© Copyright by Maria Ifeoluwa Oluyeju, 2020 All rights reserved
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NORMATIVE FRAMEWORK FOR THE REGULATION OF HOLDOUT CREDITORS IN THE SOVEREIGN DEBT MARKET ...... ERROR! BOOKMARK NOT DEFINED. ABSTRACT ...... 5 ABBREVIATIONS ...... 7 CHAPTER ONE ...... 10 INTRODUCTION ...... 10 1.1. PREFATORY NOTE ...... 10 1.2. THE CONTEXT OF THE RESEARCH ...... 12 1.3. RESEARCH PROBLEM ...... 16 1.4. RESEARCH QUESTION(S) ...... 18 1.5. CONNECTING THE DOTS: THE CONTOURS OF THE UNDERPINNING ARGUMENTS IN THE STUDY 19 1.6. THE PROPOSAL ...... 26 1.7. HOLDOUT CREDITORS: WHY THE FOCUS ON DDHFS? ...... 30 1.8. OVERVIEW OF CHAPTERS ...... 31 CHAPTER 2 ...... 33 QUEST FOR DEVELOPMENT IN THE GLOBAL SOUTH: AFRICA AS A CASE STUDY ...... 33 2.1. INTRODUCTION ...... 33 2.2. QUEST FOR DEVELOPMENT IN AFRICA ...... 33
2.2.1. DECOLONIZATION ...... 33 2.2.2. DEVELOPMENT GOALS ...... 34 2.2.3. DEARTH OF INFRASTRUCTURE ...... 35 2.2.4. THE ACUTE NEED FOR DEVELOPMENT FINANCE ...... 37 2.3. MULTILATERAL RESPONSES TO THE DEVELOPMENT CHALLENGES IN THE GLOBAL SOUTH ...... 42
2.3.1. COMPREHENSIVE DEVELOPMENT FRAMEWORK (CDF) ...... 42 2.3.2. MDGS ...... 43 a) How did Africa fare in achieving the MDGs? ...... 44 2.3.3. SDGS ...... 45 2.4. CONCLUSION ...... 46 CHAPTER 3 ...... 48 SOVEREIGN RESOURCE MOBILIZATION ...... 48 3.1. INTRODUCTION ...... 48 3.2. COMPOSITION OF CREDIT FLOWS FOR RESOURCE MOBILIZATION AND DEVELOPMENT FINANCE: SOURCES, COMPOSITION AND TRENDS IN STATE BORROWING ...... 49
3.2.1. DOMESTIC SOURCES ...... 49 3.2.2. FOREIGN-BASED OPTIONS FOR FINANCE ...... 51 a) Debt and loans sourced from foreign sources ...... 51 b) Credit from commercial sources ...... 63 c) Other market-driven channels for private capital flows ...... 66 d). International capital market bond financing ...... 72 e) Resources-for-infrastructure investments (R4I) ...... 77
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3.3. BONDS...... 78 3.3.1. Bond conventions...... 80 3.3.2. Bond markets ...... 84 3.3.3. Sale of bonds ...... 85 3.3.4. Sovereign bonds issue ...... 86 3.3.5. Repo markets ...... 88 3.4. CONCLUSION ...... 89 CHAPTER 4 ...... 91 SOVEREIGN DEBT, DEFAULT, AND CRISES ...... 91 4.1. INTRODUCTION ...... 91 4.2. SOVEREIGN DEBT AND DEFAULT ...... 91
4.2.1. SOVEREIGN DEBT ...... 91 4.2.2. SOVEREIGN DEFAULT – WHY AND HOW IT HAPPENS ...... 95 4.2.3. HISTORY OF SOVEREIGN DEBT AND DEFAULT ...... 100 4.3. TYPICAL REASONS SOVEREIGNS REPAY DEBT ...... 106 4.4. SOVEREIGN DEBT CRISES ...... 109
4.4.1. UNDERLYING CAUSES AND TRIGGERS OF SOVEREIGN DEFAULT AND DEBT CRISES ...... 110 4.4.2. THE ARGENTINIAN DEBT CRISIS ...... 112 4.5. VARIOUS APPROACHES TO RESOLVING DEBT CRISES IN THE GLOBAL SOUTH ...... 117
4.5.1. BILATERAL DEBT: ...... 117 a) Paris Club: ...... 117 b) Non-Paris Club Creditors: ...... 120 4.5.2. MULTILATERAL DEBT ...... 121 4.5.3. COMMERCIAL DEBT ...... 122 a) London Club: ...... 122 b) Non-London Club Creditors:...... 123 4.6. CONCLUSION ...... 124 CHAPTER 5 ...... 125 DISTRESSED-DEBT HEDGE FUNDS: A LINCHPIN FOR AN EFFICIENT SOVEREIGN DEBT MARKET? ..... 125 5.1. INTRODUCTION ...... 125 5.2. HEDGE FUNDS ...... 125
5.2.1. CHARACTERISTICS OF HEDGE FUNDS ...... 126 5.2.2. INVESTMENT STRATEGIES OF HEDGE FUNDS ...... 127 5.3. DDHFS – MEANING, FEATURES, AND HISTORICAL PERSPECTIVES ...... 130
5.3.1. CHARACTERISTICS OF DDHFS ...... 135 5.3.2. DDHFS IN SOVEREIGN DEBT MARKETS ...... 136 5.3.3. DDHFS’ ACTIONS IN ENFORCING SOVEREIGN DEBT CLAIMS ...... 137 5.3.4. THE CASE AGAINST DDHFS: THE SOCIAL AND ECONOMIC COSTS OF THEIR ACTIVITIES ...... 139 5.4. DDHFS AND HOLDOUT LITIGATION: A LINCHPIN FOR AN EFFICIENT SOVEREIGN DEBT MARKET? ...... 146
5.4.1. THE ADVANTAGES OF THE PRESENCE OF DDHFS IN THE SOVEREIGN DEBT MARKET ...... 146 5.4.2. HOLDOUT LITIGATION AND ITS ADVANTAGES ...... 149
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5.5. WHY SHOULD THERE BE REGULATION OF DDHFS? ...... 153 5.7. CONCLUSION ...... 155 CHAPTER 6 ...... 158 NORMATIVE FRAMEWORK FOR REGULATION OF HOLDOUT CREDITORS IN THE SOVEREIGN DEBT 158 6.1. INTRODUCTION ...... 158 6.2. PUBLIC INTERNATIONAL REGULATION VERSUS PRIVATE INTERNATIONAL REGULATION: WHICH WAY? ...... 161 6.3. NORMATIVE REGULATORY GOVERNANCE: VARIOUS OPTIONS ON THE PLATE ...... 164
6.3.1. PUBLIC NON-MARKET STANDARD-SETTING...... 164 6.3.2. PUBLIC MARKET-BASED STANDARD-SETTING ...... 165 6.3.3. MARKET-BASED PRIVATE INTERNATIONAL STANDARD-SETTING ...... 167 6.3.4. NON-MARKET PRIVATE INTERNATIONAL STANDARD-SETTING ...... 169 6.4. NORMATIVE REGULATION OF THE ACTIVITIES OF DDHFS ...... 174
6.4.1. HOW MUCH PROFIT DDHFS CAN RECOUP ...... 182 6.4.2. WHO BEARS LEGAL COSTS? ...... 183 6.5. THE ROLE OF THE IMF IN ESTABLISHING THE PROPOSED NORMATIVE INITIATIVE ...... ERROR! BOOKMARK NOT DEFINED. 6.6. HOW MY PROPOSAL DIFFERS FROM OTHER INITIATIVES THAT HAVE BEEN ESTABLISHED TO DEAL WITH HOLDOUT CREDITOR PROBLEMS IN RELATION TO SOVEREIGN DEBT RESTRUCTURINGS ...... 185
6.6.1. THE SOVEREIGN DEBT RESTRUCTURING MECHANISM (SDRM) ...... 186 6.6.2. COLLECTIVE ACTION CAUSES (CACS) AND EXIT CONSENTS – ARE THEY PERMANENT SOLUTIONS? ...... 189 A) EXCHANGE OFFERS AND EXIT CONSENTS: ...... 189 B) COLLECTIVE ACTION CLAUSES (CACS) ...... 191 6.7. CONCLUSION ...... 196 CHAPTER 7 ...... 198 CONCLUSION ...... 198 7.1 RECAP OF THE RESEARCH PROBLEM ...... 198 7.2 THE THESIS OF THE STUDY ...... 199 7.3 SUMMARY OF FINDINGS ...... 200 7.4 FINAL CONCLUSIONS ...... 205 7.5 RECOMMENDATIONS ...... 205 BIBLIOGRAPHY ...... 207
CASE LAW ...... 207 LEGISLATION ...... 207 JOURNAL ARTICLES (AND FACULTY SCHOLARSHIP) ...... 207 BOOKS (AND CHAPTERS IN BOOKS) ...... 213 REPORTS ...... 223 THESES ...... 226 BUSINESS MAGAZINES ...... 226 NEWSPAPERS AND MAGAZINES ...... 226 INTERNET LINKS ...... 227
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Abstract The overarching argument in this study is that although sovereign distressed debt investors can create holdout problems during the debt restructuring of a defaulting sovereign, the reality is that they remain a linchpin for an efficient sovereign debt market that guarantees the flow of private credit for capital formation in the Global
South. In other words, holdout creditors are a bit of a curate's egg, a necessary feature of the sovereign debt markets. They are not the “spawn of the devil”.
The presence of distressed debt investors in the market contributes to the liquidity and efficiency of the market. They enable non-litigant investors who would like to sell their debt and exit the market on their own volition to do so. In addition, they tend to put pressure on recalcitrant sovereign debtors who might not be acting in good faith. They therefore possess “nuisance value” that could spur efficiency in the sovereign debt market.
In this context, a universal framework for dealing with holdout problems during the debt restructuring of a defaulting sovereign is needed and that is what this study proposes. Such rules can be developed into a soft-law mechanism spearheaded by the
International Monetary Fund (IMF). A global normative framework that has elements of nonmarket private standard setting and nonmarket public standard setting, is therefore proposed to address the disruptive and exploitative activities of these creditors in the sovereign debt market. This normative framework would strike the delicate balance between the rights of commercial creditors on the one hand, and interests of sovereign debtors on the other hand, and inject some measure of equity into the process.
In summary, this study challenges the contemporary negative and dismissive narratives about holdout creditors, and the assumption and unshaken faith placed on
“restructuring or workout of sovereign debt” as the only favored path to alleviating the
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Acknowledgements First, I want to thank GOD, my Awesome Heavenly Father who made this possible literally. I give all the glory and credit to Him. The road was harsh and tough sometimes, and I would not have made it without His Grace.
Second, I want to my parents Professor Olufemi Oluyeju and Mrs Tolulope
Oluyeju. Once again, I could not have made it this far without them. Literally. My father is my biggest encourager; when I needed someone to talk to, I called him first. My mother gave me the biggest moral support; she was always encouraging me. When I went home, she exempted me from house chores and would cook for me and take care of me so that I could focus on my doctoral research. I am forever grateful to them. I also want to thank my siblings: Sarah, Aaron, and Sharon Oluyeju. These three made me laugh, teased me a lot, and supported me in various ways. They are some of the best siblings anyone could have in my opinion!
Third, I want to thank my advisor, Professor Adam Feibelman for his guidance, leadership, patience, and help during the process. I am thankful to have had the opportunity to study at Tulane Law School under his leadership. I also want to thank
Professors Adam Dombalagian and Guiguo Wang, who graciously accepted my request to be on my Graduate Committee, despite their busy schedules. Their input and insight proved to be very invaluable. I could not have had a better Graduate Committee in my opinion!
Finally, I want to give a shout out to the friends and community I had while I was Tulane including Chi Alpha Christian Fellowship, the Bloc Young Adults Church at Celebration Church, the African Christian Fellowship, and all other great people who made my stay in New Orleans pleasant. Thank you all!
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Abbreviations Abbreviations Meaning 1. AfDB African Development Bank 2. BEY Bond Equivalent Yield 3. BIS Bank for International Settlements 4. BITs Bilateral Investment Treaties 5. BoNY Mellon Bank Of New York Mellon 6. CACs Collective Action Clauses 7. CARE Cooperative for American Relief Everywhere 8. CDF Comprehensive Development Framework 9. CDOs Collateralized Debt Obligations 10. CDS Credit Default Swaps 11. CMOs Collateralized Mortgage Obligations 12. DDHF Distressed Debt Hedge Fund(S) 13. DMO Debt Management Office 14. EAY Effective Annual Yield 15. EC European Commission 16. ECAs Export Credit Agencies 17. ECB European Central Bank 18. EEZ Exclusive Economic Zones 19. ERM Exchange Rate Mechanism 20. EU European Union 21. FCP Fonds Commun de Placement – Investment Funds 22. FDI Foreign Direct Investment 23. FNMA or Fannie Mae Federal National Mortgage Association 24. FPI Foreign Portfolio Investment 25. FSIA Foreign Sovereign Immunities Act Of 1976 26. FTAs Free Trade Agreements 27. GFC Global Financial Crisis 28. HIPC Heavily Indebted Poor Country 29. IBRD International Bank for Reconstruction and Development 30. ICSID International Center For Settlement of Investment Disputes 31. IDA International Development Association 32. IET Interest Equalization Tax 33. IFC International Finance Corporation 34. IFIs International Financial Institutions 35. IMF International Monetary Fund 36. IPPs Independent Power Producers 37. ISMA International Securities Market Association 38. ITLOS International Tribunal of The Law of The Sea
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39. LIBOR London Interbank Offered Rate 40. LICs Low-Income Countries 41. LLC Limited Liability Company 42. MDBs Multilateral Development Banks 43. MDGs Multilateral Development Goals 44. MDRI Multilateral Debt Relief Initiative 45. MICs Middle-Income Countries 46. MIGA Multilateral Investment Guarantee Agency 47. NGOs Nongovernmental Organizations 48. NYSE New York Stock Exchange 49. ODA Official Development Assistance 50. OECD Organization for Economic Cooperation and Development (OECD) 51. OTC Over-The-Counter 52. PDVSA Petróleos de Venezuela, S.A. 53. PPPs Public-Private-Partnerships 54. R4I agreements Resources-For-Infrastructure Agreements 55. S&P Standard & Poor’s 56. SDGs Sustainable Development Goals 57. SDNY Southern District Of New York 58. SDRM Sovereign Debt Restructuring Mechanism 59. SDRs Special Drawing Rights 60. SOEs State-Owned Enterprises 61. SPV Special Purpose Vehicle 62. SSA Sub-Saharan Africa 63. SWIFT Society for Worldwide Interbank Financial Telecommunication 64. UAC Unanimous Action Clause 65. UN United Nations 66. UNCLOS UN Convention on The Law of The Sea 67. UNCTAD United Nations Conference on Trade and Development 68. UNCTAD Principles UNCTAD Principles on Responsible Sovereign Lending and Borrowing 69. UNECA United Nations Commission for Africa 70. UNGA United Nations General Assembly 71. WBG World Bank Group 72. YTM Yield to Maturity
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CHAPTER ONE
INTRODUCTION
1.1. Prefatory note
One of the causes of under-development in the Global South,1 particularly
Africa, is the perennial lack of access to capital to finance development programs such as infrastructure, education, and healthcare which are critical to economic and human development in the region. 2 Stable and consistent flows of capital therefore remain one of the linchpins for national economic growth and development in this region.3
The negligibility of intra-regional trade and low level of global economic exchanges have made a region like Africa the least integrated globally. These problems are rooted in the bigger challenge of lack of productive capacities critical to intra- regional trade and market integration.4 “Productive capacities” in this context refer to the productive resources, entrepreneurial capabilities, and production linkages which together determine the capacity of a country or region to produce goods and services and enable it to grow and develop.5 They enable countries to compete in international markets in goods and services, which go beyond primary commodities and are not
1 The Global South generally refers to the regions of Africa, Asia, Latin America, and Oceania. It is part of a group of terms used to refer to countries outside North America and Europe which are mostly developing countries. In this study, it is simply used as a synonym for developing countries. See Nour Dados & Raewyn Connell, The Global South, 11 Contexts (American Sociological Association) 12 (2012). 2 Bradley K. Boyd, “The Development of a Global Market-Based Debt Strategy to Regulate Private Lending to Developing Countries” 18 Georgia Journal International & Comparative Law, 461, 464 (1988) cited in Rumu Sarkar, ‘Development Law and International Finance’ (2002) Second Edition, Kluwer Law International Series, Springer, Netherlands, 134. See also Dambisa Moyo, ‘Dead Aid’ Why aid is not working and how there is a better way for Africa (2009) Douglas & McIntyre Ltd, 77. 3 Rumu Sarkar, ‘Development Law and International Finance’ (2002) Second Edition, Kluwer Law International Series, Springer, Netherlands, 168. 4 UNCTAD, The Least Developed Countries Report, (2006) 3.
5 Id.
Page | 10 dependent on special market access preferences. Unfortunately, the existing production and trade structures of most of the developing countries, especially the least developed, offer very limited opportunities in a rapidly globalizing world driven by new knowledge-intensive products with demanding conditions of market entry.6 The countries of the Global South especially the ones in Africa therefore need financial resources to fund investment in human capacity and critical physical infrastructure assets especially trade-related stocks to enhance trade capacity for poverty reduction and their integration into the global economy.7
The lack of access to finance has therefore remained one of the most profound inhibitions to the acquisition of competitive supply productive capacities for economic growth and development in the Global South.
Various sources of capital available to states include domestic sources (such as tax revenue), foreign-based sources such as Official Development Assistance (ODA), sovereign loans or bilateral aid, loans from foreign banks, and so on. These funding sources have however proven to have many associated problems and are insufficient in some cases.8
It is in this context, coupled with rapidly declining commodity prices and slower growth prospects, that many poor nations are resorting to market-based sources of finance to raise capital to fund budgetary deficits and development programs including critical infrastructure requirements.9 Such market-based sources include commercial banks and the debt market.
6 Id. 7 Rubens Ricupero, How can the impoverishment of the poorest countries be stopped? United Nations University, Tokyo (26 November 2002) 12. 8 These funding sources are further discussed under para. 3.2. in chapter 3. 9 S. Ketkar & D. Ratha, Innovative financing for development: overview in Innovative Financing for Development, (2009) 1.
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1.2. The context of the research
Ever since the birth of the modern fiscal and borrowing state in the 17th century, disputes on the non-payment of sovereign debt have been common.10 Sovereign default has therefore been a perennial feature of sovereign lending.11 Their occurrence is high even though the causes vary.12
For over two decades after the Second World War, ODA was the major source of foreign capital flows to developing countries especially Africa. With the decline in
ODA, big international banks joined the fray, and stepped in to cover the gaps by providing massive amounts of credit to developing countries. Thereafter, the debt stock shot up astronomically. With two-thirds of the debt on floating interest rates, the run- up in the U.S interest rates during the early 1980s triggered an unprecedented surge in the debt service burden, which was a contributory factor to the debt overhang of that period. The emergence of Brady bonds in the sovereign debt market played a critical role by converting some of the “difficult-to-trade” bank debt into tradable bonds.13
The secondary market for distressed sovereign debt emerged and became attractive to investors who are not willing to invest in equity markets in the debtor countries.14 As a result, the investors began to buy sovereign debt assets with the sole objective of speculating on short-term appreciation in the value of a debtor nation’s debts as its economy improved.15
10 Michael Waibel, Sovereign defaults before international Courts and tribunals, 23. 11 Id. 12 K. Rogoff & C Reinhart, This Time is Different:Eight Centuries of Financial Folly, Princeton University Press (2009) 9. 13 Id. 14 Tracy Corrigan, “Picking Up the Pieces of an Emerging Market, Financial cited in Philip Power, Sovereign Debt: The Rise of the Secondary Market and Its Implications for Future Restructurings” Fordham Law Review, Volume 64, Issue 6, Article 9 (1996) 2718. 15 Id. at 2719.
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In recent years however, the composition of debt of many of the developing nations has markedly shifted from concessional to non-concessional debt.16 Generally, the terms of concessional loans are more generous than the market-based loans.
According to the World Bank, the share of concessional lending to Africa, for instance, has declined from 42.4% to 36.8% in the period 2001-2013. Non-concessional debt from commercial lenders and international bond markets rose from USD2.4 billion in
2010 to USD25.25 billion in 2015. The sharp decline in the prices of commodities and the plummeting growth rates in African countries is currently driving another wave of debt spree with a rising debt profile. The bond issuance that slowed down in 2016 rose again in 2017. As at May 2017, African governments had raised USD5.9 billion, more than the total for the whole of 2016.17
Sovereign bonds are therefore at the center of market-based public finance and are very crucial in the development of capital markets.18 Sovereign bond markets are therefore an essential part of the international financial system and developed capital markets.19
In developed countries, sovereign bond markets are a method of fiscal management which includes current and capital expenditure, as well as the execution of monetary policies. Sovereign bonds also indirectly help corporate debt instruments and derivatives by establishing a benchmark for hedging and pricing.20
16 African Business, AFRICA’S DEBT SPREE: Precursor to a new debt crisis?, No. 441 12 (May 2017). 17 Id. 18 Michael Waibel, Sovereign defaults before international Courts and tribunals, Cambridge University Press 11 (2011). 19 Judith Tyson ‘Sub-Saharan Africa International Sovereign Bonds’ Part 1, Investor and Issuer Perspectives, (2015) Overseas Development Institute, available at https://www.odi.org/publications/9205-sub-saharan-africa-international-sovereign-bonds (Last accessed 21 February 2018), 1. 20 Id.
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The issuance of sovereign debt also serves as the primary means for many developing governments to finance development priorities and expenses such as health, education and infrastructure, and particularly to cover gaps between cash outlays and inflows from genuine revenues, such as those derived from taxation.21 Sovereign debtors are generally incentivized by the lack of conditions (which is a feature of concessional financing), relatively cheaper borrowing costs compared to domestic financing, more leverage in negotiating the terms, and liquidity of sovereign bonds.22
This has led to overborrowing on the part of sovereigns.
For instance, in the early part of the previous decade, nations and companies across Africa tapped into global capital markets at interest rates that were unprecedentedly low. “Easy money” continually flooded the market, and where there was a government guarantee backing the bonds, investors were all too eager. For example, in 2014, sovereign bond issues in sub-Saharan Africa exceeded USD6.25 billion.23 Most of these bonds were denominated in US dollars resulting in foreign exchange risk for sovereign debtors.24 The end result however is that many countries overborrowed and are consequently mired in indebtedness. To make matters worse, some of the sovereign debtors did not use the borrowed funds for the stated purposes or for any developmental purposes.25
21 Arturo Porzecanski, “Borrowing and debt: how do sovereigns get into trouble?” in Sovereign Debt Management Rosa Lastra & Lee Buchheit eds., Oxford University Press (2016) 309. See also Judith E. Tyson, Sub-Saharan Africa International Sovereign Bonds: Investor and Issuer Perspectives (Part I), 1 Overseas Development Institute (January 2015). 22 Judith E. Tyson, Sub-Saharan Africa International Sovereign Bonds: Investor and Issuer Perspectives (Part I), 1. See also Dirk Willim te Velde, Sovereign bonds in sub-Saharan Africa: good for growth or ahead of time?, Briefing 87, Overseas Development Initiative 2 (April 2014). 23 Id. at 3. 24 Id. at 5. 25 Kanika Saigal, Mozambique: Drowning in Debt? 4th Quarter: Issue 38, AFRICAN BANKER, 16 (2016).
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In addition, the sovereign bond markets for most developing nations are still underdeveloped and illiquid.26 In order to continually raise money on the sovereign debt market therefore, it is therefore necessary for both the primary and secondary segments of the market to be liquid, and for states to prioritize capital market development in their jurisdictions.27
The absence of a statutory framework for addressing distressed sovereign debt has made the resolution of sovereign debt crises even more complicated and characterized by inequities and inefficiencies in various forms. Negotiations between debtors and creditors usually occur based on non-binding and decentralized market- based contracts containing Collective Action Clauses (CACs), as well as “competing codes of conduct”. The International Monetary Fund (IMF) sometimes steps in to facilitate the procedure of bargaining between a defaulting sovereign debtor and creditors. It is however not always successful in ensuring that debt restructuring occurs in a timely fashion. The status quo therefore does not resolve inter-creditor equities, provide for debtor-in-possession financing, affirm priority agreements, and importantly, does not resolve ex ante issues such as ensuring that sovereign debtors are incentivized enough to borrow prudently and creditors are incentivized enough to lend based on the right terms.28
26 Id. See Andrei Shleifer, Will the Sovereign Debt Market Survive? NBER WORKING PAPER SERIES: Working Paper 9493, 1 (February 2003). 27 Dirk Willim te Velde, Sovereign bonds in sub-Saharan Africa: good for growth or ahead of time?, Briefing 87, Overseas Development Initiative 4 (April 2014). 27 Id. at 3. 28 Martin Guzman & Joseph E. Stiglitz, A Soft Law Mechanism for Sovereign Debt Restructuring: Based on the UN Principles, Friedrich-Ebert-Stiftung (FES): International Policy Dialogue 3 (October 2016).
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Experience has however showed that the debt markets generally work best when the rights of creditors are protected most effectively. The stronger the creditor rights in the event of a default, the better developed are the debt markets.29
1.3. Research problem
Borrowing is an integral part of the development process and lately, sovereign debt crises have emerged as some of the biggest challenges facing the international financial system. One of the main reasons for the emergence of the secondary market for sovereign debt is getting the market to deliver vast amounts of private capital to the
Global South, especially Africa.30 According to the African Development Bank
(AfDB), “a secondary market for sovereign debt is a fundamental feature of sovereign borrowing and lending. When creditors can freely sell the debt they hold in the secondary market, there is less risk involved in lending to sovereigns, and creditors are therefore more likely to provide the capital sovereigns need”.31
Unlike an ideal debt market however, the market for sovereign debt in the developing countries is generally dysfunctional because, among other reasons, the creditors’ rights are too weak.32 In addition, the secondary market for distressed sovereign debt in most countries in the Global South, particularly Africa, is “thin,
29 Id. 30 Andrei Shleifer, “Will the Sovereign Debt Market Survive?” in Debt, Equity, and Financial Openness, volume 93, No. 2, 89 (May 2003). 31 African Development Bank ‘Vulture Funds in the Sovereign Debt Context’, https://www.afdb.org/en/topics-and-sectors/initiatives-partnerships/african-legal-support- facility/vulture-funds-in-the-sovereign-debt-context/ (last accessed 26/01/2018). 32 Andrei Shleifer, Will the Sovereign Debt Market Survive? NBER WORKING PAPER SERIES: Working Paper 9493, 1 (February 2003).
Page | 16 illiquid and peripheral”.33 Besides, experience has however shown that debt markets are more liquid when creditor rights are protected or at least not drastically reduced.34
It was the upsurge in debt-offerings through the capital markets and the opportunities for arbitrage in the secondary markets that induced the exponential growth in the distressed debt investor industry. Distressed-debt investors have however been accused of allegedly creating holdout problems during debt restructuring of a defaulting sovereign and dubbed as ‘demons of sort’. This is true to some extent as will be shown later in this study; there are excesses in relation to the activities of these distressed debt investors.35 A case that illustrates the issues raised about holdout investors is the infamous litigation by NML Capital against Argentina, 36 where the US
Court of Appeals for the Second Circuit held that because of the pari passu clause in the bonds contracts that Argentina had defaulted upon, Argentina could not pay the holders of its restructured bonds without paying holdouts.37 This case caused alarm among market participants including paying agents, trustees, clearing systems, infrastructure providers, debtors, creditors who participated in Argentina’s restructuring, and others in the official sector. The decision has also created a lot of uncertainty, and has potentially made debt restructuring less attractive for creditors
33 Anayiotos, George & Jaime De Pinies, “The secondary market and the international debt problem’ World Development” Volume 18, No. 12, 1990, 1656. 34 Patrick Bolton & Olivier Jeanne, “Structuring and Restructuring Sovereign Debt: The Role of a Bankruptcy Regime”, 115 Journal of Political Economy 901, 904 (2007). 35 The normative initiative this study proposes is to regulate holdout creditors which are a subset of distressed debt investors. Holdout creditors, simply put, are creditors who choose to opt out or “hold out” of debt restructuring procedures. Not all distressed debt investors choose to hold out however. In this study therefore, the terms “holdout creditors”, “distressed debt investors”, and “DDHFs” will be used interchangeably, depending on the context. 36 NML Capital, Ltd. v. Republic of Argentina, 727 F.3d 230, 238-245 (2d Cir. 2013). 37 Id. Argentina was essentially forced to default on the restructured bonds, and eventually, Argentina had to settle with the holdouts, because, either way, it was going to default on its debt. See Steven L. Schwarcz, Sovereign Debt Restructuring: A Model-Law Approach, https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=6185&=&context=faculty_s cholarship&=&sei-redir=1&referer=https%253A%252F%252F, Duke Law Scholarship (2016).
Page | 17 going forward.38 There has therefore been an outcry against this decision and the interpretation of the pari passu clause that US courts have accepted among academics and legal practitioners in this field.39
It is in view of the above that this study proposes a framework for the normative regulation of litigating holdout creditors in order to address the disruptive effects of their activities in relation to sovereign debt restructuring. Essentially, the aim is to prevent another NML v. Argentina for obvious reasons as delineated in the previous paragraph. The proposed regulatory framework would therefore aim at suppressing the perceived ‘mischiefs’ or exploitative tendencies of distressed debt investors.
This study therefore supports distressed debt investors and argues that they are a necessary feature of the sovereign debt markets. It is submitted therefore that they are not the “spawn of the devil”.
1.4. Research question(s)
Since distressed debt investors are an essential part of the sovereign debt market to maintain efficiency and ensure the flow of private credit for capital formation in the
Global South, the core research question which this study seeks to answer therefore is: how can a normative regulatory framework be used to curtail the perceived ‘mischiefs’ or exploitative tendencies of holdout creditors in the sovereign debt market?
38 Mark Jewett, “Approaches to Sovereign Debt Resolution: Recent Developments” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, xix Oxford University Press: United Kingdom (2014). 39 Examples are: David Newfield, Pari Passu as a Weapon and the Changes to Sovereign Debt Boilerplate after Argentina v. NML, 24 U. Miami Bus. L. Rev. 175 (2016); Lee C. Buchheit and G. Mitu Gulati, Restructuring sovereign debt after NML v. Argentina, https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=6342&context=faculty_scholarsh ip Oxford University Press (2017); Brett Neve, NML Capital, Ltd. v. Republic of Argentina: An Alternative to the Inadequate Remedies under the Foreign Sovereign Immunities Act, 39 N.C.J. Int’l L. & Com. Reg. 631 (2014); and Lee C. Buchheit & Jeremiah S. Pam, The Pari Passu Clause in Sovereign Debt Instruments, 53 Emory L.J. 869 (2004).
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In addressing the core research question, the study will also address the following sub-questions –
i. What is the development trajectory in the Global South, particularly Africa?
ii. What are the sources, composition and trends in credit flows to developing
countries including those in Africa? iii. What is sovereign default? iv. What are the causes of sovereign debt crises and how are they resolved?
v. Are holdout creditors one of the linchpins for an efficient sovereign debt
market? vi. How can a global normative regulatory framework be used to address the
perceived ‘mischiefs’ and exploitative tendencies of DDHFs in the sovereign
debt market?
1.5. Connecting the dots: the contours of the underpinning arguments in the study The overarching argument in this study is that although sovereign distressed debt investors can create holdout problems during the debt restructuring of a defaulting sovereign, the reality is that they remain a linchpin for an efficient sovereign debt market that guarantees the flow of private credit for capital formation in the Global
South. In other words, holdout creditors are a bit of a curate's egg, a necessary feature of the sovereign debt markets. As mentioned above, this author avers that they are not the spawn of the devil.
Distressed debt investors arguably play a crucial role in the global capital market. They make the secondary markets more liquid and make it possible for non- litigant investors who would like to sell their debt and exit the market on their own volition to do so. In addition, they tend to put pressure on recalcitrant sovereign debtors
Page | 19 who might not be acting in good faith. They therefore possess “nuisance value” that could spur efficiency in the sovereign debt market. The presence of distressed debt investors in the market contributes to the liquidity and efficiency of the market.40
Distressed debt investors practically play the role of stabilizing the market for distressed sovereign debt by providing a “safety net to other investors who would normally face large losses when a government defaults”.41
In summary, distressed debt investors are beneficial to the market because: 1) they provide needed liquidity in the sovereign debt market; 2) their presence will likely ensure there is continuous flow of private credit for capital formation in sovereign nations, especially in the Global South; 3) their existence keeps sovereign debtors on their toes by making the cost of default more expensive. This is likely to alleviate the perennial problem of sovereign default and debt overhang.
Due to the unique characteristics of sovereign debtors such as sovereign immunity, litigation is however one of the few avenues creditors have to challenge unfavorable debt restructuring terms.42 Basically, creditors should not have too little bargaining powers.43 In addition, if it is possible for sovereigns to get more funds without first paying up what they already owe, there is no incentive to repay what they owe.44 If sovereign debtors however are incentivized to pay back, they would be able to continually access the capital markets which is necessary to get financing for
40 David Bosco, The Debt Frenzy, Foreign Policy, (Oct. 13, 2009 6:20PM) available at https://foreignpolicy.com/2009/10/13/the-debt-frenzy/. 41 UNCTAD, “Sovereign debt restructurings: lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to holdout creditors”, 71st General Assembly Second Committee Meetings: Side Event, 7 (Oct. 26, 2016), available at https://www.un.org/en/ga/second/71/se2610cn.pdf. 42 Andrei Shleifer, Will the Sovereign Debt Market Survive? NBER WORKING PAPER SERIES: Working Paper 9493, 4, 8 (February 2003). 43 Patrick Bolton & Olivier Jeanne, “Structuring and Restructuring Sovereign Debt: The Role of a Bankruptcy Regime”, 115 Journal of Political Economy 901, 904 (2007). 44 Andrei Shleifer, Will the Sovereign Debt Market Survive? NBER WORKING PAPER SERIES: Working Paper 9493, 4, 8 (February 2003).
Page | 20 development and other needs. As will be shown in this study therefore, it is submitted that distressed debt investors, specifically, holdout creditors are an essential part of the sovereign debt market. A framework to achieve equitable resolutions between these investors and sovereign debtors is however necessary.
It is further argued that when legal limitations are raised on secondary market trading or on the possibility to litigate to enforce claims, this might affect and increase the borrowing costs of sovereign nations. In addition, Fisch and Gentile argue that
“judicial enforcement of sovereign debt obligations enhances the operation of the sovereign debt market by lowering the cost of financing to sovereign debtors and increasing the value of the obligations to creditors”.45
The main criticism against distressed debt investors however is that by buying distressed debt at discounted prices, opting out of debt restructuring procedures, and aiming to recover the total value of the debt via litigation, they take advantage of creditors who are cooperative and distressed sovereign debtors. The nations whose debt is traded at huge discounts are obviously financially distressed and poor, which is why their debt is trading so low on the secondary market in the first place.46 By holding out, these creditors make restructuring harder, more uncertain, and slower. Sovereign debtors are therefore hurt by the high uncertainty and having to pay a minority of
45 Jill E. Fisch & Caroline M. Gentile, Vultures or Vanguards: The Role of Litigation in Sovereign Debt Restructuring Conference on Sovereign Debt Restructuring: The View from the Legal Academy, 53 Em. L. J. 1044, 1112 (2004). 46 African Development Bank ‘Vulture Funds in the Sovereign Debt Contex’, https://www.afdb.org/en/topics-and-sectors/initiatives-partnerships/african-legal-support- facility/vulture-funds-in-the-sovereign-debt-context/ (last accessed 26/01/2018). About twenty Heavily Indebtedness Poor Countries (HIPC) have either been subjected to or threatened with legal actions by distressed debt investors since 1999 including Cote d’Ivoire, Burkina Faso by Industrie Biscoti and Sierra Leone by Greganti Secondo. Other nations that have been wither targeted or involved in sovereign debt litigation include Angola, Cameroon, Congo Brazaville, Democratic Republic of Congo (DRC), Ethiopia, Liberia, Madagascar, Mozambique, Niger, Sao Tome and Principe, Tanzania, and Uganda.
Page | 21 holdouts way more than the other creditors have agreed to in a restructuring agreement.47
In addition, the loopholes in the “legal architecture” promote the wrong incentives to engage in legal arbitrage and opt to hold out. This has led to the advent of so-called “vulture funds”.48 These funds are hedge funds whose business modus operandi is founded on taking advantage of the deficiencies in the rule of law that they helped to develop.49 Essentially, they go after nations in debt crises. First, they buy distressed sovereign debt at discount prices on the secondary markets, usually issued based on New York law. They then proceed to sue the sovereign debtor or issuer for full payment, including the full principal, full interest, punitive interest,50 and compensation for risks they did not undertake. If a court rules in their favor and the sovereign debtor refuses to pay them, they resort to tactics designed to intimidate the sovereign into paying.51 This kind of occurrence has been on the rise in the past two
47 Id. 48 In this study, the use of the derogatory term ‘vulture funds’ shall be deliberately avoided. The term is a metaphor used to describe the perceived predatory character of the hedge funds in the distressed sovereign debt market to that of vultures. The use of the derogatory term seems to obfuscate the salutary effects of the activities of these distressed debt investors on the integrity and efficiency of the market and in the international financial system as a whole. Going forward, this will be referred to with the short form, DDHFs. 49 African Development Bank ‘Vulture Funds in the Sovereign Debt Contex’, https://www.afdb.org/en/topics-and-sectors/initiatives-partnerships/african-legal-support- facility/vulture-funds-in-the-sovereign-debt-context/ (last accessed 26/01/2018).. For example, formerly, the doctrine of champerty prevented parties from buying defaulted debt with the intent to sue the issuer. In 2004 however, the New York State legislature removed the defense of champerty for purchases of debt or assignments of debt exceeding US$500,000. 50 Martin Guzman & Joseph E. Stiglitz, A Soft Law Mechanism for Sovereign Debt Restructuring: Based on the UN Principles, Friedrich-Ebert-Stiftung (FES): International Policy Dialogue 3 (October 2016). In New York, pre-judgment interest rate is nine percent. It has not been modified since 1981 inspite of the huge decrease in inflation since then. This interest rate is quite punitive rather than compensatory. Distressed debt investors which buy defaulted debt could get paid interest payments at this rate before here is a court judgment, including for periods of time between the date of default and the date of purchase – a time when they were not actually holding the bonds. 51 Id. For instance, distressed debt investors were able to capture a ship belonging to Argentina following its 2001 default and unsuccessfully tried to capture deposits of the country’s Central Bank in the Federal Reserve Bank of New York. In addition, sometimes, they are able to recover ten times the amount they paid for the distressed debt on the market. The judgement awards that have been awarded to them vary from one to six the initial value of the debt. The average recovery amount has been 2.2 times the initial value of the debt. More than fourteen settlements
Page | 22 decades; in the 1980s, only around five percent of debt restructurings happened along with legal disputes. This statistic was almost 50% in 2010.52
The actions of these holdout creditors result in aggravated inter-creditor inequities which exacerbate the moral hazard issue that hampers the possibility of successfully completing a sovereign debt restructuring process. Good faith creditors have probably gotten the message that holding out has benefits.53
In the NML v. Argentina saga, one did not need to be a litigant to get the same treatment that the court gave to the distressed debt investors. The court ruled that
Argentina should give non-litigant holdout creditors the same treatment and terms the litigant ones were given. Why would a creditor decide to participate in a debt restructuring process if it could just hold out, follow in the steps of a litigating distressed debt investor, and get better returns that could be hundreds or thousands percent more?
The issue is that if enough bondholders adopt this measure, debt restructuring will be practically impossible.54
The flip side to the above is that when arrangements for resolving sovereign debt difficulties are not designed well, this can lead to inequities and “Pareto-inferior outcomes”. In addition, delay in debt restructuring has huge cost implications. History has shown that when sovereigns intentionally postpone debt restructuring, resolving the crisis ultimately would be more expensive for the debtor, citizens, and creditors. It
have been beyond US$50 million in value. See Rommel C. Gavieta, The Global Financial Crisis, Vulture Funds, and Chinese Official Development Assistance: Impact on Philippine Infrastructure Development, 16 Journal of Structured Finance 62, 68 (2010). 52 Id. 53 Id. 54 Id. If debt restructuring is unsuccessful, the nation’s economic crises might worsen. In Argentina’s case, if its creditors had comprehended the detrimental implications of NML v. Argentina (in relation to the vultures), they might have been uncooperative and it would have been harder for the nation’s economy to improve. The country would have been in turmoil – being unable to repay and restructure debts without subjecting its citizens to pain. Even then, repaying all the debt would have been impossible.
Page | 23 becomes more complicated when debt restructuring is hampered by litigating holdout creditors.55 When the debt restructuring framework is not adequate, borrowing costs and benefits of lending are increased, resulting in “sub-optimal levels of credit flows”.
When debt restructuring procedures impose more burdens on the debtor, this could lead to lenders failing to perform due diligence before lending,56 because they know that the debtor has the most pressure and they can eventually get their money back.
It must be noted here that debt restructuring is complicated by the heterogeneity of creditors. The change from bank to market finance has made the creditor base more diverse. In other words, there are different categories of creditors which have differing financial and political aims, and usually conflicting claims. The success of a debt restructuring therefore depends not just on the dynamics between the creditors and the sovereign debtors, but also between the various classes of creditors.57
The oft-mentioned contractual approach in the form of Collective Action
Clauses (CACs) advocated by the private sector has been proven to be insufficient to resolve the issues that arise with debt restructuring including debtor-creditor and inter- creditor equity.58 While these clauses might perform better if there is only one class of bondholders, problems still persist when there is aggregation across all classes of bonds.
A supermajority rule could result in junior creditors voting to be treated equally with more senior creditors. Coordination problems can even be more complicated when bonds are issued in various jurisdictions and currencies, because proving priority of
55 Lee C. Buchheit, An open letter to the minister of finance of Ruritania, The Banker, 8 (September 1, 2011). 56 Joseph E. Stiglitz et. al., Framework for Sovereign Debt Restructuring, Columbia Center on Global Economic Governance 3 (Nov. 17, 2014). 57 Id. 58 Skylar Brooks et. al., Identifying and Resolving Inter-Creditor and Debtor-Creditor Equity Issues in Sovereign Debt Restructuring, 1 Centre for International Governance Innovation (2015). See Joseph E. Stiglitz et. al., Framework for Sovereign Debt Restructuring, Columbia Center on Global Economic Governance 1 (Nov. 17, 2014).
Page | 24 claims could be daunting, along with several contradictions. It is also a complicated process to have coordination between natural person claimants such as pensioners, and legal person claimants such as hedge funds. There is therefore the consensus that none of the suggestions for dealing with aggregation or coordination problems can resolve them in an effective and equitable way.59
Even the “stronger” CACs which made aggregation possible, advocated by the
International Capital Market Association (ICMA) and the International Monetary Fund
(IMF), and were used by Mexico and Kazakhstan, are not good enough to resolve these issues. First, CACs do not provide a guarantee for the execution of “priority agreements”; do not provide for debtor-in-possession financing; and do not resolve the holdout creditor problem. Second, CACs do not resolve ex ante issues including the tendency to have debt restructurings delayed. Third, CACs do not guarantee that the debtor will have sustainable debt post restructuring.60
Besides, some studies have shown that in certain cases, debtor and creditor interests might be aligned to the extent that they want to prevent debt crises or at least have debt crises with the least disruption, even if this results in an early and quick, sustainable sovereign debt restructuring. Of course, this is usually not the case especially when the classes of creditors are not homogenous. When these conflicts of interest exist, debtor-creditor and inter-creditor cooperation might be undermined.
These conflicts of interest can aggravate holdout creditor issues by making holding out in debt restructuring processes look more attractive. This is quite worrisome particularly following NML v. Argentina which has practically handed holdouts the
59 Joseph E. Stiglitz, Frameworks for Sovereign Debt Restructuring, 5 …. 60 Id. at 2.
Page | 25 tools to pursue repayment in full and prevent repayment to those who choose to participate in debt restructuring, thereby increasing the incentive to holdout.61
Due to the issues delineated above, it is submitted that the contractual approach is insufficient to resolve the sovereign debt conundrum and holdout problems.
Arguably, if the private contractual method was good enough, why has no country’s legislature chosen to enact those measures into law?62 Some of the measures that have therefore been suggested to remedy the problems with the current method of debt restructuring include establishing a system of common norms that apply in relation to sovereign debt restructuring and holdout creditors.63
1.6. The proposal A universal framework for dealing with holdout problems during the debt restructuring of a defaulting sovereign is therefore needed and that is what this study proposes. Such rules can be developed into a soft-law mechanism spearheaded by the
IMF which is what this study also suggests. As posited by Joseph E. Stiglitz, the Nobel
Laureate in Economics, even though a formal international agreement between nations is not viable, there is room for an international framework that would establish norms and provide for mediation between parties, aimed at fostering sustainable debt workouts especially between sovereigns and holdout creditors. Such a framework might eventually become more formal, but that is not the focus of this study.64
A formal or statutory global framework for debt restructuring and dealing with holdout investors is not politically feasible. A soft law regime is proposed, therefore.
61 Id. at 3. 62 Joseph E. Stiglitz et. al., Framework for Sovereign Debt Restructuring, Columbia Center on Global Economic Governance 6 (Nov. 17, 2014). 63 Id. at 10. 64 Id. at 7.
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Soft law can establish a better and healthier environment for sovereign debtors and creditors. Soft law is based on market acceptance and social norms, instead of formal legal mechanisms, to enforce the norms.65
This study therefore proposes a normative framework for the regulation of holdout creditors in order to address the disruptive and exploitative activities of these creditors in the sovereign debt market.
A normative framework would strike the delicate balance between the rights of commercial creditors on the one hand, and interests of sovereign debtors on the other hand, and inject some measure of equity into the process.
This normative framework is proposed because it can: 1) foster consistency in the development of jurisprudence in the area of sovereign debt and holdout litigation; and 2) limit “regulatory arbitrage”. Regulatory arbitrage, in general terms, occurs when persons such as companies take advantage of differences in regulation with the aim of avoiding laws or regulations perceived as unfavorable.66 This can be achieved through forum shopping (a practice where litigants try to get their cases heard in a certain court just because it would likely deliver a favorable judgement for them),67 relocation, financial engineering, restructuring of contracts, among others. Although the practice is strictly speaking, legal, it can also be seen as unethical especially when it intensifies information asymmetries which can impede market competition, weaken sufficient
65 Martin Guzman & Joseph E. Stiglitz, A Soft Law Mechanism for Sovereign Debt Restructuring: Based on the UN Principles, Friedrich-Ebert-Stiftung (FES): International Policy Dialogue 3 (October 2016). 66 Adam Hayes, Regulatory Arbitrage, INVESTOPEDIA, (Oct. 4, 2019), https://www.investopedia.com/terms/r/regulatory-arbitrage.asp. 67 Forum Shopping Law and Legal Definition, US LEGAL, https://definitions.uslegal.com/f/forum-shopping/.
Page | 27 capital coverage in capital markets, or result in the absence of liquidity in regulated markets due to the “leaking of transactions” to unregulated or less regulated markets.68
While regulatory arbitrage cannot completely be prevented, its prevalence can be reduced.69 It probably does not help in any way to have regulatory arbitrage be prevalent in the field of sovereign debt.
On the flip side, regulatory arbitrage might be acceptable when it leads to an effective allocation of capital and a more effective financial services industry; and alleviates or removes the effects of market-distorting regulation.70 In the field of sovereign debt and holdout litigation however, regulatory arbitrage should be limited because it is in the interests of most stakeholders, especially the “weaker” ones such as defaulting developing nations. Nations that are already heavily indebted usually have to pay much to hire lawyers and defend themselves in the fora where court decisions take place. The holdout creditors who usually have the resources and the clout to pursue any claim should not continually have the power to decide where suits are brought and decided because it would be to the detriment of the sovereign debtors. After all, their aim is to make the sovereign debtors capitulate and just pay up all their claims.
In this context, a global normative framework that has elements of nonmarket private standard setting and nonmarket public standard setting, is therefore proposed.71
This initiative would involve stakeholders such as: 1) the IMF, 2) IOSCO, 3) private
68 Gaston Siegelaer & Pieter Walhof, “Regulatory arbitrage: between the art of exploiting loopholes and the spirit of innovation”, (September 2007), https://www.ag-ai.nl/download/819- 15-1-PPSiegelaer%26Walhof.pdf. 69 Adam Hayes, Regulatory Arbitrage, INVESTOPEDIA, (Oct. 4, 2019), https://www.investopedia.com/terms/r/regulatory-arbitrage.asp.
70 Id. 71 In nonmarket private global regulation, standards are set by an international nongovernmental organization, which is recognized by private and public players on the international scene as the “obvious forum” for that purpose. In nonmarket public global regulation, standards are set by a public international governmental organization. More discussion on this in chapter 6.
Page | 28 creditors and investors in the secondary sovereign debt market, including the distressed debt investors, 4) relevant representatives from debtor nations, 5) lawyers and international law firms that specialize in sovereign debt, and 6) academics that are versed in and have published extensively in this field, coming together to create an initiative that is focused on establishing international standards that would regulate the activities of the litigating holdout creditors.72 This normative regulation would aim at curbing the excesses of holdout creditors such as DDHFs which include: 1) making excess profit at the expense of the debtor nations; and 2) unnecessarily holding out on debt restructuring processes.
Such a soft law mechanism can be a guide to national legislatures in enacting domestic legislation. This might help courts when adjudicating on sovereign debt matters, “remind” them of the “big picture” in debt restructuring procedures, and probably alleviate bias that leads to stricter interpretations of sovereign debt agreements.
The proposed soft law framework will build upon the United Nations Conference on Trade and Development (UNCTAD) Principles on Sovereign Lending and
Borrowing (UNCTAD Principles). Essentially, a normative framework is suggested which balances the rights of creditors and debtors and leads to fair and efficient solutions.73 A final point is that automatic stay or some form of stay on litigation is
72 The viewpoints of sovereign debt networks and groups should also be welcome such as: the Emerging Markets Traders Association (EMTA), Institute for International Finance (an association of big financial institutions), International Primary Market Association (IPMA), International Securities Market Association (ISMA), Emerging Markets Creditors Association (EMCA), Bond Market Association (BMA), Securities Industry Association (SIA), among other sovereign debt-related organizations. See Robert B. Ahdieh, 6 Chi. J. Int’l L. 231, 233.240-241. 73 Martin Guzman & Joseph E. Stiglitz, A Soft Law Mechanism for Sovereign Debt Restructuring: Based on the UN Principles, Friedrich-Ebert-Stiftung (FES): International Policy Dialogue 8 (October 2016).
Page | 29 suggested as part of the proposal. More details on this proposal will be expounded upon as this study progresses, especially in chapter 6.
In summary, this study, in essence, challenges the contemporary negative and dismissive narratives about holdout creditors, and the assumption and unshaken faith placed on “restructuring or workout of sovereign debt” as the only favored path to alleviating the perennial problem of sovereign default and the attendant debt crises in the developing world. It also seeks to extend the frontiers of existing scholarship in the field of sovereign debt as a legal discipline. It is obvious that there is a regulatory vacuum in the sovereign debt market that needs to be filled and this research proposes an initiative to fill this perceived gap.
1.7. Holdout creditors: Why the focus on DDHFs? The overarching reason for the focus of this study on DDHFs (as a subset of holdout creditors/distressed debt investors) is that most of the holdout creditors involved in high-profile litigation like NML v. Argentina, are hedge funds. Essentially,
DDHFs are known to be ahead of the pack of holdout creditors that are involved in holdout litigation.74 Such well-known DDHFs include: Elliot Management Corporation which sued Peru in 1995 for USD58 million (of which NML Capital Limited is a
74 Relevant sovereign debt litigation precedent include: Pravin Banker Associates v. Banco Popular del Peru, 165 BR 379, SDNY (24 February 1994); Elliot Associates LP v. Republic of Peru and Banco de la Nación del Peru, 194 F.3d. 363, 2nd Cir (1999); Red Mountain Financial Inc. v. Democratic Republic of Congo and National Bank of Congo, No CV 00-0164 R (CD Cal, 29 May 2001); Kensington International Ltd v. Republic of Congo, [unreported] 16 April, 2003 (the Court of Appeals approved it in [2003] ECWA Civ 709); Kensington International Limited v. BNP Paribas SA, No 03602569 (NY Sup Ct, 13 August 2003); LNC Investment Inc v. The Republic of Nicaragua, No 96 Civ 6360, 2000 US Dist LEXIS 7738 (SDNY, 6 June 2000); Macrotecnic Int’l Corp. v. Republic of Argentina and EM Ltd v. Republic of Argentina (SDNY, 12 January 2004) (No 02 CV 5932 (TPG), No 03 CV 2507 (TPG)); Applestein v. Republic of Argentina and Province of Buenos Aires (SDNY, 15 January 2004) (No 02 CV- 1773 (TPG)); Donegal Int’l v. Zambia, EWHC 197 (Comm) (Eng.), and then the famous NML Capital Ltd v. Argentina which is discussed at length in this study. Of all these plaintiffs, the author thinks that only about four are/were hedge funds, including: Elliot Associates LP, Kensington International Ltd, Dolegal Int’l, and NML Capital Ltd. Not all distressed debt investors, therefore, are hedge funds.
Page | 30 subsidiary located in the Cayman Islands), and Kensington International which successfully sued Congo-Brazzaville and got at least USD100 million in interest in
2002-03); FG Hemisphere (FG Capital Management) which sued DRC successfully for
USD100 million; and Donegal International Ltd., which was awarded USD15.5 million in 2007 against the Democratic Republic of Congo.75
The likely reasons for why most holdout creditors involved in litigation are
DDHFs could be because: 1) hedge funds invest using a lot of leverage and take on risky ventures they believe will be profitable (in general, this is their business model); and 2) they have the money to hire the best lawyers and other relevant professionals to sue sovereigns and target their assets all over the globe. Holdout creditors can also be natural persons or entities set up and run in the form of other legal channels that are not operated as hedge funds, such as a corporation or a trust. While the focus will be on
DDHFs, the proposal this study presents will apply to all holdout creditors whether they are DDHFs or not. As mentioned above, holdouts can be natural or legal persons (set up as hedge funds or otherwise). More emphasis will be placed on substance rather than form.76 Going forward in this dissertation therefore, the term “DDHF(s)” will be used generally to refer to DDHFs and other holdout creditors.
1.8. Overview of chapters Chapter 1: Introduction – discusses introductory matters such as the research problem, research questions, and the overview of chapters.
75 THE GUARDIAN, “Vulture funds – the key players”, https://www.theguardian.com/global- development/2011/nov/15/vulture-funds-key-players (last visited 10/23/2019). 76 The normative framework proposed in this study is intended to apply to all holdout creditors regardless of their form or name.
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Chapter 2: Quest for Development in the Global South: Africa as a case study – aims to interrogate how development has fared in the Global South, using Africa as a case study.
Chapter 3: Sovereign capital formation – investigates the sources, composition and trends in credit flows to developing countries including those in Africa.
Chapter 4: Sovereign Default and Debt Crises– investigates the meaning, history, causes and the effects of the perennial problem of sovereign debt crises and the various approaches by which they are resolved.
Chapter 5: Distressed-Debt Hedge Funds: A Linchpin for Efficient Sovereign Debt
Market? – interrogates the role of the DDHFs in inducing the depth and liquidity of the distressed sovereign debt market.
Chapter 6: Normative Framework for Regulation of Holdout Creditors in the
Sovereign Debt Market – examines how the normative regulation of the distressed- debt hedge fund industry can be used to drive the development of the sovereign debt market to ensure the delivery of private capital flows to the Global South, particularly
Africa.
Chapter 7: Conclusion – findings are summarized, conclusions are drawn, and recommendations are made.
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CHAPTER 2
QUEST FOR DEVELOPMENT IN THE GLOBAL SOUTH: AFRICA AS A CASE STUDY
2.1. Introduction
The aim of this chapter is to chart the path of development in the Global South, particularly Africa. Essentially, the aim to is to provide the background to the development trajectory of African nations. Many of the issues discussed apply to most developing nations outside Africa, even if they were not colonized. There have been multilateral responses to the development challenges in the Global South; these will be explored. Finally, the need for capital in the Global South, particularly Africa will be examined.
This chapter in section 2.2. will discuss the quest for development in Africa.
Section 2.3 will examine certain multilateral responses which have been made to respond to development problems in the global south will be discussed. Finally, section
2.4. concludes and summarizes salient points.
2.2. Quest for development in Africa
This section will be divided into four subsections that cover respectively: decolonization, development goals, the need for infrastructure development, and the need for capital which is essential to ensure capital formation and development finance.
2.2.1. Decolonization All African states, except Ethiopia and Liberia, were colonized by European countries. Most of these states started gaining independence in the late 1950s and 1960s, starting with Ghana. Colonization had the colonies organized to produce mostly the
Page | 33 commodities that benefited their colonizers and the traditional structure of society broken up to favor them structurally and economically.77 Handing over of power to successors chosen by the colonizers, of course, did not mean that the essence of the state changed. In some states, there were nationalist movements, civil disturbances and political instability which made it hard to foster development. Some states hardly had funding to finance development as hoped for or to even adequately maintain the already existing infrastructure built by the colonizers, hence, African states began to borrow to finance development, and the quest for development began.78
2.2.2. Development goals
According to Hammouda and Osakwe, one of the major issues Africa faces is the alleviation of hunger and poverty in the region.79 The 2005 Commission for Africa report stated that, “African poverty and stagnation is the greatest tragedy of our time”.80
An examination of poverty facts for the developing world since the 1970s shows that sub-Saharan Africa (SSA) is the only sub-region where there has been an increase in the number of impoverished people so far. Impoverished people numbered about 1.2 billion people in developing countries as at 1970. Of this number, there were 36 million in Latin America, 830 million in East Asia, 208 million in South Asia, 27 million in the
Middle East and North Africa and 104 million in SSA. There was a reduction in these
77 Chris N. Okeke, The Debt Burden: An African Perspective, 35 Int’l Law 1489, 1491 (2001). 78 Id at 1493. 79 Hakim Ben Hammouda & Patrick N Osakwe, Financing Development in Africa: Trends, Issues and Challenges in the Context of the Aid for Trade Initiative, 44 J. World Trade 687, 687 (2010). Africa, as a continent comprises of five geographical regions as follows: West Africa has 16 countries and a population of about 300 million people; Southern Africa as 12 countries and a population of about 165 million people; East Africa has 12 countries and a population of about 280 million; Central Africa with seven countries and total population of over 107 million people. See Mthuli Ncube et al., “Introduction: Infrastructure in African Development” in Infrastructure in Africa: Lessons for Future Development, Mthuli Ncube and Charles Leyeka Lufumpa (eds.) 35 Policy Press: UK (2017). 79 Id at 11 80 Commission for Africa, Our Common Interest: Report of the Commission for Africa, (March 2005).
Page | 34 numbers in the intervening period between 1970 and 2000 and then went down to 647 million people in 2000. The decrease in this number came mostly from East Asia where the number of impoverished people went down from 830 million in 1970 to 114 million in 2000.81 During this same period however, it seems that SSA was the only region where the number of poor people increased during this same period.82 The authors, however, argue that one of the crucial reasons for this is the absence of “high and sustained economic growth”.83
Other reasons that have contributed to the high level of poverty in some regions in Africa include, among others: the heritage of colonialism, the absence of a good investment climate, political instability, and unfavorable external factors such as trade policies enacted by the Organization for Economic Cooperation and Development
(OECD) which make it harder for African states to have their exports penetrate their markets. 84 The next section will discuss the dearth of infrastructure in Africa which illustrates the need for infrastructure development on the continent.
2.2.3. Dearth of infrastructure
One big indicator of underdevelopment in some regions in Africa is the dearth of infrastructure or poorly maintained infrastructure assets and service delivery.
Infrastructure is a crucial enabler of development and it advances socio-economic growth.85 Africa’s infrastructure has been found to lag behind those of other states in the developing world,86 and there has been scant household access to social and
81 Hakim Ben Hammouda & Patrick N Osakwe, 44 J. World Trade 687, 687. 82 Id. In 2000, SSA had a headcount ratio of 84.8% - yet, it had the largest portion of domestic population that was impoverished. 83 Id at 688. 84 Id. 85 Mthuli Ncube et al., “Introduction: Infrastructure in African Development” in Infrastructure in Africa: Lessons for Future Development, 1, 86 Id. at 11.
Page | 35 economic infrastructure and the lack of regional links. Infrastructure services have also been found to be two times more expensive than similar services elsewhere. This reflects the problems of high profit margins and diseconomies of scale in production resulting from lack of competition. Power, a crucial infrastructure service, remains
Africa’s biggest infrastructure challenge. So many countries in Africa are still at the throes of frequent power outages and paying a lot for emergency power services,87 or having to buy fuel for generators to have power at homes and business places. This adds to the overall cost of living and doing business in these countries.
According to Mthuli Ncube et al., infrastructure is one of the pillars of achieving the Sustainable Development Goals (SDGs) and other development goals in Africa. For instance, access to clean water and sanitation facilities could prevent diseases
(especially water-borne diseases) and the spread thereof, and decrease the rate of infant mortality. Access to frequent power supply would bolster the provisions of other services like education and health services, and it would also help small businesses to reduce business costs, innovate more and employ more people. Access to well- maintained roads would provide easier access to markets, and so on.88
Studies have shown that poor physical infrastructure is one of the obstacles hindering the integration of Africa into the global market.89 Poor infrastructure results in higher trade and business costs, compared with other regions in the developing world and this creates a competitive disadvantage. According to the World Economic Forum’s
Global Competitiveness Index 2017-2018, SSA’s competitiveness has not really changed in the last ten years. Although some progress was made between 2011 and
87 Vivien Foster and Cecilia Briceno-Garmendia (eds.), Africa’s Infrastructure: a Time for Transformation, 1 The World Bank (2010). 88 Mthuli Ncube et al., “Introduction: Infrastructure in African Development” in Infrastructure in Africa: Lessons for Future Development, 1. 89 Other obstacles include corruption and inadequate access to capital.
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2015, some of that progress has been lost over the last two years.90 The region, therefore, remains one of the least competitive regions in the world.
Africa’s development and infrastructure plans see sustainable economic growth as a way of alleviating poverty on the continent. Achieving this goal requires, among others, that the productivity of businesses be improved and ensuring that people have better living conditions on the continent;91 and resolving three main aspects of
“geographical aggregation” which are: 1) making cities to be more attractive and productive places to live in; 2) connecting large population areas across the region and
3) “integrating rural areas through the spill-overs of urban growth”.92 As noted above, infrastructure plays a major role in improving competitiveness, integrating the continent into the world economy and fostering domestic and international trade. The spill-over effects from infrastructure development, along with improved human development outcomes, could help Africa realize her goals of poverty reduction and economic growth. Better infrastructure could also help her realize more of the benefits of globalization.93
Now that the development challenges in the Global South, particularly Africa have been discussed, the next section will discuss the need for capital and how it is one of the main reasons for underdevelopment across that continent.
2.2.4. The acute need for development finance It has been found that one other critical reason for underdevelopment in the global South, particularly Africa, is the absence of capital. More advanced economies
90 Klaus Schwab, The Global Competitiveness Report, 2017-2018. 91 Mthuli Ncube et al., “Introduction: Infrastructure in African Development” in Infrastructure in Africa: Lessons for Future Development, 89. 92 Id at 90. 93 Albert Mafusire et al., “Infrastructure deficit and opportunities in Africa” in Infrastructure in Africa: Lessons for Future Development, 545.
Page | 37 have marshalled capital investments and savings over centuries, but African nations do not have the same story. As mentioned above, many African nations only started gaining independence in the 1950s and 1960s. In addition, profits from foreign investments have not been reinvested in businesses in Africa except pursuant to agreements to provide infrastructure or to provide transport and communications facilities to aid the export of finished goods or raw material.94 Profits generally have been shipped back to European or Western private investors’ home countries. Many businesses in African nations are thus undercapitalized because profits generated from these economies are not reinvested in them. The failure of African nations to be fully integrated into the international monetary market has not helped the development of their domestic financial markets. Stock markets have therefore, not been a viable option for accumulation of finance for development on the continent.95
The mobilization of capital can be hard to achieve in nations that are cash strapped. Many of these nations produce mainly agricultural products, raw materials and essential commodities. The global prices for these commodities are usually set at nonmarket, “false rates” or sold below their value in inflexible world markets. Many
African nations and other countries in the developing world thus find it hard to generate foreign currency or foreign exchange. The meagre foreign exchange some of these nations manage to accumulate are used to service external debts and pay for imported goods. Industrial manufacturing, for the most part, take place in the Global North, thus, there is less concern for the resource-rich but mostly technology-deficient Global South to produce value-added goods.96
94 Rumu Sarkar, International Development Law: Rule of Law, Human Rights and Global Finance, 259. 95 Id at 260. 96 Id.
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The next few paragraphs will discuss the concept of financing for development.
Financing for development is the process of mobilizing financial resources to fund development, in its various forms, including infrastructure development, ensuring increase in standards of living, etc. Financing for development has been at the forefront of discussion around global development since the beginning of the Millennium. It was against this backdrop that the world leaders found it necessary to convene in Monterrey,
Mexico in 2002 to reach an international consensus on financing for development.
It has been estimated that about US$93 billion in financing is required yearly until 2020, in order to bridge Africa’s infrastructure gap.97 In Africa’s Middle-Income
Countries (MICs), infrastructure financing requirements are about 10% of GDP annually until 2020. Lower Income Countries (LICs) might need a smaller amount than
MICs, but their investment needs are more – about 15% of GDP annually. The infrastructure investment requirements that are needed in MICs and LICs are about twice the current investment levels seen so far in these countries.98 African countries and other nations in the Global South have always sourced for new and creative ways of raising finance. This is because meeting these needs requires more than reliance on traditional financing sources alone.99 The next few paragraphs will focus on the funding gaps still existing in Africa.
There are huge funding gaps for development in Africa. Infrastructure investment on the continent have not been keeping up with the growth in demand, which has resulted in a large deficit. For instance, less than half of rural population have
97 Vivien Foster and Cecilia Briceno-Garmendia (eds.), Africa’s Infrastructure: A Time for Transformation, 6 The World Bank (2010). 98 Mthuli Ncube et al., “Introduction: Infrastructure in African Development” in Infrastructure in Africa: Lessons for Future Development, 155. 99 Id at 556.
Page | 39 access to roads that function well in all seasons, only about 5% of arable land are under irrigation, and less than half of the continent’s population have frequent access to electricity. Regarding social infrastructure, only about 65% of the people have access to clean water and about 34% have access to improved sanitation. As of 2014, seven out of 10 Africans had access to mobile phones, but internet density amounted to about two in 10 people, and for fixed telephones, the situation was not any better.100
Africa also has higher costs of access compared to other regions in the developing world. Mobile telephone costs US$12 a month compared to US$8 in other regions; power costs 14 US cents per kilowatt-hour rather than 5-10 US cents elsewhere and road freight on the continent is about four times more expensive compared to other regions.101 There are thus, several opportunities for infrastructure investment and financing for development and some examples will be given in the following paragraph.
In the electricity sector, only 43% of the population had access to electricity, and as at 2017, the rate of electricity in sub-Saharan Africa was about 32%. Independent
Power Producers (IPPs) have thus arisen in the power sector. In South Africa for instance, the National Energy Regulator has developed an environment where IPPs can increase tariffs hence, enhancing their profitability. And in Morocco, about two-thirds of electricity is provided by IPPs.102 In addition, the aggregate road network is about
204 km per 1000km² – only about 25% of this is paved. This results in about 3.6km of road per 1,000 persons, compared to about 7km of road per 1,000 persons. There is a dearth of rural roads, such as 0.5km per 1,000 persons in Malawi to 35.5km in
Namibia.103 With the realization that public funds are not adequate to improve road
100 Albert Mafusire et al., “Infrastructure deficit and opportunities in Africa” in Infrastructure in Africa: Lessons for Future Development, 546. 101 Id. 102 Id at 546-547. 103 Id at 547.
Page | 40 infrastructure, private sector participation has come on the scene in the form of toll roads.104
There are issues regarding the operation of Africa’s existing ports and costs of handling. Albert Mafusire et al., state that: “Over-the-quay container-handling performance is below 20 moves/hour, compared with 25-30 in modern terminals around the world. In addition, handling costs average 50% more than in other parts of the world”. The problems associated with transport infrastructure on the continent include little or no connectivity to ports and hardly any linkages between roads and rail lines.
As a result, Africa was rated the worst on the 2016 Logistics Performance Index, although the situation varies across the countries. There are therefore opportunities for investment in Africa’s transport sector.105
A significant number of development challenges will be alleviated when
African sovereign nations and other developing nations have sufficient access to capital.106 Capital and access thereto are therefore very vital for development. Many of the nations in the developing world, particularly those in Africa, might find it difficult to borrow due to bad credit history, low credit ratings, or history of default. The resources they have (which might be gotten from an overreliance on commodities and resources) are used to service external debt rather than finance critical infrastructure and other development needs. It is therefore important that sovereign nations continually have access to capital to finance development.
104 A recent example is the Lagos Lekki-Epe toll road which cost $385 million. 105 Albert Mafusire et al., “Infrastructure deficit and opportunities in Africa” in Infrastructure in Africa: Lessons for Future Development, 550. 106 Sufficient access to capital is not the only required solution; even with enough capital, other development challenges might remain. If corruption for instance, remains undealt with in many of these countries, capital will hardly be channeled to the right projects and the few elite are the ones who benefit. Development challenges will remain sustained.
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In the next section, certain multilateral responses which have been made to respond to development problems in the global south will be discussed.
2.3. Multilateral responses to the development challenges in the
Global South
Several programs have been initiated on the multilateral level to respond to development crises across the Global South. The ones that will be discussed in the ensuing sections include the: Comprehensive Development Framework (CDF),
Millennium Development Goals (MDGs), and the Sustainable Development Goals
(SDGs).
2.3.1. Comprehensive Development Framework (CDF)
There have been multilateral efforts to promote development in the Global
South, of which Africa is a part. One of the multilateral efforts that preceded the MDGs and/or were formulated at the beginning of the millennium included the Comprehensive
Development Framework (CDF). In 1999, the World Bank advanced the CDF as a mechanism through which States could bring resources and knowledge together creatively to initiate and develop efficient plans for poverty reduction and economic development. The CDF was voluntary and encouraged partnerships between civil society, government, the private sector and other external aid agencies. Along with this program, governments could develop Poverty Reduction Strategy Paper (PRSP) in conjunction with local and foreign partners based on CDF Principles, which streamline poverty alleviation plans into a “coherent, growth oriented macroeconomic
Page | 42 framework”.107 The CDF was a method by which nations could achieve poverty reduction more effectively, and constituted a set of principles to help achieve poverty reduction and development, including the provision of aid. Such principles included: 1) an all-inclusive, long-term vision; 2) ownership by the developing nation of its development agenda; 3) partnership led by the developing nation; 4) focus on results.
It accentuated the interconnectedness between all aspects of development, including environmental, financial, human, governance and structural.108 The next multilateral initiative that will be discussed is the Millennium Development Goals (MDGs).
2.3.2. MDGs
The development of the CDF was immediately followed by the creation of the
MDGs when at the beginning of this millennium, world leaders convened at the United
Nations to develop a broad mechanism for alleviating all forms of poverty. This resulted in the eight MDGs which constituted the world’s development framework for 15 years.109
According to a UN report, the MDGs mobilized the global community to achieve the most successful anti-poverty drive in history.110 The MDGs resulted in global, regional, national and local efforts which have saved millions of lives and improved living conditions for many others. The report, for instance, found that in 1990, nearly half of the people living in the developing world lived on less than $1.25 daily; in 2015 however, that proportion had reduced to 14 percent. The net enrolment rate of
107 James D. Wolfensohn & Stanley Fischer, The Comprehensive Development Framework (CDF) and Poverty Reduction Strategy Papers (PRSP), https://www.imf.org/external/np/prsp/pdf/cdfprsp.pdf (last visited 10/08/2018). 108 WORLD BANK, Comprehensive Development Framework: What is CDF: CDF Principles, http://web.worldbank.org/archive/website01013/WEB/0__CON-3.HTM (last visited 02/09/2019). 109 See Stephen Spratt, Development Finance: debates, dogmas and new directions, 176. 110 UNITED NATIONS, The Millennium Development Goals Report: 2015, Foreword by Ban Ki- Moon United Nations: New York (2015).
Page | 43 children in the developing world was up to 91% in 2015, from 83% in 2000, among many other improvements in living conditions arising from implementation of the
MDGs.111
There were underperformances or gaps in many areas and unequal achievements. With intentional efforts, political will, enough resources and sound policies and plans, the poorest States could have made huge progress.112 Not all regions were able to achieve the ambitious goals of the MDGs by 2015, however.
The next section will specifically discuss how Africa fared in achieving the
MDGs.
a) How did Africa fare in achieving the MDGs?
The ensuing paragraphs will provide a scorecard of Africa’s performance in relation to the MDGs.
According to a report co-written by the African Development Bank, Africa did make some progress towards achieving the MDGs despite challenges that existed at the beginning. Baseline figures for most MDG indicators in Africa were low compared to other parts of the world. Nonetheless, more children (including girls) were able to attend primary schools, more women were represented in national parliaments, incidence of
HIV/AIDS was reduced, and the prevalence of child and maternal deaths decreased.
Poverty did reduce in Sub-Saharan Africa (SSA) from 56.5% in 1990 to 48.4% in 2010, which was below the MDG target of 28.25%. Yet, economic growth was not robust enough to maintain poverty reduction efforts. Many SSA nations were also dependent on primary commodities and affected by shocks that disrupted economic development
111 Id. at 4. 112 Id. There is still much work to be done and it continues under the auspices of post-2015 SDGs.
Page | 44 such as the Global Financial Crisis (GFC) and the outbreak of the Ebola virus. In addition, even though economic growth was quite positive in terms of GDP growth, it was not inclusive or fast enough to create enough employment opportunities. Many
Africans therefore remained trapped in “vulnerable employment”, mostly found in the informal sphere.113
Furthermore, SSA had the highest level of food-deficiency in the world with a quarter of its population having dealt with malnutrition and starvation between 2011 and 2013. Perennial conflicts and hostile weather conditions such as drought, as well as the outbreak of Ebola, undoubtedly did not help matters in this regard. Access to sanitation and clean drinking water did improve but such improvement was largely in the urban areas. Huge rural-urban disparities existed with regards to access to clean drinking water which reduced the total figures for some nations. The poverty levels of people that live in the rural areas exacerbated the said rural-urban divide. About 24% of the current African population has had access to a better drinking source since the beginning of the millennium, which is the lowest worldwide. Only about 16% of the continent’s population has access to piped drinking water, which is also the lowest, worldwide.114 Now that the MDGs have been discussed, the next multilateral response which will be highlighted is the Sustainable Development Goals (SDGs), which is the successor to the MDGs.
2.3.3. SDGs
On 25 September 2015, the United Nations General Assembly (UNGA) adopted a Resolution titled, “Transforming our world: the 2030 Agenda for Sustainable
113 UNITED NATIONS ECONOMIC COMMISSION FOR AFRICA, MDG Report 2015: LESSONS LEARNED IN IMPLEMENTING THE MDGS, xiii-xiv (2015). 114 Id. at xvi.
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Development”. This is “a plan of action for people, planet and prosperity…which seeks to strengthen universal peace in larger freedom”. The Assembly recognized that the most pressing global problem is extreme poverty, and the alleviation thereof is essential to achieve sustainable development. This Resolution therefore advanced the 17 SDGs and 169 targets which sought to achieve what the MDGs did not realize and build on the previous development framework. The SDGs also aim to achieve gender equality and the empowerment of all women and girls,115 ensure that the planet is protected through sustainable production and consumption and taking necessary action on climate change, encourage peaceful and just societies, and renew a “Global Partnership for
Sustainable Development, based on a spirit of strengthened global solidarity”.116
A common factor among all the multilateral responses discussed in this chapter is the need for capital to implement them. Development goals cannot achieve themselves. Capital is needed. For instance, more could probably have been done with the MDG initiative if developing nations had more capital, managed their resources well, or those resources were not misused via corruption. There is therefore a clear link between development goals and capital; achieving the former is impossible without the latter.
2.4. Conclusion
In this chapter, the quest for development in the Global South (using Africa as a case study) was outlined, as well as other development challenges besetting the continent. It was also noted in this chapter that Africa has not met the development expectations of her citizens, despite her abundance of resources. Infrastructure deficit,
115 UNITED NATIONS GENERAL ASSEMBLY, Resolution adopted by the General Assembly on 25 September 2015, 1 Seventieth session: Agenda items 15 and 116 A/RES/70/1 (2015). 116 Id at 2.
Page | 46 inadequacy of capital, and corruption are some of the factors that contribute to Africa’s development dilemma. There is therefore much room for improvement in relation to realizing development goals.
Furthermore, this chapter examined the multilateral efforts that have been made by the international community to address development challenges that are confronting the
Global South. Such efforts include the CDF Framework, the MDGs, and the SDGs.
Africa’s progress in relation to these efforts was examined and it was found that Africa did not score too well in the realization of these development goals, with high unemployment and poverty levels, high crime rates, and debt overhang still existent in many of her nations.
In addition, the need for capital or development finance in the Global South, particularly Africa, was investigated. As mentioned above, it is crucial that sovereign nations continually have access to capital to finance development. It is crucial to note that one of the channels through which sovereign nations can access capital is the sovereign debt market.
Now that this chapter on the quest for development has been concluded, the next one will explore sources and trends in the composition of credit flows to the Global
South, Africa in particular. The concept of debt, including loans and bonds will also be examined in-depth.
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CHAPTER 3
SOVEREIGN RESOURCE MOBILIZATION
3.1. Introduction
In the previous chapter, the quest for development in the Global South (with emphasis on Africa) was briefly explored and multilateral efforts to drive development in the Global South were highlighted. Some of the topics discussed include decolonization, development aims, infrastructure requirements, and the need for capital. It was found that with the level of infrastructure deficit in many developing nations, development finance is needed. As public sources and ODA have proven insufficient to close the gaps, it is crucial that these capital-importing states continually have access to financing from commercial and multilateral lenders.
In this chapter however, the sources, composition and trends in credit flows to developing countries for resource mobilization including those in Africa, will be investigated. In addition, the concept of debt will be explored including bond conventions, bond markets, repo markets, American and Dutch auctions, among others.
Section 3.2. therefore, will investigate the sources, composition and trends in credit flows to the developing countries including those in Africa. Section 3.3. will specifically focus on bonds including bond conventions, bond markets, repo markets,
American and Dutch auctions, among others. Finally, section 3.4. concludes and summarizes salient points.
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3.2. Composition of credit flows for resource mobilization and development finance: sources, composition and trends in state borrowing
As will be seen below, already existing funds for infrastructure development are not enough for the current infrastructure gaps that exist in many parts of the Global
South, including Africa. Official Development Assistance (ODA) is not enough to close these gaps. Despite the high capital intensity of infrastructure projects in the Global
South, official and traditional aid have not been projected to increase and are not enough to fill the gap. It is therefore necessary that these developing nations mobilize more of their domestic and other resources for financing. The various sources of finance, including domestic and foreign sources will therefore be explored in the following sections.
3.2.1. Domestic sources
Domestic sources refer to sources of funds that are from within the state, and not from foreign entities, such as taxes and duties levied, loans from domestic banks, issuance of securities to nationals and permanent residents, remittances, income from government investments, among other sources.117
For example, Africa meets around two-thirds of its infrastructure spending through domestic sources.118 Calls have therefore been made for nations to explore traditional domestic sources of development capital and potential innovative sources further.
117 Albert Mafusire et al., “Infrastructure deficit and opportunities in Africa” in Infrastructure in Africa: Lessons for Future Development, 556. 118 Id.
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The following are reasons why domestic resources should be leveraged upon to meet medium- to long-term development needs:
i. Exploiting more of domestic resources reduces the dependence of countries
on foreign loans and other external capital inflows such as ODA. This allows
such nations to control their own development process and policy space.119
ii. Mobilizing domestic public revenue could lead to a better system of
governance; it improves cooperation between the state and the entities
through which it generates revenue in taxes, etc.120
iii. ODA and FDI and other external capital inflows have been known to be
volatile.121
Ways of mobilizing domestic financial resources therefore include, among others:
1) enhancing private savings in the formal financial system; 2) improving collection of taxes and the fiscal space; 3) tapping into remittances for development; 4) improving the investment climate and the legal and regulatory framework for investment; 5) deepening capital markets; 6) developing diaspora bonds issues; 7) strengthening the insurance industry and establishing pension funds.122 In addition, states can leverage on foreign exchange earnings to finance development. States could also borrow from local banks to finance development projects that do not have a high capital intensity.
As domestic sources of finance have been discussed, the next section will focus on foreign-based options states have for accessing finance.
119 UNCTAD, Enhancing the Role of Domestic Financial Resources in Africa’s Development: A Policy Handbook, 6 United Nations: New York & Geneva (2009). 120 Id. 121 Id. ODA is about four times more volatile than domestic tax income. 122 Id. at 9-27.
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3.2.2. Foreign-based options for finance
Foreign-based sources refer to sources of finance received from foreign persons such as foreign and multilateral banks, issuance of securities to foreign persons (non- nationals and residents), Official Development Assistance (ODA), among other foreign sources.
These sources will be expounded upon more below. a) Debt and loans sourced from foreign sources
Debt in general terms refers to an amount of money one party lends to another, to be repaid later, along with interest. Debt also refers to financial instruments in terms of which a borrower must pay a predetermined amount to the security holder in exchange for capital that the borrower has received upfront.123 Debt is employed by individuals, businesses, legal persons, and governments alike to make purchases, invest in businesses, or establish infrastructure or public services, when the borrower does not have the funds to do these things at the time the money is being borrowed.124
For the purposes of this study, the two forms of debt that will be examined include: bonds and loans.125 The main difference is that bonds are traded while loans are generally not traded unless securitized. Governments borrow mainly through issuing bonds, while corporations borrow through bonds and loans.126
123 Id. at 1. 124 James Chen, Debt, INVESTOPEDIA, (Jul. 15, 2019), https://www.investopedia.com/terms/d/debt.asp. 125 Although debt exists in various forms, all debt can be grouped into a few major categories: revolving debt, mortgages, secured debt, and unsecured debt. See What are the main categories of debt? INVESTOPEDIA (Nov. 6, 2014), https://www.investopedia.com/ask/answers/110614/what-are-main-categories-debt.asp. 126 WALL STREET PREP FOUNDATIONAL COURSE, Crash Course in Bonds and Debt, 6 (2019).
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Debt securities include corporate bonds, certificate of deposit, municipal bonds, government bonds, preferred stock, collateralized securities (including collateralized mortgage obligations [CMOs], collateralized debt obligations [CDOs], zero-coupon securities, and mortgage-based securities issued by the Government National Mortgage
Association [GNMAs]) etc., which can be traded between two parties with basic terms including interest rate, maturity and renewal date, and notional amount defined.127
The interest rate on a debt security is determined by the borrower’s repayment ability as prior determined by the lender. A higher risk of default would lead to higher interest rates, therefore. Debt securities differ from equity securities in that the latter embody claims on the assets and earnings of a company.128 Equity holders are therefore owners of a company and have lower priority than debt holders in cases of liquidation or bankruptcy.
The next two subsections will discuss the sources from which sovereigns get loans. A sovereign could get a loan through several channels including concessional and official sources or from commercial sources. Two classes of concessional funds include: 1) Official Development Assistance (ODA) which has the highest level of concessionality and usually satisfies the requirements of the Organization for Economic
Cooperation and Development (OECD); 2) other official funds which do not meet the aforementioned requirements and may have some degree of concessionality.129
i. Official (and concessional) sources for sovereign borrowing The Bretton Woods International Financial Institutions (IFIs) including the
International Monetary Fund (IMF) and the World Bank Group (WBG) are a crucial
127 James Chen, Debt Security, https://www.investopedia.com/terms/d/debtsecurity.asp (updated Mar. 23, 2018), last visited 08/28/2019. 128 Id. 129 Daniel D. Bradlow (ed.), International Borrowing: Negotiating and Structuring International Debt Transactions, 63 International Law Institute: Washington, D.C. (1994).
Page | 52 source of funds for sovereign nations.130 These institutions are mandated to promote development and economic growth. The loans they give therefore, have more favorable terms than loans granted from commercial and bilateral lenders.131
The World Bank:
What the World Bank does can be encapsulated in one sentence: “It lends for development projects”.132 Five organizations constitute the World Bank Group, including the International Bank for Reconstruction and Development (IBRD) – which
“lends to governments of middle-income and creditworthy low-income countries” and the International Development Association (IDA) – which grants interest-free loans,
“credits”, and grants to the poorest of nations. These two organizations constitute the
World Bank. There is also the International Finance Corporation (IFC) – which is the biggest global institution that focuses on the private sector in mobilizing capital in international financial markets, financing investment to assist developing nations in having sustainable growth and giving advisory services to governments and businesses.
The International Center for Settlement of Investment Disputes (ICSID) – offers facilities for the arbitration and conciliation of international investment disputes. The
Multilateral Investment Guarantee Agency (MIGA) advances FDI in developing nations to alleviate poverty, enhance economic growth and people’s standard of living, by providing political risk insurance or guarantees to lenders and investors.133
Essentially, the Group works with the private sector, civil society, governments, think tanks, regional development banks and other international development institutions
130 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 1 Edward Elgar: Cheltenham, UK (2012). 131 Id at 21. 132 Warren C. Baum, “The Project Cycle” in Daniel D. Bradlow (ed.), International Borrowing: Negotiating and Structuring International Debt Transactions, 67. 133 WORLD BANK GROUP, Five Institutions, One Group, http://www.worldbank.org/en/about (last visited 10/25/2018).
Page | 53 regarding issues including climate change, food security, conflict, trade, finance, agriculture and education.134 In 2012, just after its former president, Jim Yong Kim, took office, the WBG developed two goals that would define their work: 1) “to end extreme poverty by 2030”, and 2) “boost shared prosperity”, with specific focus on the lower 40% of populations in developing nations.135
IMF:
The IMF was founded at the United Nations Bretton Woods Conference, New
Hampshire, in July 1944. The IMF’s main purpose is ensuring that the international monetary system remains stable.136 The IMF has six responsibilities as outlined in
Article 1 of its Articles of Agreement: 1) fostering exchange rate stability; 2) widening the growth of international trade; 3) adjusting imbalances of balance-of-payments in an orderly way; 4) provision of general resources of the Fund temporarily to members; 5) fostering international monetary cooperation; and 6) ensuring exchange rate stability.137
The IMF’s mandate of enhancing international monetary stability is achieved by performing the following functions: 1) surveillance of monetary and economic conditions in member nations and in the global economy; 2) provision of technical assistance and advisory services to member nations; and 3) provision of financial assistance to assist nations to overcome primary balance-of-payments problems.138 The
IMF therefore watches over the policies of member states, and national, regional and global economic events through a system called “surveillance”, in a bid to avert
134 WORLD BANK GROUP, History, http://www.worldbank.org/en/about/history (last visited 10/25/2018). 135 WORLD BANK GROUP, About Jim Yong Kim, http://president.worldbankgroup.org/ (last visited 10/25/2018). 136 The international monetary system refers to the “system of exchange rates and international payments that enables countries and their citizens to transact with each other”. 137 Martin A. Weiss, “The International Monetary Fund”, Congressional Research Service, Summary (May 24, 2018). 138 Id. at 10.
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financial crises and maintain stability in the international financial system.139
Surveillance will be discussed further under the next subheading.
Surveillance:
Although the IMF is mostly known for offering conditional lending to states,
and as an international lender of last resort (ILOLR), it also has the duty to enforce the
formal duties of its sovereign members, as well as sovereign members’ duties regarding
their fiscal policies. The IMF’s Articles of Agreement (Articles) imposes on sovereign
members the duty to maintain their national stability. The main regulatory obligation
of the IMF is to undertake bilateral surveillance of its sovereign members’ execution of
these duties and multilateral surveillance to provide oversight over the global financial
system to ensure that it runs efficiently. Surveillance is therefore technically a method
of enforcement which is based on persuasion rather than coercive sanctions.140
Surveillance became a standard practice of the IMF in order to ensure that the
sovereign members fulfilled their duties following the Second Amendment to the IMF’s
Articles, after the fixed exchange rate system failed.141 There are three types of
surveillance that the IMF undertakes: 1) bilateral surveillance, 2) multilateral
surveillance, and 3) fund surveillance.142 These forms of surveillance will be
subsequently discussed. i. Bilateral surveillance:
139 Id. 140 Adam Feibelman, Law in the Global Order: The IMF and Financial Regulation, 49 N.Y.U. J. Int’l L. & Pol. 687, 690 (2017). 141 See section 3 of Article IV of the IMF’s Articles. 142 Adam Feibelman, 49 N.Y.U. J. Int’l L. & Pol. 687, 688 (2017).
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Based on sections 1 and 3 of Article 4 of the Articles, the IMF undertakes bilateral
surveillance of all the policies of its sovereign members that could affect national
economic stability.143
The methods of undertaking surveillance are cooperative. The main aspects of
surveillance include persuasion and regular discussions. The IMF basically assesses
relevant policies and risks of member nations, and gives advice regarding them. The
said assessments, discussions, and advice given are meant to help sovereign nations to
make policy choices and create a platform to engage with other member nations
regarding those policy choices.144
Surveillance entails more than just monitoring. Annually, the IMF consults with
each member nation in respect of their policies impacting national stability. These are
known as “Article IV consultations”. Essentially, the IMF staff garners pertinent
financial information from and regarding the member nation. The IMF mission
thereafter meets with the policymakers of the nation to get more information. The staff
will eventually write a report for the IMF Executive Board that assesses the nation’s
policies which impact its external and national stability.145 ii. Multilateral surveillance:
The IMF does not impose on member nations to change their policies in order
to ensure the efficient running of the global financial system. It might nonetheless
deliberate the effect the policies of member nations have on the efficient operation
of the global financial system and might propose other strategies that foster the
sovereign nation’s financial stability while ensuring the efficient running of the
143 Id. at 706-7. 144 Id. at 708. 145 Id. at 707.
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global financial system. Finally, bi- and multilateral surveillance both deal with
threats to international financial stability. Bilateral surveillance deals with policies
that might lead to national instability, and eventually contribute to systemic
financial instability. Multilateral surveillance on the other hand simply focuses on
problems that has the potential to impact the effective running of the global financial
system, and spill-over effects from a member nation’s economic policies which
could threaten international economic stability even if they do not present a problem
to that sovereign’s own financial stability.146
iii. Financial surveillance:
Over the previous 20 years, the IMF has substantially widened the scope of its
surveillance of member nations’ economic policies while it undertakes both bi- and
multilateral surveillance. Since the GFC of 2008/9, financial surveillance has
become a substantial part of the IMF’s widening mandate. Essentially, the IMF
undertakes surveillance in relation to global payment mechanisms, policies dealing
with cross-border capital flows, and administration and restructuring of
transnational financial companies.147 Economic stability is therefore one of the main
aspects of IMF surveillance. Three main examples of the IMF financial surveillance
include: 1) the Financial Sector Assessment Program; 2) the IMF’s working with
European sovereign nations to resolve their debt crises and to foster governance and
financial regulation reforms in the European Union; and 3) the IMF’s work to assist
its members to deal with cross-border capital flows.148 Consequently, the IMF has
146 Id. at 710. 147 Id. at 714. 148 Id. at 711.
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begun to exercise a larger regulatory role in the global financial system which
extends beyond its place as a lender to nations in crisis.
It is important to note that since the beginning of the worldwide debt crisis in
1982, the IMF has exercised several roles in sovereign debt workouts. In the 1980s, it played the role of a “master of ceremonies” guiding all stakeholders involved – creditors (bilateral and commercial) and sovereign debtors – towards resolving their disputes. As the IMF is a lender of last resort, it has the leverage to insist that the sovereign debtors undertake economic adjustment programs while requiring other creditors to either defer or adjust their claims against the sovereign debtor so that it can have a “sustainable debt profile”.149
The surveillance responsibility of the IMF is crucial regarding sovereign nations and sovereign debt. Its surveillance systems and facilities enable it to have valuable information about the state of an indebted nation’s economic health. It can therefore step in when a nation is in financial distress and can give valuable input on debt restructuring and other options to alleviate debt crises, and advise the nation on how to make better financial decisions going forward.150
The IMF therefore undertakes a “convening function” in respect of international financial regulation,151 because it has the clout and the resources to pressure the parties
149 This was progress from the approach the “official sector” might have taken in such circumstances previously – in other words, try to change the behavior of recalcitrant sovereign debtors. 150 The IMF used to be very involved in debt restructuring especially when most lenders to sovereigns were commercial banks which were overexposed to risk, and when it was a lender to a defaulting sovereign. The IMF still plays a role in debt restructuring today when it is a lender to a defaulting sovereign. 151 Lee C. Buccheit, “The Role of the Official Sector in Sovereign Debt Workouts”, 6 Chic. J. Int. L. 333, 341 (2005). The official sector in this context is an umbrella term referring to governments of nations where commercial creditors are located and IFIs (including the World Bank, IMF and other regional financial institutions) where these governments are members and have substantial influence.
Page | 58 involved into taking actions that ensure sustainable, economic solutions (such as a sustainable orderly sovereign debt workout). It is hoped therefore that the IMF can use the same clout and resources to take the forefront in “getting the ball rolling” on the normative initiative this study proposes for the regulation of holdout creditors in the sovereign debt market.
Other institutions that grant concessional or multilateral loans include:
• Multilateral financial institutions such as the European Investment Bank,
European Commission, International Fund for Agricultural Development, Islamic
Development Bank, Nordic Development Fund, Nederlandse
Financieringsmaatschappij voor Ontwikkelingslanden NV, OPEC Fund for
International Development.152
• Regional multilateral banks such as the African Development Bank, Asian
Development Bank, European Bank for Reconstruction and Development, Inter-
American Development Bank.153
• Sub-regional multilateral banks such as the West African Development Bank, East
African Development Bank, Caribbean Development Bank, Corporación Andina
de Fomento, Black Sea Trade and Development Bank.154
The above-mentioned institutions have a similar mandate to the World Bank, albeit with a specific emphasis on particular kinds of projects or regions. Multilateral lenders are usually “lenders of last resort”. This means that these institutions have the upper hand: the choice of whether to grant a loan and what the terms and conditions would be.155
152 Id at 21. 153 Id. 154 Id. 155 Id.
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ii. Bilateral sources for sovereign borrowing: Bilateral loans refer to loans that a nation would directly provide to another. The lender and borrower are both sovereigns. There are several methods of granting bilateral loans:
Export credit agencies (ECAs)
ECAs are state agencies that give support to their country’s businesses by growing their investment and exports abroad, and they exist in all big exporting economies, and among other duties, give loans to buyer nations. Publicly funded, they give credit to local companies for investment and exports abroad. They also give credit to buying nations, especially developing nations, to assist them in paying for the goods ECA- backed companies are exporting to them. Both end users and suppliers are therefore provided with credit. ECAs also guarantee credit that private lending institutions such as banks give, to assist exporters and local companies to export goods.156 The loans and credit ECAs provide therefore, are “tied loans”. When they provide credit to a buying nation, that nation is “forced” contractually to buy the goods from the credit-giver, regardless of whether there are other suppliers with lower costs. ECAs give credit on terms which sometimes, can be more beneficial than market rates because their main goal is to support their country’s exporters and businesses. According to Wong, ECAs have been found to be the “largest group creditor” for African nations – for many of these nations, over half of their debts is to ECAs.157 ECAs have made small loans to
156 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 24. 157 These ECAs are located in nations including, the US, United Kingdom (UK), Sweden, Netherlands, Japan, Italy, Germany, France, Finland, Denmark, Canada, Belgium, Austria and Australia.
Page | 60 these countries, but the latter have had to pay back huge amounts in interest and arrears along with the original loans.158
Bilateral loans
Bilateral loans sometimes have profit motives, but like multilateral loans, they are usually granted on political grounds, and are accommodations made for political reasons, therefore. Geopolitical reasons are usually prominent in decisions of whether to make bilateral loans, instead of economic or profit reasons. Creditor nations also have much more discretion and freedom in using bilateral loans to further their political interests, compared to multilateral loans, because there are no other competing interests of other nations to consider. For example, the US and the former Soviet Union gave bilateral loans to nations that had just become independent to gain and solidify solidarity and further respective interests during the cold war. History has also shown that bilateral loans have always been used to buy favor, gain allies, and garner political influence with other nations.159 Many countries, such as China, Australia and the United
States, give bilateral loans to various nations to achieve different objectives including humanitarian assistance, improving military programs and abilities, and economic development. In many cases, the lending nations do not expect repayment – many loans became grants over time or were forgiven. Unfortunately, nations have also granted bilateral loans to dictators because some nations only grant loans to further their interests regardless of the human rights violations that might result.160
A major difference between bilateral and multilateral loans is that the former is more evasive. Bilateral loan transactions are less transparent than multilateral loans
158 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 25. 159 Id. 160 Id. at 26.
Page | 61 because they are between a single lender and borrower. Sometimes, bilateral loans are not documented as properly as multilateral loans because of the absence of resources or technology, or because of the “smaller audience”. With the absence of global laws that insist that bilateral loan documents be uniform, the parties have absolute discretion.
In some cases, they might find it strategically beneficial to prevent transparency of the agreements.161
• Other methods of granting bilateral loans include government debentures,
bonds issued by government agencies, delayed payment for goods and
services, “project specific finance”, and private loans guaranteed by the
government.162
Nongovernmental concessional sources
Nongovernmental organizations (NGOs) in advanced economies gave about
US$6.4 billion to developing nations in 1989. About US$4.2 billion of this amount came in the form of grants. This transfer of funds, reportedly, was greater than the net transfer of funds from the World Bank to developing nations in 1989. These funds were raised through official aid mechanisms and public contributions and used for developmental purposes and emergency aid.163
Some NGOs from the Global South were established as a result of the struggle for independence from colonizing authorities. NGOs in the Global North came on the scene after the First World War including organizations such as the Save the Children
Fund, the Catholic Church-founded CARITAS, OXFAM, and Cooperative for
American Relief Everywhere (CARE) and Catholic Relief Services. Most of such
161 Id. 162 Id. at 24. 163 Daniel D. Bradlow (ed.), International Borrowing: Negotiating and Structuring International Debt Transactions, 277. Some of these organizations – the largest of them – have bigger fiscal purses than aid programs of some nations.
Page | 62 organizations mostly worked to provide relief in war-ravished Europe. They eventually started to work in developing nations to provide poverty relief and other development programs.164 When it turned out that poverty has a political side, they also took on the role of advocacy.165 In any event, funding from these NGOs are useful for nations that find it hard to get capital from other conventional sources of finance or need funds relating to nongovernmental sector causes.166 b) Credit from commercial sources
Institutions who usually grant credit include banks, other financial institutions and private investors. Finance is raised through mechanisms such as bond issues, currency and interest swaps, loan transactions and co-financing arrangements. Raising finance through these sources tends to be more confidential and quicker than other sources.167
Not all borrowers, however, have access to these markets. Commercial lenders are profit-seeking; thus, they have higher standards of creditworthiness. They usually transfer all transaction risks and costs onto the borrowers. Commercial lenders therefore provide expensive finance.
Kemi Adeosun, the former Nigerian Finance Minister, opined that international debt is quite cheaper than domestic debt. Indeed, international financial markets constitute the biggest and most flexible financing source sovereigns have available to them. State governments usually need cheaper and longer-term debt to invest in
164 J. Clark, “What are Voluntary Organizations and Where Have They Come From?” in Daniel D. Bradlow (ed.), International Borrowing: Negotiating and Structuring International Debt Transactions, 279. 165 Id. at 280. 166 Daniel D. Bradlow (ed.), International Borrowing: Negotiating and Structuring International Debt Transactions, 277. 167 Id. at 341.
Page | 63 infrastructure assets, thus, they find debt from foreign sources such as Eurobonds more beneficial than domestic debt in certain cases.168
There are several markets that constitute the international capital markets and they include the following:
i. The eurocurrency market:
This market is one of financial intermediation. Essentially, “deposits are
accepted by banks, funds are commingled before being re-loaned, and the supplier
of the funds, the depositor, looks to the bank rather than to the downstream end user
for return of capital”. Currency that is deposited with a bank outside the nation
where the currency involved is the unit of account”. The eurocurrency that is used
the most refers to the Eurodollar – when US dollars are deposited in a bank that is
off the shores of the U.S. Euromarks are deutsche marks that are deposited in banks
outside Germany and Eurosterling deposits also refer to pound sterlings deposited
in banks that are not located within the UK, and so on. The holding banks are
located in Europe and elsewhere in the world.169
ii. The Asian currency market:
In 1969, an Asian version of the Eurocurrency market, also known as the
“Asiadollar market”, was developed when Singaporean commercial banks began to accept deposits in foreign currency. This market developed because many Asian people and entities had foreign currencies including dollars that were being deposited in
Europe and the U.S. instead of being used for better purposes such as development in
168 Innocent Akoma, Vanguard “$1bn Eurobond: We’ve plenty headroom to borrow further – Adeosun”, https://www.vanguardngr.com/2017/02/nigeria-needs-1bn-eurobond-fund- infrastructural-projects-adeosun/, Feb. 12, 2017, (last visited 08/12/2019). 169 David K. Eiteman, “International Capital Markets” in Daniel D. Bradlow (ed.), International Borrowing: Negotiating and Structuring International Debt Transactions, 343.
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Asia. Essentially, the idea was that “[A] regional version of the Eurocurrency market would serve both investors and entities that wanted to borrow American or European funds by providing a mechanism to reinvest in Asian projects”.170 iii. The international bond market:
Bonds are sold to investors who are not from the issuer’s nation on the
international bond market. International bonds are either Eurobonds or foreign
bonds. Borrowers issue bonds (to foreign investors) which are underwritten by a
syndicate that comprises members from a single nation other than the borrower’s,
sold mainly and denominated in the currency of that nation. Foreign bonds traded
in Japan are sometimes referred to as “samurai bonds” and foreign bonds traded in
the U.S. have been called “Yankee bonds”. A Eurobond on the other hand, is
guaranteed by a syndicate of banks and securities firms from several nations and is
traded to investors in other nations apart from the nation of the issuer. The Eurobond
could be denominated in the currency of the issuer’s country. American firms that
issue Eurobonds in Europe usually have them denominated in U.S. dollars.171
British firms have also been known to issue Eurobonds denominated in Eurodollars
or Swiss francs. Eurobonds have sometimes been denominated in Special Drawing
Rights (SDRs).172
The Eurocurrency and Eurobond markets are quite similar because contractual
obligations in a certain currency which are executed in a nation other than the nation
in whose currency the bonds are issued. The eurocurrency market, nonetheless, is a
market where financial intermediation takes place – big banks operate as
170 Id. at 344. 171 Id. at 346. 172 Id. at 347.
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intermediaries between depositors and borrowers of Eurocurrencies. The Eurobond
market on the other hand, is a “direct market” where investors hold bonds that have
been issued by the final borrowers. Institutions in this market execute “an
underwriting and direct marketing function”.173
Finally, it is worthwhile to talk about “currency cocktail bonds”. Fluctuating
market-based exchange rates have been known to make servicing of debt
denominated in foreign currencies more uncertain and expensive. This resulted in
the practice of issuing bonds that are in various multicurrency units – so-called
“currency cocktails” – which constitute a “weighted average of several currencies”.
The actual subscription to the bonds, and principal and interest payments are not
made in the currency cocktail.174 Payments instead, are made in any of the
currencies that are part of the cocktail, in “an amount sufficient to ‘buy’ other
components of the unit at current exchange rates and in the proportion defined by
the unit”. Essentially, diversification makes the cost of servicing the debt cheaper
and more stable than the cost of servicing debt issued in just one currency.
According to the portfolio theory, a portfolio of securities usually has “a lower
standard deviation of expected returns than the standard deviation of expected
returns from a single security within that portfolio”.175 c) Other market-driven channels for private capital flows i. Foreign direct investment (FDI)
When a person or company from one country invests in a business located in another country, such as by establishing a subsidiary company abroad, or buying
173 Id. 174 Id. 175 Id. at 348.
Page | 66 business assets abroad, they are engaging in FDI.176 FDI is therefore, a type of investment which could provide a long-term and reliable source of finance for investment. Generally, FDI growth has been quite modest in Africa since the Monterrey
Consensus in 2002.177 It increased by about 1.5% of GDP between 2002 and 2013.178
FDI flows to SSA, for example, nonetheless, reached about $17.1 billion in 2006, and causing it to be the second largest external funding source in the region. Almost all private capital flows to Low Income Countries (LICs) in SSA are in the form of FDI.179
FDI has usually been concentrated in extractive industries, but there has been much diversification in FDI flows to Africa. The value of FDI flows from China has continued to increase. Besides, inter-regional FDI has been on the increase, showing that regional corporations in manufacturing, telecommunications and financial services have been on the rise.180 Due to the political risk associated with FDI, Bilateral Investment
Treaties (BITs) are usually concluded for protection of foreign investment, by stipulating consistent action regarding foreign investors in relation to profit repatriation, dispute settlement, and the expropriation of property.181
176 INVESTOPEDIA, Foreign Direct investment – FDI, https://www.investopedia.com/terms/f/fdi.asp (last visited 10/12/2018). 177 United Nations Economic Commission for Africa, Development financing in Africa, 13 Economic Commission for Africa: Ethiopia (2017). The Monterrey Consensus refers to a convention and agreement concluded by heads of state from around the world when they gathered in Monterrey, Mexico, on March 21-22, 2002, to resolve the issues surrounding financing for development, especially in the developing world. Their main goal was to “eradicate poverty, achieve sustained economic growth and promote sustainable development as we advance to a fully inclusive and equitable global economic system”. The Consensus acknowledged that mobilizing financial resources and encouraging their effective use was essential to achieving globally agreed development goals such as the MDGs. See UNITED NATIONS, Monterrey Consensus on Financing for Development, http://www.un.org/esa/ffd/monterrey/MonterreyConsensus.pdf (last visited 10/08/2018). 178 Id. 179 Suhas Ketkar & Dilip Ratha, “Innovative Financing for Development: Overview” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 149. . 180 United Nations Economic Commission for Africa, Development financing in Africa, 14 Economic Commission for Africa: Ethiopia (2017). 181 Rumu Sarkar, Transnational Business Law: A Development Law Perspective, 236 Kluwer Law International: The Hague (2003).
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FDI transactions and sale of government assets or concessions have been a major source of finance for sovereign nations, even though they are not loans. These include the sale of things like property rights, tax holidays, land concessions, crude oil, jewels, and timber. As bilateral loans are, these financing sources are governed by local regulations.182 Countries have absolute discretion to decide what resources it would sell, and the extent to which FDI would take place within its territories, because of its sovereign immunity. FDI transactions and sale of government assets or concessions are usually made based on a range of factors including geopolitical interests and political interests.183
FDI has been found to be an investment form that is favored because it causes a medium-to-long term relationship between the host nation and the foreign investor to develop. FDI might help the host country and the sector in which it would operate be more marketable. Nonetheless, it usually entails a lot of oversight and supervision from investors and has therefore been refused for political reasons. Many nations have found it too risky to reveal their financial status and business to investors. Many developing countries put up protectionist policies to protect their economies from outside influence because they believe that the concept of free trade operates in a way that is biased against them.184 ii. Foreign Portfolio Investment (FPI)
A major part of the financial resources that are mobilized for Africa’s development is portfolio investment in the form of bonds and equities.185 Their unstable
182 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 30. 183 Id. at 31. 184 Rumu Sarkar, International Development Law: Rule of Law, Human Rights and Global Finance, 263. 185 Development Financing in Africa, United Nations Economic Commission for Africa, 14 (2017).
Page | 68 and short-term nature make them quite risky investment. A UNECA 2017 report states that –
Portfolio flows can be attracted by opportunities for speculation and have been
associated with asset bubbles, especially in real estate and stock markets, and
with financial crises in developing countries. This association is explained
partially by the fact that the scale of such inflows has often been contrasted
with the relatively small size of the recipient domestic markets.186
Due to “push factors” in bigger economies because interest rates are sometimes
driven down by “quantitative easing”,187 investors look for yield opportunities
outside advanced countries, and this has resulted in “strong portfolio flows to
Africa”, and the rest of the Global South. Such flows, have however, acquired a
volatile and uncertain nature because of speculation concerning quantitative easing
in 2013 and 2014.188 Portfolio flows, unfortunately, have been found to go almost
exclusively to South Africa. FPI has been found to be quite low in low- and middle-
income sub-Saharan African nations. Some of the reasons for this might be: 1) due
to the absence of information, investors might be worried about making FPI;189 2)
the securities markets are relatively thin and illiquid; and 3) a “severe risk
perception” exists.190
186 Id. 187 Quantitative easing refers to an unusual monetary policy where a central bank buys government securities or other securities with the aim of lowering interest rates and enhancing money supply. See INVESTOPEDIA, Quantitative Easing, https://www.investopedia.com/terms/q/quantitative-easing.asp (last visited 10/12/18). 188 United Nations Economic Commission for Africa, Development financing in Africa, 14 Economic Commission for Africa: Ethiopia (2017). 189 Dilip Ratha et al., “Beyond Aid: New Sources and Innovative Mechanisms for Financing Development in sub-Saharan Africa” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 151. 190 Id. at 152.
Page | 69 iii. Project finance
Project finance is a mechanism whereby funds are raised for projects – especially in the mining, infrastructure, and energy sectors. It has also been employed in relation to public-private-partnerships (PPPs) to finance projects where private companies working with the government would deliver services traditionally provided by the government. International project financing exists where the project involved has parties and/or financing from more than one nation.191 Project finance is part of the broader group of financial mechanisms called “structured finance”. This means that an asset (or assets) that generate income is isolated to be the source from which the debt would be repaid, and repayment obligations are transferred from the person or entity that developed that asset to the income stream the asset generates. The cash flows generated by the asset or group of assets is therefore utilized as the essential source of repayment instead of the “balance sheet of the originator of the transaction”.192 Project finance presents a different mechanism, apart from sovereign borrowing or corporate finance, for financing projects that rely on the cash flow the project itself produces and does not depend totally on the solvency or creditworthiness of the corporation or government involved.193 The sponsor of the project would develop a new entity which is usually called the “Project Entity” or the “Special Purpose Vehicle” (SPV). The SPV owns the project assets, concludes contracts, and acts as borrower of the money raised for the project. The SPV essentially is the pivot of all the activities surrounding the project.194
191 John M. Niehuss, International Project Finance in a Nutshell, 1 Thomson Reuters: Minnesota (2010). 192 Id. at 2. 193 Id. at 3. 194 Id. at 4.
Page | 70 iv. Trade financing
Trade finance relates to the funding of imports and exports.195 Trade finance is good for very poor, developing nations, who have not been able to get funding from commercial lenders. Banks are willing to lend states money when traded goods can serve as collateral for the loan.196 An efficient trade finance system requires infrastructure for trade finance, and is helpful if: 1) granting support services to manage the risk involved in these transactions; 2) providing international payment devices; and
3) granting capital to companies that engage in international trade.197
At the Monterrey Consensus on Financing for Development, trade was acknowledged as a mechanism of growth.198 Africa has two trade issues: 1) diversifying trade into diverse services and goods, rather than just raw materials; and 2) the volume of trade needs to be increased in Africa and internationally.199 Trade within Africa has been quite low. Unfortunately, many African nations have found it easier to trade with foreign countries than with their fellow African nations, due to the existence of trade barriers such as unnecessarily complicated customs procedures and corruption, poor infrastructure, and tariffs.200 A UNECA report states as follows:
A recent study of trade finance in Africa estimated unmet annual demand at around
$110 billion and identified barriers to meeting that demand as low United States dollar
liquidity, low regulation compliance, and the inability to assess the creditworthiness of
potential borrowers. The lack of capacity in commercial banks implies that
195 See Stephen Spratt, Development Finance: debates, dogmas and new directions, 300 Routledge: New York (2009). 196 Id. at 301. 197 Id. at 300-301. 198 DOCUMENT AND COMMENTARY: United Nations Report of the International Conference on Financing for Development Monterrey, Mexico, 18-22 March 2002, 10 Law & Bus. Rev. Am. 85. 199 United Nations Economic Commission for Africa, Development financing in Africa, 19-20 Economic Commission for Africa: Ethiopia (2017). 200 Id. at 21.
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governments and development finance institutions have a major role to play in
financing trade.201 d). International capital market bond financing
Capital markets, which consist of bonds and equity, are crucial parts of the financial system that are employed to finance development. Capital markets usually make available funds for investment in advanced financial systems. The capital markets in the Global South, particularly African nations, are still underdeveloped unfortunately. Capital markets abroad have more liquidity, better legal frameworks, and stronger market regulation. They also foster “investor participation in primary issuances, especially from international institutional investors, and so enlarge the pool of potential capital and ensure optimal pricing for such issuances”.202
Over time, financial markets and countries have innovated ways of financing development in times of distress, especially in the international capital market.203
Such innovations in financing include:
i. Diaspora bonds
Citizens in the diaspora and the economic heights they have attained are not just a thing of pride but are becoming a source of development finance. Through remittances, a country can tap into income flows from the diaspora regularly. One of the ways to tap into the wealth of the diaspora that has been accumulated in other countries is to issue “hard currency-denominated bonds”.204
201 Id. 202 Development financing in Africa, United Nations Economic Commission for Africa, 18 (February 2017). 203 Id. 204 Suhas Ketkar & Dilip Ratha, “Development Finance via Diaspora Bonds” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 59. Diaspora bonds have not yet been widely used for development financing. India since 1991 and Israel since 1951 have been raising funds through diaspora bonds from their citizens in diaspora. The Development
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Diaspora bonds are a source of finance for development.205 These bonds are usually long-term securities which may only be redeemed upon maturity and cannot just be withdrawn at any time. The proceeds from such bonds can thus be used for development.206 Citizens in the diaspora are attracted to such bonds because of their patriotism, and because they are an option for diversifying risk. Investors in the diaspora have been reported to exhibit more forbearance than dollar-based investors if the issuing country was approaching insolvency. Diaspora bonds can therefore be sold at a substantial yield discount.207
ii. GDP-indexed bonds
Essentially, GDP-indexed bonds “pay an interest coupon based on the issuing country’s rate of growth”.208 Griffith-Jones and Krishnan Sharma give an example to explain GDP-indexed bonds as follows:
An example would be a country with a trend growth rate of 3 percent a year
and an ability to borrow on plain vanilla terms at 7 percent a year. Such a
country might issue bonds that pay 1 percentage point above or below 7 percent
for every 1 percent that its growth rate exceeded or fell short of 3 percent. Of
course, the country would also pay an insurance premium, which most experts
expect to be small. Whether the coupon yield needs to vary systemically, in
line with the gap between actual and trend growth and on both the upside and
the downside, is an open question.209
Corporation for Israel issued bonds to Jews in the diaspora of over $25 billion. Similarly, the State Bank of India has raised over $11 billion from Indians in the diaspora. 205 Suhas Ketkar & Dilip Ratha, “Innovative Financing for Development: Overview” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 7. 206 Suhas Ketkar & Dilip Ratha, “Development Finance via Diaspora Bonds” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 60. 207 Suhas Ketkar & Dilip Ratha, “Innovative Financing for Development: Overview” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 7. 208 Stephany Griffith-Jones & Krishnan Sharma, “GDP-Indexed Bonds: Making It Happen” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 79. 209 Id. at 79-80.
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GDP-indexed bonds “link the coupon to the economy’s performance”. This characteristic of GDP-indexed bonds allows the issuing nations to have countercyclical economic policies, thus, reducing the risk of default. One of the main reasons why issuers could pay yield premium on the bonds is because of the decreased risk of default.
Creditors may also willingly accept a yield discount for this reason.210
Some concerns investors have had with GDP-indexed bonds include: 1) concerns about whether such bonds are liquid enough; 2) concerns about possible inaccurate reporting of GDP data; 3) concerns about the problems involved in pricing such bonds.211
Nations raising funds through GDP-indexed bonds however enjoy two benefits.
First, GDP-indexed bonds decrease the likelihood of debt crises because debt service ratios fall in periods of little economic growth. Crises have negative effects on growth, production, and the financial situation of the issuing country.212 Second, GDP-indexed bonds decrease the procyclicality of fiscal pressures by requiring that smaller interest payments be paid in periods of slower growth. This allows space for more fiscal spending or at least prevents more taxes from being imposed on citizens. These bonds also make national spending more secure.213 According to Griffith-Jones and Krishnan
Sharma, expanding more on this point:
By allowing greater fiscal space during downturns, growth-indexed bonds can
also be thought to disproportionately benefit the poor by reducing the need to
210 Suhas Ketkar & Dilip Ratha, “Innovative Financing for Development: Overview” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 7. 211 Id. at 87. 212 Id. at 81. 213 Id. at 80.
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cut social spending when growth slows. They could also curb excessively
expansionary fiscal policy in times of rapid growth.214
An issue is that nations that could benefit from GDP-indexed bonds the most could find it difficult to issue bonds based on reasonable premiums, because of markets that question the policy and economic circumstances of the issuing countries. It would therefore be more beneficial if GDP-indexed bonds are first issued by nations that have more credibility, especially if GDP-indexed bonds are to be widely used for development finance.215 Future-flow securitization
A relatively new financial instrument is securitization.216 A future-flow transaction exists when the borrower, also called an “originator”, sells its receivables to a Special Purpose Vehicle (SPV), directly or indirectly. The SPV would thereafter issue the debt instrument. Obligors or international clients are then told to pay for the exports from the borrower directly to an “offshore collection account” which a trustee manages. The collection agent would distribute the receivables to the SPV, which thereafter, would pay the investors principal and interest payments. The borrower would receive any excess collections.217
The advantage from such securitization is that receivables in the form of hard currency do not get to the borrower until all the bondholders have received their payments. The borrower therefore cannot prevent service of securitized bonds according to schedule. This structure alleviates risks relating to convertibility and transfer, and allows developing nation-borrowers to get financing at lower interest rates
214 Id. 215 Id. at 81. 216 Suhas Ketkar & Dilip Ratha, “Future-Flow Securitization for Development Finance” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 25. 217 Id. at 26.
Page | 75 with longer maturities and go beyond the sovereign credit ceiling.218 The risks securitization does not alleviate are: 1) product risk related to the stability of receivables because of fluctuations in volume and price; 2) diversion risk of the borrower insisting that sales be made to clients that have not been selected; and 3) performance risk associated with the capability of the issuer to produce the receivables.219
Securitized transactions first appeared in the 1970s in the US and involved gathering and repacking home mortgages for lenders to resell as tradable securities.220
Securitized markets have therefore become more sophisticated to cover a broad range of assets.221 Securitizing a broad range of future-flow receivables including tax income, net international phone charges, credit card vouchers, exports of natural resources and agricultural raw materials, and paper and electronic remittances, has been dominant in developing states. In recent times, banks have been securitizing payments that flow through the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system – essentially, diversified payment rights (DPRs). Securitization of net international phone receivables was fist achieved by Telmex in Mexico in 1987, and since then, many sovereign (especially developing ones), sub-sovereign and private sector borrowers have employed future-flow securitization to raise about USD80 billion.222 Rating agencies including Moody’s, Standard & Poor’s and Fitch Ratings, have rated over 400 transactions.223 Developing-nation issuers found that due to the structure of these securities allowing issuers to go beyond the sovereign credit ceiling,
218 Id. at 27. 219 Suhas Ketkar & Dilip Ratha, “Innovative Financing for Development: Overview” in Suhas Ketkar & Dilip Ratha (eds.) in Innovative Financing for Development, 8. 220 Id.at 25. 221 Id. at 25-26. 222 Id. at 26. 223 Id. at 34.
Page | 76 market placements which were based on hard currency receivables came in handy when the country was in financial distress.224 e) Resources-for-infrastructure investments (R4I)
R4I transactions, also known as the Angola Mode,225 are a financing mechanism through which a state can gain crucial infrastructure assets without first having the funds required to finance such assets. This is one of the main benefits of this financing model. This model also enables a state government to work with the private sector in resource projects, and to employ nonrecourse financing to shield the state’s public purse from credit exposure. It is particularly useful when a state licenses a private developer to exploit its mineral resources, and the state borrows against the anticipated revenue from the resource and infrastructure development project.226 From its name, it is obvious that this is an infrastructure financing option for resource-rich nations.
The R4I financing model entails three steps that are interconnected. Firstly, the state issues a resource development/production license which would have a firm development timeline and a fiscal regime that shows clear revenue streams to the state when the mineral resource is being developed. Secondly, the said revenue streams the state is set to receive is promised to a lending institution as collateral for credit received.
224 Id. at 26. 225 It is called the Angola Mode because the first R4I agreement was concluded in Angola. China’s Exim Bank furnished a $2 billion loan to fund the reconstruction of critical infrastructure assets destroyed during Angola’s civil war. The loan was to be repaid through the export income from 10,000 barrels of oil daily over 17 years. This initiative was quite successful as it enabled Angola to diversify her oil-reliant economy, provided jobs for low-skilled Angolans, and assisted in the restoration of Angola’s poor infrastructure. See Peter Konijn (September 2014) Chinese Resources-For Infrastructure (R4I) Swaps: An Escape from the Resource Curse? Occasional Paper 201 South African Institute of International Affairs, pg 8. 226 Maria Ifeoluwa Oluyeju, Resource-for-Infrastructure (R4I) Investment Agreement Between Resource-Rich sub-Saharan African (SSA) Countries and Corporate Developers: A Cooperative Pursuit of Mutual Interests or Poisoned Chalice? 8 (unpublished LL.M. dissertation) (on file with the O.R. Tambo Law Library, University of Pretoria) (2017).
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Finally, contracts are concluded with the entities that would undertake relevant construction projects.227
This financing model has been criticized however, because there is little or no transparency in the negotiation and implementation of R4I transactions, as well as worries about self-dealing and corruption.228 There has also been concerns that some of the infrastructure that were products of this financing model were either “vanity projects” that do not really meet the country’s needs, or not of good quality, and/or not properly maintained.229
Given the discussion on composition of credit flows for capital formation and development financing, the next section will specifically focus on bonds.
3.3. Bonds
The archetypal type of a bond is the “bullet bond”, which is the vanilla or conventional bond. Essentially, the full principal is paid on the maturity date rather than amortize the bond over its lifetime. The issuer cannot redeem the bullet bond early therefore they are callable. Bullet bonds therefore pay a relatively low interest rate because of the issuer’s interest rate exposure.230 Bonds with shorter maturities are called notes. Other bonds include the annuity bond and the zero-coupon bond. An annuity bond refers to a fixed-rate bond that pays out the same amount of money to the bondholder every year over the term of the bond.231 A zero-coupon bond on the other hand is a bond which does not pay interest hence being traded at a huge discount, and
227 Id. at 38. 228 Havard Halland et al., Resource Financed Infrastructure: A Discussion on a New Form of Infrastructure Financing, 13 The World Bank: Washington DC (2014). 229 Id. at 13-14. 230 James Chen, Straight Bond, https://www.investopedia.com/terms/b/bulletbond.asp (updated Feb. 23, 2018), last visited 08/28/2019. 231 COLLINS DICTIONARY, annuity bond, https://www.collinsdictionary.com/dictionary/english/annuity-bond (last visited 08/29/2019).
Page | 78 provides the profit at maturity when the bond is redeemed for its entire face value. As these bonds only pay at maturity, they usually fluctuate in price more than coupon bonds. A zero-coupon bond is also called an accrual bond.232 The interest that is paid, usually semi-annually is known as the coupon. The price paid for the bond is the bond price which in formulas is called the present value (PV). The price the borrower will pay the bondholders at maturity is referred to as the bond’s principal, par value, or face value. In bond formulas, this is known as future value (FV). The rate of interest that will be paid to the bondholders is called the coupon rate, and also known as the nominal yield or nominal rate. The duration of the loan is called the loan term.233
When bond price is greater than par value, it is said that the bond is at a premium. When a bond price is less than par value, it is said that the bond is at a discount. Bonds are often traded in $1,000 denominations. Bond prices are quoted as a percentage of par value, and the % is usually removed. The price of a bond is 95.15 or
95.15%. The number before the decimal point is called “the handle”. The decimals are referred to as the “bps” or “basis points”. One basis point is 1/100th of 1%. Corporate bonds are rounded to the nearest 1/8th. 98.32 will therefore be quoted as 98.375.
Government bonds are rounded to the nearest 1/32nd, thus 98.32 will be quoted as
101.030125.234
Bond transactions between issuers and buyers occur in the primary market.
Bond transactions between non-issuer sellers and buyers occur in the secondary market.
Usually, brokers (which are middlemen) buy from the seller at a low price or bid and
232 James Chen, Zero-coupon bond, https://www.investopedia.com/terms/z/zero-couponbond.asp (updated Jul. 7, 2019), last visited 08/29/2019. 233 WALL STREET PREP FOUNDATIONAL COURSE, Crash Course in Bonds and Debt, 16-7 (2019). 234 Id. at 34.
Page | 79 sell to a buyer at a higher price or ask. The difference – the bid-ask spread – is the dealer or market maker’s profit.235
3.3.1. Bond conventions
Debt instruments and derivatives therefrom are highly structured transactions that evolved before the integration of capital markets.236 Various national bond markets have thus created their own rules for quoting bond prices and yields, paying coupons, and for calculating accrued interest.237
Some bond conventions will be explained below:
i. Price:
The preliminary price of most bonds is usually set at par – typically $100 or
$1,000 face value per individual bond. The price of a bond is determined by
certain factors including: the amount of time until maturity; issuer’s
creditworthiness or credit quality, and the coupon rate compared to the general
interest rate. The issue price is the price at which the issuer initially sells the
bonds.238
For instance, if a bond is quoted in terms of a hypothetical 100 par value,
the quote can be interpreted as a percentage of par. If a US Treasury bond is
quoted at $90, this can be interpreted to mean that the market value of the bond
is 90% of its face value so that a $40 million face value Treasury bond
investment would be worth $36 million. Another common practice, albeit not
worldwide, is to quote in terms of decimal values. US Treasury bonds are quoted
235 Id. at 42-3. 236 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 2. The UK bond market developed from the 1694 £1.2 million loan to fund a war with France. 237 Id. 238 Adam Hayes, Bond, https://www.investopedia.com/terms/b/bond.asp, updated Jun. 25, 2019 (last visited 08/29/2019).
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in terms of 1/32 (3.124 cents) and 1/64 (1.5625 cents), therefore, a quote of $90-
3 means a price of $90 plus 5/32 or $90.15625 per $100 of face value. If the
bond price is quoted with a plus sign such as $90-5+, one extra 64th is added so
the price will be $90.171875.239
Bond prices are inversely linked to interest rates – when rates increase,
bond prices fall and vice versa.240
ii. Settlement date:
Ownership of the bond usually changes hands on the date of trade
depending on the level of its liquidity.241
Most liquid bonds such as UK gilts have at least one day between
transfer of ownership and the date of trade. Bonds that are not as liquid such as
Eurobonds are settled five business days from the date of trade, therefore
settlement is T + 5. This time is needful for the back offices of the investment
banks to do all the needed paperwork to finish the trade. The settlement date is
crucial because the seller can only receive compensation for accrued interest
only up to the date that ownership of the bonds transfer.242 iii. Maturity date:
This refers to the date the bond matures, and the issuer pays the
bondholders the face value of the bond.243 iv. Coupons:
239 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 2 Elsevier Butterworth-Heinemann: Massachusetts (2005). 240 Id. 241 Id. 242 Id. 243 Adam Hayes, Bond, https://www.investopedia.com/terms/b/bond.asp, updated Jun. 25, 2019 (last visited 08/29/2019).
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Coupon rates are sometimes quoted at annual rates but are paid semi-
annually.
In many national bond markets including the US, Japan, Italy, Canada,
Britain and Australia, a 6% seminal coupon bond would pay $3 per $100 of face
value in six months and $3 per $100 again at the end of the year. In most
European capital markets such as the Eurobond market, Germany and France,
coupons are quoted at annual rates and paid annually. The 6% coupon pay bond
would therefore pay €6 per €100 of face value.244
v. Coupon dates:
This refers to the dates on which the issuer will pay interest, which is usually semi- annually.245 vi. Accrued interest:
This is interest that is earned on the bonds. Accrued interest is sometimes calculated based on the actual/actual day count conversion.246
Accrued interest is crucial because it differentiates between the clean or flat price and dirty or full price. The clean price does not take into account any accrued interest, while the dirty price is the clean price plus the accrued interest.247
When purchasing a bond halfway into the next coupon period, interest must be calculated in order to be included in the purchase price. Interest is calculated thus: the ratio between the number of days that have elapsed since the last coupon payment was made and the number of days that are in the coupon period is calculated; this ratio is
244 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 2. 245 Adam Hayes, Bond, https://www.investopedia.com/terms/b/bond.asp, updated Jun. 25, 2019 (last visited 08/29/2019). 246 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 3. 247 WALL STREET PREP FOUNDATIONAL COURSE, Crash Course in Bonds and Debt, 100; 102 (2019).
Page | 82 then multiplied by the coupon payment to calculate the accrued interest to be paid to the seller of bond. Many bond markets have tried to streamline the calculation of accrued interest by estimating the number of days in the month to 30, and the number of days in a year to 360. This 30/360-day count method provides that the ratio required to calculate accrued interest views each semi-annual coupon period as 180 days and calendar month as 30 days. The actual/actual day count method on the other hand employs the calendar to calculate the actual days that have passed since the last coupon was paid and the actual number of days in the said coupon period. The actual/actual day calculation is easier done using a computer; the 30/360 calculation can be done by hand.248 vii. Yield:
The yield refers to the profits an investor makes on a bond. Various methods of calculating a bond yield exist, and some of them take into consideration the compounding interest payments and time value of money, including the Effective
Annual Yield (EAY), Yield to Maturity (YTM), and Bond Equivalent Yield (BEY).249
Yields are sometimes quoted at annual rates founded on semi-annual compounding.
This is usually referred to as bond equivalent yield (BEY). For instance, if there is a 6% semi-annual coupon bond that matures in 10 years and is quoted at 98.32 and yields
6.228%. This means that the bond costs $98.32 per $100 face value. The bond will pay
$3 semi-annually for a decade; 20 payments in total. The final payment will be $103
($100 principal + $3 yield). The yield (also known as the internal rate of return) for the bond investment is 3.114% (6.228% annual yield / 2).250
248 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 3. 249 James Chen, Bond Yield, https://www.investopedia.com/terms/b/bond-yield.asp, updated Jul. 22, 2019 (last visited 08/29/2019). 250 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 3.
Page | 83 viii. Issue size:
This refers to the “face value trade” of bonds. A set of 100 bonds where the face
value of each bond is 1000 therefore has a face value trade of 100,000.251
ix. Face value:
This refers to the amount of money that the bond will be worth at maturity, and it
is the reference amount that is used when calculating interest payments.252
The next section will discuss bond markets.
3.3.2. Bond markets
Sovereign governments have realized the importance of improving liquidity in
their national sovereign debt markets. Liquidity is very important to investors because
it enables them to be able to sell their investment as quickly and cheaply as possible
when they want to. Bond investors therefore find it worthwhile to invest in relatively
low coupon bonds at par if they believe that these bonds will be easier to dispose of at
the current market price later in the future. Sovereigns have therefore endeavored to
enhance liquidity by issuing “plain vanilla” straight bonds that have key maturities,253
so that they can save on interest costs by issuing low coupon, liquid bonds.254
Straight bonds are bonds which pay interest at regular intervals and it pays back
the principal that was initially invested at maturity.255 Straight bonds are easier to value
and trade,256 and most sovereign bonds are straight bonds. Concentrating bond issues
at key maturities ensures that issue size increases. This is helpful to enhance liquidity
251 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 2. 252 WALL STREET PREP FOUNDATIONAL COURSE, Crash Course in Bonds and Debt, 16 (2019). 253 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 3. 254 Id. 255 James Chen, Straight Bond, https://www.investopedia.com/terms/s/straight-bond.asp (updated Feb. 16, 2018), last visited 08/27/2019. 256 Id.
Page | 84 because a bigger issue size ensures a larger possibility that investors will buy the bonds and trade them regularly. Bigger bond issues at key maturities may be seen as
“benchmark” issues which can be utilized to determine the comparative attractiveness of “non-benchmark issues”, improve the liquidity of those bonds, and ultimately improve the entire sovereign bond market.257
Another market that is linked to domestic bond markets is the international bond market. The Eurobond market is about the biggest section of the international bond market. London is the financial center of trades in this market. Sovereigns issue
Eurobonds (as well as corporations and semi-governments) and are traded through several international investment banks to investors from various nations. This can get quite complicated because if a bond is sold in several jurisdictions simultaneously, traders might be unsure of the laws that must be obeyed in these jurisdictions in respect of these trades. The International Securities Market Association (ISMA) was therefore formed to address this issue and is financed by the investment bank members who agree to a set of trading conventions and dispute mechanisms applicable when completing trades on the Eurobond market.258
3.3.3. Sale of bonds
Bonds and interest sensitive instruments associated with them are usually traded over the counter. International investment banks therefore have their own trading floor or department where traders are set up in rows in open plan style, with each trader having a computer and telephone for communicating their trades. Each trader usually
257 Id. 258 Id. at 7. The Eurobond is attractive because possession determines proof of ownership; it a bearer bond. Many domestic bonds are registered hence the seller knowing the owner’s name and address. This allows the taxing authority to be able to tax coupon income at the source if the bond is registered, but it is more difficult to tax income at source if the bond is a bearer bond.
Page | 85 has access to information terminals including Bloomberg and Reuters that provide the latest information on businesses and activities in the market that they are trading in.
The traders are set up in desks and operate in such a way that each desk is responsible for all the trading in a certain market segment. Trading activity is largely based in New
York, London, and Tokyo. The traders work quite long hours but are duly compensated for their work. They deal in several currencies depending on the instruments they are trading in. English is the main language of communication, but many traders are able to speak other languages such as French, German, Japanese, and Spanish. This over- the-counter market is global.259
3.3.4. Sovereign bonds issue
Sovereign bonds are issued in a different way from equity securities. The issue of sovereign bonds is a crucial part of a country’s bond market. There are two types of auctions where sovereign debt is sold: the American and Dutch auctions.260 These auctions have no geographic attachments. The US government uses both types of auctions for various maturities of US Treasury bonds.261
Sovereign nations issue bonds to finance necessary government functions and infrastructure and reduce finance costs at the same time. What works for one country may not necessarily work for another.262 These auctions will be discussed as follows:
i. American auction
Competitive and non-competitive bidders engage in the American auction.
Competitive bidders stipulate the price and amount they want to pay. Non-competitive
259 Id. at 8. 260 An auction, in general, is a place where sales take place and potential purchasers are allowed to bid competitively on goods and services in an open or closed form. See Will Kenton & Caroline Banton, Auction, (Jun. 25, 2019), https://www.investopedia.com/terms/a/auction.asp. 261 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 36. 262 Id.
Page | 86 bidders stipulate only the amount of bonds they are willing to purchase. The price the non-competitive bidders pay and the yield they will receive will be determined as the average of the successful competitive bids. The most non-competitive bidders can bid for is a very low amount. For instance, the maximum amount a non-competitive bidder can bid for in the US is $1 million. The reason this is the case is likely to limit non- competitive bids to smaller investors. The issue with the American auction is the
“winner’s curse”.263 The winner’s curse is a propensity for the winning bid in an auction to surpass the inherent value or actual value of an item. Due to emotions, incomplete information and other subjective factors regarding the item being auctioned, bidders can be influenced and have a hard time in determining the item’s accurate inherent worth. The biggest overestimation of an item’s value therefore winds up taking the item home.264 This creates caution and discourages hostile bidding while incentivizing collusion.265
ii. Dutch auctions
The major difference between the American and Dutch auctions is that in the latter, the lowest price or highest yield required to sell the whole offering is the price at which all competitive and non-competitive bids are sold. The competitive bids are distributed based on classes A, B, C, etc. Some bids receive a pro rata share while some are shut out; it is therefore sensible for small bidders to submit non-competitive bids.266
The main disadvantage of the Dutch auction from the sovereign issuer’s viewpoint is that they might wind up paying a higher interest rate. The benefit is that it
263 Id. at 37. 264 Adam Hayes, Winner’s Curse, https://www.investopedia.com/terms/w/winnerscurse.asp (updated 04/29/2019), last visited 08/27/2019. 265 Frank Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments, 38. 266 Id.
Page | 87 incentivizes aggressive bidding because it decreases the likelihood of the so-called winner’s curse. If a bidder suspects that their competitors are bidding low, there is an incentive to bid high because they will get their entire bid at the higher yield. If, on the other hand, they suspect that their competitors are bidding high prices, there is the incentive to submit low bid prices as this will lower the price for them and everyone else, but they may be shut out. The better plan is to bid at what they think is the right price as there is no incentive to bid at cautious, lower prices.267
Finally, from the sovereign’s viewpoint, it is not that obvious that the Dutch auction is more expensive. The US Treasury nonetheless uses the Dutch auction for most of its auctions.268
3.3.5. Repo markets
Repo markets exist for sovereign bonds. A repo is essentially a sale and repurchase agreement. If a bond trader does a repo, they will trade their sovereign bonds while simultaneously agreeing to buy it back some days later at a higher price.
Basically, the trader is still “long” the sovereign bond.269 As the trader has agreed to buy the sovereign bond back at a predetermined price soon afterwards, any increase in value resulting from a decrease in interest rates would accrue to them. In the meantime, since the security has been sold, the bond trader does not have to use any of their money to fund this long position.270
267 Id. at 39. 268 Id. 269 A trader is “long” a bond when they buy with the hope that it will increase in value. When it is later sold, they will make a profit which is the difference between the initial purchase price and the sale price when it is sold eventually. See James Chen, Long Position – Long, (May 14, 2019), https://www.investopedia.com/terms/l/long.asp. 270 Id. at 41.
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This transaction comes at a cost. The bond trader sells at a low price and must purchase the sovereign bond back at a higher price. The trader therefore borrows money to buy the sovereign bond and pays interest, which is the difference between the relatively low sale price and the higher price at which the bond is repurchased (repo rate). This is still an acceptable deal for the trader because the repo rate is quite low.271
The loan does not have much risk for the person who agrees to buy the repo.
The buyer of the repo buys the sovereign bond at a low price while agreeing to sell it back at a higher price a few days later; they can also be referred to as the lender. The lender receives title due to the transaction. If the borrower defaults and does not repurchase the bond as stipulated, the lender can retain the security and sell it if they want to. Basically, the sovereign bond that is “repoed” serves as collateral for the transaction. In addition, the collateral practically has no credit risk particularly if they are sovereign securities and they are ones that are reasonably easy to dispose of.
Besides, the repo transaction usually spans a short period of time, usually a few days.
There is therefore little time for things to go wrong such as the rise of interest rates.272
Having discussed loans from domestic and foreign sources under the composition of credit flows to developing nations above, another section on loans will not be included in this chapter.
3.4. Conclusion
In this chapter, the sources, composition, and trends in credit flows to the developing countries including those in Africa, were investigated. Domestic and foreign sources of capital flow into these nations were examined. Following that, the
271 Id. 272 Id at 41-2.
Page | 89 concept of debt was explored including bond conventions, bond markets, repo markets,
American and Dutch auctions, among others.
The next chapter will examine sovereign debt and default in-depth, including why nations borrow and the typical reasons they repay debt. The Argentinian Crisis will also be discussed at length and will illustrate the extent of the holdout creditor problems that exacerbated the crisis.
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CHAPTER 4
SOVEREIGN DEBT, DEFAULT, AND CRISES
4.1. Introduction In the previous chapter, the sources, composition, and trends in capital flows to developing nations including those in Africa, were examined. The concept of debt was also explored including bond conventions, repo markets, American and Dutch auctions, among others. In this chapter however, sovereign debt and default will be examined in- depth and the typical reasons sovereigns repay debt. An exploratory analysis of sovereign debt crises will also be undertaken. The Argentinian Crisis will be discussed at length and will illustrate the extent of the holdout creditor problems that exacerbated the crisis.
This chapter in section 4.2. will discuss sovereign debt and default. Section 4.3 will discuss typical reasons why sovereigns repay debt. Section 4.4 will discuss the origins of sovereign default and debt crises, while noting the ones that are underlying causes and/or trigger factors. The Argentinian Debt Crisis will also be discussed. In the next section, 4.5, various methods that have been used to resolve debt crises in the
Global South will be examined. Finally, section 4.6. concludes and summarizes salient points.
The next section will discuss sovereign debt and default.
4.2. Sovereign debt and default 4.2.1. Sovereign debt The following is a quote attributed to Bruce Golding, the Prime Minister of
Jamaica (on January 13, 2010):
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Every year for many years, we have been spending more than we earn. Every
year, we have to borrow to make up the difference, so, each year, the debt gets
bigger and bigger and each year we have to set aside more money to pay the
interest on that debt.... For the last ten years, all of the taxes we collect have
had to be used to service that debt. So, before we can pay one teacher or nurse
or policeman, before we can patch one pothole, before we can put one bottle
of medicine in our hospitals or provide one school lunch for a needy child, we
have to borrow more money, piling up the debt even further and the cost of
servicing that debt even higher.273
Sovereign debt therefore exists where a sovereign borrows. And sovereign default would result if it cannot pay the debt back or it is not timely paying the debt back. Incurring debt, therefore, is not necessarily a bad thing. Incurring debt does not necessarily cause poverty. If a country earns more income than it borrows, and can repay its loans, it would not go into default.274
Debt could help an entity postpone paying for benefits that have already been enjoyed or are being enjoyed, or to finance a project that is necessary which it cannot afford at the moment. Debt can nonetheless become problematic when the borrower goes into default and interest is incurred. Private persons and businesses can find relief in the context of bankruptcy regimes. In the sovereign debt context however, there is no sovereign bankruptcy regime – this is one of the characteristics of sovereign debt that make it easy for a nation to fall into sovereign debt. The pacta sunt servanda principle “reigns supreme”.275 Other features of sovereign debt include: 1) sovereign
273 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 1 Edward Elgar: Cheltenham, UK (2012). 274 Id. at 68. 275 Id. at 1. Pacta sunt servanda means everyone must fulfill their contractual obligations.
Page | 92 debt is perpetually enforceable; 2) willingness of creditors to knowingly lend to corrupt government leaders; 3) granting of loans does not always have a profit motive.
These features are expounded on below:
i. Absence of a sovereign bankruptcy regime
No sovereign bankruptcy regime or uniform rules for sovereign debt
restructuring exists. Regardless of how much nations over-borrow and are unable
to service their debt, there is no formal mechanism they can go to in order to
alleviate their debts. Pacta sunt servanda requires that a sovereign debtor pay its
debt whether it could pay or not.276 When a country spends more money than the
revenue it has received, it must either: 1) enter into new loan transactions to pay the
debt that is owed or 2) ask for debt relief from its lenders.277
ii. Sovereign debt is perpetually enforceable
Sovereign debt is intergenerational. Other types of debt such as personal or
corporate debt are usually accrued by the borrower along with the burden. Such
types of debt die with the borrower. Sovereign debt however attaches to the country
and survives the change of governments.278 iii. Granting of loans does not always have a profit motive
Commercial lenders always have a profit motive to lend. Bilateral and multilateral lenders, on the other hand, might lend for reasons such as getting economic benefits and getting geopolitical advantage. Some loan transactions therefore sometimes do not have much to do with the country’s needs. Lenders sometimes tend
276 Id. at 69. 277 Id. at 2. 278 Id. at 71. This is why odious debt has been a problematic and worrisome area of sovereign debt.
Page | 93 to over- or under-lend. If there is over-lending and the sovereign cannot service its debt, it goes into default and this could inhibit its growth and contribute to poverty.279 iv. Willingness of creditors to knowingly lend to corrupt government leaders
Corrupt government officials and leaders sometimes borrow to finance their corrupt deeds, including human rights violations. There are some lenders who with actual or reasonable knowledge of the facts, make huge loans to such corrupt leaders.
As sovereign debt is intergenerational, this debt survives the corrupt administration and have been dubbed “odious debt”, hence, the debate regarding whether such debt should be enforceable or not. An example is Iraq which accumulated billions of dollars in debt during the regime of Saddam Hussein, whose corrupt activities were well documented by the media.280
In addition, many developing nations which ordinarily find it difficult to accumulate foreign exchange, use whatever resources they have to service debts and thus, remain in a permanent debt cycle. The IMF has listed debts that cannot be repaid as one of the main reasons countries remain in poverty.281 For instance, Indonesia spends more than $2.5 million per hour servicing a $151 billion debt; yet, about 60% of its population live on less than $2 daily. Pakistan reportedly spent almost $3 billion servicing debts in 2009. This happened to be three times what its government spent on health care; yet, 38% of infants were reportedly underweight and only 54% of its people, literate. In these countries and other developing nations, debt keeps growing,282 because sometimes, nations borrow even more to service their debt.
279 Id. at 72. 280 Id. at 72-73. 281 Id. 282 Id. at 2.
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Furthermore, another reason for public debt is that sovereign debt serves as a standard for other issuers of debt including companies, banks, local governments, and investors – by helping them put the right price on and trade other non-sovereign debt.
This is because of the ordinarily safe supposition that the yield curve that sovereign bonds have “sets a lowest-risk floor for all … [other] securities, above which every other security will be priced (in yield or spread terms) depending on its perceived liquidity and default risk”.283
The next section will discuss sovereign default, particularly why and how it happens.
4.2.2. Sovereign default – why and how it happens Default can be defined as “any change in the stream of current and future payments on a debt contract that makes it less valuable to the creditor than the execution of the contractually agreed payments stream”. Default has been in existence as long as debt, since the discounted value of servicing a debt differs over the life of a debt contract for the parties and could become negative for one or all of the parties involved.284 A sovereign default is usually signaled by an “event of default”. Typical indications of default include: 1) cross-default; 2) non-payment of interest and principal for about thirty consecutive days; 3) a moratorium on payment of the debt; 4) a challenge is made to the legitimacy of the debt instruments; 4) the enactment of any laws or regulations that will make it illegal for the sovereign to satisfy the debt obligations; 5) the sovereign
283 Arturo C. Porzecanski, “Borrowing and Debt: How Do Sovereigns Get into Trouble?” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 309 Oxford University Press: United Kingdom (2014). 284 Willem H. Buiter & Ebrahim Rahbari, “Why Governments Default” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 257 Oxford University Press: United Kingdom (2014).
Page | 95 debtor ceases to be a member of the IMF; and 6) breach of other duties during the “grace period” after a written statement to fix failure, among others.285
Since the 1970s, many nations have not practiced sound fiscal styles that ensure a lower level of public debt in the long term.286 Rather, the trend has been to have bigger deficits during rough economic times and lesser deficits during good economic times.
This is why most nations have accumulated a lot of sovereign debt across the globe in relation to GDP, tax incomes, earnings from exports, and also in “absolute terms”. The bigger the debt burden a sovereign has, the bigger the risk that it will go into default and be unable to pay back its debt, all things being equal.287
There are other cases in which a sovereign nation can become overindebted
(eventually leading to default), usually on short notice and at debt levels which might seem sustainable at first glance. First, sometimes, large conditional debt obligations arise which reduces a country’s creditworthiness. The unanticipated need to cover the expenses of rebuilding infrastructure after a natural disaster has occurred, paying bank depositors that have suffered from a systemic banking calamity, or covering the expenses of humanitarian aid, could lead to a huge rise in sovereign debt. Second, maturity mismatches. This occurs when nations and banks use short-term funds to finance long-term projects – usually because long-term funding cannot be found or is too expensive. This could cause refunding issues “when maturing obligations cannot easily be rolled over, … when sizeable maturities come due, or when lines of credit are withdrawn during a period when new financing is hard to obtain”. Third, currency mismatches which could occur when for example, a nation or its banking system
285 Rodrigo Olivares Caminal, “Litigation Aspects of SOveriegn debt” in Rodrigo Olivares Caminal et. al. (eds.), Debt Restructuring, 389 Oxford University Press: Oxford, UK (2011). 286 Id. at 310. 287 Id.
Page | 96 experiences huge losses after the currency has really been devalued and much debt relative to assets were “denominated in foreign currencies and suddenly became very costly to keep servicing in full”. Essentially, when there is a huge difference between the amount of financing a government needs and the amount of funds the market is willing to provide, a sovereign debt crisis results. Besides, sometimes, the genuine or perceived incapability of a sovereign to pay debts that are maturing leads to a demand for debt or debt service relief, and in some instances, leads to the sovereign defaulting.
In some extraordinary cases, the sovereign might just be shirking its debt obligations from unwillingness rather than incapability.288
Sometimes, the reason why a sovereign nation might choose to default is to get undeserved debt relief from the sovereign’s creditors rather than deal with the political costs of reducing public expenses or generating income in order to service the nation’s debt on original or modified terms, therefore sometimes choose to default. A clear example is where the sovereign refrains from the use of existing central and fiscal resources to help service its debt.289 Such conduct disqualifies a nation from receiving aid from the IMF and other multilateral development institutions. This is because these institutions usually impose fiscal stabilization procedures that have been unpopular; these stabilization programs are intended to help the sovereign nation’s capability to service its debt in the future.290 The build-up of sovereign debt, therefore, is often not enough to cause a crisis. Problems arise when there is a huge, unexpected debilitating rise in sovereign debt caused by currency mismatches or contingent liabilities that have a negative impact on genuine or apparent solvency.291
288 Id. 289 Id. at 310-311. Examples of such conduct by sovereigns include: Argentina since 2001; Ecuador in 2008-2009; and Belize in 2012. 290 Id. 291 Id. at 312.
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Another reason sovereigns sometimes become overwhelmed with debt is when there are currency mismatches. Currency mismatches occur when a sovereign issues debt that is denominated in a foreign currency. This means that the cost of servicing the debt would fluctuate depending on the exchange rate.292 It may also be defined as the degree to which a state’s debt is denominated in foreign currencies, while its assets are denominated in its domestic currency.293 Nonetheless, the problems arising from currency mismatches can be a cause for concern for states, as well as systemically huge corporations and banks in developing countries. 294
Historically, bonds denominated in foreign currency have been a huge source of funding for developing countries with illiquid capital markets. Unanticipated currency devaluations can create trouble for the balance sheet of the debtor nation because the cost of servicing the debt becomes higher to the point where the currency is devalued. Currency mismatches have thus been a main reason for debt crises in developing nations and have enhanced the cost of resolving such crises.295
In addition, another reason sovereign default might occur is “deficit bias”.
Deficit bias refers to a situation where public officials refrain from decreasing the level of debt for political reasons. During hard economic times (recessions), public officials might create a budget deficit to help the people and the economy. When the economy improves however, they may be reluctant to increase taxes for reasons such as re-
292 CITIZENDIUM, Currency mismatch/Definition, http://en.citizendium.org/wiki/Currency_mismatch/Definition (last visited 11/09/2018). 293 Romain Ranciere et. al., Currency Mismatch, Systemic Risk and Growth in Emerging Europe, http://www.econ.ucla.edu/people/papers/Tornell/Tornell501.pdf (last visited 11/09/2018). 294 Arturo C. Porzecanski, “Borrowing and Debt: How Do Sovereigns Get into Trouble?” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 315 Oxford University Press: United Kingdom (2014). 295 Id.
Page | 98 election prospects.296 Deficit biases might exist due to the absence of accurate information, such as when the people are not informed about the state of the public purse and public officials are empowered to engage in unwise financial schemes than necessary. As mentioned above, when politicians are worried about losing elections, they may give the electorate unrealistic expectations of decreased taxes or more fiscal spending because these ideas appeal to voters more. A party running for re-election who is concerned that the other party might win might run up public debt in order to
“tie the hands of the opposition party” if it ends up in power. In addition, according to
Porzecanski, “Since public spending projects and targeted tax breaks favor small groups, both lobbyists and legislators may not give due consideration to the full budgetary costs of their decisions”. When public officials and the population do not give much consideration regarding the welfare of future generations, they might adopt
“spend now, tax later” attitudes”.297
Finally, according to Buiter and Rahbari, a default can cause “a positive-sum outcome” from a social viewpoint, compared with the choice of avoiding default. This might be the case when the creditor, debtor, and society would have access to more resources than when there is no default. This happens when a sovereign nation is on the “wrong side of the ‘sovereign debt Laffer curve’”.298 The authors describe the situation this way:
If very severe fiscal austerity or very high inflation are the only alternatives to
sovereign default, then default may be the lesser evil. If the alternative to bank default
296 Abi Adams, Deficit Bias: Why We Need to Tie Politicians’ Hands Loosely, https://abiadams.com/2011/08/11/deficit-bias-101-why-we-need-to-tie-politicians-hands- loosely/ (Aug. 11, 2011). 297 Arturo C. Porzecanski, “Borrowing and Debt: How Do Sovereigns Get into Trouble?” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 312 Oxford University Press: United Kingdom (2014). 298 Willem H. Buiter & Ebrahim Rahbari, “Why Governments Default” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 264.
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is shifting the losses to the taxpayers, both fairness and intertemporal incentives (the
prevention or mitigation of moral hazard) may call for default, provided that this can
be implemented in a reasonable orderly manner and does not threaten systemic
financial stability. More generally, the social costs of ‘debt overhang’ can exceed the
costs of default in situation in which debt is excessive.299
In the next section, the history of sovereign debt and default will be charted.
4.2.3. History of sovereign debt and default
Yvonne Wong does a good job of charting the history of sovereign debt and default, beginning in the 18th century as follows:
i. 1700-1820: during this period, Amsterdam was the world financial center.
English and Dutch lenders lent funds to sovereign nations, including, France,
Denmark, and Austria through official loans, bond issues, and suppliers’ credits.
As these transactions were not really related to one another, default did not
necessarily result in systemic problems and they were not intricate
transactions.300
ii. 1820-1920: during this period, London took over from Amsterdam as the
world’s financial center. Bond issues were spearheaded by London’s merchant
banks. The range of borrowers increased to include new Latin American
colonies including Argentina and Peru to help cover government costs and the
costs of liberation wars. Around 1860, Egypt started getting loans and Japan
started receiving loans circa 1870. Around the end of the nineteenth century,
Australia, like Latin America, was already getting loans to pay for infrastructure
299 Id. 300 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 40.
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development. Countries in the Middle East and Eastern Europe also borrowed
to finance government expenses.301
Sovereign debt default during this period was common. For instance, in
1825, every country apart from Brazil was bankrupt in Latin America. Defaults
led to restructuring and rescheduling agreements being concluded between
creditors and debtors, and their outcomes were varied depending on creditors’
interests and demands, economics, politics, and influence exerted by the French
and the British.302 Sometimes, based on agreements, borrowing countries gave
up more than the payment for the debt owed.303
Besides, disputes over sovereign debt resulted in outright warfare –
referred to as “gunboat diplomacy”.304 For instance, a naval blockade was
imposed against Venezuela from December 1902 till February 1903 by Italy,
Germany, and the UK when Venezuelan President, Cipriano Castro failed to
pay debts owed to and damages suffered by Europeans in previous Venezuelan
wars.305 Defaults nonetheless, did not cause problems with the world financial
system because private investors and suppliers bore the losses.306 iii. 1920s – 1970s:
After the first World War, New York took over from London as the world’s financial center. During this period, USA lent to Latin America, and new borrowers from Europe including Germany. The money that was borrowed was used to fund government expenditures, build up capital reserves, and balance national deficit. In the
301 Id. 302 Id. 303 Id. at 41. 304 Id. 305 WIKIPEDIA, “Venezuelan crisis of 1902-1903” available at https://en.m.wikipedia.org/wiki/Venezuelan_crisis_of_1902%E2%80%931903. 306 Id. at 42.
Page | 101 years following the Great Depression, lending became less available, making it even harder for borrower nations to service their debts. Rescheduling efforts began in the
1940s which went on until the early 1960s.307 iv. 1970s – 1990s:
Sovereign finance basically changed in the 1970s. The dominant sources of
loans became international banks in Western Europe and in the US.308 This shift
had huge consequences for the global financial system. Loan granting decisions of
these commercial banks were based on different motives than those of the previous
lenders. This created a “a new breed of sovereign debt”. 309
The 1973 oil crisis was the primary factor in these banks becoming
sovereign lenders. Oil prices doubled between 1973 and 1974 and doubled even
more. The price of crude oil was less than US$3 for a barrel at the end of 1973, but
the price increased to US$17 for a barrel at the end of 1979. Leaders in oil-rich
countries, including Arab sheiks, made billions of dollars as a result. These profits
were deposited with commercial banks in the West. About US$13.8 billion had
reportedly been deposited with the six biggest banks in the US. As oil prices became
ten times more expensive, advanced economies went into a recession and tried
alleviating their need for oil. These countries did not really have need for loans from
the banks because of the recession.310
As banks do not let cash lie fallow, they found customers willing to borrow
in Asia, Eastern Europe, Africa and Latin America – which were emerging market
307 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 40. 308 Id. 309 Id. at 43. 310 Id. at 43.
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economies at the time. The banks thus found it profitable to have the OPEC
countries deposit billions of dollars with them, and then make loans to developing
nations, including Mexico, brazil, Venezuela, Argentina and countries in sub-
Saharan Africa. These banks thought the loans made to the sovereigns were not as
risky as loans made to private persons, therefore, it was done on a huge scale. A
famous quote to this effect is the one made by the Chairman of Citicorp, Walter
Wriston, “the country does not go bankrupt… Any country, however badly off, will
‘own’ more than it owes”.311 This reasoning, which later turned out to be faulty,
was generally accepted. The banks were not as careful in evaluating the risks of
default in lending to sovereign debtors and diligent in performing credit checks.312
The rise in sovereign lending was also caused by the use of syndicated loans for the following reasons: 1) there were huge fees associated with these loans which incentivized the big banks to create as much of these as possible; and 2) these loans had less risk because the risk was allocated across the syndicate. Big banks in London and
New York took the lead while regional and local banks participated in the syndicate based on the promise of large returns while relying on the judgment and decisions of the bigger banks.313
At the beginning, the lending spree went satisfactorily. As these borrowing countries started having to pay back loans and facing difficulties, they got short term loans to service the debt and the cycle continued. The debt of developing countries ballooned to US$579.6 billion from U$70 billion, within the decade of 1970-1980.314
311 Id. 312 Id. at 44. 313 Id. 314 Id.
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As mentioned above, the lending spree was based on the view that sovereigns could not go bankrupt. Nonetheless, lending to developing countries alleviated to some extent the effects of the recession the West suffered which resulted in part, from the
1973 oil shock. In addition, FDI had reduced to 20% of net capital flowing into developing nations for development. By 1976, capital flows for development in these nations comprised mostly of commercial loans than official aid.315
The U.S. Federal Reserve in trying to deal with the inflationary effects of the rising prices of oil and other commodities, increased real interest rates in the US. This action had two effects: 1) servicing commercial loans that charged floating or flexible interest rates became way more expensive as the U.S. dollar increased substantially in value quickly; and 2) U.S. dollar deposits became more attractive and had the result of aggravating capital flight from developing nations. Developing nations were however granted commercial loans based on maturity periods and interest rates negotiated at market rates (“hard” terms), instead of concessionary terms or “soft” terms. Interest payments on commercial loans thus went up really high due to the increase in interest rates.316
When oil prices reduced as a result of the global recession and there was a reduction in oil demand, the economies of oil-importing nations were placed at a disadvantage. This is because demand for exports from developing, but oil-exporting nations fell as a result of the above-mentioned recession, reducing potential income streams for these nations. The reduction in oil prices negatively affected indebted, oil- exporting nations such as Nigeria, Venezuela, and Mexico because a crucial source of
315 Rumu Sarkar, International Development Law: Rule of Law, Human Rights and Global Finance, 264. 316 Id. at 264-265.
Page | 104 foreign exchange needed to service their external debt was lost. This signaled the beginning of the debt crisis of the 1980s, which although caused by several factors, was aggravated by the failure of banking supervision and regulation in advanced economies and unwise uses of commercial loans by debtor nations. Commercial banks in the developed world relaxed their loan standards and paid little consideration to their aggregate loan exposure and lending risks in lending to the developing world under the misplaced view that sovereigns cannot be bankrupt, and that if debt servicing issues cropped up, the central banks of the debtor nations were capable of filling the gaps.
These banks basically “recycled petrodollars”. “Supervised lending” which was part of the conditions that debtor nations had to fulfil, that is, implementing certain economic policies and executing certain economic policy reforms, was a responsibility given to the IMF.317 This resulted in “a vicious cycle of unrestricted commercial lending followed by painful periods of structural adjustment imposed by the IMF”.318
During the 1980s, many developing nations relied on commercial loans to meet their needs for imported goods, particularly oil imports and other imports based on hard currency. Many commercial loans were used to support failing state-owned enterprises
(SOEs) instead of using these funds to boost export industries. As servicing external debt and paying for imported goods exhausted foreign exchange reserves, these nations could not import necessary materials that could have boosted exports and boosted their
317 Id. 318 Id. at 266. The most recent example is the case of Ecuador where the implementation of the IMF policies has resulted in riots and chaos in Quito, the capital since the beginning of October 2019. The government removed government subsidies on the price of diesel and gasoline. The removal of the subsidies were pursuant to structural adjustment conditions imposed by the IMF in return for a loan of US$4.4 billion granted to the Lenin Moreno administration. The effects of the implementations of all the conditions will likely worsen the country’s socio-economic crises, and contribute to the rise of unemployment, crime, etc. See Hanna Kieschnick, The social costs of IMF policies in Ecuador, GLOBAL POLICY FORUM, (Oct. 14, 2009), https://www.globalpolicy.org/component/content/article/265-policy-papers-archives/53139- the-social-costs-of-imf-policies-in-ecuador.html.
Page | 105 economies. Soon after, these debtor nations did not just have huge external debt, but had high interest rates, domestic capital flight, high inflation, and less exports to generate foreign exchange needed to service their debt (as advanced economies responded to the recession by placing limits on imported goods).319
Since the beginning of the early 1970s, sovereign debt and fiscal deficit have been on the rise and frequent in most nations across the globe. Developed and developing nations have had budgetary deficit of about three percent of annual GDP on average. With the “economic boom” in the 1990s, public purses of developed nations improved but this changed at the beginning of the millennium. The financial crisis in
2008 led to a period of five years where about 24 of 30 developed countries suffered from fiscal deficit. Within four years afterwards, these developed countries, in concert, had total deficit that was roughly equal to more than six-and-a-half percent of annual
GDP. Fiscal deficits also became the order of the day in most developing countries during the same period except big oil-exporting countries from the Middle East who do not have large populations such as Qatar, Oman, and Kuwait.320
The next section will discuss the typical reasons sovereigns repay debt.
4.3. Typical reasons sovereigns repay debt In private debt contracts, debtors are incentivized to repay debt because of among others, third party enforcers such as the courts. Third-party enforcement, however, is the exception in relation to sovereigns, thus, they typically choose to repay their debt rather than being forced to repay their debt.321
319 Id. 320 Arturo C. Porzecanski, “Borrowing and Debt: How Do Sovereigns Get into Trouble?” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 312 Oxford University Press: United Kingdom (2014). 321 Willem H. Buiter & Ebrahim Rahbari, “Why Governments Default” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 257 Oxford University Press: United Kingdom (2014).
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As it has been mentioned above, sovereigns borrow to finance, among others, infrastructure development projects, which their fiscal purses cannot handle. The legal standard that applies to sovereign debt contracts is pacta sunt servanda – these contracts are legally binding until they are performed. Sovereign nations are technically bound, therefore, to repay their debt regardless of the change in government, and no matter how long it takes. This principle is based on the reasoning that if unjust enrichment would not result, new generations of people and successor governments who enjoy the benefits of new infrastructure should pay for it. It has been widely accepted that a stringent application of this rule is essential to have the international capital market viable and liquid. Otherwise, sovereigns could of their own accord, decide to breach their debt agreements and this would discourage potential lenders from lending to sovereigns.322
The word “sovereign” comes from the Old French word, “soverain” based on the Latin word that means “superānus”.323 Being a sovereign thus means that an entity is pretty much a law unto itself; there is no higher power to which it is subject. This is usually the case in general, if a sovereign has not already voluntarily submitted its sovereignty in relation to settlement of contractual or debt disputes in another forum.324
Sovereigns are however not necessarily so law-abiding that the pacta sunt servanda would make them repay their debt, and the fear of litigation does not necessarily make them pay up. This is in part, because, they know that even if they get sued at all, there might be issues with enforcing the judgement. International law has
322 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 31-2. 323 DICTIONARY, Sovereign: synonyms, examples and word origin, https://www.dictionary.com/browse/sovereign (last visited 11/10/2018). 324 Willem H. Buiter & Ebrahim Rahbari, “Why Governments Default” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 259 Oxford University Press: United Kingdom (2014).
Page | 107 limits especially because of sovereign immunity. Legal institutions do not really compel sovereign borrowers to perform their debt obligations.325 Sovereigns have been found to repay their debt for other reasons including the following:
a) Reputation – sovereigns might want to honor their obligations so that they
can maintain their integrity and be deemed trustworthy and creditworthy.
Otherwise, their access to credit in the future may be limited, much less on
favorable terms. Yields on sovereign bonds have been found to increase or
reduce based on the conduct and performance of the sovereign borrower.326
Sovereign nations today, therefore, are guided by the principle of self-
enforcement in servicing their debt. In addition, as default and its consequences
can be quite costly, creditors might not want to lend to debtors with a history of
default.327 Repayment therefore “may hold the carrot of a good reputation” for
the sovereign debtor. This view is based on the assumption that a defaulting
sovereign is excluded from opportunities to save, as well as to get credit again
in the future.328
b) Diplomatic problems – another reason sovereign debtors pay back is to avoid the diplomatic issues a default can cause, or direct sanctions which are usually related to trade.329 Gunboat diplomacy might no longer be the order of the day but with the advent of globalization, nations can no longer operate in isolation. Many nations therefore make the effort to pay back their debt based on political, not legal
325 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 33. 326 Id. 327 Willem H. Buiter & Ebrahim Rahbari, “Why Governments Default” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 258. 328 R. Gaston Gelos et. al., “Sovereign Borrowing by Developing Countries: What Determines Market Access” 5 IMF Working Paper WP/04/221. See also Jonathan Eaton & Mark Gersowitz, “Debt with Potential Repudiation: Theoretical and Empirical Analysis” vol. 48 289-309 (1981). 329 Id. See J. Bulow & Kenneth Rogoff, “Sovereign Debt: Is to Forgive to Forget?” American Economic Review, vol. 79 pp. 43–50 (1989).
Page | 108 considerations.330 Sovereign default can be too costly.331 Finally, sovereign debt crises are not new in history. Sovereign debt crises are however still very much a hot topic today and are no longer limited to developing countries. The 2008/9 global financial crisis and its spillover into the sovereign segments in some euro-area member nations has not helped matters. This is because it created contagion risk which threatened global financial stability, thanks to the interconnectedness of the global financial system.332
The next section will therefore discuss the origins of sovereign debt crises, while noting the ones that are underlying causes and/or trigger factors. The Argentinian Debt
Crisis will also be discussed.
4.4. Sovereign debt crises
A sovereign debt crisis occurs when a sovereign nation clearly defaults on payment of its debt either by 1) imposing debt restructuring based on less acceptable terms than the original ones (such as longer maturity period or lower interest rate) on creditors or 2) by repudiating the debt. The most common form of sovereign default is the former: restructuring of debt on less favorable terms. When a sovereign nation fails to pay principal or interest as agreed, it is said to be in default.333
Two sources of sovereign debt include external debt and domestic debt.
Domestic debt refers to debt instruments issued under the laws of the sovereign’s own jurisdiction, purchased by domestic creditors and denominated in local currency.
330 Id. 331 Willem H. Buiter & Ebrahim Rahbari, “Why Governments Default” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, 257 Oxford University Press: United Kingdom (2014). Trade sanctions, which might be the modern version of gunboat diplomacy might be inefficient and not produce desired results. 332 Mark Jewett, “Approaches to Sovereign Debt Resolution: Recent Developments” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, xix Oxford University Press: United Kingdom (2014). 333 Jakob de Haan et. al., Financial Markets and Institutions: A European Perspective, 2nd ed., 40 Cambridge University Press: Cambridge, UK (2012).
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External debt on the other hand refers to debt issued under the laws of another nation’s jurisdiction, purchased by foreign creditors and denominated in foreign currency.334
When a nation suffers from a sovereign debt crisis, it goes through financial issues resulting from the apparent inability of the nation to pay its public debt. This happens usually when a nation’s debt levels increase critically and it suffers from low economic growth.335 Essentially, a debt crisis exists when the sovereigns have more debt than resources to service it. Debt crises occur not just in developing nations, but in nations in the developed world with few exceptions like the US and Denmark.336
In the ensuing paragraphs, the origins of sovereign debt crises will be discussed.
4.4.1. Underlying causes and triggers of sovereign default and debt crises There are factors that trigger sovereign default and debt crises. Some factors set the stage for crises while others trigger them, as will be noted for each point as follows:
a) Unwise or imprudent borrowing policies in debtor nations and imprudent
lending by financial institutions (for selfish reasons) coupled with unfavorable
global macroeconomic conditions are some of the underlying causes of
sovereign debt crises.337 For instance, in the 1970s, banks lent too aggressively
without caring about borrowing nations’ individual creditworthiness or the
profitability of the projects the money was being lent for. As the debt crisis
worsened, the banks reduced the availability of loans that could be granted to
sovereign nations, thereby worsening the liquidity problem.338 This situation
334 Id. 335 Hao Li, INTERNATIONAL BUSINESS TIMES, (last updated 08/31/2019) https://www.ibtimes.com/what-sovereign-debt-crisis-why-it-so-scary-372228, . 336 Jakob de Haan et. al., Financial Markets and Institutions: A European Perspective, 2nd ed., 40.. 337 John T. Cuddington, “The Extent and Causes of the Debt Crisis of the 1980s” in Ishrat Husain & Ishac Diwan, Dealing with the Debt Crisis, 16 The World Bank: Washington, D.C. (1989). 338 Id at 17.
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coupled with asset price bubbles exacerbated the debt crises. Poor banking
regulation did not help matters.339
b) Inability to service debt resulting from issues such as absence of foreign
exchange reserves to service debt, decrease in the price of natural resources and
commodities particularly where the sovereign’s economy is over-reliant on
resources. This is an underlying cause of sovereign debt crises.340
c) Systemic factors such as when the growth rates of developing nations are not
increasing as high as interest rates are an underlying, and even structural cause
of sovereign debt crises.341
d) External shocks or negative worldwide economic policies coupled with poor
country policies are underlying causes of sovereign debt crises and can be
triggering factors when there is over-indebtedness342
e) Capital flight is another method of accumulating capital outside the jurisdiction
where it is sourced. Capital flight has been known to exacerbate sovereign debt
problems and reduce the amount of capital and resources available to service
debt. In some nations, domestic capital can only be repatriated abroad through
the violation of capital controls. In some other nations, capital repatriation is
legal. People are motivated to export capital probably to launder illegally earned
money and/or escape domestic taxation. It is therefore hard to measure the
extent of capital flight.343 Capital flight can be an underlying cause of sovereign
debt crises or a trigger factor when there is over-indebtedness.
339 Id. 340 Id. 341 Id. 342 Id. 343 Id at 33.
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f) Sovereign default (or even a downgrade of sovereign debt) contributes towards
a fomentation of sovereign debt crises. A sovereign debt crisis can result in a
serious recession, and this decreases economic activities resulting in a negative
ability to service its debt.344 Sovereign default exacerbates debt crises and is an
inherent part of debt crises. It is also a trigger factor for debt crises.
In the ensuing paragraphs, the Argentinian Debt Crisis will be discussed. DDHFs played a huge role in this crisis. The normative framework for regulation of holdout creditors being proposed in this study is to prevent another saga like the one that played out between Argentina and NML Capital.
4.4.2. The Argentinian Debt Crisis The starting point here is to state the fact that the face of legal enforcement of sovereign debt contracts has changed over the past three to four decades. In the past two centuries, absolute sovereign immunity was the norm. Nations pretty much just had their reputation and creditworthiness on the line in concluding sovereign debt contracts.
Sometimes, nations pledged export revenue as was the case with Peru in the 19th century when it hired a British enterprise to receive its export income abroad and save some of it for loan repayments. Creditors therefore did not have any effective remedy against defaulting sovereigns as local courts could not enforce claims against foreign nations.
By the 1970s nonetheless, the situation changed as creditors could now bring suit against foreign nations in local courts and have the judgments enforced through the attachment and sale of the debtor nation’s assets. Sometimes, there were enough assets to attach. The tactic creditors used was to threaten to seize the government’s assets located abroad and seek to upset the debtor nation’s foreign commercial dealings. If the
344 Id.
Page | 112 cost is too high for the sovereign involved, this would force the sovereign to come to the negotiation table to settle at terms favorable to creditors.345
The genesis of the Argentinian debt crisis is as follows. In 1994, Argentina issued international bonds to investors under a “fiscal agency agreement”. Following a few years of economic crisis and unsuccessfully trying to get its finances together, the country defaulted on its external debt in 2001. It failed to pay interest on the outstanding bonds. Historically, it was the biggest sovereign default entailing about US102.6 billion in debt.346 The nation was embroiled in a political crisis after having elected its third president in four days. This was caused by the financial crisis that engulfed the country due to the huge debt she owed. Argentina apparently, chose to default on the bonds so that the government could have more funds for public spending. Upon defaulting, it requested its creditors to come back to the negotiation table in respect of the bonds.347
Argentina began a debt restructuring process in 2005, continuing its
“recalcitrant” posture towards bondholders. It was practically a “take it or leave it” proposal. Argentine public officials constantly mentioned that holdout bondholders would not get paid. This was taken to the next level when the “Lock Law” was enacted which forbade any more debt restructuring procedures and payments to holdout bondholders.348 The Argentine government also enacted budgetary legislation that placed a cessation on the service of the holdout bonds. This was aimed at coercing holdouts to participate in the renegotiation of the bonds. Eventually, Argentina
345 Mark Weidemaier, “The New Guano: Legal Enforcement in Modern Sovereign Debt Markets” https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3245254, April 14, 2018 (last visited 12/04/2018). 346 Grygoriy Pustovit, “Sovereign Debt Contracts: Implications of Trust Arrangements for Financial (In)stability” 17 Eur. Bus. Org. Rev. 41, 46 (2016). 347 Irakli Shalolashvili, “An Analysis of the Argentinian Bond Crisis” 46 U Miami Inter-Am. L. Rev. 179, 180 (2015). 348 Grygoriy Pustovit, 17 Eur. Bus. Org. Rev. 41, 46 (2016).
Page | 113 concluded an agreement with its creditors for a portion of the total money it owed.
About 76% of debtholders took part in this restructuring, and they received about 27-
30% recovery of the initial debt. The remaining 14% were holdouts who still possessed the bonds that had been defaulted upon.349
In 2010, Argentina began negotiating with the holdouts again. The Lock Law was suspended temporarily to enable the 2010 restructuring.350 These holdouts threatened to seize Argentinian assets located in other jurisdictions and enjoin her from paying the restructured bondholders while defaulting on the holdouts. This led to another renegotiation of the bonds making the total portion of the bondholders that settled to be over 90%. The remaining 10% who were holdouts were DDHFs or the so- called “vulture funds”.351 These holdouts held bonds originally issued in 1994. The problem was that if Argentina chose to pay these holdouts, they would have secured priority over the bondholders that settled. They would also have received the full face value of their bonds even though they might have paid much less for the bonds on the secondary sovereign debt market with the knowledge that they might not be paid the full face value of the bonds.352 This outcome would have been detrimental to the debtholders who participated in the 2005 and 2010 debt restructuring processes.
349 Irakli Shalolashvili, 46 U Miami Inter-Am. L. Rev. 179, 180 (2015). 350 Grygoriy Pustovit, 17 Eur. Bus. Org. Rev. 41, 47 (2016). This shows how sovereign debtors can utilize and manipulate domestic law to further its interests. 351 Id. at 180-181. “Vulture funds” is a term that is used to refer to commercial creditors who purchase the debts of indebted nations at a low percentage of the face value of the debt and go on to bring suit against the indebted nations, apparently with the aim of earning profits. They are not primary lenders but are players on the secondary sovereign debt market. The author prefers to refer to them as distressed debt investors, and would do so in this study, going forward. See Devi Sookun, Stop Vulture Fund Lawsuits: A Handbook, 7 Commonwealth Secretariat: United Kingdom (2010). 352 ALLEN & OVERY: Global Law intelligence Unit, The pari passu clause and the Argentine case, http://www.allenovery.com/SiteCollectionDocuments/The%20pari%20passu%20clause%20a nd%20the%20Argentine%20case.pdf, 27 December 2012 (last visited 12/04/2018).
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These holdouts eventually sued Argentina in the Southern District of New York
(SDNY). They managed to persuade the court to adopt a narrow interpretation of the pari passu clause.353 These holdouts were successful in the legal proceedings against
Argentina. Essentially, these funds were able to argue that Argentina violated this clause as it was paying the bondholders who participated in the renegotiation and not paying the holdouts.354 The court ordered Argentina to make “ratable payments” to the holdouts simultaneously with or before payments are made to the creditors who participated in the 2005 and 2010 restructuring processes.355 In addition, the court held that the enactment of the moratorium law and the Lock law, several declarations and documents filed by the Argentine government, and the consistent refusal to pay the holdouts, resulted in violation of the pari passu clause.356 One of the various forms of the impugned clause goes as follows:
[t]he Securities will constitute…direct, unconditional, unsecured and
unsubordinated obligations of the Republic and shall at all time [sic] rank pari
passu without any preference among themselves. The payment obligations of
the Republic under the Securities shall at all times rank at least equally with all
its other present and future unsecured and unsubordinated External
Indebtedness….357
353 Irakli Shalolashvili, “An Analysis of the Argentinian Bond Crisis” 46 U Miami Inter-Am. L. Rev. 179, 182. The pari passu clause literally means “by equal step” in Latin, and in contracts, means that everyone should get equal treatment. 354 Id. 355 Grygoriy Pustovit, 17 Eur. Bus. Org. Rev. 41, 47 (2016). 356 ALLEN & OVERY: Global Law intelligence Unit, The pari passu clause and the Argentine case, http://www.allenovery.com/SiteCollectionDocuments/The%20pari%20passu%20clause%20a nd%20the%20Argentine%20case.pdf, 27 December 2012 (last visited 12/04/2018). 357 ALLEN & OVERY: Global Law intelligence Unit, The pari passu clause and the Argentine case, http://www.allenovery.com/SiteCollectionDocuments/The%20pari%20passu%20clause%20a nd%20the%20Argentine%20case.pdf, 27 December 2012 (last visited 12/04/2018).
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The judgement understandably shook financial markets up and was extensively debated within the academia.358 The injunction given by the court practically placed
Argentina in a fix: either pay all the debtholders ratably or default on all bondholders simultaneously. The court threatened to place financial market intermediaries and any other third parties in contempt of court if they chose to work with Argentina in paying the debtholders that participated in the 2005 and 2010 restructurings without ratably paying the holdouts. Argentina disregarded the court’s order and timely deposited
US539 million with the Bank of New York Mellon (the indenture trustee for bonds issued under New York law) in order to meet its payments duties towards the bondholders who participated in the 2005 and 2010 debt restructuring procedures. The bank, understandably not wanting to be in contempt of court and fearing problems in the “financial mecca”, refused to send the money to those bondholders. By June of
2014, those bondholders had not yet received their payments. They therefore practically did not receive their interest payments on time,359 meaning that Argentina defaulted on the restructured bonds. This case therefore illustrates the intricate problems that can arise as a result of holdout litigation.
Now that sovereign debt crises have been examined and the Argentinian debt crisis discussed at length, the next section will examine various methods that have been used to resolve debt crises in the Global South.
358 See for example: Benjamin Chabot & Mitu Gulati, “Santa Anna and his black eagle: the origins of pari passu?” 9 Cap. Mark Law J. 216-241 (2014); Anna Gelpern, “Sovereign damage control”, Peterson Institute for International Economics: Policy Brief PB 13, 1-14 (2013); and Mark C. Weidemaier, et.al., “Origin myths, contracts, and the hunt for pari passu” 38 Law Soc. Inq. 72-105 (2013). 359 Grygoriy Pustovit, 17 Eur. Bus. Org. Rev. 41, 47-8 (2016).
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4.5. Various approaches to resolving debt crises in the Global
South
When a sovereign nation defaults, there is really no international law or mechanism that applies, apart from the age-long principle of pacta sunt servanda. There may be party-specified laws in individual loan contracts, but, if there is none, there is no law that applies – treaty, statute or model law. There have been attempts in the past to develop a sovereign bankruptcy system or mechanism, nonetheless, some states, the
IMF and/or other members of the international community have refused to support such attempts. Defaulting sovereigns therefore employ informal processes in restructuring their debts. The ensuing sections will discuss various approaches have been proffered to resolve debt crises, and group these approaches under several classes of debt including bilateral debt, multilateral debt, and commercial debt.
4.5.1. Bilateral debt:
a) Paris Club:
The Paris Club refers to an informal group of official creditors who aim to develop sustainable and coordinated solutions to the debt-servicing difficulties debtor states might have.360 This Club began when Argentina agreed to convened with its public creditors in 1956, in Paris. Since then, it has concluded 433 agreements with 90 defaulting nations, and $583 billion in debt.361
The 22 permanent members of the Paris Club are states who have a “large exposure” to other states across the globe and agree on the principles and rules of the Club. These
360 Rumu Sarkar, International Development Law: Rule of Law, Human Rights and Global Finance, 324. 361 PARIS CLUB, http://www.clubdeparis.org/ (last visited 10/31/2018).
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States may owe debt directly or through one of their agencies such as ECA. These State
Creditors have also “constantly applied the terms defined in the Paris Club Agreed
Minutes to their bilateral claims and have settled any bilateral disputes or arrears with
Paris Club countries, if any”. The permanent members include Australia, Austria,
Belgium, Brazil, Canada, Denmark, Finland, France, Germany, Ireland, Israel, Italy,
Japan, Korea, Netherlands, Norway, Russian Federation, Spain, Sweden, Switzerland,
United Kingdom, and the United States of America.362
Paris Club creditors allow for proper debt treatment, even as defaulting nations implement measures to stabilize their economies. Debt treatment under the auspices of the Paris Club takes the form of debt rescheduling “which is debt relief by postponement or, in the case of concessional rescheduling, reduction in debt service obligations during a defined period (flow treatment) or as of a set date (stock treatment)”.363
When a nation defaults on bilateral debt owed to sovereign creditors, including permanent members of the Paris Club, the Club directs the process of restructuring of debts. For instance, the Club played a leading role in restructuring the debt Iraq owed.364
Although the Paris Club’s procedures are informal, there are six principles that guide their processes. These principles are as follows:365 i. Consensus: no step or decision is taken until all the participant creditor nations are
in agreement.
362 PARIS CLUB, Permanent Members, http://www.clubdeparis.org/en/communications/page/permanent-members (last visited 11/02/2018). 363 Id. 364 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 36. 365 PARIS CLUB, The Six Principles, http://www.clubdeparis.org/en/communications/page/the- six-principles (last visited 11/02/2018).
Page | 118 ii. Cohesion: all the Club’s members take all decisions together and are cognizant of
the “effect that the management of their particular claims may have on the claims
of other members”. iii. Sharing of information: the Club’s members share viewpoints and information
with one another, regularly, on the state of debtor nations. They also benefit from
the participation of the World Bank and the IMF and distribute data on their claims
reciprocally. There is no transparency with their discussions and negotiation –
they are kept confidential, “in order for discussions to remain productive”. iv. Case-by-case basis: the Club makes decisions on a case-by-case basis so that each
one is made to fit the unique circumstances of each debtor nation. The “Evian
Approach” encapsulates this principle. v. Conditions: debtor nations that qualify to be assisted by the Club to negotiate debt
restructuring must:
• Require debt relief;
• Have executed necessary reforms and are dedicated towards executing
reforms that would restore their economy; and
• Have executed reforms under the auspices of an IMF Program. vi. Comparable treatment: once a debtor country signs an agreement with its creditors
on the Paris Club, these creditors should not consent to “terms of treatment” from
other non-Paris Club creditors which are less advantageous to the debtor than
those agreed with the Paris Club.366
The Paris Club process can be described thus: when a nation seeks debt relief, it
is classified as either a Highly Indebted Poor Country (HIPC) or a non-HIPC. HIPCs
366 Id.
Page | 119 go through a process that eventually leads to debt cancellation.367 In the case of countries that are not HIPCs, they usually would undergo an “IMF debt-sustainability analysis”. The reason for this is to determine if the country has debt-sustainability issues or liquidity issues, or both. If it is determined that the nation has temporary liquidity issues, its debts would be rescheduled to a date later in the future. If it is determined that the nation has debt-sustainability issues – that is, it does not have enough fiscal reserves to pay its debt and the amount of its debt negatively affects its ability to pay in the future; the nation would be deemed eligible for cancellation of its debt.368
Finally, restructurings are deemed to have been “successful” if the parties achieve a “negotiated deal”. Political contemplations bear much weight in Paris Club deliberations, and this “provides plenty of leeway to grant concessions for foreign debt owed, and also to extract conditions for debt restructured”.369
b) Non-Paris Club Creditors:
In some Paris Club debt relief transactions, non-Club members may take part when necessary, depending on who the debtor nation is. These non-Club members thus participate on an ad-hoc basis. Paris Club transactions, nonetheless, stipulate that non-
Club creditors – whether they participate or not – consent to the Club’s negotiated deal by providing relief comparable to relief granted by the Club. The Club’s creditors usually exercise enough influence on the non-Club creditors to achieve this.370
367 Yvonne Wong, Sovereign Finance and the Poverty of Nations: Odious Debt in International Law, 36. 368 Id. 369 Id. 370 Id. at 36-37.
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Outside the Paris Club, bilateral debt negotiations with non-Paris Club creditors are more informal and on an ad hoc basis. No laws and guidelines apply and thus, the process is not as transparent as Paris Club proceedings.371
In the next sub-section, a brief note will be made about debt negotiations with multilateral creditors.
4.5.2. Multilateral debt IFIs including the IMF and the World Bank enjoy preferred status regarding loan repayments, and usually have no discounts in debt workout and restructuring transactions. Sovereign borrowers eventually give full payments to IFIs regardless of whether the projects that were financed were successful or not, even if loans are deferred or rescheduled.372 This is because such IFIs are international lenders of last resort and usually step in to lend when no other lender is willing to. Besides, the loans are usually given at concessional rates. In my view, the resources these banks have are donated by nations in return for membership shares and serve crucial purposes in the international financial system. These IFIs should therefore not be taking losses in the course of their lending practices.
During debt restructuring, dialogue takes place between the sovereign borrower and the IFI involved. The IFIs usually hold the balance of power, and because there are fewer stakeholders involved, restructuring multilateral debt is not that costly and does not take too much time. Nonetheless, the consequences might be costly because restructuring could result in a sovereign debtor’s debt stock going up.373
371 Id. at 37. 372 Id. at 35. 373 Id. at 35.
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Now that approaches to resolving debt crises under bilateral debt agreements have been discussed, the next section will talk about the methods used to resolve debt crises where commercial creditors are involved.
4.5.3. Commercial debt a) London Club:
When sovereign debtors owe commercial banks, restructuring tends to happen through the London Club – an informal process like the Paris Club. Commercial banks usually handle syndicated loans; thus, these loans are restructured through the London
Club. The London Club consists of commercial banks who band together to coordinate negotiations of their claims against sovereign borrowers. The sovereign debtor usually begins the restructuring procedure, and an “Advisory Committee” is set up to guide the process, which consists of a top financial firm and representatives from other “exposed firms”. This Committee works on the creditors’ behalf with the sovereign borrower to restructure the loan. It dissolves once an agreement is concluded.374
London Club proceedings are more expensive and take longer than those of the
Paris Club. This happens for the following reasons: first, there are more commercial creditors involved in London Club transactions, than in Paris Club negotiations. It is therefore more difficult to reach consensus, much less unanimous consent. Second, commercial banks would likely not forgive debts because they do not have geopolitical relationships at stake like sovereign creditors of the Paris Club might. Third, commercial banks have profit motives at the top of all their considerations, thus, there
374 Id. at 37.
Page | 122 are actual limitations on a bank accepting partial repayment during restructuring processes.375
If a sovereign borrower needs help from the IMF to finance its loans from commercial banks, the IMF could “influence” a London Club restructuring transaction.
The IMF usually makes the commercial banks to grant new loans to the sovereign borrower as a prerequisite for the sovereign debtor to receive credit. The US government often sways London Club proceedings through the IMF and on its own, by
“advising, and coercing, both members of the advisory committee and representatives of the sovereign debtor to adopt certain positions”.376 b) Non-London Club Creditors:
When sovereigns owe non-London Club creditors, debt restructuring would occur through ad hoc proceedings between creditors and debtors. Sovereign bonds get restructured when the sovereign borrower offers exchange bonds. Essentially, sovereign debtors offer new bonds to replace the old bonds with the effect of decreasing or rescheduling the debt owed. The sovereign might consult creditors with large holdings like banks, who usually try to advance restructuring terms that all creditors would find acceptable. Sovereign bond contracts try to resolve the issue of consent by including collective action clauses that enable restructuring based on consensus among the majority, rather than unanimous consent.377
375 Id. at 38. 376 Id. 377 Id. at 38.
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4.6. Conclusion
This chapter aimed to broadly examine the meaning, history, and features of sovereign default. The origins of debt crises were also discussed, as well as the various approaches that have been utilized to resolve sovereign crises.
It was noted that sovereign debt is a phenomenon in both developing and advanced economies, and the 2008/9 GFC did not help matters in this regard. Nations usually borrow to develop infrastructure, meet public needs and to make up for deficits in their books, among other things. Incurring sovereign debt is thus a part of running a nation. Nonetheless, if they do not earn more income than they incur liabilities, it might become difficult to service their debt, and they might consequently default.
In addition, it was found that some sovereigns intentionally default as was the case with Argentina in the early 2000s. In other cases, governments borrow and spend unwisely, and leave successive governments and future generations to battle with servicing the debt.
Having laid this groundwork and background, the next chapter will interrogate the role of the DDHFs in the development of the sovereign debt market (including the secondary debt market), their characteristics, the social and economic costs of their activities, the benefits of their presence and holdout litigation in the sovereign debt market, and why they should be regulated. As a precursor to that discussion however, hedge funds will be examined including their characteristics and investment strategies.
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CHAPTER 5
DISTRESSED-DEBT HEDGE FUNDS: A LINCHPIN FOR AN EFFICIENT SOVEREIGN DEBT MARKET?
5.1. Introduction
The previous chapter broadly explored the meaning, history, and features of sovereign default. Sovereign debt crises were also examined, with the Argentinian debt crisis discussed as an illustration. Finally, the various approaches that have been utilized to resolve sovereign crises were discussed.
This chapter nonetheless interrogates the role of DDHFs in the development of the sovereign debt market, particularly the secondary market. In this chapter, it will be argued that although sovereign distressed debt investors can create holdout problems during debt restructuring processes of a defaulting sovereign, DDHFs remain one of the linchpins of the international financial system and a ‘cholesterol’ for an efficient sovereign debt market and secondary market for distressed sovereign debt.
Section 5.2. will therefore examine hedge funds, including their characteristics and investment strategies. Section 5.3 will focus on DDHFs, and their characteristics, features, and historical perspectives. Section 5.4 will make a case for the existence of
DDHFs in the secondary sovereign debt market, and how they are a linchpin for an efficient market. In the next section, 5.5, the question as to why there should be regulation of DDHFs is discussed. Finally, section 5.6. concludes and summarizes salient points.
5.2. Hedge funds
A hedge fund is an investment scheme where the fund manager “seek [s] absolute returns by exploiting investment opportunities while protecting [the] principal from
Page | 125 potential financial loss”. Two crucial elements of hedge funds from this definition are apparent: 1) hedge funds aim to produce absolute returns through the taking of risk; and
2) prevent losses and negative build-up of capital.378
The investment methods of hedge fund managers are quite different from the investment philosophy of a fund manager who depends on a market benchmark. It is probably reasonable to say therefore that the term “hedge fund” is a narrative of what an investment fund is not rather than what it is.379
5.2.1. Characteristics of hedge funds
Although there is no universally agreed definition of a hedge fund, there are characteristics which determine whether a fund can essentially be considered a hedge fund or a fund which just seeks to take on the reputation of the “hedge fund brand”.
Legitimate hedge funds have many or all of the following distinctive features:380
i. Leverage is used;
ii. Derivatives are used for investment purposes (rather than for effective
portfolio management);
iii. Short selling;
iv. The objective is to attain absolute returns;
v. Hedge funds aim to take advantage of profitable prospects that might show
up on the markets;
vi. Funds are subject to minimal or no regulatory schemes; and
378 Peter Astleford & Dick Frase, Hedge Funds and the Law, 50-1 Thomson Reuters (Legal) Limited: London, UK (2010). 379 Peter Astleford & Dick Frase, Hedge Funds and the Law, 50-1 Thomson Reuters (Legal) Limited: London, UK (2010). 380 Id. at 51.
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vii. Management fees are usually charged in either of two forms: a performance
fee, which is usually about 15-20% of net gains; and a percentage fee
calculated based on the total pool of assets being managed.381
5.2.2. Investment strategies of hedge funds
Several investment strategies are employed by various hedge funds depending on the types of assets or markets invested in, and the class of investors that are subscribed to the funds, among other factors. Such strategies include the following:
i. Event driven strategy: funds that employ this strategy primarily engage in
investments related to companies dealing with an acquisition or a merger.
They usually wait until the merger has been publicized, and then invest in
the companies so that they can profit from the merger. These funds ground
their investment decisions on trigger events such as a spinoff, merger, or
sale of a department of a company. Some of these funds are “activists” in
the sense that in their position as shareholders, they try to direct their target
firms to take certain steps that will be of advantage to their shareholder
investors, rather than assume a passive role. The most well-known hedge
funds in this category are risk arbitrage funds. These funds sometimes take
speculative positions in companies where they suspect a bidding war is
breaking out or will soon be bought out. Most transactions nevertheless
involve trading on firms whose deals are already publicized.382
A subset of the event driven category of hedge funds is the DDHFs.
These funds usually invest in debt and sometimes in the equity of firms that
381 Id. 382 Ludwig Chincarini, “Hedge funds – an introduction” in Phoebus Athanassiou, Research Handbook on Hedge Funds, Private Equity and Alternative Investments, 33 Edward Elgar Publishing Limited: Cheltenham, UK (2012).
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have already filed for bankruptcy or almost there with the desire of gaining
a higher value in the future especially if the business can still be kept as a
going concern. These funds are usually active in the management of such
firms, in the court proceedings relating to the bankruptcy, and the
renegotiation of bondholders’ payment. They invest in private and public
companies.383 In the sovereign debt sphere, DDHFs invest in the distressed
debt of sovereign nations.
ii. Macro hedge fund strategy: the investment process of funds that have this
macro strategy is founded on the foundational global macroeconomic
picture and its effect on currency, commodity markets, equity, and fixed
income across the globe. One of the most popular macro hedge funds was
George Soros’s Quantum Fund which was accurate in staking that the UK
would not increase interest rates to levels comparable to other participating
nations in the European Exchange Rate Mechanism (ERM) and would
eventually exit the ERM. The fund sold more than US$10 billion worth of
pound sterling on September 6, 1992; as the UK government could not halt
the depreciation of the pound outside the “target zone”, the fund made US$1
billion.384 iii. Equity hedge strategy: these funds are usually involved in investment in
stocks. Some funds that employ this method are “outright long stocks”, just
like other portfolio that invests in equity. These funds are not hedged in any
sense and they are merely long the stock market with stocks they think will
outperform. Some funds are only partially hedged and are only staking that
383 Id. 384 Id.
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a certain class of stocks or the US stock market will decline, thus, they are
only “directionally short stocks”. There are some hedge funds known as
“equity market neutral” which try to be long and short in order to have little
directional exposure to the stock market in general and gain their returns
mainly from the difference in the returns of the stocks that they short and
stocks they buy.385 iv. Relative value strategy: hedge funds that employ this method are exposed
to fixed-income markets. These funds are also called relative-value
arbitrage funds or fixed-income arbitrage funds; hedge funds that are just
exposed to fixed-income markets are included. Some of their strategies
entail utilizing quantitative methods to determine relationships between
several fixed-income securities and recognizing statistical anomalies or
mispricings resulting in profitable opportunities. Convertible arbitrage
hedge funds take advantage of opportunities between non-convertible and
convertible securities by a single issuer.386
v. Other strategies:
Other hedge fund strategies include investment in sovereign bonds or bonds
issued by different nations based on relative valuation or economic models. For
example, towards the end of the previous millennium, the yields of sovereign
bonds were gradually tightening because the currency risk they carry would
ultimately disappear.387 Another strategy is volatility trading in fixed income;
by “purchasing and writing options on fixed-income instruments, those hedge
funds might be betting on the volatility of bond returns being higher or lower in
385 Id. at 32-3. 386 Id. 387 Id.
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the future, or higher or lower on one part of the curve than on another”.388 Other
hedge funds invest in exchange-listed and over-the-counter (OTC) derivatives
or in non-fixed-income kinds of financial instruments. Most of these hedge
funds however are faithful to the “hedge idea” of hedge funds because they
focus on spread betting. In addition, another strategy entails the trading of
corporate bonds of different companies, the same company, or the difference
between a company and government bond.389
The next section will proceed to discuss the meaning, features, and historical perspectives of DDHFs.
5.3. DDHFs – meaning, features, and historical perspectives
If a creditor to a sovereign state has doubts about the state’s ability to pay its debt, such creditor might consider trading the sovereign debt at a discount to buyers on the secondary market. These buyers are DDHFs (and other distressed debt investors), and some scholars and commentators argue that they provide liquidity in the market.390
These funds initially functioned in local markets before moving their operations to cross-border and sovereign debt markets. In local markets, DDHFs are associated with two major advantages: 1) they deliver liquidity in the debt market and remove
388 Ludwig Chincarini, “Hedge funds – an introduction” in Phoebus Athanassiou, Research Handbook on Hedge Funds, Private Equity and Alternative Investments, 35. 389 Id. 390 John Muse-Fisher, “Comment: Starving the Vultures: NML Capital v. Republic of Argentina and Solutions to the Problem of Distressed-Debt Funds” 102 CALIF. L. REV. 1671, 1681. See also Emma Kingdon, “Leveraging Litigation: Enforcing Sovereign Debt Obligations in NML Capital, Ltd. v. Republic of Argentina” 37 B.C. Int’l & Comp. L. Rev. E. Supp. 30 (2014); Elizabeth Broomfield, “Subduing the Vultures: Assessing Government Caps on Recovery in Sovereign Debt Litigation” 2010 COLUM. BUS. L. REV. 473 (2010); Lucas Wonzy, “National Anti-Vulture Funds Legislation: Belgium’s Turn” 2017 COLUM. BUS. L. REV. 697 (2017); and Jill E. Fisch & Caroline M. Gentile, “The View from the Legal Academy: Vultures or Vanguards? The Role of Litigation in Sovereign Debt Restructuring” 53 Emory L.J. 1043 (2004).
Page | 130 monetary constraints on temporarily distressed firms, and 2) they bring to the table wide-ranging expertise in successful restructuring of companies. As hedge funds grew in the 1980s, investment in distressed debt instruments became well-established as a source of making money for these funds and other professional investors. The elimination of restrictions on cross-border international capital flows further facilitated the activities of many of such investors who started aiming at cross-border corporate distressed securities and sovereign debt instruments.391
DDHFs began to operate more in sovereign debt markets since the beginning of the 1990s, after the implementation of the Brady Plan which was a response to the Latin
American debt crisis of the 1980s. The Brady Plan established a “financial dis- intermediation” process between lenders and sovereigns by facilitating the conversion of bank loans into tradable securities. Increase in debt-instruments issued through the capital markets and consequential opportunities for arbitrage in secondary markets resulted in a boom in the DDHF industry.392
These DDHFs purchased Credit Default Swaps (CDS) contracts so that they could gain from dwindling sovereign bond prices ensuing from growing sovereign default risks, apart from short-selling bonds in the cash market. As more CDS spreads got broader, speculators traded their CDS contracts for a profit.
In addition, concerns were already raised before the sovereign default aspects of the global financial crisis became apparent, that DDHFs bought sovereign debt with the intention to litigate for full recovery of the debt. In the debt exchange that took place
391 UNCTAD, Sovereign debt restructurings: lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to holdout creditors 2. 392 Id. at 9.
Page | 131 in Ecuador at the beginning of the millennium, DDHFs bought bonds on the secondary market worth 70 cents on the dollar; in Peru on the other hand, DDHFs who bought their Brady bonds at 25 cents on the dollar made huge profits without legal action. This situation is quite different from the more famous case of Elliot Associates L.P. v. the
Republic of Peru and the National Bank of Peru, a DDHF based in New York paid
USD11.4 million for bonds worth USD20.7 million at par value. They opposed the
Brady bond exchange Peru offered and opted to litigate in the US for the recovery of its debt in full on the basis of the pari passu clause embedded in the new loan agreements. The court upheld the interpretation of this clause: no creditors can be paid unless all creditors are paid out pro rata. Rather than default on said new loan agreements, Peru settled for USD58.45 million, leading to Elliot making over 400% returns in profit.393
As has already been noted in previous chapters, in the case of sovereign debt restructurings, many of the factors that allow active DDHFs to do business in national markets for distressed company debt are not applicable. There is no cross-border or international bankruptcy regime that is comparable to any national bankruptcy regime, and no cross-border or international regulatory equivalent to national regulation of bond markets. The United Nations General Assembly (UNGA) in September 2015 however, adopted a Resolution on Basic Principles on Sovereign Debt Restructuring which provided that sovereign debt restructuring procedures should be steered by international
393 Id. at 340-41. The interpretation the pari passu clause was given in this case has understandably been subject to much controversy. Examples are: David Newfield, Pari Passu as a Weapon and the Changes to Sovereign Debt Boilerplate after Argentina v. NML, 24 U. Miami Bus. L. Rev. 175 (2016); Lee C. Buchheit and G. Mitu Gulati, Restructuring sovereign debt after NML v. Argentina, https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=6342&context=faculty_scholarsh ip Oxford University Press (2017); Brett Neve, NML Capital, Ltd. v. Republic of Argentina: An Alternative to the Inadequate Remedies under the Foreign Sovereign Immunities Act, 39 N.C.J. Int’l L. & Com. Reg. 631 (2014); and Lee C. Buchheit & Jeremiah S. Pam, The Pari Passu Clause in Sovereign Debt Instruments, 53 Emory L.J. 869 (2004).
Page | 132 customary law and by basic principles of international law such as transparency, legitimacy, equitable treatment, sustainability, sovereignty and good faith. This does not however create a binding multilateral legal framework for sovereign debt restructuring processes.394
Unique issues arise in the case of sovereign debt restructurings which make it different for DDHFs than in the case of domestic corporate restructurings. For instance,
DDHFs cannot “take control” of a sovereign nation or change distressed debt positions into “equity” positions as they can in a company. A sovereign nation cannot be liquidated. The role of these DDHFs in sovereign debt restructuring is therefore more passive. They have a short-term investment objective – speculative financial gain. This they achieve by litigating in national jurisdictions against sovereign nations since there is no multilateral legal framework to resolve sovereign bankruptcy issues and no regulations for the secondary market for sovereign debt. This is why these funds are also referred to as “vulture funds”.395
The idea of benefitting from the hardships of nations enmeshed in crippling indebtedness is seen in a very bad light resulting in the negative publicity these funds have had within the last decade. The sovereign debt crisis in Europe has also been partially blamed on them, as it has been alleged that their trading in speculative securities upset sovereign debt markets, raised the cost of sovereign borrowing, and thereby weakened the single currency.396
The major criticism that has been levelled against DDHFs is that they disrupt sovereign debt restructuring processes that otherwise might be successful. One of the
394 Id. at 3. 395 Id. at 4. 396 Id. at 340.
Page | 133 main advantages of a bankruptcy system is the capacity to bind creditors and other stakeholders to an “in rem resolution” of restructured debt obligations, and to bind holdout creditors (those creditors who opt out of debt restructuring processes) to prevent them from disrupting debt restructuring procedures.397 In the well-known case,
NML Capital, Ltd. v. Republic of Argentina,398 the Second Circuit lamented the absence of a bankruptcy system for sovereign debtors to better deal with the problems in that case. The court felt restricted to enforcing the terms of the contracts that were brought before it, as opposed to bankruptcy courts which have the power to redistribute the assets of debtors to pay up creditor claims. The issue of holdout creditors is therefore one that is just cause for concern. The holdout problem in the Argentina case was quite interesting: about 93% of creditors accepted the bond exchanges (a supermajority by any standard); the remaining 7% were holdouts who litigated against the country.399
The practices of DDHFs have therefore been criticized from several angles for various reasons viz:
i. The negative effects of litigation on international trade and financial flows, and
on the integrity and functioning of capital markets;400
397 John A. E. Pottow, Mitigating the Problem of Vulture Holdout: International Certification Boards for Sovereign-Debt Restructurings, 49 Tex. Int’l L.J. 221, 222 (2014). 398 680 F.3d 254 (2d Cir. 2012). 399 John A. E. Pottow, 49 Tex. Int’l L.J. 221, 223. NML Capital, Ltd. v. Republic of Argentina, 727 F.3d 230, 238-245 (2d Cir. 2013). Argentina was essentially forced to default on the restructured bonds, and eventually, Argentina had to settle with the holdouts, because, either way, it was going to default on its debt. See David Newfield, Pari Passu as a Weapon and the Changes to Sovereign Debt Boilerplate after Argentina v. NML, 24 U. Miami Bus. L. Rev. 175 (2016); Lee C. Buchheit and G. Mitu Gulati, Restructuring sovereign debt after NML v. Argentina, https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=6342&context=faculty_scholarsh ip; and Steve L. Schwarcz, Sovereign Debt Restructuring: A Model-Law Approach, https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=6185&=&context=faculty_s cholarship&=&sei-redir=1&referer=https%253A%252F%252F, Duke Law Scholarship (2016). 400 Id. at 15.
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ii. The negative impact of debt repayments under rapacious circumstances and the
legal costs on economic growth and the public purse (direct impact);401
iii. The negative impact of litigation on borrowing costs for nations and on their
ability to get external finance (indirect impact);402 and
iv. The costs imposed on other members of the international community.403
The next section will specifically focus on the characteristics of DDHFs.
5.3.1. Characteristics of DDHFs
DDHFs, generally, are hedge funds which aim to recover on claims of distressed sovereign debt. They are commercial entities who buy distressed sovereign debt at discount prices in the secondary market and proceed to sue sovereign debtors to recover the full amount of the debt including interest.404 Their characteristics will specifically be delineated below.
i. DDHFs are usually non-cooperative and do not intend to participate in any
form of debt relief – reprofiling or haircut. These kinds of plaintiffs usually
do not accept exchange offers to restructure debts. They usually adopt an
aggressive, noncooperative posture during restructuring procedures and opt
to litigate or demand out-of-court settlements of their claims. DDHFs are
consequently not lenders in the true sense of the word but entities that buy
distressed debt in secondary markets with the sole purpose of litigating.405
401 Id. 402 Id. 403 John A. E. Pottow, Mitigating the Problem of Vulture Holdout: International Certification Boards for Sovereign-Debt Restructurings, 49. 404 Emilia Cornelia Stoica, Sovereign Debt Restructuring and “Vulture Funds”, 716, available at http://cks.univnt.ro/uploads/cks_2016_articles/index.php?dir=05_economics%2F&download= CKS+2016_economics_art.101.pdf. 405 UNCTAD, Sovereign debt restructurings: lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to
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ii. DDHFs take the route of aggressive litigation to get possibly huge pecuniary
returns on discounted sovereign bonds.406
The next section will briefly discuss the presence of DDHFs in sovereign debt markets.
5.3.2. DDHFs in sovereign debt markets
Even though the operations of DDHFs in the sovereign debt market have existed since the 1970s, the first well-known wins for DDHFs in sovereign debt litigation can be traced to restructurings that were begun under the Brady Initiative. The CIBC Bank and Trust Company, a company incorporated in the Cayman Islands, purchased $1.4 billion of Brazilian sovereign debt at a highly discounted price of $375 million, in 1992.
This company therefore owned about 4% of Brazil’s external debt and became the country’s biggest creditor. It later chose to refuse the debt restructuring terms of
Brazilian debt worth $49 billion and brought suit against the country in New York getting a judgement in their favour in 1994. Two years later, Brazil consented to paying interest that had accumulated, in an out-of-court settlement. The fund was able to trade the whole stake it had in Brazilian debt at a huge profit – at about 161%. About the same time, Elliot Associates L.P. (Elliot) got judgements in their favour against Panama and Peru in New York. Elliot had bought $20 million worth of debt for about $11 million, getting $58 million when Peru decided to settle.407
holdout creditors 6.. This opportunistic business model raises a widely accepted principle viz, good faith. It brings into question the effect an absence of good faith may have on a sovereign debtor and its people. The economic, social and political costs that are attached to sovereign debt restructuring procedures go beyond final settlements, but include costs from delayed process usually for years, and that are usually not accounted for. 406 Id. at 7-8. Aggressive litigation raises various ethical, legal and economic issues. Values such as impartiality, transparency, sustainability, good faith and legitimacy are implicated. This view is encapsulated by Financial Times columnist, Martin Wolf, “Servicing debt is indeed important. But it is not more important than everything else.” See Martin Wolf, Financial Times, “Holdouts give vultures a bad name”, Sep. 2014, (last visited 09/30/2019). 407 Id.
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The litigation of such DDHFs increased with the rise of huge bond issuances in frontier and emerging market economies, as well as the rise of international capital markets. Of all the litigation cases against sovereign nations since the 1970s, about
42.5% of them occurred in the 1990s and about 45.8% occurred in the 2000s. In this same timeframe, DDHFs filed more than half of the lawsuits and commercial banks filed about 25% of these lawsuits. DDHFs have now become the predominant plaintiffs in lawsuits against sovereign debtor nations and represent more than three-quarters of all cases since the beginning of the millennium.408
The prevalence of restrictive sovereign immunity in many jurisdictions does not help matters; sovereign borrowing qualifies as a commercial activity thus creditors have free rein to enforce their claims against sovereigns. In New York, one of the world’s financial centres, the Champerty doctrine was removed for claims above $500,000 under the Judiciary Law 489 in 2014. This doctrine which came from the English common law and was adopted by US state legislators prevents an abuse of process, where a creditor buys debt with the intent and purpose of suing the debtor. This defence can therefore no longer be raised by sovereigns. In the meantime, sovereign debtors get sued by other commercial creditors too.409
The next section will examine the actions of DDHFs in enforcing sovereign debt claims.
5.3.3. DDHFs’ actions in enforcing sovereign debt claims
The rate at which creditors have tried to appropriate the assets of sovereign debtors increased from about 20% in the 1990s to more than half in the past decades.
408 Id. 409 Id. at 11. Ex-Im Bank sued Grenada in 2005. In 1994, the Continental Grain Company sued Liberia which the country lost 15 years later in a US law court which awarded the company a US$8 million judgment against Liberia.
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56% of suits DDHFs filed have entailed at least one attempt to seize sovereign assets compared with 21% of cases filed by other kinds of creditors. In the last decade, creditors have attempted to attach assets that did not directly belong to debtor nations but could be classified as “state commercial assets”.410 For instance, creditors (FG
Hemisphere Associates and Af-Cap, Inc.) tried to seize tax income and royalties state- owned oil firms owed to the Democratic Republic of Congo (DRC). The fifth circuit decided that the tax income and royalties were “commercial activities” as they had formerly been utilized to repay commercial debt in the US.411 Moreover, Kensington
International in 2007, brought suit against the DRC and seized money that was already set apart for development.412 In another instance, DDHFs targeted Argentina’s Central
Bank’s foreign reserves kept in an account in the Federal Reserve Bank of New York, on the ground that the bank was an “alter ego” of the Argentine government and was not independent. This was done in an attempt to get the judgment they obtained against
Argentina enforced. The US Court of Appeals this time, ruled in favor of the government because the FSIA expressly protects assets of central banks such as foreign exchange reserves from interference of the courts, regardless of the independence of the central bank in relation to the state government. Following this, many nations have proceeded to enact legislation that will place foreign exchange reserves beyond creditors’ reach such as China, France, Spain and Slovenia. Furthermore, NML Capital, in 2014, sued Argentina in a Californian court to prevent the country from launching satellites in space. 413
410 Id. at 11-2. 411 FG Hemisphere Associates v. Republique du Congo, 455 F. 3d 575 (5th Cir. 2006) and Af-Cap, Inc. v. Republic of Congo, 383 F. 3d 361 (5th Cir. 2004). Other DDHFs sued other creditors, such as when Kensington International sued BNP Paribas: Kensington International, Ltd. v. BNP Paribas S.A., Case No. 03602569 (Sup. Ct. N.Y. Co. 2003, unpublished opinion). 412 Kensington International Ltd. V. Republic of Congo & Ors [2007] EWCA Civ 1128 (07 November 2007). 413 Id. at 11-2.
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DDHFs have also tried to seize presidential planes, and once held an Argentine military naval ship at the coast in Ghana. NML Capital, in May 2015, also had
Argentine government accounts in France and Belgium freezed including bank accounts of Argentine embassies and Argentine public organizations. The bank accounts used by missions in their operations on behalf of international organizations such as UNESCO were also seized. Attempts like these to seize and attach sovereign assets outside its jurisdiction have hardly been successful. Yet they have exerted much pressure on these sovereign states, at least through the high costs of related lawsuits.414
Now that the actions of DDHFs in the sovereign debt market have been explored, the next section will discuss the social and economic costs of their activities.
5.3.4. The case against DDHFs: the social and economic costs of their activities In general, the activities of DDHFs have been condemned as unlawful and exploitative. The UN Human Rights Council’s Advisory Committee on the activities of DDHFs opines that pursuing the full repayment of sovereign debt from a defaulting sovereign is an “illegitimate outcome”. The Committee also highlighted the negative impacts the activities of these funds have on the ability of defaulting sovereigns to meet their human rights duties, especially regarding social, economic, and cultural rights.415
Some of those negative impacts will now be discussed in turn. i. The negative impact of debt repayments under rapacious circumstances and
legal costs on economic growth and the public purse
Restructurings are a genuine and sometimes crucial exit mechanism for
defaulting sovereigns out of debt conundrum giving these nations the
414 Id. 415 UNCTAD, Sovereign debt restructurings: lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to holdout creditors 10.
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opportunity to provide essential public services and initiate economic recovery.
Privileged settlement of claims outside a consensual debt workout procedure
can rob a defaulting sovereign of essential resources to finance infrastructure
and policies designed to support welfare. Although states are usually
responsible for financial mismanagement, litigation brought by DDHFs
indirectly punishes citizens by demanding or obstructing funds that could have
been used to bring about social good.416
Measuring the effect of settlements with holdout creditors on public
purses is not as straightforward as it seems. There are counterfactual
assumptions including approximating what would have been the case if all the
creditors had participated in the restructuring procedure. It will also entail taking
into account the form the settlement takes – cash or new debt – and considering
all legal costs the state incurs with the suit (which can go on for years), along
with matching discount rates, among other factors. It has been found that the
effect of DDHFs’ holdout can cost up to a quarter of public funds or 7% of GDP
(not including legal costs). In some instances, the ratio of legal costs to debt
service duties can go up to 200%. The African Development Bank therefore
established the African Legal Support Facility (ALSF) therefore to help nations
facing holdout litigation in 2009.417 ii. The negative impact of litigation on borrowing costs for nations, on their credit
ratings, and ability to get external finance
Litigation of holdout creditors has been connected with higher costs of borrowing and loss of access to international financial markets. First, the longer crisis
416 Id. at 16. 417 Id.
Page | 140 resolution takes, the more negative the impact on sovereign credit ratings. When restructuring procedures are going on, spreads are higher and ratings are lower, making costs of getting finance higher. In Argentina, for instance, legal threats that imply that a sovereign debtor cannot meet future debt obligations has been seen as a factor negatively affecting assessments of creditworthiness by credit rating agencies. Second, if investors take into consideration the threat of “creditor attachment”, lending to a nation embroiled in holdout litigation could mean a blockade on capital flows to the nation in question. This risk may have hugely increased after the interpretation the courts in the Argentina and Peru cases gave the pari passu clause (a country cannot pay existing holders of restructured debt or new debt unless holdout creditors are paid pro rata as well). This intensifies the risk of technical default in the future. Third, holdout litigation might result in sovereign debtors being excluded from the market. This is a view that has been expressed in literature that supports the view that litigation causes reputational harm to the sovereign debtors and it has negative impacts regarding their access to the markets and investments.418
Holdout creditors have been known to go to any lengths (including lobbying) to profit from their bets. In Argentina’s case for instance, holdout creditors funded a lobbying group – the American Task Force Argentina (ATFA) – which supported media campaigns that opposed the Kirchner Fernandez government in order to block the nation’s access to capital and multilateral credit markets, and attempted to connect the nation to atrocities such as terrorist activities.419
418 Id. at 18-9. See F. Sturzenegger & J. Zettelmeyer, Creditors’ Losses versus Debt Relief: Results from a Decade of Sovereign Debt Crisis, 5 Journal of the European Economic Association 343- 51 (2007). 419 Id. at 19. The executive director of the ATFA was once reported to say that the only reason the task force was set up was to “draw attention to Argentina’s misbehavior”.
Page | 141 iii. The negative effects of litigation on international trade and financial flows, and
on the integrity and functioning of capital markets:
Holdout litigation can sometimes have the effect that trade financing is cut off, resulting in nations having to trade in “roundabout ways” to prevent “economic seizures”. Trade might also be impaired as in the case of the DRC where holdouts blocked the nation’s oil exports for many years. Holdout litigators were also able to attach trade income payable to Zambia and Ecuador from copper and oil exports respectively.420
As DDHFs aim to get repayment of debt in full or sometimes just at a profit, they do not participate in the loss-sharing and loss-bearing processes that come with the resolution of a debt crisis. Their refusal to participate prolongs the restructuring procedure unnecessarily leading to more costs for all the bondholders and market participants involved. If, when there is a sovereign debt crisis, other creditors are under the impression that “rogue” holdout creditors have so much legal enforcement benefits, they might be dissuaded from consenting to an haircut and choose to hold out instead so that they can get a “special me-too” treatment which is obviously to the disadvantage of most of the bondholders. The inability to have successful debt restructurings can worsen debt crises and thus expand the risk of contagion to other nations or global capital markets.421
Furthermore, enforcement channels founded on the pari passu injunction might have a negative impact on the standard operation of the global financial ecosystem. In
Argentina’s case, the New York courts in imposing injunctions on financial institutions located in various jurisdictions pretty much exercised “de facto universal jurisdiction”
420 Id. at 19. 421 Id.
Page | 142 thereby infringing on the sovereignty of other nations and the rule of law. Citibank for instance, in complying with the pari passu injunction (by not processing payments to bondholders), had no choice but to contravene Argentine law and risked losing its banking license, which would have caused “catastrophic and irreversible harm” to the bank. Ultimately, Citibank opted to close its Argentine branch and planned to abandon the business of keeping custody of Argentine bonds, including those governed by
Argentine law. Other institutions that were also processing payments for bonds issued under Japanese and English law were faced with conflicting orders.422 An English judge in February 2015, ordered Bank of New York Mellon (BoNY Mellon) to hand payments over to clearing houses (Euroclear and Clearstream) of Argentine restructured bonds that were governed by English law. If this order was complied with, it would have contradicted the New York order. BoNY Mellon which was incorporated in New York and has its registered office in New York chose not to be in contempt of the court in its jurisdiction.423 A Belgian court also directed BoNY Mellon to hand payments over to bondholders in euros but this had no effect.424
In addition, the business model of DDHFs has the ability to weaken the integrity of the capital market. Integrity, transparency, and inclusivity of the capital market are necessary for the development of countries. These funds have been known to file lawsuits through subsidiaries which are sometimes located in “non-cooperative jurisdictions”, that are secretive with little to no information in respect of ultimate
422 Id. at 20. 423 Matt Levine, Bloomberg “Argentina’s Bond Mess Gets Slightly More Complicated”, https://www.bloomberg.com/opinion/articles/2015-02-13/argentina-s-bond-mess-gets- slightly-more-complicated, 13 February 2015 (last visited 09/25/2019). 424 UNCTAD, Sovereign debt restructurings: lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to holdout creditors 20.
Page | 143 ownership. Activities like these might leave the financial system unguarded from reputational risks and abuse that weaken its main functions.425 iv. The costs imposed on other members of the international community
The relentless litigation strategies of DDHFs have also been heavily criticised because it imposes costs on other members of the international community and prevents consistency in the growing jurisprudence of sovereign debt law.426
As Pottow argues, the main issue with enforcement of sovereign debt obligations by private parties is the existence of a “lurching, disorganized, ad hoc casebook of judicial precedent on sovereign debt”, all decided by busy judges with little expertise and experience on these matters. The result is naïve or negative legal consequences arising from these judgements. If the reasoning in NML Capital Ltd. v.
Argentina is left unchallenged, holdout investors have more of an incentive to keep doing what they do, thereby worsening the problem. This decision resulted in panic in the sovereign debt market, and the IMF was reported as being worried that it would
“give holdout creditors greater leverage”. Another issue of concern is that of potentially contrasting judgements from different jurisdictions such as on interpretation of issues in the debt instruments.427 In any event, the benefit of a normative uniform framework for dealing with sovereign debt holdouts and litigation is that there is likely going to be coherence in the jurisprudence that evolves, which is currently absent under the status quo.428 That is where the normative initiative proposed in this study comes in handy.
425 Id. at 20-1. 426 John A. E. Pottow, 49 Tex. Int’l L.J. 221, 225. 427 John A. E Pottow., "Mitigating the Problem of Vulture Holdout: International Certification Boards for Sovereign Debt Restructurings" 81 Law & Economics Working Papers, 1, 4 (2013).In relation to this, Pottow quips that choice of forum and law clauses help to deal with the problem to some degree, “albeit … at the cost of concentrating it all on New York law, as now interpreted by the Second Circuit”. 428 Id.
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As illustrated above, NML Capital went after Argentina relentlessly for assets outside its jurisdiction, including laying claim to Belgian diplomatic accounts and an attempt to seize the presidential helicopter – the Tango 1. It however seems that the aggressive strategy that these funds take on is motivated by a complicated “signaling game of pit-bulledness” in order to make it obvious that they are “here and here to stay” thus, a sovereign debtor should just pay up the money they are claiming. NML Capital also travelled across the world to detain the Libertad in Ghana even though in a best- case scenario, this would have gotten it 1% of its unresolved claim. Argentina was able to successfully raise the defence of sovereign immunity. The jolting disconnect between the value of the claim and the legal and financial resources expended in laying claim to the vessel makes one to question whether the fund was doing this just to “posture for its larger holdout game”.429
Argentina defending herself against this claim would have cost a lot of money.
Other costs might however be involved when private plaintiffs raise elements of the international dispute resolution system. When NML Capital got the vessel attached through a Ghanaian court order Argentina had to proceed to the UN Convention on the
Law of the Sea (UNCLOS), a convention aimed at resolving maritime disputes, concluded in 1982, to determine her immunity claim. Even though Argentina was willing to arbitrate, Argentina also had to get provisional measures to deal with the detention of its frigate. This entailed assembling the International Tribunal of the Law of the Sea (ITLOS) which seldom meet. This Tribunal has met only 22 times since it was established. The issues it tends to deal with are ones that concern for instance, detained fishing vessels because of huge claims made by exclusive economic zones
(EEZ). In this case, Argentina had to bring suit against the fund in order to get its ship
429 Id. at 227.
Page | 145 returned. The problem though was that getting this panel together was costly; some of the costs were borne by the parties, but there are innumerable indirect costs that cannot be borne by the parties. When private parties make tribunals convene (which are in themselves a result of compromises made by wary states making wobbly alliances through a formal convention), it can belittle the wider sphere of international conflict resolution. Some cynical states can look at such drama and say, “See, if we sign on we could get sued by some crazy hedge fund”. It also results in confrontation among states; for instance, even though Argentina and Ghana had quite a cordial relationship beforehand, the former had to sue the latter in this matter.430
Now that the social and economic impacts of the activities of holdout investors have been examined, the next section will make a case for the presence of these investors in the market and argue that they are a linchpin for an efficient sovereign debt market.
5.4. DDHFs and holdout litigation: a linchpin for an efficient sovereign debt market? The following paragraphs will discuss the presence of DDHFs in the sovereign debt market and highlight their advantages.
5.4.1. The advantages of the presence of DDHFs in the sovereign debt market Recall that the premise of this proposal is that although the activities of DDHFs result in holdout problems that disrupt debt restructuring processes, it is submitted that
DDHFs are needed in the secondary market for the following reasons:
First, they provide liquidity in the market which is quite important, because as mentioned above, creditors and investors feel more comfortable granting credit or
430 Id. at 227-28.
Page | 146 investing in debt with the knowledge that there is a market where the debt can be sold if they need access to cash soon,431 or need to recoup their investment to invest in other ventures.
Secondly, as a consequence of their investigation in pursuing their claims (and because they have the resources to do so), DDHFs expose corruption and other dishonest activities on the part of the debtor nations in disbursing loan proceeds.432
Thirdly, their presence in the market arguably ensures that debtor nations’ market access is not restricted on account of their default. If creditors cannot get their money back, credit ratings of debtor nations go down (these nations suffer reputational risk and their credit ratings might take a hit) and their market access is restricted for future borrowing. This obviously does not benefit these debtor nations.
Fourthly, the presence of DDHFs deals with moral hazard problems that arguably exist when debtor nations get loans, irresponsibly disburse the proceeds, and hope for the creditors to “save” them from the debt crunch.433 Holdout creditors and holdout litigation actively serve as a “moral hazard counterbalance” regarding sovereign default. Moral hazard occurs when a person or government decides to take certain risks while expecting that another person or entity will carry the responsibility for such risks.434 When sovereign debtors anticipate that they will get bailout packages from the
431 John Muse-Fisher, Starving the Vultures: NML Capital v. Republic of Argentina and Solutions to the Problem of Distressed-Debt Funds, 102 Calif. L. Rev. 1671, 1681 (2014). 432 Id. See also Richard W. Rahn, RAHN: Vulture or watchdog? Beware of bill providing cover for foreign kleptocrats, Wash. Times (Aug. 30, 2010), https://www.washingtontimes.com/news/2010/aug/30/vulture-or-watchdog/ (last visited 03/11/2019). 433 “Moral hazard [also] refers to the idea that allowing countries (or companies or people) to renegotiate and lower their debts only reinforces the profligate behavior that put them in debt in the first place.” Quoted from Martin Guzman & Joseph E. Stiglitz, “How Hedge Funds Held Argentina for Ransom” NY Times (Apr. 1, 2016). 434 Lucas Wozny, 2017 COLUM. BUS. L. REV. 697, 709 (2017). A typical example occurs where a big bank takes on too many risks because it knows that its “too-big-to-fail” status will see to it that it gets a bailout eventually so that the consequences of the risks it takes does not spread to the worldwide economy.
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IMF or other sources, they might suffer from issues relating to moral hazard. Moral hazard relating to default is a feature of markets and enwraps contracts in needless uncertainty thereby raising the cost of capital. Prudent sovereign debtors might also incur more borrowing costs even if they have a lower risk of default, as a result of the moral hazard relating to default. DDHFs however counter this moral hazard by relentlessly going after sovereign debtors for their claims, to the point of hindering sovereigns from accessing the capital markets.435
If sovereigns know ex ante that DDHFs will pursue their claims relentlessly and impose substantial costs on them, they might be more disincentivized to default. For instance, sovereign debtors might be inclined to undertake irresponsible financial policies and programs expecting they can be bailed out. Knowing however that DDHFs can litigate their claims and potentially recover the bailout package or even make it impossible to get in the first place, might make them be more careful and thoughtful in making responsible financial decisions. These ex ante incentives the presence of
DDHFs provide in the market might prevent the borrowing costs from escalating unnecessarily, enabling sovereign nations to access the capital markets to get financing for development and other needs more cheaply.436
Finally, some commentators have further argued that DDHFs play a crucial role in the stabilization of distressed debt markets as they “provide a safety net” for other investors who would otherwise face huge losses when a sovereign debtor defaults.
Institutional investors are usually hesitant to bring legal suits against their sovereign clients; rather they try to prevent destroying relationships with these sovereigns by trading the defaulted debt on the secondary market for distressed debt. Most of the
435 Id. at 709-10. 436 Id.
Page | 148 buyers of the distressed debt are DDHFs. In addition, it has been argued that raising legal bars on trading distressed debt on the secondary market or on the possibility of litigation to enforce contracts could raise borrowing costs for sovereign debtors.437
Creditors are more likely to lend and invest in sovereign bonds with the knowledge that there is an avenue for them to trade their instruments for cash when they need to exit from the market.438
5.4.2. Holdout litigation and its advantages The next few paragraphs will discuss holdout litigation and its advantages.
Holdout litigation is the result of developments in two different, but associated, domains – the courts and markets. The sovereign debt market has advanced to include a variety of creditors with competing interests and the judiciary has propagated a method that gives a narrow interpretation to the defences raised by sovereign debtors in legal suits brought by creditors. As the possibility of uncooperative creditors has increased, their capability of pursuing their claims through legal action has also risen.
The restructuring process nonetheless has not progressed to reflect the advances in this field.439
In debt restructuring processes that took place in the 1930s, bondholder committees including the Foreign Bondholders Protective Council (FBPC) lacked both an effective method of compelling obstinate bondholders to accept restructuring schemes that had been negotiated with sovereign debtors. Holdout creditors were also not able to take sovereign debtors to court over their claims. Restructuring processes as a result were
437 UNCTAD, Sovereign debt restructurings: lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to holdout creditors 7. 438 John Muse-Fisher, 102 CALIF. L. REV. 1671, 1681. 439 Jill E. Fisch & Caroline M. Gentile, Vultures or Vanguards: The Role of Litigation in Sovereign Debt Restructuring Conference on Sovereign Debt Restructuring: The View from the Legal Academy, 53 Emory L.J. 1043, 1097 (2004).
Page | 149 finished only over lengthy periods of time, resulting in more losses for debtholders and more distress for sovereign debtors. These problems eventually led to the ruin of the market for sovereign debt.440
In the debt restructurings that took place in the 1980s, the bank advisory committees were capable of coercing obstinate creditor banks, usually smaller banks, to agree to proposed restructuring schemes and to desist from taking legal action concerning their claims. The terms of these restructuring schemes, nonetheless, seemed to be in line with the interests of the big commercial banks over those of the smaller banks, leading to a
“tyranny of the majority”. In addition, this led to strains among the banks that were taking part in the restructuring processes. This strain led to the growth of a secondary market for sovereign debt and possibly might have led to lesser access to credit for sovereigns in the credit market.441
The huge focus on reducing holdout litigation, nonetheless, ignores the advantages that DDHFs bring to the table in the restructuring procedure and the part that legal actions play in empowering debtholders relative to debtors and minority debtholders compared to the majority of debtholders. DDHFs in declining to participate in debt restructuring act as a check on burdensome restructuring terms and sovereign opportunistic defaults. In addition, the prospect of minority creditors holding out might reduce the prospect of collusion among majority of the debtholders. Furthermore,
DDHFs foster the functioning of the global capital markets. For instance, DDHFs intensify the flow of capital to sovereign debtors because they decrease the possibility of opportunistic defaults. DDHFs therefore offer value apart from the restructuring procedure by increasing liquidity in the distressed sovereign debt market. The extent to
440 Id. 441 Id. at 1098.
Page | 150 which DDHFs deliver these values depends on the power they have through judicial enforcement of their claims against sovereign debtors.442
The advantages of holdout litigation can therefore be summarised as follows:
i. Holdout litigation may provide a way of avoiding the failures that
occurred in the restructurings of 1930s and 1980s by enabling creditors
to pursue their claims against sovereign debtors. Sovereign debtors
might also be incentivized to ensure that the restructuring procedure is
not delayed because of the looming threat of holdout litigation. Holdout
litigation is therefore a way through which minority creditors can
challenge restructuring processes intended mainly to benefit the
majority of creditors.443
ii. Holdout litigation might indirectly entice more DDHFs to enter the
sovereign debt market. As far as DDHFs buy huge blocks of claims, they
may decrease the administrative burden that comes with the
restructuring process of sovereign debt. DDHFs might serve as a
platform for organizing the actions of creditors, particularly among
creditors who sell their claims to the funds. DDHFs simultaneously
provide a method through which negotiating costs and communications
might be decreased.444
iii. Holdout litigation might improve the operation of the market for
sovereign debt. As mentioned above, holdout litigation may act as a
check on sovereign opportunistic defaults. The threat of litigation by
442 Id. at 1047. 443 Jill E. Fisch & Caroline M. Gentile, 53 Emory L.J. 1043, 1098. 444 Id. at 1098-99.
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obstinate creditors might incentivize sovereign debtors to fulfil their
debt obligations rather than default. Through the decrease in the
possibility of opportunistic defaults, holdout litigation might cause an
increase in capital flows to sovereign nations.445 Holdout creditors
practically raise the costs of default.446
iv. Holdout litigation might also increase liquidity in the sovereign debt
market. The option of litigation incentivizes DDHFs to enter the market
and invest in distressed sovereign debt. This creates liquidity as it offers
prior investors a way of leaving the market by trading their bonds. Retail
investors, especially those which have fixed income, may profit from
the capability to trade their bonds. Such trades also offer information
about prices that institutional investors and banks need to mark their
portfolios to market.447
v. Holdout litigation incentivizes sovereign responsible economic
behaviour and efficient capital structures. There is always the need for
sovereigns to get capital to invest in infrastructure and other
development endeavors. In doing this, the sovereign can issue either
domestic- or foreign-currency denominated bonds. A proper capital
structure will aim to have a balance between inflation costs and the
expected costs of default. The possibility of holdout litigation increases
said costs of default. The absence of holdout creditors who are ready to
aggressively pursue their claims might result in the optimal ratio
445 Id. at 1099. 446 Lucas Wozny, “National Anti-Vulture Funds Legislation: Belgium’s Turn”, 2017 COLUM. BUS. L. REV. 697, 706 (2017).
447 Id. at 1100-1101.
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between currency issued and debt issued to be uneconomical, thereby
fostering overborrowing and making default an easier option for
sovereigns. Essentially, if the output realized from the issue of the debt
instruments is too low compared to the sovereign’s debt load, it might
be preferable for the sovereign to default even if it might bear “a
deadweight output loss” as a result.448
5.5. Why should there be regulation of DDHFs?
The author in this study believes that DDHFs are essential to promote liquidity, growth and efficiency in the sovereign debt market. Their activities should nonetheless be regulated to some extent; they should be held to a higher standard than they are currently held and should be held responsible for the various consequences of their actions.
Holdout creditors are a bit of a curate’s egg: they have their advantages and disadvantages that affect even people and entities who are not parties to the actual sovereign debt contracts but bear these costs coincidentally. The social and economic costs of the activities of DDHFs have already been examined above.
It should be noted that in most sovereign debt crises, the sovereign bonds held by DDHFs are usually only a small part of the total debt outstanding. The disruptive impacts of holdout litigation in such crises therefore could very well greatly outweigh any benefits to the market such as greater liquidity resulting from the activities of
DDHFs.449 DDHFs which are minority creditors therefore create more problems for the
448 Lucas Wozny, 2017 COLUM. BUS. L. REV. 697, 706-67 (2017). 449 UNCTAD “Sovereign Debt Restructurings: Lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to holdout creditors” 7. If most creditors choose to oppose sovereign debt restructuring procedures
Page | 153 restructuring process which would benefit most of the creditors, instead of helping the cause of involuntary debtholders.450
It has been argued that DDHFs get huge pecuniary benefits to the disadvantage of other creditors who are less aggressive. As a matter of course, payments made preferentially to DDHFs reduces the pool of money from which payments could be made to other creditors who participated in debt restructuring processes.451 Finally, holding out and holdout litigation practically increase restructuring costs.452 For these reasons therefore, DDHFs should be regulated in the sovereign debt market.
Fisch and Gentile agree that holdout litigation has its pitfalls.453 In many instances, the disruption associated with such litigation obliterates its good effects.
They argue however that critics of such litigation cannot justify the broad schemes that have been suggested to deal with holdout litigation. They propose rather, narrower refinements to the litigation solution implemented via market-based amendments in sovereign bond contracts such as CACs.454 The author agrees with them, but where she departs is that she is proposing a normative regulatory initiative that would establish
and instead opt to sue and demand dull repayment in courts, they have very little chance of success. 450 Id. 451 Id. 452 Many nations have thus, considered legislating to curb the effects of the activities of these funds. A good example is Belgium, which passed a law to protect Belgian funds that had been allocated towards debt relief and development to be touched by DDHFs. See Project de loi relative à la lutte contre les activités des fonds vautours [Legislation relating to the fight against the activities of vulture funds] of July 12, 2015, http://www.lachambre.be/FLWB/PDF/54/1057/54K1057005.pdf (last visited 03/19/2019); Lucas Wozny, 2017 COLUM. BUS. L. REV. 697, 700 (2017). The UK followed suit in 2010 with the Debt Relief (Developing Countries) Act of 2010, http://www.legislation.gov.uk/ukpga/2010/22/pdfs/ukpga_20100022_en.pdf (last visited 03/19/2019). In any event, these are national solutions which only have effect in the countries where these legislations have passed. 453 Jill E. Fisch & Caroline M. Gentile, 53 Emory L.J. 1043, 1047. 454 Id.
Page | 154 principles to regulate the activities of DDHFs and other holdout creditors in the sovereign debt market.
Finally, the author does not believe that holdout litigation is a permanent solution to sovereign debt crises or a guarantee for sovereigns’ lasting access to the credit markets. Holdout litigation is simply “part of the solution”.455
5.7. Conclusion
This chapter set out to interrogate the role of the DDHFs in the sovereign debt market and in the development of the secondary market for distressed sovereign debt.
In achieving this aim, a cursory exploration into hedge funds, including how they are structured and how they operate was undertaken. Following this, the meaning, features and historical perspectives of DDHFs were explored, including their activities (and the social and economic costs thereof).
It was shown in this chapter that some commentators argue that DDHFs play a crucial role in the stabilization of distressed debt markets as they “provide a safety net” for other investors who would otherwise face huge losses when a sovereign debtor defaults. These investors therefore provide needed liquidity in the market. There is also the view that creditors are more likely to lend and invest in sovereign bonds with the knowledge that there is an avenue for them to trade their instruments for cash when they need to exit the market. The author concurs with these views. Where the author diverges however is that DDHFs are a curate’s egg; in other words, they have their advantages and disadvantages. Their activities should thus be regulated to some extent;
455 Marcus Miller & Dania Thomas, “Sovereign Debt Restructuring: The Judge, the Vultures and Creditor Rights”, 30 The World Economy 1491,1502 (2007).
Page | 155 they should be held to a higher standard than they are currently held and should be held responsible for the various consequences of their actions.
The next chapter will therefore discuss at length the normative initiative that this study proposes for regulation of holdout creditors in the sovereign debt market.
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Page | 157
CHAPTER 6
NORMATIVE FRAMEWORK FOR REGULATION OF HOLDOUT
CREDITORS IN THE SOVEREIGN DEBT
6.1. Introduction The previous chapter set out to interrogate the role of DDHFs in the development of the sovereign debt market, especially the secondary market. A cursory exploration of hedge funds was undertaken. The meaning, features, and historical perspectives of DDHFs were also investigated along with their activities (and the social and economic costs thereof).
As articulated in the previous chapter, distressed debt investors (particularly holdout creditors) are a linchpin for an efficient sovereign debt market. This chapter however argues that a legal approach to the mitigation of the disruptive tendencies of holdout creditors is the normative regulation of these creditors which could potentially make the market more efficient by facilitating lending ex ante and debt restructuring ex post, and ultimately easing the lingering sovereign debt problem.
This chapter therefore proposes a normative framework for the regulation of
DDHFs to: 1) address the poorly functioning sovereign debt market by deepening and inducing the liquidity of the secondary market for distressed sovereign debt, 2) guarantee private credit flow for capital formation and finance for development especially in debtor nations to build productive capacities for integration into the global economy; and 3) contribute to solving the perennial problem of sovereign default and debt overhang because their existence in the market and the threat of holdout litigation keep sovereigns on their toes in respect of their debt obligations.
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The proposed framework would strike a delicate balance between the rights of commercial creditors on the one hand, and protection of sovereign debtors on the other hand while injecting some measure of equity into the process. Specifically, the normative initiative would aim at suppressing the perceived ‘mischiefs’ or exploitative tendencies of holdout creditors and advance their benefits to promote efficiency in the market for guaranteed flow of private credit for capital formation in the developing world.
A normative initiative is desirable in order to: 1) foster consistency in the development of jurisprudence in the field of sovereign debt and holdout litigation; and
2) to prevent regulatory arbitrage.456 Finally, a case will be made for the IMF to spearhead the push for a normative framework for the regulation of holdout creditors in the sovereign debt market, as proposed in this study.
It is crucial to note that international financial regulation operates in a cooperative and decentralized context led by national regulators and some financial regulation institutions such as the Basel Committee of Banking Supervision (BCBS), and standard-setting organizations such as the Financial Stability Board (FSB). These institutions deliver efficient platforms for recognizing regulatory issues, harmonizing policies, establishing standards, and fostering compliance. Even though international financial regulation is not founded on a formal legal framework, it has most of the important features of law including “coordination, compliance, and enforcement”. This is therefore an instance of global cooperation and how international law currently works
456 Regulatory arbitrage, in general terms, occurs when persons such as companies take advantage of loopholes in regulation with the aim of avoiding unfavourable laws or regulations. See Adam Hayes, Regulatory Arbitrage, INVESTOPEDIA, (Oct. 4, 2019), https://www.investopedia.com/terms/r/regulatory-arbitrage.asp.
Page | 159 even where there are no formal legal sovereign duties involved.457 The normative initiative being proposed therefore, is a soft law regime which would not have formal legal duties but will be “enforced” via peer pressure. This initiative would build upon the United Nations Conference on Trade and Development (UNCTAD) Principles on
Sovereign Lending and Borrowing (UNCTAD Principles).
This chapter in section 6.2. will discuss public international regulation versus private international regulation and highlight the best option that suits the normative initiative this study proposes. Section 6.3 will discuss normative regulatory governance in general and will examine the various options on the plate in this regard. Section 6.4 expands more on the role of the IMF in creating and maintaining the proposed normative initiative to regulate holdout creditors. In the next section, 6.5, the normative framework this study proposes is discussed in-depth and specific, crucial aspects are highlighted. Section 6.6. will discuss how my proposal differs from other initiatives such as the SDRM and contractual solutions like the CACs, that have been created to deal with holdout creditor problems in the context of sovereign debt restructurings.
Finally, section 6.7. concludes and summarizes salient points.
It should be noted at this juncture that international regulation can either fall under public international regulation or private international regulation. Each type has its pros and cons. The next section therefore will discuss public international regulation versus private international regulation and highlight the option that best suits the normative initiative this study proposes.
457 Adam Feibelman, 49 N.Y.U. J. Int’l L. & Pol. 687, 688 (2017).
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6.2. Public international regulation versus private international regulation: which way?
On one hand, public international regulation usually comes in the form of international organizations which are established by treaty agreements between states, where such treaty provisions are legally binding. In addition, they have international legal personality, which makes them technically and legally distinct from their founding members.458 A clear advantage of establishing a treaty between states is that the provisions can be legally enforced because they are binding and can only be changed by amending the treaty. This also means that there is more certainty that the parties which sign up will perform according to the treaty. This certainty can however be problematic especially where a novel approach is being applied to resolve or alleviate a problem that has global or cross-border implications.459
Flexibility is needed when experimenting with certain measures, thus, states might find non-binding statutory measures more preferable. Such a non-binding measure can encourage more and open dialogue which could produce better results than the formal convention approach.460 This might be one of the reasons why international economic law has largely been in the form of “soft law”. The treaty process can be a very long, time-consuming and expensive process because it takes time to rally states together and
458 Chris Brummer, Soft Law and the Global Financial System: Rule Making in the 21st Century, (2nd ed.) 63-64 Cambridge University Press: Cambridge (2015). 459 Steven L. Schwarz, Sovereign Debt Restructuring: A Model-Law Approach, https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=6185&=&context=faculty_s cholarship&=&sei- redir=1&referer=https%253A%252F%252Fwww.bing.com%252Fsearch%253Fq%253Dsove reign%252Bdebt%252Brestructuring%252Ba%252Bmodel%252Blaw%2526form%253DED GEAR%2526qs%253DPF%2526cvid%253Dbbffd2de5e65402dacbeb9a3ad103f87%2526cc% 253DUS%2526setlang%253Den- US#search=%22sovereign%20debt%20restructuring%20model%20law%22 7 (2015) (last visited 03/08/2019). 460 Id.
Page | 161 get them to agree to bind themselves via a treaty, and convening international meetings, one can imagine, are expensive endeavors.461
In some cases, it might not even be possible to garner the political will necessary to make the treaty a reality.462 Other problems with public international regulation include the lack of expertise and dearth of available funds to deal with issues as they emerge in the relevant regulated field.463
Regarding the normative initiative being proposed, one can say confidently that a treaty approach is not feasible for regulating the activities of DDHFs. Many of these funds are located in the Global North such as the US, and these nations might not want to sign a treaty, especially because the nations largely affected by the activities of these funds are located in the Global South. It might also be impossible to muster political will for such an endeavor in this age where more of Global North nations are leaning away from multilateralism. In addition, as this is a novel approach (the normative regulation of DDHFs), many stakeholders might find it preferable to go any other route but the treaty route. The treaty route can therefore be ruled out for the normative regulation of DDHFs.
Private international regulation, on the other hand, does not involve treaty agreements and consumes much less time and resources. Many of the challenges with the convention approach are therefore taken out of the way. Two types of private international regulation include market-based and nonmarket-based regulation which are fully explained below in the next section.
461 Id. 462 Many treaties are “reactionary treaties” – in other words, treaties that emerged in reaction to certain events that had huge implications for the founding states and the world at large. Other treaties were established because the parties saw a clear, sometimes, pecuniary benefit from cross-border or international cooperation, such as trade treaties. It is rare to see countries bind themselves via treaty if there is not a strategic political or monetary benefit at stake. 463 Id.
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In my view, the normative regulation of DDHFs as proposed should have elements of nonmarket private and public international regulation. Specifically, the reasons for advancing this proposition are as follows:
First, there would be a focal institution that is dedicated to establishing standards that would regulate the activities of holdout creditors in the sovereign debt market. This institution would comprise of experts and relevant stakeholders in this field. This would be more preferable than having individual stakeholders or small groups of them develop several regulatory schemes and “letting the best one win”. Establishing a focal institution for this normative purpose would prevent unnecessary duplication in the creation of standards and avoid the wastage of resources.
Secondly, ideally, regulation should be a process that evolves with changes in the market, so that it can remain efficient, effective, and stable. If regulation should remain static and not evolve with changes, eventually the efficiency and stability of the market would be affected negatively.464 The establishment of a focal institution for developing the relevant standards would make it possible to update standards as the need arises and as time progresses, and would prevent the industry from being stuck to standards that turn out to be inferior.
The next section will therefore discuss normative regulatory governance in general and will examine the various options on the plate in this regard.
464 I. Goodspeed et. al. (eds.), The Regulation of Financial Markets: Essays on the South African financial markets, 75.
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6.3. Normative regulatory governance: Various options on the plate
Buthe and Mattli in their work categorize global regulation. Global regulatory governance can be divided into public non-market standard setting; public standard- setting bodied in market competition; market-based private international standard- setting; and non-market private international standard-setting.465 These types of global regulation will be explained in the ensuing sections.
6.3.1. Public non-market standard-setting
This type of regulatory governance entails trans-governmental cooperation between national regulators or cooperation through intergovernmental organizations.466
Governments inherently have the duty or function to enact rules that guide social and economic behavior. Public regulation is especially desirable when economic activities impact crucial areas of public policy such as consumer protection or the environment, or when economic activities have national security consequences.467 Government regulation and control have therefore been seen as necessary because, for instance,
“standards for health and safety resemble ‘public goods’ which markets will undersupply”.468
Nations traditionally have cooperated internationally to regulate private and public behavior in areas that have transnational impact, including matters relating to
465 Tim Buthe & Walter Mattli, The New Global Rulers: The Privatization of Regulation in the World Economy, 14 Princeton University Press: New Jersey (2011). 466 Id. This form of regulatory governance has a “long tradition” and most political science literature on global regulation has been focused on this form. 467 Id. at 20-21. 468 Id. at 21.
Page | 164 international diplomacy or the effects of international interdependence.469
Globalization coupled with market integration has increased the need for the harmonization of rules, policies and laws especially with advances in transportation, information technology, and telecommunication. Such harmonization happens through:
1) international governmental organizations (IGOs); 2) transnational cooperation between specialized regulatory agencies; and 3) ad hoc agreements between nations.470
IGOs seem to be the most popular type of public international non-market standard- setting mechanisms,471 although recent international events indicate that more nations are leaning towards ad hoc agreements rather than binding treaty mechanisms. Two good examples are: 1) the IMF which sets standards for member nations especially regarding fiscal transparency, data distribution, and current account reporting; and 2) the International Labor Organization (ILO) which establishes norms regarding labor and garners relevant statistics from member nations in relation to its rules for determining and gauging conditions of labor.472
6.3.2. Public market-based standard-setting
Certain rules that deal with global issues usually originate in domestic or regional standard-setting bodies. Market-based public international standard-setting entails competition between regulatory bodies of individual nations and regional regulatory bodies. Geographically limited rules sometimes compete with one another
(even after they have coexisted independently for a long time). This happens for instance when norms and rules established by governmental public organizations or
469 Id. For example, international trade makes the risk of disease in port cities higher when goods or foreign traders come from nations with bad sanitation facilities. Mutual dependence on the policies of other nations therefore resulted in international cooperation between national health agencies two centuries ago, which still continues today. 470 Id. 471 Id. at 22. 472 Id.
Page | 165 public agencies compete with one another.473 For instance, the rules for determining the structure of a market created by the European Union (EU) Commission to determine if a merger would impact competition negatively is different from the standards applied by the competition regulators in US and other places. These differences result in contradictory decisions taken by regulators in these jurisdictions regarding transnational firms. These rules therefore “compete for voluntary use” by multinational companies when they consider or execute mergers.474
In another instance, public agencies traditionally have created norms regarding consumer goods including cosmetics, drugs, pesticides, vehicle emissions, etc. US regulators including the Environmental Protection Agency (EPA) created these norms which were stricter than similar norms in the EU and other jurisdictions. As more of these products have gotten traded more globally, the US norms often compete with the standards from the EU and other jurisdictions, gradually resulting in a “race to the top” where the strictest standard becomes the defacto global norm.475
Furthermore, nations sometimes assign the task of setting standards to several intergovernmental organizations or several groups of nations assign standard-setting tasks to several regulatory bodies, whose norms eventually compete. A good example is the Codex Alimentarius Commission, an international institution that is co-sponsored by the World Health Organization (WHO) and Food and Agriculture Organization
(FAO). Codex sets food safety rules for genetically modified organisms (GMOs) which member nations use as a technical basis for their national regulations based on the
WTO’s Agreement on Sanitary and Phytosanitary Measures. For live animals and plants, these norms compete with stricter norms for living modified organisms created
473 Id. at 23. 474 Id. at 24. 475 Id.
Page | 166 based on the Cartagena Protocol of the Convention on Biological Diversity, which functions as a suborganization of the UN with 190 member states.476
Finally, globalization has exposed the organizational problems associated with public international regulation. Some of these issues include:1) slow speed of standard setting when appropriate; and 2) absence of funds and technical expertise to address increasingly complex issues, among other things. These problems have led to the privatization of international regulation. Such private standard-setting still occurs in legal and political settings and are influenced by governments. Private standard-setting comes in two forms: market-based and non-market based, which will be discussed in the following sections.477
6.3.3. Market-based private international standard-setting
This form of regulation involves non-governmental organizations (NGOs) and companies making rules and competing independently or in groups to ensure their chosen technical solution is established as the global de facto standard.478 This differs from public market-based international standard-setting because in this context, the norms are created by private or nongovernmental organizations rather than by public regulatory bodies or intergovernmental organizations.479 This also differs from public nonmarket international standard-setting because that entails trans-governmental cooperation between national regulators or cooperation through intergovernmental organizations.480
For instance, a company may try to make a technology become the basis for further development in that technological area especially if the technology works better
476 Id. at 24-5. 477 Id at 25. 478 Id. at 26. 479 Id. at 23. 480 Id. at 21.
Page | 167 with its line of products than a different technology; its engineers are trained experts in the technology; or it has patented the technology. In addition, a company’s proprietary technology might become the global standard if it has a dominant position in the market or most of its competitors adopt the technology as the standard, under license.481 A good example is Microsoft which was able to ensure that its Windows operating system became the de facto global standard not only because of its domination of the market, but because firms found it profitable to adopt the technology many other companies have adopted. This is known as “network effects”, and Microsoft has great network effects.482
Although market-based private global rulemaking is quite relevant in the world economy today, this form of regulation has certain problems. One advantage of this form of regulation is its speed in coming up with a global standard after about two years of market competition between standards. If a standard is chosen too early however, the global industry might be stuck with a standard that turns out to be inferior when a better standard comes out. Besides, when rulemaking among companies is uncoordinated, duplication in the creation of standards can result in wastage of resources and time.483
Market-based private international standard-setting would not work for the normative regulatory initiative been proposed. As mentioned above, one major disadvantage of market-based private international standard-setting is the wastage of resources resulting from duplication in the creation and promotion of standards. This is an issue that will be avoided if companies pool their resources and work together to
481 Id. at 26. 482 Id. at 27. 483 Id. at 29.
Page | 168 develop relevant standards, in nonmarket-based private international regulatory groups, which will be discussed next.484
6.3.4. Non-market private international standard-setting
Non-market private regulators have set majority of private-sector global standards. As opposed to market-based private international regulation, nonmarket- based private regulation involves standard-setting by an international non- governmental organization that both private and public players on the international scene view as the “obvious forum for the issue in question”.485 Two major private regulators of this kind are: the International Electrotechnical Commission (IEC) and the
International Organization for Standardization (ISO) which together make about 85% of all international product standards.486 Another big one is the International
Accounting Standards Board (IASB) which, based in London, establishes international financial reporting standards.487
Essentially, the governments of developing nations integrate these standards into their laws by reference; the latest version of a global regulation becomes law in these countries. For example, China’s Product Quality Law imposes on its regulators the duty to utilize global standards for certification. South Africa’s Occupational Health and Safety Act also incorporates standards by reference rather than enact technical rules in the Act.488
The advantage of nonmarket private global standard-setting is that they enjoy explicit or tacit endorsement by nations thereby protecting their jurisdictional bounds
484 Id. 485 Id. at 29. 486 Id. at 29-30. 487 Id. at 31. 488 Id. at 30.
Page | 169 against “competitive pressures”. For example, IEC or ISO standards are referenced in many national laws, making it possible for public authorities to approve technological change without having to amend the laws. Besides, in many countries, IASB reporting standards are required for consolidated financial statements by firms listed on public stock exchanges.489
6.4. The role of the IMF in establishing the proposed normative initiative
It is proposed that the IMF should spearhead the proposed normative initiative.
The IMF’s mandate is to foster global monetary cooperation and stability. It could also choose to collaborate with the World Bank on this, and the author believes that it would be ideal. These IFIs periodically collaborate to help member nations and work together on certain projects.490
In laying a background for this suggestion, the role the IMF has played in relation to private creditors in the last thirty to forty years will be briefly charted in the ensuing paragraphs.
Generally, the IMF is an international lender of last resort to sovereign nations specifically. In other words, they lend when sovereign nations no longer have access to the international capital market and/or they find it prohibitively expensive to access the market for financing.491 The IMF’s primary functions include surveillance, technical assistance, and financial assistance.492 Even though the IMF primarily deals with its
489 Id. at 31. 490 Factsheet, INTERNATIONAL MONETARY FUND, (Feb. 25, 2019), https://www.imf.org/en/About/Factsheets/Sheets/2016/07/27/15/31/IMF-World-Bank. 491 Rosa M. Lastra, “The Role of the International Monetary Fund” in Rosa M. Lastra & Lee Buchheit, Sovereign Debt Management, 66. 492 Id. at 52-3. See articles IV and V of the Articles of Agreement of the International Monetary Fund (April 2016).
Page | 170 sovereign members, the relationship it has with private creditors has however morphed and expanded over time.493
When the IMF was first established, it did not directly intervene in restructuring of commercial debt. Beginning in 1982 however, with the onset of the Mexican debt crisis, it undertook the role of a “Master of Ceremonies”.494 Commercial creditors relied on the IMF to vouch for the integrity and precision of the projections of debtor nations.495 The IMF used to create rules that sovereign debtors had to abide by to achieve debt rescheduling. This gave creditors more confidence so that they would not refuse to grant crucial additional funding and withdraw needed funds during transitional periods.496 The confidence of creditors was crucial to avoid liquidity crises.497
One of the most crucial roles of the IMF is prevention of crises. The vulnerability of the world’s capital markets as illustrated by the financial crises of the
1990s and 2008/9 has presented a huge systemic risk in the global financial system.
The IMF traditionally simply acted within its mandate as delineated in the Articles of
Agreement. Over time however, its mandate has expanded. The IMF has taken on more responsibilities due to deficiencies that have been identified in the global financial system.498 In 2010 for instance, the IMF was more hands on in Europe. Essentially, the
IMF participated fully in bailout programs which were used to pay commercial
493 Id. at 49. 494 This era was when most loans given to sovereign nations came from commercial banks. 495 Rosa M. Lastra, “The Role of the International Monetary Fund” in Rosa M. Lastra & Lee Buchheit, Sovereign Debt Management, 49. 496 John T. Cuddington & Gordon W. Smith, “International Borrowing and Lending: What Have We Learned from Theory and Experience?” in Gordon W. Smith & John T. Cuddington, International Debt and the Developing Countries, 15. 497 Id. at 7. 498 Xenia Roduner, “Governance in international financial institutions: the case of the IMF” in Kern Alexander & Rahul Dhumale, Research Handbook on International Financial Regulation, 362- 63 Edward Elgar Publishing Ltd.: Cheltenham: UK (2012).
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creditors at par, as a member of the “troika”.499 The point, essentially, is that the role of
the IMF has evolved over time and will continue to do so in relation to the sovereign
debt field.
Through its surveillance function, the IMF has privileged information about
sovereign debtors, and is therefore in a position to help them to solve their problems
through technical assistance and assistance with balance-of-payments.500 The IMF
could therefore step in at times to be a “referee” – a third party apart from the creditors
and creditor groups – who will decide on which party should contribute what, and in
what amounts.
It is therefore proposed that the IMF should spearhead and drive the proposed
normative initiative. Its involvement would give credibility to the proposed non-market
private international regulatory system so that debtor nations, DDHFs, creditors and all
stakeholders in the market would have confidence in the system. It is therefore
suggested that the IMF actively engage in such an institution and give helpful input.501
The reasons why the author believes that the IMF should spearhead this initiative
include the following – a) The involvement of the IMF would give the proposed normative initiative credibility; b) The IMF has the resources and the clout to be able to establish this normative
framework;
499 This word comes from the Russian word, “troe”, and means a set of three people who work together in managerial or administrative positions. In this context however, the European troika refers to the European Central Bank, the European Commission, and the IMF. See “Troika”, LEXICO, https://www.lexico.com/en/definition/troika; and Rebecca M. Nelson et. al., “Greece’s Debt Crisis: Overview, Policy Responses and Implications”, 5 Congressional Research Service Report for Congress (August 18, 2011). See Rosa M. Lastra, “The Role of the International Monetary Fund” in Rosa M. Lastra & Lee Buchheit, Sovereign Debt Management, 49-50. 500 Rosa M. Lastra, “The Role of the International Monetary Fund” in Rosa M. Lastra & Lee Buchheit, Sovereign Debt Management, 62. 501 Id. at 15.
Page | 172 c) The IMF has the clout or power to see this normative framework “enforced”. The
normative initiative proposed is within a soft law framework. The IMF has the clout
and resources to exert the necessary pressure to ensure compliance. d) The resolution of the problems associated with unsustainable sovereign debt, disruption
of debt restructuring processes, and problems associated with holdout litigation, tie in
with the aims of the IMF in the following ways:
i. The resources that debtor nations can use to support alleviation of poverty
initiatives or finance development objectives, are spent to defend holdout
litigation.
ii. When monetary judgement awards in humongous amounts (resulting in
excessive profit) are made to DDHFs, this increases the yoke of
unsustainable debt upon the sovereign defendants. Besides, it just makes it
harder for these nations to use the scarce resources they have to eradicate
extreme poverty or enhance shared prosperity in their jurisdictions.
iii. The exploitative effects of the activities of DDHFs at their extreme likely
threaten the stability of the global financial system and impose costs on other
members of the international community.502 Working on the problems
associated with holdout litigation would likely contribute to the stability of
the global monetary system.
iv. Finally, unsustainable sovereign debt is one of the macroeconomic issues
that affect stability of the global financial system. The alleviation of the
perennial problem of sovereign default and debt overhang therefore tie in
with the objectives of the IMF. Based on Article 1 of the IMF’s Articles of
502 See John A. E. Pottow, 49 Tex. Int’l L.J. 221, 225.
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Agreement, the IMF has some of the following mandated functions, amongst
others:
• Fostering global monetary cooperation and establishing the
mechanism for dialogue and partnership to resolve global monetary
issues; and
• Promoting exchange stability. The IMF therefore has an exclusive
character as an IFI with comprehensive oversight duties to ensure
the orderly development and operation of the global financial
system.
As the alleviation of the perennial problem of sovereign default and debt overhang tie in with the objectives of the IMF, it should therefore consider spearheading this nonmarket normative initiative.
6.5. Normative regulation of the activities of DDHFs
The global normative initiative being proposed would have elements of nonmarket private global regulation and public market-based global regulation. The institution that will be established based on the proposed normative initiative will be a forum where the standards for regulating holdout creditors in the sovereign debt market will be established; this forum will be viewed by all stakeholders in the sovereign debt market as the obvious platform for this purpose. Essentially, the IMF will help to set up this international nongovernmental organization or institution that will be the focal institution for the establishment of standards that will regulate holdout creditors. As the
IMF will be involved and be the one to “get the ball rolling” on this normative initiative, it therefore has elements of public non-market global standard-setting.
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This initiative would involve stakeholders such as: 1) the IMF, 2) IOSCO, 3) private creditors and investors in the sovereign debt market, including the distressed debt investors, 4) relevant representatives from debtor nations, 5) lawyers and international law firms that specialize in sovereign debt, and 6) academics that are versed in and have published extensively in this field, coming together to create an initiative that is focused on establishing international standards that would regulate the activities of the litigating holdout creditors.503 The reason why the proposed regulation should be developed in consultation with market participants and other stakeholders involved in the sovereign debt market is so that their viewpoints can be considered and their interests taken care of. These parties have an interest in this market and in such an initiative for the maintenance of an efficient regulatory system.504
The normative approach being proposed is a soft law regime. A soft law framework is able to establish a better and healthier environment for sovereign debtors and creditors. Soft law is based on market acceptance and social norms, instead of legal mechanisms, to enforce the norms. This soft law framework also agrees with and builds upon the UNCTAD Principles. It is agreed that a multilateral framework is needed, which balances the rights of creditors and debtors and leads to fair and efficient solutions.505
Such a soft law mechanism can be a guide to domestic legislatures in enacting domestic legislation. This might help courts when adjudicating on sovereign debt
503 The viewpoints of sovereign debt networks and groups should also be welcome such as: the Emerging Markets Traders Association (EMTA), Institute for International Finance (an association of big financial institutions), International Primary Market Association (IPMA), International Securities Market Association (ISMA), Emerging Markets Creditors Association (EMCA), Bond Market Association (BMA), Securities Industry Association (SIA), among other sovereign debt-related organizations. See Robert B. Ahdieh, 6 Chi. J. Int’l L. 231, 233.240-241. 504 Id at 65. 505 Id. at 8.
Page | 175 matters, “remind” them of the “big picture” in debt restructuring procedures, and probably alleviate bias that leads to stricter interpretations of sovereign debt agreements. The institution under whose aegis the soft law mechanism is founded can keep a registry of unruly or uncooperative holdout investors and their parent companies or organizations. The registry can also provide guidance for domestic and international tribunals when they are deciding if holdout investors exercised good faith or not. The institution could also host a public, comprehensive, and searchable database of previous debt restructuring processes, including legal and financial terms; how foreign, private, public, and domestic claims were resolved; and any foundational assumptions used for arriving at a restructuring plan.506
The institution could also establish its debt sustainability assessment framework, with general rules for debt sustainability analysis. This will foster collaboration among the stakeholders in order to achieve results that are sustainable and equitable for all parties involved. Reports and declarations made by the institution would be unenforceable legally, but can serve as a guide for stakeholders involved, including domestic courts regarding what would be equitable in a debt restructuring procedure.
This type of framework can alleviate the deficiencies and inefficiencies in the current system which lead to inequitable outcomes.507
A final point is that automatic stay or some form of stay on litigation is suggested as part of the proposal. These points will be elaborated upon in the following paragraphs.
506 Id. 507 Id.
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6.5.1. Automatic stay Most domestic bankruptcy legal systems enforce an automatic stay on
claims of creditors once the debtor has filed for bankruptcy. The stay, also
known as a “standstill rule”, has two parts: i) a stay on creditors’ litigation or
enforcement efforts; and ii) a stay on payments made by the debtor to creditors.
The stay could be automatic or entail court approval, and the termination of
payments made to creditors might be mandatory or voluntary depending on the
country and the kind of bankruptcy proceedings involved – liquidation or
reorganization. The purpose of the stay is to see to the methodical advancement
and completion of the bankruptcy proceedings, to prevent unwarranted
payments to certain creditors, and to prevent them from going to court. The
stay therefore is advantageous for both debtors and creditors.508
In the sovereign debt context, the IMF’s Sovereign Debt Restructuring
Mechanism (SDRM) initially had a provision for stay or standstill. This aspect
was intensely deliberated and eventually, board members of the IMF decided
that it was not a good idea based on the following reasons: i) it is advantageous
for the sovereign state to keep making payments in order to at least not interrupt
provision of interim funding while negotiations regarding debt restructuring is
ongoing with creditors; ii) litigation before debt restructuring was rare and was
not a substantial risk (at the time, it was not apparent that the SDRM would not
see the light of day); and iii) as debtor nations cannot be made to undergo
liquidation or administration, ensuring equality of creditors entails making a
508 Matthias Goldmann, “Necessity and Feasibility of a Standstill Rule for Sovereign Debt Workouts” Paper prepared for the First Session of the Debt Workout Mechanism Working Group, 2 (Jan. 23, 2014), available at https://unctad.org/en/pages/PublicationWebflyer.aspx?publicationid=1340.
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stay effective only when a majority of creditors have consented to it. The
SDRM never came into effect in any event.509
As with everything in life, a stay or standstill rule will have its
challenges. A standstill rule is appropriate if: i) it does not negatively affect a
debtor nation’s ability to access debtor-in-possession or interim financing
during the debt restructuring process; and ii) it does not increase the risk of
moral hazard on the part of the sovereign debtor.510 Essentially, the issues that
need to be figured out if this idea is to be implemented include: i) what would
trigger the stay? For instance, would the stay be triggered when the sovereign
debtor officially defaults on its payments, etc.; ii) what should the exceptions
be? Will exceptions apply to creditors who provide interim financing? iii) how
long should the stay be in place and what factors need to be in place to have it
lifted? Should it be in place long enough for debt restructuring processes
involving cooperative creditors to be successfully completed? These are issues
that will be figured out over time if a stay or standstill rule is adopted and
implemented in the proposed normative initiative for regulation of holdout
creditors in the sovereign debt market.511
In line with the form this initiative would take, these issues would be
dealt with in a soft law setting, ensuring flexibility and dialogue. This idea still
needs to be refined and details figured out. It is hoped that the institution when
created would deliberate on the feasibility of the standstill rule with the
specifics ironed out so that it could be fully functioning.512 If successfully
implemented, it would evolve over time and likely help to delay the claims of
509 Id. at 2-3. 510 Id. at 9-10. 511 Id. at 20-1. 512 Id.
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holdout creditors so that at least they do not thwart entire sovereign debt
workout processes.513
6.5.2. The proposal embodies and builds upon the UNCTAD Principles on Responsible Sovereign Lending and Borrowing (UNCTAD Principles). In 2009, the UNCTAD Principles were set up as a mechanism to deal with the extensive negative causes and effects of the global financial crisis, in order to foster responsible sovereign lending and borrowing. This scheme was intended to be a platform to generate debate on responsible lending and borrowing practices and to establish universal rules that will guide sovereign debt practices.514
The yearly United Nations General Assembly resolution on external debt has consistently highlighted the importance of fostering responsible sovereign lending and borrowing. It has in the past, stressed that it is essential for debtors and creditors to share the responsibility for averting unsustainable sovereign debt crises and has encouraged regional development banks, Bretton Woods institutions, member states, and other crucial multilateral financial institutions and stakeholders to foster discourse within UNCTAD’s framework to promote accountable sovereign lending and borrowing.515
Sovereign lending and borrowing exists in a legal void as there are little to no rules. This has bolstered the idea that principles are necessary. Issues arising between creditors and sovereign debtors need to be resolved efficiently and amicably, and the fact that there are no legally binding rules does not prevent the rule of law from been
513 Ed Bartholomew et. al., 35 Georg. J. Int. L. 859, 872 (2004).
514 Principles on Promoting Responsible Sovereign Lending and Borrowing, UNCTAD 3 (Jan. 10, 2012). 515 Id.
Page | 179 applied. Ad hoc application of a few basic rules in sovereign lending and borrowing has proven unable to prevent sovereign debt crises.516
The principles are derived from a combination of domestic law (general principles), international law (including treaties), resolutions of the UN General
Assembly and the IMF rules that govern international relationships, and resolutions of other international organizations that represent most of the members of the international community. The legal status of these Principles is thus dynamic.517 The Principles also have some recommendations that are derived from best practices such as the suggestion for the legislature to actively participate in concluding sovereign debt contracts.518
The normative initiative for regulation of holdout creditors being proposed incorporates (as applicable) and builds upon the UNCTAD Principles.519 There are 15 principles in total. These principles address issues such as overborrowing and over lending, debt restructuring, transparency, international cooperation, and debt restructuring. Some of the draft principles applicable to a lender include: i) creditors should recognize the fiduciary duty of public officials to the sovereign nation and its nationals, which have consequences regarding averting corruption; ii) lenders should make informed choices based on proper due diligence undertaken in order to determine whether financing is appropriately authorized and valid under the law of the sovereign debtor; iii) creditors should examine the possible impacts of providing funding for a project; iv) creditors should not participate in transactions that lead to UN sanctions being violated; and v) creditors should, in the context of debt restructuring, behave in
516 Id. 517 Id. at 86. 518 Id. at 79; 85-6. 519 While the UNCTAD Principles are relevant before, during the existence of a sovereign debt contract, and after default in relation to debt restructuring, it does not help to deal with the specific problems raised by holdout creditors.
Page | 180 good faith and cooperate in order to conclude a consensual, orderly and quick agreement.520
Some of the draft principles applicable to sovereign borrowers include: i) sovereign debtors should honor debts unless their economic situation prevents timely or full repayment or a court rules that the sovereign has a legal defense; ii) the decision- making processes involved in taking on sovereign debt must be transparent; iii) the authorization for the loan must be gotten from the right party or office responsible to do so based on the country’s laws; iv) to prevent over-borrowing, sovereign debtors should carry out a costs-benefits analysis when deciding to take on debt; v) once it is clear that debt restructuring is inevitable, the process should begin immediately in a fair and efficient manner while ensuring that a supermajority of all the creditors are in agreement; vi) sovereign nations are accountable to their citizens when it comes to sovereign borrowing, and they owe the citizens a fiduciary obligation; vii) sovereign nations should create a debt management department; and viii) the legislature should have a major role in concluding sovereign debt contracts.521
Based on these principles, the normative initiative for regulation of holdout creditors being proposed will therefore embody the following guidelines:
i. Sovereign nations and creditors should comply with all the UNCTAD
Principles when deciding to borrow or lend, and in the event of a debt
restructuring.
520 Juan Pablo Bohoslavsky & Carlos Espὀsito, “Principles Matter: The Legal Status of the UNCTAD Principles” in Carlos Espὀsito et. al. (eds.), Sovereign Financing and International Law: The UNCTAD Principles on Responsible Sovereign Lending and Borrowing, 75 Oxford University Press: Oxford, UK (2013). 521 Id.
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ii. The holdout creditors in negotiating with nations should act in good faith
and cooperate in order to have a result that is fair to all parties, and
sustainable.
iii. Sovereign debtors should cooperate and honor whatever commitments
they make.
iv. There should be transparency in the decision-making processes during the
negotiation between the country and the holdout creditors.
v. The people with the right authorization according to the country’s laws
(including the legislature if necessary) should be involved in negotiating
with holdouts.
This idea still needs to be refined and details figured out. It is hoped that the institution when created would debate this and figure out the specifics so that the normative initiative would incorporate and build upon the UNCTAD Principles.
The normative regulation being proposed would aim at curbing the excesses of
DDHFs which include: 1) making excess profit at the expense of debtor nations;522 and
2) unnecessarily holding out on debt restructuring processes. The categories of issues that the regulatory system being proposed would regulate include how much profit
DDHFs can recoup and who would be responsible for the legal costs.
6.5.3. How much profit DDHFs can recoup? It is suggested that DDHFs, although they are entitled to make a tidy return
on their investment should make reasonable profit, in other words, “not excessive
522 Excess profit can be defined as profit earned “over and above what provides its owners with a normal (market equilibrium) return to capital”. In other words, profits which are beyond the extent required to enable the business owner remain in business and profitable. See Excess profit, INVESTOR GUIDE, http://www.investorguide.com/definition/excess-profit.html and Excess profit, OXFORD REFERENCE, https://www.oxfordreference.com/view/10.1093/oi/authority.20110803095803580.
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profit”.523 The author is suggesting that DDHFs recover no more than 60% of the
face value of the original debt or 50% profit, whichever is greater. 524 Take an
example where A is the sovereign debtor who borrows $1,000, B is the initial
creditor, and C is the DDHF. A defaults, and B subsequently sells the debt on the
secondary sovereign debt market to C for 10% of the face value which is $100.
Under the suggested guidelines, C should only be able to claim no more than $600
(60% of the face value of the claim), in addition to any applicable interest payments.
This is because half of the profits would amount to $450 ($1,000 less $100 equals
$900 profit; half of which is $450), which is less than $600.525
These guidelines are suggested because it ensures that DDHFs can have all
their expenses covered and still recover a reasonable amount of profit. The debtor
nations would still have to pay back part of the original debt, but whatever they
have to pay will be capped at 60% of the face value of the original debt or 50%
profit. This is not a problem, however, because there is no free lunch and states still
must pay their debt obligations. It is ideal that states are not allowed to pay back
too little, so that moral hazard problems are not encouraged.
6.5.4. Who bears legal costs? It is suggested that every party bear their own legal costs because it is appropriate. DDHFs should therefore not be able to recover their litigation costs from an already overburdened state-defendant.
523 See the definition of excess profit above. 524 These are mere suggestions which explain what the author means by “reasonable profit”. These are issues that can be clarified and decided on later when the initiative takes off and eventually made into guidelines. 525 It is also possible that recovering 50% of profits would have greater returns than 60% of the face value of the original debt. Taking the facts of the proffered hypothetical, C, the DDHF, bought the debt for $300. If C claims 60% of the face value of the debt, returns would be $300 ($600 less $300). Profits, otherwise, would be $1,000 less $300 which equals $700, half of which is $350. This is more returns than if only 60% of the face value of the debt is claimed.
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In addition, the normative initiative being proposed should aim to encourage settlement rather than litigation. Litigation is extremely costly and time-consuming.
Sovereign debt litigation usually takes place in financial centers such as London,
England and New York, USA. Debtor nations therefore have to retain counsel in these jurisdictions which can be very expensive. This further drains the debtor nations of needed funds and foreign exchange reserves to finance their expenses and satisfy non- holdout creditors who already participated in debt restructuring. Hardly anyone benefits from litigation therefore, except the DDHFs. This is why settlement would be greatly encouraged under the normative initiative being proposed, as opposed to litigation.
The next section will expand more on the role of the IMF in creating and maintaining the proposed normative initiative to regulate holdout creditors.
The next section will discuss how my proposal differs from other initiatives that have been created to deal with holdout creditor problems in the context of sovereign debt restructurings.
6.5.5. Enforcement The proposed normative initiative would therefore be enforced through
“reputational pressures that incentivize compliance”, along with the proposed accreditation system.526 This is because the normative initiative would be established in a soft law setting. This is what the author envisions: the creditor nations and other creditors who back this initiative would not sell debt to DDHFs who are not accredited under this initiative, and do not subscribe and adhere to the standards the initiative makes, thus, the DDHFs would practically be blacklisted from the market.
526 Chris Bummer, Soft Law and the Global Financial System: Rule Making in the 21st Century, 2nd ed., 125 Cambridge University Press: New York (2015).
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The reputation of a DDHF would therefore be adversely affected if it refuses to be accredited and adhere to relevant standards. Other participants in the market such as international law firms should not represent unaccredited DDHFs who do not adhere to globally recognized standards, as it would affect their own reputation. In the same way, debtor nations who do not adhere to any relevant standards based on this normative initiative should find it hard to access credit on the market. The idea is that eventually, DDHFs would be “pressured” into ensuring that they are accredited under this initiative and that their activities comply with such guidelines and make reasonable profit while providing liquidity in the secondary market. In the same vein, debtor nations should also be held accountable for their debt obligations, so that the sovereign debt market can be enabled to work more efficiently and effectively.
Finally, the idea is that on the platform of the proposed normative initiative, guidelines would be made for DDHFs and debtor nations to adhere to. Of course, this would be soft law, which is generally not legally binding, and that is why it is suggested that the IMF spearhead this initiative, and that the initiative is endorsed by official creditors, IOSCO, debtor nations, creditor nations, and the London and Paris
Clubs, to lend it their “moral support”. It should be emphasized that it will be very helpful for the IMF to give credibility to the proposed normative initiative so that debtor nations, DDHFs, creditors, and all other stakeholders in the market would have confidence in the system.
6.6. How my proposal differs from other initiatives that have been established to deal with holdout creditor problems in relation to sovereign debt restructurings There have been other initiatives that have previously been proposed to foster sustainable sovereign debt workouts and ostensibly deal with holdout creditor
Page | 185 problems. These include the SDRM and contractual approaches including CACs and exit consents. The next few sections will expound more on these initiatives.
6.6.1. The Sovereign Debt Restructuring Mechanism (SDRM)
The IMF conceived of the SDRM at the beginning of the millennium. It was aimed at facilitating orderly and timely debt restructuring when a sovereign acknowledges it has unsustainable debt. Creditor rights were to be protected in the process. Such a system could have made debt restructuring less expensive for sovereign nations and all other parties involved, and in general, foster efficiency in international capital markets. The SDRM could only be invoked by a sovereign nation, and only in limited cases (when the debt was no longer sustainable).527
The SDRM, Lee Buchheit argues, was purposed to achieve what the judges, administrators, gunboat captains, diplomats of the past two centuries could not accomplish – an efficient way by which the official sector could foster orderly sovereign debt workouts without bearing the full political, financial, and moral responsibility for the debt workouts. Essentially, the SDRM initiative was a way to create an institutional framework for dealing with sovereign debt workouts with minimal interference from the official sector. The backers of the SDRM hoped that by entrusting these issues into the hands of an institutional framework, the official sector could be freed from the criticism and pressure it has gotten for more than two centuries for its role in sovereign debt restructuring processes.528
When compared to Collective Action Clauses (CACs), the main difference between these two is that voting under CACs is determined on a series-by-series basis
527 Anne O. Krueger, A New Approach to Sovereign Debt Restructuring, INTERNATIONAL MONETARY FUND, 4 (2002). 528 Lee C. Buccheit, 6 Chic. J. Int. L. 333, 343 (2005).
Page | 186 while in the case of the SDRM, aggregated voting would have to take place across all debt instruments involved in a restructuring process. The SDRM on the other hand would have required 75% of the principal outstanding of substantiated claims on an aggregated foundation to vote in favor of a restructuring agreement, in effect binding on all creditors concerned. In addition, usually a quarter of the principal outstanding of a certain series is needed to fast-track claims of such series post default, and a qualified or simple majority is capable of reversing such acceleration when the default has been fixed. In addition, an activating member of the SDRM would have had to make a request and get the support of 75% of the total principal outstanding of substantiated claims, in order to have a temporary suspension of creditor legal actions and claims be in effect.529
According to the IMF, the SDRM would have created a statutory framework which would include the following characteristics:
i. The SDRM would be triggered only at the request of a sovereign member of the
IMF who says that the debt up for restructuring is unmanageable. This applies
to not just international sovereign debt instruments, but to all external claims.530
ii. A creditors’ committee that represents all creditors (if put together), would play
a role under the SDRM to deal with inter-creditor subjects and debtor-creditor
subjects, in order to foster dynamic and early participation of creditors. The
debtor would pay the costs for the committee.531 iii. In order to incentivize new financing, a qualified financing transaction could be
excluded from the restructuring process if the extension of the transaction in
529 INTERNATIONAL MONETARY FUND, Sovereign Debt Restructuring – Recent Developments and Implications for the Fund’s Legal and Policy Framework, 14 (Apr. 26, 2013). 530 Id. 531 Id.
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question is supported by three-quarters of the principal outstanding of
substantiated claims. 532 iv. The SDRM would end: 1) automatically after all restructuring agreements have
been certified; 2) by notice given by the activating sovereign member; or 3)
after the registration and verification procedure has been completed if 40%
percent of all substantiated claims are willing to terminate.533
v. An independent dispute resolution forum would be established to among others,
authenticate claims, implement rules as regards the voting process, decide on
disputes, suspend legal suits, and verify restructuring agreements. The IMF’s
Managing Director would choose an assortment panel of judges or private
practitioners who will choose the group of judges that could be called into
service on the forum when the SDRM is triggered.534
The reason why the SDRM concept failed to see the light of day is because it lacked enough support among the sovereign members of the fund to amend the Articles of
Agreement to create a universal convention. The sovereign members were essentially hesitant to give up the level of sovereignty needed to create such a scheme. The contractual approach was favored, along with bi- and multilateral surveillance.535 This is not surprising because it is very difficult and expensive to have a multilateral treaty regulatory framework established due to lack of political will, among other factors. This was elaborated more upon in section 6.2. above where public international regulation is contrasted with private international regulation, and the limitations of each discussed.
The next section will discuss CACs and exit consents.
532 Id. 533 Id. 534 Id. 535 Id. at 12-3.
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6.6.2. Collective Action Causes (CACs) and Exit Consents – are they permanent solutions? CACs and exit consents are some of the contractual solutions that have been proffered to deal with problems associated with holdout creditors. It is necessary to state why some of the already existing “solutions” are not working well and are not perfect.
a) Exchange offers and exit consents:
Exchange offers allow debt to be restructured through a market procedure without the need for any court proceedings and amendments to existing law. Basically, an exchange offer is an offer made by the sovereign nation to exchange new debt for old debt. As a debtholder has the choice to accept the terms of the exchange offer or not, sovereign debtors who organize exchange offers have a potential holdout problem.
Debtholders may decline the offer in order to get better terms as a holdout creditor, either by continuing to get payments under the terms of the initial debt contract or by forcing the sovereign debtor to buy their bonds at a higher price so that they can go ahead with the restructuring procedure.536
Exit consents on the other hand, are set up to mitigate the issue of holdout litigation. One of the conditions of the exchange offer is that debtholders accepting the offer must agree to the amendments made to the terms of the initial debt that decrease its value. Even though changes made to the terms of payment regarding principal and interest by fewer than all of the debtholders are not tenable if the debt instruments contain a uniform or unanimous action clause (UAC), other terms can usually be changed by a majority or supermajority. Waivers of sovereign immunity, financial agreements, and submission to jurisdiction are instances of such modifiable terms.
536 Jill E. Fisch & Caroline M. Gentile, 53 Emory L.J. 1043, 1090-091 (2004).
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These changes are set up to make the initial debt instruments less valuable thereby incentivizing investors to dispose of them. Debtholders are thus practically forced to accept the terms of the exchange offer instead of holding out.537
The use of exit consents was initiated in the 1980s with regards to capitalizations in the corporate world that usually entailed restructuring of high-yield debt instruments.
Courts typically approved of this method.538 Within the last two decades, Uruguay,
Pakistan, and Ecuador have employed exchange offers along with exit consents to have their debt instruments restructured. In Ecuador’s instance, this method led to about 97% of debtholders taking part in the restructuring procedure which entailed a huge decrease in the total amount of debt. Some authors take the position that the existence of the exit amendments significantly incentivized some of the debtholders to accept the terms of an exchange offer.539
Despite the fruitful use of exit consents and exchange offers, it is not likely however that these approaches can be used in all cases. The enormity of the amendments made to the payment terms of the initial bonds, especially the decrease in the total amount of the debt instruments required to relieve the sovereign’s financial crisis might be so great as to prevent a debt exchange from being economically viable.
A court can on the other hand find the exit amendments to be too extensive and decline to impose them on holdout creditors. In some instances, the “buoying-up effect” of the restructuring procedure might be good enough to surmount the adverse effects of the exit consents. Creditors in holding out get to keep the initial debt instruments with the initial payment terms less the protective agreements so that the value of the debt
537 Id. at 1091. 538 Id. The foremost case is Katz v. Oak Industries Inc., 508 A.2d 873 (Del. Ch. 1986). 539 Id. at 1092. See Lee C. Buchheit & G. Mitu Gulati, Exit Consents in Sovereign Bond Exchanges, 48 UCLA L. REV. 59 (2000).
Page | 190 instruments is decreased. After the restructuring procedure is completed nonetheless, the sovereign’s total debt burden goes down essentially increasing the value of those debt instruments. The increase in value resulting from the restructuring which is what is referred to as the “buoying-up effect” may be bigger than the decrease in value resulting from the exit consents.540
b) Collective Action Clauses (CACs)
CACs are another contractual solution that has been proffered to deal with collective action problems and enable smooth debt restructuring procedures by depending on an already determined majority voting by creditors. The majority voting aspect enables decision making on debt restructuring to be passed on to creditors as a group to echo their collective will. Precisely, CACs allow a supermajority of bondholders (usually 75% of the principal outstanding) to bind all bondholders in the same issue to the terms of the restructuring before or after the default.
Although CACs have been proffered as a solution, nonetheless, they do not ultimately resolve the problem of holdouts. CACs are clauses that enable a supermajority of bondholders to implement changes to the payment terms of bonds that will bind all bondholders.541 First, even if all new debt instruments have CACs, creditor coordination problems can still arise because holders of old debt instruments with longer maturity can still use the Unanimous Actions Clauses (UACs) in these old debt instruments to frustrate ongoing debt restructuring procedures.542 Second, CACs do not create automatic stay similar to the one in bankruptcy to stop claims and collections
540 Id. 541 UNCTAD, Sovereign debt restructurings: lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to holdout creditors, 20. 542 A. Mechele Dickerson, A Politically Viable Approach to Sovereign Debt Restructuring, 53 EMORY L.J. 997, 1015 (2004).
Page | 191 while sovereigns and creditors negotiate debt restructuring procedures. These clauses are therefore not as advantageous as they first seemed.543 Third, CACs appear to have failed to remove the need for litigation mostly because of the absence of the lack of case law that delineates the rights and duties of creditors in debt restructuring procedures.544 Fourth, DDHFs might be able to arrange “blocking positions” especially when the sovereign nation has issued several rounds of debt instruments.545 This is because voting thresholds are only applicable to the bonds of a certain issue.546
CACs therefore might have their benefits, but they do not do it all. CACs clearly did not fix the holdout problem in Greece. 7.3% of Greece’s debt had CACs and was governed by foreign law out of the total debt valued at EUR205 billion. Holdout creditors in some bond issues were able to get a “blocking majority” averting the operation of these CACs even though they were used for the purposes of the restructuring of these bonds. As CACs only bind bondholders on an issue-by-issue basis, therefore, a creditor or group of creditors can get a blocking position in one or more bond series, effectually averting the workings of CACs in that series. Even though binding a minority within an issuance solves collective action issues for the restructuring of that bond issue, it does not automatically solve the collective action issues resulting from various debt instruments. Creditors who have a qualified majority of a certain bond issue and otherwise do not mind concluding an agreement with the debtor might be hesitant to go the restructuring route without receiving a guarantee that
543 David A. Skeel, Jr., Can Majority Voting Provisions Do It All? 52 EMORY L.J. 417, 423 (2003). 544 Jill E. Fisch & Caroline M. Gentile, Vultures or Vanguards?: The Role of Litigation in Sovereign Debt Restructuring, 53 EMORY L.J. 1043, 1095 (2004). 545 John A. E. Pottow, 49 Tex. Int’l L.J. 221, 224. 546 Matthias Goldmann, “Necessity and Feasibility of a Standstill Rule for Sovereign Debt Workouts” Paper prepared for the First Session of the Debt Workout Mechanism Working Group, 2 (Jan. 23, 2014), available at https://unctad.org/en/pages/PublicationWebflyer.aspx?publicationid=1340.
Page | 192 creditors who have other bond issues will pursue restructuring. In Greece’s case for instance, only 17 of the 36 bonds issued under English law with CACs that could take part in the debt exchange, were fruitfully restructured. The working of CACs in the remnant bonds were practically averted by holdout creditors, leading to unrestructured creditor claims to the tune of EUR6.5 billion, 30% of the total value of debt issued under foreign law.547
The phantom of holdout problems so shadowed European policymakers that the official sector was willing to use taxpayer funds to repay timely and in full, the private sector creditors of Eurozone nations that qualified for bailouts. The only exception was the Greek debt restructuring.548 The IMF has acknowledged that contractual revisions to sovereign debt instruments will not solve potential issues with debt restructuring procedures in the future. Even if all these new clauses were included in new international sovereign issues of debt instruments, these will not be applicable to the current stock of international sovereign debt instruments approximated at more than
$900 billion. Moreover, New York law governs more than 50% of international debt instruments in a context where former decisions by New York judges have generally favored holdout creditors.549
547 INTERNATIONAL MONETARY FUND, Sovereign Debt Restructuring – Recent Developments and Implications for the Fund’s Legal and Policy Framework, 14. What worked in Greece though was a statutory method, which was quite effective. Bonds worth about EUR 184 billion were governed by Greek laws and lacked CACs. The legislature simply enacted legislation that governed these bonds which allowed a qualified majority of creditors to bind all bondholders of the domestic debt affected to the terms of the restructuring process. The main difference between the contractual approach and this legislative one is that it aggregated creditor claims for purposes of voting, across all of the impacted domestic debt issued under domestic law, thereby removing the ability of any creditor to get a blocking position in an individual issuance. Finally, the impacted domestic debt was restructured due to this legislation along with a low voting threshold – 2/3 of total principal outstanding of all impacted domestic law bonds based on a quorum of 50%. This Greek legislation has aggregation characteristics similar to that of the SDRM. 548 John A. E. Pottow, 49 Tex. Int’l L.J. 221, 225. 549 UNCTAD, Sovereign debt restructurings: lessons learned from legislative steps taken by certain countries and other appropriate action to reduce the vulnerability of sovereigns to holdout creditors 23.
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In addressing the holdout problem, the International Capital Market Association
(ICMA) and the Institute of International Finance (IIF) have suggested the establishment of a model of “aggregated CACs” for sovereign debt instruments. These are market-based institutions that endorse at least 66% creditor participation for aggregated bonds, and more than 50% participation for each individual bond series.550
These “aggregation clauses” are meant to fix the weaknesses of “issue specific” amendment clauses. An amendment to payment terms for instance is only possible if those who hold a majority of all the outstanding bond series (e.g. 80%) and those who have a smaller majority of the single bond issue (e.g. 60%) provide their consent. These clauses therefore “raise the bar” for holdouts. If the bond series has a small volume however, the bar might not be high enough to stop holdouts successfully.551
ICMA also offered a novel pari passu model that removes the right to pro rata payment by holdout creditors, as in the cases of Argentina and Peru. In addition, analysts have proposed the use of exit amendments in sovereign bond exchanges to deal with holdout creditors. For instance, debt restructuring terms might stipulate as a prerequisite to participating in the bond exchange that bondholders consent to voting in favor of a resolution that changes the terms of the already existing bonds. This is to remove most protective covenants such as listing requirements or cross-acceleration clauses, and adversely impact their value or destroy them totally. An instance is the inclusion of a clause in non-restructured bonds enabling the debtor to redeem the debt instruments at a near zero value. This would likely disincentivize creditors from holding out. This does not need the use of CACs based on New York law. Such clauses prevent
550 Id. at 22. 551 Matthias Goldmann, “Necessity and Feasibility of a Standstill Rule for Sovereign Debt Workouts” Paper prepared for the First Session of the Debt Workout Mechanism Working Group, 2 (Jan. 23, 2014), available at https://unctad.org/en/pages/PublicationWebflyer.aspx?publicationid=1340.
Page | 194 any amendments to the bonds’ payment terms without each bondholder agreeing to it.
Any other provision of the bond can be changed with the agreement of the issuer and a minimum threshold which has usually been set as low as 50 percent.552
Despite these efforts however, there are issues about how to handle aggregation.
For instance, how are bonds issued in various denominations going to be valued? Is it to be done with different maturities or with different seniorities? How broad is the list of creditors? Various inter-creditor issues including the ability of the majority to rob minority creditors of their rights and voting rights across various categories of creditors are not dealt with. CACs also do not address the “too little, too late” issues and ex ante issues. There is still the concern as to whether these problems can be resolved in a fair way that will result in effective debt restructuring and in a way that can be effortlessly and sufficiently incorporated into sovereign debt contracts. In addition, even if the
“aggregated CACs” are accepted and even if they resolve the above-mentioned issues, it will take at least ten years before they are inserted into the “existing debt stock”.553
Finally, other market-based solutions that have been used to get wider participation of creditors in restructurings include low haircuts and so-called minimum participation thresholds. Minimum participation thresholds ensure that the debtor proceeds with the debt exchange only if a certain majority of creditors choose to take part in it.554 “Low haircuts” on the other hand, means that the state promises that the
552 Id. at 22-3. It is interesting to note that the legitimacy of the strongest exit consents has been questioned. The IMF has however supported the use of the revised pari passu clause and the rise of more vigorous CACs in bonds that are governed by foreign law. 553 Skylar Brooks et. al., Identifying and Resolving Inter-Creditor and Debtor-Creditor Equity Issues in Sovereign Debt Restructuring, 8 Centre for International Governance Innovation (2015). 554 INTERNATIONAL MONETARY FUND, Sovereign Debt Restructuring – Recent Developments and Implications for the Fund’s Legal and Policy Framework, 28. See also Ran Bi, et. al., The Problem that Wasn’t: Coordination Failures in Sovereign Debt Restructurings, IMF Working Paper, available at https://www.imf.org/external/pubs/ft/wp/2011/wp11265.pdf, (last visited 10/01/2019).
Page | 195 creditors would not lose much in the restructuring deal, and the principal would not be drastically reduced.
Now that the above-mentioned contractual approaches have been discussed, the next section will conclude the chapter.
6.7. Conclusion
This chapter started by laying out the background and charting out the research problem. Thereafter, the chapter outlined different options for global regulation including public non-market standard-setting, public standard-setting bodied in market competition, market-based private international standard-setting, and non-market private international standard-setting.
A normative initiative that has elements of both public and private nonmarket international standard-setting was chosen as the preferable route. The reasons for this choice include: 1) the prevention of duplication in rulemaking to avoid wastage of resources, and 2) the need for a focal institution that has representation from all relevant stakeholders to set standards that evolve with changes in the market so that the regulatory system can remain effective, efficient and stable. The involvement of the
IMF gives the normative initiative elements of public nonmarket international standard setting.
In addition, a case was made for why the IMF should get the ball rolling on the proposed normative framework. Some of the reasons why the author thinks that the
IMF should lend its support include: 1) they have the clout and power; 2) they have the resources; and 3) the resolution of the problems associated with holdout creditors and litigation, and the achievement of the aims of this proposed normative framework tie in
Page | 196 with the IMF’s broader objectives which include among others, to assess risks regarding and strengthen the international monetary system.
The aim of this chapter was to make a persuasive case for a normative framework for the regulation of DDHFs. The purpose of such a regulatory system is to address the perceived ‘mischiefs’ or the exploitative tendencies of distressed-debt investors, while striking a delicate balance between the rights of commercial creditors on the one hand, and the protection of sovereign debtors on the other hand, while injecting some equity into the process. This chapter made the argument that this initiative would help to: 1) address the poorly functioning sovereign debt market by deepening and inducing the liquidity of the secondary market for distressed sovereign debt, 2) contribute to solving the perennial problem of sovereign default and debt overhang because their existence in the market and the threat of holdout litigation keep sovereigns on their toes in respect of their debt obligations, and 3) guarantee the private credit flow for capital formation especially in the debtor nations to build productive capacities for integration into the global economy. Finally, the point was made that the reasons why specifically a normative model is proposed are: 1) to foster consistency in the development of jurisprudence in the area of sovereign debt and holdout litigation; and 2) to prevent regulatory arbitrage.
Page | 197
CHAPTER 7
CONCLUSION
7.1 Recap of the research problem Unlike an ideal debt market, the market for sovereign debt in the developing countries is generally dysfunctional, and the secondary market for sovereign debt in most developing countries is “thin, illiquid and peripheral”.555 One of the reasons for the existence of a dysfunctional sovereign debt market and an illiquid secondary market for sovereign debt in these countries or regions is the fact that creditors’ rights are too weak.556
Distressed debt investors (especially DDHFs) which are creditors in the secondary market for sovereign debt, have been accused of allegedly creating holdout problems during debt restructuring of a defaulting sovereign. This is true to some extent as has been shown in this study. Indeed, there are excesses in relation to the activities of these distressed debt investors, including DDHFs. The case of NML Capital v. Argentina, embodies many of the concerns that have been raised regarding DDHFs. The decision in this case has created a lot of uncertainty, and has made restructuring less acceptable for creditors, going forward.557 There has therefore been an outcry among academics and legal practitioners in this field against this decision and the interpretation of the pari passu clause that US courts have accepted.558 It is in this context that this study
555 Anayiotos, George & Jaime De Pinies, “The secondary market and the international debt problem’ World Development” Volume 18, No. 12, 1990, 1656. 556 Andrei Shleifer, “Will the Sovereign Debt Market Survive?” in Debt, Equity, and Financial Openness, volume 93, No. 2, 85. 557 Mark Jewett, “Approaches to Sovereign Debt Resolution: Recent Developments” in Rosa M. Lastra & Lee Buccheit, Sovereign Debt Management, xix Oxford University Press: United Kingdom (2014). 558 Examples are: David Newfield, Pari Passu as a Weapon and the Changes to Sovereign Debt Boilerplate after Argentina v. NML, 24 U. Miami Bus. L. Rev. 175 (2016); Lee C. Buchheit and G. Mitu Gulati, Restructuring sovereign debt after NML v. Argentina, https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=6342&context=faculty_scholarsh ip Oxford University Press (2017); Brett Neve, NML Capital, Ltd. v. Republic of Argentina: An
Page | 198 has proposed a normative framework for the regulation of holdout creditors in order to address the negative effects of the activities of these creditors in sovereign debt holdout litigation.
7.2 The thesis of the study This study has argued that distressed debt investors and holdout creditors remain a linchpin for an efficient sovereign debt market. It therefore proposed a normative approach to the mitigation of the disruptive tendencies of holdout creditors which would contribute to making the market more efficient and ultimately alleviate the lingering sovereign debt problem in the Global South. It is also argued in this study that the proposed normative framework will help address the perceived “mischiefs” or the exploitative tendencies of distressed-debt investors to: 1) address the poorly functioning sovereign debt market by deepening and inducing the liquidity of the secondary market for distressed sovereign debt; 2) guarantee private credit flow for capital formation and finance for development especially in debtor nations to build productive capacities for integration into the global economy; and 3) contribute to alleviating the perennial problem of sovereign default and debt overhang because their existence in the market and the threat of holdout litigation keep sovereigns on their toes in respect of their debt obligations. This normative framework is proposed specifically for the following reasons: 1) to foster consistency in the development of jurisprudence in the area of sovereign debt and holdout litigation; and 2) to prevent regulatory arbitrage.
Alternative to the Inadequate Remedies under the Foreign Sovereign Immunities Act, 39 N.C.J. Int’l L. & Com. Reg. 631 (2014); and Lee C. Buchheit & Jeremiah S. Pam, The Pari Passu Clause in Sovereign Debt Instruments, 53 Emory L.J. 869 (2004).
Page | 199
7.3 Summary of findings In chapter 2, the main objective was to chart the path of development in the
Global South, particularly Africa, and examine the multilateral responses that have been made to the development challenges there. The need for capital in the Global South was also examined.
It was found that Africa has not met the development expectations of its citizens, despite its abundance of resources. Besides, infrastructure deficit, inadequacy of development capital, and corruption are some of the factors that contribute to Africa’s development dilemma. There is therefore much room for improvement in relation to realizing development goals.
In chapter 3, the sources, composition and trends in credit flows to the developing countries including those in Africa, were investigated. The concept of debt was also explored including bond conventions, bond markets, repo markets, American and Dutch auctions, among others.
It was found that that sovereign debt is a phenomenon in both developing and advanced economies, and the 2008/9 GFC did not help matters in this regard. Nations usually borrow to develop infrastructure, meet public needs and to make up for deficits in their books, among other things. Sovereign debt is thus a part of the development process and running a nation. Besides, some sovereign nations intentionally default as was the case with Argentina in the early 2000s, and in other cases, governments borrow and spend unwisely, and leave successive governments and future generations to grapple with servicing of the debt. Finally, with the dearth of infrastructure and the need for development finance in the nations in the Global South, there is the need to explore other sources of finance, including commercial and retail sources, to bridge the infrastructure gap.
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In chapter 4, the research agenda was to examine sovereign default in-depth, including its history and the typical reasons sovereigns repay debt. An exploratory analysis of sovereign debt crises was also undertaken and approaches that have been taken to resolve these crises were discussed.
It was found that the face of legal enforcement of sovereign debt obligations has changed over the past four decades with holdouts suing sovereigns in national courts and sovereign states’ immunity being watered down to restrictive immunity.
In chapter 5, the objective was to investigate the role of DDHFs in the development of the secondary debt market. In achieving this aim, a cursory exploration into hedge funds, including how they are structured and how they operate was undertaken. Following this, the meaning, features and historical perspectives of DDHFs were explored, including their activities (and the social and economic costs thereof).
It was found that DDHFs play a crucial role in the stabilization of distressed debt markets as they “provide a safety net” for other investors who would otherwise face huge losses when a sovereign debtor defaults. These investors therefore provide needed liquidity in the market. There is also the view that creditors are more likely to lend and invest in sovereign bonds with the knowledge that there is an avenue for them to trade their instruments for cash when they need to exit from the market. The author concurs with these views. Where the author differs is that DDHFs are a curate’s egg; they have their advantages and disadvantages. Their activities should thus be regulated to some extent; they should be held to a higher standard than they are currently being held and should account for various consequences of their actions.
In chapter 6, the objective was to make a persuasive case for the normative regulation of DDHFs (specifically holdout creditors). As stated under the thesis of the
Page | 201 study, the purpose of such a normative initiative is to address the perceived ‘mischiefs’ or the exploitative tendencies of distressed-debt investors, while striking a delicate balance between the rights of commercial creditors on the one hand, and the protection of sovereign debtors on the other hand and injecting some equity into the process.
The normative initiative that was proposed is a soft law framework. It was argued that soft law is able to establish a better and healthier environment for sovereign debtors and creditors. In addition, the proposed soft law framework would agree with and build upon the United Nations Conference on Trade and Development (UNCTAD) Principles on Sovereign Lending and Borrowing (UNCTAD Principles). Furthermore, automatic stay or some form of stay on litigation was suggested as part of the proposal. Finally, the point was made that the reasons why specifically, a normative model is proposed are: 1) to foster consistency in the development of jurisprudence in the area of sovereign debt and holdout litigation; and 2) to prevent regulatory arbitrage.559
The normative regulation being proposed would aim at curbing the excesses of DDHFs which include: 1) making excess profit at the expense of debtor nations;560 and 2) unnecessarily holding out on debt restructuring processes. The categories of issues that the regulatory system being proposed would regulate include how much profit DDHFs can recoup and who would be responsible for the legal costs.
559 Regulatory arbitrage, in general terms, occurs when persons such as companies take advantage of loopholes in regulation with the aim of avoiding unfavourable laws or regulations. See Adam Hayes, Regulatory Arbitrage, INVESTOPEDIA, (Oct. 4, 2019), https://www.investopedia.com/terms/r/regulatory-arbitrage.asp.
560 Excess profit can be defined as profit earned “over and above what provides its owners with a normal (market equilibrium) return to capital”. In other words, profits which are beyond the extent required to enable the business owner remain in business and profitable. See Excess profit, INVESTOR GUIDE, http://www.investorguide.com/definition/excess-profit.html and Excess profit, OXFORD REFERENCE, https://www.oxfordreference.com/view/10.1093/oi/authority.20110803095803580.
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In addition, several options for global regulation were outlined including public non-market standard-setting, public standard-setting bodied in market competition, market-based private international standard-setting, and non-market private international standard-setting. The regulatory initiative that was proposed however has elements of non-market private and public international standard-setting frameworks.
This was chosen as the preferable route in order to prevent duplication in rulemaking to avoid wastage of resources. Besides, there is the need for a focal institution that has representation from all relevant stakeholders to set standards that evolve with changes in the market so that the normative system can remain effective, efficient, and stable.
The involvement of the IMF in this initiative gives it elements of nonmarket public global standard-setting. Finally, a case was made for why the IMF should spearhead or
“get the ball rolling” on the normative initiative for regulation of holdout creditors this study proposes. This is because: 1) the IMF has the clout and power; 2) it has the resources; and 3) the alleviation of the problems associated with holdout creditors and litigation, and the achievement of the aims of this proposed normative framework tie in with one of the major aims of the IMF which is to assess risks in respect of and strengthen the international monetary system.
Furthermore, other initiatives that were previously proposed to foster sustainable sovereign debt workouts and ostensibly deal with holdout creditor problems were explored including the SDRM and contractual approaches including exit consents and CACs. The question of whether these contractual approaches could serve as permanent solutions to the holdout problem was further addressed.
In conclusion, the author would like to state that if the proposal posited by this study is adopted and takes off, it will not stop all DDHFs from relentlessly pursuing claims against sovereigns and insisting on making humongous profits on those claims.
Page | 203
If this proposal is adopted, it might decrease the incentives the holdouts have to be
“vultures” or “hard-hitting” in their dealings with sovereign debtors. Of course, the proposal still has to be refined and specifics fleshed out in the context of an institution or soft law mechanism being established for this purpose. If this proposal does take off, it would evolve over time and progressively become the best practices method to be applied in the dealings between sovereign debtors and holdout creditors.561
In addition, the author does not think that my proposal or any other one can be a complete or perfect solution to the problem of sovereign debt crises. Too many factors play a role in contributing to sovereign debt crises, and debtor nations, creditors, and/or their citizens are not always in control. There is also the issue of politics and the fact that sovereign debt is inter-generational, but government administrations are not.
Despite the presence of DDHFs in the market being an incentive for sovereign fiscal prudence, this does not stop a government administration from incurring unnecessary debt knowing that they or their children would not be held personally responsible in the future for the debt. Corruption which is a leading cause of imprudent sovereign borrowing policies is rife in many developing nations which have been the target of
DDHFs in recent years. No sovereign debt proposal is enough to fix the issue of corruption in these nations; they would have to deal with it on their own. The least this proposal (as well as other proposals that have and will be proposed) can do is to alleviate these problems and prevent most of the negative effects and inefficiencies that arise in the market because of them.
561 See Ed Bartholomew et. al., “Two Step Sovereign Debt Restructuring: A Market-Based Approach in a World Without International Bankruptcy Law” 35 Georg. J. Int. L. 859, 871-72 (2004).
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7.4 Final conclusions The final conclusion is that DDHFs (specifically holdout creditors) are one of the linchpins for an efficient sovereign debt market. Although they might cause delays in or hamper debt restructuring processes, they have their advantages too, such as increasing liquidity in the sovereign debt market. It is however necessary that their activities and the effects thereof be checked to some extent so that the delicate balance can be struck between the rights of commercial creditors on the one hand and the protection of sovereign debtors on the other hand, while injecting some equity into the process.
The above mentioned normative regulatory initiative is therefore being proposed. This initiative, if implemented, arguably will: 1) address the poorly functioning sovereign debt market by deepening and inducing the liquidity of the secondary market for distressed sovereign debt, 2) guarantee private credit flow for capital formation and finance for development especially in debtor nations to build productive capacities for integration into the global economy; and 3) contribute to solving the perennial problem of sovereign default and debt overhang because their existence in the market and the threat of holdout litigation keep sovereigns on their toes in respect of their debt obligations.
7.5 Recommendations Based on the findings above, the following are my recommendations:
1. The proposed normative initiative for regulation of holdout creditors should be
implemented.
2. The IMF should spearhead this initiative; the ultimate objectives of the
initiative tie in with its fundamental aims, and by hosting it, the initiative will
have credibility.
Page | 205
3. In seeing this initiative get off the ground, the IMF should bring together
stakeholders such as: 1) private creditors and investors in the sovereign debt
market, 2) DDHFs, 3) relevant representatives from debtor nations, 4) lawyers
and international law firms that specialize in sovereign debt, and 5) academics
that are versed in and have published extensively in this field, to get their input
in creating an initiative that is focused on establishing international standards
that would regulate the activities of holdout creditors in the sovereign debt
market.
Page | 206
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