Sovereign debt restructuring

1

• 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
2
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

3
Fragmentation
Debt to Multilaterals
Debt to official creditors
Debt to commercial Banks
Bond debt
Yes, London Club
No, it cannot be restructured except for HIPC
countries
Yes, at the Paris Club The terms of treatment
are determined on the basis of per capita and
debt ratios (require bilateral agreements
after Paris Club agreements) Covers only PC
members
Yes, with and without collective action clauses
4
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

5
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

6
Jurisdiction issues

• Judgment passed in one jurisdiction are not
  enforceable in other jurisdictions
• Lack of coordination between different courts and
  the WBs 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

7

• 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 cases
• Shumacher, Trebesch anf Enderline Sovereign
  Defaults in Court (May 2014)

8

• Three phases in this evolution
• Phase 1 Erosion of sovereign immunity
• 1976 US Sovereign Immunities Act to exclude
  commercial activities
• 1978 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 creditors
• Weltover Vs. Argentina - Sovereign Borrowing is
  Commercial activity
• 1995 CIBC vs Brazil holdout strategies viable-
  weakened champ defense
• 2000 Elliot vs. Peru Success of pari passu
  litigation

9

• 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
• Todays regime A hunt for assets
• 2005 and 2010 Argentinas debt exchange triggers
  USD 3.7 billion in law suits

10
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
• loss of market access
• loss in int. trade
• delays in crisis resolution
• Externalities larger than the amounts under
  litigation

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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

12
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

13
Regulation, accounting and tax rules

• Accounting 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.

14
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.

15

• 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

16
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

17
Costs of sovereign debt restructurings
Output 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
18
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

19
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.

20
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

21

• 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

22
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

23
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

24
Lending into arrears

• 1998 good faith negotiation
• 1999 good faith effort to reach a collaborative
  agreement with its creditors

25

• 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)

26
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.

27
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.

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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

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A. Improving contractual technology

• Aggregation in bond contracts
• Standardising pari passu clause
• Standstills
• Process questions in creditor coordination
  consultative vs. creditor committees

30
Statutory approach

• The IMFs 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 IMFs role of arbiter and creditor.

31
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 dont 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.

32
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

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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

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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

35
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 sovereigns debt
  restructuring where that sovereign was
  benefitting from a financial assistance program
  from the ESM.

36
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)

37
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 doesnt work, a
  panel can settle the dispute which is binding on
  all.

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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.

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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

40
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.

41
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.

42
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 debtors 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.

43
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.
44
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.

45
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.

46
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.

47
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.

48
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