As noted in the previous post, CIGI convened an Expert Group Meeting on sovereign debt restructuring with the UN Financing for Development office in New York on May 18th. The meeting featured an excellent exchange of views on a wide range of issues; many thanks to all who attended.
Sitting there, at the UN, I had an overwhelming sense of déjà vu: It was almost 10 years to the day that I had helped organize a similar meeting in New York. That earlier meeting also had an impressive list of academics and private sector participants and it too fostered a thoughtful discussion of sovereign debt restructuring.
The impetus for the discussion a decade ago was a growing sense of unease with the official sector's response to financial crises that seemed to be increasing in frequency and virulence. The problem was that efforts to mitigate crises through the provision of higher and higher levels of official financing threatened to distort international capital markets and contribute to the mis-pricing of risk. In this regard, efforts to develop a better framework for the timely, orderly restructuring of sovereign debt recognized the importance of preserving the bonding role of debt: the goal then wasn't to simply relieve governments of their debts; rather, the objective was to guard against the “privatization of return and the socialization of risk.” Preserving the link between risk and return remains a key objective.
The debate on sovereign debt restructuring, and the IMF’s proposed Sovereign Debt Restructuring Mechanism (SDRM) proposal, progressed to a remarkably advanced stage. It faced determined opposition from private sector groups, however, and was euphemistically “put on the back burner.” In its place, efforts focused on the adoption of collective action clauses (CACs) and guidelines for the voluntary restructuring of sovereign debt. In hindsight, this strategy seems prescient, at least until early 2010, say, when the full extent of the Greek problem was known. Over the past decade, there have been a number of successful voluntary restructurings; indeed, the widespread concern that collective action problems within the creditor community would block restructurings seems quaint, if not slightly misplaced. In fact, at the Expert Group meeting, the view was expressed, in effect, that the debate over the SDRM is over – it lost.
That being said, care should be taken in generalizing the success of recent voluntary approaches – in the "Great Moderation" under which these restructurings were completed, characterized by ample liquidity and a global search for yield, the net present value costs of taking a nominal face value haircut are reduced, while borrowers may have been too anxious to agree to a restructuring in order to regain access to capital markets (the risk being a scenario of ‘serial restructurings’). Moreover, it can be argued, to misquote Shakespeare, that “those who came to bury the SDRM, unknowingly praised it.” I think there is considerable merit to this interpretation. After all, what the SDRM proposal was designed to achieve was pretty much what the voluntary debt exchanges of the past decade have achieved: a process in which a proposed restructuring that is broadly acceptable to most creditors is not blocked by the actions of a few creditors holding out for full payment.
To me, the proof is in the pudding – or at least in the litigation. For much of the past decade, a group of creditors has been suing the Republic of Argentina. Unlike the vast majority of other creditors that accepted a haircut in a debt exchange in the wake of Argentina’s default, these ‘holdouts’ refused to participate in the debt exchange and, after waiting a respectable period, sued for full payment. They have been in and out of the courts ever since. Their problem is that, while they have a judgment against Argentina, they cannot enforce it. Put simply, litigation has not been the threat to timely restructurings that it was believed to pose before Argentina’s default.
Recently, however, in a surprise decision, the hopes of the holdouts were buoyed by the potential enforcement a pari passu clause under which they would gain access to the stream of payments flowing to bondholders that agreed to the restructuring. Some have speculated that the ruling was based less on jurisprudence and more on the presiding judge’s frustration with Argentina’s recalcitrance to negotiate with the holdouts and a desire to bring Argentina to the table. Regardless, what is interesting is that the U.S. Justice Department intervened in the case with an amicus brief, arguing on appeal that enforcement of the pari passu clause would undermine international efforts to resolve financial crises, particularly if “… any selective payment of external indebtedness by a sovereign debtor, including to IFIs, constitutes a violation of the pari passu clause.” The Justice brief, undoubtedly written in consultation with friends at Treasury, lays out the public policy rationale why it is necessary to cram down a restructuring agreement broadly agreeable to most creditors over the objections of a few.
The point here is that, together with the IMF lending into arrears strategy, which provides an analogue to debtor-in-possession (DIP) financing in the domestic context, the experience of the past ten years pretty much validates the underlying objectives of the SDRM: to replicate, to the extent possible, the key elements of any effective domestic bankruptcy regime – stay, DIP, bind. As one participant put it last week: “rather than having lost the debate, perhaps the SDRM has won [in terms of the process needed to secure a timely, orderly restructuring]; the question is whether to formalize the process.”
I take a quintessentially Canadian position on this question: “the SDRM if necessary, but not necessarily the SDRM.”[1] That is to say, what matters is getting timely, orderly restructurings; if we can achieve that goal without a formal statutory approach, so be it. But, if we need to formalize that process through international treaty obligations, such as an amendment to the IMF Article of Agreement, we should be prepared to mobilize the political will to do so. Time will tell whether a formal approach is necessary.
Two factors will be critical. The first is the outcome of Greece’s current difficulties. There is I think, a growing awareness that a further Greek restructuring, should it occur, would impose punitive losses on remaining private creditors. This reflects the socialization of Greek debt to official creditors, each of whom claims preferred creditor status. With a larger share of debt sheltered from restructuring, however, losses on the subordinated debt held by private investors would be correspondingly higher. A punitive haircut of private creditors would very likely increase their willingness to entertain a more rules-based approach that would both constrain private creditors, but also protect them from arbitrary and capricious actions by sovereigns. In this regard, there was a palpable sense of unease among many private sector participants of the Expert Group meeting last week – the nearer that Greece moves to the default option, the greater this sense of unease is likely to grow.
The second factor that could influence the development of a statutory approach to sovereign debt restructuring is the simple fact that the ‘bonding technology’ is endogenous: bond covenants evolve over time in response to changing legal practice as well as the external environment (as noted above). And, in this respect, the window of opportunity to use the so-called ‘voluntary’ approaches that have worked so well in the recent past is unlikely to remain open. Creditors, recovering from losses on, say, Greek debt, are likely to demand innovations to bond covenants that make it more difficult to restructure using the same legal techniques used so effectively over the past decade. Of course, the wheel of history will inevitably turn and some sovereigns will eventually need to restructure their debt. But with new debt immune to legal innovations, the potential threat of creditor coordination problems and protracted, costly restructurings would again pose a challenge to the global economy. (This would be the case even if only a small amount of new debt is issued with new, restructuring-proof clauses: since the holders of new bonds would be reluctant to agree to a voluntary restructuring, other creditors with ‘vulnerable’ bonds would be unwilling to accept a haircut so that the holders of new bonds could escape unscathed.)
So, will the debate on statutory – or treaty-based – legal frameworks for sovereign debt restructuring resume? I’d be willing to bet on it; and it may begin sooner than most people think.
[1] In defining a position on whether he would introduce conscription (the draft) to fill the ranks of the Canadian army fighting in Europe during the Second World War, Canadian Prime Minister Mackenzie King adopted a policy of “conscription if necessary, but not necessarily conscription.”