Contractual Approach: CACs
What Types of Reform Are Needed?
Among those who agree on the need to improve the handling of sovereign debt restructurings, there is much debate over what type of reforms are required, with opinions traditionally split between those who advocate a market-based, contractual approach, on one hand, and those who would prefer to see a more formal, statutory mechanism, on the other. More recently, a number of alternative proposals that do not fit cleanly into the contractual-statutory dichotomy have been put forward (Committee on International Economic Policy and Reform/Brookings 2013; House and Gitlin 2013; Mody 2013).
The Contractual Approach
One perspective on why sovereign debt restructuring is costly and unpredictable is that relations between creditors are subject to incomplete contracts (Bolton and Jeanne 2002). From this perspective, a good way to ensure more timely and orderly restructuring is to clearly outline the procedures for restructuring when the bond is first issued. Writing the terms of a restructuring into the bond contract can help mitigate the collective action problems that lead to deadweight losses by binding creditors to a common and well-specified restructuring procedure.
Collective action clauses (CACs), a widespread feature of sovereign bond contracts, embody the contractual approach to sovereign debt restructuring. These clauses consist of legal provisions that are written into the contracts that govern sovereign debt obligations. They typically include provisions that (1) establish a bondholders meeting in the event of restructuring and specify procedures for selecting the bondholders’ representative (collective representation clauses), (2) prevent individual bondholders from taking the sovereign to court (majority enforcement clauses), and (3) specify the size of the (super) majority of bondholders needed to amend payment terms” (majority restructuring clauses) (Das et al. 2012; Gulati and Weidemaier 2014).
CACs have been a common feature of the London bond market since the late nineteenth century (Helleiner 2009; Das et al. 2012; Gulati and Weidemaier). In the United States, however, CACs did not become widely used until fairly recently. In 2003, Mexico became the first major emerging market debtor to include CACs in its sovereign bonds – a move that precipitated a rapid and widespread shift toward the use of CACs for emerging markets. At the end of 2002, only about 30 percent of emerging market sovereign bonds included CACs (and most were issued in London). By 2004, close to 90 percent of new international bonds issued included CACs, and by the first half of 2005 the figure had approached close to 100 percent (Helleiner 2009). In response to the euro zone crisis, Europe has introduced a new requirement that all euro zone sovereign bonds issued after January 1, 2013, include CACs (Bradley and Gulati 2013; Weidemaier and Gulati 2014).
Although the more widespread use of CACs in sovereign bond issuances seems to represent a step in the right direction, many argue that the presence of CACs alone is not enough to ensure a timely and orderly restructuring process.[1] Empirical evidence on the actual effectiveness of CACs in past debt restructurings is mixed (Das et al. 2012). The Greek restructuring enjoyed a high rate of participation amongst bondholders (97%), but those who refused to participate – the holdout creditors – were successful in recovering their investments in full, which only strengthens the incentive for others to holdout from future deals. Indeed, the IMF (2013) notes that the Greek restructuring highlighted the limitations of CACs in addressing non-participating creditors. The recent court ruling in favour of Argentina’s holdout creditors may also make the problem more acute going forward (IMF 2013). Buchheit et al. (2013a: 1) declare that “any future Eurozone debt restructuring will be surely plagued by the problem of non-participating creditors.”More importantly, the Greek restructuring was seen as a case of “too little, too late” – a problem that many consider to be more challenging than holdout creditors, and one that CACs are not equipped to handle (IMF 2013; Gitlin 2014). In fact, some scholars go as far as to argue that the inclusion of CACs in bond issuances can actually increase incentives to free ride and, in doing so, further delay the resolution of a debt restructuring deal (Pitchford and Wright 2010). For some, the persistence and potential worsening of the holdout creditor problem — following the success of Greek holdouts and the US court ruling in favour of Argentina’s holdouts – only reinforces the need to improve the way sovereign debt restructuring is governed beyond the contractual approach of CACs.
[1]Bi, Chamon, and Zettelmeyer 2011; Bradley, Cox, and Gulati 2010; Das, Papaioannou, and Trebesch 2012.