Sovereign debt restructuring

Benu Schneider

The views expressed do not necessarily represent those of the Financing for Development Office, Department of Economic and Social Affairs, UN

What would the SDRM1 have done?

• Creditor committees / Voting thresholds

• Priority financing

• Restructuring agreement

• Sovereign debt dispute resolution forum

• Type of debt to be treated, verification, comprehensiveness

• Stays by majority rule

• Sanctions

Fragmentation

Debt to MultilateralsDebt to official

creditorsDebt to commercial

BanksBond debt

No, it cannot be restructured exceptfor HIPC countries

Yes, at the Paris Club The terms of treatment

are determined onthe basis of per capita

and debt ratios (require bilateral agreements after

Paris Club agreements)Covers only PC members

Yes, London ClubYes, with and

without collectiveaction clauses

Efficacy of CACs limited

Public policy: Contractual terms cannot take on the role of public policy such as externalities,

societal distribution problems and broad

equity terms for stakeholders

Aggregation

• Problem of existing stock• Voluntary –even after years may not have

bonds issued with the new clauses• Underlying assumption that no single

investor has the scale of resources to block a restructuring plan – but easy for example in the case of bonds issued by frontier markets or when some hedge funds form a single firm to prevent a restruct. plan

Jurisdiction issues

• Judgment passed in one jurisdiction are not enforceable in other jurisdictions

• Lack of coordination between different courts and the WB’s ICSID

• All litigation cannot be settled under one umbrella, ensure inter-creditor equity

• The lack of coordination has high human and financial costs for debtors

• They result in delay – high costs- lack of access to markets

Litigation in sovereign debt defaults is more common than the general perception•In recent times 50% of debt crises involved legal disputes affecting 25 countries(data base covers US and UK).

•Increasing strength of holdout creditors -Argentine case is part of a general trend

•Distressed debt funds involved in 75 % of casesShumacher, Trebesch anf Enderline “Sovereign Defaults in Court” (May 2014)

Three phases in this evolutionPhase 1: Erosion of sovereign immunity1976: US Sovereign Immunities Act to exclude commercial activities1978: UK State Immunities Act (followed by other European States)1985: Allied v. Costa Rico (Collapse of Comity Defense and Act of State Defense) – imp precedent hold out strategies work – settled out of court

Phase 2: Entry of “Vulture” creditorsWeltover Vs. Argentina - Sovereign Borrowing is Commercial activity1995: CIBC vs Brazil – holdout strategies viable- weakened champ defense2000: Elliot vs. Peru: Success of pari passu litigation

• August 2004 NY State legislature amended judiciary law 489 to effectively eliminate the defense of champerty of any debt purchases valued more that $500, 000

Today’s regime: A hunt for assets

• 2005 and 2010: Argentina’s debt exchange triggers USD 3.7 billion in law suits

Creditor returns high in litigation cases

Lack of systematic work but in the past known to be high•400 % for Elliot in Peru•Elliot 60 % in Panama•Cardinal Financial Inv. 270 % in Yemen

Litigation is associated with a)loss of market access b)loss in int. trade c) delays in crisis resolutionExternalities larger than the amounts under litigation

Implications of the Argentine Debt Litigation

• Consensus that this is game changer – will impact future debt restructurings by strengthening the hands of holdout creditors – illustrates the legal gaps in architecture

• Support improvement in contractual technology but something else is needed in addition – moreover there is still the problem of the existing debt stock + voluntarity

Some options-Legal treaty –Retroactive fitting of clauses in existing stock

-HIPC type law to protect from vulture funds

-Law to immunize assets of sovereigns from recovery

-Belgian precedent to prevent blocking of int payments

-champerty defense

-amend FSIA to exclude sovereign debt as commercial activity

Regulation, accounting and tax rulesAccounting and regulatory frameworks create

disincentives for debt write-downs and cause delays

Reg. requirements to classify loans as performing, int. payments have to be received on a regular basis, providing a disincentive for banks to enter a debt restructuring negotiation

Off. sector fin. keeps the debtor current on payments to avert a banking crisis

Research needed in this area.

Diversity in debt restructurings

• Most restructurings had low present value haircuts and most with no nominal haircuts move rapidly, fewer holdouts, but need multiple restructurings. Costly in the long run for both debtors and creditors.

• Few with large PV haircuts and big principal haircuts. For deeper “haircuts” negotiations are protracted.

• There have been a substantial number of “voluntary” restructurings with low PV haircuts, as the fall-back position has been protracted legal processes characterized by uncertainty.

• Deeper haircuts - creditor cajoling - litigation

Growth and defaults

• Default and restructuring appears to be negative for debt and positive for growth.

• There is always a massive reduction in growth before a default. Is this inevitable?

• Could be Pareto improving if we could design a debt restructuring system that minimized that deep decline in growth before default

Costs of sovereign debt restructuringsOutput losses Around 5 per cent a year, Up to 10 years.

Higher if twin or triple crises

Trade losses Falls bilaterally by about 7 percent per year, average 15 years

Decreased access to external credit

Drop in private sector access of up to 40 per cent in the year after

Higher spreads Greater haircuts = larger post-restructuring bond spreads until 6-7 years after

Also highly correlated with duration of capital market exclusion

Financial instability Loss of value of restructured assets, deposit withdrawals and interruption of interbank credit lines, interest rate hikes

Lower FDI Drop in flows of up to 2% of GDP per year

Lower credit ratings After 1 year most sovereign bonds: C- rating

IMF 2012, Sovereign debt restructurings 1950-2010: Literature survey, data and stylized facts

Reasons for lack of consensus between official and private

sector• Different indicators to gauge the success of a

debt restructuring• The private sector measures success by

percentage of bondholders who participated in the debt restructuring

• How quickly the debt restructuring is completed• How well the instruments perform after a debt

restructuring – they cite 80 – 90 percent participation as success

Official sector criteria

• The costs to the local economy of debt restructuring

• The residual debt burden which in many restructuring is even higher than before

• How fast the country can return to a sustainable debt and growth trajectory.

Delay: Different criteria between official and private sector

• For the private sector delay means once the process is initiated, how long it takes reach a settlement in the negotiation

• For the official sector “delay” has two parts»Delay in initiating a debt

restructuring»Once initiated, the time it takes to

reach a settlement

• Delay gives vulture funds the opportunity to purchase debt at a discount and then holdout for high gains

• In the next EGM, participants are ready to work collectively to find solutions

Meet the gap in architecture

The IMF plays a unique role in assisting its members to strike a judicious balance between financing and adjustment

but

it runs the risk of being less effective in this role due to the absence of a framework for timely and orderly debt restructuring

Moral hazard of IMF lending to both debtors and creditors

• Debtors defer needed adjustments hoping for an improvement in economic conditions

• Lenders do not correctly price in risk

• Banks may postpone recognizing losses on their balance sheets

Lending into arrears

• 1998: good faith negotiation

• 1999: good faith effort to reach a collaborative agreement with its creditors

• 2002: good faith criterion elaborated into a full-blown set of prescriptions and procedures

Gave grounds for intense lobbying by the private sector (but nothing in its arsenal over jurisdiction over private sector)

IMF arbiter and referee of good behaviour and good faith

• After Asian fin crisis – policy of exceptional access (post Greece, amendment of policy)

Lack of a credible exit strategy

Sometimes the lack of an acceptable alternative in terms of an orderly exit gives the IMF little choice but to exercise forbearance and continue disbursements even in cases where, on the balance of probabilities, an inter-temporal solvency condition may be violated.

Costs of non-system

The current implied costs of debt restructuring provide incentives for debtors to gamble that recovery will allow them to avoid a debt treatment ---private-sector debt is effectively shifted to more senior public creditors, thereby implying an increase in the size of any haircut that must eventually be imposed on remaining private-sector creditors.

Options going forward

• An improvement in the contractual technology to improve the voluntary market-based approach

• A statutory solution to address holdouts by minimizing litigation risks in the Eurozone

• A regime incorporating both the voluntary contractual and statutory approach

• A statutory regime• An informal platform for creditor-debtor

exchanges

A. Improving contractual technology

• Aggregation in bond contracts

• Standardising pari passu clause

• Standstills

• Process questions in creditor coordination – consultative vs. creditor committees

Statutory approach

• The IMF’s capacity under Article VIII, 2(b) to temporarily approve restrictions on current payments (that is to say, interest payments) could result in partial stays on creditor actions on arrears.

• For other arrears relating to capital payments (for example, non-payment of bullet payments of principal), an amendment of the IMF Articles of Agreement would be required to achieve symmetry between the treatment of arrears arising from capital and those from current payments.

Need to resolve possible conflict of interest in the IMF’s role of arbiter and creditor.

Contractual approach to Standstills

• Standstills in bond contracts to set out the contractual terms for non-payment of interest and suspension of payments.

• Presently it is typical to have a grace period of three to13 days, for resolution of any technical difficulties in making payments only

• Although consent for new financing could be obtained through trustee relationships or collective action management, trustees don’t like discretion, and thus clearer rules are needed. Moreover, timing issues would also have to be overcome, since notice of 21 days is required to call a meeting of creditor committees.

Sovereign Cocos

• Bonds that would extend in repayment maturity when a country receives official sector liquidity assistance.

• Addresses liquidity crisis, gives country breathing space to assess whether it is in a liquidity crisis or a solvency crisis

Can clearer rules of the game help to remove the impediments to an early

initiation of debt restructurings?

 Process issues:

•Ex-ante structures for creditor committees with a governance and oversight body

Or

•Consultancy approach through a legal advisory and informal soundings with creditors

EX-Ante Structures for Creditor Committees

Ex-ante structures for creditor committees, with pre-defined rules with a governance structure and oversight body

Verification of fin data and eco assumptions, Soundings, Single negotiation, stress testing, endorsement, creditor coordination

B. Statutory solution for litigation risks in the Eurozone

• ESM Treaty could be amended so that the assets of a sovereign located within the Eurozone would be immunized from attachment by those creditors not participating in any such sovereign’s debt restructuring where that sovereign was benefitting from a financial assistance program from the ESM.

C. Combing the voluntary and statutory approach

• Creating the shadow of the court house in voluntary debt restructuring

A version of the dispute settlement mechanism of the WTO

IMF structure convening power

A system in which there are panels of experts (not IMF staff)

Combining voluntary and statutory approaches (contd..)

STAGE 1: Negotiations are voluntary but with a deadline.

Stage 2: If no agreement is reached, the second stage could be a panel, which serves as an arbiter.

Stage 3: And finally, if that doesn’t work, a panel can settle the dispute which is binding on all.

Advantages of the proposal

• This can assuage the fears of the private sector because the proposal includes all creditors, including new creditors, EXIM and development banks, IMF and MDBs. Private creditors can gain, in a scheme which is statutory in nature.

• If debt is bought in the secondary market, it should not have any preference in debt restructuring.

Re-solvency procedure

• 1st step: Re-solvency clause: a contractual clause which permits the sovereign to commence a re-solvency procedure if it reaches an insolvency state.

• 2nd step: a re-solvency court led by a permanent president and a limited pool of potential judges who would act if appointed for a particular case.

• 3rd step: a set the rules governing the procedures

D. Statutory Regime

• a) International Debt Restructuring Court: Independent court, a permanent debt mediation and arbitration mechanism created under the auspices of the UN with technical support from the IMF and the World Bank and its legitimacy recognized by national courts.

Functions of the court

• Clarify process and sequence questions and its functions based on internationally agreed principles to determine the priority of claims, the required debt reduction (by systematical involving all classes of creditors) and determining inter-creditor equity.

• Evaluate the legitimacy of debt claims and enable private and official creditors to extend new loans despite a default.

b) Europe crisis Resolution Mechanism (ECRM)

• Draws upon the IMF 2002 proposal for an SDRM in the European context but does not assign a role to the IMF.

• It could be initiated on a debtor’s request and like the SDRM impose a stay on litigation against the debtor country

• A cram down process by a super-majority of creditors and an aggregated voting across all creditor claims.

Interim financing envisaged through a financial body such as the ESM, an assessment of debt sustainability and oversight of economic adjustment through an economic body and legal body to resolve disputes.

c) Sovereign Debt Adjustment Facility

A facility at the IMF which would combine IMF lending with debt restructuring.

A set of pre-defined criteria would need to be developed to access this facility.

An amendment of the articles of agreement of the IMF to shield countries undergoing a restructuring from holdout creditors when decisions had been reached by a super-majority of creditors.

E. An informal platform for creditor-debtor exchanges

• Assuage the information and analytical issues associated with the question of debt sustainability

• Neutral organization with broad participation - permanent, neutral staff seconded from debtors, private creditors and multilateral institutions

• aim to design a collective, consistent process to enhance sovereign debt as an asset class.

Sovereign Debt Forum

SDF would foster timely, orderly restructuring of sovereign debt by

• improving information flows between creditors and debtors

• providing a template for negotiations

• facilitating a frank discussion of debt sustainability and the feasibility of required adjustment efforts.

Information on debt stocks and flows

• Reliable and consistent information on international liabilities is needed to facilitate timely debt restructurings.

• Proposal to establish an international registry of debt, reported by creditors and reconciled with debtors.

Gaps in architecture

• Lack of a centralized dispute resolution mechanism – no platform for a comprehensive solution

• Lack of organized representation of all stakeholders

• Lack of enforceable priority rules for creditors

• Problems with inter-creditor equity and equity between the private and public sector

• No international law governing international bankruptcies – judgments passed in one jurisdiction is not enforceable in another jurisdiction – legal diff across jurisdictions

• No provisions for standstills that provide “breathing space.”

• Problems with holdout creditors