Sovereign Debt
Developed by Written by Professor Rodrigo Olivares-Caminal, Principal, Pari Passu Consulting Ltd. (in collaboration with Willkie Farr & Gallagher, LLP). All opinions are personal.
2 TABLE OF CONTENTS
CHAPTER 1: KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
1. Introduction 11 1.1. The Financial System and Types of Financing 11 1.2. Capital Markets 13 1.3. Money Markets 13 1.4. Derivatives Markets 14 1.5. Loan Markets 14
2. What is sovereign finance? 15 2.1. Taxation 15 2.2. Debt Finance 16
3. Domestic and External Debt 16 3.1. Governing law 16 3.2. Choice of jurisdiction 17 3.3. Currency 17
4. Bonds and Loans: What is the difference? 18 4.1. Liquidity 18 4.2. Customisation 18 4.3. Repayment 19 4.4. Investor base 19 4.5. Private or public nature
5. Bills, Notes, and Bonds: Different Maturity, Similar Terms 19
6. Coupons and Zero-Coupon Bonds 20
7. Fixed and Floating Interest Rates 20
8. Secured and Unsecured Debt 21
9. A Relatively Recent Innovation: GDP-linked warrants 21
10. The Principal Actors in Sovereign Finance 22 10.1. Debtor / Issuer 22 10.2. Central Bank 22 10.3. Arranger / Underwriter 22 10.4. Agent Bank / Fiscal Agent / Trustee 23 10.5. Credit Ratings Agencies (CRAs) 23 10.6. Creditors / Lenders 23 10.7. Clearing Houses 25
11. Conclusion 25
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References 25
CHAPTER 2: FUNDAMENTAL PRINCIPLES OF SOVEREIGN DEBT
1. Introduction 27
2. Sovereign debt as an interdisciplinary problem 28
3. Sovereign insolvency: is it possible? 29 3.1. Definitions of insolvency 29 3.2. The sovereign’s assets 30 3.3. Reasons for default 31
4. The bank-sovereign nexus 32
5. Different definitions of default 33 5.1. The contractual definition 33 5.2. Credit events under a credit default swap 34 5.3. The Credit Rating Agency definition 34
6. An ongoing debate: the costs of default 34
7. The role of sovereignty in contracting and structuring debt 36 7.1. The law-making power of governments 36 7.2. The dynamics of sovereign debt restructuring and the lack of a legal regime 36
8. Conclusion 37
References 37
CHAPTER 3: THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
1. Introduction 40
2. Multilateral debt 42 2.1. The IMF 42 2.2. Regional Development Banks 43 2.3. The European Stability Mechanism 45
3. Sovereign debt and restructuring in bilateral loans 46 3.1. The Paris Club 46 3.2. China 46 3.3. Russia v. Ukraine: An anomaly in official sector lending 47
4. Private sector lending: a process shaped by national law 47
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4.1. The London Club 48 4.2. Sovereign immunity: the initial hurdle 48
5. Proposals for reform 51 5.1.The Sovereign Debt Restructuring Mechanism (SDRM) 51 5.2. The United Nations Conference on Trade and Development (UNCTAD) Principles 51 5.3. The United Nations (UN) Draft Principles 51 5.4. Principles for Stable Capital Flows and Fair Debt Restructuring 52 5.5. The contractual approach to reform: Collective Action Clauses (CACs) 52
6. Conclusion 53
References 53
CHAPTER 4: INTRODUCTION TO CREDIT FACILITIES AND PRINCIPAL DOCUMENTATION
1. Introduction to Credit Facilities 54
2. Single or Multicurrency 56
3. Pari Passu or Subordinated 57
4. Secured, Partially Secured or Unsecured 57
5. Guaranteed, Partially Guaranteed or Unguaranteed 57
6. Bilateral or Multilateral 58 6.1 Bilateral 61 6.2 Multilateral 58 6.3 Syndicated Loans 58
7. Conclusion 66
References 67
CHAPTER 5: INTRODUCTION TO BOND ISSUANCES: PROCESS AND PRINCIPAL DOCUMENTATION
1. Introduction 69 1.1. A Note on Medium Term Notes (MTNs) 70 1.2. Subordinated Bonds 70
2. Parties involved 71
3. A note on underwriting 72
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4. Overview of Key Documents 76
5. Procedure 75
6. Listing of Bonds 77
7. Rating of Bonds 77
8. Trustees and Fiscal Agents 79
9. Conclusion 80
References 81
CHAPTER 6: UNDERSTANDING RISKS AND CHALLENGES
1. Introduction 83
2. Sovereign Risks 85 2.1 Non-Financial Sovereign Risks 6 85
3 .Debt-to-GDP Ratio 92
4. Outlining and monitoring the use of funds 95
5. Predecessor debt 95
6. Conclusion 96
References 97
CHAPTER 7: INTRODUCTION TO DISPUTE RESOLUTION IN SOVEREIGN DEBT
1. Introduction 99
2. Choosing Where to Sue 100
3. Enforcing the Judgment 101
4. Using a Fiscal Agent or a Trust Structure 102
5. The History of the Pari Passu clause 103
6. Pari passu litigation: Prominent case studies 104 6.1. Peru 104 6.2. Argentina 105
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7. Debtor strategies to neutralise holdouts 108 7.1 Contractual sweeteners 108 7.2 Collective Action Clauses (CACs) 109 7.3 Exit consents 110
8 .Conclusion 110
References 111
CHAPTER 8: SOVEREIGN DEBT IN AFRICA
1. Introduction 114
2. Sovereign debt crisis in Africa 114 2.1. A History 114 2.2. The HIPC initiative 115 2.3. Post-mortem: African debt today 117
3. Case Studies 118 3.1. Case Study 1: Kenya’s Eurobond 122 3.2. Case Study 2: Ecuador 124 3.3. Case Study 3: Grenada 125 3.4. Case Study 4: Seychelles
4 .Conclusion 126
References 127
7 CHAPTER 1
KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
1. Introduction 5. Bills, Notes, and Bonds: Different 1.1. The Financial System and Types of Maturity, Similar Terms Financing 1.2. Capital Markets 6. Coupons and Zero-Coupon Bonds 1.3. Money Markets 1.4. Derivatives Markets 7. Fixed and Floating Interest Rates 1.5. Loan Markets 8. Secured and Unsecured Debt 2. What is sovereign finance? 2.1. Taxation 9. A Relatively Recent Innovation: GDP- 2.2. Debt Finance linked warrants
3. Domestic and External Debt 10. The Principal Actors in Sovereign 3.1. Governing law Finance 3.2. Choice of jurisdiction 10.1 Debtor / Issuer 3.3. Currency 10.2 Central Bank 10.3 Arranger / Underwriter 4. Bonds and Loans: What is the 10.4 Agent Bank / Fiscal Agent / Trustee difference? 10.5 Credit Ratings Agencies (CRAs) 4.1. Liquidity 10.6 Creditors / Lenders 4.2. Customisation 10.7 Clearing Houses 4.3. Repayment 11. Conclusion 4.4. Investor base 4.5. Private or public nature Reference
9 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
1. INTRODUCTION
For all the talk of sovereignty, countries and their governments are not omnipotent. They have limitations just like the citizens that compose them. Much like its citizens, a country will face pressures in paying all of its bills on time, and in creating wealth through sound investments. Much of this is handled through fiscal policy, which is the discipline of what government revenues to collect, from whom to collect them, and how to spend them. However, much like with a person living day-to-day from a salary, fiscal policy has its limitations, in that a government that has to spend in services what it raises in taxes will never be able to save money for large expenditures of the sort that are sometimes required for necessary public investment.
Thus, countries, like corporations, turn to the financial markets for their financing needs. When countries use debt as a financing tool, the debt is termed sovereign debt, and the country is known, in its status as a borrower, as a sovereign debtor. The lender, for its part, will be known as a creditor, and as will be seen, both creditors and sovereign debtors come in all shapes and sizes, and can be either public or private in character.
While these Modules will concentrate on how to issue sovereign debt, the legal and economic aspects for sovereign debt, and what to do when things “do not go as planned” (sovereign debt restructuring), any discussion of sovereign finance must be grounded, first, in an introduction to the financial markets. While governments principally access the bond and loan markets to satisfy their financing needs, they also occasionally engage in transactions in other markets, such as the money markets and the derivatives markets, when they require the liquidity or risk management offered by these markets. Thus, in understanding the wide gamut of markets in existence, policymakers increase the tools at their disposal for addressing the myriad needs of government.
In particular, this specific Module will focus on the basic characteristics that underlie sovereign finance, such as the distinction between domestic and external debt, and the similarities and differences between the two financial instruments that governments use to incur procure financing, bonds and loans. While both are forms of debt, their legal terms, market treatment, and investor-base/lenders are entirely different. The Module finishes with a discussion of the principal actors in sovereign finance, the relevance of which will be clearer in subsequent Modules dealing with loan and bond documentation and debt restructuring. 1.1 The Financial System and Types of Financing
The financial system is divided into different types of markets, each catering to a broad class of financial instruments. Any entity in search of financing will consider its particular needs in deciding what market to turn to. Broadly speaking, these markets may be defined as the capital markets (consisting of the stock markets and the bond markets), the money markets, the derivatives markets, and the loan markets. 1.2 Capital Markets
The international capital markets are typified by two main characteristics: 1) their main purpose as fundraising sources for entities, and 2) the negotiability of the instruments it encompasses.
9 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
Tradeable financial instruments are known as “securities”, but not all securities are used for fundraising. Some are used for hedging (i.e., managing risk), as explained below with the derivatives market, or for short-term liquidity needs, such as the money markets. The capital markets, thus, concentrate on those securities that are used to raise relatively long- term capital, namely, equity and bonds.
Securities are issued by entities such as corporations and sovereigns, and initially subscribed (a promise to buy the securities) by a syndicate of specialist firms known as “underwriters”, who will then sell them forward to the wider market and take-up any issued securities to the extent they are undersubscribed. This initial issuance is done in what is termed as the primary market, and the market for successive trades of already- issued instruments is known as the “secondary market.”
For the secondary market to function smoothly, financial instruments must be “negotiable” (i.e. a tradeable instrument with a promise to make a future payment based on the issuance conditions). Negotiability allows for an instrument to be traded legally and without any encumbrance or previous conditions, so that the acquirer can easily feel secure in knowing that it is the legal owner with full rights over the instrument it has purchased. In facilitating the tradability of assets, negotiability appeals to investors that require assets that are liquid. Liquidity is important for market players because it allows them to rapidly convert assets into cash in order to facilitate other transactions, meet its liabilities, or comply with regulatory capital requirements.
The origins of securities laws
As Wood (2008) explains, securities regulation in the United Kingdom and the United States emerged as a response to a number of fraud scandals in the open market.
The main driver of the regulatory ‘revolution’ in securities law was the Wall Street Crash of 1929 that triggered a complete revision of the status quo and highlighted the need for revamped securities regulations.
As a matter of fact, the first state laws implemented in the United States to regulate the issuance of securities were called ‘blue sky laws,’ because financial fraudsters were said to be so shameless so as to attempt to sell pieces of the blue sky to gullible investors.
Securities regulators heavily regulate the international capital markets. This is precisely because of the open nature of the market and the tradability of its instruments. These markets are open to any investor that wants to participate in them; as such, there is a need to protect unsophisticated investors from misrepresentations or fraud. These regulations, aside from prohibiting fraudulent statements, also require disclosure of certain material information to investors about the nature of the investment they are to undertake, both at the moment of the instrument’s issuance, and throughout its existence. Sovereigns listing their debt instruments in the United States, for example, have disclosure requirements imposed by the Securities and Exchange Commission (SEC) that require them to
10 11 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE periodically submit reports on their financial condition, and to inform investors when a material event has occurred that may impact the bond’s future.
There are two principal capital markets: the stock markets and the bond markets: 1.2.1 Stock Markets
The stock or equity markets trade in corporate shares. Shares constitute equity ownership in a particular company. They encompass two principal rights: an unsecured claim of ownership over all assets of the particular company, which also entitles the owner to a share of the dividends that the company may from time to time disburse to its shareholders, and voting rights over the company’s affairs. Stock markets are irrelevant to sovereign financing, because countries cannot sell away ownership and voting rights over their political decisions because it can undermine their sovereign prerogative. 1.2.2 Bond Markets
The other principal type of instrument traded on the capital markets is the bond instrument. Bonds are, like stocks, tradeable instruments, but they are debentures (a debt obligation usually only backed by the integrity of the borrower). A bond instrument represents an outstanding debt to the owner of the bond from the issuer. Unlike shares, bonds will have a maturity date, at which point the principal amount and any remaining due interest at a fixed or floating rate on the bond must be fully paid off and the bond will be retired. Also, unlike shares, a bond does not endow its owner with voting rights over the issuer’s affairs. Rather, the rights that the bondholder has to enforce its money claim are contractual.
Bonds can be issued in one of two forms: bearer or registered. Historically, bonds were issued in bearer form so that ownership was evidenced solely by physical possession of the bond instrument. However, bonds are now more likely to be issued in registered form because laws in certain jurisdictions require most securities to be registered. Today, it is unlikely that the owner of a bond will have physical possession of the instrument. Rather, common depositaries like Euroclear and Clearstream hold the physical instruments in the form of a “master” or “global” bond, which is a single document representing the whole issuance. These common depositaries hold the bonds and register the ownership interests over them as they are traded in the market. It is also possible that the instrument is not in a paper copy, in which case they are considered to be ‘dematerialised’, and in those cases, the common depositary will also be responsible for recording the transferral of ownership as the instrument is traded in the market.
Today, countries borrow funds principally through the bond markets. 1.3 Money Markets
The money markets are securities markets characterised by the trading of debt instruments that have a very short-term maturity. Their maturity may range from one day to a year. This market includes both government-issued (such as United States T-Bills, the German bunds or the U.K. gilts) and private instruments (such as commercial paper issued by banks or corporations). These instruments are mainly traded between financial
11 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE institutions to address any short-term liquidity problems. Central banks also buy and sell them for monetary policy purposes.
Governments may choose to issue money market instruments to address fiscal shortfalls. They can be useful to address the mismatch between the time when a government receives its revenues and the moment in which it requires money to fund its services during the fiscal year. For example, in the United States, most state governments rely on income taxes, and they will receive most of the proceeds from the tax close to the filing deadline day. As such, state governments and municipalities will issue Tax Revenue Anticipation Notes (TRANs), debt instruments with a maturity of no more than a few months, which helps them address funding gaps. They then retire this debt when they receive the tax proceeds. 1.4 Derivatives Markets
Derivatives are financial instruments whose value will depend on the value of another financial instrument, known in market jargon as the ‘underlying’. These are most often financial contracts related to the underlying, such as options (the right to buy the underlying at a certain point in the future), futures (a contract of purchase for the underlying at an agreed amount at a time in the future), and swaps (an exchange of certain obligations in underlying instruments, such as interest rates). Derivatives are not principally used to raise capital or to address immediate liquidity shortfalls, although they can form part of a strategy to do both of these things. Rather, their main purpose is to address risks such as price volatility, interest rate risk, exchange rate risk, default risk, etc. A sovereign debtor may see a need to access the derivatives markets in order to address some of these risks. For example, by entering into an interest rate swap, a sovereign debtor can ensure that it can pay a fixed interest rate instead of a floating one, and thus have predictable interest payments throughout the life of the debt instrument. 1.5 Loan Markets
The loan markets, although used for raising capital like the capital markets, fundamentally differ from the capital markets because they do not deal in tradable instruments.
Loans represent a debt just like bonds, but they cannot be traded freely. The lender in a loan can divest itself of the loan by assigning its rights under the loan, effecting a novation of the loan, or engaging another investor as a sub-participant in the loan (a participation in the original participation, i.e. like fractioning the original obligation). However, none of these forms of divestment reach the level of negotiability, because the acquirer will not assume full rights over the loan, without any encumbrance, by the mere purchase of the loan. However, as discussed below, loans offer a flexibility for debtors that bonds do not because of their highly customisable nature, and debtors are willing to pay a premium to lenders for that flexibility.
The international loan markets are dominated by syndicate lending. A syndicate is a group of banks that pool their funds to offer large loans to meet borrowers’ funding needs under a master agreement. Syndication is done both because the borrowers’ funding needs may be too high for any one bank, and because banks do not want to (and often under regulatory requirements, cannot) have large risk exposures to any one borrower
12 13 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE whose default can threaten the existence of the bank.
In the sovereign lending context, lenders may also be multilateral lending institutions such as the International Monetary Fund and regional development banks, as well as other countries. These ‘official’ loans are often accompanied by ‘conditionalities’ or ‘adjustment programmes’, under which the debtor commits to implementing certain public policies or reaching certain fiscal goals in exchange for the financing.
Because loans are not publicly traded, loan markets are not subject to the same regulation that the capital markets are. Any trade of loans is private and usually involves sophisticated investors, some of whom may be subject to regulatory requirements and follow best practice (albeit non-binding) guidelines issued by the Loan Market Association. 2. WHAT IS SOVEREIGN FINANCE?
A state principally exists to provide essential functions to its citizens, such as security, infrastructure, transportation, education, and health. Each of these services is costly, and a sovereign state needs to ensure that it has available funds to provide them effectively and without interruption. To do this, governments have two options: taxation and financing (specifically debt financing, as sovereigns cannot obtain equity financing). 2.1 Taxation
A government can use its taxing power to raise funds, either by raising funds from its citizens directly (through an income tax, for example) or by taxing economic activity within its territory (through import and export tariffs, for example). Taxation, however, has its limitations. Any form of tax takes funds from the private sector to redistribute as the government sees fit. As such, it may have a deleterious effect on the economy if the redistribution effected by the government is less productive than the use that the private sector would have given the funds otherwise. Furthermore, and more relevantly, a government’s taxing power only extends to its economic base. This means that taxation by itself may not be enough to finance government initiatives that are capital intensive and long-term, because the outlay of funds required to begin a particular project may surpass the government’s ability to extract the required monies through taxation without unduly harming the country’s economic activity. If taxation is insufficient, a government can attempt to fund its projects through debt finance. 2.2 Debt Finance
A government can also turn to the loan market or capital markets for credit. This has advantages and disadvantages. Not unlike a residential mortgage that an individual uses to buy a house he or she may not otherwise be able to afford; sovereign debt permits a country to make necessary investments for its future in the present time by borrowing the required moneys. Similar to the residential mortgage, it is expected that the sovereign will apply the funds that it receives from contracting long-term debt towards long-term investments; otherwise, it will run into balance of payments problems, because it will have large new liabilities without a corresponding increase in government revenues to endow it with capacity to repay. Among the worst practices in sovereign borrowing is taking long-term debt and directing the funds towards covering operational deficits for
13 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE a defined fiscal year. This creates what is known as an “intergenerational problem”, where future generations are left to pay for the liabilities incurred and unsustainable benefits enjoyed by existing generations. However, even following best practices, contracting debt always involves an element of risk. For that reason, it is important for government officials to bear in mind the specific characteristics of the debt instruments they issue to maintain effective sovereign debt management practices. 3. DOMESTIC AND EXTERNAL DEBT
One of the traditional distinctions made in the sovereign debt context is that between domestic and external debt.
The percentage of gross external debt a country has, defined as the totality of outstanding liabilities of residents of a country to non-residents of the country, is a traditional macroeconomic indicator. However, this distinction, simply based on the place of residence of the lenders and borrowers, is insufficient for proper management of public external debt. Simply considering the place of residence of the parties is outdated, because due to the loosening of controls on international capital flows, non-residents now regularly invest in instruments that were traditionally targeted for residents, and vice-versa. Instead, in sovereign debt management, governments must also pay special attention to the governing law, the choice of jurisdiction, and the currency under which they issue their bonds.
3.1 Governing law
Bonds can be issued (and loans contracted) under the domestic law of the country that issues the debt, or their terms and performance can be submitted to a foreign law regime. This may be done because the sovereign wants to list its bonds in a foreign exchange, and its financial advisors consider that it will be unlikely that the bond will be adequately subscribed if it is issued under domestic law, which can be perceived as risky by investors. In the case of a loan, it may be that the lender specifically requests that the loan be contracted under a foreign law regime in order to make the loan more transferable on the secondary loan market.
A sovereign that owes a debt governed by its domestic law has more tools at its disposal to manage its indebtedness if it finds itself in a distress scenario where it faces difficulties in making repayment. Under a domestic governing law, the sovereign can use its law- making power to effect changes to its domestic law so that the debt’s terms are interpreted differently under the law, made invalid in one way or another, or altered altogether. According to the rules of private international law, if a creditor contracts under the law of a particular sovereign state, for example, by acquiring bonds issued under the governing law of that State, then any changes made by the State, to that governing law are built into the contract. In other words, you cannot freeze a legal system at a particular moment in time. A sovereign is at the apex of its power when restructuring or re-profiling debt issued under its domestic law, because the sovereign itself is in position to define what is legal and what are the ‘rules of the game’. As such, a creditor cannot contest the legality of a sovereign’s actions unless the sovereign is somehow in violation of the rules that it itself has the power to impose. This is not to say that a sovereign will readily exercise a power
14 15 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE that is likely to alienate its creditors in the future.
A sovereign that owes debt governed by foreign law will, on the other hand, be committing itself to paying a debt under a law imposed by another sovereign, which it is unable to affect. As explained in a forthcoming Module, this does not mean that the sovereign debtor will lack any options in a distress scenario, but it does mean that it will have to concentrate its restructuring strategy on the contract terms, and not on a shift in the legal regime under which the contract is performed.
Foreign law-denominated debt is mostly issued under New York law or English law, due to the roles of New York City and London as global financial centres and objective and impartial well-reputed jurisdictions. 3.2 Choice of jurisdiction
Bond instruments and loan contracts will also have a jurisdiction provision, which will give creditors the right to sue for repayment in a particular court. Like governing law, the relevant distinction here will be whether the court is domestic one or foreign. Domestic judges, whose re-appointment by the political authorities or re-election by the citizenry may depend on how they rule on a sovereign debt case with massive national implications, may be more reticent to issue a ruling that favours private creditors, especially if these creditors are principally non-residents of the country. Foreign courts, especially those in large financial centres, may be both more impartial in their consideration of such a case and more attuned to the commercial considerations and market practices that may be relevant to the litigation. 3.3 Currency
If a debt is denominated in a foreign currency, there will be a mismatch between the currency in which the sovereign receives funds to repay the debt (because tax revenues will invariably be in the sovereign’s domestic currency) and the currency in which the debt must be paid. As such, the ability of the sovereign to repay that debt will depend on the exchange rate between that currency and the sovereign’s domestic currency. This may become a problem if the domestic currency depreciates against the foreign currency, in which case the debt will become more and more expensive in practical terms.
On the other hand, if a debt is denominated in domestic currency, this problem will not exist. Additionally, if necessary, the sovereign can use its seigniorage power (money printing ability) power to simply print enough currency to pay off any debt denominated under its domestic currency (at the risk, of course, of rising inflation).
Did you know?
A bond issued under a foreign currency is referred to as a euro-bond. Autostrade, an Italian company that operated the country’s highways, issued the first ever euro-bond in 1963.
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It is not necessary for all of the aforementioned factors to converge for debt to be understood as domestic or foreign. Although academics have proposed different definitions to distinguish between domestic debt and external debt, this distinction must be grounded, first, on its practical consequences for a government’s management of its sovereign debt. 4. BONDS AND LOANS: WHAT IS THE DIFFERENCE?
When you issue a bond or take out a loan, you are doing much the same thing: borrowing money, which you need to repay at a certain point in the future. These forms of borrowings, however, differ in several respects: liquidity, customisation, repayment, investor base and the private v. public nature. 4.1 Liquidity
As previously mentioned, bonds are negotiable instruments. This means, in general terms, that the bondholder can be sure that it has good title to the instrument it purchased (due to the role of common depositories). Loans, on the other hand, are not negotiable instruments, and their transferral often involves more than a simple purchase. Thus, bonds are more liquid than loans, in that it is easier for an investor to quickly convert their bonds into money by selling them as compared to loans. This is mainly due to their “standard” format plus the fact that they are traded on an established platform that facilitates the creation of a market. 4.2 Customisation
Loan facilities generally offer much more flexibility than bonds because they are negotiated to suit the borrower’s very specific needs. For example, a loan facility can allow for borrowing in multiple currencies, it can be structured so that the borrower only draws down the money that it needs at any particular time, it can allow for early repayment under certain conditions and it can have a revolving nature so that the borrower can withdraw more money from the facility after repaying previous draw-downs. A bond issue, on the other hand, will usually not allow for early repayment (unless on the occurrence of certain pre-agreed events, such as an event of default or a change of control of the issuer), will be in a single currency, and the borrower will receive all the money at once. While the customisable quality of loans appeals to borrowers, it can also act to the benefit of the lenders. Provisions that protect the lenders’ investment, like covenants, representations and warranties, and events of default, tend to be more robust in loan facilities than in the terms of a bond. 4.3 Repayment
With bonds, the issuer promises to pay interest at a fixed or floating rate at regular intervals throughout the life of the debt (except with zero coupon bonds, as explained below) and repay the principal at the maturity date. With a loan facility, the loan may last twenty years, and be made on a revolving basis, so that the borrower may repay the
16 17 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE principal it owes and re-draw available funds in the facility many times over. Interest will vary accordingly, but is usually at floating rather than fixed rates. 4.4 Investor base
Bondholders can range from individuals (known as “retail investors”) to large investment firms and banks. Loans are generally only offered by specialist banks (though there has been an increase in lending by so-called peer to peer lenders in the SME (small and medium-sized enterprise) Market in recent years). This means that borrowing under bonds will be cheaper because of their higher demand/number of lenders. 4.5 Private or public nature
Bonds are usually issued through public transactions, unless there is a private placement to a very limited number of investors. If it is a public transaction, there is first a distribution of information about the bond issue through a document called a ‘prospectus’, which will give financial information about the issuer and give an outlook for the future that will hopefully entice potential investors to subscribe to the issue. Since bonds are issued in regulated markets, issuers must ensure that any information they offer in the prospectus does not mislead or deceive investors regarding their financial status. Loans are private matters between the borrower and a limited number of lenders. Their terms can remain confidential, and regulators do not scrutinise loan documentation as they do bond documentation. 5. BILLS, NOTES, AND BONDS: DIFFERENT MATURITY, SIMILAR TERMS
Until now, all negotiable debt instruments have been referred as bonds. However, the market refers to negotiable debt instruments in different ways depending on their maturity date:
• Bills Bills were previously mentioned when discussing the money markets. They tend to have the shortest maturity date, which can range from a day to no more than a year.
• Notes Notes have a maturity date of one to ten years.
• Bonds Bonds usually have a maturity date of more than ten years.
These distinctions are mainly used in market parlance, and they mean little in terms of how these instruments will be legally treated. They should be taken into consideration, however, when considering market appetite for a particular type of instrument to be issued, and, more importantly, when considering a sovereign issuer’s financing needs.
17 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
While a bill may be issued to address a short-term funding gap, notes or bonds may be issued if the sovereign needs to finance a medium to long-term investment.
Eurobonds are a type of bond that, as previously stated, are issued in a currency other than that of the issuer. Eurobonds usually have a maturity of more than 20 years. 6. COUPONS AND ZERO-COUPON BONDS
The interest rate on a bond is known as the bond’s “coupon.” The term comes from the fact that historically, bonds were issued with coupons on the back of the instrument that were detachable from the instrument, and with which the bondholder could go and claim the interest payment from the debtor.
‘Zero coupon’ bonds also exist. As the term suggests, these bonds seemingly carry no interest, but investors still profit from lending under these conditions. In zero coupon bonds, the interest rate is built into the principal amount to be repaid. Bonds will be issued at a discount, meaning that the issuer will receive less than the principal amount of the debt. For example, a sovereign will issue a zero-coupon bond for USD11 million, but only receive USD10 million from the subscribers. Since the sovereign will have to pay USD11 million of principal when the bonds mature even though it only received USD10 million, in practical terms, one could say that it is paying USD1 million, or 10%, in interest to bondholders on maturity.
The practical difference between bonds with coupons and zero-coupon bonds is that the issuer will not have to make interest payments over the life of the loan, but rather simply pay the principal amount when it comes due. This may offer some relief to the issuer over the life of the bond as well as reduce the amount of tax payable by bondholders because they receive no interest, but it will make the financial burden on the bond’s maturity date more onerous for the issuer.
An example of a zero-coupon bond in the African continent is the African Development Bank’s (AfDB) issuance of a USD 50,000,000 bond maturing in 2046 (XS1520973014). 7. FIXED AND FLOATING INTEREST RATES
The interest rate for a loan or bond may be fixed throughout the term of the bond or loan, or it might be variable (known as “floating”). A fixed rate is relatively straightforward; it is simply a percentage of the principal amount. However, for loans particularly, banks may not be willing to offer a fixed interest rate, because of their own borrowing costs. Banks constantly borrow from each other to fund their clients’ financing needs. The banks’ borrowing comes at a cost to themselves because they also have to pay an interest rate, known as the interbank offering rate. The main interbank offering rate in the world is called LIBOR (the London Inter-Bank Offered Rate). To cover their own borrowing costs, banks will offer loans with a floating interest rate that will change depending on the LIBOR benchmark, so if it becomes more expensive for banks to service the loan, they can pass that cost on to the debtor. A floating rate will often be referred to as a ‘spread over LIBOR’, where the spread means the fixed interest rate on top of the LIBOR benchmark. As an example, a loan may have 3% interest over LIBOR, and so the payable interest rate on the loan will depend on the cost of borrowing in the market. This can be good or
18 19 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE bad for the debtor, depending on market conditions, but generally, debtors prefer fixed interest rates so that their payments are predictable and can be appropriately planned for in advance. 8. SECURED AND UNSECURED DEBT
What is a security? A security reduces credit risk for a creditor by providing it with a specific avenue for recovery of the debt. A security over an asset gives a creditor a right to execute on the security and sell that debtor’s asset in case of non-payment by the debtor to satisfy its monetary claim.
As well as reducing credit risk, the primary purpose of security is to obtain priority over other creditors over a particular asset/s. While an unsecured creditor has a general claim against the assets of the debtor, this may not be enough to recover on the debt, especially if it is competing with other debtors to recover from an insolvent debtor. A security not only gives a creditor a specific asset to recover from, but it also gives it priority over other creditors for the proceeds from that asset (subject to certain classes of unsecured claim, such as employee claims, which, for policy reasons, most legal systems award priority over certain classes of secured creditors). Sovereign bonds are mostly unsecured when issued by central governments, but secured debt instruments are issued as well, especially by state-owned companies (such as government-owned utilities) that can offer security over their revenues.
Finally, although not strictly a security, sovereign debtors can also obtain loan guarantees from multilateral institutions or other countries. Loan guarantees ensure the creditors that the guarantor will repay the debt in case the debtor defaults on the same. As such, a loan guarantee reduces the cost of borrowing, since the creditors will charge a lower rate of interest due to the lower probability of default on the debt.
An interesting example of the use of guarantees can be drawn from the Government of Seychelles when it approached the AfDB in 2009. It requested a partial credit guarantee to be applied to the interest payments of the new instruments offered by the Seychelles’ to its commercial creditors as a result of a restructuring. On 1 February 2010, after the successful bond exchange, Fitch Ratings rated the Seychelles as having Long-term foreign and local currency Issuer Default Ratings (IDRs) of ‘B-’ and ‘B’ with positive outlooks. 9. A RELATIVELY RECENT INNOVATION: GDP-LINKED WARRANTS
In the 1990s, a new form of sovereign-linked instrument emerged: GDP-linked warrants. These are detachable instruments linked to the main instrument (i.e. the bonds). GDP linked warrants link debt service to a macroeconomic variable, like GDP growth. This would mean, for example, that if a country’s economy performed well in a particular fiscal year, it would pay a higher amount (like a bonus payment) on its state contingent instruments (i.e. the GDP linked warrants) than if it performed poorly. For example, in the post-World War II period, the Allied Powers reached a debt agreement with West Germany that tied the amounts owed in any fiscal year to the country’s ability to pay the debt.
19 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
Value Recovery Rights (VRRs) are a slight variation on GDP linked warrants, as these are linked to the performance of an underlying asset. The most common example of VRRs are those that are linked to oil prices as have been used by Brazil, Mexico and Nigeria.
GDP-linked warrants or VRRs are issued as a ‘contractual sweetener’, meaning that they are offered as part of the restructuring of a separate, primary bond, in order to entice investors to agree to the restructuring. The warrants are detachable from the primary bond, and as such can be traded separately. GDP-linked warrants or VRRs in general are touted as an effective way to manage sovereign debt because repayment is precisely linked to a sovereign’s capacity to repay. However, they are a double-edged sword; it can reduce the overall effect of an economic recovery on public investment because governments will have to direct an increasing quantity of its revenues into debt repayment. They are also instruments that are poorly understood by the market because of their rarity and complexity to structure; therefore, they tend to be undervalued or overvalued, which has historically affected their effectiveness in enticing bondholders to agree to a debt restructuring. 10. THE PRINCIPAL ACTORS IN SOVEREIGN FINANCE
The relevant actors in sovereign finance will depend on whether the sovereign seeks a bond or a loan, the financial condition of the sovereign, and the legal structure it uses to repay the debt: 10.1 Debtor / Issuer
Sovereign debtors are, of course, central governments, but they can also be political subdivisions, state-owned companies or central banks. State-owned companies may contract loans and issue debt like any other private corporation and be treated as such, but depending on their juridical status and operational reality, they could instead be considered an alter ego of the central government. For example, this happened very recently in Crystallex International Corp. v. Bolivarian Republic of Venezuela, a case in the United States that concluded that Petróleos de Venezuela Sociedad Anonima (PDVSA), the Venezuelan state-owned oil company, was an alter ego of Venezuela. 10.2 Central Bank
Central banks act as the fiscal agent for governments, supervising and sometimes conducting their governments’ issuance and servicing of debts. They also formulate monetary policy, which affects the domestic currency’s exchange rate, and can thus be important if the debt is paid in a foreign currency, as seen before. 10.3 Arranger / Underwriter
In a syndicated loan, the main bank of the syndicate will be known as the “arranging bank.” It will take care of preparing the necessary documentation for the loan and conducting the due diligence process with the borrower.
In a bond issuance, the sovereign will engage with investment banks to act as underwriters.
20 21 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
Underwriters will advise the sovereign on how to price the bond, and they will guarantee that they will purchase any unsubscribed bonds at the time of issuance. This, of course, may vary on each transaction based on the commercial understanding between the sovereign and the investment banks acting as underwriters. 10.4 Agent Bank / Fiscal Agent / Trustee
In a syndicated loan, a bank will be appointed as the agent bank, which is responsible for receiving payments from the borrower and distributing them in a pro rata manner among all the members of the syndicate.
A bank fulfils this role in a bond issue as well, but in that case, it is called a fiscal agent. A fiscal agent is properly an agent of the issuer, which assists the issuer in making its necessary payments.
Bond issues often take another, alternative approach in naming a trustee who represents the bondholders and manages payments to them. The trustee (typically a division of a major bank such as Deutsche Bank, or a specialist corporate trustee services provider such as Law Debenture Corp) acts for the bondholders and not for the debtor, and as the name suggests, any funds which it receives are put in a trust for the benefit of the bondholders until they are disbursed to them. The “trust” created under this arrangement is not a true trust in the property law sense, but rather an irrevocable authority given by the issuer to the trustee and consented to by the bondholder, to act on behalf of the bondholders collectively in monitoring performance by the issuer and taking enforcement measures in the event of default. Since the trustee acts for the bondholders, the trust agreement will often give it robust enforcement powers against the issuer, exercisable at the direction of a specified majority (in value) of bondholders.
The trustee figure also offers more legal protection for the funds destined for repayment to the bondholders. If anyone sought to attach the assets of the sovereign, any funds already placed with a trustee would be outside of their reach because such funds would be beneficially owned by the bondholders. 10.5 Credit Ratings Agencies (CRAs)
Credit ratings agencies, as the name suggests, will assign credit ratings to sovereign bond issuers and to particular bond issues of the sovereign. Credit ratings are essentially an estimation of the issuer’s ability to repay the debt, also known as “default risk.” A good credit rating will make borrowing much cheaper. Since repayment will be very likely, investors will not feel the need to price in a high default risk into the debt instrument. 10.6 Creditors / Lenders
The investor profile for sovereign debt will largely depend on the credit rating of the debt. As noted, private syndicated loans are almost exclusively undertaken with banks. However, international financial institutions and other countries also extend sovereign loans. This sovereign debt is termed official debt and is provided by international financial institutions (multilateral lending) or bilateral lenders.
21 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
10.6.1 International Financial Institutions (IFIs)
International financial institutions like the World Bank offer development loans at favourable rates to countries that may otherwise not be able to secure financing from the markets. While the World Bank offers loans to meet development goals, the International Monetary Fund (IMF) offers loans that help countries address balance-of-payment problems, and due to the IMF’s role as a lender of last resort for countries, it is treated as a senior creditor of debtor countries as a market convention. 10.6.2 Bilateral Lenders
Developed countries also offer loans to less developed countries. In this context, countries are known as “bilateral creditors.”
Did you know?
In 2016, China committed over USD30 billion in loans to countries in the African continent, mainly directed towards infrastructure projects.
10.6.3 Private Creditors
With bonds, due to their tradability, it is possible for the investor base to change completely during the life of the instrument based on the credit outlook of the bond. These usually include institutional and retail investors and, occasionally distressed investors. 10.6.3.1 Institutional Investors and Retail Investors
Traditional purchasers of bonds are institutional investors with a long-term investment outlook. Institutional investors are large, non-bank entities that pool funds to purchase assets. This includes private wealth managers, sovereign wealth funds, pension fund managers, and the like. Institutional investors invest in fixed income products like bonds because they tend to offer a steady, measurable return, and are generally safer than stocks. This approach is sometimes also followed by unsophisticated retail investors. 10.6.3.2 Distressed Debt Investors
Distressed debt investors, known pejoratively as ‘vulture funds’, are typically hedge funds that specialise in purchasing assets in financial distress. Their strategy is to take advantage of the fact that assets in distress are sold at deeply discounted values to purchase them cheaply, and then engage in aggressive debt recovery strategies to multiply their investment. For example, if a country like Venezuela is expected to default on its debt, institutional investors that hold Venezuelan bonds will want to sell them to divest themselves of that financial position, because they prefer safe assets with a steady return. Since institutional and retail investors would not be willing to buy, there will be no buyers and consequently no liquidity in the market. However, distressed debt investors will come in, buy the bonds at a price far below their par value, and then spend their
22 23 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE considerable resources in ensuring that the sovereign pays the par value for the bonds, or a quantity close to that that allows them to multiply their original investment based on the assumed risk. 10.7 Clearing Houses
Clearing houses are important cogs in the financial system, because they facilitate the exchange of payments between market participants, they record the exchange of financial instruments, register their ownership and, often hold the physical copies of the instruments. 11. CONCLUSION
Throughout this Module, the basic distinctions between financial markets for equity capital, debt capital, money market instruments, and derivatives have been provided. The different characteristics that traditionally underlie the domestic/external debt distinction, the similarities and differences between bonds and loans, the main characteristics of debt, and the principal market participants in sovereign finance were explained. In the following Modules the terms and the interaction between participants, both in the good times (when the sovereign issues debt) and in the bad (when the sovereign cannot, or will not, make good on its debt) are illustrated in more detail.
References
ENCYCLOPAEDIA OF BANKING LAW (Butterworths, 1982) Andrew McKnight, THE LAW OF INTERNATIONAL FINANCE (Oxford University Press, 2008) Philip Wood, THE LAW AND PRACTICE OF INTERNATIONAL FINANCE (Sweet & Maxwell, 2008). Eduardo Borensztein, Eduardo Levy-Yeyati & Ugo Panizza, LIVING WITH DEBT: HOW TO LIMIT THE RISKS OF SOVEREIGN FINANCE (2006). Mark L. J. Wright, Sovereign Debt Restructuring: Problems and Prospects, 2 Harv. Bus. L. Rev. 153 (2012). Anna Gelpern, Brad Setser, Domestic and External Debt: The Doomed Quest for Equal Treatment, Geo. J. Int’l L. 795 (2004). China-Africa Research Initiative, The Path Ahead: The 7th Forum on China-Africa Cooperation, Briefing Paper No. 1 (2018). Crystallex International Corp. v. Bolivarian Republic of Venezuela, No. 17-mc-00151-LPS (D. Del. Aug. 10, 2018).
23 CHAPTER 2
FUNDAMENTAL PRINCIPLES OF SOVEREIGN DEBT
1. Introduction 5.3 The Credit Rating Agency definition 2. Sovereign debt as an interdisciplinary problem 6. An ongoing debate: the costs of default
3. Sovereign insolvency: is it possible? 7. The role of sovereignty in contracting 3.1 Definitions of insolvency and structuring debt 3.2 The sovereign’s assets 7.1 The law-making power of governments 3.3 Reasons for default 7.2 The dynamics of sovereign debt restructuring and the lack of a legal regime 4. The bank-sovereign nexus 8. Conclusion 5. Different definitions of default 5.1 The contractual definition References 5.2 Credit events under a credit default swap
25 FUNDAMENTAL PRINCIPLES OF SOVEREIGN DEBT
1. INTRODUCTION
The dynamics of sovereign debt are full of contradictions, dilemmas, catch-22 situations, and unpleasant surprises. Some examples of these include:
• A government faces financial hardship and its citizens protest in the streets. The government tries to prevent a default because of its damaging implications. Despite all efforts, it finally defaults and subsequently restructures the debt, submitting the country to austerity policies as part of an adjustment programme. Its citizens return to protest in the streets (Greece, 2010).
• A government comes to the conclusion that it cannot pay its sovereign debt. This, despite the fact that it is rich in natural resources and it continues to fund its social programmes and pay its employees without fault (Ecuador, 2009).
• A government is fiscally responsible and has made ample provision for paying down its debt. Its banking sector, however, has been taking excessive and illegal risks in its deposit-taking and lending practices. In a span of a few short months, the government has to bail out the banking sector to stop the economy from collapsing, and its sovereign debt becomes an unsustainable burden (Ireland, 2008; and, Iceland, 2008).
• A government defaults and subsequently restructures its debt. A short time later, the private sector welcomes it with open arms for a new bond issue at favourable market rates (Uruguay, 2003).
• A government defaults, so it needs to reorganise its finances by restructuring its debt payments. There is no pre-determined process for doing so. Chaos ensues (Puerto Rico, 2015).
The above are all real-life examples of the uniqueness of the challenges of sovereign finance. They are a product of the strange behaviour of a market that caters to entities whose primary goal is not to engage in commercial activity but to respond to the needs of their citizens, and who, as sovereign states, are generally free from legal restrictions that they have not consented to.
This Module will explore a number of principles of sovereign debt that must be understood by policymakers when making decisions regarding the debt burden of their governments. After reviewing it, the reader will be able to look at sovereign debt, not from the narrow viewpoint of the sovereign debt market’s minutiae of requirements and documentation and the government’s immediate financing needs, but instead from a macrocosm, with all the financial, political, economic, social, and legal considerations that entails.
The Module begins by addressing the interdisciplinary nature of sovereign debt, and its practical consequences. Thereafter, the Module discusses how solvency is quintessential to sovereign debt, and how it should be discussed in light of the unique nature of a sovereign debtor. Then, the Module delves more deeply into the interplay between government
25 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE finances and the banking sector, and sheds some light on why this has been termed a “doomed loop” in the past. The Module will discuss what it means for a sovereign to default, and how different entities may interpret the same event to constitute a default or not. Additionally, the Module will briefly touch upon the large debate in the academic community regarding the costs of sovereign default. How the role of sovereignty makes crucial certain contractual clauses in bond instruments that would be non-existent or boilerplate in other financing arrangements will also be reviewed. Additionally, the Module will study to what extent, if any, the law-making power of governments affects their sovereign debt management, especially in light of both the aforementioned contractual design and the democratic limitations of political institutions. Finally, in anticipation of the next Module, which discusses the applicable framework for sovereign debt management in detail, the Module will briefly outline what these dynamics are due to the lack of a legal regime that can bind and subject both sovereign debtors and creditors to an orderly restructuring process (both, as a cause and an effect of it). 2. SOVEREIGN DEBT AS AN INTERDISCIPLINARY PROBLEM
Brian Wynter, the Governor of the Bank of Jamaica, delivered the keynote address at the first annual Interdisciplinary Sovereign Debt Research and Management Conference, held in Washington, D.C., in 2016. Governor Wynter did not mention the word “interdisciplinary” once in his brief address, and yet his account of Jamaica’s efforts in managing its sovereign debt managed to perfectly encapsulate why sovereign debt is an interdisciplinary problem.
Regarding fiscal policy and the economy, he detailed Jamaica’s fiscal state, lamenting the country’s “debt overhang”, which is the situation that arises when a country’s debt burden impedes it from borrowing any new debt to make good, worthwhile investments. The country’s debt-to-GDP ratio was extremely high, and its debt service obligations accounted for a large portion of its expenditures. On the legal front, he mentioned recent innovations in Jamaica, and how a new Banking Services Act would improve stability in the financial system, and consequently, how that would ameliorate threats to the public purse from the financial sector. He further discussed how a particular legal tool used in restructuring processes, “bail-in”, would be unsuitable for Jamaica’s debt reform programme, because its impact on the country’s investor base would be too damaging. In political terms, he discussed the commitment required, and to that point displayed, by the political authorities in Jamaica to implement a long-term economic reform programme that would tackle the country’s challenges. Finally, his discussion of whether to discriminate against non-resident bondholders in favour of domestic bondholders due to there being an incentive for countries to protect their own citizens was relevant from both a political and sociological perspective, because it presents the question of who should bear the costs of a social problem, namely, a sovereign debt crisis.
This is just one example of the myriad disciplines that policymakers encounter when managing sovereign debt. Addressing sovereign debt problems successfully will almost invariably require a maximisation of the potential (the toolbox) presented by each
26 27 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE discipline, and a harmonisation of the goals at hand. Too often, policymakers will make the fatal mistake of ignoring one discipline over another, thus dooming their endeavour. They may push for a particular economic strategy in debt negotiations without thinking about their legal options, or conduct a ‘successful’ debt restructuring in participation terms without paying due consideration to the financial sustainability of the resulting debt burden, or even yet, set certain debt management goals for their governments without considering whether they have the political capital to enact necessary reforms. In each case, the mistake of misconstruing the nature of sovereign debt as unidimensional can be catastrophic for the country in question. 3. SOVEREIGN INSOLVENCY: IS IT POSSIBLE? 3.1 Definitions of insolvency
In everyday parlance, the terms “bankrupt” and “insolvent” are often used interchangeably to describe a state where a person cannot pay their debts as they fall due and must reorganise their finances through a court supervised process. However, in the sovereign debt context, a sovereign can never be bankrupt, because there is no court supervised bankruptcy process for sovereigns. Nonetheless, sovereigns do default. They stop paying their debts for one reason or another and most often, the stated reason is, simply, that they have an inability to pay them. As such, sovereigns are also understood to become insolvent. The questions, considering the inherent powers and assets of a state, are how and why. 3.1.1 Liquidity insolvency
Liquidity insolvency, often termed equitable insolvency or cash-flow insolvency, is the failure or inability to pay debts as they fall due. This is the most widely-used definition of insolvency. Liquidity is at the heart of the matter here. As learned in the previous Module, liquidity is the ability of an asset to be converted into money relatively easily. With liquidity insolvency, a debtor will have enough assets to pay all of its outstanding debts, but they are not assets that can be easily converted to cash in order to make the necessary debt payments when needed. Thus, the debtor’s obligations will come due and it will be unable to make good on its commitments. In the sovereign debt context, the bulk of the sovereign’s ‘assets’, as seen below, will not only often be illiquid, but they will be outside the scope of what is considered politically acceptable for a government to transfer away.
3.1.2 Balance sheet insolvency
Balance sheet insolvency is when the debtor’s liabilities exceed its assets. Thus, the concept of liquidity does not come into play, because even if the debtor managed to turn all of its assets into cash in order to repay its debts, it would still fall short of meeting all of its obligations. In practice, the test for balance sheet insolvency is more sophisticated than simply comparing assets against liabilities: it usually requires a court to be satisfied that, on the facts, the present assets of the debtor will, taking into account the nature of the
27 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE debtor’s business (which may be cyclical) and any contingent and future liabilities it may have, not be sufficient to meet the debtor’s present and future liabilities. Thus, the debtor will never be able to make its creditors whole.
Balance sheet insolvency is not a useful standard for the insolvency of a sovereign state because the very concept of a balance sheet is problematic for sovereigns. Yes, governments may have assets on a balance sheet such as bank accounts, investments, state-owned enterprises, public buildings, and the like, but these do not comprise the principal means of repayment for sovereign debt. Instead, credit rating agencies and potential investors will be looking at a government’s economic base for its capacity to repay. Governments do not operate in a vacuum; they exert a monopoly of political authority over their territorial domain to extract and redistribute wealth from its human and natural resources. As such, it is these non-traditional assets that are relevant for sovereign finance, and they are not on a balance sheet. 3.2 The sovereign’s assets
As mentioned, a sovereign has traditional balance sheet items, but it does not draw its ability to repay its sovereign debt from those assets. It does not even draw its annual budget from them. Rather, a country will depend on its tax base and natural resources to raise most of the funds that it must in order to finance its operations, social services and investments. 3.2.1 Taxing base
The tax base of a country is, of course, the entirety of the country’s economically productive sector, whether it be individuals or corporations. With its taxing power, the government’s ‘assets’ rise to potentially encompass the underlying national economic base, because the government could, theoretically, tax its citizens 100% of their wealth (which would be a use of its power to expropriate wealth from its citizens). Of course, if the state decided to take the entire wealth of its citizens for itself, and to repay its own debt, there would be massive social upheaval, and the state would be deemed to have failed its citizens. Thus, while it is important to consider the tax base of a country when analysing the sustainability of its debt and its ability to repay, it is inappropriate to consider this a traditional balance sheet item, because it cannot be disposed of at whim. Aside from the socio-political implications, any reform to raise taxes forms part of the law-making process, which is uncertain and left to the discretion of not just the ruling government that sets public policy, but legislators who may have their own agenda. 3.2.2 Territory, natural resources, etc.
Aside from the citizens of the state, governments have another large, potentially invaluable resource: their real estate. Some sovereign debtors have plentiful reserves of minerals and precious metals, others of petroleum, and others yet will have beautiful islands full of sandy beaches and paradise-like landscapes. A country in financial trouble
1 A debt trap is a situation in which a debt is difficult or impossible to repay because high interest payments prevent repayment of the principal. This situation is typically the result of successive cumulative lending arrangements incurred to repay previous obligations where principal tends not to be reduced.
28 29 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE could easily sell off some of its rights to its precious natural resources or to some of its land in exchange for debt relief. It has happened in the past, for example, in 1803 the French authorities decided to sell Louisiana (which included land of 15 present day states within the United States, including, of course, the state of Louisiana) to the United States to finance the Napoleonic war. So, why not? A country’s sovereignty is predicated upon its control over a particular territory and people. If that is given away at a moment’s whim to satisfy some temporary financial need, the entire legitimacy of the state may be called into question. However, it is not entirely impossible to be coerced into giving up such rights, even temporarily, for debt relief, and when governments contract sovereign debt they must be aware of potential debt traps that saddle them with unsustainable debt from the beginning and, due to the contractual terms of the debt or the bargaining power of the counterparty, later require them to take decisions to the detriment of their sovereignty.
Did you know? In 2016, Sri Lanka restructured some of its outstanding debt to China by swapping its debt obligations for a 99-year leasehold in one of its ports and appurtenant areas.
3.3 Reasons for default
The balance sheet of countries is not a proper way to evaluate whether they are insolvent or not. It is also not a useful measure for whether they are close to a default or not. Countries default for many reasons, and not all of them are strictly economic or financial in nature. A country may repudiate a debt as an illegal undertaking of a previous government administration, or it may refuse to pay a debt on the grounds that it is odious, which implies that it was issued by a government that, by its very nature (through being an oppressive colonial administration or a dictatorship, for example), was not working to the benefit of the people who now have the debt burden. The result of a default, if economic and financial, could range from years of mismanagement of the public purse, to a natural disaster that wipes out the nation’s erstwhile optimistic economic outlook.
What causes a default, in terms of what economic factors make one inevitable, is an active debate between economists even today. Since the late 1990s, economists have published a number of articles attempting to propose early warning systems that, through a study of countries’ economic metrics, would be able to predict when a sovereign debtor is in financial distress, and when it is likely that a sovereign debt crisis is at hand.
The key to these early warning systems is to identify the relevant economic variables that robustly predict debt crises. A common variable throughout the literature that is almost universally considered a good predictor of financial distress is a country’s debt-to-GDP ratio. This is no surprise, given that the bigger the debt burden for a country vis-à-vis its economic production, the bigger the debt burden will be in relation to government revenues, and in relation to government expenditures. This is precisely a good measure because of its relative nature; a country’s debt burden can be high as long as its GDP is high as well, because it will have the capacity to repay. Thus, policymakers should closely
29 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE watch their countries’ debt-to-GDP ratio to assess the sustainability of taking on more debt and of managing their present burden.
A meta-analysis by two economists, Chakrabarti and Zeaiter (2014), established a robust statistical relationship between a debt crisis and: (1) external debt as a percentage of GNP; (2) reserves in months of imports; (3) total debt service as a percentage of the export of goods; (4) annual GDP growth; (5) external debt as a percentage of the export of goods; (6) real effective exchange rate; (7) inflation; and, (8) current account balance as a percentage of GDP. They also studied whether political factors also contribute to a higher probability of default, and found that countries with high corruption, low democratic accountability, government instability, military involvement in government, and ethnic tensions are likelier to fall into arrears with their debt.
Carmen Reinhart, Kenneth Rogoff, and Miguel Savastano (2003) have also argued for the existence of an intolerance to debt, the idea that a sovereign debtor’s past payment history matters when considering the probability of a future default on its debt. For some countries, “[d]efault can become a way of life.” Based on the research of these scholars, countries with a poor payment history are more likely to default on future debt, they are more likely to have levels of indebtedness and higher overall economic volatility. As such, for countries that are ‘intolerant,’ debt becomes unsustainable much faster and at a much lower level than other sovereigns; they may have a lower debt to GDP ratio than another sovereign debtor, but due to their ‘intolerance’, their risk of default may be greater.
4. THE BANK-SOVEREIGN NEXUS
Another body of academic literature focuses on the relationship between sovereign debt crises and banking crises, known as the “bank-sovereign nexus”, variably described as a ‘doomed loop’ or ‘deadly embrace’. A country’s banks will often hold a significant amount of sovereign debt, there are links between the credit ratings of a sovereign and those of its banks, and the public sector—whether the central government or the central bank—often stands ready to step in and prevent the banking sector from collapsing, lest one risk a collapse of the entire national economy. These conditions make for a dangerous position for the sovereign, where the concentration of risk in the banking sector may lead to it imploding in the sovereign’s face sooner or later.
One seminal study by Carmen Reinhart and Kenneth Rogoff (2011) found, through an analysis of two centuries worth of data, that distress in the financial sector historically increases the possibility of a sovereign debt default. This happens either directly, because the government “bails out” the financial sector by infusing it with money, incurring unsustainable debt itself in the process, or indirectly, when the government does not act to save the banking sector, but it is affected nonetheless negatively by the private sector’s crisis because government revenues collapse due to a weak economy and the value of the domestic currency plunges, which makes it harder to repay debt denominated in foreign currency.
30 31 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
The global financial crisis of 2007-2008, and more specifically, the eurozone crisis, was a prime example of the bank-sovereign nexus. The crisis, with some exceptions like Greece and Portugal which had long-standing high debt burdens, began in the private sector. Most European countries were able to inject funds into their financial sectors in order to prevent a collapse of the same and retained a healthy fiscal outlook themselves, but others were not so lucky, and their attempts to save their financial sector drove them to near-ruin. This was certainly the case in Ireland, where, similar to the United States, the financial sector was too exposed to a weak housing sector. Unlike the United States, however, Ireland’s banking sector was heavily concentrated in three banks, and Ireland did not have the financial wherewithal to save these banks and the economy from collapse and keep government finances safe at the same time. The government opted for the former, and having effectively assumed previously private debt as public debt, faced down a sovereign debt crisis.
However, the most acute manifestation of the bank-sovereign nexus was in Iceland. There, a small country of just 300,000 inhabitants had a banking sector dominated by three banks with huge international operations. These banks held a significant number of their liabilities in foreign denominated currency and not in the Icelandic domestic currency. Thus, when it started to face constraints at the beginning of the financial crisis, Iceland wanted to save the banks to prevent a total collapse of its economy, but the banks’ foreign-denominated liabilities were too large for the government’s capacity to assume them. It was a situation where the banks “were too big to fail and at the same too big to be saved.” Such an episode should remind policymakers of the importance of keeping the financial sector in check, with sufficient controls to rein in negative spill over from the banking sector into a country’s debt management. 5. DIFFERENT DEFINITIONS OF DEFAULT
Because there is no statutory definition of insolvency for sovereign states, the condition of sovereign insolvency is typically satisfied by events of default being triggered in bond issues or under loan agreements (hinging on a failure to pay or cross-default clauses) and downgrades of the sovereign’s credit rating by rating agencies. In practice, a default is not as simple as the moment when a sovereign debtor does not make a scheduled payment on its interest or its principal. A particular sovereign debtor’s action or inaction may be seen by different market stakeholders at any point in time as a default or not, depending both on how they define and interpret a “default” and what their intention was in defining it in that way. 5.1 The contractual definition
The contractual definition is that which is set forth in the debt instrument as detailing the ‘events of default’.
These are broader than non-payment to the creditors of that particular debt. They also often include a cross-default clause. This allows the creditor to declare a default on the
31 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE debtor’s obligations to itself if the debtor defaults on another creditor or on another debt instrument. The purpose of this is simple: when a debtor defaults, there is going to be a race to the courthouse (in the case of a sovereign, it may be many courthouses all around the world) to seize upon the debtor’s assets. A cross-default across the debtor’s total indebtedness will usually trigger it entering into a bankruptcy process, which then works to the protection of all creditors because no particular creditor will receive preferential treatment. But in a sovereign default with no bankruptcy process, a creditor does not want to be left behind and be the last to be formally defaulted upon, with the dubious honour of arriving last to the courthouse to find that the sovereign debtor’s available assets, if any are available, have already been plundered.
Other events of default may include a moratorium, which is a decision by the sovereign debtor to postpone payment of its outstanding principal and/or interest payments, a contestation, in which the debtor disputes the validity and legality of the debt it has itself incurred, and the breach of other material obligations in the agreement, such as any representations and warranties and protective covenants. 5.2 Credit events under a credit default swap
A credit event is a definition for default used by the International Swaps and Derivatives Association (ISDA) to trigger the activation of a payment under a credit default swap. If a bondholder holds bonds of a sovereign debtor, the bondholder can arrange for a third party to pay the bondholder on the occurrence of certain events (“credit events”) that imply financial problems in the relevant sovereign state, such as non-payment of the debt, a moratorium in respect of or repudiation of the debt, or a restructuring of the debt (basically, it depends on what has been contractually agreed as the “protection” coverage). On the occurrence of a credit event, the third party makes a payment to the bondholder to reflect the drop in value of the bond caused by the circumstances surrounding the event compared to the bond’s par value. In return for this protection, the bondholder (called the buyer) pays the third party (called the seller) a fee. 5.3 The Credit Rating Agency definition
Credit rating agencies can determine a sovereign debtor to be in default even if there has been no default under the terms of the debt instrument (e.g. the Eurobond). If the debtor has defaulted on one class of debt and not another, they may hold it to be in a “selective default.” Since the credit ratings agencies may be harsher in their assessment of what constitutes a default for sovereigns, it is worth keeping an eye on their analyses. While not necessarily a formal default, a determination that a sovereign is in default by the credit ratings agencies will be disastrous for the country’s debt on the secondary markets, because central banks around the world have prudential requirements for financial institutions that limit them from holding such risky debt, and institutional investors with a long-term investment strategy will have no interest in keeping it either, leading to a change in investor base that might affect the dynamics of any restructuring process. 6. AN ONGOING DEBATE: THE COSTS OF DEFAULT
Why, despite the lack of a clear regime where creditors can pursue their monetary claims against a state, do sovereigns often go above and beyond to pay their debts? They do so
32 33 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE not to be good global citizens and out of a moral imperative, but because of the fear that the costs of defaulting on their debt will be massive. Countries are often suffering from economic malaise when they commit a default, but default itself can entail deleterious effects upon a country’s economy. However, there is ample academic debate about what these costs actually are and their scale. The orthodox economic literature on the subject has focused on what are termed reputational costs and trade costs. Reputational costs are associated with a ‘punishment’ by the market for the default, that leads to higher borrowing costs for the sovereign when it attempts to access the credit markets in the future. Trade costs refer to a reduction in trade either from trade sanctions or a reduction in trade credit.
Reputational costs have, for quite some time, been considered a red herring. Empirical research has shown that, a short while after completing a successful restructuring, sovereigns can again access the credit markets at normal market rates. Thus, the effects, if any, are very short. However, this is not necessarily the case. While most of the empirical research on post-default borrowing costs shows that reputational effects are limited and short-lived, more recent research shows that not all sovereign debtors are treated equally, and their reputational costs are different depending on the magnitude of the haircut, or reduction in principal amount outstanding, that creditors suffer during the restructuring process. That is, the harsher the restructuring, the harsher the markets will be with the sovereign when it again attempts to secure financing.
Trade costs are also a point of debate. While a sovereign default does bring with it a reduction in foreign direct investment inflows from creditor countries, scholars have found that there may even be an increase in foreign direct investment inflows from non- creditor countries. As such, while the evidence would seem to point to a punishment of sorts by creditor countries, that does not necessarily mean that the sovereign debtor will suffer for it.
Scholars have also conducted studies on the effect of a default on economic performance. The results are linked to the above discussion on the causes of a default. While scholars have found that the quarter following a default is usually characterised by an economic uptick, it is likely that this is because there was a very large GDP decline that preceded the decision to finally default. Since policymakers decide to wait until the last possible moment to default, in order to signal to the market that they are financially responsible, they often incur all the costs that a default would anyway entail (such as debt overhang, austerity measures, liquidity issues) before the default actually occurs.
However, some scholarship suggests that in the short to medium term after a default, economic output may contract for defaulting countries. To avoid conflating the effects of a bad economy with the effects of default, the authors of a study analysed the impact of defaults on the growth of sovereign debtors that boasted a healthy economy at the time of a default and where the default was not preceded by a banking or currency crisis. The authors found that the negative effect on output growth was significant for these countries.
Nevertheless, it may be the case that the effect of a default on a country’s economy, much like the aforementioned reputational costs, may depend on the severity of the restructuring pursued. Evidence suggests that there is a distinction in post-default
33 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE economic performance between ‘hard’ defaults and ‘soft’ defaults, where the difference between the two is determined by the size of reduction on outstanding principal (the haircut) and the aggressiveness of the debtor’s legal strategies in negotiating with its creditors. The evidence shows that countries that effect hard defaults are much likelier to suffer from negative economic output in the aftermath of the default.
From both the reputational costs perspective and the economic costs perspective, then, it may be best to consider default costs from a differentiated approach that establishes that the severity of any costs will depend on the magnitude of the debt relief pursued and the aggressiveness with which the restructuring is conducted. 7. THE ROLE OF SOVEREIGNTY IN CONTRACTING AND STRUCTURING DEBT
The fact that national governments are sovereigns is of course central to the principles that underlie the dynamics of sovereign debt. When contracting and structuring sovereign debt, this takes on additional importance in the negotiations, and as will be seen in the next Module, certain concessions will always have to be made by governments in order to receive financing. The main one, which will be discussed in detail in the next Module, is to waive its sovereign immunity, because a traditional privilege afforded sovereigns, as a matter of comity, is immunity from suits in national courts. Once a sovereign debtor relinquishes its sovereign immunity, it still has other defences, but at least creditors will not see the courthouse doors shut in their faces. 7.1 The law-making power of governments
Another crucial aspect of sovereignty is the ability of governments to make their own laws. As seen in the last Module, in the distinction between domestic and external debt, this is more of a concrete worry for creditors that have debt instruments whose governing law is domestic. But the law-making power of governments is a fluid power, which can be both a benefit and detriment to creditors. It does not have to be a stick to beat creditors with, but a channel for cooperation and consensus. The power to make laws means the power to procure additional revenue streams for repayment if need be, and it means the power to effect structural reforms to address growth prospects and financial accountability and transparency in government. The law-making power of the ruling government that represents the country at any given time, of course, is limited by the political constraints enshrined in both legislative practice and constitutional limitations. Thus, it is important to keep in mind that, although the sovereign’s power to make laws is in theory absolute, governments may not be so unrestrained in their policy options. 7.2 The dynamics of sovereign debt restructuring and the lack of a legal regime
Finally, sovereignty means that a national government is the ultimate political authority within its territory. An inherent feature of sovereignty is that a nation cannot be subjected to any process to which it has not consented, and countries in general are wary of supranational structures that have the power to make binding decisions upon the sovereign, without it having the opportunity to back out of a decision that may run
34 35 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE counter to its interests. As such, up until now, there has not emerged an internationally agreed legal regime for restructuring the debts of sovereign debtors. This is in part because of concerns about how the process would be structured, and in part because the market has formulated some informal rules on how to conduct sovereign restructurings. This will be discussed in more detail in Module 3. 8. CONCLUSION
In this Module, a brief overview of the principles that shape the dynamics of sovereign finance has been provided. These principles are all shaped, in one way or another, by the uniqueness of a national government serving as a commercial actor in an international system where sovereigns hold absolute political power. The Module has discussed how traditional concepts like insolvency and default, which have established definitions across financial markets, suddenly must be reinterpreted to fit the idiosyncrasies of sovereign debt. The way in which a sovereign may end up in a position where it does not pay on its debt has been discussed, even considering the seemingly ample resources at its disposal. At the same time, this Module has surveyed the academic literature on the costs of a default, which unlike bankruptcy costs for corporations, are indirect, diffuse, and oftentimes debatable. Finally, the particular aspects of sovereignty that make all of these principles operate in the way they do have been detailed. In the next Module (3), the applicable legal framework for sovereign debt that has arisen through market practice due to the lack of an established process for debt restructuring will be discussed.
References
Paolo Angelini & Giuseppe Grande, How to loosen the banks-sovereign nexus, Vox, 08 April 2014, available at https://voxeu.org/article/how-loosen-banks-sovereign-nexus
Christopher Balding, Venezuela’s Road to Disaster is Littered with Chinese Cash, Foreign Policy, 6 June 2017, available at https://foreignpolicy.com/2017/06/06/venezuelas-road-to- disaster-is-littered-with-chinese-cash/.
Eduardo Borensztein & Ugo Panizza, The Costs of Sovereign Default (Int’l Monetary Fund, Working Paper No. WP/08/238, 2008), at 3.
Avik Chakrabarti, Hussein Zeaiter, The determinants of sovereign default: A sensitivity analysis International Review of Economics and Finance 33 (2014) 300–318.
35 KEY CONCEPTS AND PLAYERS IN SOVEREIGN FINANCE
Juan Cruces & Christoph Trebesch, Sovereign Defaults: The Price of Haircuts, American Economic Journal: Macroeconomics 5(3) (2013) 85-117.
Mary Dawood, Nicholas Horsewood, Frank Strobel, Predicting sovereign debt crises: An Early Warning System approach, Journal of Financial Stability 28 (2017) 16–28.
Miguel Fuentes & Diego Saravia, Sovereign Defaulters: Do international capital markets punish them?, Journal of Development Economics 91 (2010) 336-347.
Davide Furceri & Aleksandra Zdzienicka, How costly are debt crises?, Journal of International Money and Finance 31 (2012) 726-742
Rosa M. Lastra, International Financial and Monetary Law (OUP, 2015).
Eduardo Levy Yeyati & Ugo Panizza, The elusive costs of sovereign defaults, Journal of Development Economics 94 (2011) 95-105
Paolo Manasse, Nouriel Roubini, “Rules of thumb” for sovereign debt crises, Journal of International Economics 78 (2009) 192–205.
Carmen Reinhart, Kenneth Rogoff & Miguel Savastano, Debt Intolerance, Brookings Papers on Economic Activity 1 (2003) 1-74.
Carmen M. Reinhart and Kenneth S. Rogoff, From Financial Crash to Debt Crisis, American Economic Review 101 (August 2011): 1676–1706.
Rok Spruk (2010), ‘Iceland’s Economic and Financial Crisis: Causes, Consequences and Implications’. EEI Policy Paper Vol. 1 (23 February 2010).
Arabella Thorp, Ian Townsend and Tim Edmonds (2009), ‘Iceland’s Financial Crisis’. House of Commons Library Briefing Paper.
Christoph Trebesch & Michael Zabel, The output costs of hard and soft sovereign default, European Economic Review 92 (2017) 416-432
Brian Wynter, Keynote Address, First Annual Interdisciplinary Sovereign Debt Research and Management Conference, available at http://boj.org.jm/uploads/news/keynote_-_debtcon1,_ georgetown_law_-_brian_wynter_-_2016-1-21.pdf
36 CHAPTER 3
THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
1. Introduction and their treatment in national laws and jurisprudence 2. Multilateral debt 2.1. The IMF 5. Proposals for reform 2.2. Regional Development Banks 5.1.The Sovereign Debt Restructuring 2.3. The European Stability Mechanism Mechanism (SDRM) 5.2. The United Nations Conference on Trade 3. Sovereign debt and restructuring in and Development (UNCTAD) Principles bilateral loans 5.3. The United Nations (UN) Draft Principles 3.1. The Paris Club 5.4. Principles for Stable Capital Flows and Fair 3.2. China Debt Restructuring 3.3. Russia v. Ukraine: An anomaly in official 5.5. The contractual approach to reform: sector lending Collective Action Clauses (CACs)
4. Private sector lending: a process shaped by 6. Conclusion national law 4.1. The London Club References 4.2. Sovereign immunity: the initial hurdle 4.3. Examples of restructuring techniques THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
1. INTRODUCTION
The modern concept of sovereignty is relatively young. Almost four hundred years ago, in the wake of the Protestant Reformation, war raged in Europe over religious divisions. The Thirty Years’ War, born out of the desire of the Holy Roman Emperor to impose Catholicism over his principalities, claimed millions of lives, and is generally regarded as one of the bloodiest conflicts in history. The resulting peace agreement, called the “Peace of Westphalia”, laid out the modern concept of sovereignty as a country’s exclusive jurisdiction over its own borders, with no country superior in sovereignty to another. As the legal scholar Gross (1948) eloquently remarked:
“The Peace of Westphalia, for better or worse, marks the end of an epoch and the opening of another. It represents the majestic portal which leads from the old into the new world... In the political field it marked man’s abandonment of the idea of a hierarchical structure of society and his option for a new system characterized by a multitude of states, each sovereign within its territory, equal to one another, and free from any external sovereignty.” Thus, international law, unlike national law, faces a quandary: there is no higher authority over sovereigns that can formulate and enforce binding rules of conduct. What international law has developed and been determined as binding by international courts and arbitral tribunals has been considered as such principally because states themselves have consented to them, either through custom (customary principles of law) or formal agreement (treaties). Although sovereigns may not be coerced into accepting a norm they did not agree to, they can freely enter into binding obligations that they cannot later evade, under the general contractual principle of pacta sunt servanda, that parties must honour their agreements.
The lack of any higher power over states has generally precluded the application of any universally applicable, binding norms in the field of sovereign debt. However, the one historical exception to this illustrates how international consensus can emerge when conflicts over sovereign debt endanger the stability of the international system itself. In the 19th and early 20th century, countries employed gunboat diplomacy to force other countries to acquiesce to their foreign policy objectives. Most notably, in 1902, Italy, Germany, and the United Kingdom conducted a naval blockade of Venezuela to force it to repay its public debt, on which it had defaulted, to private creditors within their countries. Their efforts were hugely problematic for two reasons: first, neutral, non-intervening countries were incensed that the creditors of the intervening countries would receive preferential treatment in payment simply because their country threatened to invade and not because of any superior legal rights, and secondly, and most importantly, the use of force to recover on a sovereign debt affected the stability of the international system.
This opposition was best articulated by Luis Drago, an Argentine jurist and foreign minister, who argued that using military force to coerce a country into paying its sovereign debt was an illegitimate exercise of sovereignty itself, and a violation of international law. This became known as the “Drago Doctrine”, and despite initial reservations by European powers, a modified version of it was adopted as one of the Hague Conventions at the Second Hague Peace Conference in 1907. The Porter Convention precludes the use of force by one state against another to enforce contractual debt. However, the prohibition is not absolute; it is dependent on the debtor country agreeing to arbitration and to
38 39 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT respecting the arbitral award. Furthermore, the prohibition against the use of force for recovery of debts only applies to debts owed to private creditors, not to other countries; as such, the question of whether a state had discretion to invade another to recover on payments due to it was left open.
Such as it is, the Porter Convention is the only binding obligation upon states in the area of sovereign debt. The need for it in the era of imperialism was paramount, as debt enforcement could have become a dangerous new casus belli that divided sovereign states into two, creditor states and debtor states, and created differentiated rights for both groups.
The absolute sovereign immunity was sustained in the U.S.—in one way or another—until 1952, when the U.S. State Department announced a change of policy by means of the so- called ‘Tate’ letter. A key paragraph of the Tate letter reads as follows ‘… the widespread and increasing practice on the part of governments of engaging in commercial activities makes necessary a practice which will enable persons doing business with them to have their rights determined in the courts. For these reasons it will hereafter be the Department’s policy to follow the restrictive theory of sovereign immunity in the consideration of requests of foreign governments for a grant of sovereign immunity’. It is worth noting that, prior to 1952, Austria, Belgium, Egypt, France, Greece, Italy, Switzerland and, to a certain extent Argentina, Denmark, Netherlands, Peru, Romania and Sweden were supporting a restrictive theory. This restrictive position was sometimes influenced by diplomatic pressures, until it was decided that a legislative solution was necessary. The United States restricted sovereign immunity through its Foreign Sovereign Immunities Act (FSIA) and the U.K. through its State Immunity Act 1978 (SIA). In Africa, for example, South Africa did it through Foreign States Immunities Act 87 of 1981 and Malawi did it through the Immunities and Privileges Act 1984.
Private creditors, countries, and multilateral institutions have nonetheless needed to develop an informal, hodgepodge framework to deal with conflicts in this area, mostly deriving from international practice and national laws.
In this Module, the applicable legal framework to sovereign debt that has emerged in the absence of a formal process to entertain disputes is discussed, as well as proposals in the international arena to formalise a restructuring regime to which creditors and sovereign debtors would both be subject. First, the Module will discuss the role of the multilateral institutions in issuing debt and helping restructure it, which currently is the closest to an agreed international system for debt restructuring. Secondly, the role of official creditors is discussed, and how they engage in negotiations with debtor countries. Thereafter, the Module will examine the current regime for private creditors, which is developed mainly from national laws and jurisprudence that have informed market stakeholders on a number of dos and don’ts in the sovereign debt restructuring arena. Finally, the Module will look at a number of proposals developed over the past two decades to introduce either formal processes for debt restructuring that would be binding over countries, or introduce, in their stead, guiding principles for debt restructuring.
39 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
2. MULTILATERAL DEBT
Multilateral lending institutions, or international financial institutions (IFIs), hold a preferred place in the international financial system as regards sovereign lending because of the composition of their membership and the source of their funding. IFIs are composed of states, and their funding is provided by these very same states. Given that a default on an IFI is essentially a default on the international community as a whole, a country defaulting on one would risk becoming a pariah (as of 31 August 2017, only Somalia and Sudan are in protracted arrears with the IMF). As such, considering both that their creation has been the result of international agreement and that their mandates are widely respected by sovereigns, IFIs are the closest thing to a formal regime for issuing and restructuring debt in the world today. 2.1 The IMF
In the wake of the Second World War, world leaders from the Allied nations convened to delineate the structure of the post-war international financial architecture. Both the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, now an arm of the World Bank Group, emerged from what is now known as the “Bretton Woods Conference” in July 1944.
At present, 189 countries form part of the IMF. The purpose of the IMF, at its inception, was to ensure the smooth functioning of the international balance of payments system. That is, if a member state of the IMF faced an event that caused it to have a balance of payments deficit, the IMF would be able to provide monetary assistance. Balance of payments, as defined by the IMF, does not simply pertain to public finance, but also to trade imbalances that occur when a country as a whole cannot pay for the imports it needs to sustain its economy.
More recently, the IMF became a significant stakeholder in protracted sovereign debt crises, and it has assumed the role of an international lender of last resort, providing monetary assistance to countries where no other creditor will. 2.1.1 How does IMF funding work?
The IMF almost never provides funds of its own (except, if it were necessary, to the most creditworthy of its members), but instead extracts commitments from its members to conduct a currency repurchase agreement with the IMF member in trouble. The troubled sovereign will be able to conduct a swap of its own (often lowly valued) currency for an equivalent amount of a more stable, more widely accepted currency. Although this is not a loan, it provides financing in the same way, and is described by the IMF as “similar to conditional lines of credit.” The IMF will impose an interest rate and disburse the assistance in stages, depending on the needs of the member and their compliance with the programme of economic and financial policy conditions imposed by the IMF as conditionality for the financing. 2.1.2 Conditionalities
The Articles of Agreement, which govern the operations of the IMF, currently require
40 41 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT members who seek financing from the IMF to follow the stipulations of the Stand- By Arrangements (SBAs) in order to enter into the repurchase agreements. SBAs are the standard form of IMF funding. However, SBAs do not just establish the terms for the funding itself; rather, they embody the IMF’s policy of conditionality, and as such encompass a whole set of economic and financial policy prescriptions that seek both to ensure that the countries can cope with their balance of payments in the future and that they can repay the sums drawn from the IMF through the SBA.
Conditionality became a widely criticised policy because of its focus on economic austerity measures and because its structural reform prescriptions were seen as too intrusive on the sovereignty of member states. The former was seen as an ineffectual, sometimes disastrous, economic strategy, and the latter was seen as overreaching; where the Articles of Agreement of the International Bank for Reconstruction and Development specifically prohibited such interference in the domestic affairs of states, the IMF had no such clear prohibition. With this in consideration, the IMF published new Guidelines on Conditionality in 2002 (as revised in 2009 and reviewed in 2012) that take a country’s specific macroeconomic objectives into account and attempt to balance the organisation’s strict structural reform requirements with the need for social stability and economic growth. 2.1.3 Lending into arrears
The IMF enjoys an informal ‘preferred creditor’ status in the sovereign debt markets because it, as an international ‘lender of last resort’, stands ready to provide fresh funds into distressed sovereign debt scenarios. This is termed “lending into arrears.” In its current form, for the IMF to provide financing to a sovereign that is in default with its private creditors (there is a policy of not lending when the country is in arrears with official creditors), three elements must be present:
• Support by the IMF must be essential to implement the member’s adjustment programme (the set of economic and financial policy recommendations to get the country back on track);
• Negotiations between the country and its private creditors must have already begun, and;
• The country is making a good faith effort to reach an agreement with its creditors. This third and last point has been the most problematic, historically, with sovereign debtors and private creditors debating back and forth whether negotiations have been conducted in good faith.
2.2 Regional Development Banks
The regional development banks, as their name suggests, limit their services to a defined geographical area. Their mandates vary and they may offer direct loans to member countries or to private sector entities and state-owned enterprises to fund investments that have a public benefit. Most of these banks, aside from having a development goal, also have an interest in regional integration, and will provide capital to projects that work towards that goal. Some examples are considered below.
41 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
2.2.1 The Inter-American Development Bank
The Inter-American Development Bank, or IADB, provides both loans and loan guarantees (discussed in Module 1) to its member states and to political subdivisions of its member states, such as provinces, municipalities, agencies, and state-owned enterprises. Its member states comprise most of the states in the American hemisphere; after initially limiting membership only to countries belonging to the Organisation of American States, now there are a number of European countries that act as non-borrowing members of the IADB.
In evaluating whether to grant financing to a member state or political subdivision of the same, the IADB will first analyse whether the entity can acquire the funds from other sources at a reasonable rate of financing. This is because the purpose is not to compete with the sovereign debt market, but to supplement it. In terms of funding, aside from its own funds, the IADB engages with commercial banks to arrange the loan agreement between itself and the debtor, and then allows commercial banks to take an interest in the loan through a sub-participation agreement. This allows it to mobilise funds from the private sector to increase its lending capacity substantially. 2.2.2 The European Bank for Reconstruction and Development
The European Bank for Reconstruction and Development (EBRD) was created in the aftermath of the Cold War, to allow former Soviet economies to transition smoothly into market economies. While its principal mandate is not to provide financing to states, it does provide loans to state-owned enterprises, and its main goal is to allow transition economies to fulfil their own reform policy objectives such as developing the necessary infrastructure for the private sector to thrive, and enabling a market economy through policies like decentralisation and demonopolisation. In this way, while not an avenue for direct funding, it fulfils many of the same goals for which countries seek to issue sovereign debt.
The EBRD is unusual in that it is an openly ideological initiative; it includes explicit political values as part of its mandate, such as respect for human rights and the rule of law, and favours market economies and multiparty democracies. This is consistent with the historical moment in which it was founded, where the interest was that previously socialist, one-party states would join the liberal democratic Western European community of nations. 2.2.3 The African Development Bank
The AfDB, created in 1963, was modelled on the IADB, and seeks to tackle poverty and improve economic conditions in the African continent by providing financing to member states that focus on investment projects related to economic and social development. While the AfDB includes regional member countries (RMCs) and member states that are not African countries, it caps the voting power of non-regional member countries regardless of the funds contributed, in order to prevent the regional bank from losing its African character.
42 43 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
Like the IADB, the AfDB will first assess whether the entity seeking financing can find financing elsewhere at reasonable rates. It can similarly provide loans not just to sovereigns, but to political sub-divisions, state-owned companies and agencies; however, if the debtor is not a sovereign, the AfDB may require that the relevant country provide a loan guarantee for the political sub-division taking out a loan from the AfDB within its territory. Throughout the development of any project to which it is a party, the AfDB will provide technical assistance to the debtor country in order to ensure the success of the initiative. 2.3 The European Stability Mechanism
The Great Financial Crisis exposed the tremendous risk to sovereign credit from the doomed loop between the banking sector and the sovereign debtor that was discussed in the previous Module. With a banking crisis, the outlook for a country’s sovereign debt may turn sour from one day to another, if the country is forced to come to the rescue of its banking sector, and thus assume private debts as public, in order to stave off an economic debacle.
In the midst of a crisis that brought down the economies of Greece and Portugal due to long-standing debt problems and the economies of Cyprus, Ireland, and Spain due to the bank-sovereign nexus, policymakers in the European Union (EU) created, first the European Financial Stability Facility, and later the European Financial Stabilisation Mechanism, as emergency funding measures for Eurozone states in distress.
In the aftermath of the crisis, the EU established a permanent fund, the European Stability Mechanism (ESM), to prevent financial contagion from one member state to another. The ESM was created by the Treaty Establishing the European Stability Mechanism, meaning that its structure is binding upon the Eurozone states that agreed to it as a matter of international law. The treaty itself, in a departure from the IMF’s informal approach to asserting its ‘preferred creditor’ status, states explicitly that the debt owed to the ESM enjoys super-priority status, only subordinated to that of the IMF. States may request ESM funding both on a precautionary ex-ante basis and ex-post, after they have fallen into a crisis. Similarly, they may request it because they themselves are suffering from financial problems, or because their financial sector is in disarray and aid is necessary to prevent the crisis in the financial sector from spilling over into the public sector and the financial sectors of other Eurozone states. Finally, and similarly to the IMF, the ESM operates on a policy of conditionality both for the ex-ante and ex-post credit lines that it sponsors.
3. SOVEREIGN DEBT AND RESTRUCTURING IN BILATERAL LOANS 3.1 The Paris Club
The Paris Club is an informal yet permanent forum of officials from creditor governments that meet to discuss how to renegotiate public debts owed by debtors to government creditors. The French government provides facilities for Paris Club members to meet, and appoints a senior member of the French Treasury as its Chairman. While the Paris
43 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
Club is composed of 22 major international creditor governments, it has started to meet with emerging creditor nations such as Brazil, China, and India, in order to attempt to harmonise principles around lending and restructuring sovereign debt. Paris Club agreements, to date, have covered over USD583 billion in either restructuring (with principal or interest reduction) or rescheduling (a simple extension of payment dates) agreements.
The Paris Club rests on five fundamental principles that guide its negotiations:
1. Case-by-case basis - its decisions are made taking into consideration the particular sovereign debtor at issue and its economic context;
2. Consensus - its decisions are only arrived at with the consent of all the governments that are creditors to the sovereign debtor;
3. Conditionality - it only applies debt relief to countries that need it, and that need is evidenced by entering into an adjustment programme under the IMF’s policy of conditionality;
4. Solidarity - the restructuring agreement requires that all creditor nations and the sovereign debtor commit to abiding by its terms, and;
5. Comparability of treatment - after a Paris Club agreement is reached, a creditor country cannot then give a debtor country better terms than those that were agreed to through the consensus of the group.
The forum also has developed different renegotiating terms (Classic, Houston, Naples, and Cologne) that correspond to the level of concessions that the creditor nations are prepared to give to the sovereign debtor in relation to the precariousness of their economic condition.
The Paris Club has adapted to provide debt relief in exceptional cases. Specifically in the African continent, the Paris Club has provided debt relief to Liberia and Togo by granting a three-year deferral of all debt service payments due to long-standing internal political conflicts and to rocketing food and petroleum prices, respectively. 3.2 China
The rise of once-developing countries as economic powerhouses has seen them also transform from debtor countries to creditor countries in the official sector. No emerging market country has been more proactive in its role as an official creditor than China. Through its Belt and Road Initiative, the country has lent hundreds of billions of U.S. dollars to sovereign debtors to finance infrastructure projects all around the world. The country has declined to join the Paris Club until now, considering it best to manage its financing through purely bilateral relationships. The prevalence of China as an official creditor creates a challenge to the relevance of the Paris Club as the principal forum for renegotiating sovereign debt in the official sector. As some have estimated, while claims
44 45 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT outstanding to Paris Club members total just over USD300 billion, “China’s claims alone likely approach this figure, if not surpass it.” (Hurley et al. 2018).
The fact that China operates outside of the Paris Club framework may encourage it to take actions that would not be agreed to within the guiding consensus principle of the Paris Club, because they are simply to China’s benefit, and would not accrue to the benefit of all creditor countries. For example, in 2011, China agreed to write off some of Tajikistan’s debt in exchange for Tajik authorities acknowledging Chinese claims over disputed territory. Similarly, as observed in the previous Module, as part of the resolution to debt negotiations with Sri Lanka over a USD8 billion loan used to finance the construction of a Sri Lankan port, the government of Sri Lanka agreed to give China a 99-year lease for managing the port. Whether the added flexibility in finding solutions to debt issues is welcome is certainly a point of debate, because while the aforementioned cases may be creative solutions to sovereign debt problems, they also impinge on some of the most essential aspects of sovereignty (such as the exclusive authority over the sovereign’s own territory, discussed in the introduction). In the end, time will tell whether China joins other countries in seeking a consensus-based approach to sovereign debt restructuring, whether within the Paris Club, or within a new organisation created and shaped by China’s newly dominant role in official sector lending. 3.3 Russia v. Ukraine: An anomaly in official sector lending
A recent development in official sector lending has been the ongoing litigation between Russia and Ukraine out of a USD3 billion debt that Ukraine owed to Russia since 2013. Unusual for bilateral lending, the debt was issued as a bond, although it was solely held by Russia. The bond was issued during Ukraine’s previous pro-Russia administration led by Victor Yanukovych, and, since then, Russia and Ukraine have been in conflict due to the former’s interference and eventual annexation of the eastern Ukrainian region of Crimea. When Ukraine refused to pay on the bond, both due to financial constraints and because it considered that the debt was issued under economic and political pressure by Russia, the indenture trustee sued for repayment in English courts . The result is an ongoing litigation that bears little resemblance to the consensual negotiations in the official sector, and more in common with the litigation-based approach that has become more and more prevalent in private sector lending. 4. PRIVATE SECTOR LENDING: A PROCESS SHAPED BY NATIONAL LAW
In the private sector lending, there has been an absence of any international formal or informal restructuring processes or fora. Instead, national law, usually American or English (due to the prevalence of New York and London as financial centres), has shaped the limitations and possibilities of restructuring processes for sovereigns.
4.1 The London Club
An exception to this lack of any forum for restructuring private sector debt is the London
45 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
Club. The London Club is another informal forum, like the Paris Club, for renegotiating sovereign debt when the debt is held by the private sector, typically large commercial banks, in the form of loans. Unlike the Paris Club, it is not a permanent forum. Rather, it is convened on an ad hoc basis when a sovereign debtor desires to reunite its commercial bank creditors in order to reach an amicable solution. Thus, it follows the consensus- based approach of the Paris Club, but for private sector sovereign loans extended by commercial banks. The first meeting of the London Club took place in 1976 in response to Zaire’s debt payment problems and further negotiations between 1976 and 1981 with Peru, Turkey, Sudan and Poland were instrumental in coining what would be known as the “London Approach.” 4.2 Sovereign immunity: the initial hurdle
As a principle of comity in international relations, sovereign immunity states that sovereigns will not be subject to the jurisdiction of the courts of other nations without their consent. In the United States, sovereign immunity is written into the statute books as the Foreign Sovereign Immunities Act of 1976 (FSIA) and in the United Kingdom, it is regulated by the State Immunity Act of 1978 (SIA). Both laws include an exception from sovereign immunity first, when the state consents to a waiver, and secondly, when the state acts in a commercial capacity. The FSIA’s definition of commercial activity subject to this exception specifically concentrates on the nature of the conduct carried out by the state, and not on the nature of the purpose pursued by the activity. That is to say, even if the commercial activity has a public purpose, if it is of the sort that private market actors regularly engage in, then it will fall under the exception. 4.2.1 Issuing sovereign debt as commercial activity: Republic of Argentina v. Weltover
In a 1992 U.S. Supreme Court case concerning the Republic of Argentina, the Court confirmed that the commercial activity exemption applies when the state issues sovereign debt (a Eurobond), as this is a commercial activity. 4.2.2 Central bank assets and sovereign immunity: EM Ltd. v. Banco Central de la República Argentina [2015]
Certain creditors of Argentina sought a judicial determination that the Argentine Central Bank was an alter ego of the Republic of Argentina, in order to make its assets available for attachment to satisfy debts owed to them by the Republic. The Second Circuit Court of Appeals considered that central bank operations would be viewed as independent from the government absent evidence that the Republic exerted day to day control over the central bank’s operations. The fact that the government appointed the board of the central bank and coordinated with it to formulate monetary policy did not establish this level control. 4.2.3 Alter egos and sovereign immunity: Crystallex v. PDVSA [2018]
Most recently, a federal judge in the state of Delaware determined that an instrumentality of the Bolivarian Republic of Venezuela, the state-owned oil company PDVSA, was an alter ego of Venezuela, and as such, its assets in the United States were attachable as assets of Venezuela.
46 47 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
Zambia’s immunity under the lens of a foreign court A relative recent case where the issue of sovereign immunity was considered involved Zambia. In Donegal International Ltd v Zambia ([2007] EWHC 197 (Comm)), the latter applied for a determination that it was entitled to state immunity in respect of a claim for USD42.3 million (inc. penalty interests) under a settlement agreement signed by Donegal and the Ministry of Finance. The claim originated on a debt owed to Romania for the purchase of agricultural machinery. At a later stage Romania assigned the debt claim (already in default) to Donegal. After negotiations, Donegal and Zambia entered into the settlement agreement totalling USD14.78 million to be repaid in 36 monthly instalments. The settlement agreement included a clause that upon an event of default Donegal could terminate the agreement and be entitled to judgment in respect of the debt in full with interest at eight per cent compounding quarterly and Zambia would consent to the award of a judgment by the English High Court.
Zambia argued that the settlement agreement could not be enforced because, inter alia, it was (1) tainted with illegality and corruption due to the way in which certain information had been obtained from government officials; (2) that the finance minister did not have the authority to enter into the settlement agreement (which in addition was the result of misrepresentations or mistakes); and, (3) that the provisions of the agreement were penal. The court concluded that Zambia was not entitled to state immunity in respect of a claim to enforce a settlement agreement relating to sovereign debt but the state had a real prospect of defending the claim on the basis that certain provisions of the agreement were penal.
4.3 Examples of restructuring techniques and their treatment in national laws and jurisprudence
Some lessons on the defences that sovereign debtors can present when they seek to restructure debt are discussed below as well as whether they have worked in practice. Some of the cases below will be analysed again in Module 7 and 8 for their relevance in the interpretation of the pari passu clause, which has become central to sovereign debt litigation. 4.3.1 Trust indenture as adequate payment protection: Elliott Associates v. Republic of Perú [1996]
In defining the distinction between the trust indenture and the fiscal agency agreement in the first Module, it was discussed that the former offers more protection to bondholders because, aside from being set up to act in their interest, once the money is transferred to the trustee, it is no longer in the hands of the sovereign (because the trustee is acting as a representative of the creditors) and it is free from attachment by litigious creditors seeking to seize the assets of the sovereign debtor. However, the trustee figure may not be so useful if the creditor can find a way to block payments made to it. In the litigation saga between
47 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
Elliott Associates and the Republic of Perú, Elliott, after securing a money judgment in New York against Perú, went to Brussels with the court order seeking to enforce the judgment. The reason it went to Brussels is because it is the home of Euroclear, one of the two main European clearing houses through which payments on bond instruments are processed. Having secured a Belgian court order to block any payments to other bondholders until Elliott was also paid, Elliott put Perú in the uncomfortable position of having to decide whether to default with all of its bondholders or negotiate with Elliott. It chose the latter. In this case, whether Perú had a trust indenture or a fiscal agent was irrelevant, because in targeting the payments systems, Elliott could ensure that Perú could not disburse any funds to try to pay its other bondholders. It would have been different if the money was deposited with the trustee’s account in the local jurisdiction of the debtor because it would have been insulated from creditor claims. 4.3.2 Legal pronouncement that a bond will no longer be paid: NML Capital v. Republic of Argentina [2016]
In the Argentine litigation saga, which will be discussed extensively in Module 7, Argentina, in order to ensure holdout bondholders that it would never pay them, enacted a law, which legally prohibited the government from making any payments to holdout bondholders, or from ever negotiating with holdout bondholders in the future to reach a settlement, the so-called “Lock law.” This backfired spectacularly. While this was sought as legal authorisation for the government to avoid payment on defaulted and non-restructured bonds, the bonds held by holdouts were issued under New York law and not Argentine law. As such, when a New York federal court analysed the effect of the Lock Law, it considered that Argentina acted in a ‘uniquely recalcitrant’ manner, and considered that by doing so, it had legally subordinated those bonds, which it was under an obligation not to do. 4.3.3 Exit consents: Assenagon Asset Management S.A.v. Irish Bank Resolution Corporation Ltd [2012]
Although not a sovereign debt litigation case, Assenagon does have lessons for how the sovereign debt technique of exit consents would be treated under English law. Exit consent is the technique by which holders of bonds in default, who decide to accept an exchange offer, at the moment of accepting the said offer, grant their consent to amend certain terms of the bonds that are being exchanged. By using the exit consent technique, the exchange offer is conditioned to a minimum threshold of creditors’ acceptance and the amendments to the terms are performed once the required majority has been obtained. By means of these amendments, the defaulted bonds become less attractive (in legal and financial terms), forcing a greater number of bondholders to accept the exchange offer. Otherwise, if bondholders hold out and do not accept the exchange offer, they will be holding an impaired bond not featuring some of the original contractual terms.
This case related to the financial rescue of an Irish bank by the Irish government. As part of the rescue, the government wanted the bank’s creditors to acquiesce to exchanging their old debt for new, restructured debt. It warned that, for those that would not, the government intended to extract the consent of the outgoing bondholders to change the terms of the original bonds so as to substantially destroy their value. After conducting the exchange offer for the new bonds and extracting the consent from a supermajority of the creditors, the Irish government convened a bondholder meeting under the terms
48 49 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT of the original bond where it proposed, and approved (having a supermajority of the votes), to drastically reduce the principal and interest payable on the bonds. The English High Court, deciding on the legality of such an action, considered it to be an unfair use of voting rights by a majority to oppress the rights of a minority. U.S. courts are more permissive on the use of exit consents. 5. PROPOSALS FOR REFORM 5.1 The Sovereign Debt Restructuring Mechanism (SDRM)
The current system for restructuring sovereign debt with the private sector is done on an ad-hoc basis following a market-oriented contractual approach which is built on previous experience and few legal precedents (mainly from the State of New York), due to the lack of any formal or informal mechanism to conduct it. As a result, the IMF has proposed the idea of a Sovereign Debt Restructuring Mechanism (SDRM) to which everyone would be subject. The SDRM, in any of its iterations, functions much like a bankruptcy process for sovereigns. There is a stay on creditor recovery actions while the process is ongoing, which gives the sovereign debtor breathing space to organise its financial affairs in an orderly manner. There is a preferred creditor status for any new financing that is extended to the debtor during the process to facilitate the reorganisation, much like a formalisation of the lending into arrears policy of the IMF. The negotiation with the creditors is also led by the IMF, and in the end, a restructuring that is binding upon all parties (including dissident creditors) is confirmed with the approval of a supermajority of creditors.
The IMF proposal has not gained supporters, neither from developing countries, nor from developed ones. Consequently, the idea has been “shelved.”
5.2 The United Nations Conference on Trade and Development (UNCTAD) Principles
A more modest approach has been to attempt to formulate principles that should guide any restructuring. The UNCTAD Principles on Promoting Responsible Sovereign Lending and Borrowing contain obligations for both lenders and borrowers, and emphasise the responsibility of both parties not just during the negotiation and restructuring process, but also during the decision to subscribe to or issue sovereign debt, respectively.
5.3 The United Nations (UN) Draft Principles
The draft Basic Principles on Sovereign Debt Restructuring Processes, approved in the UN General Assembly over the objections of some creditor nations (notably the United States), states that sovereign states have a right to restructure their debt, and ties restructuring processes to the concept of sustainability, whereby the level and timeliness of debt restructuring is tied to promoting sustainable economic growth and minimising social costs. 5.4 Principles for Stable Capital Flows and Fair Debt Restructuring
The Principles for Stable Capital Flows and Fair Debt Restructuring issued by the Institute of International Finance (IIF) serve as a very useful framework for crisis prevention and
49 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT resolution in sovereign debt restructuring. The Principles are a voluntary code of conduct between sovereign debt issuers and their private sector creditors, which was agreed to in 2004 and endorsed by the G20. Until October 2010, the Principles were applicable only to sovereign issuers in emerging markets, however, their use has been broadened to encompass all sovereign issuers applying them on a voluntary basis. Non-sovereign entities, in cases where the state plays a major role in establishing the legal parameters of the debt restructuring, are also invited to apply them.
As stated in the introduction to the Principles, they “… incorporate voluntary, market- based, flexible guidelines for the behaviour of sovereign debtors and private creditors with the aim of promoting and maintaining stable capital flows, financial stability and sustainable growth. The Principles promote crisis prevention through the pursuit of strong policies, data and policy transparency, and open communication and dialogue with creditors and investors —particularly through investor relations programs (IRPs). The Principles strive for effective crisis resolution through, inter alia, good-faith negotiations with representative groups of creditors and non-discriminatory treatment of all creditors.”
5.5 The contractual approach to reform: Collective Action Clauses (CACs)
Given that proposals like the SDRM or the UN and UNCTAD principles have not gotten traction in the international sphere, a viable alternative has been to improve the contractual framework of sovereign debt instruments so as to facilitate debt restructurings through clauses built into the agreement. Through a collective action clause in a debt instrument, a supermajority of creditors can vote to consent to a restructuring offer from a sovereign, and in so doing, bind all of the creditors to the decision.
CACs are, of course, only a solution that can be implemented for new bonds that are issued, not for already issued bonds that do not include these clauses. While it was standard practice to include CACs in English law denominated bonds, most sovereign bonds issued under New York law do not include them until 2003. Furthermore, even if they are in the debt instrument, CACs have their limitations. If the bond is relatively small in value, an ambitious creditor set on blocking the restructuring could assume a position that would defeat the supermajority with ease. For this reason, policymakers have urged sovereign debtors to adopt aggregated CACs instead; for aggregated CACs, there is a lower threshold of approval for each bond series affected by the modification, but the restructuring must be approved by a supermajority of the bondholders of all outstanding bonds. In this way, the restructuring is protected against holdout bondholders entrenching their position in any particular bond, but it retains high standards for bondholder participation. Furthermore, in requiring the approval of all the bondholders affected by the restructuring, it ensures that if approval is received, the restructuring will be successful, because the country will not have particular un-restructured bond issues that threaten the sustainability of its restructuring strategy.
The International Capital Markets Association (ICMA) has played an instrumental role in advancing the development of better contractual terms aiming at preventing sovereign debt litigation and facilitating—if needed—debt restructuring. ICMA has been following closely latest developments and pushed for the most modern ‘single-limb’ CACs and streamlined pari passu clauses.
50 51 THE APPLICABLE LEGAL FRAMEWORK TO SOVEREIGN DEBT
6. CONCLUSION
This Module first reviewed the origins of sovereignty to understand why there is no overarching legal authority under which sovereign debtors can restructure their debts, and why, generally, there are no controlling international laws in the area. The Module then studied the institution which is the closest to functioning as a formal process for sovereign debt management, the IMF. After summarising the functions of other multilateral institutions, the Module then discussed how official sector debt is treated, how the informal procedure for renegotiating it through the Paris Club works, and new dynamics in the official sector with emerging market creditor countries. Thereafter, issues such as how national law has shaped the restructuring of sovereign debt owed to the private sector, from laws that define sovereign immunity to jurisprudence that affects what restructuring strategies are available to sovereigns, were analysed. Finally, the Module looked at proposals for reform in the sovereign debt arena, whether based on a formal process, guiding principles, or a contractual, market-based approach.
References
Mauro Megliani, SOVEREIGN DEBT: GENESIS - RESTRUCTURING - LITIGATION (2015).
Michael Waibel, SOVEREIGN DEFAULTS BEFORE INTERNATIONAL COURTS AND TRIBUNALS (2011).
Lee Buchheit, The Role of the Official Sector in Sovereign Debt Workouts, 6 U. Chi. J. Int’l L. 333 (2005).
Lee Buchheit & Rosa Lastra, Lending Into Arrears - A Policy Adrift, 41 The Int’l Lawyer 939 (2007).
Leo Gross, (1948), ‘The Peace of Westphalia: 1648-1948’, American Journal of International Law.
Anna Gelpern, Brad Setser &; Ben Heller, Count the Limbs: Designing Robust Aggregation Clauses in Sovereign Bonds, in TOO LITTLE, TOO LATE: THE QUEST TO RESOLVE SOVEREIGN DEBT CRISES (Martin Guzmán, José Ocampo & Joseph Stiglitz eds. 2016).
Sean Hagan, Designing a Legal Framework to Restructure Sovereign Debt, 36 Geo. J. Int’l L. 299 (2005).
Rodrigo Olivares-Caminal, Transactional Aspects of Sovereign Debt Restructuring, in DEBT RESTRUCTURING (2nd ed., 2016). Rodrigo Olivares-Caminal, Understanding the Pari Passu Clause in Sovereign Debt Instruments: A Complex Quest, 43 The Int’l Lawyer 1217 (2009).
Rodrigo Olivares-Caminal, The EU Architecture to Avert a Sovereign Debt Crisis, 2011 OECD Journal Issue 2.
51 Martin Weiss, The Paris Club and International Debt Relief, Congressional Research Service, 11 December 2013, available at https://fas.org/sgp/crs/misc/RS21482.pdf.
John Hurley, Scott Morris, & Gailyn Portelance, Examining the Debt Implications of the Belt and Road Initiative from a Policy Perspective, Center for Global Development, CGD Policy Paper 121 (March 2018).
Peter Stirk, The Westphalian model and sovereign equality, Review of international studies, 38 (3) pp. 641-660 (2012).
International Monetary Fund, Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructuring, available at https://www.imf.org/external/np/pp/ eng/2014/090214.pdf.
UNCTAD, Principles on Promoting Responsible Sovereign Lending and Borrowing, available at http://unctad.org/en/PublicationsLibrary/gdsddf2012misc1_en.pdf.
Resolution A/RES/69/319 on Basic Principles on Sovereign Debt Restructuring Processes. Convention Respecting the Limitation of the Employment of Force for the Recovery of Contract Debts.
Republic of Argentina v. Weltover, Inc., 504 U.S. 607 (1992). Elliott Assocs., L.P. v. Banco de la Nacion, No. 96 Civ. 7916 (RWS), 2000 U.S. Dist. LEXIS 14169 (S.D.N.Y. Sept. 29, 2000).
Elliott Assocs., L.P., General Docket No. 2oo0/QRl92 (Ct. App. of Brussels, 8th Chamber, Sept. 26, 2000).
NML Capital v. Republic of Argentina, 699 F.3d 246 (2nd Cir. 2012).
Assenagon Asset Mgmt. v. Irish Bank Resolution Corp., [2012] EWHC (Ch) 2090 (Eng.).
28 U.S.C.A. secs. 1330, 1332, 1391, 1441, 1602-1611.
Paris Club, Homepage, available at http://www.clubdeparis.org/en.
Izabella Kaminska, Why you can’t technically default on the IMF, Financial Times, 16 July 2015, available at https://ftalphaville.ft.com/2015/07/16/2134539/why-you-cant-technically-default-on-the- imf/. Jonathan Browning and Kaye Wiggins, Russia-Ukraine $3 billion Battle Back in London Court, Bloomberg, 12 September 2018, available at https://www.bloomberg.com/news/articles/2018-09-12/ russia-ukraine-3-billion-battle-returns-to-staid-london-courts.
52 CHAPTER 4
INTRODUCTION TO CREDIT FACILITIES AND PRINCIPAL DOCUMENTATION
1. Introduction to Credit Facilities 2. Single or Multicurrency 3. Pari Passu or Subordinated 4. Secured, Partially Secured or Unsecured 5. Guaranteed, Partially Guaranteed or Unguaranteed 6. Bilateral or Multilateral 6.1 Bilateral 6.2 Multilateral 6.3 Syndicated Loans 7. Conclusion References INTRODUCTION TO CREDIT FACILITIES AND PRINCIPAL DOCUMENTATION
1. INTRODUCTION TO CREDIT FACILITIES
In English, the word “credit” may have several meanings. According to the Oxford English Dictionary, credit can vary and be understood as “[t]he ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future”, to “[t]he money lent or borrowed under a credit arrangement”, or put it simply, “[g]ood reputation.”
Based on this broad definition, it is possible to understand the term “credit” as two different stages of the process that will lead to lending money. In a first stage, the credit will refer to the “good reputation” of the prospective borrower. This aspect of credit is mainly focused on the trust that the borrowing party has gained and regarding its ability to repay a prospective debt as is perceived by others.
Shaping the Credibility Credit: Signalling In terms of credit as credibility, it is worth mentioning the signalling theory developed by Michael Spence (1973). Although his research focused mainly in the job market, his findings have a wide variety of applications.
His main theory is based on the lack of information an employer faces when aiming to hire an individual. Due to the fact that getting to know someone takes time, and the hiring process is too short to achieve a knowledgeable decision, hiring someone is an investment. In that sense, employees rely on indices (factors that cannot be manipulated by the prospective employer, such as race, height, weight, etc.), and signals (things that can be manipulated by prospective employers, such as specialised education, languages, soft skills, etc.).
From this point of view, applicants would try to reduce the uncertainty by investing in their signals. However, they would also have to consider their signalling cost (the cost of investing in the signal). According to Spence, even when signals such as education did not contribute in reality to the employee’s productivity, it was still valuable for both.
In the field of credit facilities, signals may include a good credit record, monetary policies, the debt-to-GDP ratio, contingent liabilities, etc. All these signals may help reduce the lack of information between the lender and the borrower, making them a part of the prospective borrower’s credit.
In the second stage, i.e. once the interested party has been identified as a prospective borrower, “credit” refers to the actual financial credit. In other words, after bearing out the trustworthiness of the prospective borrower and reassuring that they will be able to comply with the payments, the next step consists in the financial accommodation. The financial accommodation should be understood as any loan, advance, purchase of notes, security or other instrument under which the borrower may be indebted to the lender, whether
54 INTRODUCTION TO CREDIT FACILITIES AND PRINCIPAL DOCUMENTATION existing or that will arise in the future, whether direct or indirect, absolute or contingent, joint or several, due or not due, primary or secondary, liquidated or unliquidated, secured or not secured (Law Insider 2018). This Module will focus on loans (generally speaking) and the next one on bonds (and their variations).
In simple terms, a loan contract involves a lender who provides a certain amount of money to a borrower who has to pay that money back, plus the interest accruing from the time that money was not available to the lender. Term loans refer to those loans that contemplate a fixed repayment schedule and period of time by which the borrower needs to repay the loan. Term loans may contemplate certain conditions under which the debt may be cancellable, and can also include premature repayment in, for example, an event of default. The main objective of these types of loans is to contribute to the predictability of the finance (Wood 2008).
A credit facility, on the other hand, refers to a maximum amount of money that is readily available to the borrower that can be borrowed at any time, partially or in its entirety. Once the monies are borrowed, then a credit facility would operate as a loan. The main differences between a loan and a credit facility are the treatment of interest and borrowing fees: (1) while under a loan interest starts running from when the money is lent (i.e. right from the start), interest on credit facilities starts to run when the borrower withdraws any amount from the credit facility; and, (2) in the credit facility there is a fee being charged for having the money available to be borrowed at any time whether it is used (partially or in its entirety) or not (i.e. a fee for the availability of the credit). For the purposes of this Module, credit facilities and loans are going to be treated as synonymous. Examples of these loans or credit facilities include: revolving credit facilities, term loans, syndicated bank loans and letters of credit.
Once the key terms of the financial credit are agreed, the loan terms need to be documented in a loan contract. The details of the loan contract will depend on the party’s interests, objectives and motivations. Thus, loans can be:
(1) for a fixed sum and for a set period or structured as a revolving credit;
(2) single or multicurrency;
(3) pari passu to other obligations or subordinated;
(4) secured, partially secured or unsecured;
(5) guaranteed, partially guaranteed or unguaranteed; and
(6) bilateral or multilateral, in which case the loan can be documented as a syndicated loan or a bond/Eurobond.
55 The term loan is the most common type of loan. Under a term loan, a lender or a group of lenders agree to provide the borrower a fixed amount of money to be repaid together with interest, at a certain point in time. The principal feature of the term loan contract is that the amount of credit available to the debtor is predetermined and the contract lasts for a set period of time (the term) (Goode 2010). Once a term loan is repaid on its pre-determined maturity date, it generally cannot be re-borrowed, unlike a revolving credit facility.
On the other hand, in the revolving credit facility, the debtor receives a line of credit or a credit limit for an agreed period within which the debtor can withdraw up to the pre-agreed maximum amount and repay (which, depending on the agreed conditions, might become available again). Usually, each withdrawal reduces the available credit while the repayment restores it. The borrower can draw as much or a little as it requires at any time and, if cash flow is sufficient, it can repay outstanding amounts that it no longer requires.
As noted by Roy Goode,
“[t]he credit is said to be revolving because what comes off at the top by drawings is restored at the bottom by repayments” (Goode 2010).
The technical distinction between term and revolving credit facilities relies on the nature of the contracts. While the term loan implies always a bilateral or multilateral exchange of promises, the revolving credit implies a standing offer where each drawing represents a unilateral and independent contract, each accepting the original standing offer. 2. SINGLE OR MULTICURRENCY
Credit facilities may be agreed in one single currency or multiple currencies depending on the needs of the borrower and the capabilities of the lender(s). A borrower that has the need to access different currencies may benefit from a multi-currency credit facility.
A factor that usually affects the type of currency agreed on is the perceived strength of the currency. A credit facility agreed in a “soft currency” (i.e. a currency which is not an international means of reserve) may be worth a lot less at the time of payment, thus implying a higher risk for the lender. For that reason, international loans are usually agreed in what are known as “hard currencies.” These are CHF, EUR, GBP, JPY, and USD.
56 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY
3. PARI PASSU OR SUBORDINATED
The difference between the pari passu and subordinated credit facility relies on the rights of the creditor to receive payments before or after the rest of the creditors. In this sense, loans granted without a priority of repayment and that have not been subordinated to other loan arrangements will be considered to be pari passu with other creditors. Pari passu means in equal step or ranking, which implies that the lender will be entitled to receive their payment at the same time as the rest of the creditors. This situation reflects a non-preferential treatment of any one creditor over the others.
On the other hand, a subordinated credit facility refers to the creditor that willingly accepts to be subordinated to the payment of another creditor(s). In other words, the creditor with a subordinated credit facility will receive payment after the creditor(s) ranking above it are paid. Creditors under this type of credit facility will typically benefit from a higher interest rate to compensate them for assuming a greater risk. By accepting to be subordinated, the creditor assumes a higher credit risk. 4. SECURED, PARTIALLY SECURED OR UNSECURED
A loan with a security interest over a specific asset or cash flow, is a secured loan. The secured loan gives the lender proprietary interest over an asset owned by the debtor which enables the lender to realise that asset in order to get paid ahead of creditors without security in the event of the debtor’s insolvency (Wood 2008). If unpaid, the creditor can force a sale of, seize or realise in any other way the asset in order to be repaid. The security can cover the loan entirely or up to a given amount; if the latter the loan would be partially secured. Assets commonly used as security include land, buildings, machinery, intellectual property, trading stock, cash held in bank accounts, etc.
Under an unsecured loan the lender has no recourse to specific assets if the borrower fails to repay the loan. In these types of loans, the credit risk to the lender is higher and therefore, they would expect a higher return in terms of interest payable. 5. GUARANTEED, PARTIALLY GUARANTEED OR UNGUARANTEED
A loan may be unsecured but benefit from a guarantee, which is where a third party (the guarantor) promises the lender that if the borrower fails to repay the loan or the interest thereon, the guarantor will pay it instead of the borrower. A typical example of a guaranteed credit facility would be a central bank that signs up for a credit and sets the sovereign as guarantor. In this case, if the central bank is unable to pay, the sovereign would have to fulfil the obligation.
An unguaranteed credit facility, in which there is no guarantor to pay for the debt in case of default, implies a higher credit risk for the lender.
Under a partially guaranteed credit facility the guarantor will guarantee payment of the debt up to a certain amount. For example, a partially guaranteed credit facility will be a government guaranteeing USD10 million out of a USD100 million loan agreed
57 by the central bank. In this particular case, the loan would be 10 per cent guaranteed. As mentioned in Module 1, the Government of Seychelles approached the African Development Bank in 2009 to obtain a partial credit guarantee for the interest payments of the new instruments offered by Seychelles to its commercial creditors. 6. BILATERAL OR MULTILATERAL
The combination of parties in a facility can, as figure 2 below shows, be categorised in terms of bilateral or multilateral. The first being the smallest number of parties involved in a credit facility, and the latter including as many creditors as people willing to lend.
Figure 1 - Bilateral and Multilateral Categorisation
6.1 Bilateral
A bilateral facility is where a single lender (typically a bank) lends to a single borrower. Small term loans are usually bilateral because the larger the sum advanced, the greater the risk for a lender and therefore the more likely it is that the loan will be syndicated. Sometimes, multiple guarantors guarantee bilateral facilities. 6.2 Multilateral
Multilateral facilities on the other hand, refer to loans between a borrower and two or more lenders. As figure 2 shows, when this type of credit facility involves multiple lenders, the credit facilities tend to be classified either as syndicated loans or bonds/Eurobonds as these are the two main categories. Syndicated loans are discussed in more detail below while bonds will be addressed in the next Module. 6.3 Syndicated Loans
Syndicated loans refer to the where a single lender is not willing or able to lend the whole amount needed by the borrower, and thus several lenders each lend a portion of the total loan amount on a several basis. If one lender drops out of the syndicate for any reason, the other lenders are under no obligation to increase their portions of the loan to cover
58 the lost amount.
As described by Philip Wood,
“[t]he essence of syndication is that two or more banks agree to make loans to a borrower on common terms governed by a single agreement between all parties. The number of banks may be very small, sometimes called a “club loan”, or very numerous and, exceptionally, may run into hundreds of lenders” (Wood 2008: 93/94).
In terms of process, the borrower first requests the required loan amount needed for a project or to finance a budgetary deficit. Then, the lender would assess whether it is in a position to lend and sustain the exposure requested and if not, would then suggest other lenders or a group of lenders to arrange the loan. Alternatively, one of the lenders would act as the Arranger and, as its name indicates, would “arrange” the loan. The Arranger will conduct a brief due diligence on the borrower and prepare an information memorandum to market the loan and its main features among participants. Finally, the lenders will agree upon the terms of the loan. Once the terms of the loan have been agreed, the lenders will appoint an “Agent” who will act as the representative of all lenders with the borrower to deal with all the matters related to the loan. Usually the Agent is the lender that previously acted as Arranger, although it can also be a third party.
Figure 2 - Syndicate Loans Procedure
6.3.1 Sub-participation
Another way of structuring a syndicated loan is through sub-participation. The term “sub-participation” has no strict legal meaning, but it is used in the market to mean two different types of structures:
(1) funded participations and (2) risk participations. Funded participation is where a number of participating lenders lend a proportion of the total loan amount to the principal lender (an original syndicate lender). The principal pays a fee to the participants and also transfers to them capital and interest received from the borrower (but only when the principal receives these from the borrower). The advantage for the principal lender is that the risk of the loan is removed from its balance sheet. Risk participation, on the other
59 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY hand, works as a sort of guarantee. The participant agrees to reimburse the principal any amounts under the loan that are unpaid by the borrower in the event that it fails to fulfil its obligations under the original syndicated loan agreement. In exchange for this “guarantee”, the principal pays a fee to the participant. As this agreement is between the principal and the participant, if the original syndicated loan is in default and the guarantee has been called in, the participant will acquire the principal’s rights against the borrower by way of subrogation and may pursue the borrower for payment. Risk participation enables a lender to discharge its credit risk to a borrower, but not its funding commitment. 6.3.2 Parties to Syndicated Loans
The parties to a syndicated loan usually are:
• The borrower (the sovereign); • Some loans may have guarantors or other borrowers (co-obligors); • The lender acting as the Arranger (i.e. prior to the loan/credit agreement coming into existence); • The lenders; and • The Agent (the lenders’ intermediary between them and the borrower after the agreement is entered). 6.3.3 The request of the Borrower
The borrower’s request to obtain a syndicated loan is usually made in the form of a mandate where the borrower asks a lender to arrange the syndicated loan. This mandate is a non-legally binding commitment subjected to contract.
The Arranger will negotiate the term sheet for the loan and help with the information memorandum or due diligence on the borrower. The term sheet will contain the main financial provisions of the loan agreement. It will detail the amount of money required to be lent; the repayment schedule; whether it is a term loan or a revolving facility; if it is single or multicurrency; if there is any subordination; if any security will be granted by the borrower; and/or any guarantor; and other main legal provisions (including covenants and events of default).
The mandate is usually subject to certain conditions such as the syndicate members receiving internal credit committee approval for the loan agreement and receipt of required documentation from the borrower; the outcome of financial and legal due diligence; any material change regarding the borrower’s or lenders’ financial conditions; etc. 6.3.4 Market Flex Clause
The market flex clause is usually used when there is a fluid financial condition and the
60 Arranger cannot agree a specific syndication prior to the announcement of the deal. This clause allows the Arranger to make non-arbitrary modifications to the deal. A sample of market flex clause reads as follows:
“If, prior to the close of syndication, the arranger determines, having regard to prevailing conditions in the domestic or international financial markets, that a change to the price, structure or terms of the bank facilities would be advisable in order to enhance the prospects of a successful syndication of the bank facilities, then the arranger shall be entitled to make such change” (Wood 2008:95). 6.3.5 Functions of the Arranger and the Agent (Manager)
The Arranger is in charge of helping the borrower prepare the information memorandum, finding prospective lenders, and negotiating the terms of the loan. The information memorandum will typically contain the term sheet of the loan, the borrower’s most recent financial statements as well as its detailed financial history. The mandate letter between the borrower and the Arranger will determine the extent of the Arranger’s obligations.
Usually, the Arranger also becomes the Agent for the loan. Sometimes, rather than being an Agent it can also be appointed as a “manager.” In this sense, the Agent has fiduciary duties while the manager’s position is more administrative in nature. The role of the Agent/manager is to operate as a nexus or mediator between the borrower and the lenders, although it might hold some power to change the legal position of the lender/s. This will depend on the exact terms of the agreement in any given case. 6.3.6 The syndicated arrangements
From the syndicate point of view, these sorts of loans consist of several individual agreements documented within a single contract. Each lender agrees under the main syndicated loan contract to make a loan to the borrower up to the individual agreed amount. Thus, when the individual commitments of each lender are added together, these independent agreements constitute the syndicate (the whole agreement).
As a consequence, the payments made by the borrower are made to the syndicate and divided according to the proportional participation of each lender. In this sense, it is common practice for syndicate loan contracts to include a pro rata sharing clause. This clause provides that if any syndicate member receives a payment from the borrower, such payment must be shared proportionately amongst the other syndicate members (pro rata according to their individual commitments) (Wood 2008).
The loan agreement will also provide for certain important decisions regarding the loan to be made by a specified majority of lenders, usually expressed as 66⅔% of the principal outstanding amounts under the loan. 6.3.7 Syndicated loan terms
Although there is no standard form of contract used on all syndicated loans, there are market guidelines and practices which are widely used. In Europe the Loan Market Association (LMA), for example, publishes standard form loan agreements and guidance
61 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY notes on syndicated loan terms. As the LMA states, it “… has as its key objective improving liquidity, efficiency and transparency in the primary and secondary syndicated loan markets in Europe, the Middle East and Africa (EMEA). By establishing sound, widely accepted market practice, the LMA seeks to promote the syndicated loan as one of the key debt products available to borrowers across the region” (Loan Market Association 2018). Some of the usual clauses included in these agreements are:
• Agreement to Lend: A simplified example of this clause can read: “The bank will make loans up to its specified commitment during the commitment period” (Wood 2008). The commitment period implies the time until the monies can be drawn down by the borrower. The agreement to lend can also be for a single amount for a specified term, available in instalments, available on a revolving basis, or a combination of these. • Syndicated loan Commitments: This clause ensures that each of the prospective lenders will deliver the loan and honour the agreement, while stating that each lender remains independent and not jointly liable in respect of other lenders’ commitments. Each bank is only liable to provide its own proportion of the syndicated loan. • Payable Fees: The borrower usually agrees to pay three fees: (1) a commitment fee (for the lenders making the loan amount available for the borrower’s use); (2) an arrangement fee (for arranging the loan); and, (3) an agency fee (for performing the role of the agent). • Conditions Precedent: This clause enables the lenders not to lend the money unless certain previously agreed conditions are met. These can be at the beginning of the loan or prior to any subsequent request of funds (e.g. in a revolving credit facility).
A simplified example of the initial conditions precedent clause reads as follows: “No Borrower may request an advancement of funds unless the Agent has received all of the documents and other evidence listed in Schedule X (Conditions Precedent) in form and substance satisfactory to the Agent. The Agent shall notify the Borrower and the Lenders promptly upon being so satisfied.” And, a simplified example of a “Further Conditions Precedent” clause can read as follows: “The banks are not obliged to make a loan unless, at the time of the request for the loan and the borrowing of the loan, and immediately after the loan is made: the representations and warranties are true on an up-dated basis; no event of default or event which with giving of notice, lapse of time or other conditions that would constitute an event of default has occurred; there has been no material adverse change in the borrower’s financial condition; and, borrower’s certificates are made available as to the above, if the Agent so requests.”
• Remedies for Lender’s Default in Lending: This clause provides for the circumstance in which the lender fails to lend the money that it has committed to lend under the terms of the loan agreement. The damages payable as a result of the lender’s default need to be agreed between the parties. Under English law, the borrower’s remedy may only be for damages (South African Territories
62 v Wallington (1898)). However, specific performance under exceptional circumstances may be awarded for unsecured loan agreements (Loan Investment Corporation of Australasia v Bonner (1970)). • Application of Proceeds or Purpose Clause: This clause specifies the permitted purpose for which the loan monies will be used by the borrower. An example of this clause is as follows: “The borrower will apply the proceeds of the loan towards …” This clause reassures lenders that the loan will be applied for an agreed business or purpose and is usually supported by an undertaking given by the borrower.
• Payments: This clause establishes the modality in which payments should be made and that they should be free and clear of any deduction or set-off. A simplified example of this clause is as follows: “The borrower and the banks will make all payments in the specified currenc[y/ies], in immediately available funds, to the specified bank/s account/s, without set-off, deductions or counterclaims.”
• Prepayments: Prepayments are repayments made on the loan before its contractual maturity date. Prepayments can be voluntary or compulsory. Voluntary prepayments can be total or partial. Total prepayments (cancellations) are very rarely agreed to in practice. Prepayments and cancellations can be subject to minimum amounts, notice periods, only available on interest payments dates, and, sometimes are made subject to a premium being payable by the borrower. Compulsory prepayments will be required in the event of illegality, to avoid triggering an event of default or on a change of control of the borrower (the latter in the sovereign debt context might only apply in the case of state-owned enterprises). Pre-payments to a single bank are allowed if there is a need for gross- up due to taxes or increased costs and usually take place at the end of the current interest period.
• Repayment: This clause states the terms on which repayment of the loan must be made by the borrower. Repayment can be made in instalments or in one single “bullet” repayment. In the case of payments made in instalments or in the case of a revolving facility, this clause will also stipulate whether any amounts paid will be made available again for redrawing.
• Interest: The applicable interest rate is contractually agreed in the loan contract. It can be fixed or floating (e.g. linked to LIBOR or SONIA), or a combination of the two (e.g. a fixed component and a floating component). Interest is payable at the end of stipulated interest periods, which are typically 1, 3 and 6 months (other periods are available, e.g. 12 months). The interest rate is agreed at the beginning of the “interest period” and is for the length of that period. The parties can agree to consolidate the interest periods or allow more than one tranche with different interest periods (on some occasions, loans can even be split). Interests are usually calculated on a 360-day a year (12 months of 30 days each) or 365-day a year basis. The loan agreement will also provide for the borrower to pay default interest at a specified rate following an event of default under the loan agreement having been triggered.
63 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY
• Increased Costs Provision: The purpose of this clause is to protect the lenders’ margin in the event of an unforeseen change in the lender’s circumstances, e.g. an increased in the lender’s cost of lending. A simplified example of this clause may read:
“If by reason of (1) the introduction of or any change in the existing law or in its interpretation or administration by a competent authority of same; and/or, (2) compliance with any request from or requirement of any central bank or other fiscal, monetary or other authority whatsoever the Lenders incur a cost as a result of its having entered into and/or performing its obligations under this Agreement and/or making one or more advances or extending any credit hereunder or there is any increase in the cost to the Lenders of funding or maintaining all or any of the advances made by it hereunder, then the borrower shall from time to time within five (5) days of demand by the Lender/s pay to the Lender/s against such cost or increased costs.”
A possible remedy for the borrower would be to prepay the obligation, if this is permitted under the loan contract. The borrower can ask the lenders to agree to more time to pay any increased costs or to renegotiate these with the syndicate (represented by the Agent).
•Representations and Warranties given by borrower: It is standard for a loan agreement to refer to both «representations» and «warranties» as these two terms are legally distinct. Representations can be divided into legal or financial. Legal representations refer to the legal status of the borrower, while financial representations refer to the borrower’s financial condition. Representations are statements of fact as at a specified moment in time and are intended to be relied on by the lenders. If one of the representations is incorrect, this constitutes a misrepresentation and will result in an event of default being triggered under the loan. Examples of financial representations include financial projections or forecasts provided by the borrower being based on reasonable assumptions, the information memorandum being true and accurate in all material respects, etc. Examples of legal representations include: the entry into and performance by the borrower of the transactions contemplated by the loan not conflicting with the borrower’s laws; the borrower’s obligations under the loan being valid, binding and enforceable, and that all necessary authorisations have been obtained by the borrower to enable it to enter into the loan agreement. Warranties are promises by the borrower that the representations made by it are true in order to provide an indemnity if they are not true. A representation that is incorrect entitles the lender, as a matter of law, to terminate the loan contract and seek damages. Breach of a warranty does not give this right; the lender will only have a right to damages. However, these differences will not normally be critical because a loan agreement will typically include a specific contractual remedy for misrepresentation by the borrower. 6.3.7.1 Specific Covenants in Syndicated Lending Arrangements
A covenant is a formal agreement or promise, usually in a contract. They are undertakings where the borrower promises to do (positive covenants) or refrain from doing certain
64 activities (negative covenants), giving the lender a degree of control over the borrower to prevent a change in the borrower’s financial condition or its assets. The most common activities a lender may seek to curtail are: making distributions; opening bank accounts with another financial institutions; disposals of assets; incurring financial indebtedness; granting guarantees or security over assets, etc. The gist of covenants is the promise by the borrower (or other obligor) to do something or the prohibition of an activity. A simple example of a covenant can be the purpose clause (as discussed above) or the undertaking to repay the loan in full or pay interest. All these are positive covenants, i.e. a promise (a contractual commitment) to do something.
Besides the basic promises that are usually included in a contract, as described above, there are some specific covenants that require further analysis. In loan arrangements, specific covenant clauses can be divided into: (1) information supply; (2) financial performance; and (3) protection of assets (negative pledge and restrictions on disposals). The first type, information supply, is intended to enable the lenders to have control over the loan and have regular access to information about the borrower. Examples of information covenants may include, provision by the borrower of compliance certificates or prompt notification by the borrower of defaults and of potential or actual (material) litigation.
Regarding the second type of covenant, i.e. financial or performance covenants, these covenants operate as a constant test to measure the liquidity and solvency of the borrower. These sorts of covenants aim to reassure financial issues, such as current assets to current liabilities. In the sovereign context, a simplified clause may read as follows: “so long as the Loan remains outstanding the Borrower will ensure that the volume of the total state debt and state guaranteed debt should not at any time exceed an amount equal to 60 per cent. of the annual nominal gross domestic product of the country.”
Regarding the third type of covenant, i.e. asset protection, the most relevant clause is the negative pledge clause. The primary purpose of a negative pledge is to prevent a borrower from creating security over its assets and for this reason it is one of the most important covenants in unsecured loan contracts. Among the many reasons to incorporate this clause in the contract is to improve equality among creditors and mitigate any issues raised by the creation of a second security interest. Pre-existing security is typically exempted from the negative pledge, and specific carve-outs can be agreed between the parties. Sometimes, the negative pledge may also include a restriction on the disposal of assets to prevent the borrower from selling or modifying the legal status of all or part of its assets. The main reason for incorporating this clause is to prevent any asset-stripping. A simplified example of this clause may read as follows:
“So long as the loan or any part of it remains outstanding, the debtor will not grant or permit to be outstanding, and it will procure that there is not granted or permitted to be outstanding, any Security Interest (other than a Permitted Security Interest) over any of its present or future assets or revenues or any part thereof, to secure any Relevant Indebtedness of the borrower.” 6.3.7.2 Events of Default
The events of default clause is instrumental in syndicated loan agreements as it list a series of events that, if any of them materialise, will result in the borrower being in default of the
65 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY loan. Upon an event of default, the usual consequences are: (1) acceleration of outstanding loans; and, (2) a cross-default being triggered under another agreement to which the borrower is an obligor (assuming a cross-default clause is included in such other debt agreement). It is customary that if there is an event of default, the parties agree to allow for remedial action to be taken by the borrower during a pre-agreed “grace period.” This notwithstanding, default interest will continue to run irrespective of any grace period. As noted by Wood (2008), default is considered to be the last resort and normally leads to the collapse of the borrower. If there were no event of default clause, the lenders would have to resort to a court to determine the consequences for a breach.
Events of default are mutually agreed among the parties to the loan but they usually include the following: (1) non-payment (of principal or interest); (2) breach of borrower’s other obligations under the loan contract; (3) misrepresentation; (4) cross-default; (5) moratorium; (6) borrower’s repudiation of the loan; (7) monetary judgment being obtained against the borrower exceeding an amount previously agreed); (8) illegality (the adoption of any applicable law, rule or regulation which would make it unlawful to comply with the obligations agreed under the loan); and, (9) IMF membership cessation. The lender’s chief remedy on the occurrence of an event of default is the acceleration of the loan and cancellation of commitments to make further loans. 6.3.8 Loan Transfers
Loans granted to a borrower can be subsequently transferred. This transfer of rights can be made through:
• Assignment: applicable to rights under the loan only, obligations cannot be assigned and thus assignment is inappropriate in the case of partly drawn loans.
• Novation: transfers both rights and obligations. It substitutes the “old” contract for a “new” contract where the borrower must be a party. All the parties (the borrower, the existing lenders and the new lender) agree to novate a portion of the original loan contract to the new creditor.
• Sub-participation: as explained above, a separate contract between the relevant creditors. The existing creditor agrees to pay the new creditor the same amount the borrowers is due to pay the existing creditor. 7. CONCLUSION
This Module provided an overview of credit facilities and loans. The main purpose of the Module was to understand the key features of these instruments and how the relevant agreements are structured. As explained, an instrumental aspect is the need of the parties and their bargaining power as well as the constraints imposed by market conditions. The Module additionally addressed the main contractual features, focusing on conditions precedent, representations and warranties, covenants and events of default. These clauses are very important as they are also used in bonds, as will be seen in the next Module.
66 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY
References
Buchheit, L. C., 1986, ‘The State of the Loan Sub-Participation’ Journal of Comparative Business and Capital Market Law.
Desjardins, D., 1986, ‘Assignment and Sub-Participation Agreements - A Basic Overview’ Canadian Bar Review, 1986.
Goode, R., 2010, Goode on Commercial Law, Fourth Edition, Penguin Books, London.
Law Insider, 2018, Financial Accommodation | legal definition of Financial Accommodation by Lawinsider.com.
Spence, M., 1973, ‘Job Market Signaling’, The Quarterly Journal of Economics, 87(3), 355–374.
Wood, P., 2008, Law and Practice of International Finance, University Edition, Sweet & Maxwell, London.
1898, South African Territories v Wallington.
1970, Loan Investment Corporation of Australasia v Bonner.
Loan Market Association, 2018, About the Loan Market Association.
Buchheit, L. C., 1986, ‘The State of the Loan Sub-Participation’ Journal of Comparative Business and Capital Market Law.
Desjardins, D., 1986, ‘Assignment and Sub-Participation Agreements - A Basic Overview’ Canadian Bar Review, 1986.
67 CHAPTER 5
INTRODUCTION TO BOND ISSUANCES: PROCESS AND PRINCIPAL DOCUMENTATION
1. Introduction 1.1 A Note on Medium Term Notes (MTNs) 1.2 Subordinated Bonds 2. Parties involved 3. A note on underwriting 4. Overview of Key Documents 5. Procedure 6. Listing of Bonds 7. Rating of Bonds 8. Trustees and Fiscal Agents 9. Conclusion References 1. INTRODUCTION
Bond issuances are a type of multilateral loan or credit, which include several creditors who buy pieces of a debt that the borrower sells. They represent an alternative financing option to syndicated loans. In this sense, investors (or creditors) lend the money to the debtor for a fixed period of time, and get in return a fixed or variable interest rate.
Bonds are tradeable debt securities, usually issued and listed in the capital markets. According to Wood,
“Bond or note issues are loans: (1) made typically by sophisticated investors such as insurance companies, banks, large corporate pension and investment funds, and (2) evidenced by transferable debt securities issued by the borrower (issuer) to the initial lender (subscribers) ” (Wood 2008:159).
The term “bonds” is colloquially used as a genus that encompasses several subspecies. How these subspecies are classified varies from jurisdiction to jurisdiction, but generally speaking, the classification would be as follows:
Table 1 – Bonds’ Genealogy
The term Eurobond is usually used to refer to a tradeable instrument (i.e. a security) issued in an international bond issuance. Originally, the definition was narrow, but with different transactions, the use of the term has been relaxed. McKnight (2008) argues that “as many things in this area, the nomenclature that is used, often rather than nonchalantly, is usually not of great importance, so long as the true nature of the transaction and the ensuing instrument is properly understood.”
A Eurobond was traditionally defined as bonds which are issued outside the domestic market of the currency in that they are denominated. The use of the term has water- downed this traditional definition to broaden it to encompass international issuances generally and that is why a more common definition is that of an issuance in a currency other than that of the issuer.
4 The issuer could be a political subdivision, the central bank or a state-owned enterprise. For methodological purposes, reference is made to the sovereign issuer in a broad sense.
69 INTRODUCTION TO BOND ISSUANCES: PROCESS AND PRINCIPAL DOCUMENTATION
The financial world has invented colourful names to refer to Eurobonds issued targeting a specific market. For example: Masala Bonds, Samurai Bonds, Panda Bonds, Yankee Bonds, etc. Masala bonds refer to bonds issued in India, denominated in Indian rupees, by a foreign issuer. Samurai Bonds, refer to those bonds issued in Japan by a non-Japanese organisation, and denominated in Japanese Yen. Panda Bonds refer to notes issued in China by a non-Chinese issuer and denominated in renminbi (Chinese Yuan). Yankee Bonds are securities denominated in U.S. Dollars, issued in the U.S. by foreign issuers.
For the purpose of this Module, the term “bond” will be used in a broad sense. Another name for bonds is “fixed-income securities” as they provide a fixed periodic payment: interest. Even if the quantum of the interest is variable, the contract will stipulate a fixed periodic variable return and this is why it is referred as a fixed income security. In addition, stocks are not fixed income securities as they do not guarantee a return. The exception to this is the zero-coupon (interest) bond, i.e. a bond that makes no periodic interest payments because it is sold at a steep discount from its face-value.
This Module will focus on the issuance process and the documentation involved. For now, it is relevant to bear in mind that the issuer (who will become the sovereign debtor ) sells its debt securities (short-term paper, notes, MTNs, bonds or Eurobonds) in the stock market in order to reach a greater amount of prospective investors (who will become creditors), who can buy these debt instruments aiming for a periodic return (fixed income) plus the repayment of the principal amount (the entirety of the borrowed money) upon maturity. 1.1 A Note on Medium Term Notes (MTNs)
MTNs are bonds that reach maturity in between 5 to 10 years, although they can also extend up to as long as 30 years on a rolling basis. They are designed to offer low cost, fast and frequent issue of different debt instruments by issuers with recurrent needs. According to Wood (2008),
“[t]he main purpose of these debt instrument programmes is to standardise the terms on which an issuer issues securities and consequently to seek to minimise the documentation for issues of notes, and to restrict the cost, time and administration involved in separately documenting each issue. The market can then respond quickly to borrowing requirements or lending opportunities. Further, many of the non-commercial terms on which large issuers of debt securities in the international capital markets borrow tend not to vary greatly.” 1.2. Subordinated Bonds
Bonds can also be subordinated to other obligations of the sovereign debtor. As explained in previous Modules, subordinated bonds operate in a similar way to subordinated loans. In this sense, a subordination clause in sovereign bonds would contractually postpone repayment of the bonds behind other bond or debt obligations of the sovereign debtor. As a trade-off for being subordinated, i.e. assuming additional risk, subordinated bonds will
70 offer higher interest rates. 2. PARTIES INVOLVED
The parties usually involved in a bond issuance include:
• Issuer * Takes the decision of incurring the debt. * Gives a mandate letter to the manager to pursue or initiate the issuance process. * Remains the principal debtor.
• Arranger/Manager * Develops the individual bond issue structure and parameters, based on the issuer’s needs. * Assists in drafting documents required to register the bond issuance. * Delivers presentations for potential investors (roadshows) prior to the bond placement. * Arranges for any bonds not sold on issuance to be bought (either by itself or by a syndicate of financial institutions on a joint and several basis), i.e. underwriting the issue.
• Guarantor * A third party guaranteeing totally or partially a bond issuance.
• Trustee or Fiscal agent * A fiscal agent acts on behalf of the issuer as a principal paying agent. * A trustee acts on behalf of the bondholders as an intermediary between them and the issuer. * Only one would be appointed, both cannot co-exist in the same issuance.
• Registrar (for registered bonds only) * A third-party collecting applications from investors with respect to an issuance. * Maintains a register for the issue of names/addresses of bondholders and assists the issuer in the allotment of bonds (processing and dispatching allotment letters).
• Transfer agent (for registered bonds only) * A third party (usually the same entity as the registrar) that issues and cancels bond certificates to reflect any change in ownership when bonds are transferred to new owners.
• Listing agent (for bonds listed on stock exchange) * he listing agent advises the issuer on the requirements and procedure for listing the bonds. * Submits all necessary documentation for listing the bonds on the relevant stock exchange.
71 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY
•Rating agent * A rating agency (usually Fitch, Moody’s or Standard & Poor’s) that assesses the creditworthiness of the issuer and assigns a rating to its bond prior to the issuance.
• Calculation agent * A third party that will be responsible for making required calculations fordeterminations under the bonds, e.g. to calculate an interest rate that derives from different indexes.
• Paying agent * An agent (usually banks) who makes payments of interest and principal to the bondholders in return for receiving payment from the issuer.
• Process agent (if the issuer is not domiciled in the same jurisdiction in which the bonds are issued) *It is common practice for the issuer to appoint a process agent to act on its behalf when a bond is being issued in a foreign jurisdiction, to receive any legal documents that are served on the issuer in legal proceedings. 3. A NOTE ON UNDERWRITING
When a bond is being issued in the primary market, the issuer will employ the services of one or more investment banks to act as underwriter/s. The underwriter plays a key role assuming a substantial part of the risk related to an initial placement. In doing this, it will (1) assist the issuer (and the arranger, if different from the underwriter, as many times the role of the arranger and the underwriter are performed by the same entity) on the financial terms and timing of the proposed issuance; and (2) use its best efforts to distribute the bonds to the public and/or buy them from the issuer.
The second of these functions (i.e. buy), is the core function of underwriting, as the first one is the role of the arranger/manager. In general terms, underwriting refers to the process of collecting investments from investors on behalf of issuers. This process is not or may not always be part of the initial arrangement. In cases where it is part of the arrangement, the bank may buy the whole issue then try to resell the securities to the public in the secondary market. Another option would be for it to first try to distribute the securities to the public and agree to take up any that are not taken up by the public. In a nutshell, in a simplified structure underwriting can be:
• Level 1: using best efforts, minimum risk as there would be a success fee;
• Level 2: subscribing for any unsold bonds, greater degree of risk as, if the best efforts in allocating the bonds to prospective investors have failed, the underwriter can end up with a sizeable amount of debt on its books; and
• Level 3: subscribing for the entirety of the bond issuance to later offload it in the secondary markets, this—needless to say—entails the highest degree of risk.
72 Did you know? The term “underwrite” derives from the tradition of writing the name of the person or entity assuming the risk, under the total amount of the assumed risk.
Underwriting obviously involves risks for the investment bank acting as underwriter, since the investment bank could effectively be agreeing to invest its own funds in the company rather than simply providing professional services. Investment banks naturally charge a commission for taking such risk.
Exponential growth or its next development phase? As previously seen, the first Eurobond was issued in 1963. Authors like Lockhart also argue that the growth of the Eurobond market has been exponential. So, how did this happen in such a short period of time? According to Lockhart, “[w]hat is evident is that this market could not have developed to the extent of being able to marshal over $4.5 billion of new long-term financing in such a short space of time without some machinery having already been available to effect it. This machinery had been in existence since the 1920’s in roughly the present form of internationally oriented investment houses—called banks, brokers, investment dealers or merchant bankers, depending on the country of residence. These houses generally have at their disposal sizeable amounts of capital and certain traditional skills in dealing in foreign markets. They have developed these characteristics somewhat more intensively in recent years as the demands of the market place have changed and grown and as various pressures have been put on them in this constantly-evolving area, but their essential common characteristic remains the same—the underwriting and trading of a wide range of international securities without regard to national or regional boundary” (J. Anthony Lockhart 1969).
4. OVERVIEW OF KEY DOCUMENTS
A bond issuance requires a substantial amount of preparation. Consequently, several documents are required for an issuance, particularly bearing in mind that they will be offered to the general public (unless it is done through a private placement ). The main documents involved in a bond issuance are listed below, together with a brief explanation of their purpose.
• Mandate letter: A document signed by the issuer, which authorises a bank or an investment bank to arrange the issuance of debt.
• Subscription agreement: This document states the terms that govern the manager-issuer contractual relation. It stablishes the conditions under which the manager would buy or procure investors to buy the issuer’s bonds. These terms can be summarised in:
73 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY
* Proper Subscription: implies the actual agreement of issuance and subscription both from the issuer and the manager respectively. The managers will agree to subscribe for or get someone to subscribe for the bonds.
* Warranties: Warranties established in the subscription agreement aim to solve problems in advance. The idea is to have contingency plans for hypothetical problems that might arise during the bond issuance. Contrary to the warranties described in Module 4, these warranties are arranged between the manager and the issuer and their incorrectness does not constitute an event of default.
* Listing: Listing refers to the process of listing the bonds on a stock exchange where prospective investors may purchase/trade them.
* Market disruption: Prior to the closing phase, the managers are allowed, through this clause, to terminate the agreement if there are causes of market disruption that would prevent them from fulfilling their obligations.
* Selling restrictions: These terms refer to the selling limitations imposed on the manager when the transaction is deemed to be unlawful or beyond the disclosure agreement. If this happens, the issuer will have grounds for indemnification.
* Miscellaneous: These terms encompass all the other possible agreements such as limitations regarding jurisdiction, waivers of immunity, etc.
• Manager’s agreement: These are the terms and conditions agreed between the lead manager and the other possible co-managers (or junior managers). They govern the details of their contractual relationship, from expenses, to commissions and underwriting obligations, if any. If there is an underwriting obligation, the different managers will agree between themselves that they will be bound by and will comply with the International Capital Market Association Standard Form Agreement Among Managers
• Fiscal Agency Agreement or Trust Indenture: * Fiscal agent agreement: the fiscal agent represents the interests of the issuer and this agreement aims to fulfil the payments of the issued bonds, maintains records of payments, etc. The fiscal agent is appointed by the issuer in an international financial centre and will direct payment to the paying agent on interest payment dates and on maturity; and, will deal with issues related to the relationship with bondholders. The fiscal agent is appointed by the issuer to act as its agent. If the issuer fails to make an interest payment, the bondholders cannot take action against the fiscal agent.
* Trust Indenture: the trust indenture regulates the relationship between the trustee (usually a financial institution) and the issuer. The trustee’s role is to represent and act in the best interests of the bondholders. A key difference from the fiscal agent is that the trustee is not a paying agent—it will appoint a paying agent to handle the payment mechanics of interest and principal to
74 bondholders.
• Preliminary Prospectus (or Red-herring Prospectus): This is a preliminary first version of an offering document produced by the sovereign issuer providing information about the issuance. Some financial information is still subject to confirmation.
• Prospectus (or Final Prospectus): This is a legal offering document which is required when submitting the bonds to be listed providing details about the investment offer to the public and subject to the approval of the securities authorities. The main difference with the Preliminary Prospectus is that the latter is not an offer to sell.
• Offering Circular: This is equivalent to the Prospectus but used in private placements.
• Global certificate (or bond): This refers to the bond (issued by the issuer) which represents—irrespective the numbers of investors—the entire amount of the issuance. The global certificate will include the main features of the bond issuance.
• Legal Opinion: It is a common requirement to obtain a legal opinion stating that the sovereign issuer has the capacity and power to issue the bonds and that they are a legally binding obligation of the issuer.
• Interest hedging agreement (optional and dependent upon the circumstances): This agreement would, for example, enable the issuer to pay a fixed rate of interest and receive a floating rate instead (or vice versa) from the hedging bank. This type of tool is used so that when an issuer needs to offer a floating rate (because of a market preference), but it is in its interest to pay a fixed rate (e.g. its source of income generate a fixed interest rate), it is possible to hedge the interest. This means that the issuer will agree with a third party to pay a fixed rate in exchange for a fixed fee.
• Service Process Agreement: This is an agreement where the issuer appoints someone to act as service agent in the jurisdiction where the securities are being issued. In the case of sovereigns, it is common to appoint the Ambassador or the Commercial attaché in the jurisdiction. 5. PROCEDURE
In the field of bond issuances and particularly in the context of sovereign debt, it is worth stressing that there is no predetermined set of rules that need to be applied consistently. The order of the factors and the clauses used in contracts and transactional instruments will depend entirely on the parties involved, their context, motives and financial strategies and market conditions.
That being said, a standard procedure for issuing bonds includes five stages: (1) pre- launch; (2) launch; (3) signing; (4) closing; and, (5) post-issuance.
75 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY
The pre-launch starts when the issuer instructs, by means of a mandate letter, a manager (or managers, in which case there will be a lead-manager and managers) to arrange the issue of the bonds. Simultaneously, the issuer will instruct the fiscal agent or trustee of the desired structure for the issuance and will negotiate the respective agreement. The manager/lead manager will inform the clearing system and the stock exchange of the issuance and will liaise with the lawyers to draft the required documentation.
In the launch phase, while finalising the definitive documents for the issuance, the manager/lead manager contacts potential investors and sets the terms of the issue with the exception of the final price and interest. Managers may also be allowed to ask co- managers to underwrite the bonds. In some cases, the manager would also have to present a summary of the issuer, specifying the issuer’s financial condition. A preliminary prospectus is used for marketing purposes; this prospectus is known as a “red-herring prospectus” because it includes a legend in red stating that it is not the definitive prospectus.
In the signing phase, the manager sends the preliminary offer to the prospective investors and agrees with them the price and interest of the bond.
After the agreement has settled, the closing phase starts. The manager and the issuer sign the subscription agreement that legally binds the managers. The final proposal is sent to investors who agree on the number of bonds they would be willing to buy. All the other parties involved in the issuance execute their respective agreements (paying agent, fiscal agent/trustee, etc.), and the listing of the bonds is settled and confirmed by the stock exchange. Finally, bonds are rated by the rating agency.
The issuer provides the agreed documentation, such as legal opinions and authorising resolutions. The issuer also sends the global certificate to the clearing system’s custodian, normally this depository position is covered by the deposit bank which will pay the issuer once it receives the global bond. The investors pay the agreed price and the manager then transfers the money to the issuer.
In the final post-issue phase, as agreed, the issuer pays the bondholder the interest until maturity when the issuer pays the principal.
Nowadays, there is no individual underwriting separated from the main process. A dealer usually announces the issue, with the fixed terms, to the market. Then the bonds are delivered. The managers and the issuer agree to underwrite the whole issuance and then proceed to sell the bonds on their own.
Regarding the duration of this process, it will depend on the complexity of the issuance as well as the jurisdiction, parties involved, particularities of the market, etc. Thus, it can last from a few days to several months.
76 6. LISTING OF BONDS
Some bonds may target as many prospective investors as they can possibly reach. For that purpose, they are normally listed on a stock exchange. Eurobonds aim to reach the highest possible number of investors in an international playing field, and the most common stock exchanges targeted in these issuances are London, Luxembourg, New York and Tokyo, but of course, this will depend on the targeted investors.
One of the advantages of listing is the vast number of prospective investors being reached. The publicity of the debt, its presentation as an investment opportunity and the fact that the stock exchange gathers all sorts of investaors (from conservative to risk taking investors), increases the chances of raising funds amongst a diverse investor base.
Moreover, the listing procedure provides an extra sense of security to investors. Considering that the stock exchange quotes bonds based on the price by which such bonds have been exchanged in previous transactions, the probabilities of having above- market prices are low.
In terms of disadvantages, the issuer ought to comply with all the requirements established by the stock exchange. Issuers that decide to enter the listing process must agree the disclosure requirements, the duties to periodically report factors that can prevent the issuer from meeting its obligations, and all material aspects that may affect their legal standing or produce a deterioration in value or unforeseen increased costs.
Needless to say, the listing process takes time. This time may prove critical in cases of rapid windows of opportunity in fast paced markets. A common practice to minimise the impact that the registration time has on an issuance is to proceed with a shelf registration (also known as a “shelf offering” or “shelf prospectus”). This type of public offering allows for splitting the issuance into multiple issuances. Therefore, an issuer can—foreseeing its financing needs—do a shelf registration for an amount higher than its actual debt- raising needs (e.g. double or triple the amount to be issued) and then, dependent upon future needs, simply proceed to issue a new series of bonds without the burdensome requirements of a full issuance registration. Finally, many stock exchanges require a paying agent based in the jurisdiction of the stock exchange.
Another practice is to proceed with a private placement. In a private placement the bonds being issued are allocated through a private offering to a single or a small number of investors (i.e. not through a public offering). 7. RATING OF BONDS
Once listed, bonds are usually rated by credit rating agencies (“CRAs”) that are independent companies acting upon request of the issuer to assess the credit-worthiness of the financial instrument. These independent companies seek to reduce the information asymmetry by presenting the probability of default that certain bonds may have to investors. There are three CRAs dominating the rating market, these are: Fitch Ratings; Moody’s Investors Service Limited; and, Standard & Poor’s Rating Services.
77 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY
The importance of the rating from the investors’ point of view relies on the foreseeability of the risk to be taken (or actually taken). Through the rating process, it is possible to assess the suitability of certain investment profiles of investors. If an investor has a risk- taking profile, such investor may be comfortable acquiring speculative bonds that carry a greater chance of default.
Moreover, ratings may also be of high importance to hedging counterparties that may set the terms of their agreements and fees in accordance to the risk associated to the bonds, as evidenced by its rating.
Table 2 below illustrates the different ratings and modality employed by each CRA. Although each rating agency develops its own set of denomination, it is possible to oversee a common pattern which correlates to the probabilities of default. For example, “…over a five-year period, AAA may have a 0.1 per cent probability of default, A, 0.3 per cent probability; BB, 15 per cent; B, 32 per cent and CCC, 57 per cent” (Wood 2008:333).
Table 2 – CRAs Bonds’ Ratings
78 Did you know? Authors like Flandreau and Flores argue that before the CRAs developed into the role that they currently play in the sovereign debt context, at the beginning of the nineteenth century underwriters fulfilled the role of balancing the information asymmetry. In this sense, they explain that, “[t]he system rested on a transfer of credibility from the underwriter to the borrower. Investors could not learn about borrowers, but they could learn about underwriters. Prestigious underwriters came to monopolize the market for good sovereign debt. Lower quality intermediaries tried and did occasionally break in but their involvement signalled higher risks. Investors got the message, and the market for bad debt collapsed and did not resume for a while. We conclude that hierarchy among intermediaries offered a remedy against what theoreticians call the “contracting” and “collective action” externalities in sovereign debt” (Flandreau & Flores 2009).
8. TRUSTEES AND FISCAL AGENTS
As it was briefly explained above in the “key documents” section, and in Module 1, trustees and fiscal agents represent two alternatives but required sides of the same coin in a bond issuance. In this sense, the issuer-bondholder relationship can be translated into the trustee/fiscal agent-bondholder relationship.
The trustee is an agent appointed to represent the bondholders. Among its duties, the trustee has to look after the interests of the bondholders, keep a separate provision for personal and bondholders accounts, be diligent when managing the trust assets, and meet the obligations agreed in the trust indenture.
A trustee indenture may also be accompanied with a no-action clause. This clause prevents the bondholders from taking independent enforcement action against the issuer, thus only being able to do so through the trustee.
By entering into a trust indenture, bondholders gain several advantages. Among them, they can channel all the claims through the trustee and thus they are able to put forward a clear and consistent message. They may also be able to have a better allocation of resources by having all the administrative features concentrated in the trustee. Moreover, they would have a concentrated and unified enforcement power. Under U.S. law, individual bondholders may take action in case of non-payment.
On the other hand, the trustee and the no-action clause represent an advantage to sovereign issuers too. Thanks to them, issuers have an element of protection against “holdout” bondholders. If, during a debt restructuring, bondholders that wish to be paid no matter what would be prevented from doing so by the no-action clause. Additionally, trustees present an advantage to issuers for they enable them to deal with one entity instead of a vast number of rogue bondholders.
Fiscal agents on the other hand, represent the issuer. They are appointed by the issuer and
79 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY help the sovereign with all the administrative and—as its name indicates—fiscal matters of the bond. The fiscal agents act as if it were the issuer in the allocated jurisdiction. In this sense, if the issuer transfers the funds to the fiscal agent to pay the bondholders, this “first payment” between the issuer and the fiscal agent will not be considered as if the issuer has paid the bondholders because the fiscal agent is merely acting as agent of the sovereign and not as principal, thus any bondholder may claim an enforcement action and seize the sovereign assets (monies transferred) from the fiscal agent.
The advantage of having a fiscal agent for the issuer is that they may channel and outsource all the administrative issues and assign an individual entity to deal with bondholders, stock exchange and local territory regulations. In economic terms, the costs associated with a fiscal agent are less than those of the trustee due to the tasks and exposure associated with the role.
Table 3 below compares and contrasts the Fiscal Agency Agreements and Trustee Indentures, including slight differences in the latter under English and New York law.
Table 3 – Comparison between Fiscal Agent Agreements and Trustee Indentures
9. CONCLUSION
This Module provided an overview of bonds. First, the Module dealt with terminological issues, highlighting that while the nomenclature can differ, the essential aspect is to understand the true nature of the transaction and the instrument. Then, the Module dealt with the parties involved and the contracts used in connection with a bond issuance. In doing this, some specific or more technical aspects were highlighted, e.g. the role of the underwriters, the distinction between offer and trading, trust or fiscal agency structures, etc. Understanding the parties involved, how the process is conducted, and the contracts involved is instrumental to understanding the potential risks and litigation weaknesses and will be analysed in the forthcoming Modules.
80 INTRODUCTION TO DISPUTE RESOLUTION IN THE OIL AND GAS INDUSTRY
References
Flandreau, M. & Flores, J.H., 2009, ‘Bonds and Brands: Foundations of Sovereign Debt Markets, 1820–1830’, The Journal of Economic History, 69(3), 646–684.
J. Anthony Lockhart, 1969, ‘The Eurobond Market Today: Some Facts, Some Fancies’, Financial Analysts Journal, 25(2), 128–132.
McKnight, A., 2008, The Law of International Finance, Oxford University Press, Oxford.
Wood, P., 2008, Law and Practice of International Finance, University Edition, Sweet & Maxwell, London.
81 CHAPTER VI
UNDERSTANDING RISKS AND CHALLENGES
1. Introduction 2. Sovereign Risks 2.1 Non-Financial Sovereign Risks 6 2.2 Financial Sovereign Risk
3 .Debt-to-GDP Ratio 4. Outlining and monitoring the use of funds 5. Predecessor debt 6. Conclusion References 1. INTRODUCTION
With the proliferation of social needs and sovereign initiatives, along with the search for optimal funding options, comes the need to manage any debt incurred at a sovereign level (national, political subdivisions, state owned enterprises, etc.). Although, as previously observed, debt is the preferred way for sovereigns to finance, as will be observed in this Module, risks (financial or not) are embedded in any borrowing operation.
As Ulrich Beck pointed out, modern societies are characterised as risk societies (Beck 1992). People live their lives surrounded by all different sorts of hazards. They incorporate these daily risks and manage to add them into the equation behind every calculated decision.
A bit of history … Sovereign risk can be traced back to the mid-14th century loans granted by Florentine banks to Edward III in England.
On that occasion, Edward III borrowed money to sponsor his war against France but he ended-up defaulting in 1340. As a result of the default, a bank run was triggered in Florence and it resulted in the bankruptcy of Peruzzi Bank (1343) and Compagnia dei Bardi (1346).
Authors like Stasavage (2015) consider that because of such events, no one was willing to lend to monarchs long-term. Other authors (Reinhart and Rogoff) argue that “[a] king’s promise to repay could often be removed as easy as the lender’s head.” This sustained the idea that monarchs where highly credit risky. They tended to borrow short term and with high interest rates. Nowadays, sovereigns can default and shield themselves within the borders of their territory but in modern integrated economies it is difficult to sustain this model over time.
Societies tend to constantly play with the odds, while aiming to take these risks to a minimum. For this reason, several standards regulate the acceptable rate of risk to be undertaken. In the same way, sovereigns, when dealing contracting a credit facility (e.g. a revolving credit facility) or issuing a Eurobond need to foresee potential risks and measure and manage them in order to neutralise or reduce them to an absolute minimum. Reducing risks would allow to reduce funding costs and minimise undesirable consequences.
Debt management offices and sovereign debt portfolio managers may confront several risks linked to debt incurrence/issuance, idiosyncratic market matters, currency mismatches, international shocks and all sorts of unforeseeable contingencies. On top of the risks associated with borrowing, sovereign debt presents an added risk related to the impact that such market operations may have on internal monetary and fiscal policies.
83 UNDERSTANDING RISKS AND CHALLENGES
In the field of sovereign debt, risks need to be defined in an operational way in order to assess the counter measures needed to contain them (Inter-American Development Bank 2007). In a broader sense, the risks associated with debt contracts can be defined as the issuer’s likelihood of compliance with the debt contract. Risks embedded in debt contracts can also be identified in factors that may affect the stability of the private sector in certain sovereign countries. In other words, sovereign risks will encompass all the factors that can potentially affect the ability of the sovereign to meet the terms of the contractual debt.
Issues such as the total aggregated outstanding amount of debt, the structural maturity, the composition of interest rates, the currencies in which the debt has been incurred, market conditions and investors’ behaviour, among others, may contribute to the assessment of sovereign risk. Traditional risk assessments focus mainly on credit, liquidity, market conditions, the trade-off between cost and maturity. More recently, mainly after the global financial crisis of 2008 and the subsequent European Sovereign Debt Crisis, considering the chances of sovereign default and the financial implications of certain market conditions, the analysis of credit risks and liquidity risk has developed even further—into more granular components.
A bit of more modern history … In the late 20th century (1970-1990), banks were pursuing a highly profitable business, which consisted in rechannelling the money generated by the Organisation of the Petroleum Exporting Countries (OPEC) and lending it to developing countries in the form of loans.
Banks perceived these loans to sovereign countries as less risky than commercial or individual loans. As Walter Wriston (Chairman of Citibank from 1967-1984), stated in the New York Times on 14 September 1982, “… the country does not go bankrupt. Bankruptcy is a procedure developed in Western law to forgive the obligations of a person or a company that owes more than it has. Any country, however badly off, will “own” more than it “owes.” Needless to say, this was a paradigm shift from Edward III but also different from current times where there have been several episodes of countries incurring unsustainable amounts of debts that ended in unforgettable crises.
As one can imagine, different financial hazards have the potential effect of preventing a sovereign state from meeting its financial obligations. Sovereign risks can be categorised in different ways.
Figure 1 below presents a categorisation of sovereign risks, classified in two categories: financial and non-financial sovereign risks. Within the non-financial sovereign risks, the following risks can be observed: political, legal, and natural disasters (geophysical, hydrological, meteorological and climatic). Within the financial sovereign risks, the following risks can be observed: liquidity risk (funding and market), refinancing risk,
84 credit risk (sovereign credit and counterparty’s ability to meet the terms), contractual risk, contingent risk, market risk (foreign exchange, currency and interest rate risks) and operational risk.
Figure 3 - Sovereign Risks typology
2. SOVEREIGN RISKS 2.1 Non-Financial Sovereign Risks 2.1.1 Political
Political risk refers to the changes in domestic politics that may affect the sovereign’s ability to service its debt obligations. In other words, it refers to the political decisions that can jeopardise the fulfilment of previously acquired obligations.
An example would be a sovereign with future elections in which the majority candidate is campaigning on the possible repudiation of all its outstanding debt obligations. That single act—although it might not amount to a contractual default—will carry with it a
85 UNDERSTANDING RISKS AND CHALLENGES negative effect for the sovereign. This in turn can trigger an increase in financing costs or a lack of financing options since lenders would question the sovereign’s future willingness to repay validly entered debt obligations. Consequently, it may affect the sovereign’s ability to meet its obligations. 2.1.2 Legal
The sovereign legal risk is strongly linked with the political risk described above.
Following on the previous example, the majority candidate wins the election and creates a commission to examine the validity of all its outstanding debt obligations. There would be a legal instrument, i.e. an act of parliament, a law, an executive decree, a ministerial decision, etc. adopting the decision and creating a commission. From an ex post point of view, it can be seen as a materialization of a political decision through a legal act with a new (and sometimes greater) impact on the market.
It can also be connected with the passing of a new law, the enactment of a presidential decree or an administrative provision emanated from a relevant authority that can have a direct impact on the assumed obligations by the sovereign. Legal risk is quite relevant because in certain jurisdictions the division of powers envisaged by Montesquieu in his seminal work the Spirit of the Laws (1748) is not so evident.
Other sources of risk within the legal control have to do with compliance with particular terms such as administrative regulations of a foreign country or specific listing requirements, in the case of bonds/Eurobonds.
On the other hand, legal risks also relate to the possibility of being sued or affected by a counterparty contingency. In the case of the sovereign debt, it can be associated with the risk of being sued or an arbitration procedure being brought against the sovereign for non-compliance (directly or indirectly as a result of the counterparty’s non-compliance). 2.1.3 Natural Disasters
This sovereign risk is one to which no sovereign is exempt, although some sovereigns are more prone than others. It includes different variables or external forces geophysical (e.g. earthquakes), hydrological (e.g. floods), meteorological (e.g. hurricanes) and climatic (e.g. drought).
It refers to the effect of natural disasters on the sovereign’s ability to meet the financial obligations. Certain natural disasters may seriously affect the sovereign’s resources and strike at the core of its economy. This unforeseen sovereign risk needs to be taken into consideration when managing sovereign debt portfolios, especially in countries that are susceptible to suffering from these types of natural disasters. For example, Grenada, the sovereign nation located in the Caribbean, has included a provision in their debt instruments known as a “hurricane clause” that allows Grenada—if hit by a hurricane and depending on its severity—to stop servicing its interest payment for a pre-agreed period of time until the economy recovers. The interests are not forgone but will be capitalized into the principal amount. It provides the sovereign debtor with breathing space to regularize its finances and resume payments without a major disruption.
86 2.1.4 Operational Risk
In general terms, the operational risk in a non-sovereign context—refers to the operating costs in a given industry or its potential pitfalls (e.g. internal procedures, people and systems). It relates to the costs/risks of pragmatic logistics specific to the actual operation. In the field of sovereign debt, operational risk relates to all risks that can prevent the debt manager from performing the underlying debt obligations. The operational risk belongs to endogenous factors affecting the debt manager. Examples of this risk are broad and wide, but some of them may be the lack of technical knowledge, failure to track or record transactions, non-compliance with internal procedures (e.g. compliance management systems). 2.2 Financial Sovereign Risk 2.2.1 Liquidity risks
Companies, banks and sovereigns (or its political subdivisions) require access to borrowed funds (i.e. a liquid asset ) to operate on a regular basis and cover their costs. The inability to borrow or access financing within a reasonable timeframe could place their operations at risk.
Liquidity is defined as the ability to meet debt obligations when due, without incurring unacceptably large losses (otherwise, in the case of corporations, it can immediately lead to insolvency). Liquidity risk is the risk linked to the impossibility to meet outstanding obligations when due. In the area of sovereign debt, liquidity risk will relate to the impossibility of the sovereign to timely meet its obligations with the required immediacy, either through the internal procedure for money collection (e.g. taxes) or accessing new financing.
Liquidity risk in turn can be divided into “funding liquidity risk” and “market liquidity risk”, as two sub-types in which a sovereign may be presented with problems to comply with its obligations. While the first one will refer to internal means, the latter implies debt release to the market. 2.2.1.1 Funding Liquidity Risk
Sovereign funding liquidity risk relates to the inability of the sovereign to fund its needs (e.g. due to the shortage of cash flow generated through taxes) or lack of availability of securing alternative sources of financing to settle obligations with immediacy (Drehmann & Nikolaou 2009). It refers to the actual possibility that during a given period of time, a sovereign may not be able to cover or fund (and therefore “funding” liquidity risk) its borrowing needs, putting in peril its outstanding obligations. Not because it is insolvent, but because it does not have the temporary liquidity to do so. It would be a matter of time until the sovereign regains funding access to be able to face its liabilities. It is a financial
6 Cash or an asset that can easily be converted into cash is also known as a liquid asset.
87 UNDERSTANDING RISKS AND CHALLENGES problem, not an economic one. The main issue at stake is the cash flow constrain and the unavailability of the liquid resources to face liabilities. Sometimes, the sovereign funding liquidity risk would be caused not necessarily just by the inability to obtain the financing but due to difficulties generated in regular internal financing cycles, e.g. through the collection of taxes (or other means of financing by the sovereign).
It is important to highlight that once this risk is identified, neutralizing it may be difficult because it tends to encompass other risks such as contagion risk (the spread of the risk from one sovereign state to another) (Jonasson & Papaioannou 2018). 2.2.1.2 Market Liquidity Risk
Sovereign market liquidity risk relates to the liquidity of the sovereign instruments in the market. In this sense, it affects the ability to trade e.g. its bonds in international markets. This prospective difficulty to liquefy the financial instruments in the market is described as a multidimensional concept, which can be observed through several indicators.
Contrary to the concept of funding liquidity risk, this hazard is measured by the capability to collect funds in a required time. An excessive debt issuance may decrease the interest in the instruments of a particular issuer and as a consequence suffer a devaluation in its price making it harder to achieve the threshold of the obligation needs.
To an extent, the two liquidity risks (funding and market liquidity risks) can be seen as two sides of the same coin. When confronted with the task of identifying the sovereign liquidity risk, this may appear in the form of issues with temporary cash-flow issues, either as a result of: (1) funding, due to the lack of means to obtain the financing; or (2) market, not necessarily a reputational matter for the sovereign per se but an inability of the market to absorb the amount of debt and provide the required liquidity. 2.2.2 Refinancing Risk
This risk, also known as “rollover risk”, refers to the probability that the debt stock of a sovereign will need to be restructured because of recurring financial difficulties by the sovereign debtor. As it was presented in the introduction, several factors may affect the way in which sovereigns may be at risk of not being able to meet their obligations. One of the variables that could affect this ability to pay the debts was a structural maturity.
Maturity means the due date or deadline to meet outstanding obligations. It refers to the due day in which either the debtor pays, of there is a need to look for other alternatives to solve the failure of complying with the obligations stemming from the contract.
In this sense, one of the variables that best measures the rollover or refinancing risk is the maturity structure of the debt portfolio. This means that, if the terms to maturity of different instruments within a debt portfolio are concentrated on a particular date, the risk would be higher. The same may happen when the terms to fulfil the obligation are short and there are large individual needs of restructuration (Jonasson & Papaioannou 2018).
88 The interaction between sovereign refinancing risk and exchange risk: a dangerous correlation. In the case of short-term debts with due day payments compressed over a short time frame, the materialisation of the refinancing or rollover risk may easily lead to a sovereign debt crisis. This becomes more relevant when the debt is also exposed to foreign exchange risk.
Payment days gathered in a very short period of time may lead to a financing gap that can turn in a self-inflicted liquidity problem (and might trigger another risk, although it would be irrelevant as the conjunction of the other two could already be devastating).
As noted in a publication by the Inter-American Development Bank (2006),
“[m]ost of the literature on debt crises has focused on the combination of these two risks and shows that short-term external (hence, mostly foreign-currency- denominated) debt is a strong predictor of debt crises. In particular, studies have found that the higher the ratio of a country’s short-term dollar debt to international reserves, the higher the probability of a crisis in that country (Manasse, Roubini, and Schimmelpfennig, 2003). This provided a rationale for what became known as the Guidotti-Greenspan rule of reserve adequacy, which states that countries should always hold enough reserves to cover at least their external liabilities falling due within one year.”
2.2.3 Credit Risk
Broadly speaking, from an investor’s point of view, credit risk refers to the probability of not getting paid, as a result of the failure of the borrower to meet its obligations. This will amount to a contractual breach, which if not cured within the grace period, will produce a default. This risk may, consequently, trigger an interruption in the cash flow and consequently produce an increase in other risks. 2.2.3.1 Sovereign Credit Risk
This risk relates, from the perspective of the lender, to the capability of the sovereign to meet the payment obligations. In other words, the sovereign’s own credit risk to meet its obligations. It materialises when, e.g., the sovereign fails to meet its debt obligations and consequently leads to a higher risk perception in the market. The higher the debt assumed by a sovereign state, the higher the perceived risk of such state. 2.2.3.2 Counterparty Risk
Counterparty risk deals with any possible limitation to a counterparty’s ability to meet its obligations. In general terms, counterparty risk means the possibility that the counterparty of an obligation may not meet the terms of its agreement. To an extent, it
89 UNDERSTANDING RISKS AND CHALLENGES can be argued that it represents the other side of the same coin of sovereign credit risk. The main difference in terms of sovereign debt, is the perspective from where it is looked at: from the debtor or a related party (e.g. paying agent or underwriter). 2.2.4 Contractual Risk
Sovereign contractual risk can be seen as sub-category of the legal risk that was observed before under the “non-financial” risks. Sovereign contractual risk technically is a more precise sub-category of the more general category of legal risk. Contractual risk, although a legal risk, is only linked with legal risks of the contract, which is a financial instrument (and therefore is better to present it under the financial risks’ classification). Sovereign contractual risk refers to all the hazards derived from the interpretation, validity and enforceability of contracts. This risk encompasses the expected results of legal contests, the interpretation of the contractual provisions and the readings of same by the courts.
Carefully drafted contracts do not leave much space for legal loopholes that may affect the stability of the contracted obligations. Nowadays, carefully drafted contracts include state- of-the-art clauses that have been carefully assessed and recommended by international organizations with vast experience in debt contracts such as the International Capital Markets Association (ICMA). Some of these clauses are the collective action clauses (CACs) or the post-Argentine litigation streamlined pari passu clause. 2.2.5 Contingent Risk
Donald Rumsfeld (former U.S. Secretary of Defence) infamously stated “… as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.” In the area of sovereign risk, his reference to “known unknowns” can be relevant to explain contingent risk. Sovereign contingent risk encompasses those risks or liabilities that might arise depending on other particular events. Important characteristic elements of this risk relate to whether they are future and potential or contingent.
Contingent risk can result from potential financial claims, granted guarantees, unforeseen risk factors, exchange rate fluctuations, administrative fees and other liability circumstances that can directly affect the sovereign debt portfolio and the prospective borrowing plan.
A typical example of contingent risk is when a sovereign guarantees a credit facility of a political subdivision or of a state-owned enterprise. If the financial situation deteriorates and the borrower defaults, this is a liability that will pass onto the sovereign’s balance sheet.
Because of this risk, it is always advisable that sovereign debt portfolio managers secure the sovereign financial position and generate several plans which include a margin for
90 UNDERSTANDING RISKS AND CHALLENGES
contingency risks. The higher the amount of operations and transactions, the higher the overall risks. The point in which more transactions implicate a raise in the risk which becomes not worth assuming, should be a part of the debt management strategy. 2.2.5.1 Fiscal Risk
Jonasson & Papaioannou define fiscal risk as a possibility of deviations of fiscal outcomes from what was expected affecting the overall financing needs resulting from macroeconomic shocks and the materialisation of contingent liabilities (Jonasson & Papaioannou 2018). Unexpected expenses as a result of a shock to interest and exchange rates may modify the costs of meeting the contracted obligations, resulting in a fiscal risk. Fiscal risk can be classified as a type of risk in itself although it tends to have a contingent element that usually creates confusion and is subsumed into a category or variation of contingent risk.
In a study of fiscal risk, Polackova created a detailed table—known as the “fiscal risk matrix” — to illustrate four types of fiscal risk faced by Governments, out of which a liability has to combine two of these characteristics: explicit versus implicit and direct versus contingent. This table shows the interaction between fiscal and contingent risk providing actual examples.
Liabilities of a Direct (obligation in any event) Contingent (obligation if a particular event occurs) fiscal authority (not the Central Bank)
Explicit • Foreign and domestic • State guarantees for non-sovereign borrowing Government liability sovereign borrowing (loans and obligations issued to subnational governments and is recognized by law contracted and securities issued by public and private sector entities (development banks) or contract the central government) • Umbrella state guarantees for various types of • Expenditures by budget loans (such as for mortgages, students studying law agriculture, and small businesses) • Budget expenditures • State guarantees (for trade and the exchange legally binding in the long-term (civil rate, borrowing by a foreign sovereign state, private service salaries, civil service investments) pensions) • State insurance schemes (for deposits, minimum returns from private pension funds, crops, floods, war risk)
Implicit • Future recurrent costs of • Default of a subnational government and public A “moral” obligation public investment projects or private entity on nonguaranteed debt and other of the government • Future public pensions liabilities that mainly reflects (as opposed to civil service • Clean-up of the liabilities of privatized entities public expectations pensions) if not required by law • Bank failure (beyond state insurance) and pressures by • Social security schemes if • Investment failure of a nonguaranteed pension interest groups not required by law fund, employment fund, or social security fund (social • Future health care protection of small investors) financing if not specified by law • Default of the central bank on its obligations (foreign exchange contracts, currency defence, balance of payments stability) • Bailouts following a reversal in private capital flows • Residual environmental damage, disaster relief, military financing, and the like
91 2.2.6 Market Risk
In general terms, market risk refers to the overall possibility of an investor or debtor suffering unexpected losses due to issues that affect the holistic performance of the markets in which they operate. Sovereign market risk is embedded in any operation that takes place in the financial markets. It is sometimes also referred to as systemic risk, because it affects the whole “system” or environment of operation. It is worth mentioning that the factors that may affect the markets can be both, financial and non-financial.
Probably in the context of sovereign debt, the two more relevant are: foreign exchange risk and interest risk, which are explained below. In the same way as all the other risks, this risk cannot be reduced to zero, although it can be properly hedged. 2.2.6.1 Foreign Exchange Risk
One of the risks embedded in a market is the currency in which this market normally operates, or the exchange rates with other currencies. Literature has shown that when assuming a foreign currency debt, the sovereign may present an aggregate currency mismatch. If the exchange rate suffers a devaluation, the national product’s net liability would increase. On the other hand, an increase in the value would reduce it. This may represent an exposure to the risk of currency fluctuations (Inter-American Development Bank 2007).
Foreign exchange risk is related to the fluctuation in foreign currencies and the consequential effect that it has on the interests and costs of debt issuance. This represents a principal risk in some government debt portfolios and requires particular attention. As stated in an IMF working paper,
“A risk factor is the volatility of the exchange rate, and the extent of the exchange rate exposure of the debt portfolio depends on the magnitude of the changes in exchange rates. The debt manager can affect the exposure by varying the composition of his debt portfolio, but he cannot affect the risk factor: the exchange rate. From this relationship, it is easy to observe that the more the risk factor is transferred into the foreign currency risk, the greater the exposure to foreign currency risk” (Jonasson & Papaioannou 2018). 2.2.6.2 Interest Rate Risk
This risk is related to the cost of servicing sovereign debt, taking into consideration domestic and foreign interest rates’ fluctuations. In general terms, it means the probability that the cost of debt or value of an investment changes due to the change in the general interest rates, or any other interest rate related issue.
The principal measures to contain and manage such risk, are diversification of the debt portfolio or hedging. 3. DEBT-TO-GDP RATIO
The debt-to-GDP ratio reflects the ratio between the government’s debt and its gross domestic product. This ratio presupposes that by comparing the sovereign’s production
92 UNDERSTANDING RISKS AND CHALLENGES with its debt assumed, will provide a variable to measure and predict the sovereign’s ability to repay its debts.
Some scholars had argued that, when analysing emerging-market countries, capital flows have a very important impact operating with a cyclic pattern. According to Reinhart et al.,
“[w]hen interest rates are low, when liquidity is ample, and when the prospects for equity markets dim in the world’s financial centers, investors will seek higher returns elsewhere. During these periods, it is easier for governments in emerging markets to borrow abroad— and borrow they do. But history has shown that, for many of these countries, to borrow is to brook default. As the track record of serial default highlights, many of these booms ended in tears. The policy challenge for these countries is to address a chronic long-term problem— their own debt intolerance—rather than take remedial measures that will allow them to regain the favor of international capital markets for a few brief months or years.” (Reinhart, Rogoff & Savastano 2003).
The diagram below illustrates the classification provided by Reinhart et. al. based on the type of countries and their default proneness/access to the international capital markets.
Advanced countries Benefit from that have never continuous access defaulted (at least in to the international recent history) capital markets
Intermediate group of Type 1: Countries above the average ratings countries where default and low indebtedness > close to «Club A» risk is quite relevant Type 2: Countries below the average and self-fulfilling runs ratings and with high indebtedness >> low can trigger a crisis creditworthiness and pay high interest rates
Sporadic access to the Debt intolerant international capital markets
These authors, Reinhart et. al., argue that “safe” thresholds for highly debt-intolerant emerging markets (the so called “serial” defaulters) should be as low as 15 to 20% of their GNP but this will depend on the sovereign’s record of default and inflation (other factors, such as the degree of dollarization, indexation to inflation or short-term interest rates, the maturity structure of a country’s debt, are also relevant to assessing a country’s vulnerability). These debt-intolerant countries tend to be dragged into spiralling crises due to their characteristic weak fiscal structures and weak financial systems where the lack of reputation does not prevent them from defaulting again—they have not much to lose.
Reinhart et al. conclude that once a country slips into being a serial defaulter, it retains a
7 GNP is different to GDP as it also includes production/income of national entities abroad. GDP measures value of all goods and services produced within a nation’s geographic borders over a specified period of time, i.e. the domestic levels of production in a country. GNP measures the levels of production, compensation and investment income of all the citizens or corporations from a particular country working or producing in any country.
93 high level of debt intolerance that is very difficult to revert. Therefore, emerging market economies should have a maximum prudent debt-to-GNP of 35%. Other authors suggest a debt-to-GDP of 30% (Artana, Lopez-Murphy and Navajas 2003).
On the contrary, Porzecanski, argues that the debt-to-GDP ratio is a “simplistic notion” that just equates the public debt burden to the difficulties of meeting the terms of the assumed obligations. According to this author, there is no reliable evidence of a pattern that proves a correlation between the assumed sovereign debt and the debt-servicing risks (Porzecanski 2018). Examples such as Ecuador in 2008 (27%) and Nicaragua in 2003 (236%) show a huge standard deviation, evidencing a non-reliable variance (Porzecanski 2018).
Debt-to-GDP in the European Union In the case of the European Union, the debt-to-GDP ratio has been one of the indicators to assess debt sustainability. The 1992 Maastricht Treaty foresaw a maximum of 3% GDP for actual or planned budget deficit and the stock of government debt should not exceed 60% of the GDP. The criterium established in the Maastricht Treaty has been improved through technical regulation. Member states have to maintain cyclically adjusted positions close to balance or in surplus. In the event of non-compliance, EU member States can be subject to warnings and eventually, sanctions. This notwithstanding, in practice, countries tend to exceed this requirement in the European continent and elsewhere.
For example, the average debt-to-GDP in the whole of Africa is 55%. However, the top 10 countries with the highest debt-to-GDP ratios are (estimates as of Nov. 2018):
94 4. OUTLINING AND MONITORING THE USE OF FUNDS
The way of managing the sovereign debt portfolio is through Liability Management Operations (LMOs). LMOs are market-based transactions which aim to deal with funding, debt risks and debt portfolio profiles (Jonasson & Papaioannou 2018). These LMOs are regularly used in situations of normal day-to-day debt management (e.g. bond buy-backs, swapping indebtedness currencies, issuing long-term obligations to redeem short-term obligations, transforming fixed-rate coupons into floating-rate coupons or vice versa, etc.). However, they may also be used for restructuring or re-profiling sovereign debt.
In order to minimise the risks that come with the debt portfolio management, there is a need for transparency in every operation. A traceable thread of the transactions and investments will help to reduce a vast amount of risks and liabilities, such as contingent and legal risks.
Equally important, and deeply connected with transparency, is the need for accountability. Debt managers need to explain their actions and be accountable for them. This justification needs to be seen as a plan of action, an outline of their debt managing strategies to be able to entice investors through a clearly planned and logical strategy that serves to reduce risks.
Authors like Buchheit remind us the intergenerational aspect of sovereign debt where the debts incurred by a present government will have to be repaid by generations to come (Lastra and Buchheit, 2014). In analysing the intergenerational nature of sovereign debt, the following aspects should be considered: (1) debts are transferred by one government to another due to the principle of public international law of state succession; (2) that these debts are issued with long-term horizons (long stop maturity dates); and, (3) most likely the governments that incurred the debt will not be in office when the debt has to be repaid. Bearing this in mind and that—most likely—we are paying our predecessors’ debts and our successors will have to pay our debts, and so on and so forth, the issue of accountability is quintessential to sovereign debt.
5. PREDECESSOR DEBT
Aristotle, in Book III of Politics already posed the question of whether debts should be attached to a new state (Aristotle, Politics). Towards the end of Part II of Book III, he discusses the situation where citizens have been required to fulfil their obligations after a revolution and whether a certain act is or is not an act of the state. At the beginning of Book III, he questions:
“…whether a certain act is or is not an act of the state; for example, in the transition from an oligarchy or a tyranny to a democracy. In such cases persons refuse to fulfil their contracts or any other obligations, on the ground that the tyrant, and not the state, contracted them; they argue that some constitutions are established by force, and not for the sake of the common good. But this would apply equally to democracies, for they too may be founded on violence,
95 UNDERSTANDING RISKS AND CHALLENGES and then the acts of the democracy will be neither more nor less acts of the state in question than those of an oligarchy or of a tyranny”
In modern times this gap has been filled by an international public law doctrine that contends that a successor government is liable for the financial obligations incurred by the prior government despite the nature of the government, i.e. the doctrine of state succession. Although there might be a change of regime (e.g. a monarchy for a republic) or in the governing nature (e.g. absolutism by constitutionalism), these issues do not affect the international position of the sovereign as such. In Moore’s words, the:
‘[c]hanges in the government or the internal polity of a state do not as a rule affect its position in international law. A monarchy may be transformed into a republic, or a republic into a monarchy; absolute principles may be substituted for constitutional, or the reverse; but, though the government changes, the nation remains, with rights and obligations unimpaired’(Moore, 1970).
The rationale behind the state succession doctrine is that the government in office should be separated from the sovereign state (Hoeflich, 1982). In other words, the government is an agent contracting on behalf of the debtor, the sovereign state. 6. CONCLUSION
In this Module, the sources of risk and challenges that sovereigns may confront when managing their debt portfolio were outlined. The main objective was to present some of the main sources of risk in the sovereign debt context.
Overall, risks are embedded in every transaction. The new paradigm in modern societies towards risk, i.e. hedging risk, relies on the acceptable threshold of “assumable” risk. Once the acceptable amount of risk is defined, the following steps are the management of these risks plus those that are contingent (known unknowns) or even those that we do not know that we know (unknown, unknowns). This management activity should include policies and procedures to assure transparency and delimit the levels of risk assumed with every operation. Moreover, a more responsible attitude should be encouraged were accountability plays a key role. While risks may never be eradicated, properly implemented debt management activities (LMOs) can considerably reduce the liability impact that risks may have on national and international economies, if materialised.
96 UNDERSTANDING RISKS AND CHALLENGES
References
Aristotle, Politics, Book III, Part III, available online at http://classics.mit.edu/Aristotle/ politics.3.three.html , translated by Benjamin Jowett.
Artana, D., Lopez-Murphy, R. and Navajas, F., A Fiscal Policy Agenda, in Kuczynski, P. and Williamson, J., After the Washington Consensus: Restarting Growth and Reform in Latin America (eds.), Institute for International Economics 2003.
Beck, U., 1992, Risk society: towards a new modernity, Sage, London.
Drehmann, M. & Nikolaou, K., 2009, ‘Funding Liquidity Risk: Definition and Measurement’, 51.
Hoeflich, M.H., 1982, ‘Through a Glass Darkly: Reflections upon the History of the International Law of Public Debt in Connection with State Succession Symposium: Default by Foreign Government Debtors’, University of Illinois Law Review, 39.
Inter-American Development Bank, 2007, Living with Debt: How to Limit the Risks of Sovereign Finance, 2007 Report.
Lastra, R. and Buchheit, L., Sovereign Debt Management, Oxford University Press, 2014.
Moore, J.B., 1970, A digest of international law, vol. 1, AMS, New York.
Polackova, H., Government Contingent Liabilities: A Hidden Risk to Fiscal Stability, World Bank, 1998.
Porzecanski, A., 2018, Debunking the Relevance of the Debt-to-GDP Ratio.
Reinhart, C.M., Rogoff, K.S. & Savastano, M.A., 2003, ‘Debt Intolerance’, National Bureau of Economic Research Working Paper Series, No. 9908.
Reinhart, C.M., Rogoff, K.S., 2009, ‘This Time is Different: Eight Centuries of Financial Folly’, Princeton.
Jonasson, T. & Papaioannou, M., 2018, A Primer on Managing Sovereign Debt-Portfolio Risks, International Monetary Fund.
97 CHAPTER 7
INTRODUCTION TO DISPUTE RESOLUTION IN SOVEREIGN DEBT
1. Introduction 2. Choosing Where to Sue 3. Enforcing the Judgment 4. Using a Fiscal Agent or a Trust Structure 5. The History of the Pari Passu clause 6. Pari passu litigation: Prominent case studies 6.1 Peru
6.2 Argentina 7 Debtor strategies to neutralise holdouts 7.1 Contractual sweeteners 7.2 Collective Action Clauses (CACs) 7.3 Exit consents 8 Conclusion References INTRODUCTION TO DISPUTE RESOLUTION IN SOVEREIGN DEBT
1. INTRODUCTION
There are a myriad of ways in which a country can fall into financial distress. It is, many times, a slow descent, a deterioration of economic conditions equally owing to mismanagement, domestic constraints and external pressures that increasingly thin the public purse and threaten the country’s ability to repay its obligations. Other times, it is a sudden tragedy, an earthquake or hurricane that, aside from the pain it inflicts, from the human cost it wreaks, leaves behind a ravaged, barren land, deprived of the resources to invest in a much-needed recovery, and of paying out external creditors whose monetary satisfaction will imply the diminishment of recovery efforts. In some unfortunate cases, as in the case of the U.S. territory of Puerto Rico, one comes after the other.
When either is the case, and paying their monetary obligations in full and on time seems untenable, countries will seek to restructure their debt. In so doing, as mentioned before, sovereign debtors have three options, that may be used separately or in tandem. They can seek a rescheduling, which solely implies the extension of the maturity date for the payment of principal or the forbearance of interest payments until a later date. They can also seek to reduce the interest rate payable on their debt without affecting the payable principal amount on the debt. Finally, they can seek a haircut, the most drastic of the three, which is a reduction of the principal for which the sovereign debtor contracted the debt. Often, restructurings will contain some combination of the three.
To do any of these, a sovereign debtor will propose what is known as an “exchange offer.” They will offer their creditors new bonds that contain the terms under which they desire to restructure their debt in exchange for the old bonds that the sovereign has defaulted on or will default on. The exchange offer will contain a cut-off date by which the sovereign debtor will exchange the bonds to any consenting creditors. Thereafter, the sovereign debtor will usually cancel the old bonds and proceed to make payments solely on the new, restructured bonds. Creditors that refuse to exchange their defaulted bonds for the new, restructured ones are known as “holdout creditors.”
For most of the 20th century, sovereign debt restructuring took place through a mostly consensual dynamic, within informal frameworks such as the Paris Club in respect of official bilateral debt, or ad-hoc London Club meetings in respect of private syndicated loans. It was a system that worked for both lenders and borrowers; it was, in any case, very difficult for creditors to attach the assets of sovereigns outside of the sovereign’s country, even if they could pierce the threshold shield of sovereign immunity. Furthermore, lending banks in a syndicate acted through consensus mechanisms, and were routinely inclined to negotiate with sovereign debtors instead of choosing a more litigious route, lest they harmed their chances of recovery. Sovereign debtors, for their part, feared the reputational cost that they could face in the markets from adopting an aggressive stance towards creditors.
All of that changed roughly twenty years ago. Due to the transition from syndicated lending to bonds in private sector sovereign lending, ownership of bonds has become diffuse and has expanded to all types of investors. The recovery strategies of these bondholders have also become diverse, depending on their investment strategies. Distressed debt funds, derogatorily known as “vulture funds”, have increasingly taken on a vanguard role in sovereign debt restructurings through their litigious stance against sovereign debtors.
99 This Module discusses the choice of law and jurisdiction clauses in sovereign debt instruments, the relevance of state immunity to sovereign debt litigation, the difference between a fiscal agent arrangement and a trust structure and its repercussions for attachment over the sovereign’s assets, it traces the legal history of the pari passu clause in sovereign finance, reviews recent case studies in sovereign debt litigation, and will present a survey of strategies employed by sovereign debtors to deal with holdout creditors and conduct successful restructurings. 2. CHOOSING WHERE TO SUE
Upon an event of default, sovereign states usually establish that the situation is a public emergency by means of passing a law or enacting an executive order or decree. For example, upon the Argentine crisis of 2001 the Congress passed law 25,561 declaring the public emergency of Argentina, particularly in the social, economic, administrative, financial, and currency exchange areas. After such a proclamation with the force of law, it is likely that local courts would not dare rule against the default and the extraordinary measures instituted by the sovereign’s government due to the emergency situation faced by the country. This is the reason why creditors are virtually left with no choice but to pursue their credit in a country different from that of the debtor. Otherwise, they have to face the uncertainty of litigating in an unpredictable and unfriendly jurisdiction where the legislative machinery can change the rules of process. In pursuit of fairness and neutrality, creditors will prefer to sue in the courts of their own country or in the courts of the applicable law of the debt instruments, which usually is not that of the debtor’s country.
As discussed in previous Modules, bond instruments will include a choice of law clause. However, when interpreting the bond instrument, a court would apply its own choice of law rules to determine whether the contractual choice made by the parties can be upheld. This could imply that a court might have to apply a law with which it has no familiarity. In international bond issuances, this uncertainty has been resolved by the sovereign borrower’s submission to a perceived fair, neutral, and expert forum in the jurisdiction of the selected governing law, which in most cases means English or New York state law. Thus, bond instruments often include submission to jurisdiction to the courts of New York or England and Wales. These two jurisdictions will provide the certainty and predictability that a creditor requires.
After having preliminarily decided where to sue, the creditor is faced with another dilemma. Is the debtor entitled to sovereign or state immunity, as referred under New York and English law, respectively? Both under New York law and English law there are certain situations in which the sovereign is entitled to sovereign/state immunity from jurisdiction or adjudication as well as from attachment and execution.
In addition to proving the effectiveness of a waiver of immunity or an immunity exception from jurisdiction, a bondholder has to demonstrate that the court has personal jurisdiction over the sovereign as well as subject matter jurisdiction over the suit to be able to sue a sovereign.
A common practice in sovereign debt financing is the submission to jurisdiction, i.e. that the sovereign has: (1) submitted to the court; (2) appointed a process agent; and, (3) expressly waived immunity from suit. Even, if this is not the case, obtaining a favourable judgement to
100 collect on defaulted debt instruments issued by a sovereign under New York and English law is relatively straightforward. Since issuing a bond is a commercial activity, the sovereign issuer submits himself to the jurisdiction as a private party subject to the courts of law. If there were any doubts in this respect, in 1992 the U.S. Supreme Court had to resolve a case involving the rescheduling of sovereign bonds, which became a landmark in sovereign immunity. In Republic of Argentina v Weltover, Inc, bondholders brought a breach of contract action against Argentina and its central bank pleading that the issuance of bonds and Argentina’s unilateral extension of its payment date falls within the U.S. Foreign State Immunity Act 1976 (FSIA) immunity exception because it is ‘a commercial activity of the foreign state’ that has ‘a direct effect in the United States’. The U.S. Supreme Court held that: (1) “[w]hen a foreign government acts, not as a regulator of a market, but in the manner of a private player within it, the foreign sovereign’s actions are ‘commercial’ within the meaning of the Foreign Sovereign Immunities Act”; and (2) a unilateral rescheduling of the bond payments has a ‘direct effect’ in the United States, which was designated as the place of performance for Argentina’s ultimate contractual obligations even though the bondholders were foreign corporations. Therefore, New York courts normally have personal and subject matter jurisdiction. In addition, issuing a bond is neither protected by sovereign immunity nor is it an act of state. State immunity will bar the court from hearing the case and passing judgment over the sovereign. An act of state will bar the court from questioning an act of a foreign state—it assumes the lawfulness of the act. Whether the sovereign has submitted to jurisdiction or not, the creditor would be able to bring a suit and, if it is successful, he will be entitled to a court judgment for the payment of money. 3. ENFORCING THE JUDGMENT
Upon obtaining a favourable judgment, the creditor would have different alternatives to enforce the money judgment. However, the basic enforcement device is property execution. Here is where creditors are faced with two alternatives: (1) execute property within the debtors’ territory by means of recognition of a foreign court decision; or (2) try to execute property abroad. These two alternatives have pros and cons. Executing property in the sovereign state faces the creditor with the issue that it would be highly probable that due to public policy reasons, the judgment would not be enforced or if enforced it would be payable with other debt instruments with very unattractive financial terms (long-term maturity and trading in a secondary market at discount). The benefits are that there would be assets to enforce the money judgment forcing the sovereign to settle or be condemned to pay in specie (with bonds). The drawback is that the execution process would be completely uncertain plus a new law (or executive decree) can change the ‘rules of the game’. On the other hand, if the creditor tries to execute the monetary judgment abroad, for example in New York or England, the pros are that the whole process is clearly determined and even an outcome can be predicted because there have been many cases where sovereigns have been sued as a result of their default (in opposition to suing in the sovereign’s own courts where the process will be characterised by its uncertainty). However, the cons are that it would be very difficult to find assets to enforce the money judgment.
The basic enforcement device is execution of property. Sovereign states usually do not have
101 INTRODUCTION TO DISPUTE RESOLUTION IN SOVEREIGN DEBT many assets located abroad and if they do, not all of them are capable of being attached because some of them enjoy statutory immunity from the processes of execution (injunctive relief and execution). The U.S. restricted sovereign immunity through its FSIA and the U.K. through its State Immunity Act 1978 (SIA). Thus, while a waiver of sovereign immunity by itself may ensure a victory in court when the sovereign debtor is in default, without any attachable assets, a rendered judgment can be useless. Given that creditors can only attach assets that are in the court’s jurisdiction, a smart sovereign can simply avoid placing any assets in the U.S. or U.K., where most of these litigations take place. Furthermore, the assets of state instrumentalities and central banks may not be subject to attachment in a litigation against the sovereign, despite their public nature and close association, and often control, by the sovereign’s central government. Finally, sovereign debtors, in opting for a trust structure over a fiscal agent arrangement, can protect their funds destined to certain creditors from attachment by other litigious creditors through the legal structure they use to issue their bonds. It is worth remembering that sovereigns usually transfer funds to international financial centres to pay outstanding financial obligations (e.g. newly issued restructured bonds). 4. USING A FISCAL AGENT OR A TRUST STRUCTURE
When issuing debt, the sovereign has to choose between using either a fiscal agent or a trust structure. Trust deeds and fiscal agreements represent an important aspect of structuring sovereign debt issues, particularly in the case of potential litigation. Under a fiscal agent agreement, a fiscal agent is appointed to handle the ‘fiscal’ matters of the issuer (e.g., redeeming bonds and coupons at maturity). Under a trust structure (termed as an indenture or a deed, depending if it is under New York or English law, respectively), a trustee is appointed as a fiduciary managing the matters related to the issuance to ensure that the issuer meets all the terms and conditions of the issuance. The main difference between these two structures used in bond issuances is that the fiscal agent acts as a representative and agent of the issuer while the trustee is a fiduciary representing the bondholders. Although the fiscal agent structure has been the prevailing practice in international bond issuances, recent bond issuances have shifted to the use of trust structures. The distinction between the fiscal agent and the trustee is not a minor issue. The difference is that payments made through a trustee cannot be attached because as soon as the funds are deposited in the trustee’s account, they are no longer the sovereign’s funds, on the contrary, they are held by the trustee acting on behalf of the bondholders. In the case of the fiscal agent, since the funds held on a fiscal agent account are funds of the sovereign, until those funds are deposited in each bondholder’s account, they are susceptible to attachment as assets of the sovereign debtor.
However, until the funds have been deposited in the trust account, they are in transit and subject to attachments (they still are funds of the sovereign). This is the reason why the place of payment is relevant and indistinctly if they are going to be deposited in the fiscal agent or the trustee’s account. There are two possible scenarios: first is that the fiscal agent or the trustee has an account outside or inside the sovereign’s jurisdiction. If the account is held outside the sovereign’s jurisdiction, the funds can be threatened by an attachment. The second scenario, i.e. accounts held within the sovereign’s jurisdiction, requires a twofold analysis: the case of the
102 INTRODUCTION TO DISPUTE RESOLUTION IN SOVEREIGN DEBT fiscal agent and the case of the trustee. In the case of the fiscal agent with an account within the jurisdiction of the sovereign, the situation would be the same as in the case of an account outside the jurisdiction because the fiscal agent will have to repatriate the funds to arrange the payments to the sovereign’s creditors. The case of the trustee is different because funds can be safely deposited in the trustee’s account within the sovereign’s jurisdiction and then be transferred abroad. Once the funds have safely reached the trustee’s account, the ownership over those funds is transferred to the creditors via the fiduciary duty of the trustee.
Finally, it is worth mentioning that the ‘safety’ of the governmental funds within its own jurisdiction is so because it will implement the required mechanisms to shield or insulate said funds from potential attachments. It could be either by passing or enacting emergency laws, decrees, resorting to the legislative branch and ‘bending’ its arm in favour of the stability and wellbeing of the country’s economy.
Despite the added protection that trust structures bring to sovereign’s assets, sovereign debtors have been brought to their knees in some litigations over the past two decades through a formerly little-known clause included in sovereign bond contracts known as the “pari passu clause.” Holdout creditors have repeatedly requested courts to enforce the pari passu clause, and particularly, their novel interpretation of what that clause means, in order to prevent sovereign debtors from making payments to any new bonds tendered in an exchange offer if the sovereign does not, at the same time, make payments on the old bonds held by the holdout creditors. This has, in practice, frustrated the goal of exchange offers for sovereign debtors. 5. THE HISTORY OF THE PARI PASSU CLAUSE
The pari passu clause is common in contemporary sovereign debt instruments, and has played an outsized role in recent sovereign debt restructurings; however, its origins in the world of sovereign debt are an anomaly, albeit one that has proved very useful for creditors. In its basic iteration, the pari passu clause states that, at all times, the payment obligations under the loan agreement or bond will rank equally with the borrower’s other external indebtedness.
Originally, this clause was only present in secured lending, where the debt was secured by an asset as collateral. Its purpose was to achieve inter-creditor parity; through the clause, no creditor could receive a more senior claim on the asset used as collateral. This was important because otherwise, in a bankruptcy procedure one creditor with a senior claim over the collateral could take it for itself, leaving other lenders bereft of protection.
Given the aforementioned origin of the clause, its inclusion in sovereign debt instruments, which are largely unsecured, would seem odd. Slowly, however, as the market for Eurobonds and Eurodollar loan facilities (i.e. foreign currency-denominated debt) grew in magnitude and sophistication, financial lawyers sought to include more and more clauses that purported to offer additional legal protection to lenders. One of these was the pari passu clause. The specific reason the pari passu clause was included in sovereign debt instruments was country- specific. Lawyers that specialised in sovereign debt realised that in civil law jurisdictions, specifically those with a Spanish law tradition, an unsecured lender could be subordinated to a new unsecured lender without the former’s consent, with the legal effect that in a bankruptcy proceeding, the debtor would be compelled to pay the new unsecured lender first. As such, lawyers introduced the pari passu clause initially for corporate loan arrangements. This clause later migrated into sovereign bond issues.
103 Over time, it became part of the legal boilerplate for these agreements, although under New York and English law, unsecured creditors could not be involuntarily subordinated to other unsecured creditors. Additionally, as Buchheit and Pam (2004) have commented, the idea of payment obligations that are junior, mezzanine, and senior, do not make sense in the context of sovereign debtors; since sovereigns are not subject to bankruptcy procedures, there is no orderly process by which creditors are organised according to the position they hold in the priority of payments.
Even though the pari passu clause had its origin and raison d’ être in a specific class of debt instruments, and its initial inclusion was only for sovereign debt instruments governed by a limited set of governing laws, its interpretation by litigious creditors would have far-reaching consequences for countries seeking to restructure their debt. Holdouts of exchange offers, seeking legal grounds to achieve recovery on the face value of the debt they held, pored over bond clauses to fashion legal strategies. In the pari passu clause, they found unexpectedly useful terms. According to their interpretation of the terms of pari passu clauses, the text implied obligations for the borrower that went beyond the traditional understanding of the clause, namely, that a debtor could not formally subordinate one creditor in respect to the rest of its indebtedness. Instead, the clause was creatively read to require that the borrower make payments on all of its obligations on a pro rata basis. 6. PARI PASSU LITIGATION: PROMINENT CASE STUDIES 6.1 Peru
This broad interpretation of the pari passu clause was first tested in a litigation brought against the Republic of Perú by a now notorious distressed debt fund, Elliot Associates (“Elliot”). But before they were victorious, Elliot had to wage a legal battle on both sides of the Atlantic. 6.1.1 Champerty
Peru defaulted on its debt in 1984, and in 1996, it conducted an exchange offer, offering investors new, restructured bonds with a fifty percent haircut over the original value of the old bonds. Ninety percent of the country’s creditors agreed to the exchange. Elliot, for its part, declined to participate in the exchange offer; instead, it held out for full repayment on the face value of its old bonds, which Peru did not intend to pay anymore.
In order to force the Republic of Perú to make good on its payment obligations, Elliott did what any borrower would do: it sued the country for specific performance of the contract in order to receive a monetary judgment. However, Elliott had one major obstacle to achieving this: the champerty rule. The champerty defence, a product of English common law that persisted in state law in the United States, prohibited the enforcement of a claim that had been purchased for the sole intent of suing for repayment, on the grounds that this was an abuse of the legal process.
In consideration of the champerty rule, the federal district court that originally oversaw the case of Elliott Associates L.P. v. Republic of Peru barred the claims brought by Elliott based on its determination that Elliott had bought the already distressed debt specifically to sue for repayment. However, on appeal, the Second Circuit Court of Appeals rendered a verdict: it considered that Elliott’s intent to sue on the debt was only contingent on whether it would be
104 paid or not. As such, since suing on the debt was only an alternative and not the sole intent of Elliott, it did not fulfil the intent requirement of the rule. This effectively rendered the champerty defence toothless, because although it was clear that Elliott Associates had bought defaulted debt to sue for breach, the court established such a strict standard for the intent element that it would be extremely difficult for debtors to prove that a creditor had bought a debt solely for the intent of suing. The champerty defence has been stricken from the books for debts having a face value of over USD500,000. 6.1.2 Pari Passu
Thanks to this victory, Elliott received a monetary judgment against Peru in the U.S. But even with this success, the judgment that Elliott received was not very useful, because there were no assets that Elliott could attach in that country. Elliott Associates thus had to take its legal battle to the courts of Belgium, where the firm Euroclear, one of the main clearing houses in Europe and the world was located. Peru used Euroclear’s service to make payments on its debt to creditors who had agreed to its 1996 exchange offer and held restructured bonds.
In Belgian court, Elliott argued not simply for breach of contract and an enforcement of its monetary claim, as it had done in the United States; instead, it requested that the court enforce the pari passu clause in the bond instrument, using a broad interpretation of what that clause stood for. According to Elliott, Belgian courts had to order a halt to payments to creditors with restructured bonds, unless and until Peru made rateable payments on all of its outstanding bonds, including the defaulted bonds held by Elliott. Although, as in New York, the trial court disagreed with the firm, the Brussels Court of Appeals reversed the trial court and issued a restraining order to Peru’s fiscal agent and Euroclear to enjoin them from making any payments on restructured bonds unless payments on all bonds were made on a pro rata basis. The Brussels Court of Appeals directly adopted Elliott’s theory in the reasoning laid out in its resolution.
The novel, broad interpretation of the pari passu clause in sovereign bond instruments was remarkable, but dismissed by most practitioners as an ill-conceived judgment from a court not necessarily versed in the interpretation of New York law. However, it set a precedent; although the result was reached in Belgium, it set the stage for Elliott and other distressed debt funds to rely on that legal theory and employ it elsewhere, which they proceeded to do. Nowhere was this more prominent than in Argentina’s debt litigation saga. 6.2 Argentina
In 1994, Argentina started issuing bonds to investors under a Fiscal Agency Agreement (FAA). The FAA’s clauses would end up being decisive when, in late 2001, Argentina would default on USD82 billion of its sovereign debt, then the largest sovereign default in history. The FAA, like other bond agreements of the time, contained a pari passu clause. The text, in relevant part, declared that:
“The Securities will constitute . . . direct, unconditional, unsecured and unsubordinated obligations of the Republic and shall at all times 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
105 INTRODUCTION TO DISPUTE RESOLUTION IN SOVEREIGN DEBT
Indebtedness.”
The pari passu clause in question had two parts, an internal and external part. The first part stated that the bonds issued under the FAA would not be ranked unequally between themselves. But, of course, Argentina had other external debt aside from that issued under this Agreement. Thus, the text also ensured that the bonds under the FAA would not be ranked unequally with any other Argentinian debt. In order to do that, the second part states that the bonds under the FAA will rank equally with present and future unsecured and unsubordinated external indebtedness. This prevented Argentina from, in the future, issuing bonds that could rank ahead of the bonds issued under the FAA in terms of the country’s payment obligations. 6.2.1 Lock Law
After its default in late 2001, Argentina spent the next three years without coming to an agreement with creditors, with one failed exchange offer in 2003. Finally, in 2005, Argentina presented an exchange offer to which 76% of bondholders consented. Argentina was clear that it had no intention of paying bondholders that did not tender their bonds in the exchange and instead decided to hold out. The Prospectus document for the exchange offer stressed that bonds not tendered “may remain in default indefinitely. . . Argentina has announced that it has no intention of resuming payments on any Eligible Securities that remain outstanding following the expiration of the Offer.” Argentina wanted to achieve maximum participation, and to show that it would show no reprieve to those who decided to hold out. To further cement this position, the Argentine government passed Law No. 25,017, known as the “Lock Law.” The Lock Law stated, in explicit terms, that “[t]he National Government is prohibited from performing any type of judicial, extra-judicial or private transaction in relation to the bonds.” Thus, it legally prohibited the government from offering new terms to holdouts. This was designed to ensure that holdouts would not have a second chance to tender their bonds for an exchange, and would instead be stuck with the defaulted bonds, which the government did not intend to repay.
Despite the strong terms of the Lock Law, the Argentine government lifted the Lock Law in 2010 when it announced a second exchange offer to entice those very same holdouts to come to the table. With this second exchange offer, the rate of participating creditors from Argentina’s 2001 default increased to 92%. 6.2.2 Rights Upon Future Offers (RUFO)
When dealing with holdouts, a sovereign debtor always has the option to simply pay them with some of the money that it has saved from having participating creditors in an exchange offer who agree to a haircut on their principal. However, this would be a terrible decision, because it makes fools of participating creditors who agreed to exchange their bonds and rewards those holdout creditors that decided to oppose the sovereign debtor’s restructuring plans. Furthermore, it betrays the good faith of the participating creditors in coming to the table. Finally, it encourages the strategy of holding out in future restructurings, because it proves that holding out can pay off.
Argentina wanted to give the impression to participating creditors that it would not do this to them. Thus, the bonds offered in the exchange offer had a most favoured creditor clause,
106 INTRODUCTION TO DISPUTE RESOLUTION IN SOVEREIGN DEBT known there as Rights Upon Future Offers (RUFO), which stated that if Argentina proposed a new exchange offer or reached a settlement with holdout creditors, it would have the legal obligation to offer the same terms to participating creditors. This way, participating creditors could be sure that they would not receive worst treatment than holdouts. However, the RUFO clause had a strange caveat: an expiration date. It would only be valid until 31 December 2014; after that, participating creditors would lose their most favoured creditor status. This clause, and its expiration date, would later play a crucial role in Argentina’s restructuring options in its litigation and eventual settlement with the holdouts. 6.2.3 Pari Passu
Holdout creditors, of which many were distressed debt funds (but also some retail pensioners), sued Argentina in New York federal court to enforce Argentina’s payment obligations on their bonds. They sought full repayment of the face value of their bonds, many of which they had bought in the secondary market at a discount. The holdouts pursued a similar, if not identical, strategy to the one that Elliott Associates had successfully used against Perú. After obtaining judgments against Argentina that required Argentina to pay what was due on their bonds, Argentina refused to pay, and there were no attachable Argentine assets in the U.S. that its litigious creditors could reach. Thus, the holdouts then argued for the enforcement of the pari passu clause. Specifically, they argued that Argentina had subordinated the holdout creditors’ bonds to the new bonds given to the participating creditors by not making ratable payments to all of the Republic’s bondholders.
While Judge Griesa, the presiding judge in all of the Argentina debt cases in New York, did not adopt the broad interpretation of the pari passu clause that bondholders were arguing for, he did find that the totality of the circumstances indicated that Argentina had legally subordinated the holdouts’ bonds to the participating creditors’ bonds. The judge found that Argentina’s steadfast refusal to pay the old bonds, and the Lock Law that forbade the government from even negotiating with holdout creditors, when combined, resulted in a formal subordination of the holdout creditors’ bonds under the pari passu clause in its narrow sense.
Thereafter, based on that determination, the holdout creditors requested an injunction from the judge that would prevent Argentina from paying the participating creditors’ bonds unless and until it made ratable payments to the holdout creditors. The injunction granted and issued by Judge Griesa was expansive in its scope; it did not just target Argentina, but it also forbade any third party from aiding Argentina in evading the injunction, under the threat of contempt of court.
The decision was confirmed on appeal. In its appeal, Argentina argued that such an injunction would set a dangerous precedent that would make future sovereign debt restructurings much more difficult. However, the court disagreed. It found that the use of such an expansive injunction was due to an “exceptional” situation in the case of Argentina, and that it would “not control the interpretation of all pari passu clauses or the obligations of other sovereign debtors under pari passu clauses in other debt instruments.” On the contrary, it considered that such a remedy in future sovereign debt litigations would be unlikely, and that this case was an anomaly, because Argentina had been “a uniquely recalcitrant debtor.”
However, change came relatively quickly for Argentina after that. Not soon after, a new administration was sworn in, and the new President had campaigned on finally finding a
107 resolution to the years-long conflict with the holdout creditors. Furthermore, and crucially, the RUFO clause expired on December 2014, so by December 2015, when the new administration began negotiations with holdout creditors, it could offer them whatever terms were necessary to end the conflict without having to do the same for all bondholders. 7. DEBTOR STRATEGIES TO NEUTRALISE HOLDOUTS
Despite the pronouncements of the U.S. Court of Appeals for the Second Circuit in regards to the pari passu injunction being an “exceptional” remedy in the Argentina case that is unlikely to repeat itself, now there are two cases where sovereign debtors have been brought to their knees by such clause. It is probable, if not a certainty, that holdouts will continue to weaponize pari passu in future sovereign debt litigations. Given the effectiveness of the pari passu clause in sovereign debt litigation, it is necessary for sovereign debtors to develop strategies to, first, maximise creditor participation during exchange offers, and second, to be able to effectively counter any holdout creditors that are left after an exchange offer and decide to pursue a litigious route. 7.1 Contractual sweeteners
Contractual sweeteners are incentives included in exchange offers that are designed to maximise creditor participation in the same. 7.1.1 Most Favoured Creditor Clauses
In the Argentina 2005 exchange offer, a version of the most favoured creditor clause in the RUFO clause has been observed. Essentially, most favoured creditor clauses require sovereign debtors to give participating creditors in an exchange offer the option to participate in any other future exchange offer proposed by the sovereign, which may or may not have better terms than the exchange offer the participating creditor originally tendered its bonds in. The uniqueness of the RUFO clause in the Argentina case was the inclusion of an expiration date. This could be a useful addition to these clauses in future exchange offers, because the clause itself gives security to creditors, but an expiration date might give the sovereign some breathing room to reach a settlement with recalcitrant holdouts. 7.1.2 GDP-linked warrants
As discussed in the first Module, GDP-linked warrants are detachable, independently tradeable coupons that can be issued with the new bonds proffered in the exchange offer. They may differ in the formula used to calculate payments, but essentially, payments on the warrants are linked to the economic performance indicators of a country. Argentina also issued GDP-linked warrants as part of the 2005 exchange offer, and these performed superbly from 2005-2010, when Argentina was experiencing an economic boom. In fact, according to one study, the GDP-linked warrants issued by Argentina outperformed the returns on a number of blue-chip stocks over the same period.
Creditors may be wary of the value of GDP-linked warrants because of the potential of the sovereign debtor to manipulate its economic statistics in order to downplay positive economic performance and thus reduce pay-outs. To dispel this fear, the reference indicators used to calculate pay-outs should be developed by independent organisations.
108 Sovereign debtors themselves should also be aware of some of the risks of GDP-linked warrants. First, these force the country to divert resources from an economic boom away from the public purse and into the payment of these warrants. Thus, it may diminish the overall effect of a recovery on government revenues. Furthermore, participating creditors who are already wary about the economic performance of a country may not place much value on a GDP-linked warrant that will only pay out if the country experiences a recovery. There is evidence that the GDP-linked warrants in the 2005 exchange offer, seen in retrospect, were grossly undervalued; they accounted for only 10% of the value received by creditors in the exchange offer, but ended up serving returns that were much above that figure. 7.1.3 Hurricane clauses
Countries in disaster-prone areas have often had to restructure their debt repeatedly in a relatively short amount of time due to the proliferation of tragedies striking their territory and population. Thus, a recent innovation in the sovereign debt space has been the inclusion of ‘hurricane clauses’ in sovereign debt instruments. These clauses contractually allow for a moratorium on debt payments in the case of a predefined event occurring in the country. The provision is structured as follows: (1) there is a definition of what an Eligible Event is, taking into account the natural disaster risks for the country; (2) the clause established that if an Eligible Event occurs, the sovereign debtor will not incur a default for failing to make payments on the debt; (3) it establishes a predetermined schedule for resuming payments; and, (4) missed interest payments are added to due principal. 7.2 Collective Action Clauses (CACs)
The most popular proposal for dealing with holdouts in sovereign debt restructurings has been the inclusion of collective action clauses (CACs) in bond instruments; given that these are contractually agreed to by all purchasers of sovereign bonds, they are an amicable way for sovereigns to deal with the issue. CACs follow a democratic process; all bondholders vote on whether they consent to accept a modification of the payment terms of their bonds, and the decision of a qualified majority is binding on all the bondholders. Although CACs have traditionally been included in English law sovereign bonds, this has not been the case with bonds issued under New York law. CACs have grown in prominence since the late 1990s, when the International Monetary Fund encouraged developing countries that sought to issue sovereign debt to deal with the issue of holdouts pre-emptively. CACs have already been successfully used in debt restructurings; Belize conducted a restructuring using CACs in 2006. Its bonds required a supermajority of 85% of creditors to agree to the modification of the terms; 87.3% ended up consenting.
Within CACs, aggregate CACs are promoted as those most useful for a sovereign debtor. These were first introduced by Uruguay in 2003. Aggregate CACs prevent holdouts from blocking a restructuring by controlling one small series of bonds. An aggregate CAC, specifically those with single limb aggregation, restructures all bonds at once through a single vote across all bond series with a supermajority requirement. CACs are promising, and they have shown that they do allow for an orderly restructuring of sovereign debt without the need for a bankruptcy process, but they are still not as widely adopted in existing sovereign debt to solve the issue entirely. There is currently around USD900 billion worth of outstanding external debt without collective action clauses, and all of that debt will face the same problems as ever.
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7.3 Exit consents
Exit consents are another, more aggressive way to neutralise holdouts. They also do not require the inclusion of collective action clauses. Exit consents make use of the common mechanism in bond instruments that allows for bondholder democracy. They consist of an agreement between the debtor and participating creditors in an exchange offer. Before participating creditors tender their old bonds for new ones, they give the sovereign debtor their consent for the sovereign to represent them as their proxy at a bondholder meeting. The sovereign debtor, usually holding a supermajority of the bonds after the exchange, will call a meeting of bondholders, in which it will propose, and subsequently approve through its majority voting power, amendments to the terms of the defaulted bonds that will reduce the value of these bonds and the possibility of litigation alternatives for holdout creditors. The sovereign debtor may act drastically and vote to amend the principal payment terms, or it may act more shrewdly, and change other terms in the bonds that will negatively affect holdouts. For example, it may change the governing law to its own, remove the waiver of sovereign immunity, or any pari passu clauses in the document. Without affecting the principal payment terms, these changes may reduce the chances of holdouts scoring a victory against sovereign debtors to zero.
However, as previously mentioned, exit consents are a particularly aggressive strategy that may not be well received by the markets, and may lead to some reputational damage for the sovereign debtor that employs it. As such, exit consents are principally used to dissuade creditors from holding out in the first place. Ordinarily, the sovereign debtor will reveal that it intends to amend the terms of the bonds through exit consents beforehand, and this will thus maximise the number of participating creditors in an exchange offer.
In recent years, English law and U.S. law have taken opposite and unexpected views as to the validity of exit consents. Although the U.S., through the Trust Indenture Act, has a strict unanimity requirement for the amendment of principal payment terms, U.S. courts have shown a permissive attitude towards the use of exit consents. In the recent Marblegate case, the Court of Appeals for the Second Circuit determined that a corporate reorganisation strategy that did not formally change the principal payment terms, even though it functionally left holdout creditors without any chance of recovery, was permissible. While the Trust Indenture Act’s prohibition does not apply to sovereign bonds, it is likely that the same court would rule favourably towards exit consents that, as stated above, would change governing law, remove the waiver of sovereign immunity, etc. On the other side of the Atlantic, England had no such restrictions on the amendment of principal payment terms as those imposed by the Trust Indenture Act. However, in another recent case in the High Court of England and Wales, Assenagon Asset Management, the judge decided that the use of exit consents to drastically reduce the principal payment terms on certain bonds in order to leave holdout creditors with nothing was an impermissible use of voting rights as a form of minority oppression. Thus, the outcome of exit consents that amend other terms aside from the principal payment terms is uncertain in England, but if it leaves holdouts with little to no chance of recovery, such an action might be reversed by the judiciary. 8. CONCLUSION
The transition from loans to bonds has brought with it distressed debt investors that specialise in litigation strategies to recoup the face value of debt instruments they bought at discounted prices. These investors have engaged in high-profile litigation cases with sovereign debtors to
110 INTRODUCTION TO DISPUTE RESOLUTION IN SOVEREIGN DEBT enforce the contractual terms of bonds that the debtors have defaulted on. So far, they have been very successful. Particularly in Perú, and most prominently Argentina, what ultimately drew the countries to the negotiating table was the use of the pari passu clause.
This Module reviewed the choice of law and jurisdiction clauses, the theory and relevant laws on sovereign immunity, the legal repercussions of having a fiscal agent arrangement or a trust structure, the history of the pari passu clause, and analysed the cases of Peru and Argentina, which have been prominent studies of sovereign debt litigation and contributed to the development of the contemporary understanding of the pari passu clause. Thereafter, ways in which sovereign debtors could incentivise creditors to participate in exchange offers, in order to minimise the number of holdouts, were detailed as well as strategies, both proven and proposed, that sovereigns can use to neutralise holdout creditors that seek to derail a sovereign debt restructuring process.
References
Rodrigo Olivares-Caminal, Transactional Aspects of Sovereign Debt Restructuring, in DEBT RESTRUCTURING (2nd ed., 2016).
Rodrigo Olivares-Caminal, To Rank Pari Passu Or Not To Rank Pari Passu: That is the Question in Sovereign Bonds After the Latest Episode of the Argentine Saga, 15 L. & Bus. Rev. Amer. 745 (2009).
Lee C. Buchheit and Jeremiah S. Pam, The Pari Passu Clause in Sovereign Debt Instruments, 53 Emory L. J. 869 (2004).
Paul L. Lee, Central Banks and Sovereign Immunity, 41 Colum. J. Transnt’l L. 394 (2003).
Lee Buchheit, The pari passu clause sub specie aeternitatis, Int’l Fin. L. Rev. December 1991.
Lee C Buchheit, Supermajority Control Wins Out, Int’l Fin. L. Rev., April 2007.
Rodrigo Olivares-Caminal, The Pari Passu Interpretation in the Elliott Case: A Brilliant Strategy But An Awful (Mid-Long Term) Outcome?, 40 Hofstra L. Rev. 39 (2011).
Rodrigo Olivares-Caminal, Understanding the Pari Passu Clause in Sovereign Debt Instruments: A Complex Quest, 43 The Int’l Lawyer 1217 (2009).
Stephen J. Choi, Mitu Gulati & Robert E. Scott, The Black Hole Problem in Commercial Boilerplate, 67 Duke L. J. 1, 46-50 (2017).
Lee Buchheit & G. Mitu Gulati, Exit Consents in Sovereign Bond Restructurings, 48 UCLA L. Rev. 59 (2000).
Lee Buchheit & G. Mitu Gulati, Restructuring Sovereign Debt After NML v. Argentina, 12 Capital Markets L. J. 224 (2017).
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Jonathan Blackman & Rahul Mukhi, The Evolution of Modern Sovereign Debt Litigation: Vultures, Alter Egos, and other Legal Fauna, 73 Law & Contemp. Probs. 47 (2010).
Michele Robinson, INTRODUCING HURRICANE CLAUSES: LESSONS FROM GRENADA’S RECENT EXPERIENCE: A COUNTERCYCLICAL FINANCIAL INSTRUMENT, available at http:// thecommonwealth.org/sites/default/files/inline/Introducing%20Hurricance%20Clauses.PDF.
Republic of Argentina v Weltover, Inc, 504 U.S. 607 (1992).
EM Ltd., NML Capital, Ltd. v. Banco Central de la República Argentina, 800 F.3d 78 (1st Cir. 2015). NML Capital v. Republic of Argentina, 2011 WL 9522565 (S.D.N.Y. 2011). NML Capital v. Republic of Argentina, 699 F.3d 246, 254-55 (2nd Cir. 2012).
NML Capital v. Republic of Argentina, 727 F.3d 230, 247 (2nd Cir. 2013).
NML Capital v. Republic of Argentina, 2016 WL 836773 (S.D.N.Y. 2016).
Marblegate Asset Management, LLC v. Education Management Corp., 846 F.3d 1 (2nd Cir. 2017).
Assenagon Asset Mgmt. v. Irish Bank Resolution Corp., [2012] EWHC (Ch) 2090, [21] (Eng.).
Grenada Offer to Exchange, Offering Memorandum 18 (Sep. 9, 2005), available at http:// www.iilj.org/ courses/documents/GrenadaOfferingMemo.pdf.
Fiscal Agency Agreement between the Republic of Argentina and Bankers’ Trust Company, Fiscal Agent, dated as of October 19, 1994.
Ministry of Finance and Public Credit of the Republic of Argentina, Propuesta, 5 February 2016.
112 CHAPTER 8
SOVEREIGN DEBT IN AFRICA
1. Introduction 2. Sovereign debt crisis in Africa 2.1 A History 2.2 The HIPC initiative 2.3 Post-mortem: African debt today 3. Case Studies 3.1 Case Study 1: Kenya’s Eurobond 3.2 Case Study 2: Ecuador 3.3 Case Study 3: Grenada 3.4 Case Study 4: Seychelles
4 . Conclusion References SOVEREIGN DEBT IN AFRICA
1. INTRODUCTION
Debt is not necessarily bad. In fact, it can be good if it serves the right purpose. For that, a robust debt management policy is required. Since the world wars, debt has been used to finance the reconstruction and development of nations. Africa is not far behind on this agenda borrowing eagerly to catch up on its development goals. However, this debt appetite has not been complemented by strict and robust debt management policies. It has instead been accompanied by bad debt management policies and, in some i@nstances, corrupt systems, and compromised institutions. As a result, it has eroded the profitability these countries would otherwise have gained from the credit extended to them for development.
Further, the main areas of development being financed are infrastructure, health and education, which do not have a direct and immediate return on investment. These factors are forcing these already volatile economies to source for even more credit to refinance their falling obligations. As if the situation could not already be difficult, this volatility of economies increases default risk and in turn causes an increase in borrowing cost. The cycle has been endless and current generations are still repaying the loans taken out by past regimes that did not delve into the roots of the problem, i.e. poor debt management policies and implementation bodies. ` While there has been exponential growth recorded in the past couple of years, there has also been a rise in the unsustainable debt accumulated within the African continent.
This Module will look at the history of the debt crisis in Africa, different debt relief initiatives, the face of debt in Africa today, and will then discuss the industry standard of the “new age” Eurobond prospectuses. 2. SOVEREIGN DEBT CRISIS IN AFRICA 2.1 A History
Sovereign debt default is as old as the concept of sovereign debt itself dating back to the fourteenth century. According to Brooks et al. (2014) there have been over 317 sovereign debt restructurings in Africa since the early 1980s, far more than any other continent (an average of 8.3 defaults per year). While there is no one factor that led to the exponential growth of debt Africa managed to amass since the 1970s, certain major events have contributed greatly to it: (1) two oil price hits that oil producing countries failed to absorb properly and led them to seek large amounts of external credit to sustain their economies; (2) over lending by banks in the 1980s and sudden withdrawal of financing; (3) extremely high interest rates on loans; (4) poor fiscal management policies; and, (5) excessive borrowing and corruption (see inter alia, Ezenwe). By the tail end of the seventies when it became evident the continent was in a debt crisis, Africa’s total debt stock stood at USD 140 billion but by the nineties, it has shot up to USD270 billion (approx.). The situation had to be contained. Several initiatives emerged to assist African countries manage their debt situation, however, none was so effective as the Highly Indebted Poor Country (HIPC) initiative.
The chronology of events that led to the HIPC initiative is summarized in the diagram below:
114 115 SOVEREIGN DEBT IN AFRICA
Diagram 1: HIPC initiative - Chronology of Events
2.2 The HIPC initiative
The HIPC initiative is a programme that is run by the World Bank, in conjunction with the IMF. It began in 1996 and was structured to reduce the debt burden of the poorest countries in the world (low-income countries). It is a two-step program: (1) “Decision Point” where the World Bank ascertains if a country is eligible to participate in the initiative and the country begins to receive its debt relief; and, (2) “Completion Point” when countries receive the balance of the debt relief that was committed to at the Decision Point. The HIPC initiative provides exceptional assistance to eligible countries to reduce their external debt burden to sustainable levels, thereby enabling them to service their external debt without the need for further debt relief and without compromising growth.
In 1997, this initiative was linked to the Poverty Reduction and Growth Facility (PRGF) and a trust administered by the IMF was set up, i.e. the HIPC-PRGF Trust.
According to the IMF’s glossary of selected financial terms: to be eligible for the HIPC initiative, countries must: (1) have established a strong track record of performance under programs supported by the IMF’s Poverty Reduction and Growth Facility (PRGF) and the International Development Association (IDA); (2) be IDA-only and PRGF-eligible; (3) face an unsustainable debt burden; and, (4) have developed a Poverty Reduction Strategy Paper.
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In 2005, the HIPC Initiative was supplemented by the Multilateral Debt Relief Initiative (MDRI) which allows for 100% relief on eligible debts by the IMF, AfDB and the International Development Association of countries completing the HIPC initiative process. In 1999, the international community recognised the need of a consorted effort to deal with the external debt problem of certain countries (mostly Africa) and revamped the HIPC initiative to provide faster and deeper debt relief to allow HIPC reach a level of sustainability. The HIPC initiative include the following countries: Afghanistan Benin, Bolivia, Burkina Faso, Burundi, Cameroon, Central African Republic, Chad, Comoros, Côte d’Ivoire, Democratic Republic of the Congo, Eritrea, Ethiopia, Ghana, Guinea, Guinea-Bissau, Guyana, Haiti, Honduras, Liberia, Madagascar, Malawi, Mali, Mauritania, Mozambique, Nicaragua, Niger, Republic of Congo, Rwanda, São Tomé & Príncipe, Senegal, Sierra Leone, Somalia, Sudan, Tanzania, The Gambia, Togo, Uganda and, Zambia. On 8 December 2005, the IMF’s Executive Board approved the Multilateral Debt Relief Initiative (MDRI) involving a total debt relief of HIPC and those countries with per capita income below USD 380 and outstanding debt to the IMF at end-2004. On the same date, the Exogenous Shocks Facility was also approved as a part of the PRGF Trust to support HIPCs in the event of economic shocks caused by rising oil prices, natural disasters, contagion of conflicts or crisis in neighbouring countries, etc. To date, the HIPC Initiative, together with the MDRI, have assisted 35 participating countries (predominantly in Africa) cancel over USD99 billion in external debt. These programmes were intended to find a sustainable solution to the continent’s debt problems. Debt relief under the HIPC and MDRI Initiatives has substantially alleviated debt burdens in recipient countries and has enabled them to increase their poverty-reducing expenditures, as illustrated in the diagram below.
Diagram 2: Poverty-reducing Expenditure and Debt Service in 36 Post-decision-point HIPCs (in % of GDP)
‘t’ indicates completion point rather than decision point. As a result, the effect of debt relief may be underestimated since some debt relief may have occurred prior to completion point. Source: WB/IMF (2017
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2.3 Post-mortem: African debt today
After South Asia, Africa is the second fastest growing economic region in the world. In 2017, the AfDB (2017) reported that the continent’s economy would improve further to average 4.3% growth in 2018. African countries are continuing to rely a great deal on external debt to develop their economies. For example, according to the AfDB (2012), Africa needs to spend USD360 billion by 2040 on infrastructure. The drive to develop has led to the necessity and increase in the continent’s debt appetite.
The diagram below shows the drastic increase in debt accumulated in sub-Saharan Africa in a 3-year period which Friedman and Schneider (2018) argue closely resembles the situation before the debt crisis in early 1990.
Figure 3: Three Year Gap: Sub-Saharan’s Public Debt Increase
Source: GPF based on IMF World Economic Outlook data, on an article by G. Friedman and X. Snyder (Mauldin Economics), How China Benefits from Africa’s Debt, (2018)
The increased appetite for debt has led to competition for funding which has pushed countries to seek credit from new sources. Lured by the low interest rates, African countries moved to the international bond market to borrow money. Over the past few years, there has been a running trend of Eurobond issuances as evidence by the year that several countries initiated their sovereign ratings.
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Furthermore, China has been very active in providing financing to the region, becoming Africa’s most popular creditor. China has lent more than any Paris Club member country in some countries in Sub-Saharan Africa. These two factors, the Eurobond boom and China’s lending, have caused a drastic shift in the debt profile of African countries since the nineties and an increase in the debt amassed since then. 3. CASE STUDIES
This section provides four case studies to illustrate some good and bad practices in the sovereign debt context. These case studies should be learnt in addition to those of Peru and Ecuador analysed in the previous Module. The case studies included below, allow the reader to draw some important conclusions based on other countries experiences dealing with several factors, such as external shocks, natural disasters, bad policies, etc.
The cases analysed are those of Kenya, Ecuador, Grenada and the Seychelles. Kenya is a good example of a sovereign debt issuer who has adopted recommended international standards (state-of-the-art CACs) and adopted an alternative dispute resolution mechanism
118 119 SOVEREIGN DEBT IN AFRICA with specific exceptions. Ecuador, on the contrary, is an example of practices that need to be avoided. Ecuador created a commission to audit the debt leading to an opportunistic or political default with serious reputational consequences. Grenada and the Seychelles provide interesting examples of contractual innovation. In the case of Grenada, a hurricane prone nation, a contractual feature was incorporated to avoid a disruptive default in the event of the occurrence of devastating natural disaster. Lastly, the Seychelles is an example of the creative use of a multilateral agency providing a partial guarantee on interest payments to entice the participation of creditors in an exchange offer. 3.1 Case Study 1: Kenya’s Eurobond
Although African countries have notable experience in sovereign debt restructuring, the nature of their debt composition has changed significantly over the past decade. As discussed above, there has been a surge on the issuance of Eurobonds across the continent, and a reliance on China (a non-Paris Club Member) for financing.
The shift in the debt composition has resulted in a shift in the nature of creditors and consequently, in the event of default, a new debt restructure toolkit would be required in comparison to the last sovereign debt crisis that swept across a majority of countries on the continent in the nineties. In the nineties, most dents were documented through syndicated loans. Now, due to the Eurobonds issuances most debt obligations are documents as tradeable instruments in the capital markets. Moreover, the loans granted by China are considered bilateral official lending of a non-Paris Club member. Therefore, it is difficult to anticipate, if a restructuring is required, the treatment that the Chinese authorities would expect. As is the case with non-Paris Club official bilateral lending, an ad-hoc agreement would have to be agreed on a case-by-case basis.
The key to a seamless debt restructuring is having the right tools to undertake such a restructuring. As Eurobonds is the novel addition to Africa’s external debt composition, this section will discuss the structure of Eurobonds and the most fundamental elements of Eurobonds necessary for a restructure in the event of a debt crisis, using Kenya as a case study. Kenya has three Eurobonds currently outstanding, the first of which was issued in June 2004 and followed by a second issuance in February 2018. The country’s Eurobonds comply with industry standards, primarily in comparison to the International Capital Markets Association standards. Three main aspects of bonds are used in the analysis provided: collective action clauses, governance structure and dispute resolution. The 2018 Eurobond issuance is used as a template for the analysis provided in this section. 3.1.1 Collective Action Clauses (CACs)
The core principle of CACs is the principle of democracy. This means that where the majority of the bondholders vote for a particular decision, all the bondholders are bound by this decision. This means the majority can vote for a modification of a matter such as bond repayment terms in order to facilitate a debt rescheduling plan and reduce the debt burden of the sovereign debtor.
Aggregation was introduced to cure the inter-series hold out problem as the majority aggregated vote binds bondholders in all the series. The modifications are to be uniformly
119 SOVEREIGN DEBT IN AFRICA applied across all the series that are bound by the vote. For the sovereign to be able to exercise their option of a cross series modification, the terms of aggregation must be included in the bond.
The table below showcases the voting thresholds and features of Kenya’s CACs, following ICMA’s model clauses recommendations.
Kenya has incorporated ICMA’s recommended CACs that are up to date with international standards that—if properly implemented—can be used to quickly and swiftly restructure its Eurobonds. If needed, CACs can facilitate a relatively fast and straight forward restructuring which can be far more beneficial than a voluntary exchange offer or straining an economy with an attempt to repay all its debts falling. 3.1.2 Bond’s Governance structure
The bond’s governance structure refers to the way the relationship between the issuer and the bondholders is governed. Usually, either an Agent (representing the interests of the sovereign issuer) or a Trustee (representing the interests of the bondholders) is used during the life of the bond.
As noted by Fisch and Gentile (2004), the fiscal agent is an agent of the sovereign issuer and owes no duty or obligations to any other party including the bondholders. The agent carries
8 Debt Series Capable of Aggregation is defined in subsection (ii) Aggregation.
120 121 SOVEREIGN DEBT IN AFRICA out administrative duties throughout the life of the bond. Their main duty is to act as a paying agent. In addition to this, other administrative functions carried out by the agent may include being the information channel between the sovereign and the bondholders.
A trustee can be appointed either by way of an indenture of trust or a trust deed. An indenture of trust is generally used where bonds are governed by New York Law. Under this instrument, each bondholder retains the right to institute claims against the issuer for amounts that have fallen due. The trustee holds all other rights including enforcements rights for amounts that are due by virtue of acceleration. On the other hand, a trust deed is used to appoint a trustee under English law. The trust deed sets out the extent of responsibilities of the trustee. Here, the trustee holds all the rights of enforcement and as such, is responsible to monitor the issuers compliance with the terms of the Bond.
The effect, benefits and repercussions of the choice of governance structure used in a bond is appreciated more in the context of an event of default (or likely default) than during the life of the bond. Based on the powers and duties of trustees and agents set out and discussed above and in previous Modules, there are a lot more benefits to adopting the trustee structure than there are in an agency structure, primarily in the event the sovereign issuer defaults. Although, even throughout the life of the bond, the trustee structure remains superior to the agency structure, as the trustee is more flexible in dealing with changing circumstances that would not necessitate consultation with bondholders
Kenya’s governance structure in its 2018 Eurobond is the use of an agent. The IMF (2017) reported that sovereigns issuing bonds governed by English law are more biased towards using the fiscal agent governance structure; primarily lower income sovereign issuers who are wary of the cost implication of using a trustee. Buchheit (2018) have also stated that over and above the annual fee of using a fiscal agent, ignorance is another reason that lower income countries may still be using the agency structure; that sovereigns and their legal counsel do not understand or care for the benefits of a trust structure.
Given: (1) the unpredictable nature of the cost and outcome of a debt restructuring in the event of default; (2) the additional protection afforded to the sovereign when using the trust structure; and, (3) the complimentary nature of a trust structure with the use of CACs; in the long run it is more cost effective to use a trust structure. While it is noble of low-income African countries like Kenya (lower-middle income) to issue their Eurobonds pursuant to a fiscal agency agreement, with no intention to default or reschedule the bonds; it could be argued that it should have adopted the best practice to protect its interests. To mitigate the cost implications of issuing the Eurobonds pursuant to a trust deed, Kenya could modify their agency structure to provide some protection that they would enjoy under the trust structure. Fortunately, as per industry standards, Kenya’s 2018 Eurobond provides that the Agency Agreement can be modified at any given time and the bondholders will be bound by any such modification.
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3.1.3 Dispute Resolution
Dispute resolution mechanisms in sovereign bonds are a fundamental term of a contract. There are two main methods of dispute resolution adopted in bond prospectus: (1) arbitration and (2) litigation. Litigation is by far the most prevalent method of dispute resolution used. Though sovereign bonds with arbitration clauses are not unheard of, they are the exception rather than the rule.
Kenya’s 2018 Eurobond is governed by English Law and has adopted arbitration in the London Court of International Arbitration (LCIA) and its Rules. As such, it has conformed its Eurobond to English practice by (1) ensuring the Arbitration Agreement conforms to the requirements under the Arbitration Act 1996 (therefore eliminating a contest on the mode of dispute resolution); (2) giving explicit consent to be subject to arbitration as a sovereign State; and, (3) expressly waived its state immunity it enjoys for purpose of arbitration or enforcement with respect to the Eurobond (although Kenya has wisely excluded enforcement of awards within Kenya itself and the United States of America).
In order to contrast Kenya’s decision to go down the route of arbitration, the AfDB (2018) observed that litigation is costly for these debtor countries and distracts financial and other authorities from important policy issues. It is of worthy note that the majority of the pending creditor litigation cases are against African countries and primarily in countries involved in the HIPC initiative. These lawsuits threaten the core objectives of the HIPC initiative. The lawsuits effectively reduce the impact of the debt relief for the HIPCs and cause inequitable burden sharing among creditors.
Although Kenya is not a HIPC country, it needs not bear the burden and expense of litigation that its counterpart countries have and continue to face in the name of dispute resolution. Arbitration as set up in Kenya’s 2018 Eurobond will allow Kenya to benefit from an expedient and confidential dispute resolution forum. Further, as LCIA publish the estimated cost of arbitration disputes, the country can budget for this expenditure once proceedings are commenced. 3.2 Case Study 2: Ecuador
Ecuador underwent a restructuring in 2000 and managed to amass a reserve accumulation due to high oil prices. As a result of this, market participants did not perceive Ecuador as having an unsustainable debt situation. This notwithstanding, Ecuador decided to stop servicing a subset of its external bonds because a debt audit commission created by the recently elected President (Comisión para la Auditoría Integral del Crédito Público, also known by its acronym CAIC) mandated by a presidential decree in 2006 found the bonds to be illegitimate or illegal. The objective of the CAIC is to audit the processes by which public debt has been incurred to determine its legitimacy, legality, transparency, quality, efficacy, and efficiency, considering legal and financial aspects; economic, social, gender, and environmental impacts; and the impacts on nationalities and people. The audit covered agreements, contracts, and other forms of public financing entered between 1976 and 2006.
Following the recommendation of the CAIC, in November 2008 Ecuador suspended interest payments on the 2012 global bonds, deemed to be illegitimate. After a 30-day grace period, it formally entered into default on 15 December 2008. At the moment of the default, Ecuador
122 123 SOVEREIGN DEBT IN AFRICA had three outstanding series of bonds: 12 percent dollar global bonds due 2012, dollar step-up global bonds due 2030, and dollar global bonds due 2015.
The 2012 and 2030 bonds were issued in 2000 to restructure the Brady bonds. The 2015 bonds were issued to purchase some of the 2012 bonds in accordance with the issuance terms of the mandatory prepayment arrangement included in its terms. Although the CAIC concluded that the 2012, 2015 and 2030 bonds and several other debt instruments were illegal or illegitimate, the government decided to default only on the 2012 and 2030 bonds.
On 20 April 2009, Ecuador launched a cash offer to repurchase the 2012 and 2030 bonds. The offer expired on 15 May 2009. The buyback transaction was structured with a minimum price of USD0.30 per dollar of outstanding principal. Offers by bondholders were considered irrevocable. The buyback offer highlighted the risks of not participating in the invitation.
The final buyback price was USD0.35 per dollar of outstanding principal, accepted by 91 percent of bondholders. Only 7.2 percent of the original USD2.7 billion issued under the 2030 bonds and 18.7 percent of the USD510 million of the 2012 remained outstanding in the market.
The Ecuadorian default is a landmark case because it is the first default in modern history in which ability to pay played almost no role.
Ecuador allegedly engaged in an aggressive secondary repurchase through intermediaries when the price for the defaulted 2012 and 2030 bonds hit rock bottom but before an official moratorium was announced or default actually occurred (Miller 2009; Porzecanski 2010). The 2012 and 2030 Ecuadorian bonds included a debt purchase provision (a mandatory prepayment arrangement). This contractual arrangement required the retirement of an aggregate outstanding amount for each type of bond by a specified percentage each year starting after 6 years for the 2012 and 11 years for the 2030 bonds, through purchases in the secondary market, debt-equity swaps, or any other means. According to an IMF publication, “[t]his feature is intended to give bondholders some assurance that the aggregate amount of the new bonds would be reduced to a manageable size before their maturity dates while giving Ecuador flexibility to manage its debt profile” (IMF 2001). If Ecuador failed to meet the reduction target, a mandatory partial redemption of the relevant bond would be triggered an amount equal to the shortfall.
This contractual provision included in the Ecuadorian bonds clearly denotes that the purchase in the secondary market of a debtor’s own debt is not only legal but also desirable, because it can reduce the amount of outstanding debt to make it more manageable. However, Ecuador’s repurchase took place after certain events that could have affected the trading price of the debt instruments, including announcements of the delay in interest payments and videos showing the finance minister meeting privately with other individuals discussing debt instruments (Economist 2007). This behaviour revealed a systemic failure affecting “market integrity,” as Ecuador could have disclosed information that affects the market while deciding whether to default. Therefore, even if the ties between the secondary actors and the Ecuadorian government were to be proven, the actual default made it very difficult to demonstrate an undesirable behaviour, as the default occurred, mooting possible allegations of deliberate market manipulation. Ecuador allegedly managed to acquire about half of the total outstanding debt in each series in the secondary market, which could have distorted the readings from the outcome of the buyback exercise.
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3.3 Case Study 3: Grenada
Grenada, a small island economy, entered 2004 with a large current account deficit (almost 13 percent of GDP) and substantial external debt. Both the debt and the deficit had been shrinking, in comparison with previous years, and the country appeared to be on the path to achieving external sustainability. The situation changed after Hurricane Ivan hit, in September 2004, causing economic damage that exceeded 200 percent of Grenada’s GDP. The hurricane rendered inoperable about 70 percent of hotel rooms and damaged 70 percent of the producing acreage of nutmeg plantations, the country’s main sources of income. As a result, unemployment rose sharply and the current account deficit almost tripled.
Grenada stopped servicing its external debt in the fall of 2004. In July 2005, 10 months later, prior to launching an exchange offer to regularize its debt situation Grenada was hit by another hurricane: Emily. Hurricane Emily exacerbated Ivan’s losses by more than 12% of its nominal G D P.
In September 2005, Grenada launched an exchange offer to swap its bonds in default for 20 years USD and XCD denominated bonds with a step-up interest rate from 0.85 to 8% plus a 20% decrease of the outstanding amount of debt per annum from 2021 onwards.
More than 85 per cent of the holders of the eligible debt (bondholders and holders of other types of commercial debts) accepted the offer. About 15 percent of creditors neither exchanged their debt instruments nor reached a later agreement. This put Grenada in a deadlock situation, because it did not want to repudiate its debts but did not have the means to satisfy the requests of the holdout creditors. Grenada addressed this issue by adopting language similar to that used in the Commonwealth of Dominica’s 2004 exchange offer:
“Treatment of Eligible Claims Not Tendered … if any Eligible Claims are not tendered in connection with this Offer, the Government intends to pay those non-tendered Eligible Claims as and when resources to do so become available to the Government. The Government does not intend, however, to pay any amount in respect of a non-tendered Eligible Claim if, at the time such payment is due, a payment default then exists under any [of the new issued bonds] (see Commonwealth of Dominica Offer to Exchange Eligible Claims for XCD 3.5 percent bonds due 2014, 2024, and 2034, dated 6 April 2004).”
Grenada did not commit any additional funds to service the non-tendered instruments, but it allowed for the possibility of servicing these debts once additional resources became available. No actual promises were made, but the debt was not repudiated.
The treatment of holdout creditors provided by Grenada—that is, neither repudiating nor repaying the debt but waiting until there is a clearer picture—can be dubbed the Caribbean Approach (Buchheit and Karpinski 2006). Although the sovereign is not providing an actual solution, it is not providing a legal ground for claims based on the repudiation of the debts of debtholders who decide not to participate in the exchange offer.
The other relevant feature of the Grenadian exchange offer is the structuring of individual enforcement rights under the trust indenture, which was subject to New York law. As explained in previous Modules, there is a substantial difference between English trust deeds and U.S.
124 125 SOVEREIGN DEBT IN AFRICA trust indentures regarding the extent of the trustee’s enforcement powers. 3.4 Case Study 4: Seychelles
The Seychelles is a small island country that depends heavily on imported commodities and tourism revenues (tourism represents about 70 percent of total foreign exchange earnings). The period 2006–07 was characterized by rapid growth as well as mounting structural imbalances. Although an overvalued currency was causing unsustainable current account deficits on the order of 32 percent of GDP, the central bank was reluctant to depreciate the currency, because of concerns over the fiscal costs of negative balance sheet effects. Although at 3.7 percent of GDP the fiscal deficit was not very high, large current account deficits led to a rapid accumulation of external debt (mostly to commercial creditors), which more than doubled over the period 2005–07.
The hike in commodity prices in 2007–08 and the collapse in tourism revenues that followed the global crisis amplified the effects of these structural imbalances. On 31 July 2008, the Seychelles notified bondholders of its intention to default on privately placed bonds worth EUR54.8 million (USD78 million) maturing in 2011. The government stated that the reason for missing the payment was the presence of “irregularities in the issuance-approval process and a lack of transparency in the note documentation” (Bloomberg 2008).
In October 2008, when its international reserves were basically depleted, the government announced that it would not be able to make a coupon payment on a USD230 million Eurobond and would approach creditors to seek an agreement on a comprehensive debt restructuring. AS a result, Standard and Poor’s downgraded the Eurobond (9.125 percent due 2011) to D (default) and assigned a recovery rating of 4, indicating its expectation of an average recovery of 30–50 percent on defaulted debt. The exchange offer was launched in December 2009 and completed in mid-January 2010, with 89 percent of the aggregate amount of the eligible claims settled.
The default process was accompanied by an IMF program aimed at supporting public debt restructuring and restoring external sustainability. In November 2008 the Seychelles agreed to a comprehensive reform program in exchange for a two-year IMF Stand-By Arrangement of SDR 17.6 million (about USD26.6 million). The main elements of the program consisted of a more flexible exchange rate policy and tighter fiscal and monetary policies.
In mid-April 2009, Paris Club creditors granted exceptional debt treatment to Seychelles under the Paris Club’s Evian approach, reducing the initial debt stock of USD163 million by 45 percent in nominal terms in two phases and agreeing to reschedule the remaining amount over 18 years, including a five-year grace period. They also agreed to defer part of the payments due in the coming years.
The Debt Sustainability Assessment conducted by the IMF in July 2009 found that the Seychelles’ public debt remained unsustainable. The finding probably reflected the country’s substantial obligations with commercial creditors. On 1 February 2010, after the successful bond exchange with private creditors, Fitch gave the Seychelles a rating of B– on its long-term
9 Special Drawing Rights
125 SOVEREIGN DEBT IN AFRICA foreign currency debt and B’ on its local currency debt, with positive outlooks for the future. The restructuring carried out by the Seychelles included a partial guarantee on interest payments from the African Development Bank, a novel element aimed at sweetening the terms and reaching agreement. The guarantee was executed as a side agreement, but its text was included in the prospectus. The guarantee states that if the Seychelles fails to make payments of interest under the new bonds, the AfDB will be responsible for an aggregate maximum guarantee in the amount of USD10 million. The guarantee is a senior, unsubordinated, unconditional, and unsecured obligation by the AfDB. The amounts payable do not include principal, costs, fees, expenses, or other amounts or any payment of interest that in aggregate exceeds USD10 million. 4. CONCLUSION
Proper debt management policies, implementation and respect for the same are fundamental for African countries to steer clear of debt default crisis. The notion of borrow today for tomorrow’s generation to repay is catching up with countries faster than political terms are coming to an end. In addition to this the long-standing elephant in the room, ‘Corruption’ is no longer a proverbial reference. Corruption has been reported to be one of the main reasons African countries are unable to service their debts, but by recent examples, it may also be one of the reasons they are deadlocked from restructuring them. There are recent examples of African countries that have been caught attempting to restructure their bonds while allegations of corruption hang over their heads. Creditors have begun to scrutinize closely how funds have been appropriated and, based on the billions lost through such scandals, it is fair to consider whether the debt situation in Africa would be less mortifying if there was increased transparency in the appropriation of external credit.
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