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IMF Board Discusses Possible Features of A Sovereign Debt Restructuring Mechanism
On December 19 and December 20, 2002, the Executive Board of the International Monetary Fund (IMF) continued its discussions on the possible features of a new Sovereign Debt Restructuring Mechanism (SDRM).
As part of its ongoing work on crisis prevention and resolution, the IMF has been discussing how to help countries with unsustainable debt burdens. Emerging markets have benefited in recent years from the availability of wider sources of financing. However, the diverse nature of the creditor community of bond holders can be problematic when debt has become unsustainable and has to be restructured.
The IMF is considering two complementary approaches to creating a more orderly and predictable process for sovereign debt restructuring: (i) a contractual approach, in which debt restructurings would be facilitated by enhanced use of certain contractual provisions in sovereign debt contracts, and (ii) the establishment of a universal statutory framework which would create a legal framework for collective decisions by debtors and a super-majority of its creditors.
In September 2002, the International Monetary and Financial Committee (IMFC), which represents the interests of the IMF's 184 member countries, endorsed the Fund's work on crisis prevention and its efforts to create a framework for an equitable debt restructuring that restores sustainability without including incentives that unintentionally increase the risk of default. The IMFC requested the IMF to develop a concrete SDRM proposal for consideration at the IMFC's next meeting scheduled for April 12, 2003.
The 24-member Executive Board of the IMF, which has day-to-day responsibility for the interests of the Fund's member countries, had held a series of informal discussions in the lead up to the IMFC meeting last September. The Board discussion in December was the first detailed review of issues associated with a possible design of a SDRM. The discussion revolved around a staff paper, "The Design of the Sovereign Debt Restructuring Mechanism - Further Considerations," which provides a comprehensive review of the principal features of a possible statutory approach. The paper was drafted after extensive staff contacts with private market participants, debt-restructuring practitioners and other workout specialists, academics, and members of the official community.
Executive Board Assessment
At the conclusion of the Executive Board's discussion, First Deputy Managing Director Anne Krueger issued the following statement:
"Executive Directors welcomed the opportunity to consider further the possible features of a new Sovereign Debt Restructuring Mechanism. The paper discussed today is an important step in responding to the request by the International Monetary and Financial Committee to develop, for consideration at its meeting in April 2003, a concrete proposal for a statutory sovereign debt restructuring mechanism to be considered by the membership. The design of the mechanism has, so far, benefited considerably from consultation with market participants and members of the judicial and legal professions and of the official community. These outreach efforts will continue, and intensify, as we move forward in search of a consensus on the need for—and the design of—an SDRM. At the same time, however, many Directors stressed that the efforts to achieve a broad support from market participants, which they strongly welcomed, should not dilute the mechanism to a point that it would lose its effectiveness. Other Directors stressed the importance of market and issuer acceptance, as the SDRM aims at fostering an orderly, voluntary debt restructuring by parties to the financial transactions. Given the wide ranging and complex issues involved, the summing up of today's discussion will probably not do full justice to the wealth of views expressed on every single aspect of a possible SDRM, but let me assure Directors that these will be very carefully taken into account in the revised paper that will be prepared based on today's discussion, and that will lay the basis for a report to the IMFC.
Objectives and Guiding Principles
"Most Directors reaffirmed their belief that a carefully designed debt restructuring mechanism can make an important contribution to improve the comprehensive framework for crisis resolution and the international financial architecture, more generally. The objective of the SDRM is to provide a framework that strengthens incentives for a sovereign and its creditors to reach a rapid and collaborative agreement on a restructuring of unsustainable debt in a manner that preserves the economic value of assets and facilitates a return to medium-term viability, and thereby reduces the cost of the restructuring process. To achieve this objective, the SDRM must not only address collective action problems amongst creditors, but also catalyze an early and effective dialogue and exchange of information between the debtor and its creditors. By creating greater predictability in the restructuring process, the SDRM should also be expected to improve the functioning of international capital markets—an objective which should remain a primary concern going forward. Most Directors stressed, in this regard, that the SDRM must continue to be part of a general effort to continue to strengthen the framework for crisis prevention and resolution, including the policy on exceptional access to Fund resources.
"Against this background, most Directors considered the general principles, set forth in paragraph 14 of the staff paper, to be a sound basis to help guide the design of the mechanism. A concern, highlighted by many Directors and that will need to be carefully taken into account as we seek to garner support for a mechanism that minimizes interference with contractual relations, will be to ensure an incentive structure which is both effective and balanced. Directors also looked forward to a forthcoming companion paper that will address economic policy issues that arise in connection with sovereign debt restructuring. Today's discussion has allowed us to make progress on the many financial and legal design aspects of the SDRM, although on several of them the views expressed were still of a preliminary nature, and on some important aspects of the mechanism Directors insisted that, at this stage, all options under consideration should remain on the table.
Scope of the Claims to be Covered
"There is broad agreement that, in cases in which a sovereign's debt burden is unsustainable, the scope of claims that may need to be restructured will likely be broad. This will help engineer a sufficient adjustment to the debt and debt service profile to create a reasonable prospect of a return to viability, and achieve sufficient inter-creditor equity to garner broad support for a restructuring. At the same time, Directors observed that the debtor may decide to exclude certain types of claims from a restructuring, in particular to limit the extent of economic and financial dislocation.
"On balance, Directors considered that these objectives will probably best be achieved by identifying the range of claims that potentially could be restructured under the provisions of the SDRM, while leaving it to the debtor, in negotiation with its creditors, to determine which subset of eligible claims would need to be restructured in a particular case. Some Directors, however, preferred an approach whereby the types of claims to be included would be more specifically targeted in the provisions of the SDRM.
"Directors discussed various definitional issues pertinent to delineating the scope of claims to be covered under the mechanism. These issues, as well as those related to the specific exclusion of certain types from the SDRM—which will be discussed next—raise numerous technical questions, which Directors expect to be further clarified in the course of future work. As regards the definition of what will constitute "sovereign" claims for purposes of the mechanism, most Directors agreed that the member's central government would have the option to include its own debt and, subject to the consent of the debtor in question, claims on the central bank, and public entities or sub national governments that are not subject to a domestic debt restructuring framework. The importance of well-developed domestic insolvency regimes was highlighted, in this regard. Some Directors, however, did not support extending the definition of eligible debt beyond that of the central government. In defining the nature of the claims that would be subject to the mechanism, most Directors saw merit in adopting a sufficiently broad definition—as laid out in the paper (paragraphs 49-53)—to reduce risks of circumvention through the use of a wide range of contractual techniques that could, over time, limit the utility of the mechanism.
"Directors noted that including contingent liabilities in the scope of the SDRM would raise a number of difficult challenges, and generally supported further pursuit of the proposed approach that guarantees only be eligible for inclusion under the SDRM if the underlying claim is in default. With regard to contingent claims other than guarantees, debtors should be able to include such contingent claims if they have matured or, in cases where they have not matured, if it is possible to assess market value.
"Directors also recognized the merits of restructuring claims, benefiting from a statutory or a contractual privilege, outside the SDRM framework. This would protect the value of these privileges, and avoid a significant interference with contractual relations, which could severely complicate the operation of the mechanism. Some Directors expressed concern that protecting the value of such privileges might increase incentives to use them in attracting finance. Some other Directors, however, saw this risk as rather low given the hesitancy of most sovereigns to take on secured debt obligations, and the mitigating role played by the negative pledge clauses in the loans extended by multilateral development banks and private creditors.
"Directors supported excluding from the SDRM claims that are governed by domestic law and subject to the exclusive jurisdiction of domestic courts, as sovereigns typically have mechanisms to restructure such claims which do not give rise to collective action difficulties. Directors noted that the transparency requirements of the SDRM would serve to help ensure that the restructuring of these claims is adequately coordinated with the restructuring of claims under the mechanism. In this context, however, a few Directors expressed concern that the obligation of full information sharing, including on domestic debt, would place the debtor at a disadvantage, especially since creditors could terminate the SDRM at any time.
"There was broad agreement that claims held by international financial institutions should be excluded, reflecting the unique role that these institutions play in the existing international financial system. Some Directors cautioned that conferring preferred creditor status should not be overly broad in terms of institutions covered. Directors did not yet reach a definite view on how to treat claims held by official bilateral creditors. Many Directors reiterated their view that official bilateral claims should be excluded from the SDRM but that close coordination would be needed between the Paris Club and SDRM restructurings. These Directors noted that the Paris Club has been an effective, and flexible, mechanism for restructuring official bilateral claims and mobilizing support from such creditors for members' adjustment programs. A number of other Directors, however, saw the inclusion of official bilateral creditors, albeit as a separate class, as an important element of a comprehensive effort to coordinate the restructuring of the sovereign's debt and achieve greater inter-creditor equity, or did not want to rule out this option at this stage. Taking into account these various views, the preferred course of action would appear to be to proceed, at least initially, on the basis of excluding official bilateral creditors from the SDRM, while recognizing that this will require the formulation of additional principles and procedures, to be developed jointly with private creditors and official creditors, to address coordination and sequencing issues. The staff will continue discussions with the Paris Club Secretariat about the possible modalities of coordination between the restructurings of official bilateral debt and private debt, whether outside the SDRM or within the SDRM as a separate class.
"There is general agreement that the proposed mechanism is to assist members whose debt is unsustainable. The question arises, however, whether this general statement of purpose should be enforced as a condition for activation. Most Directors were of the view that the debtor should be allowed to activate the mechanism unilaterally, without third-party confirmation that the activation is justified. These Directors noted that several proposed features of the mechanism would discourage abuse of the SDRM. Furthermore, the Fund, through its policy dialogue with members, including on assessing debt sustainability, as well as through the exercise of its financial powers, can indirectly influence a member's decision to activate the mechanism. Some Directors, however, suggested to explore further whether a third party—possibly the Fund—could provide independent confirmation of a member's representation of unsustainability, including to ensure the public good character of decisions to activate or not activate the SDRM in a given situation. Other Directors did not wish to enhance the IMF's role. Directors looked forward to further clarification of the role of the Fund in the activation process.
Consequences of Activation
"Directors saw the general features of the information, registration, and verification procedures set out in paragraphs 96-122 of the paper as a useful basis for further work. While some Directors considered it desirable to require end-investors to register their claims in order to provide creditors with all relevant information, several other Directors noted that this would involve a significant change from market practice and would not necessarily result in greater transparency. Directors encouraged the staff to continue discussions with the private sector on the appropriate design of the registration and verification procedures, including on approaches that will ensure the transparency and accountability of the process. Several Directors saw merit in exploring means by which much of the registration and verification process could be performed by private parties.
"A key issue in the design of the mechanism is whether to provide a stay on creditor enforcement, either automatically upon activation or upon an affirmative vote by a qualified majority of creditors. While most creditor litigations to date have been pursued after a restructuring, the SDRM might change this dynamic and elicit a proliferation of creditor litigations upon the activation of the mechanism. To safeguard the important protection which a stay could provide to the debtor during the initial stage of a restructuring process and to ensure inter-creditor equity, many Directors saw considerable merit in keeping open, at this stage, the option of imposing an automatic stay on litigation that would remain in place for a brief period until creditors are sufficiently organized to vote on an extension. These Directors observed that such a stay would encourage early engagement of the debtor and creditors in restructuring negotiations.
"Many other Directors, however, recognized that an automatic stay would constitute a significant, and possibly unnecessary, erosion of contractual rights. These Directors viewed the use of the so-called "hotchpot" provision as a workable alternative that would discourage litigation without imposing a limitation on enforcement rights. Some Directors were of the view that this rule could usefully be supplemented by a feature that would enable the Sovereign Debt Dispute Resolution Forum (SDDRF), upon the request of the debtor and the approval of a qualified majority of creditors or a representative creditors' committee, to issue an order that would stay specific enforcement actions in circumstances where such enforcement could undermine the restructuring process. Other Directors, however, cautioned that this could be an unwarranted extension of the powers of the SDDRF beyond what may be deemed necessary for an effective SDRM.
Creditor Participation: Organization, Voting, and Decisions
"Directors considered that, in many cases, a representative creditors' committee could play an important role under the SDRM to address both debtor-creditor and inter-creditor issues (as described in paragraphs 157-161), although it was noted that decisions in this regard should best be left to market participants. Consistent with best practices in this area, some Directors considered it appropriate that the debtor bear the reasonable cost associated with the operation of these committees. Some other Directors, however, favored a cost-sharing formula between the debtor and creditors.
"There is broad agreement that a voting threshold of 75 percent of registered claims would provide an adequate balance between the need to resolve collective action problems and the need to protect the interests of creditors. On the method by which the threshold would be calculated, most Directors expressed a preference for calculating the vote on the basis of the outstanding principal of registered claims, rather than one based on quorum rules.
"Most Directors saw the establishment of a framework that would create incentives for private creditors to provide financing during the restructuring period as a useful supplement to financing provided by multilateral organizations. To induce new financing, they encouraged further exploration of the proposal that a specified amount of financing would be excluded from the restructuring if such exclusion is supported by 75 percent of outstanding principal of registered claims.
"Directors generally supported the broad thrust of the features of the decision-making process relating to the final restructuring agreement, as set out in paragraphs 178-212 of the paper, including the proposal that the restructuring of privileged claims would require consent of the creditor in question; that the mechanism would not provide for mandatory classification of unsecured creditors; and that, upon activation of the SDRM, the outstanding amount of claims of unsecured creditors would be deemed to be due and payable for voting and distribution purposes. A particular point discussed by Directors related to whether the SDRM would allow the debtor to create optional creditor classes. While a number of Directors considered that this could facilitate a sustainable restructuring in certain circumstances, other Directors cautioned that, in the absence of pre-specified criteria for the creation of optional classes, the predictability of the mechanism could be hampered. In particular, it would be important to guard against the creation of optional classes that could result in unjustified discrimination of creditor groups.
"Several Directors noted the complexities of having multiple debtors within the same restructuring process and emphasized the importance of designing the mechanism in a manner that would facilitate effective coordination between such multiple restructurings.
"Several Directors commented on the proposal that the provision of false information by the sovereign during the restructuring process would constitute a breach of the member's obligations under the Articles of Agreement. While some Directors saw merit in this proposal, a number of other Directors considered that the Fund should not have a formal role in this regard. They noted that the Fund's existing financial policies, including its lending into arrears policy, would be the appropriate instrument to assess the member's good faith efforts to reach a collaborative agreement with its creditors.
"The SDRM would automatically terminate upon the effectiveness of the restructuring agreement by the SDDRF. In addition, and consistent with the principle of sovereignty, the sovereign debtor could terminate the operation of the mechanism at any time, although disincentives would need to be put in place to ensure that this right is not exercised in a manner that results in an abuse of the mechanism. There is also broad support for granting creditors the right to terminate the mechanism at the end of the registration process, and the staff will further reflect on what should be the appropriate voting threshold in this regard, in light of comments by Directors on the proposal to set this threshold at 40 percent.
Sovereign Debt Dispute Resolution Forum (SDDRF)
"Most Directors generally supported the considerations for establishing, through an amendment of the Articles of Agreement, an independent dispute resolution body. Other Directors questioned the practical need for the SDDRF. While Directors expressed varying views on the modalities for establishing the SDDRF, most Directors were of the view that the proposals set forth in paragraphs 230 through 244 of the paper would probably strike an appropriate balance between the desirability to keep the role of the Fund in this process as small as possible, and suggestions for a more elaborate process, including involvement of the Executive Board. While a few Directors also supported granting the SDDRF the power to terminate the operation of the mechanism when it reaches the view that continuation does not serve a constructive purpose, most Directors felt that this would constitute an unnecessary expansion in the role of the SDDRF, given other safeguards built into the mechanism. As outlined in the staff paper, the Managing Director would appoint members of the selection panel on the advice of outside professional associations and insolvency and debt restructuring experts and public or private international organizations that have developed an expertise in insolvency and debt restructuring matters, and the selection panel would be entrusted with the identification of potential candidates to the SDDRF, to be approved by the Board of Governors. Some Directors were of the view that the selection and nomination process should be subject to special voting majorities in both the Executive Board and the Board of Governors. Directors who supported the SDDRF underscored the importance of establishing professional competence and impartiality as the key criteria for the selection of SDDRF members. A few Directors also emphasized the importance of taking into consideration national diversity.
"Most Directors generally supported the staff's proposals concerning the organization and operations of the SDDRF and the legal effect of its decisions, although, in light of today's discussion, there appears considerable emphasis on the need to limit the SDDRF's powers to the administration of claims and the resolution of disputes. Directors agreed that the SDDRF should have no authority to challenge decisions of the Executive Board, including with regard to the adequacy of a member's policies or the sustainability of the member's debt for purposes of Fund financial assistance. In this regard, many Directors underscored the importance of a clear delineation of powers between the SDDRF and the Executive Board.
"Regarding the legal basis for the SDRM, most Directors agreed that an amendment of the Fund's Articles would provide the most appropriate vehicle for the establishment of the SDRM. A few Directors however, considered that the objectives of the SDRM fall outside of the Fund's purposes, and that it would be inappropriate to use the faculty of amending the Articles for creating the SDRM. Directors noted that the preparation of this amendment will need careful further consideration in view of the important issues that it involves for both the role of the Fund and the members' domestic legal systems. In this regard, a number of Directors called on the staff to draft a questionnaire that would usefully support the assessment by members of the implications of the SDRM for their legal systems.
"Directors encouraged management and the staff to continue to work on the design features of the SDRM and look forward to a revised paper. They emphasized the importance of continuing to engage the private sector and sovereign issuers in the discussions about the design features of the SDRM. The upcoming conference on the SDRM to be hosted by the Fund in mid-January 2003 will be an important opportunity to make further progress in clarifying outstanding issues and building consensus on the design of the SDRM."
IMF EXTERNAL RELATIONS DEPARTMENT