Guest Post: Recent Reforms for More Orderly Sovereign Debt Restructurings at the IMF

[Yanying Li is a Ph.D researcher at Leiden University, the Netherlands, and a visiting research fellow at the University of Cambridge]

Recent reforms for more orderly sovereign debt restructurings have been prompted by the so-called “trial of the century” in sovereign debt restructuring— NML Capital Ltd. v. Republic of Argentina. In short, various court decisions in New York found Argentina in breach of the pari passu clause in its defaulted bonds, and prohibited Argentina from making payments to those creditors who accepted the bond exchange offer unless other creditors who rejected the exchange offer (i.e. holdout creditors), including plaintiffs in this case, were paid the same percentage of the amount due to them. The pari passu clause in question provides that the debtor’s payment obligation under that particular bond series shall rank equally with all other existing and future unsubordinated and unsecured external indebtedness. Given that Julian has already addressed the latest development in this case, my little contribution here will only focus on the issues of legal reform in the context of sovereign debt restructuring.

As discussed in my earlier post, on September 9, 2014, the United Nations General Assembly adopted a resolution entitled “Towards the establishment of a multilateral legal framework for sovereign debt restructuring processes”. The modalities for the intergovernmental negotiations and the adoption of the text of the multilateral legal framework will be discussed at the General Assembly’s 69th session plenary meeting on November 14, 2014. In the meantime, the directors and staff at the International Monetary Fund did not just sit back and relax. As noted in Press Release No.14/459dated October 6, the IMF’s Executive Board approved the staff paper on “Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructuring”. The staff paper suggests a few contractual reforms designed to tackle collective action problems so as to achieve orderly sovereign debt restructurings. These reforms include potential changes to international sovereign bond contracts, namely the pari passu clause and the collective action clause (“CAC”).

According to the staff paper, the pari passu clause should be modified to make it clear that this clause does not require ratable payment to all creditors, but only equal legal ranking. The difference is that the former would prohibit debtors from making payments to exchange bondholders unless holdout creditors are paid in full, and the latter would only prohibit actions that lead to legal subordination of certain unsecured creditors over others. While the proposed modification of the pari passu clause seems quite straight-forward, the suggested changes to CACs are much more complex. By way of background, CAC is a majority voting provision that could enable a qualified majority of bondholders to bind all holders of the same bond series to an amendment of the contract terms, including the maturity date as well as the amount of interest and principal. As I have discussed elsewhere, existing CACs typically take the form of a series-by-series voting procedure, under which a creditor or a group of creditors could obtain a blocking position in a particular series and effectively prevent the operation of CAC in that series. Another form of CAC that has been used less often by sovereign issuers contains a two-limb aggregated voting procedure. This procedure requires a minimum threshold of support both (a) in each series and (b) across all series involved. Compared with a series-by-series voting procedure, this two-limb aggregated voting process often entails a lower minimum threshold of support but still allows a creditor or a group of creditors to block the operation of CAC in a particular series. With the aim to introduce a more robust aggregation clause, the staff paper advocates in favor of a single CAC with a menu of voting procedures, including (1) a series-by-series voting procedure, (2) a two-limb aggregated voting procedure, and (3) a single-limb voting procedure with the possibility for “sub-aggregation”. As explained in the staff paper, a single-limb voting procedure will enable contract terms to be amended on the basis of a single vote across all affected instruments, thereby limiting the ability of holdout creditors to undermine the restructuring process. In order to protect the interests of creditors, the CAC will require all affected creditors to be offered the same instrument or an identical menu of instruments. The phrase “sub-aggregation” refers to the possibility to organize separate votes for different groups of bond issuances.

Here is the important question: how would this contractual reform at the IMF affect the work towards the establishment of a multilateral legal framework for sovereign debt restructuring processes at the UN? Would it make the legal reform at the UN redundant? I doubt so! First of all, the staff paper (para. 58) acknowledges that, even if the IMF succeeds in promoting the inclusion of these new clauses in future sovereign bond issuances, this will not affect the large number of outstanding stock, which will not mature in some time. To accelerate the turn-over, sovereign issuers could in theory exchange their existing bonds for newly issued bonds with new pari passu clause and new CAC. But the IMF’s consultation with issuers and the market suggests that such bond buybacks and swaps are likely not feasible, at least in the short term (staff paper, para. 60). On the other hand, a multilateral legal framework adopted by the UN and subsequently endorsed by member States is likely to bring immediate changes to the current practice of sovereign debt restructuring.

Moreover, having recognized that the CAC should appear in a broad range of instruments, the IMF directors considered the promotion of the inclusion of the new CAC in bonds governed by foreign law as its priority. In practical terms, this means that the impact of this contractual reform may be more limited than we have expected. It excludes bonds governed by domestic law, and also leaves other debt instruments untouched, such as commercial bank loan, bilateral loan from other governments as well as multilateral loan from international and regional development banks. Although the draft text of the multilateral legal framework at the UN is not yet available, presumably such a legal framework will be more comprehensive than the contractual reform at the IMF.

Last but not least, in my view, the possibility for “sub-aggregation” in a single-limb voting procedure advanced by the IMF is problematic. “Sub-aggregation” reminds me of the concept of class classification in insolvency law. According to the UNCITRAL Legislative Guide on Insolvency Law (p. 222), ordinary unsecured creditors can be divided into “different classes based upon their varying economic interests”. In respect of the situation where the debtor divides creditors into different classes in the first instance, the Legislative Guide mentions that in such circumstances the debtor will have some limited flexibility regarding the composition of each class. Importantly, the Guide provides that “unsecured creditors who are dissatisfied with the composition of the class can seek to have the issue reviewed by the court”. By contrast, the contractual reform at the IMF is silent about the potential recourse for unsecured creditors who disagree with the manner in which different classes are divided. We all know that contractual reforms cannot create a new international court for this purpose.

To conclude, the IMF’s on-going contractual reform certainly represents an important step forward in terms of reform initiatives in sovereign debt restructuring. As noted above, however, such contractual reform has many limitations. In my view, all stakeholders in the international community should build on the IMF’s experience and work together towards a more comprehensive multilateral legal framework at the UN, instead of using the IMF’s on-going work as an excuse to hinder the negotiation process at the UN.