Creditor engagement in sovereign debt restructuring 1

Briefing note April 2016

Creditor engagement in sovereign debt restructuring The lack of a regime for sovereign insolvency leaves contractual terms as the prime means to facilitate efficient and fair sovereign debt restructuring (including re-profiling), should it prove necessary. The growing use of aggregated collective action clauses in sovereign bonds represents a major step in this direction. Some believe that the next step should be the inclusion in bonds of terms that facilitate open and meaningful discussions between sovereigns and their creditors. The logic is that information sharing and close cooperation between sovereigns and their bondholders are key elements in quick and successful debt restructuring arrangements. The IMF has said that it will consider later this year debtor-creditor engagement during debt restructuring.

"Sovereign bonds are essentially through the so-called London Club. restructuring might not be the same junk bonds, and it is crazy to buy This was generally a manageable as that of the older school of investors. or sell them without realizing that process as the lenders were both This change in structure gave rise to they are very likely to be identifiable and relatively many challenges for sovereign debt restructured", according to a homogeneous in outlook. Loan restructurings, which in the main have Stanford-based academic. This agreements also generally contained been met. Where necessary, overstates the position - most sharing provisions that encouraged successful restructurings generally do sovereign bonds issued on the cooperation. Direct discussion take place. The situation in Argentina international capital markets between lenders and the sovereign should be seen as an outlier rather proceed from issue to maturity was both feasible and, in practice, than the epitome, though it appears at without incident - but even the IMF almost unavoidable. the time of writing that even the has accepted that sovereign debt Following the successful issue of protracted litigation arising from restructurings are a "pervasive Brady bonds in the late 1980s as a Argentina's default may now be phenomenon". response to the Latin American debt reaching a conclusion. Nevertheless, In a 2012 Working Paper, the IMF crisis and changes in bank regulatory that does not mean that the process identified 186 restructurings in 68 capital rules, sovereign debt moved of restructuring is always as countries with private creditors in the more into the bond markets. This transparent, efficient and fair as it period from 1950 to 2010 (on top of opened up a new set of issues for might be. restructurings. Bondholders are not the 447 restructuring agreements in Techniques to improve the only more numerous than bankers, 88 countries carried out under the restructuring process have been but also more difficult to identify and aegis of the Paris Club, i.e. sovereign suggested. For example, in the early potentially different in outlook. to sovereign restructurings). Over the 2000s, a sovereign debt restructuring Sovereign bonds might more easily first half of this period, restructurings mechanism – an insolvency regime end up in the hands of distressed tended to involve loans by banks to for states – was proposed. Whatever debt funds, whose approach to sovereigns, which were restructured may have been the merits or

2 Creditor engagement in sovereign debt restructuring

otherwise of this proposal, the reality particular issue to ensure that it versions for issuances governed by is that it is not going to be adopted remained outside any restructuring English law and by New York law). wholesale, at least in the foreseeable agreed by others (and, the more This form of aggregated CAC resulted future. That leaves the contracting distressed the bonds were perceived from work undertaken by an Expert parties – sovereigns, trustees, fiscal to be, the cheaper it was to do this). Group convened by US Treasury staff agents and so on through to the Greece provides a relatively recent and consisting of representatives of bondholders themselves – to provide example of this problem. A sufficient the official sector (including the IMF), through the applicable contractual minority of the holders of certain the ICMA and a number of debtor terms and conditions sensible means short-dated Greek bond issues voted countries, as well as buy-side of ensuring that bonds can be against Greece's restructuring plan of stakeholders, legal practitioners and restructured if it is really necessary. In 2012, keeping their issues outside the academics. (See our client briefing this, the parties have the restructuring. Greece opted to pay off entitled New ICMA sovereign encouragement of those concerned to these holdouts rather than risk the collective action and pari passu ensure an orderly market as well as cross-defaults on other transactions clauses, October 2014.) economic prosperity, including supra- that could have followed non-payment. Use of the ICMA form of aggregated national bodies such as the IMF, The holders of these bonds therefore CAC has been encouraged by ICMA, national governments such as the US, recovered in full, while most holders the IMF, the IIF and the G20, and the UK and euro area member states of Greek bonds accepted a large there has been significant take up of and trade organisations like the write-down. This situation also the new provisions. As at September International Capital Market resulted from the fact that the holdout 2015, over 90% of new bond issues Association (ICMA). bonds were governed by laws other under New York law and than Greek law so that the holders of approximately 75% of new bond The first step: aggregated these bonds were not bound by the issues under English law included the Greek legislation passed to aggregate CACs new enhanced CACs (see IMF Staff holders of Greek law governed bonds. Sovereign bonds governed by English Paper Progress Report on Inclusion law have, for more than a century, The limitations of CACs within of Enhanced Contractual Provisions commonly contained collective action individual bond issues shifted the in International Sovereign Bond clauses (CACs), i.e. clauses that focus to aggregated CACs, i.e. CACs Contracts, September 2015). It will allow a super-majority of the that apply not within a single bond take some time, however, for bondholders (typically 75%) to vote issue but across a number of issues aggregated CACs to have full impact. through changes to the terms of the (ideally, over time, all issues), making It is only when all bonds issued by a bonds that bind all the bondholders the acquisition of a blocking minority particular sovereign include (New York law governed sovereign far more difficult. Aggregated CACs aggregated CACs that the holdout bonds generally did not include CACs, were discussed as early as the 1990s, problem will be removed, giving a at least until the 2000s). These CACs and included in isolated issues by, for majority of all bondholders the ability could in principle be used to facilitate example, Uruguay (2003) and to bind a dissenting minority - until a restructuring by preventing a small Argentina (2005). However, impetus that time, the risk of particular issues number of bondholders from holding has been given to the use of holding out against a restructuring the sovereign, and the other aggregated CACs by two recent agreed by others remains. bondholders, to ransom by refusing to events. Nevertheless, the inclusion of agree to terms acceptable to the vast aggregated CACs in sovereign bond First, since 1 January 2013, the Euro majority. issues unquestionably represents a area has required that bonds issued major step forward towards more However, these traditional CACs by euro area governments contain a orderly debt restructuring. showed mixed results when it came to standard aggregated CAC. assisting restructuring. In particular, Secondly, the ICMA published in Engagement with these CACs only operate within an August 2014 a standard form of creditors individual bond issue. A bondholder aggregated CAC, for inclusion in or group of bondholders could "All available evidence indicates that sovereign bonds (including, ultimately, therefore buy a blocking minority in a information sharing and close

Creditor engagement in sovereign debt restructuring 3

consultations with banks and by both sovereign debtor and all its governed sovereign debt issues have bondholders go hand-in-hand with creditors would entail their not included creditor engagement quick and successful restructuring" engagement in constructive sovereign provisions, but a significant number of according to the IMF in a review of debt restructuring workout English law governed bond issues literature on sovereign debt negotiations." have done so in the past (including, restructurings. by way of illustration, issues by This institutional support for creditor Albania, Belarus, Bulgaria, Croatia, The benefits of engagement between engagement has not so far been Czech Republic, Denmark, Ghana, creditors and debtors observed by the matched by the inclusion of bond Kazakhstan, Kenya, Montenegro, IMF has been matched by institutional terms designed to facilitate this Pakistan, Poland, Romania, Rwanda, support. For example, in 2004 the engagement. The ICMA published in Serbia, Seychelles and Sweden). IIF's Principles for Stable Capital 2004 a template noteholders' Evidence seems to suggest therefore Flows and Fair Debt Restructuring committee provision for use within a that at a time when private sector urged that, if restructuring proved single issue. This provision was involvement in debt crises will necessary, debtors and creditors updated in 2014 for use across increasingly be the norm (pre- as well should "engage in a restructuring issuances in conjunction with the as post- default) and collective action process that is voluntary and based ICMA aggregated CAC and deals with mechanisms have been strengthened, on good faith." In a 2012 Addendum matters associated with the formation the accompanying procedure to to its Principles, the IIF went further. It of a committee rather than detailed deliver majority acceptance in a more said that private creditors "should matters governing its operation once streamlined way has not continued to organise themselves in a broadly formed. Whilst ad hoc creditor gain traction. This could in part be based representative creditor committees have been formed many because, pending its paper on committee as early as possible in the times in the sovereign context, creditor engagement, the IMF debt restructuring process, certainly express creditor engagement specifically did not endorse the before default" and that "early provisions in the terms and conditions inclusion of creditor engagement discussion is necessary between the of sovereign bonds have, with the provisions, because of varying representative private creditor exception of Belize in 2013, followed practices in the English and New York committee and the sovereign debtor, the ICMA 2004 form or the ICMA law capital markets, or because there in close consultation with the official 2014 form. may simply be a greater difference of sector". There were over 50 sovereign bond opinion on the matter. In 2014, the IMF recognised that it issuances between October 2014 and Creditor engagement in general can would be wise for a sovereign issuer July 2015, but only a few contained occur, and the establishment of a to engage with a properly the updated version of the creditors' committee in particular can representative creditor committee in noteholders' committee clause (e.g. take place, if and when the need to order to achieve a high participation Kazakhstan, Bulgaria, Croatia, restructure a sovereign's debt arises rate in a debt restructuring. It noted Montenegro and Pakistan). Hungary, (without any express clause in the that high participation had also been Jordan, Namibia and Zambia, which terms and conditions of the bonds). reached without a creditor committee had included the provision in earlier But that will usually be in a time of in some cases and added that the issuances, dropped it. This limited stress, when it may be significantly "modalities of creditor engagement" use of the clause led the IIF to more difficult to secure cooperation would be discussed in greater detail emphasise in November 2015 that it than it is in the more optimistic time of in a subsequent staff paper (we "strongly encourage[s] sovereign issue, particularly if a financial crisis understand that IMF staff are issuers and investors to include a coincides with or is precipitated by a currently working on this paper). On creditor engagement clause in bond political crisis (which is often the 10 September 2015, the UN General contracts to help guide market case). Common objections to Assembly adopted nine principles on expectations in case a debt including creditor engagement sovereign debt restructuring restructuring becomes unavoidable". clauses in bond documents (and, (A/RES/69/139) Basic Principles on Historically, with the exception of Côte indeed, to creditor engagement at all) Sovereign Debt Restructuring d'Ivoire in 2010, Qatar in 2011 and include the following: Processes, including that "good faith Belize in 2013, New York law

4 Creditor engagement in sovereign debt restructuring

 Reluctance to pay the potentially with creditors; the speed of new discussing this openly as part of open-ended costs of a creditors' market access, the quantum, the committee process. committee. The ICMA creditor tenor and price are all likely to be  Reluctance to share information engagement clause provides for adversely affected. Support for a with creditors for fear of creating the debtor to meet those restructuring from a creditors' a privileged class of investors reasonable costs incurred by the committee will in practice be of and of misuse of the information creditors' committee which are huge influence, as well as by the creditors on the inside, agreed with the debtor. These offering comfort, to creditors who ultimately market abuse. That is, need to be evidenced and might are not on the committee. however, an issue for any include legal advice and  Reluctance to bring creditors interaction between a debtor and economic analysis. If a sovereign together for fear of giving them its creditors. If a debtor has so issuer wants its creditors to agree greater collective bargaining little trust in its creditors' to a departure from (and, typically, power. Bilateral discussions representatives, it may make a reduction in the value of) the might enable the debtor to divide anything other than an imposed terms originally agreed, it is not and rule the creditors and solution impracticable. The unreasonable to expect the thereby secure a better deal. benefits of engaging with issuer to pay the costs involved. However, a sovereign cannot creditors need to be weighed Further, in practice the costs of a prevent creditors from coalescing against the risk that one creditor creditors' committee are likely to into a committee, nor does the might misbehave. The debtor will, be lower than the debtor's existence of a committee in any event, always be in control additional costs of dealing with necessarily rule out bilateral of what information it passes to a creditors individually, still more so discussions. A degree of control committee and when. if the lack of a creditors' over, or at least knowledge of,  Debtors have also raised representative body with which to the way in which creditors concerns that if the committee negotiate results in a greater interact could be advantageous, does not agree unanimously with number of holdouts or, ultimately, as well as enabling the sovereign a restructuring proposal, it may in the rejection of the sovereign's to identify those creditors who be held to ransom. However, the restructuring proposal. may play a significant role in ICMA creditor engagement  Reluctance to create a structure forming opinions in the market as provision is silent on this - there that might help creditors' a whole. is no requirement that the negotiate a better deal. This  Concerns linked to credit default committee should unanimously assumes that the process is swaps (CDS). In particular the agree with a proposal or that it effectively a zero sum game: debtor may feel that potential should express public support (or what is good for creditors must committee members who have otherwise) for a proposal at the be bad for debtors. The ultimate purchased CDS protection end of the discussions. It is for aim is, however, to secure a should not participate or that if a the parties to succeed in their consensual restructuring. If a Credit Event occurs prior to the discussions at the time and agree creditors' committee helps to restructuring being launched the any outcomes. The obligation is achieve that aim, then it should composition of the committee merely for the debtor to engage be a worthwhile investment. would need to change radically. with creditors. The incentive is for Further, even if a debtor In reality hedging in various both parties to cooperate so that considers that it can refuse to different forms has been part of any restructuring deal can negotiate with creditors and, the landscape in sovereign and succeed without holdouts instead, can impose a corporate restructurings for many undermining the outcome. restructuring, that debtor is likely years, and sovereign debtors are Moreover, it is counter-intuitive to find it more difficult to secure likely to gain greater insight into that prior to an issue of sovereign subsequent market access on the potential impact of CDS in debt, sovereigns will meet with good terms than another debtor their particular circumstances by investors on tailored roadshows, that has dealt fairly and openly and thereafter will, in most

Creditor engagement in sovereign debt restructuring 5

instances, engage in investor advisers and the sovereign same issues at the inception stage as relations and yet, at a time of debtor which is unfettered by the the creditor engagement provision. crisis, would prefer to bring the contractual provision itself. This is because the provision itself is shutters down. Indeed, the new Where there are understandable high level and not prescriptive. The aggregated CACs require certain concerns as to the participation protection its inclusion gives information to be provided to of a particular institution, bondholders is that it will ensure bondholders, the very same inevitably common sense some engagement with them, albeit information which the creditor prevails resulting in a mutually the formation of a formal committee or engagement clause also requires acceptable outcome. an ad hoc committee will require the - no more, no less. Other objections have been raised, agreement of further ground rules.  Concerns have been raised that such as that once a committee is Conclusion multiple committees could result formed, it is hard for the sovereign to at a time of crisis if different "divorce" the committee (but a refusal Creditor engagement is, as most now series of bonds have creditor to marry because divorce might prove recognise, a vital part of securing a engagement provisions. The difficult displays an unduly pessimistic fast and fair sovereign debt ICMA creditor engagement outlook, and is scarcely the best restructuring. Engagement is vital clause addresses this concern by reason for remaining resolutely both for creditors in order to ensure stating that, if more than one single), it may be difficult to that their representatives have access committee is formed, a steering coordinate the different constituencies to necessary information and can group should be created from the of bondholders (that is a problem in negotiate a satisfactory resolution, various committees. This is any event) and membership of a and for debtors in order to maximise beneficial to the sovereign debtor, committee may change over time (a the prospects of a successful especially in a world where necessary feature to ensure that restructuring and to reduce the risk of aggregated CACs become the those economically interested in the being bound up in litigation for years. norm, because inevitably a series outcome remain those with whom While creditor engagement can be by series approach to creditor engagement takes place). organised when the need arises, it is engagement would cut across prudent to seek to put in place a Some have suggested that the advantages of any structure in the good times rather than engagement in good faith creates an aggregated approach. to wait until the crisis is at hand. One unclear standard for the sovereign simple way to achieve this outcome is  Some have argued that the debtor to meet. However, there is a for there to be increased use of the sovereign debtor should have a significant body of learning and ICMA standard form creditor veto right over the members of judicial guidance on 'good faith' engagement clause or similar the creditor committee. It is requirements from the English Courts provisions that operate alongside the difficult from the creditors' which can be drawn upon by advisers ICMA aggregated CACs. If a perspective to contemplate to guide the sovereign debtor in case sovereign has concerns with express provisions to this effect, of need. particularly in an environment in particular elements of the ICMA which sovereign bonds are freely The bottom line is that good faith standard form creditor engagement tradeable. Creditor engagement engagement between sovereign clause, then those could be raised clauses included in bonds to date debtors and creditors is a helpful with the lead managers of the issue are not prescriptive on the feature of successful restructurings. If and appropriate revisions from the process of formation or engagement is not built into the standard form agreed prior to composition of the creditor transaction documents at the outset, issuance. This is preferable to committee, and this approach reliance must be placed on ad hoc omitting the creditor engagement provides helpful flexibility. In arrangements created at a time of provisions altogether. practice most creditor crisis, which may prove to be committees result from an problematic. informal dialogue between a Ad hoc arrangements, although they small number of creditors, can work well, raise many of the

6 Creditor engagement in sovereign debt restructuring

Authors

Deborah Zandstra Andrew Yianni Simon James Partner, London Consultant to Clifford Chance Partner, London T: +44 20 7006 8234 T: +44 20 7006 2436 T: +44 20 7006 8405 E: deborah.zandstra E: andrew.yianni E: simon.james @cliffordchance.com @cliffordchance.com @cliffordchance.com

This publication does not necessarily deal with every important topic Clifford Chance, 10 Upper Bank Street, London, E14 5JJ or cover every aspect of the topics with which it deals. It is not © Clifford Chance 2016 designed to provide legal or other advice. Clifford Chance LLP is a limited liability partnership registered in England and Wales under number OC323571 Registered office: 10 Upper Bank Street, London, E14 5JJ We use the word 'partner' to refer to a member of Clifford Chance LLP, or an employee or consultant with equivalent standing and qualifications www.cliffordchance.com If you do not wish to receive further information from Clifford Chance about events or legal developments which we believe may be of interest to you, please either send an email to [email protected] or by post at Clifford Chance LLP, 10 Upper Bank Street, Canary Wharf, London E14 5JJ Abu Dhabi ■ Amsterdam ■ Bangkok ■ Barcelona ■ Beijing ■ Brussels ■ Bucharest ■ Casablanca ■ Doha ■ Dubai ■ Düsseldorf ■ Frankfurt ■ Hong Kong ■ Istanbul ■ Jakarta* ■ London ■ Luxembourg ■ Madrid ■ Milan ■ Moscow ■ Munich ■ New York ■ Paris ■ Perth ■ Prague ■ Riyadh ■ Rome ■ São Paulo ■ Seoul ■ Shanghai ■ Singapore ■ Sydney ■ Tokyo ■ Warsaw ■ Washington, D.C.

*Linda Widyati & Partners in association with Clifford Chance. Clifford Chance has a best friends relationship with Redcliffe Partners in Ukraine.