Challenges in Restructuring Sovereign Debt: Do we need “Creditor Engagement Clauses”?
March 9, 2015
Last year’s decision by the New York courts to block payments from Argentina to its creditors has threatened to increase the incentives and opportunities for predatory behavior in global debt markets. The ruling is characterized by a new interpretation of the pari passu clause (i.e. the principle that all bond holders should be treated equally), but its precise implications for global bond markets are not yet known. The latest development is a ruling by a London court which confirms the rather obvious: bonds issued in the UK are governed by UK law and not US court rulings. The litigation continues.
A stronger Collective Action Clause (CAC) framework could help reduce predatory behavior in bond markets. In an effort to strengthen CACs, the International Capital Markets Association (ICMA) proposed new standards for CACs in sovereign debt contracts in August 2014. The key elements of these new standards address pari passu, aggregated collective action and creditor engagement clauses. These standards have been widely acknowledged – from the IMF to the government of Argentina – as a step in the right direction. However, these standards are not perfect and their adoption depends on how a country issuing the sovereign bonds views them.
In regards to the “creditor engagement clauses,” some countries and experts have questioned their necessity. In response, the ICMA has noted in its proposal that this clause is “not an integral part” of the new CAC framework.
So, what are Creditor Engagement Clauses?
The creditor engagement clause – a provision in a sovereign bond contract – allows creditors which hold at least 25 percent of aggregated bonds to form a “creditor committee” to negotiate with the country that issued the bonds. If such a committee is formed, then the borrowing country would be required to negotiate with that committee or its appointed leadership. The country is required to cover the costs of this committee.
Historical Context of Creditor Committees: Starting in late nineteenth century, banks which lent to sovereigns established committees to coordinate debt workouts when necessary. Some examples include the early Corporation of Bondholders and the Foreign Bondholders Protective Counsel which formed in the aftermath of the market collapse in 1929. These “bank advisory committees” operated on the basis of unanimous decision making, which worked reasonably well due to strong and similar interests among banks. This was especially the case where banks operated in the countries they financed. This arrangement, where sovereigns retained leverage vis-à-vis banks through their central banks, lasted until the 1990s when sovereign lending began to shift from banks to bonds markets. As bondholders became more disparate, so did their interests. As a result, cooperation between creditors has become a growing challenge.
On Monday (March 2), the Emerging Markets Traders Association, in partnership with ICMA and IIF, hosted the seminar “Creditor Engagement Clauses – Pros and Cons” to debate the merits of including this clause in bond contracts. The panel consisted of representatives from the legal, investment and financial industries.[1] Below are some of the takeaways from that discussion:
PROS
- Creditor committees have worked in the past. Creditor committees were formed – voluntarily – in 12 of 16 sovereign debt restructuring cases since 2003. In 11 or those 12 cases, the issuer (i.e. country) negotiated with the committee and creditor participation in the restructuring exceeded 94 percent.
- Creditor committees mean that creditors relinquish some control/power to the committee as a whole and, as a result, can help to address directly the collective action problems creditors.
- Most panelists agreed that that it would be an act of “good faith” on behalf of the sovereign borrower to include creditor engagement clauses in bond contracts. The argument is that “good faith” – which would generate greater market confidence – would be rewarded with greater access to private capital and on better terms.
CONS
- There are cases where creditor committees are ineffective and perhaps even counterproductive (e.g. Iraq 2005-06). Given the downside risks of creditor committees, they should not be mandated in bond contracts, especially if creditor committees are already forming and working on a voluntary basis (as mentioned above).
- Sovereign issuer is responsible for covering the costs of the creditor committee. Covering these costs is obviously a concern for debtors, particularly during a time of debt distress. A related concern is that this arrangement may encourage creditors to holdout longer than they would if the costs were not covered. Some panelists suggested that the costs be rationalized and limited as much as possible, but no panelist suggested that the costs be covered by creditors.
- If creditor committee and country cannot agree on terms, the country will be forced to propose a restructuring offer “without” approval from the creditor committee. As a result, capital markets would view the offer as not credible or characterize the country as recalcitrant. These perceptions damage a country’s access to finance. With this in mind, countries issuing debt may be less willing to include creditor engagement clauses.
- Is this a unilateral act of “good faith” on behalf of the country issuing debt? Should there also be an act of “good faith” from the creditor side? Creditors could add to bond contracts a “champerty” clause – a doctrine that would prohibit the purchase of sovereign debt for the purpose of bringing legal action against the bond issuer (i.e. essentially you cannot sell or buy lawsuits). The champerty doctrine is part of New York state law, but was amended in 2004 to only apply to cases under $500,000.
Given these pros and cons, it does not seem necessary that creditor engagement clauses be included into sovereign bond contracts. Since creditor committees seem to form and function on a voluntary basis, the best argument for including the clause is to demonstrate "good faith" as a borrower. However, without mutual acts of good faith, there is little incentive for countries to include this additional commitment into their bond contracts.
OTHER ISSUES
Official Sector Resistance: Official sector may be opposed to include “creditor engagement clauses” since this means relinquishing some power to a committee that includes other sovereign states and private sector actors. Sovereign lenders may wish to retain autonomy as a creditor (especially for political reasons). In addition, the Paris Club is outdated and does not include many new official sector creditors. This means that coordination among official sector creditors is less predictable and in such an environment, official creditors may be more wary of delegating power to a committee.
Role of IMF: There was a brief discussion on if creditor committees would give creditors greater leverage in negotiating the terms of restructuring – i.e. determining what a country can afford to pay. The panel agreed that the IMF effectively decides what is reasonably affordable or “sustainable” for the respective country and that a creditor committee would not be able to move this very much.
It was also noted that almost all countries that have undergone restructuring since 2003 had IMF programs in place. The panel acknowledged that the IMF is not a neutral party, and thus not an ideal arbitrator. The IMF’s conflict of interest was not attributed to its role as a creditor, but viewed biased due to its mandate to serve its member countries.
Concerns about bond contracts becoming too complex: There was concern among both audience and panelists that sovereign bond agreements are becoming too complex and, thus, more vulnerable to gaming by financial sector and disparate interpretations by jurisdictions. An ideal solution to the latter problem would be for the key jurisdictions that govern foreign bonds (New York, London, Singapore) to agree to a single legal framework that would apply to all foreign bonds. However, as highlighted by the differences between the recent rulings in the US and UK courts, this is unlikely to materialize any time soon.
The complexity issues where emphasized in reference to Mexico’s new bond contracts – which actually include much of the new language suggested by the IMF and ICMA. Mexico’s new bonds do not include the “creditor engagement clause” and contain fairly opaque details regarding exchange rates. These two issues, part of a long and complex bond contract, were overlooked by many investors. At the time of this event (March 2, 2015), ICMA had not yet responded (they had only found 3 days before). There was concern among panelists that the language on exchange rates might provoke greater discord among creditors as they could jockey for favorable rates. Mr. Lee Buchheit, who is advising the government of Mexico, said that these issues were being sorted out.
Developing Countries: It was asked if there should be different considerations for smaller countries, like Zambia, where acquiring a blocking position (26 percent of bonds) is easier. The panel’s response was: “that is democracy.” This response demonstrated a poor understanding of democracy – because it is a minority (25 percent bondholders) that can block the will of the majority. This is a better arrangement than earlier CAC frameworks, but not a strong example of democracy.
Nathan Coplin
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[1] Panelists included: Hans Humes, Greylock Capital; Charles Blitzer, Blitzer Consulting; Lee Buchheit, Cleary, Gottlieb, Steen & Hamilton; Hung Tran, Institute of International Finance; and Aaron Kim, PIMCO