EMTA Special Seminar: Further Improvements in the Market-Based Approach to Sovereign Debt Restructuring (NYC) - Sept. 28

Sovereign Debt Restructuring Panel

EMTA’s Special Seminar “Further Improvements in the Market-Based Approach to Sovereign Debt Restructuring” was held on September 28, 2017 at Clifford Chance’s NYC offices. Benu Schneider (Adjunct Senior Research Fellow, Research and Information Systems, Formerly UN Staff and Project Leader) moderated the panel, with Deborah Zandstra (Clifford Chance), Mark Stumpf (Arnold & Porter Kaye Scholer), Lee Buchheit (Cleary Gottlieb Steen & Hamilton), Whitney Debevoise (Arnold & Porter Kaye Scholer) and Hans Humes (Greylock Capital) as panelists.

In the early 2000’s, the introduction of collective action clauses (CACs) in international bond contracts was a significant contract-based development, designed to mitigate holdout risks by allowing for bondholder majority voting within a series of bonds. In recent times, holdout risks, such as in the cases of Argentina and Greece, and aggressive use of litigation by holdout creditors, received renewed attention. Significant improvements in contractual technology for bonds followed, including (i) improving CACs to allow aggregation of bondholder voting (across multiple series of bonds), known as aggregated CACs, to further mitigate holdout risk and enhance coordination across different series of bond issuances, (ii) enhanced pari passu provisions to disavow the ratable payment interpretation of pari passu clauses, and (iii) in a few cases, use of trust structures (a potential dampener on holdout litigation).

The IMF also updated its sovereign lending policies with an increasing focus on pre-default restructurings, is reviewing its lending in arrears policy (LIA), reviewed its Debt Sustainability Analysis (DSA) methodologies, scrapped its systemic exemption for exceptional access lending and agreed, in certain circumstances, to tolerate official sector arrears. These developments have been important steps forward in improving sovereign bond contracts and the role of the IMF. To build on this progress, a technical study group was set up under the aegis of the FFDO-UNDESA (with participants from the fields of academia, the legal sector, as well as some representatives from international institutions, central banks, ministries of finance and the private sector). The panel will present some identifiable incremental steps that can be taken to make further improvements in the market-based approach to sovereign debt restructuring. The main issues covered in the UN Technical Study Group Report on Sovereign Debt Restructuring: Further Improvements in the Market-Based Approach (Click Here for the Report) are:

Click Here for a paper by Michael Waibel (University of Cambridge) on Engagement Between Creditors and Sovereign Debtors: Guidance on Setting Up Creditor Committees.

Ms. Schneider opened her remarks by describing the current inefficiencies prevalent in sovereign debt restructurings, such as issues in “burden sharing”, “legal predictability” and “timeliness” that have featured in various UN resolutions, and explaining the UN mandate for multi-stakeholder consultations and work in this area. She stated that the Report was a consensus document with specific recommendations. The Report was attempting to find solutions for some specific restructuring issues, such as the role of information and standardization, guidance on debtor-creditor engagement, strengthening the role of trustees, making contractual technology for bonds and commercial bank debt more robust and exploring the links between regulation and sovereign debt restructuring. The Report is now out in the public domain for comment and public discussion.

Ms. Zandstra provided an overview of the issues. Recent sovereign bond reforms were implemented because of two main factors – pari passu-based litigation, especially against Argentina (with the attendant risk of disrupting otherwise consensual restructurings and preventing restoration of market access) and holdout creditors blocking positions in individual series of bonds in the case of Greece. This led to two major sovereign bond innovations, published as template provisions by ICMA – aggregated collective action clauses and enhanced pari passu clauses. These bond contracts reforms could be expanded to foreign laws beyond NY and English law (i.e., Sukuk and Japanese/German/Swiss law) and to domestic law governed instruments. She described the Euro Area Model CAC, which allows aggregation of multiple series of debt securities, but still requires approval by bondholders series by series (so called two limb aggregation) and the “Single limb aggregation” included in ICMA‘s Aggregated CACs, which is more favorable and the possibility of bringing the Euro Area Model CAC in line with ICMA’s Aggregated CACs. She also summarized the diverse types of instruments that sovereigns could issue and the possibilities but challenges in building interest and principal deferrals to be triggered in certain specific circumstances, with broad market considerations at play. Suspending legal actions against sovereigns through standstills and otherwise was also a topic addressed, as well as encouraging debtor/creditor engagement. She concluded by emphasizing that flexibility was needed and standardization across issuers was not advisable as different processes of restructurings were required depending on the circumstances. Click Here for Ms. Zandstra’s PowerPoint presentation.

Mr. Buchheit explained the differences between sovereign bonds issued under trust indentures (where the trustee is the fiduciary of the bondholders) vs. those issued under fiscal agency agreements, the more traditional approach (where the agent is acting on behalf of the issuer, and not to protect the interests of the bondholders). Under the trust structure, payments received by the trustee are the bondholders’ property, not subject to attachment by third party creditors of the issuer (although some fiscal agency agreements can provide that payment to the agent is for the benefit of bondholders). He quoted Professor Gelpern that the differences in the documents can cause a great deal of mischief. He considered it antediluvian not to have access to the documents and suggested that a centralized area for investors to access these crucial provisions be established by some body. Regarding enforcement, a trustee is responsible to enforce the provisions on behalf of all the bondholders (assuming the requisite number of bondholders so direct the trustee, which also reduces the risk of holdout creditors, but is not a guarantee against it, as Mr. Debevoise notes) vs. in the fiscal agent context, any bondholder can sue, although trustees are “pathologically passive, pusillanimous and persnickety” and getting them to take any action is very difficult. Some of the downsides of the trustee structure relate to questions of money and alignment of incentives. Mr. Buchheit also discussed some issues related to odious debt.

Mr. Stumpf focused on the issue of whether the three main innovations for bond contracts – pari passu, creditor engagement and CACs – should be applicable to sovereign commercial bank loan architecture. In this connection, he stated that there was no apparent reason why the new pari passu language should not be equally relevant in the loan agreement context. He discussed amendment provisions (where 100% approval was not in the interests of debtors or creditors) and assignment clauses to limit assignments to “financial institutions” (but not necessarily only to such financial institutions) so the issuer’s debt doesn’t fall into the hands of “unscrupulous people.” He noted the fact that approval rights for assignments (usually that it can’t be unreasonably withheld and must be granted by a certain time) disappear in the default context. He also discussed the issue of creditor good faith, including whether a specific clause addressing the existence and scope of this concept should be included in the loan contract.

Mr. Debevoise suggested that a “comprehensive regulatory look” was needed, especially in light of the changing creditor body from commercial banks to a larger array of creditors. Topics he addressed included regulatory capital and accounting aspects (and if there should be differential treatment), differing types of investment limitations (registered and unregistered), precautionary restructurings, fiduciary standards and what’s in the best interests of holders, derivatives regulation and the role of CDS (where from time to time the government intervenes to prevent “naked” holdings of CDS), appropriate capital to support positions, rules about margining and central clearing, the ISDA Determinations Committee procedures and definitions (with Greece as an example and does a particular structure trigger CDS), disclosure in Offering Circulars and other places, the Transparency Directive (similar to the ’34 Act), the need for a well-informed market, rules for discounting paper and short selling, regulation of credit agencies, intermediary banks and clearing systems, insider trading and material nonpublic information and its impact on the conduct of negotiations and creditor engagement, and access to IMF reports and the DSA that underlie them.

Addressing a Report on engagement clauses for sovereign bonds, Ms. Schneider noted that there are no uniform views in the private sector on contractual engagement clauses as lead managers and mainstream buy-side investors have no keen interest in them. Similarly, there is lack of interest from sovereigns as well. We need a practical way to move forward with creditor/debtor engagement, the contours of which are suggested in the Report.

Mr. Humes identified the problem with the Report corralling bad actors on the creditor side, but not dealing with the rogues on the debtor side (e.g., Argentina and Mozambique). And, the Report is not only not blocking such rogue debtors, but can be seen to enable them to game the system. He is disheartened by the buy-side who doesn’t seem to be sufficiently engaged in the process, as well as the underwriters who don’t have an interest in creating a robust structure when things go wrong. There does seem to be an “ecosystem” to sovereign debt restructurings with an organic process.

In general, most creditors are scarred by trying to get Argentina to engage with creditors and, while not all the panelists agreed that a definitive creditor committee be included in the bond contract, it can be used as an option. In general, as Ms. Zandstra states, and on which there was no disagreement, that engagement between issuers and their creditors is vital.