Holdout Litigation and Sovereign Debt Enforcement

Holdout litigation and sovereign debt enforcement

Kartik Ananda and Prasanna Gaib

aDeutsche Bundesbank, Wilhelm-Epstein-Strasse 14, 60431 Frankfurt am Main, Germany

bUniversity of Auckland, 12 Grafton Road, Auckland 1142, New Zealand

Abstract

We present a model that characterises the ex ante and ex post implications of holdout litigation, and which highlights the importance of debt ownership and jurisdictional competition in determining the eﬃcacy of the legal threat to sovereign debt enforcement. Our optimal contracting framework allows a role for secondary markets to mitigate liquidity risk and a role for bankruptcy courts to adjudicate disputes. We endogenise the extent to which the bankruptcy regime is based on judge-made law and identify conditions under which the disciplining eﬀect of holdout creditors prevails. Our model contributes to the policy debate on sovereign debt restructuring by formalising some of the insights in Bolton and Skeel’s(2004) proposal for a sovereign bankruptcy framework.

Keywords: Sovereign debt restructuring, holdout creditors, bankruptcy procedures, forum shopping, enabling law JEL classiﬁcation codes: F34, F55, G33, K4

∗We thank Jonathan Thomas and Di Li and seminar participants at the Workshop on Sovereign Debt Re- structuring, Glasgow, and Twelfth Annual FIRS Finance Conference, Hong Kong for helpful comments. We wish to acknowledge the generous support of the Institute for New Economic Thinking (INET Grant INO1400004). Gai is extremely grateful to the Warden and Fellows of All Souls College, Oxford, and colleagues at INET@Oxford for their warm support and hospitality during the preparation of this paper. The views in this paper are those of the authors and do not necessarily reﬂect the views of Deutsche Bundesbank. ∗∗E-mails: [email protected], [email protected]. 1. Introduction

The messy legal disputes surrounding Argentina’s recent default and the Eu- ropean debt crisis of 2012 have rekindled interest in frameworks for sovereign bankruptcy. Increased globalisation has meant that sovereign debt contracts now allow for the attachment of of collateralised assets under court procedure and, in recent years, nearly 50% of debt crises have involved litigation, compared with less than 10% in the 1980s and 1990s (Schumacher et al., 2014; Miller and Thomas, 2007). The high proﬁle of hedge fund managers such as Paul Singer and US Dis- trict Court Judge Thomas Griesa has also cast a spotlight on the role of holdout creditors and courts in the enforcement of sovereign debt contracts.

A commonplace perspective on holdout creditors is that they interfere with orderly debt restructuring, justifying reforms to bankruptcy procedures. Krueger (2002) suggests, for instance, that their presence increases concerns among other debt holders that the court will grant the holdouts a claim on the sovereign with a higher priority than their own. And Buchheit et al.(2013) express concern that countries may be less disposed to imposing haircuts on creditors for fear of be- ing entangled in a prolonged and costly legal dispute. But others (e.g. Dooley, 2000; Shleifer, 2003; Fisch and Gentile, 2004; and Scott, 2006) counter that the threat of successful litigation helps maintain the viability of sovereign debt markets, making for cheaper sovereign lending and reinforced creditor rights. Shleifer (2003) contends, moreover, that sovereign bankruptcy reform will “...only work if counterbalanced by...the presence of a court with...a duty to ﬁnd solutions that best serve the interests of creditors.”

In an important contribution to the debate, Bolton and Skeel(2004) propose a framework where, instead of a supranational tribunal, sovereigns in diﬃculty are free to ﬁle for bankruptcy in a court of a jurisdiction in which they have issued bonds. They argue that competition between bankruptcy courts makes for better

2 decision making and more speedy resolution of restructuring. The proposal also eschews the idea of a mandatory set of provisions governing bankruptcy in favour of a degree of opt-out that would enhance eﬃciency by enabling a country to best tailor provisions to their own circumstances. While recognising that sovereigns may have an incentive to select overly hard provisions to maximise access to credit, Bolton and Skeel point to the vital and delicate role of the court in precluding such outcomes.

The renewed importance of holdout litigation in sovereign debt restructuring raises some important questions. First, what are the consequences of vesting oversight for sovereign debt restructuring with the bankruptcy court of a jurisdiction where the sovereign has issued bonds? Second, should the bankruptcy framework be based on a mandatory set of provisions established by statute or should it be more “enabling”, thereby permitting countries to seek exemptions and granting individual judges the discretion to make law? And third, what is the impact of such choices on lending to sovereigns?

This paper explores these questions in the context of a canonical model of sovereign debt. In our optimal contracting framework, the secondary market allows creditors who initially lend to the borrower to manage their liquidity risk. An increased incidence of liquidity shocks has two eﬀects – it increases the expected liquidation cost for the original creditors, making it less attractive for them to lend. And it also opens up the possibility that debt securities are purchased by secondary market investors who are more litigious than the initial creditors. Shifts in the composition of the creditor base are thus crucial to debt enforcement, and we identify conditions under which the market discipline of holdout creditors promotes ex ante capital inﬂows.

We also allow troubled debtors to ﬁle for bankruptcy and, moreover, choose the bankruptcy court in which their case is heard. We model judicial competition

3 explicitly and examine its implications for the holdout effect. If there is significant judicial emphasis on the fiduciary duty of the debtor to its creditors, then it induces more creditors to consider litigation and sharpens holdout discipline. But counter to this, as the emphasis on judge-made law increases, it improves the efficiency of the court and lowers the cost of filing for the debtor. The holdout effect is more prevalent in situations where court adjudication speed is low, or where lobbying by bankruptcy professionals stymies legal reform and prevents a reduction in filing costs.

Secondary markets and jurisdictional competition thus have an important bearing on whether control rights over collateral in bankruptcy should be vested with individual judges or determined via mandatory statutes. Since specific skills are required to run projects, placing collateral under creditor management opens the door to dead weight costs. These costs do not feature in the optimal contract, and so the social planner must allocate ex ante lawmaking rights in a way that takes these into account. Our results show that as the underlying creditor pool shifts in favour of investors with low litigation costs, the holdout effect dominates over higher expected liquidation costs for the original creditors and prevails even when courts are very efficient. Equilibrium bankruptcy law is more enabling under these conditions. Only in circumstances where court efficiency dominates the holdout effect does the planner opt for a mandatory framework.

Our findings are broadly supportive of the Bolton-Skeel perspective, although the effects of creditor composition and judicial competition suggest more nuanced conclusions. In particular, the idea of permitting sovereigns to have the choice of opting out from some provisions of the bankruptcy framework and allowing judges the latitude to grant or deny those exemptions is consistent with our findings. A “one size fits all” approach, where a uniform and mandatory set of provisions is applied to all debtors would seem to work best when there is a very high degree of judicial efficiency and limits to legal lobbying. Unlike Bolton and Skeel, however,

4 we suggest that the gains from ex post forum shopping by debtor stems more from the beneﬁts of the holdout eﬀect than from judicial competition.

The literature on creditor litigation in sovereign debt includes Haldane et al. (2005), Engelen and Lambsdorff(2009), Pitchford and Wright(2012), Bai and Zhang(2012). and Schumacher et al.(2015). But these papers focus on the ex post debt renegotiation stage rather than the ex ante implications for sovereign borrowing and the design of the bankruptcy framework considered here.1 Recent work has also highlighted the importance of the composition of the creditor base in sovereign debt enforcement. Broner et al.(2010) develop a model in which once it becomes apparent that default is looming and penalties are insufficient, foreign creditors are able to sell debt securities on the secondary market to domestic residents. Since domestic residents expect the government to enforce domestic debts, they purchase the securities at face value. Trading in the secondary market thus allows foreign creditors to circumvent default.2 The secondary market channel through which debt is enforced in our model is very different, however.

The links between sovereign debt and judicial activism are yet to be fully ex- plored. Miller and Thomas(2007) note that judicial activism is made possible due to the lack of statutory regulation of sovereign debt and highlight the lack of attention paid to common law traditions in sovereign debt litigation. The role of common and civil law in shaping bankruptcy has, however, been examined ex- tensively in the corporate ﬁnance literature. On one perspective (La Porta et al., 2008), common law systems are better at promoting credit markets and the use

1Contributions that examine how policy intervention in sovereign lending influences both ex ante and ex post efficiency include Ghosal and Miller(2003), Gai et al.(2004) and Bolton and Jeanne(2007). 2Two recent papers provide evidence in support of Broner et al’s thesis. Using data from the euro area, Brutti and Sauré(2012) point to a reallocation of debt positions from foreign creditors to domestic banks following the recent debt crisis. And Papadia and Schioppa(2014) examine German foreign debt during the Inter-war years to show that German and foreign investors faced different probabilities of repayment that were decisively influence by the possibility of trading on secondary markets.

5 of innovative contracts. Franks et al.(2009) observe, however, that UK courts took a long time to protect investors and creditors and suggest that it is unclear whether common law systems automatically offer strong investor protection. Pis- tor et al.(2003) argue, moreover, that the differences between law traditions are exaggerated. They classify the effects on corporate law from judicial decision- making as belonging on a continuum from “mandatory” to “enabling”. When the law is mandatory, judges have little influence on control rights over collateral since these are reserved for the legislature. But when law is enabling, judge-made law determines the allocation of control rights.

Finally, our model is related to recent work on bankruptcy venue choice (“forum shopping”) and the attitude of courts to the fiduciary duty of loyalty. Gen- naioli and Rossi(2010) model judicial discretion in bankruptcy. On the demand side, debtors choose where to file for bankruptcy (forum shop), while on the sup- ply side, judges exhibit biases towards creditors or debtors and are motivated by career concerns. They show how greater creditor protection reduces the bias in the bankruptcy code by lowering the incentives for the debtor to forum shop and for judges to establish pro-debtor reputations. Becker and Stromberg(2012) study the 1991 Credit Lyonnais v Pathe Communications bankruptcy case in the Delaware court. The court ruling held that duties to creditors were owed not just when the firm entered bankruptcy, but also as the firm approached the “zone of insolvency”. The authors document important changes in firm behaviour following the ruling, which gave creditors more power. In particular, firms responded by reducing financial risk and reliance on covenants, and by increasing equity issues and investment to lower debt overhang.

6 2. The Model

Our model is inspired by Gertler and Rogoﬀ(1990). We extend their framework to allow for a secondary market in debt securities and a role for bankruptcy courts to adjudicate disputes. The shifting composition of the creditor base and judicial competition between bankruptcy courts are key factors determining ex ante lending. They also shape the extent to which the legal framework for bankruptcy follows a “one-size-ﬁts-all” approach, with a uniform and mandatory set of bankruptcy provisions.

2.1. Setup

A small open economy extends over three periods, t = 0, 1, 2. It is made up of two distinct groups, each of unit mass – borrowers (‘entrepreneurs’) and domestic creditors (‘bankers’). There is a single consumption good and the world interest rate is denoted by r. All agents in the economy are risk-neutral and have access to a risk-free asset that yields 1 + r units for sure at t = 2 for every unit invested at t = 0.

At t = 0, a social planner decides on the extent to which the legal system is based on judicial decisions and acts of legislation. In line with Pistor et al. (2003), we model the legal framework for bankruptcy as residing along a continuum, z ∈ [0, 1] from ‘mandatory’ to ‘enabling’ in terms of its implications for judicial decision-making. When z is low, judges are called upon to implement statute law but have little inﬂuence on control rights. But when z is high, bankruptcy law is enabling in the sense that judges have a greater say in determining the extent of the ﬁduciary duty that is owed to the creditors.

Faced with the legal system chosen by the planner, entrepreneurs can borrow funds from bankers to ﬁnance risky projects. These projects are ex ante identical

7 and yield ex post returns as follows: k units invested at t = 0 yields Y units at t = 2 with probability π(k) and zero units with probability 1 − π(k). We assume that π0(k) > 0, π00(k) ≤ 0, π(0) = 0, and π(∞) = 1, so projects have the property that greater investment raises the probability of a high level of output. Output realisations are independent across the projects of individual entrepreneurs. The function π(k) is common knowledge and, to ensure that it is optimal to invest under perfect information, πk(0) > (1 + r)/Y .

The representative entrepreneur receives an initial endowment of wealth, W > 0, at t = 0. The endowment is illiquid and can only be consumed at t = 2. It can be viewed as a necessary asset, essential for the ongoing operation of the project. Since consumption only takes place at the ﬁnal date, the entrepreneur’s utility function is

E U (c) = c2 , (1)

where c2 is consumption at t = 2.

The domestic credit market is perfectly competitive. Bankers are deep-pocketed individuals who cannot invest directly in projects and face idiosyncratic liquidity shocks at t = 1. The utility function of banker i is

B ui = δi ci,1 + (1 − δi) ci,2 , (2)

where δi ∈ {0, 1} is a publicly observable random variable, with Prob(δi = 1) = q. The probability q captures the likelihood that the banker receives a liquidity shock that forces early consumption at t = 1. We refer to bankers that prefer to consume early as ‘impatient’.

Bankers differ in their willingness to pursue litigation in the event that an entrepreneur declares bankruptcy at t = 2. There are many reasons why litigation costs may differ across creditors. For example, there may be differences in bal-

8 ance sheet structures, investment horizons and regulatory rules. Buchheit(1998) and Alfaro(2015) also suggest that creditors diﬀer greatly in their specialized knowledge and sophistication to pursue litigation as an option. Bankers’ marginal costs of litigation, ` ∈ [0, 1] are drawn at t = 0 according to the cumulative distribution function Gb(`), and are mutually independent. While the distribution function Gb is common-knowledge, actual realisations are private information for each individual banker.

In the event of a liquidity shock at t = 1, impatient bankers sell their hold- ings of debt securities that are issued by entrepreneurs in a secondary market. Trade is facilitated by competitive market-makers who sell the securities to pa- tient and risk-neutral foreign investors. Like domestic bankers, foreign investors are characterized by private and mutually independent marginal costs of litigation,

`f ∈ [0, 1], drawn from the common-knowledge cumulative distribution function

Gf (`f ). Thus, following the realisation of liquidity shocks and secondary market trading, the probability that a creditor holding a debt security issued by the representative entrepreneur has litigation cost less than or equal to `b is given by the mixture G(`b) = (1 − q) Gb(`b) + q Gf (`b).

A credit contract is the triple (R, θ, b), where R ≤ Y is the payment made by the entrepreneur if the project is successful, θ ≤ W is the payment made when the project fails, and b > 0 is the amount borrowed. We refer to θ as the collateral pledged by the entrepreneur in what follows. Project risk is diversiﬁable in the capital market so each banker i holds the state-contingent contract (Ri, θi, bi). These contracts are constrained by ex ante moral hazard considerations and the ex post willingness of the entrepreneur to part with collateral assets in the event of bankruptcy. Speciﬁcally, at t = 0, the entrepreneur may secretly siphon funds received away from the risky project and towards risk-free assets. And, in the event of project failure at t = 2, the entrepreneur may select a bankruptcy court to secure collateral exemptions instead of honouring the contracted commitment

9 to pay θ.

Table1 depicts the timeline of events in the model. t = 0 t = 1 t = 2 t = 2 (cont.)

Planner chooses z. Bankers learn δi’s. Output realised. Entrepreneur oﬀers (1 − ) θ to creditors.

Entrepreneur Impatient bankers If output is Y , Creditors holdout issues securities sell debt securi- then creditors re- depending on liti- in exchange for ties. ceives R. gation costs, `. ﬁnancing.

Entrepreneur If output is 0, A judge rules over invests k ≤ b in entrepreneur de- revoking exemp- risky project. clares bankruptcy. tions; the verdict is binding.

Table 1: Timeline of events.

2.2. Filing for bankruptcy, secondary markets, and moral hazard in investment

In modeling the decision of the representative entrepreneur to ﬁle for bankruptcy at t = 2, we make explicit the role of (i) judicial competition and choice of bankruptcy venue; and (ii) judicial discretion, i.e the scope for judges to make the law and settle disputes between agents with diﬀerent claims to control rights over collateral. Our stylized account consists of the following sequence of events:

• The entrepreneur chooses the court in which to ﬁle for bankruptcy. Bankruptcy courts compete on the basis of administrative and legal fees, ρ W , where ρ < 1;

• Upon ﬁling for bankruptcy, an automatic stay is imposed on collateral assets, preventing a creditor grab race;

10 • The entrepreneur claims exemptions to collateral of θ. The remaining (1 − ) θ of collateral assets is subsequently oﬀered to creditors;

• Creditors can either accept the oﬀer or ‘hold out’ by petitioning the judge to revoke some (or all) of the exemptions;

• A judge hears the petition and rules on the allocation of collateral. This verdict is binding and is accepted by all parties.

We suppose there are two courts, n and s, that compete with each other to administer bankruptcies. Both courts are bound by the same legal framework and scope for judicial discretion, z, but engage in Bertrand competition over the price

3 that entrepreneurs pay to ﬁle for bankruptcy. If ρi ≥ 0 and χi(z) ≥ 0 denote the bankruptcy fee and the marginal cost of administering bankruptcy, then expected proﬁts for court i ∈ {n, s} are give by

h i Πi = φi(ρi, ρ6=i) ρi − χi(z) , (3)

where φi(·, ·) is the fraction of bankruptcies that court i administers, namely

 1 if ρi < ρ6=i   1 φi(ρi, ρ6=i) = if ρi = ρ6=i . (4)  2   0 if ρi > ρ6=i

0 In what follows, we focus on the case where χi(z) < 0, i.e. the marginal cost of administration declines as the legal framework become more enabling and shifts away from statute law. Legal scholarship (Rasmussen and Thomas, 2001; Ayotte

3At the national level, this corresponds to US-style forum shopping, where debtors can choose between states (e.g., Nevada or Delaware) when ﬁling for bankruptcy. Both states follow the same Federal bankruptcy law and thus z is the same. At the international level, it corresponds to countries operating under a multilateral legal framework or convention for sovereign debt restructuring with an agreed upon mandatory/enabling balance.

11 and Skeel, 2006; Ellias, 2016) suggests that in jurisdictions that emphasise judge- made law and where judicial experience and legal precedent are well developed, bankruptcy cases are dealt with more speedily, statutory ambiguities are quickly resolved, and ﬁling costs are lower as a result.4

We therefore assume χi(z) = 1 − z ξi. The parameter ξi ∈ [0, 1] can be viewed

as a measure of the speed of court i’s speed of adjudication, with low ξi reﬂecting a slow and less eﬃcient court and hence higher bankruptcy administration costs.

Another interpretation of ξi is as a measure of the extent to which bankruptcy professionals stymie legal reforms generating higher costs in the process. On this

view, low values of ξi point to the lobbying dominance of bankruptcy professionals for court i.5

∗ ∗ Lemma 1. There is a unique Nash equilibrium for the prices ρn and ρs in the ∗ ∗ market to administer bankruptcies. If ξs = ξn, then ρn = ρs and the entrepreneur ∗ ∗ is indiﬀerent between venues, i.e., φs = φn = 1/2.

Proof. See Appendix A.

Given the discretion accorded to them by the bankruptcy framework, z, the judge makes a ruling, x, that balances two factors: on the one hand, the desire to adjudicate the case in a way that recognizes the importance of the entrepreneur’s

4Ayotte and Skeel(2004, 2006) find that bankruptcy cases adjudicated in the Delaware courts are resolved 200 days faster than equivalent cases in other US courts. The Delaware courts are, according to Pistor et al.(2003), the most enabled internationally. Delaware’s greater speed reflects its strength in pre-packaging bankruptcies (or “pre-packs”) which, in turn, are a consequence of its pro-debtor laws. In a pre-pack, the debtor and its major creditors negotiate the terms of reorganisation before filing for bankruptcy. Rasmussen and Thomas(2001) point out that pre-packs eliminate the holdout problem altogether. But, while they allow firms to adjust their capital structure, they are not good vehicles for changing operations. A standard Chapter 11 proceeding, on the other hand, allows both an adjustment of capital structure and a revamping of the firm’s operations. Pre-packs are, thus, initiated when firms encounter only financial distress and not economic distress. 5See Skeel(2001) for a detailed account of the role played by the bankruptcy bar in shaping the US bankruptcy code.

12 ﬁduciary duty to the creditors and, on the other, ensures that the ruling complies with statutory law. We capture the judicial decision with a simple loss function that is quadratic in deviations of the ruling from established statute and deviations from granting restitution to the creditors. The judge thus selects

x ≡ argmin z (x − θ)2 + (1 − z)(x − 0)2 . (5) b x

The solution to the judge’s problem, xb = z θ, implies that the judge revokes the exemptions on z θ of the collateral asset. These revoked exemptions are then added to the bankruptcy estate and distributed amongst creditors.

The cost of litigation for creditor i is ì θ. If a creditor files a petition to revoke some exemptions on collateral, then the benefit to the creditor is z θ. So creditor

i will a petition whenever z − `i ≥ 0. The probability that a petition is ﬁled by

any creditor is G( z) = (1 − q) Gb( z) + q Gf ( z). Accordingly, the entrepreneur honours commitments in the event of the project failing whenever

W − θ ≥ (1 − ρ) W − (1 − ) θ − G( z) z θ , (6) which can be rearranged to yield

ρ W θ ≤ . (7) 1 − z G( z)]

Lemma1 further implies that the collateral the entrepreneur pledges is

∗ ∗ ∗ ∗ φs ρs + φn ρn W θ ≤ ∗ ∗ × , (8) ρs + ρn γ(z, q, )

where γ(z, q, ) = 1 − z G( z)]. In what follows, we focus on the case where

13 ξs = ξn = ξ. Denoting χ(z) ≡ 1 − z ξ, equation (8) reduces to

χ(z) W θ ≤ . (9) γ(z, q, )

At t = 1, a fraction q of impatient bankers trade their claims on the secondary market in return for the consumption good. Following Amihud and Mendelson (1986), trade is facilitated by competitive market markers who quote bid and ask prices for the debt securities and are compensated with the bid-ask spread. The risk-free asset is liquid and readily tradeable and its bid-ask spread is zero by assumption. Market makers incur trading costs when transacting the risky debt security and, accordingly, charge an exogenous spread, S. If the face value of impatient banker i’s claim is Vi ≡ π(k) Ri + (1 − π(k)) θi, where k ∈ [bi, b], then the amount obtained from selling the security to the market maker is Vi(1 − S). So the zero-proﬁt condition for banker i is

(1 − q) Vi + q Vi (1 − S) = bi (1 + r) . (10)

Aggregating over all the securities issued by the representative entrepreneur, we obtain b (1 + r) π(k) R + (1 − π(k)) θ = , (11) 1 − q S where k ≤ b.

In line with Gertler and Rogoﬀ(1990), we suppose that while bankers and foreign investors can observe an entrepreneur’s endowment and output, they are unable to observe how the entrepreneur invests these funds at t = 0. The entrepreneur can secretly siphon funds away from the risky project and into risk-free assets. Under asymmetric information, the marginal beneﬁt from investing in the risky project is equated with the opportunity cost of secretly investing in the risk- free asset. So investment in the project must satisfy the incentive compatibility

14 constraint, namely π0(k)Y − R + θ] = 1 + r . (12)

2.3. Optimal contract and ex ante investment

Given the legal framework for bankruptcy, z, chosen by the planner, the optimal contract and investment for the representative entrepreneur is given by the solution to

max π(k)Y − R + W − 1 − π(k) θ + (1 + r) b − k (13) R,θ,b,k subject to

b ≥ k χ(z) W ≥ θ γ(z, q, ) π0(k)[Y − R + θ] = 1 + r b 1 + r π(k) R + 1 − π(k) θ = 1 − q S

In other words, the entrepreneur maximizes expected consumption at t = 2 (comprising the net expected return from the project, the endowment and the return from the risk-free asset) subject to the willingness to pay in bankruptcy constraint, the bankers’ zero-proﬁt condition, and the incentive compatibility constraint governing ex ante moral hazard.

Proposition 1. In equilibrium, all funds are invested in production, b∗ = k∗. The amount of collateral pledged is θ∗ = χ(z) W γ (z, , q), ex ante investment is implicitly deﬁned by The promised return, R∗, is given by

1 + r k∗ χ(z) W / γ(z, q, ) π0(k∗) Y − − = 1 + r , (14) π(k) 1 − q S 1 + r

15 and the promised return by

χ(z) W 1 + r k∗ χ(z) W / γ(z, q, ) R∗ − = − . (15) γ(z, q, ) π(k) 1 − q S 1 + r

Proof. See Appendix B.

As Equation (14) makes clear, the ex ante level of investment, k∗ implied by the contract is below the frictionless benchmark – where the entrepreneur invests to the point where expected marginal project return is equated with the world

0 interest rate, i.e. π (kf ) = (1 + r) /Y . We readily obtain the following corollary.

Corollary 1. If the probability of project success in linear in k, such that π(k) = min{1, A k}, then the equilibrium levels of investment and repayment are given by

   1 χ(z) W / γ(z, q, )  k∗ = min , , (16) A 1 AY  1 + r 1 − q S − 1 + r − 1  and χ(z) W (1 + r) R∗ = Y + − , (17) γ(z, q, ) A provided that the world interest rate is bounded from above and below, r ≤ r ≤ r.

Proof. See Appendix C.

In our model, an increased incidence of liquidity shocks, q, to domestic bankers has the eﬀect of changing the composition of the underlying creditor base in the lead-up to potential bankruptcy, as impatient bankers sell debt securities to potentially more litigious foreign investors.

Proposition 2. If Gb(·) ﬁrst-order stochastic dominates Gf (·), there is a critical

Yb such that for Y ≤ Yb, an increase in q leads to an increase in equilibrium investment. For Y > Yb, the opposite is true. If Gf (·) ﬁrst-order stochastic dominates

16 Gb(·) on the other hand, an increase in q results in an unambiguous decrease in investment.

Proof. See Appendix B.

Two opposing eﬀects arise from the increased incidence of liquidity shocks. First, a rise in q implies an increased mass of impatient bankers in the economy whose willingness to invest depends on their ability to manage liquidity risk and, hence, on the bid-ask spread charged by the market makers in the secondary market. The positive spread, S > 0, for debt securities means that a rise in q makes these securities less attractive to domestic bankers and reduces their desire to lend to entrepreneurs.

Second, insofar as Gb(·) first-order stochastic dominates Gf (·), an increase in q means a larger fraction of foreign creditors with low litigation costs. This increases the probability of a hold out, where petitions against collateral exemptions are filed in the event of bankruptcy proceedings. The entrepreneur’s incentives to file for bankruptcy are tempered as a result and more collateral is credibly pledged. Ex ante investment levels rise as a result.

When the return from project success, Y , is sufficiently high, domestic bankers view the debt security as attractive. So an increase in the expected liquidation cost, q S, has a much greater bearing on aggregate ex ante investment and this (negative) effect outweighs the (positive) disciplining effect of a large fraction of litigious foreign investors in the secondary market. But when project returns fall below a threshold level, Yb, the effect is reversed and aggregate investment is higher. In the case where Gf (·) first-order stochastic dominates Gb(·) higher expected liquidation costs and weaker secondary market discipline reinforce each other, lowering investment unambiguously.

17 Proposition2 contributes to the debate on the role of secondary markets and vulture fund discipline in sovereign debt. Fisch and Gentile(2004) and Scott (2006) suggest that, in addition to providing valuable liquidity to the secondary market for sovereign debt, the threat of successful litigation by hold out creditors reinforces creditor rights and makes lending to sovereigns cheaper. Broner et al.(2010) also contend that secondary markets are a key part of the enforcement mechanism for sovereign debt. They also highlight the crucial role of debt ownership. But their analysis emphasizes the sale of sovereign debt by foreigners to domestic investors during a debt crisis as a critical element in weakening the debtor’s incentives to default.

By contrast, our results point to an alternative channel. Liquidity shocks to creditors shape both the incentive to lend directly, and through shifts in the composition of debt ownership, the willingness of the debtor to repay in the event of bankruptcy.

We next turn to the impact that a more enabling bankruptcy law regime has on ex ante investment.

Proposition 3. There exists a critical threshold of court eﬃciency, ξb, above which the more enabling is bankruptcy law, the lower is ex ante investment. But, for

ξ ≤ ξb, a greater emphasis on judge-made law increases ex ante investment.

Proof. See Appendix B.

Proposition3 again reflects two effects. On one hand, as the emphasis on judge- made law increases, the court is able to process bankruptcy cases more efficiently. This implies a lower cost of filing for the entrepreneur who pledges less collateral ex ante. On the other hand, the greater is the scope for judicial discretion, the more likely is the judge to revoke exemptions on collateral when petitioned. This reduces the entrepreneur’s incentives to file for bankruptcy in the first instance

18 and more collateral is pledged ex ante. The overall impact on investment depends on which effect dominates. The “holdout effect” is more prevalent the less efficient is the bankruptcy court (or the more powerful the legal lobby), since this keeps administration costs high.

Finally, an increase in the world interest rate, r, raises the opportunity cost of lending to entrepreneurs and reduces the present value of the endowment. As a result, bankers are less willing to fund risky projects and investment declines. Higher interest rates, moreover, make it attractive for the entrepreneur to secretly siphon funds away from the project. The overall eﬀect is an unambiguous decline in ex ante equilibrium investment.

2.4. Determinants of law making authority

We complete the model by endogenising z. Arguably, collateral is most valuable to society if it remains with the entrepreneur. To the extent that speciﬁc skills are required to run projects, placing collateral assets under creditor management entails dead weight losses (Diamond and Rajan, 2000).6 These losses are not taken into account by agents in the model and so do not feature in the optimal contract.

The task for the planner is to allocate law making rights between the legislature and the courts in a way that weight up the beneﬁts of greater creditor discipline against the costs that arise when collateral assets are placed in the hands of a second best operator. The planner selects z to maximize expected output net of

6An extreme example was the seizure, in 2012, of the Argentine navy ship Libertad by Elliot Capital. Arguably, the hedge fund’s employees were less well placed to make use of this collateral than the ship’s original owners.

19 dead weight losses, i.e

z∗ ≡ argmax π(k∗(z)) Y − C(z) , (18) z∈[0,1]

where the cost function C(z) is increasing and convex, and summarizes the dead weight losses that accrue when the collateral asset is transferred.7

�� )

* ��

�� Exponential(λ d=1,λ f =1.1)

Exponential(λ d=1,λ f =2) �� Beta(α d=αf =1,β d=1,β f =1.1) Beta(α =α =1,β =1,β =2) �� d f d f �� ( � �� (�)

Figure 1: Legal ﬂexibility as a function of liquidity risk, q. Additional parameters were ξ = 0.01, A = 0.1, Y = 20, r = 0.4, W = 3.5, S = 0.1, χ = 0.4, = 0.3, and λd = 1.

Our results point to the important role that capital markets and jurisdictional competition play in determining whether the state or individual judges are vested with a say in control rights. Figure1 plots z∗ as a function of liquidity risk, q. To facilitate the analysis, we appeal to Corollary1 and treat π(k) as linear. We also assume that that litigation cost distribution functions follow exponential and beta distributions.

For a given class of litigation cost distributions, when the heterogeneity of the creditor base is low, foreign investors resemble domestic bankers in terms of their litigation costs. Hence, in bankruptcy, foreign investors are equally likely to hold out as domestic bankers. As liquidity risk for domestic creditors rises, the

7Diamond and Rajan(2000) observe that crucial human capital is lost when assets are transferred between creditors in secondary markets. They suggest that domestic bankers are more likely to know how best to deploy the assets. See Plantin(2009) for a model of learning by holding in asset markets.

20 eﬀect of increased expected liquidation costs dominates, reducing the incentives for domestic bankers to extend credit. This lowers expected output and induces a lower level of z∗ by the planner (see the solid downward sloping lines in Figure1).

But, when creditor heterogeneity increases (represented by a larger λf for the

exponential distribution, and a larger βf for the beta distribution), there are many more foreign investors with low litigation costs. So when impatient domestic bankers sell securities, the overall pool of creditors with low litigation costs is bigger. The holdout eﬀect is more potent than the eﬀects of a higher expected liquidation cost. Accordingly, the entrepreneur pledges more collateral. Expected output and z∗ both increase, as show by the dashed lines in Figure1.

) ��

�� Exponential(λ d=1,λ f =2) �� Exponential(λ d=1,λ f =3) Beta(α d=αf =2,β d=2,β f =3)

�� Beta(α d=αf =2,β d=2,β f =5) �� ( �

�� ( ξ )

Figure 2: Optimal legal ﬂexibility, z∗, as a function the courts’ eﬃciency, ξ. Additional parameters were q = 0.5, A = 0.1, Y = 20, r = 0.4, W = 3.5, S = 0.1, χ = 0.4, = 0.3, and λd = 1.

Figure2 illustrates how judicial competition between courts interacts with creditor composition to shape z∗. A large value of ξ is associated with more eﬃcient courts. Moreover, Bertrand competition means that the entrepreneur’s costs of ﬁling for bankruptcy are brought into line with court administration costs. As ξ increases, bankruptcy becomes more attractive for the entrepreneur and the amount of collateral that is credibly pledged declines.

As Proposition3 suggests, once ξ exceeds the threshold ξb, the price beneﬁts

21 of low filing costs outweigh the disciplining effects of holdout creditors. Since investment is declining about the threshold, the planner is better off adopting a mandatory framework for bankruptcy, and sets z∗ = 0. Below the threshold, however, the holdout effect is dominant and the entrepreneur pledges a greater amount of collateral. As ξ declines, the strength of the holdout effect increases, and z∗ rises, as depicted by the solid lines in Figure2.

Figure2 also shows that, as creditor heterogeneity increases (so that the pool

of low litigation cost creditors becomes larger), the threshold ξb shifts to the right for a given class of distributions (illustrated by the dashed lines). In other words, the holdout eﬀect is dominant for a much wider range of parameter values of ξ. The optimal allocation of lawmaking shifts further towards judge-made law as a consequence.

3. Implications for sovereign debt restructuring

In an important contribution to the debate on sovereign debt restructuring, Bolton and Skeel(2004) propose that the bankruptcy framework be designed so that (a) decision making authority be vested in existing bankruptcy courts of any jurisdiction where the sovereign has issued debt; and (b) sovereign debtors can opt out of provisions and tailor the bankruptcy process to local norms instead of adopting a “one size ﬁts all” approach with a mandatory and uniform set of provisions. Our paper sheds light on both of these issues.

The question of who the decision-maker should be in sovereign bankruptcy has aroused much debate due to conﬂict of interest concerns. The initial proposals for a Sovereign Debt Restructuring Mechanism (SDRM) initially viewed the IMF as overseer, while subsequent proposals advocated a hybrid between IMF oversight and a debt resolution forum comprising an independent group of judges (Krueger, 2002; IMF, 2002). In their proposal, Bolton and Skeel suggest that, rather than

22 looking to a supranational body, politicisation maybe best addressed by allowing debtor countries to “forum shop”, i.e. ﬁle for bankruptcy in the court of any jurisdiction whose law governs a portion of their debt. Thus, a sovereign could ﬁle in a bankruptcy court in New York, London, Frankfurt, or any other jurisdiction and, thus, rely on an existing legal community with the expertise to conduct the bankruptcy process.

Ex post forum shopping has considerable attractions. Bolton and Skeel point to the speed and expertise of the Delaware bankruptcy court in handling com- plex Chapter 11 cases, and suggest that sovereign debtors will also be attracted to courts that are demonstrably eﬃcient and restructure debt obligations rapidly so as to facilitate a speedy return to international capital markets. Moreover, tying the choice of courts to the location of the debt (New York, London) ensures that the case is heard by a judge who is sympathetic to creditors and counterbal- ances the debtor’s advantage in selecting a bankruptcy venue. Arguably, healthy jurisdictional competition amongst bankruptcy courts facilitates eﬃciency and contributes to the quality of decision making.

Our model suggests that the key benefit from a system that permits ex post forum shopping stems from the disciplining effect of holdout creditors, rather than from greater judicial efficiency and superior decision-making per se. We have shown that the benefits to the debtor from jurisdictional competition must be set against the greater scope for holdouts and the increased likelihood that judges revoke exemptions on collateral. The holdout effect is also more powerful, the more influential are the vested interests of bankruptcy professionals. Moreover, the more litigious the creditor base, the more enabling is the legal framework for bankruptcy. This enhances the holdout effect even further, notwithstanding the (less critical) role of the legal lobby.

In questioning the wisdom of a uniform and mandatory set of SDRM provisions,

23 Bolton and Skeel make the case for designer SDRMs in which sovereigns are able to tailor exemptions that fit their circumstances. They base their argument on US bankruptcy history – in order to pass the first US bankruptcy law at the Federal level in the 19th century, each state was allowed to determine what collateral a debtor could exempt from its creditors if it filed for bankruptcy. State lawmakers could thus adjust their exemptions to local norms and had discretion over how much collateral a debtor could retain. Bankruptcy law was Federal, but tailored on a state-by-state basis.

Allowing sovereigns to seek exemptions to provisions to fit with local norms potentially makes the take-up of a sovereign bankruptcy framework more appeal- ing. But Bolton and Skeel warn that countries may be hesitant to seek important provisions for fear that the effects of market discipline would soften and limit access to capital inflows. They point to the risk that countries may adopt provisions that are too harsh in order to maximize access to credit. There is, thus, an open question as to how a court in such a bespoke system might act to best ensure that countries do not adopt amendments that make restructuring more, rather than less, difficult.

Our focus on the mandatory/enabling balance of bankruptcy law speaks to how such a bespoke system might be designed. In our optimal contracting framework, the exemptions that obtain are incentive compatible in equilibrium and market discipline ensures the maximal allocation to credit for the debtor. But since agents in the model do not take into account the dead weight losses of harsh provisions (i.e. the judge revokes exemptions without regard for the human capital lost when assigning collateral to holdout creditors), the social planner must choose the allocation of lawmaking rights that offsets this. Our results suggest that when the holdout effect is dominant, there is an emphasis on judge-made law. But the extent of this enabling is less that unity, reflecting the balancing of marginal benefits against the marginal costs. But when court efficiency is very high and

24 low ﬁling costs prevail over the holdout eﬀect, a mandatory bankruptcy framework may be more desirable.

4. Conclusion

The debate on sovereign debt restructuring has typically been characterised by extremes. Some commentators advocate institutional solutions, such as a Sovereign Debt Restructuring Mechanism with uniform and mandatory provisions, while others recommend market-based solutions including collective action clauses in debt contracts and question the wisdom of curbing holdout litigation. In this paper, we have sought to examine a middle ground between these positions, in which the presence of a court that emphasises the ﬁduciary duty of the debtor to its creditors assumes centre-stage. We present a model that characterises the ex ante and ex post implications of holdout litigation, and highlights the important part that debt ownership and jurisdictional competition play in determining the eﬃcacy of the legal threat to sovereign debt enforcement. Our model formalises some of the insights of the Bolton and Skeel(2004) proposal for a sovereign bankruptcy framework and sheds light on the allocation of lawmaking rights in sovereign debt.

While our model has the virtues of simplicity and tractability, it can no doubt be improved in many ways. Enriching the analysis to better capture the social dead weight losses that accrue when entrepreneurs hand over collateral to creditors and when domestic bankers sell debt securities to outsiders is an important extension. A more considered perspective on the relationship between case law and sovereign debt enforcement is another. The existing framework can also be modiﬁed to allow creditors to purchase credit default swaps ex ante, thereby insuring themselves against a bankruptcy event. It can also be adapted to capture “grey zone crises”. As highlighted by Becker and Stromberg(2012), judges may rule in the creditors

25 favour well before the moment of insolvency. Such behaviour could risk blurring the line between solvency and liquidity problems since expected recovery rates in a restructuring are a critical inﬂuence on short-term decisions on liquidity (Haldane et al., 2004). We leave consideration of these topics for future work.

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30 Appendix A. Proof for Lemma1

We prove the result in four steps.

Step 1

∗ ∗ Suppose that ρs > ρn > χ(z) is a Nash equilibrium.

∗ ∗ ∗ No entrepreneur would choose court S to ﬁle for bankruptcy, and hence φs(ρs, ρn) =

0, and Πs = 0. In contrast, all entrepreneurs seeking to ﬁle for bankruptcy would

∗ ∗ ∗ ∗ approach Court N, implying φn(ρn, ρs) = 1, and Πn = ρn − χ(z) > 0.

But this cannot be an equilibrium, because Court S’s best-response to Court

∗ 0 ∗ N’s price of ρn is to set a new price ρs = ρn − δ, where δ is an infinitesimally small number. This, in turn, would lead to Court S having positive profits, and Court N having zero profits.

∗ ∗ Thus, ρs > ρn > χ(z) cannot be an equilibrium.

Step 2

∗ ∗ Suppose that ρs = ρn > χ(z) is an equilibrium.

In this case both courts equally share the market for administering bankrupt-

∗ ∗ cies. Consequently, Πs = ρs − χ(z) = Πn = ρn − χ(z) > 0. But, this cannot be an ∗ equilibrium, because the best response of Court S to Court N’s price of ρn is to set 0 ∗ a new price ρs = ρn−δ. In this case, all entrepreneurs will choose Court S to file for 0 ∗ bankruptcies. Thus, Court S’s profits increase to Πs = ρs −χ(z) > 0.5 ρs −χ(z) , and the profits for Court N are zero, i.e Πn = 0.

∗ ∗ Thus, ρs = ρn > χ(z) cannot be an equilibrium.

31 Step 3

∗ ∗ Suppose that ρn > ρs = χ(z) is an equilibrium.

In this case, all entrepreneurs will turn to Court N to ﬁle for bankruptcies,

∗ and therefore Πs = 0 and Πn = ρn −χ(z) > 0. But, this cannot be an equilibrium, 0 ∗ since Court S’s best response is to set the price ρs = ρn − δ, i.e., just below Court 0 N’s price to capture the full market from Court N. In this case Πs = ρs −χ(s) > 0.

∗ ∗ Therefore ρn > ρs = χ(z) cannot be an equilibrium.

Step 4

∗ ∗ The only possible equilibrium is ρs = ρn = χ(z). In this case, both courts share the market, but have zero proﬁts. Moreover, no court has any incentive to

0 ∗ deviate. To see this, consider Court S setting the price at ρs = ρn − δ. In this case, Court S captures the full market share. But, because the price is less than the marginal cost of administering bankruptcies, Court S has negative proﬁts. Therefore, Court S has no incentives to deviate.

Appendix B. Proof for Propositions1–3

The optimal contract for the representative entrepreneur, {R∗, θ∗, b∗}, and the amount invested by the entrepreneur, k∗, are jointly determined by maximizing

π(k)[Y − R] + W − [1 − π(k)] θ + 1 + r [b − k] , (B.1)

32 subject to

b ≥ k (B.2) χ(z) W ≥ θ (B.3) γ(z, q, ) π0(k)[Y − R + θ] = 1 + r (B.4) b 1 + r π(k) R + (1 − π(k)) θ = . (B.5) 1 − q S

Let λ1, λ2, λ3 and λ4 be the Lagrange multiplier for the above four constraints, respectively. The ﬁrst-order conditions are

π00(k) r −λ + λ + λ π0(k) 1 − q S R − θ) = 0 , (B.6) 1 3 π0(k) 4 λ1 = 1 + r [λ4 − 1] (B.7)

0 λ2 = 1 − π(k) λ4 1 − q S − 1 + π (k) λ3 (B.8) π(k) λ = λ 1 − q S − 1 . (B.9) 3 π0(k) 4

Since, the incentive compatibility constraint, Equation (B.4), is binding, λ3 > 0. It, therefore, follows from Equation (B.9) that λ4 > 1 1 − q S > 1, and hence, λ1 > 0 and λ2 > 0. Inserting the binding collateral constraint into the participation and incentive compatibility constraints, we obtain that R∗ and k∗ are given by the solution to

χ(z) W 1 + r k∗ χ(z) W /γ(z, q, ) R∗ − = − , (B.10) γ(z, q, ) π(k) 1 − q S 1 + r and

1 + r k∗ χ(z) W /γ(z, q, ) π0(k∗) Y − − − 1 + r = 0 , (B.11) π(k) 1 − q S 1 + r respectively.

In what follows, we deﬁne IK to be equal to the lefthand side of Equation

33 (B.11). Deﬁning φ(k) = π0(k)k/π(k) ∈ [0, 1], we have that

∂IK π00(k∗) π0(k∗) 1 + r = 1 + r − 1 − φ(k∗) < 0 . (B.12) ∂k∗ π0(k∗) π(k∗) 1 − q S

The partial derivative of IK with respect to q is

0 ∗ " ∗ # ∂IK π (k ) z χ(z) W S k (1 + r) = Gf ( z) − Gb( z) − . (B.13) ∂q π(k∗) γ(z, q, )2 1 − q S2

If Gf ﬁrst-order stochastic dominates Gb, then ∂IK/∂q < 0, and hence, by the

∗ implicit function, dk /dq < 0. On the other hand, if Gb ﬁrst-order stochastic

dominates Gf , then whenever

2 z χ(z) W Gf ( z) − Gd( z) 1 − q S) k∗ < bk ≡ , γ(z, q, )2 S (1 + r)

we have that ∂IK/∂q > 0. For k∗ to be less than bk in equilibrium, it must be the case that IK(bk) < 1 + r. This is true as long as

( " #) 1 1 bk χ(z) W / γ(z, q, ) Y < Yb ≡ 1 + r + − . (B.14) π0(bk) π(bk) 1 − q S 1 + r

Consequently, we have that dk∗/dq > 0. However, for Y ≥ Yb, it follows that ∂IK/∂q < 0, and hence dk∗/dq < 0.

Next, the partial derivative of IK with respect to z yields

∂IK π0(k∗) ∂ χ(z) = W ∂z π(k∗) ∂ z γ(z, q, ) ∝ G( z) − ξ 1 − 2 z2 g( z) − 2 z g( z) ,

where g( z) ≡ (1 − q) gb( z) + q gf ( z). Consequently, ∂IK/∂z > 0 whenever

G( z) − 2 z g( z) ξ < ξb≡ , (B.15) 1 − 2 z2 g( z)

34 and hence, dk∗/dz > 0. While, for xi > ξb, it follows that ∂IK/∂z < 0, and hence, dk∗/dz < 0 as well.

Finally, the partial derivative of IK with respect of r is

∂IK φ(k∗) = − − 1 < 0 , (B.16) ∂r 1 − q S

and therefore dk∗/dr < 0.

Appendix C. Proof for Corollary1

With complete information, the ﬁrst-best solution is kf = 1/A. To ensure this

AY is indeed an equilibrium, we assume 1+r − 1 > 0. This, in turn, implies an upper bound, r ≤ r ≡ AY − 1 for the world interest rate.

The Lagrangian for this optimal contract with the linear production function is

h i L = k A Y − R + θ − 1 + r + W − θ + 1 + r b

+ λ1 [b − k] + λ2 [χ(z)W/γ(z, q, ) − θ] + λ3 Y + θ − 1 + r /A − R h i + λ4 k A R − θ + θ 1 − q S − (1 + r) b . (C.1)

Following identical lines of reasoning to Appendix B, we obtain that λ3 > 0,

and λ4 > 1. Hence, λ1 > 0 and λ2 > 0, and all constraints are binding. We thus have that the equilibrium returns are

χ(z)W 1 + r R∗ = Y + − , (C.2) γ(z, q, ) A

35 and level of investment is

   1 χ(z) W / γ(z, q, )  k∗ = min , . (C.3) A 1 AY  1 + r 1 − q S − 1 + r − 1 

1 To ensure that the interior solution is strictly positive, we require that 1−qS − AY 1+r − 1 > 0. This condition is most binding when q = 0, which, in turn, yields AY a lower bound for the world interest rate, r ≥ r ≡ 2 − 1.