Q. 3.6 Mechanisms for Sovereign Debt Restructuring
IMF initiatives on sovereign debt restructuring
One of the key manifestations of a severe financial crisis is the occurrence of a
sovereign debt default. In such an instance, the country itself defaults on its debt
payments to international creditors, sparking an immediate cessation in the country’s ability to access any new external financial flows. The moment immediately following the declaration of sovereign default can be critical. If well managed, the occasion can be used to settle markets and to find quick agreement among international creditors that have been affected by the default, on the way in which the country will resume its access to capital markets and in so doing repay the creditors. If well managed, this process can also contribute to a situation in which the affected creditors decide not to pursue legal processes to reclaim the amounts due to them – in effect, staying or holding back legal action momentarily.
By contrast, if the moment following default is not well managed, this can lead to legal action by affected creditors, large-scale attempts by these and other creditors to take their money out of the country, a precipitous decline in confidence and in economic activity. This is the scenario which confronted most of the East Asian countries in 1997 and subsequently.
In the section above, on the IMF’s policy on lending into sovereign arrears, you studied the approach the IMF takes when lending to a country in arrears in its
payments to private creditors. The purpose of this lending is to enable the country to overcome short-term liquidity crises and to ensure a speedy resumption of private capital flows. An important element in this process is the need for the country to arrive at an arrangement with private creditors, which calms creditor concerns and arrives at a restructuring of sovereign debt in a manner that minimises capital outflows.
In the period since 1997, after modifying its policy to allow for lending into
sovereign arrears to private creditors, the IMF has also focused attention on the
issue of what would be required to achieve a sovereign debt restructuring in a manner least disruptive to capital flows, which protected creditor interests and which also ensured that countries have the time and space in which to come to an orderly restructuring arrangement with their private creditors.
The focus of the IMF’s work on sovereign debt restructuring has been to find ways to create a more orderly and transparent legal framework for such restructurings and to identify more clearly the considerations that should guide the availability of Fund financing during and after a restructuring. This issue has received international attention, with the tabling of an initial set of proposals by the First Deputy Managing Director, Anne Krueger.
One of the key challenges in restructuring sovereign debt once a country has defaulted to its private creditors, is the danger that individual creditors will
refuse to participate in a voluntary restructuring process, in the hope that these
individual creditors will recover payments due to them on the original contractual
terms of the loan. Where a significant number of creditors adopts such an approach, it becomes difficult for the country to negotiate with creditors collectively, and accordingly it becomes much more difficult to stem a rush by creditors to withdraw their loans.
One of the most significant challenges in sovereign debt restructuring has therefore become the challenge of finding mechanisms to convince creditors to act as a group and not to fragment their responses. For by acting as a group, an orderly debt workout can prevent the herd behaviour that causes creditors to individually rush to call in their loans, the worst-case scenario which creditors themselves fear. The IMF has promoted two such mechanisms in its contribution to finding ways to achieve orderly sovereign debt restructuring:
• the promotion of the process of including collective action clauses in
sovereign bond contracts
• the recommendation to establish a statutory framework to guide creditors
and debtors in all instances of sovereign debt restructuring, thereby
preventing individual creditors splitting from the broader creditor group
and precipitating a panic.
Collective action clauses are provisions in bond contracts that enable the sovereign
that issues the bond and a qualified majority of those who hold the bond to make decisions that become binding on all bondholders of that particular issuance. Perhaps the most important provision of these clauses is majority restructuring, which enables a qualified majority of bondholders to bind all bondholders within the same issuance to the terms of a restructuring agreement, either before or after default. In addition, majority enforcement enables a qualified majority of bondholders to prevent individual creditors from taking disruptive legal actions after a default takes place but before a restructuring agreement is reached.
Majority restructuring provisions currently exist in sovereign bonds governed by English, Japanese and Luxembourg law. But bonds governed by New York law, which currently represent the largest portion of the emerging market sovereign bond market, have traditionally not included majority-restructuring provisions. For this reason, the recent decision by a number of emerging market countries to include these provisions in bonds issued under New York law represents an important breakthrough.
Proposed Sovereign Debt Restructuring Mechanism
Besides encouraging CACs, the IMF has also followed a second, parallel, approach in seeking ways to ensure orderly debt workouts once a sovereign debt default occurs. This second approach has focused on a proposal by the IMF to institute a formal, legally binding, Sovereign Debt Restructuring Mechanism (SDRM). There are two key distinguishing features of this proposal. The first is that a statutory SDRM as proposed by the IMF would create a legally binding framework that provides for collective action for all instruments involved in a sovereign debt default, including those whose contracts stipulate that the financial terms can only be restructured through a unanimous decision of all creditors. The implication of the statutory SDRM is that because it would be legally binding, its force would over-ride contracts which explicitly recognised the ability of a single creditor to step outside a collective creditor arrangement.
The second important distinguishing feature of the statutory SDRM proposal is that it seeks a comprehensive solution, rather than an instrument-byinstrument, or bond-by-bond, solution to a sovereign debt default. For this reason, the SDRM proposes that the votes of similarly situated creditors who Unit 5 Stabilisation and the Financial Sector Centre for Financial and Management Studies 19
hold participating debt instruments will be aggregated, so that a single vote will
be able to be taken among all creditors, to restructure multiple debt instruments.
The statutory SDRM effectively contains three key provisions: firstly that a qualified majority of creditors across aggregated claims could vote to accept new terms under a restructuring agreement, thereby binding all affected creditors. Secondly, that the mechanism would include provisions to prevent enforcement actions by creditors from disrupting the negotiating process, or delaying agreement on a restructuring that could be acceptable to a broad majority of creditors.
The third key element of the statutory SDRM proposals is the proposal to create an independent dispute resolution forum, to verify claims, to ensure the integrity of the voting process and to adjudicate disputes that could arise once the SDRM has been activated.
The IMF’s proposal to establish a statutory SDRM is a relatively new proposal, which was first broached in 2002. However, both the legally binding element and the proposal to aggregate votes across different classes of debt instrument have opened the IMF to considerable criticism. Firstly, it is argued that the IMF is not a party to international bond contracts between sovereigns and their private creditors and should therefore not influence the nature of the provisions contained in these contracts. Secondly, critics argue that IMF financing, even when it is provided in the context of sovereign debt defaults, is comparatively small in relation to total financial requirements during the crisis period. Accordingly, the relative influence of the IMF’s approach should be diminished. Thirdly, creditors have objected to the concept that clauses which they negotiate with their debtors can be over-ridden by a seemingly supra-national entity.
Thus far, the proposal for a statutory SDRM has not been accepted by all IMF members, with three key issues requiring further consensus before an agreement is likely:
• arrangements for improving equity among creditors, as the current proposals significantly favour those who are likely to have a majority of voting power in any dispute
• the need to enhance transparency and disclosure, as some creditors fear
that their interests are likely to be over-ridden in any debt resolution, by
side-deals in which they are not present
• concern regarding the principle of aggregation of votes, as well as the
process through which aggregation takes place.
One of the key manifestations of a severe financial crisis is the occurrence of a
sovereign debt default. In such an instance, the country itself defaults on its debt
payments to international creditors, sparking an immediate cessation in the country’s ability to access any new external financial flows. The moment immediately following the declaration of sovereign default can be critical. If well managed, the occasion can be used to settle markets and to find quick agreement among international creditors that have been affected by the default, on the way in which the country will resume its access to capital markets and in so doing repay the creditors. If well managed, this process can also contribute to a situation in which the affected creditors decide not to pursue legal processes to reclaim the amounts due to them – in effect, staying or holding back legal action momentarily.
By contrast, if the moment following default is not well managed, this can lead to legal action by affected creditors, large-scale attempts by these and other creditors to take their money out of the country, a precipitous decline in confidence and in economic activity. This is the scenario which confronted most of the East Asian countries in 1997 and subsequently.
In the section above, on the IMF’s policy on lending into sovereign arrears, you studied the approach the IMF takes when lending to a country in arrears in its
payments to private creditors. The purpose of this lending is to enable the country to overcome short-term liquidity crises and to ensure a speedy resumption of private capital flows. An important element in this process is the need for the country to arrive at an arrangement with private creditors, which calms creditor concerns and arrives at a restructuring of sovereign debt in a manner that minimises capital outflows.
In the period since 1997, after modifying its policy to allow for lending into
sovereign arrears to private creditors, the IMF has also focused attention on the
issue of what would be required to achieve a sovereign debt restructuring in a manner least disruptive to capital flows, which protected creditor interests and which also ensured that countries have the time and space in which to come to an orderly restructuring arrangement with their private creditors.
The focus of the IMF’s work on sovereign debt restructuring has been to find ways to create a more orderly and transparent legal framework for such restructurings and to identify more clearly the considerations that should guide the availability of Fund financing during and after a restructuring. This issue has received international attention, with the tabling of an initial set of proposals by the First Deputy Managing Director, Anne Krueger.
One of the key challenges in restructuring sovereign debt once a country has defaulted to its private creditors, is the danger that individual creditors will
refuse to participate in a voluntary restructuring process, in the hope that these
individual creditors will recover payments due to them on the original contractual
terms of the loan. Where a significant number of creditors adopts such an approach, it becomes difficult for the country to negotiate with creditors collectively, and accordingly it becomes much more difficult to stem a rush by creditors to withdraw their loans.
One of the most significant challenges in sovereign debt restructuring has therefore become the challenge of finding mechanisms to convince creditors to act as a group and not to fragment their responses. For by acting as a group, an orderly debt workout can prevent the herd behaviour that causes creditors to individually rush to call in their loans, the worst-case scenario which creditors themselves fear. The IMF has promoted two such mechanisms in its contribution to finding ways to achieve orderly sovereign debt restructuring:
• the promotion of the process of including collective action clauses in
sovereign bond contracts
• the recommendation to establish a statutory framework to guide creditors
and debtors in all instances of sovereign debt restructuring, thereby
preventing individual creditors splitting from the broader creditor group
and precipitating a panic.
Collective action clauses are provisions in bond contracts that enable the sovereign
that issues the bond and a qualified majority of those who hold the bond to make decisions that become binding on all bondholders of that particular issuance. Perhaps the most important provision of these clauses is majority restructuring, which enables a qualified majority of bondholders to bind all bondholders within the same issuance to the terms of a restructuring agreement, either before or after default. In addition, majority enforcement enables a qualified majority of bondholders to prevent individual creditors from taking disruptive legal actions after a default takes place but before a restructuring agreement is reached.
Majority restructuring provisions currently exist in sovereign bonds governed by English, Japanese and Luxembourg law. But bonds governed by New York law, which currently represent the largest portion of the emerging market sovereign bond market, have traditionally not included majority-restructuring provisions. For this reason, the recent decision by a number of emerging market countries to include these provisions in bonds issued under New York law represents an important breakthrough.
Proposed Sovereign Debt Restructuring Mechanism
Besides encouraging CACs, the IMF has also followed a second, parallel, approach in seeking ways to ensure orderly debt workouts once a sovereign debt default occurs. This second approach has focused on a proposal by the IMF to institute a formal, legally binding, Sovereign Debt Restructuring Mechanism (SDRM). There are two key distinguishing features of this proposal. The first is that a statutory SDRM as proposed by the IMF would create a legally binding framework that provides for collective action for all instruments involved in a sovereign debt default, including those whose contracts stipulate that the financial terms can only be restructured through a unanimous decision of all creditors. The implication of the statutory SDRM is that because it would be legally binding, its force would over-ride contracts which explicitly recognised the ability of a single creditor to step outside a collective creditor arrangement.
The second important distinguishing feature of the statutory SDRM proposal is that it seeks a comprehensive solution, rather than an instrument-byinstrument, or bond-by-bond, solution to a sovereign debt default. For this reason, the SDRM proposes that the votes of similarly situated creditors who Unit 5 Stabilisation and the Financial Sector Centre for Financial and Management Studies 19
hold participating debt instruments will be aggregated, so that a single vote will
be able to be taken among all creditors, to restructure multiple debt instruments.
The statutory SDRM effectively contains three key provisions: firstly that a qualified majority of creditors across aggregated claims could vote to accept new terms under a restructuring agreement, thereby binding all affected creditors. Secondly, that the mechanism would include provisions to prevent enforcement actions by creditors from disrupting the negotiating process, or delaying agreement on a restructuring that could be acceptable to a broad majority of creditors.
The third key element of the statutory SDRM proposals is the proposal to create an independent dispute resolution forum, to verify claims, to ensure the integrity of the voting process and to adjudicate disputes that could arise once the SDRM has been activated.
The IMF’s proposal to establish a statutory SDRM is a relatively new proposal, which was first broached in 2002. However, both the legally binding element and the proposal to aggregate votes across different classes of debt instrument have opened the IMF to considerable criticism. Firstly, it is argued that the IMF is not a party to international bond contracts between sovereigns and their private creditors and should therefore not influence the nature of the provisions contained in these contracts. Secondly, critics argue that IMF financing, even when it is provided in the context of sovereign debt defaults, is comparatively small in relation to total financial requirements during the crisis period. Accordingly, the relative influence of the IMF’s approach should be diminished. Thirdly, creditors have objected to the concept that clauses which they negotiate with their debtors can be over-ridden by a seemingly supra-national entity.
Thus far, the proposal for a statutory SDRM has not been accepted by all IMF members, with three key issues requiring further consensus before an agreement is likely:
• arrangements for improving equity among creditors, as the current proposals significantly favour those who are likely to have a majority of voting power in any dispute
• the need to enhance transparency and disclosure, as some creditors fear
that their interests are likely to be over-ridden in any debt resolution, by
side-deals in which they are not present
• concern regarding the principle of aggregation of votes, as well as the
process through which aggregation takes place.
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posted by Ronald Rutherford at 6:15 PM
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