“The proposals set forth in the paper reflect the outcome of intensive discussions that took place over an 18-month period,” says Hagan (photo: IMF)
Sovereign Debt
The IMF is engaged in a number of reforms designed to reduce the costs of sovereign debt restructurings—for the benefit of debtors, creditors, and the system more generally. These reforms include possible changes to the IMF’s lending framework that are designed to give the IMF a broader range of policy responses in the context of sovereign debt distress. Separately, there is a recognition that, in circumstances where a sovereign and its creditors have reached the conclusion that a debt restructuring is necessary, the existing legal framework may not be sufficiently robust to prevent “holdout” creditors from undermining the restructuring process. Recent developments, including the Argentine litigation in the United States, have highlighted these vulnerabilities. The IMF recently endorsed reforms to sovereign bond contracts that are designed to address these issues.
Sean Hagan, the IMF’s General Counsel, has led the IMF’s latest work in this area. In an interview, he discusses both the reasons why these reforms are important and the nature of the Fund’s role going forward.
IMF Survey: Last week, the IMF’s Executive Board discussed a paper on strengthening the contractual framework for sovereign debt restructuring. What is the significance of the Board’s discussion?
As you know, the IMF has embarked on a broad reform agenda in the area of sovereign debt restructuring. An important element of that agenda is the strengthening of the legal framework that supports the restructuring process. It has been agreed that reform in this area should be market-based and, accordingly, we have been focusing on potential changes to international sovereign bonds contracts. This is the subject of the paper that was discussed by the Board last week.
The proposals set forth in the paper reflect the outcome of intensive discussions that took place over an 18-month period with the private sector, sovereign issuers, and representatives of the official sector. More specifically, the proposals in the paper are consistent with a number of the features of the clauses that were recently adopted by the International Capital Market Association (ICMA) —which has been a key counterpart in our discussions. ICMA represents many major global financial institutions and sovereign issuers.
IMF Survey: The paper identifies contractual reforms to address so-called “collective action problems” in sovereign debt restructurings. Let’s step back a bit. Can you explain what collective action problems are and how they affect the sovereign debt restructuring process? Why was this work considered necessary for the Fund?
There’s a broad recognition among the official sector, sovereign issuers, and creditors that—while debt restructuring is the exception rather than the norm—there may come a point at which it is in everyone’s best interests for a sovereign’s debt to be restructured.
When that time comes, there is a risk that individual creditors might decide not to participate in a restructuring in the hope that they will be able to recover the full value of their claims. If these so-called holdout creditors have a significant chance of recovering their claims in full, creditors who would otherwise have agreed to participate in the restructuring will become less willing to do so—even though it would be in the collective best interest of all creditors to agree to a restructuring as soon as possible. In particular, they would be concerned about receiving less than other similarly situated creditors who have chosen not to participate. We refer to this problem as a collective action problem. The uncertainty generated by collective action problems can create delays in the restructuring process—and may possibly push a country into default unnecessarily—to the detriment of the debtor, the creditors, and the system more generally.
IMF Survey: So collective action problems could seriously undermine the restructuring of sovereign debt. Can you tell us more about the reforms that the IMF is proposing to address these problems?
The contractual reforms that we have focused on during this extensive period of consultation relate to two provisions in particular. The first is the collective action clause—which enables a qualified majority of creditors to take a decision regarding the terms of the restructuring that is then binding on the minority. These clauses are essentially designed to address the holdout problem that we talked about earlier, by ensuring that all creditors are bound by the decision of the majority.
The second reform relates to a provision that is found in most international sovereign bonds—known as the pari passu provision—that most recently has been used by holdout creditors to undermine Argentina’s debt restructuring.
IMF Survey: Collective action clauses already exist. Why do they need to be changed?
That’s right, collective action clauses exist in most international sovereign bonds. However, they are subject to important limitations. The existing clauses generally require a vote to take place on a per-series basis—that is, bond issuance by bond issuance. As a result, it’s possible for holdout creditors to obtain a sufficiently large share of the bonds in a particular issuance, thereby blocking the operation of the collective action clause, and therefore, the restructuring of that issuance. As I mentioned earlier, this could also reduce the willingness of other creditors to consent to the restructuring.
The important reform that is reflected in the clauses adopted by ICMA—and which now have been endorsed by the Executive Board—introduces a new voting procedure that allows decisions to be taken by a majority of creditors across all bond issuances, without the need for an issuance-by-issuance vote. This will severely limit the ability of holdout creditors to avoid a restructuring by obtaining a large share of the bonds in any one issuance. One of the key advantages of having a single vote is that either no one is in or everybody is in. It creates certainty that provides a tremendous amount of comfort for market participants and their support was a key reason why ICMA ended up adopting this voting procedure. It is important to recognize that collective action clauses do not transfer legal leverage from the creditors to the debtor. Rather, they transfer legal leverage from individual creditors to the group.
Finally, the single voting procedure includes important safeguards to ensure inter-creditor equity across different issuances. Also, the clause provides for flexibility in that it also allows for more traditional voting procedures to be used when the sovereign and its creditors judge it to be appropriate. These issues are discussed in detail in the paper.
IMF Survey: What about the pari passu provision, why does this need to be changed?
The primary motivation for the reform of this provision is, in fact, the litigation involving Argentina. In that case, the pari passu provision was interpreted by the New York courts as requiring ratable or pro rata payment to all creditors. So Argentina—as well as the bond trustee and other parties in the payment chain—were prevented from making any payments to those bondholders who had agreed to restructure their debt unless it also made payment in full to the holdout creditors. The concern—and this is a concern shared by many, not just by the IMF—is that this case may have systemic implications since it will enhance the holdout strategy in future cases.
The reform that has just been endorsed by the IMF would involve introducing a proviso into the pari passu clause that clarifies that this clause does not require ratable payment to all creditors, but, rather, only equal legal ranking. In other words, it would only prohibit actions that result in legal subordination of certain unsecured creditors over others.
IMF Survey: The reforms you have just identified clearly have important systemic implications. What role can the Fund play in encouraging these reforms?
It’s important to recognize that how these clauses are designed, and whether or not they’re included in bond contracts going forward, is ultimately a decision that will be taken by creditors and debtors. This is, by definition, a market-based approach, and in this respect the role of the IMF is necessarily limited. It is, nevertheless, an important role. As in 2003, when we also promoted the introduction of collective action clauses for the first time in bonds governed by New York law, the Fund intends to encourage the use of these provisions in its dialogue with the IMF member countries that will be issuing bonds governed by foreign law. The Board’s endorsement was the essential first stage. Staff will now engage with the IMF membership to promote the reforms.
It’s also useful to highlight that the modified pari passu clause that the IMF has endorsed is already being used by some sovereign issuers. With respect to collective action clauses, Kazakhstan recently issued a Eurobond that includes for the first time the key features that were endorsed by the Board last week. This is a very significant first step and the task now will be to encourage more widespread adoption of the new clauses.
IMF Survey: Isn't there an outstanding stock of bonds that will not be affected by these reforms? Don't they still pose a risk to the system? And what can the Fund do about them?
As the paper highlights, there is a significant volume of outstanding stock that does not contain the new clauses, and which will not mature for some time. We have explored whether or not sovereign issuers and market participants would be willing to accelerate the turnover of the existing stock through liability management exercises—essentially exchanging their existing bonds for new bonds that don’t have these problematic provisions. Right now, the appetite for liability management is somewhat limited, but that may change if, in fact, the Argentine litigation begins to have a broader impact on the system.
We will continue to monitor this situation both in terms of the dangers presented with respect to the outstanding stock and in light of additional steps that may need to be taken.
