By Sean Hagan
(version in Español)
To restructure or not to restructure? That is a question few governments would like to face. Yet, if a country does find itself with an unsustainable debt burden, one way or another, it will have to be restructured. And if that time comes, it is better for the debtor, creditors, and the entire financial system that the restructuring be carried out in a prompt, predictable, and orderly manner.
The global financial crisis ushered in a new wave of sovereign debt crises that has reinvigorated discussions over the current framework for sovereign debt restructuring. The experience with Greece’s debt restructuring in 2012 and the ongoing litigation involving Argentina, in particular, provide a salutary reminder that vulnerabilities remain.
Recognizing the need for reform, the International Monetary Fund recently endorsed changes to sovereign bond contracts designed to improve the sovereign debt restructuring process. The reforms—which are detailed in an IMF paper—aim to minimize the risk that a restructuring supported by a large majority of a sovereign’s creditors could be obstructed by a small group of creditors. Importantly, the reforms resulted from a successful, 18-month process of consultation and good collaboration among the IMF, sovereign issuers, market participants, and other representatives of the official sector. The International Capital Markets Association (ICMA) and U.S. Treasury were key counterparts in our discussions.
At the Fund, we see these reforms as part of a broader effort to reduce the cost of crisis resolution through market-based solutions. This includes reviewing our lending framework to help our member countries address debt sustainability problems more effectively. We will also be looking at issues surrounding the process of engagement during the restructuring period—both between the debtor and its creditors, and among creditors themselves. Through these reforms, we aim to reduce the costs of crises for everyone.
What the reforms achieve
The first big change is to the “pari passu” clause—a boilerplate clause that was given a new lease on life by the New York courts in the recent Argentina litigation. As a result, a minority of creditors succeeded in paralyzing a restructuring that was approved by 93% of bondholders. The new clause that we endorse explicitly rules out the interpretation taken by the New York courts—namely, requiring equal payment to all bondholders—and limits it to a protection of legal ranking.
The second key reform is to “collective action clauses,” which allow a qualified majority of bondholders to agree to a debt restructuring. While the widespread adoption of collective action clauses in the early 2000s was a major development, they are still highly susceptible to obstructive behavior by a minority of creditors—so-called “holdout” creditors. Why? Most of these clauses require a majority of each bond series to vote in favor of the restructuring. As a result, holdouts can acquire a blocking stake (normally, 25% of that series) at a relatively low cost, and thereby prevent the restructuring of that series. This limitation was evident in the 2012 Greek bond restructuring, where holdouts were eventually paid out in full—to the tune of €6.5 billion.
The new collective action clauses allow a restructuring to be carried out on an aggregated voting basis. Under the most robust form of aggregated voting, a restructuring can be passed by a 75% majority across all bond series. This does not shift the balance of power from creditors to debtors—the restructuring still needs the backing of a 75% supermajority of creditors. Rather, it takes power away from an obstructive minority and restores it to the body of creditors as a whole. This gives certainty to creditors that either no one is in, or everybody is in. The support of creditors was a key reason for ICMA adopting the single voting procedure in their new standard bond terms.
To ensure adequate protection for creditor rights—as well as market acceptability and legal enforceability in key jurisdictions—the use of the single voting procedure described above is subject to important safeguards. In particular, all creditors must be offered the same restructuring terms, or menu of terms. There are also protections against sovereigns influencing the vote, for example by buying up a large share of the bonds. At the same time, the new clause gives issuers and creditors the flexibility to use other voting procedures—for example, in order to offer different terms—depending on the needs of the restructuring.
Putting the new model to the test
In a critical first move, Mexico, Vietnam, and Kazakhstan have recently issued bonds incorporating the new clauses. Importantly, the use of the new clauses did not have any meaningful price impact. The next step is for the clauses to be adopted widely by sovereign issuers, which is something we will actively encourage and monitor. It is important to emphasize that the IMF is endorsing critical features of these clauses—not specific language. It is recognized that, in various jurisdictions, these features can be drafted in different ways.
Are these reforms a panacea? No. Importantly, there remains an outstanding stock of sovereign bonds (worth a significant $900 billion) that do not contain the new clauses, a large portion of which do not mature for another 10 years. The extent of the risk posed by these “legacy bonds” for debt restructurings that may occur during this transitional period will depend on how the New York court decisions are interpreted in future litigation. Going forward, we will be monitoring this issue closely and advising our member countries on what additional steps could be taken to manage the transitional risks. This could include issuers swapping their old bond contracts for new ones even before they mature. More generally, of course, countries must put in place sound policies to prevent their public debt burdens from becoming unsustainable in the first place.
Relative to some of the other reforms currently being considered—including at the United Nations—these contractual reforms may appear somewhat incremental. Policymaking, however, is often about achieving incremental but meaningful progress. Just as important as the outcome, the process reflected excellent collaboration between the private and official sectors. In this light, we believe that the latest reforms represent a good outcome from a good process—one that makes it a whole lot easier to carry out sovereign debt restructuring when countries need it.