Sunday, October 6, 2013

Sovereign Debt Restructuring – A discussion about collective action clauses, negotiation principles, and timing

In times where the level of indebtedness is high in many countries and future growth expectations oftentimes decline, the topic of how to restructure sovereign debt becomes ever more important. The discussion at the IIF spring meeting on June 26, 2013, was, therefore, very helpful to follow.

Statutory vs. contractual approach

To restructure sovereign debt, you can take two principal approaches: The idea of the statutory top-down approach is to fix binding rules on a supranational level. As there is currently no international consensus on such rules, the contractual approach, namely through collective action clauses (CACs), is the only approach which is left. Besides this pragmatic argument in favor of collective action clauses, Ramon Fernandez, Director General for Treasury and Economic Policy in France and Chairman of the Paris Club, says: “There is a collective agreement that the contractual approach to debt problems is preferable over a more statutory approach and this is where CACs [collective action clauses] kick in.”

Ramon Fernandez

Broadly speaking, collective action clauses allow a super-majority of bondholders to buy in 100 % of all bondholders.

However, as Whitney Debevoise, Partner at Arnold & Porter, points out: “Collective action clauses can be both a shield and a sword.” Ergo, they are not always the panacea for any sovereign restructuring. Whitney says that most important is the degree of support among bondholders for a restructuring – At 97 %, you will always strike a deal whereas a 60 % support will hardly be sufficient to restructure. “If you believe in the market, there will always be a market-clearing price for a deal.”

Whitney Debevoise

Finally, CACs should only be implemented prior to a bond issue. This is, at least the opinion of Jean Lemierre, Advisor to the Chairman, BNP Paribas who says: “I think it's a reasonable tool when it is embedded at the beginning in the bond. You know the rule of the game.” [However,] “retroactive CACs are horrible.”

Jean Lemierre

Aggregation clauses is another important tool to organize sovereign debt restructurings efficiently. An aggregation clause tries to combine interrelated claims into a single litigation. In the case of bonds, this means to combine several bond issues of a sovereign and apply voting majorities (typically 75-85 %) at aggregate level and, at the same time, respect lower majority levels (typically 2/3) on an individual issue basis. Obviously, this type of clause is especially important, if you seek to replace the entire debt stock of a country in one go, as was the case in Argentina’s recent debt restructuring.

Finally, engagement clauses, organizing creditors among themselves as well as recognizing and structuring creditor committees, play an important role. Such clauses should be aim at a transparent debt sustainability analysis and a fair burden sharing among creditors.

Principles of sovereign debt restructurings

Ramon Fernandez, Director General for Treasury and Economic Policy in France and Chairman of the Paris Club, reminds the need for common principles guiding sovereign debt restructurings: “We have to be aware that each case [of sovereign debt restructuring] is different. But we need principles in order to deal with them.”

The general principles which should apply to any sovereign debt restructuring are the following:

  • Transparency and availability of information
  • Dialogue and cooperation between creditors and debtors
  • Good faith negotiations: “Good faith is crucial. There is a tendency to lead bilateral discussions with separate bondholders. But it is childish because people talk to each-other and understand what is happening. This makes the process only more complicated. It's better to sit around the table altogether.” (Jean Lemierre, Advisor to the Chairman, BNP Paribas)
  • Inter-creditor equity

On the merits, solutions must address not only debt sustainability, but also long-term economic growth and international financial stability.

Timing of sovereign debt restructurings

Negotiations must get two sorts of timing right:

  • First, it is hard for the kick-off for sovereign debt restructurings to intervene timely, as the necessity for restructuring is not always obvious and subject to market perception. Ramon Fernandez says – “It is and it will remain difficult to establish in a clear-cut way the necessity of debt restructuring and its optimal timing.” Because market perception of the necessity fluctuates.” Jean Lemierre, Advisor to the Chairman of BNP Paribas seems to agree on this point: “I am extremely surprised by the level of information that is given before the difficulties.”. On the other hand, his talk implies that people tend to ignore the necessity for sovereign debt restructurings: “From time to time, the market doesn't give the exact risk.” and “We should not act with a herd instinct and we should not be led only by the upper end yield on the bond but the real risk.”
  • Second, negotiations are complex and require a lot of time. “Negotiations can take time and need to take time in order to go to a good solution, in good faith, and in a cooperative way.” (Ramon Fernandez, Director General for Treasury and Economic Policy in France and Chairman of the Paris Club) / “It [the Greek debt restructuring] was extremely difficult. It took time – a lot of nights – this is part of the game, but it was well managed.” (Jean Lemierre, Advisor to the Chairman, BNP Paribas)

Sovereign debt restructurings data

Bart Oosterveld

Bart Oosterveld, (Managing Director, Head of Sovereign Risk Group, Moody’s Investors Service) summarizes some Moody’s research about sovereign debt restructurings:

  • A high debt/GDP ratio is neither necessary nor sufficient for a [sovereign debt] default to occur.”
  • Sovereigns that default are likely to do that again.”
  • Final losses to investors [in sovereign debt restructurings] are widely distributed. The range is 5 % to 95 %, the average is 50 %.”
  • Maturity extensions are the preferred tool [in sovereign debt restructurings], followed by a reduction in the coupon. Hardly ever is there a normal haircut on the debt.”
  • Holdout problems are not so relevant as the current public debate suggests. According to Moody's research, the Argentina case is the only really relevant case here.