Sovereign Debt and Collective Action Clauses

The Wall Street Journal’s “Heard on the Street” column yesterday made an interesting comparison between sovereign bonds and corporate bonds.  It pointed out that although in ordinary times, developed country sovereign debt is typically considered safer than corporate bonds of the same jurisdiction – the risk free rate of return, and the sovereign power to be able to tax, etc. – in extraordinary times, sovereign debt presents political risks not present in corporate bonds.

[T]he Greek debt restructuring is showing that in some ways, corporate-bond investors have more clout—and are less exposed to arbitrary actions—than their government peers. Greece is hoping bondholders will write off over €100 billion ($132.4 billion) of debt in a voluntary bond swap. But in an attempt to ensure the swap is completed, it is also introducing collective-action clauses in its bonds. That will mean that if enough bondholders sign up, even those that don’t will be swept up in the swap. Meanwhile, the European Central Bank has done a side deal with Greece that means its bonds are excluded from these clauses and thus won’t take losses. Unlike the International Monetary Fund, which injects new money to help fund a distressed country on the understanding its debt is ranked above other bonds, the ECB simply bought in the secondary market and then declared it wouldn’t take a loss. Its estimated holding of €45 billion of Greek bonds means that private-sector investors have to take deeper losses to make the numbers work.

No company can change the terms of its bonds retroactively, as Greece is able to do since over 90% of its debt is governed by Greek law. Any corporate borrower that tried to treat one of its existing bondholders more generously than others would get short shrift. Further, creditors have no recourse to sovereign assets in Greece, whereas in a corporate-debt restructuring, there are underlying assets—factories, stock, equipment—that ultimately can be seized and valued. If corporate bondholders convert their debt into equity as part of a restructuring, they then have the power that equity ownership confers: They could demand new management. Greek bondholders can’t demand a new Greek government. There is no such thing as sovereign equity. That makes corporate bonds look safer in some situations than government debt.

The article goes on to point out that the markets are valuing some Portuguese corporate bonds in exactly this way – as less risky than Portuguese sovereign bonds.  Of course, the traditional method of imposing political risk was simply through inflation and devaluation, which is not available to EZ members unilaterally – so the emphasis turns to retroactive imposition of collective action clauses and such mechanisms.  But via Fabrizio Goria’s Twitter feed, we can take a look at a number of samples of collective action clauses with aggregation mechanisms, via a useful document prepared by Cleary Gottlieb.  It simply offers a sample of the language found in various prospectuses from the last ten years or so, including Argentina, the Dominican Republic, and other places – very instructive reading.

In addition, Goria also points us to a useful short article at Bepress, by Joy Dey from 2009 – useful primer to the issues involved.  Of course, my colleague Anna Gelpern, plus Mitu Gulati and several others, have been writing extensively on these questions, posted at SSRN and elsewhere. Talking about this occasionally with Anna Gelpern, I always wonder to what extent the fact of Greek law controlling most of the bonds rather than English law was considered at all, let alone rationally priced in.  The WSJ column ends with the observation that the safety of sovereign bonds was always considered the power to tax.  As the EZ sends special envoys to monitor Greece’s fiscal posture, the ability actually to collect the taxes levied looks rather in doubt.  No amount of legal or financial engineering, it would seem, creates the ability for foreign tax collectors to collect what the Greeks themselves have never been willing or able to collect.  As Reinhardt and Rogoff observed in This Time is Different, in sovereign debt crises, it is the control exercised by the local government in response to local stakeholders that causes it to favor local interests over foreign ones – no matter what the pieces of financial paper say.  It is unlikely that in Greece, this time will be different.