making sovereign bonds more vulture-proof

In response to recent events, the staff of the International Monetary Fund (IMF) has recommended significant changes to the way sovereign governments issue their foreign debt. In a report issued on October 6, the Fund addressed complications in Greece’s 2012 debt restructuring and the still-ongoing court battles between Argentina and a small minority of its creditors stemming from the country’s 2001 debt default. Both cases question the continued feasibility of the existing so-called “market-based” or “voluntary” approach to sovereign debt restructuring. While a major step in the right direction, the IMF’s proposals may not be sufficient to protect other nations from the predatory behaviour of a group of speculative investors, known colloquially as “vulture funds,” that has complicated Greece and Argentina’s efforts to restructure their sovereign debt and return to long-term solvency.

Greece and Argentina: a tale of two sovereign debt crises

In the 2012 Greek debt restructuring, small minorities of creditors managed to block efforts to reduce the value of their claims in about half of Greece’s foreign-law bonds. Rather than suffering a haircut on their bonds, many of them freeloaded on the pain accepted by other creditors. These “holdout creditors” are being paid in full using aid from the IMF and Europe that was provided to the Greek authorities to support the country through its insolvency.

This summer’s new Argentine debt crisis, by contrast, began as a courtroom drama. In June, the United States Supreme Court declined to hear an Argentine appeal of a New York lower court ruling that found that Argentina could not service debt restructured in 2005 and 2010, two successive debt treatments intended to cure Argentina’s 2001 default, without also making payments to creditors who refused to participate in either write-down. Since paying these “holdouts” is anathema to the Kirchner government, Argentina decided to default on a June 30, 2014 payment to its restructured bond holders rather than pay creditors holding bonds that were not tendered in either the 2005 or 2010 debt exchanges.

The experiences of Greece and Argentina have forced action by the IMF. Prior to these cases, most bondholders took the view that their interests were better served by accepting upfront cents on each dollar of distressed debt they owned rather than pushing for full payment through arduous legal processes. In Greece and Argentina, a small but still sizeable group of creditors decided instead to push for full payment as legal aspects of both restructurings tilted the balance of negotiating power toward creditors.

Together, these two situations imply that it is now more likely that creditors who hold out for special treatment will profit from their noncooperation. As a result, bondholders who were previously inclined to participate in an upfront restructuring of a bankrupt government’s debt may instead push for richer terms—potentially making debt restructuring negotiations very difficult to conclude and even raising the possibility that past, settled restructurings could be re-opened by new legal action by nonparticipating creditors.

This is a problem because negotiated, market-based settlements between creditors and debtors are the only means the global financial system has to give countries a fresh start when they prove unable to pay their bills. Unlike individuals and corporations, countries cannot seek help from an international bankruptcy court empowered to prioritize creditors and enforce a reduction in their claims—for sovereign nations, no such entity exists.

A decades-old problem

A major attempt by the IMF to create a bankruptcy process for countries, known as the sovereign debt restructuring mechanism (SDRM), fell apart in 2003 when the United States and some large emerging economies refused to support it. Despite concerns about the Greece and Argentina cases, as well as some recent interest in legislated debt frameworks from the G77 countries and China at the United Nations, other major countries and financial markets have demonstrated limited interest in revisiting the IMF’s SDRM proposal from a decade ago.

Instead, the IMF staff has helped facilitate a wide-ranging consultative process with market participants, national policymakers, and academics to refine the way bond contracts are written to limit the potential fallout from Greece and Argentina. The IMF staff has focused on reform under New York and English law because about 90 percent of emerging market foreign-law debt gets issued under the jurisdiction of these financial centers. Traditionally, emerging economies issue abroad to provide an assurance to potential investors that their claims are protected by strong legal regimes that cannot be altered by the issuing country’s legislative system. As a result, the costs for emerging economies to borrow under these laws are usually lower than in their own domestic legal frameworks.

Richer countries, by contrast, tend to issue debt under their own laws. Amongst other things, this means that they can change the terms of their bonds ex post by passing legislation in their local parliaments. As a result, these nations don’t need the reforms proposed by the IMF to deal with creditors that refuse to participate in debt restructurings.

New proposals from the IMF and the markets

To better protect emerging economies, the October 6 IMF report makes two major recommendations for changes to debt contracts written under New York and English law. The Fund staff first proposes changes to a boilerplate provision included in most sovereign bonds known as the “pari passu” clause, which formed the basis of holdout creditor claims to full payment in Argentina’s case. The clause—which in Latin literally means “on equal footing”—was interpreted by U.S. District Court Judge Griesa in 2011 as requiring concurrent proportionate or “ratable” payments to all bondholders regardless of whether or not they had agreed to a previous restructuring. The IMF report argues that this standard clause should be changed to explicitly exclude any expectation or possibility that holdout creditors will be paid on terms that exceed those offered in restructuring deals that they had earlier refused.

Second, the report advocates refinements to the now-standard format of collective action clauses—also indelicately referred to as “CACs”—in New-York and English law bonds. These provisions help conclude debt treatments by forcing the terms of a restructuring on all bondholders once a critical supermajority of them reach agreement on the details of a debt exchange.

Several of the CACs in Greece’s foreign-law bonds failed to activate in 2012. In the case of small bond issues, it was relatively easy for speculative investors to assemble a minority position large enough to prevent the bond’s CAC from coming into effect. This made the restructuring of these bond series impossible, and allowed the holdout creditors to insist on full payment of the bond’s obligations.

The IMF report advocates a more effective CAC template with a menu of voting procedures by which creditors could agree to conclude a restructuring and force the hand of their uncooperative peers. It would be up to the debtor nation and creditors to decide which voting procedure to use at the time of a restructuring. The IMF staff principally advocates a “single limb” procedure under which a restructuring can be concluded following agreement by a 75 percent supermajority of creditors across all foreign-law bonds, rather than requiring supermajorities of creditors within each individual bond series—the format that stymied Greece’s restructuring efforts.

A sea change in thinking

The IMF’s proposals closely mirror similar language advocated in August by the International Capital Markets Association (ICMA), a group composed of market participants and debt issuers. This is not a coincidence: the two organizations coordinated closely on their proposals and consulted many of the same individuals during their deliberations.

Nevertheless, there is one important difference between the two sets of proposals. In addition to reformed CAC language, the ICMA paper advocates the inclusion of provisions in future bonds that mandate sovereign issuers to recognize creditor negotiation committees, support their work, and exchange information openly. Investors have long argued that such clauses represent a reasonable counterbalance to the limitations on creditor rights implied by more robust CACs. The absence of an endorsement for ICMA’s creditor committee proposals in the IMF’s October paper is an irritant to some market participants, but it is unlikely to hamper the inclusion of the reformed pari passu and CAC language in new bond issues.

Some governments are already on-board with these new proposals. Greece and Ecuador, amongst others, have issued bonds that feature variations on the proposed new pari passu language, while Honduras and Belize clarified in the offering memoranda for recent bond issues that these bonds’ pari passu provisions did not provide for ratable payments to holdouts. Moreover, on October 7, Kazakhstan issued a new bond that features the IMF and ICMA’s recommended CAC and pari passu language.

The proposed reforms are another step toward making it easier for distressed countries to restructure their sovereign debt. The IMF staff’s new paper follows a June IMF staff report that advocated a menu of progressively aggressive approaches to helping governments handle debt crises, including support for a temporary rescheduling (i.e., deferral) of debt service when a more substantial debt write-down may not be necessary to ensure a sovereign’s solvency. This option to “reprofile” debt service falling due during a crisis widens the range of situations in which the IMF can offer its support and lowers the stakes for countries concerned that accepting the Fund’s help will hurt their standing in markets.

Together, these proposed reforms are the product of a sea change in thinking about how the world should assist governments in financial distress. For decades, theorists and practitioners argued that sovereign debt restructuring had to be a punishing affair for debtor countries. Otherwise, these governments might be tempted to default on their obligations gratuitously and often since creditors have few options to seize sovereign public assets that are largely shielded by countries’ domestic laws.

Experience shows, however, that governments shy away from restructuring their foreign debt because they recognize that the political and reputational costs of a default are enormous. If anything, governments are too reluctant to initiate talks with their creditors: they typically pursue too little debt relief during periods of distress, and they do so too late in the game to avoid harsh penalties for their economies and citizens.

Important steps, but a long road ahead

The IMF’s June and October proposals address this “too little, too late” problem only indirectly. Together, the June report’s recommendations widen the range of options for dealing with a debt crisis, while the October report’s contractual language should make a debt restructuring easier to impose on reluctant creditors. As a result, the IMF’s package of proposed reforms may provide some encouragement for distressed sovereigns to address their financing problems more proactively. But these reforms may still be too modest to deal effectively with the challenges presented by the recent experiences of Greece and Argentina. Debt vultures aren’t suddenly about to become an endangered species—their wings are simply being clipped.

What’s more, including better pari passu and collective action clauses in new bonds will not fix any of the large stock of sovereign debt that is already outstanding. The average remaining maturity of most countries’ debt is about 6 to 7 years. It will take at least that much time to get the new clauses into about half of existing emerging-market foreign-law sovereign debt as it matures and is replaced by new bonds.

In fact, more than 40 percent of sovereign bonds issued under New York law won’t mature for at least a decade. Even if today’s proposals are widely adopted, hundreds of billions of dollars of debt that preceded the proposed IMF reforms will remain on secondary markets for years to come. Some of this debt lacks even the more basic bond-by-bond CACs that failed in so many instances for Greece. This leaves a lot of potential debt carrion on the table for future attacks by vulture funds.

Of course, sovereign nations could choose to make these reforms more immediate by swapping outstanding bonds for new paper that features the proposed IMF contractual language, but the Fund’s consultations with governments found little interest in initiating such operations. This attitude may change, however, if more countries in distress see future debt restructurings complicated or rendered impossible by holdout creditors.

Even the IMF staff recognizes that its proposals are likely to be insufficient. The October report notes that holdout creditors and vulture funds may not be discouraged by improved pari passu and CAC language in sovereign bonds. The report observes that reform of the U.S. Foreign Sovereign Immunities Act (FSIA) may also be needed to shield noncommercial sovereign assets used to service foreign debt from the effects of Judge Griesa’s interpretation of pari passu. This is a big admission, and foreshadows the possibility of more ambitious national-level legal reforms or international treaty negotiations if the present IMF proposals—even if fully adopted—prove less than fully effective.

Given the wide consensus in support for the IMF’s ideas and the fact that some sovereigns have already incorporated the Fund’s pari passu and CAC proposals into their bonds, this model language is likely to be adopted quickly by debt issuers. As new bond series whose contracts are compliant with the Fund staff’s recommended language accumulate, they will make these reforms a fait accompli. Agreement on the IMF’s June proposals on reprofiling distressed countries’ debt payments may take longer.

Certainly, there is more to be done to make sovereign debt restructuring work better and to preserve greater value for debtor governments, their citizens, and their creditors. But after a decade in which sovereign debt restructuring was the third rail of international financial discussions, the IMF’s proposals are a useful step forward: they illustrate that consensus can be built to effect meaningful change on sovereign debt. The Fund’s efforts are a glass half full; nations, citizens, scholars—and even some creditors—are ready for more.

A version of this essay was published by the Georgetown Journal of International Affairs.