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 ju- risdictional 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 hold- out 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 mar- kets, 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 over- sight 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 al- lows 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 bear- ing 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 Saur´e(2012) point to a reallocation of debt positions from foreign creditors to domestic banks following the recent debt crisis.