Current Legal Issues Affecting Central Banks, Volume V
Chapter

Chapter 13 Legal Framework for Dealing with Sovereign Debt Defaults

Author(s):
Robert Effros
Published Date:
May 1998
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Author(s)
HERBERT V. MORAIS

Introduction

The Mexican financial crisis in December 1994 was a wakeup call to the international financial and political community to urgently consider improved procedures to deal with sovereign liquidity crises. The increasing size and diversity of financial flows to the emerging market economies, the growing liberalization of capital markets, and the revolution in information technology have made it clear that countries are much more susceptible to sudden and large shifts in their foreign reserves positions.

It took “all the King’s horses and all the King’s men” to rescue Mexico from its financial crisis. The International Monetary Fund (IMF), for its part, provided the largest financial assistance package in its history—totaling about $17.8 billion equivalent—under an emergency Stand-By Arrangement. In addition, the United States provided about $20 billion, and the Bank for International Settlements offered about $10 billion to Mexico. If there ever was a balance of payments crisis, this was it. The quick provision of this temporary financial lifeline to Mexico contributed significantly to averting an even bigger crisis worldwide and served to restore investor confidence in the Mexican economy.

Mexico has taught a couple of important lessons that national treasuries and central banks need to carefully study and benefit from. The first lesson is that the world simply cannot afford to face repeated sovereign liquidity crises of the magnitude of Mexico. The second lesson is that, if such crises were to occur again in spite of the best preventive measures, including strengthened surveillance by the IMF and better provision of information on economic and financial data to the public by member countries, both the IMF and the international financial community must be ready to respond effectively.

Therefore, treasury officials, central bankers, and lawyers have a formidable challenge to urgently examine the inadequacies of the present legal framework for dealing with sovereign liquidity crises and to come up with new ideas and improvements in legal procedures for resolving such crises in a comprehensive and meaningful way.

Traditional Legal Framework for Dealing with Sovereign Debt Problems

To be able to consider and propose improvements in legal procedures for dealing with sovereign debt problems in the future, it is necessary to first identify and analyze the deficiencies in the existing “traditional” legal framework for rescheduling sovereign debt. There are several different categories of sovereign debt. The main categories of such debt are financial assistance from multilateral financial institutions like the IMF, the World Bank, and the regional development banks; credits from official bilateral sources (including export credit agencies); syndicated loans from private financial institutions (mainly commercial banks); and bonds publicly issued by sovereign borrowers in the international capital markets.1

The legal framework governing each of the main categories of sovereign debt is addressed below, including essential features, contractual provisions, and overall adequacy and effectiveness.

Multilateral Credits

The first category of debt is that owed to multilateral financial institutions (MFIs), such as the IMF, the World Bank, and the regional development banks. Debt owed to MFIs has consistently been excluded from debt reschedulings because these institutions are considered “preferred creditors.” Moreover, member countries, as a practice, give higher priority to servicing their multilateral debt over other external debts when faced with a shortage of foreign currency. This preferred creditor status is not based on any contractual provisions in the relevant loan or other financing agreements, but on the unique status of these institutions and their special relationship to their member countries. The policy reasons that underpin their preferred creditor status include the following: first, these institutions make loans in circumstances under which other lenders would not participate; and, second, a reduction in the value of debt to such institutions affects all members, including the debtor. Furthermore, in the case of the World Bank the policy against rescheduling is designed to protect its triple-A credit rating in the international bond markets, from which it draws most of its loanable resources and where it is one of the largest borrowers.

Bilateral Credits

The bulk of official bilateral credits to sovereign borrowers in the Third World is provided by the governments of the major industrial countries that constitute the Organization for Economic Cooperation and Development (OECD). When a sovereign borrower anticipates default in the service of its debt to these official creditors, it usually contacts the Paris Club. The Paris Club is not a formal legal entity or international organization. Rather, it is an informally organized group of official creditors that has operated for many years under the chairmanship of a member of the French Finance Ministry.

The Paris Club first met in 1956 specifically to deal with Argentina’s difficulties in servicing its debt to several European sovereign creditors. It has continued since that time as a forum for handling the restructuring of official bilateral credits and guarantees extended by OECD countries. For each sovereign borrower, the Paris Club negotiations conclude with an Agreed Minute, setting forth a uniform formula on the basis of which each creditor will renegotiate directly with the borrower. This formula does not constitute the restructuring; rather, it provides the broad legal framework or principles to be followed in negotiating subsequent bilateral restructuring agreements. A fixed period (for example, 12–18 months) is allowed for renegotiation. While not constituting a formal, contractual standstill, it is generally understood that a creditor will not press its claims during this period.2 The borrower, in turn, gives the Paris Club creditors an undertaking that non-Paris Club creditors would receive “comparable treatment,” although the precise meaning of this term has never been fully understood. The IMF, the World Bank, the OECD, and the European Union are invited as observers to Paris Club meetings. It is important to note in this context that the existence of an economic adjustment program supported by the IMF is a precondition for restructuring agreements concluded under the framework of the Paris Club. In turn, reaching agreement with the Paris Club is also usually a precondition for London Club reschedulings with the commercial banks. Similarly, the existence of arrears to Paris Club creditors would normally disqualify a country from access to IMF resources.

The terms of Paris Club reschedulings have varied from time to time. They have ranged from straightforward postponement of maturities to interest rate reductions and, in more recent years, have gone as far as providing partial debt forgiveness or cancellation. Under the latest terms, known as the Naples Terms and adopted in December 1994, low-income rescheduling countries are eligible to receive a reduction in eligible official bilateral debt ranging from 50 percent to 67 percent in net present value (NPV) terms.

On the whole, Paris Club reschedulings have been efficient and satisfactory and have provided significant debt relief to many countries, particularly those less-creditworthy countries in Africa that rely more heavily on official sources of credit. The only remaining problem with respect to official bilateral credits is that several major bilateral creditors (such as Russia and countries in the Middle East, like Saudi Arabia and Kuwait) do not operate within the framework of the Paris Club. It would, therefore, be more difficult to coordinate the inclusion and participation of non-Paris Club creditors within the framework of any comprehensive debt adjustment procedure for sovereign debtors.

Syndicated Loans

Financing under syndicated loans is generally provided by financial institutions, mainly private commercial banks but also including investment banks and insurance companies. Since the early 1970s when banks were awash with petro dollars, syndicated bank lending has been the principal source of financing for sovereign borrowers, although there has been a significant decline in recent years. For the most part, the loans are provided by foreign or nonresident financial institutions.

The term “syndication” signifies that a number of financial institutions agree to jointly provide the loan to the sovereign borrower under one loan agreement. On the other hand, a curious feature of loan syndications is that lenders also reserve the right to take independent action under certain circumstances, such as the right to institute legal proceedings against the debtor. The result has been the exercise by one or more syndicate members of the right to institute legal proceedings for the recovery of the debt, which has caused problems for some sovereign debtors as they attempted to negotiate and implement rescheduling agreements with a majority of their creditors.

Syndicated loan agreements do not contain any explicit provisions for the rescheduling of the loan under specified circumstances. The usual legal basis for effecting any change in the repayment terms of the loan is the amendment clause included in the loan agreement. This clause ordinarily provides, among other things, that any amendment that seeks to reduce the principal of, or interest on, the loan requires the unanimous consent of the lenders. This requirement of unanimity has delayed the conclusion of several rescheduling negotiations with sovereign debtors.

One of the cardinal principles enshrined in syndicated loan agreements is the equal treatment of creditors. This principle manifests itself in two different ways. First, the principle calls for equal treatment of creditors within the loan syndicate. This principle is given effect through the “sharing of payments” clause, which is found in virtually all loans. The sharing clause provides that, if any bank obtains payment with respect to principal of, or interest on, the loan owed to it that is proportionately greater than the payment obtained by any other bank with respect to such principal or interest, then the bank receiving such payment must share such payment with all co-lenders under the agreement on a pro rata basis. This sharing clause is designed to ensure that no one lender is placed, at the discretion of the borrower, in a more favorable position with respect to loan recovery than its co-lenders under the loan agreement. Typically, the pro rata sharing is achieved by an agreement to pool all payments received into the hands of the agent bank, which then distributes the proceeds to all lenders on a pro rata basis. Although the loan agreements generally recognize an individual bank’s right to institute legal proceedings against the borrower, the effect of the sharing clause (which stipulates that payments of principal or interest obtained through litigation must be shared pro rata with the other banks) is that there is a strong expectation that even legal proceedings should be instituted jointly because it usually follows an acceleration decision taken by the syndicate.

The second facet of the equal treatment of creditors is designed to achieve intercreditor equality; that is, each lender in the syndicate seeks the assurance of the borrower that it will receive treatment no less favorable than that accorded to other external creditors of the debtor. This principle of intercreditor equality is given effect through four separate but related clauses. These clauses are (i) the pari passu clause, (ii) the negative pledge, (iii) the mandatory prepayment clause, and (iv) the cross-default clause.

The “events of default” clause, which appears in all loan agreements, usually provides that, upon the occurrence and continuance of any of the enumerated events, the lenders may exercise certain legal remedies against the borrower. The single most important event of default is the failure of the borrower to pay principal or interest when due. Such failure is generally considered to be the clearest signal to the lenders that the prospect of repayment of the loan by the borrower is impaired. In the debt crisis scenario, the “failure to pay” event has assumed the greatest significance, as it is invariably the first sign of a borrower’s debt servicing difficulties arising from a liquidity squeeze. The other relevant event of default usually included in loan agreements is that the borrower has admitted in writing its inability to pay its debts as they come due or has declared a moratorium. Upon the occurrence and continuance of an event of default, the lenders are entitled, upon notice to the borrower, to terminate the commitment to lend and/or accelerate the maturity of the loan.3

The lenders’ remedy for default by the borrower following acceleration is to institute legal proceedings against the borrower. Usually, any individual lender may institute legal proceedings in its own name against the borrower, although acceleration decisions normally require a collective decision by a specified majority of the lenders, as noted above. This individual right to bring suits has been recognized in numerous judicial decisions in the main lenders’ jurisdictions, such as London and New York.

When faced with actual or imminent default by a sovereign borrower, commercial banks have had little difficulty organizing themselves as a representative group to conduct rescheduling negotiations with the borrower. Thus, commercial banks have organized themselves under arrangements known as the London Club (which first met in 1976 to restructure the Democratic Republic of the Congo’s debt). This forum has continued to handle the restructuring of loans made by commercial banks to sovereign debtors. Banks that participate in the London Club are represented by a steering committee or advisory committee, which typically consists of no more than 15-20 banks and which deals directly with the sovereign borrower. During the period of negotiation, creditor banks generally refrain from commencing legal proceedings against the defaulting sovereign. The negotiations between the sovereign borrower and the committee are completed when agreement is reached on a term sheet, which outlines the proposed restructuring terms. The term sheet is then sent to all members in the syndicate for their approval. As noted above, syndicated loan agreements usually require the unanimous consent of creditor banks to change the payment terms. This consent has been impossible to achieve in some recent cases, as some banks were dissatisfied with the terms being offered. A few reluctant banks assigned their claims to other parties, which then initiated legal suits against the sovereign debtor.

The typical reschedulings concluded under this framework from about 1982 to 1989 were characterized by four essential features: first, there was maintenance of the full stock of debt; second, the rescheduling essentially involved postponing some of the loan maturities (for example, for two to three years); third, such reschedulings were predicated on the borrower’s implementation of an IMF-supported adjustment program; and finally, as noted above, prior agreement on a Paris Club rescheduling was reached.

On the whole, this London Club process has worked reasonably well in the sense that it has succeeded in achieving rescheduling agreements for some of the biggest and most highly indebted middle-income countries like Argentina, Brazil, Chile, Mexico, and Nigeria. When compared with the Paris Club, the London Club negotiation process has been characterized by prolonged delays (sometimes one to two years), friction, and even confrontation. The bargaining positions of the sovereign debtor and bankers have never really been equal, with the bankers usually having the upper hand. Moreover, with the wisdom of hindsight it can now be said that much of the debt relief offered to sovereign debtors was not very meaningful, as evidenced by successive reschedulings. In addition, of course, there was always a problem with a few banks that refused to go along with the agreed rescheduling terms. These banks have been affectionately called by a number of different names—free riders, rogue creditors, dissenting creditors, and maverick creditors.

A watershed in the sovereign debt crisis was reached when, on March 10, 1989, the then U.S. Treasury Secretary, Nicholas Brady, announced a major new initiative to break the back of the debt problem. Following several years of “muddling through” under the so-called case-by-case approach, the U.S. government (supported by other creditor countries) endorsed debt forgiveness for the first time by encouraging commercial banks to enter into debt and debt service reduction transactions with borrowers that were implementing economic adjustment programs supported by the IMF and the World Bank.

The debt reduction transactions envisaged by the Brady initiative would result in either a reduction of the outstanding principal of the loans (that is, a reduction in the stock of debt) or a reduction in the interest payable on these loans, or both. The sweetener that was suggested under this proposal was that the commercial banks would be offered credit enhancement (funded by the IMF, the World Bank, bilateral sources, and the borrower itself) on the remaining reduced obligations. The three principal instruments that were subsequently used by the commercial banks and some borrowers to implement the Brady initiative were (i) cash buybacks, (ii) discount bonds, and (iii) par bonds.

Under the Brady initiative, several debt and debt service reduction transactions were entered into with the highly indebted countries, particularly the big debtors like Brazil, Chile, Mexico, the Philippines, and Venezuela. The first point to note about these transactions is that, unlike the traditional reschedulings, the Brady debt and debt service reduction transactions provided significant and therefore meaningful debt relief to sovereign borrowers, thereby enabling them to implement their economic adjustment program without an unbearable debt burden. The second point to note is that these transactions have also resulted in a massive transformation of sovereign debt instruments from loans to bonds.

International Bonds

For many years, bonds publicly issued by sovereign debtors in the international capital markets represented only a small component of the external debt stock of most highly indebted middle-income countries. However, the situation changed dramatically in recent years. The total amount of sovereign bonds outstanding has increased from about $20 million in 1980 to about $225 billion in 1993. This was matched by a significant decline in syndicated bank lending. There are several reasons for this shift, including the gradual drying up of bank loans to sovereign borrowers, the desire of borrowers to broaden and diversify their investor base, and the relative ease with which bonds could be issued.

The most important feature of bonds is that, in contrast to the relative homogeneity of bank lenders under a syndicated loan, the investors in bonds are a very diverse group, ranging from the proverbial Belgian dentist to mutual funds, insurance companies, pension funds, and other institutional investors. The diversity in the investor base seriously complicates any effort toward the rescheduling of the bonds. It is important also to note that, historically, the principal attractiveness of bonds has been that they have generally been excluded from sovereign debt reschedulings, except for a few instances, such as those in Europe between the 1930s and 1950s.

In contrast to the Paris and London Clubs, there is no organized forum for negotiations with bondholders. Therefore, collective representation of, and decision making by, bondholders has been made more difficult by their large number and wide dispersion, and by the proliferation of bearer bonds. However, there are terms and conditions in existing bonds that permit a limited form of organization of bondholders. Currently, representative bond terms and conditions include a trust deed or indenture. The deed normally includes (i) the appointment of a trustee, who manages various aspects of the bond, including implementing certain decisions of bondholders; (ii) clauses providing for the calling of general meetings of bondholders, during which decisions can be made that alter the terms and conditions of the bonds; and (iii) clauses stipulating the quorum required for adoption of changes to the terms and conditions of the bonds. Although the current legal framework does not empower the trustee to serve as agent of the bondholders with regard to negotiating a standstill, a bondholders’ meeting called either by the issuer or the trustee could consider resolutions regarding various proposals, including a resolution amending the dates of payment of interest.

With regard to changes in dates of interest payments or any other significant change in the bonds’ terms and conditions, representative deeds normally require the consent of all bondholders, not only of those present and voting. Such unanimous consent terms virtually eliminate the ability to restrain “free-rider” bondholders. While the representative trust deeds require unanimous consent, one recent example (an Argentine note issue) provided for majority, rather than unanimous, consent to change such terms and conditions.

Another important point to note is that, unlike syndicated loan agreements, the terms and conditions normally appearing in bonds do not include a sharing-of-payments clause. The absence of a sharing clause could be seen as offering a perverse incentive to bondholders to commence legal suits against defaulting sovereigns because they would not have to share the proceeds of any judgment with other bondholders. These additional aspects further evidence the lack of cohesiveness and coordination within the investor group and make decision making most difficult.

When reschedulings for sovereign bonds became necessary in the past, especially between the 1930s and the 1950s, the task proved more manageable because the cases were few and far between. A number of ad hoc procedures, such as the establishment of bondholders’ committees, were put in place to facilitate negotiations between sovereign bondholders and their creditors; following such negotiations, the bondholders’ committees presented their recommendations to the bondholders for approval. Thus, under this framework a standstill was negotiated by a bondholders’ committee for Romania’s debt in 1933; in 1937, the League of Nations Loans Committee made a similar recommendation in respect of Hungary’s debt.

In recent years, there has been a substantial increase in the use of bonds by sovereign borrowers to raise foreign exchange. At the same time, there has been an explosive growth in Brady bonds. This suggests that, in the event of a sovereign liquidity or foreign exchange crisis in the future, it may be impossible to hold bond investors harmless. In these instances, it may be necessary to attempt to arrange a standstill and rescheduling with these creditors as well as those represented in the Paris Club and the London Club.

Two Proposals for Dealing with Future Sovereign Liquidity Crises

Although the Paris Club and the London Club provide reasonably effective forums for restructuring negotiations with official lenders and commercial bank lenders, respectively, there is no such forum for bondholders. Furthermore, there is no single legal framework or tribunal to deal with sovereign debt problems in an orderly and comprehensive way.

A number of proposals have been put forward by scholars and commentators for dealing with these problems. This chapter examines two specific proposals: first, to strengthen the legal framework for negotiating with bondholders; and, second, to establish an international debt adjustment facility patterned to a limited extent on the domestic bankruptcy model.

Strengthening the Legal Framework for Negotiating with Bondholders

Some commentators have suggested that bondholders of sovereign debt could successfully be brought into standstill and rescheduling negotiations by creating a forum representing all or a substantial number of these bondholders, and through which such negotiations could be conducted. A decision by a majority of these bondholders would have to be binding on all bondholders, eliminating the free-rider problem. Three techniques have been mentioned to implement these suggestions:

  • encouraging issuers to include appropriate mechanisms in the terms and conditions of each sovereign bond issue;

  • requiring the inclusion of such mechanisms by domestic law; and

  • establishing bondholders’ committees or associations for sovereign bonds through domestic law.

Mechanisms Under the Terms and Conditions of Bonds

The terms and conditions of bonds could provide for (i) the establishment of a bondholders’ council (as a forum for negotiation) or the appointment of a bondholders’ representative (to represent bondholders during negotiations); (ii) a procedure for bondholder registration (to identify those who have voting rights to approve a standstill negotiated by a representative); and (iii) the binding effect on all bondholders of a decision by a specified majority to prevent free riders from holding up agreement.

As mentioned above, representative bond terms and conditions already have a procedure for calling bondholders’ meetings. However, contacting bondholders for the purpose of calling meetings, or perhaps for selecting a group of bondholders to speak informally with a sovereign regarding a standstill or restructuring, may be difficult, especially because most of these bonds are in bearer, and not registered, form. Representative trust deeds do provide for notices of bondholders’ meetings to be published in a major newspaper of the jurisdiction where the bonds are listed (often Luxembourg) and the jurisdiction of choice of law and venue (often New York or London). Given the development of modern technology, the notice could be even more widely circulated with little additional cost on the Internet. The addition of such a new term to a trust deed could potentially increase the effectiveness of any notice without materially affecting the bonds’ terms and conditions.

Also, as noted above, while representative bond terms require unanimity to effect a standstill or restructuring, there are a few examples of bonds providing for majority decisions that are binding on dissenting bondholders. It cannot yet be concluded whether the majority rule provisions have had any adverse effect on the cost of capital, but these examples suggest the possibility of including similar, or even more flexible, majority rule provisions in future bond issues. To the extent that such a change makes it appear more likely that a sovereign may default, it could raise the cost of borrowing. However, to the extent that it makes a restructuring more orderly in the event of a default, it could reduce the cost of borrowing. The possibility of extending majority rule provisions in future bond issues could be explored with the relatively small number of major underwriters of such bond issues.

Mechanisms Under the Domestic Laws of Creditor Countries

Many jurisdictions have legal rules that specifically provide for, or otherwise regulate, the organization of bondholders. These may include provisions for bondholder meetings and rules for binding dissenting bondholders through majority votes. These rules are of two types: (i) those that are based primarily in commercial law, which tend to apply to all resident commercial issuers of bonds, and (ii) those that are based primarily in securities law, which apply to bonds that are offered for public sale or market listing in the jurisdiction. The rules based in securities law are unlikely to apply to bonds not offered in the jurisdiction.

Currently, some jurisdictions such as the United States (State of New York) and the United Kingdom have specific provisions in their securities rules only for bonds offered or listed in their jurisdictions, while others, such as France and Germany, do so through commercial laws, which apply to local corporations. Current practice has been not to offer sovereign debt in New York or London, thereby obviating the application of securities laws in these jurisdictions. Because sovereign borrowers are not local corporations, they are not subject to rules governing those corporations.

It is highly unlikely that New York or the United Kingdom would enact laws requiring bondholder councils or majority voting in bonds that are not listed within their territories, or that France or Germany would extend their rules on corporations to sovereign borrowers. Moreover, representative bonds are often listed in Luxembourg, which is also unlikely to change its laws in a way that might adversely affect listings there. Therefore, there is little likelihood that a strategy of requiring specific terms and conditions through national laws would work.

Establishment of Bondholder Associations

Provisions have been made in the past under various domestic laws for the establishment of associations of foreign bondholders. These associations have played important roles in helping to organize bondholders and in adding prestige and diplomatic authority to negotiations with foreign sovereign borrowers. However, they do not in any way affect the legal status of the terms and conditions of any bond, including the power to call bondholder meetings or for a majority to bind a minority. As these are the principal problems, such associations are unlikely to add materially to any solutions. Until now, there has been no attempt by governments to confer upon these associations the power to consent to changes in the terms and conditions of bonds on behalf of the bondholders.

Adopting the Bankruptcy Approach

One of the most serious problems with current mechanisms and approaches for dealing with sovereign liquidity crises is that there is no single international legal framework or forum that provides for an orderly process of dealing with such crises in a comprehensive manner along the lines of a domestic bankruptcy court. The first aspect of this problem is that there are several different forums (for example, the Paris Club and the London Club), each with its own set of rules, principles, and operating procedures, or no forums (for example, bondholders). The rules of the game are not uniform. The motivations of the Paris Club (politics, economics, aid, security) are quite different from those of the London Club (profit). The second problem is that existing mechanisms fail to deal, or to deal adequately, with certain important categories of debt, for example, bonds and domestic debts, such as Mexican tesobonos. The net result is that the debt restructuring process as it currently exists has some serious shortcomings that need to be corrected.

Various proposals have, from time to time, been put forward for a comprehensive process of debt adjustment at the international level, which would draw on the experience under national laws to the extent relevant or appropriate. Such a process would be based on a sound economic and financial analysis of the country’s problems, the formulation of a realistic plan for recovery, and a proper balancing of the interests of the debtor and its creditors in a spirit of cooperation.

In some proposals, reference has been made to Chapters 9 and 11 of the U.S. Bankruptcy Code (U.S. Code). Chapter 11, like the laws of many other countries, allows a debtor or a group of the debtor’s creditors to file a petition for reorganization. However, this procedure does not apply to the federal government, states, or other national public entities.

Chapter 9, on the other hand, is more relevant in that it allows a municipality to file a petition for the adjustment of its debts. Chapter 9 differs from Chapter 11 in a number of significant ways: (i) the municipality must be insolvent in order to file a petition; (ii) only the municipality (and not its creditors) may file a petition; (iii) only the municipality may file a plan for the adjustment of its debts; (iv) unless the debtor consents or the plan so provides, the court may not interfere with any of the municipality’s political or governmental powers, property, or revenues, or use or enjoyment of any income-producing property; and (v) a Chapter 9 case may not be converted into a liquidation case. Under either Chapter 9 or 11, the legal effect of the filing of a petition is the “automatic stay,” or suspension of debt collection and lien enforcement by creditors so that the debtor can continue to operate its business or affairs and prepare a plan without interference or threats of legal action.

Although Chapter 9 and Chapter 11 suggest interesting approaches, the issues raised by the indebtedness of sovereign debtors are too specific to be addressed only by an extension of the principles of these provisions. The mere fact that these provisions do not apply to the federal government or even to the individual states of the United States demonstrates the difficulty of such an extension. However, there may be situations where both sovereign debtors and their creditors would find it advantageous to resort to some type of legally binding debt adjustment procedure under a new international legal framework. On the basis of this assumption, it is proposed to briefly examine the key elements of such a debt adjustment facility for sovereign debtors. The main purpose of this analysis is to draw attention to issues that would need to be settled and difficulties that would need to be overcome before a facility could be established.

Mode of Establishment

Proponents of the bankruptcy approach for dealing with sovereign liquidity crises have put forward a variety of ideas for establishing the facility. Some have proposed that the IMF play a central role in the facility and that it be located within or operate under the aegis of the IMF. The rationale behind this suggestion is that the IMF is the premier international financial institution responsible for monitoring and assisting its member countries with their balance of payments problems, and has the technical expertise and financial resources to discharge this role within the framework of its Articles of Agreement. However, some others have argued that the IMF is not a sufficiently neutral body to handle this task because of its perceived close relationships with its member countries and also because the IMF is itself a major creditor to the debtor countries and may have a conflict of interest problem unless its own claims were excluded (which exclusion, in itself, would generate further controversy). If the IMF were to play a central role, it could do this in one of several ways.

The IMF could establish the facility under Article V, Section 2(b), which authorizes it “to perform financial and technical services,” if requested to do so. Thus, for example, the IMF may agree to perform specific financial services or carry out technical services by providing advice, mediation, or good offices. This approach would allow the IMF to assist a sovereign debtor in negotiating an alleviation of its foreign debt service, but only with consenting creditors. However, the free riders would remain free to enforce their claims, which would put the consenting creditors at a disadvantage and might dissuade them from subjecting their claims to the facility. There would still be no mechanism for binding all creditors to a debt adjustment plan agreed to by a majority. Without either a freeze on the right to enforce claims or a mechanism to enforce a negotiated debt adjustment plan among creditors, no orderly procedures for negotiations could be established.

New international treaty obligations could be created, which would, either directly or through specific enactments, become part of the domestic law of participating countries. The principal consequence of this approach is that the facility would apply to all creditors attempting to enforce their claims within the territories of any of the signatory countries. Under this approach, the initial question to consider is whether the task of sovereign debt adjustment could or should be handled by an existing organ, such as the Executive Board of the IMF, or by a separate organ or institution. The task of the facility would be a very technical and specialized one, calling for economic, financial, and legal expertise. It would involve undertaking a detailed analysis of the country’s debt problems, resolving disputes with respect to particular categories of debt, and making decisions of a judicial nature. As evidenced by the experience with past sovereign debt reschedulings, this process could be a very time-consuming and complex exercise that would significantly expand the Executive Board’s already heavy responsibilities. Moreover, in domestic legal systems debt adjustment procedures are normally administered by courts of law that are independent both of parties and governments. Because Executive Directors are elected or appointed by governments that may themselves be parties (as creditors or debtors) to certain cases, there could be a perception, particularly among private creditors, of a conflict of interest. Therefore, to clothe it with the status of an independent judicial organ, it is important that the facility be established as a separate organ or institution. In this regard, three possible methods may be envisaged:

  • Establish a separate organ of the IMF for the specific and limited purpose of facilitating debt adjustment by sovereign debtors through an amendment to the IMF’s Articles of Agreement. The organ, which would have a quasi-judicial or arbitral character, would be managed and operated independently from the IMF’s regular operations. The Administrative Tribunal of the IMF provides an example of an independent judicial organ within the IMF.

  • Establish an affiliate institution. There are some precedents within the World Bank Group for the establishment of affiliates for specialized purposes, notably the International Centre for Settlement of Investment Disputes (ICSID) and the Multilateral Investment Guarantee Agency (MIGA).

  • Establish the facility as a separate international organization under a new international agreement, which all countries would be invited to sign and ratify. This approach, however, could be quite time consuming.

The main difference between the first method and the other two is that an amendment of the Articles would bind all members, while a new treaty would leave individual countries free to participate or not. The former method would avoid the perception that certain countries intended to use the facility as debtors and that others have agreed that their rights as creditors may be impaired while those of other creditor countries would remain unaffected.

Structure and Composition

If a special organ were established within the IMF, the organization would perform the functions of the facility using its staff and resources. If a separate organ of the IMF were to be established, two alternatives may be considered: first, the facility could be established as an independent judicial organ of the IMF, like the Administrative Tribunal. If a separate affiliate or a new international organization were to be established, ICSID and MIGA are possible models. In this case, the facility would be set up as a public international organization whose members would be sovereign states, both debtor states and creditor states (that is, states in their capacity as official creditors or as representatives of private creditors). Like ICSID, the facility should preferably be independent of the multilateral financing institutions and have a lean administrative structure, possibly headed by a secretary-general; and the arbitral organ of the facility should consist of prominent and internationally respected persons with relevant economic, financial, and legal expertise.

Although private creditors cannot become members of public international organizations, their claims may constitute the bulk of external debt owed by a sovereign debtor. A way would have to be found to provide representation to such creditors, possibly through a creditors’ committee to serve in an advisory capacity to the facility.

Eligible Debt

For any debt adjustment plan to be viable, all or most of the sovereign debtor’s external obligations (including guarantees of other debtors’ liabilities) would need to be brought under the purview of the facility. Moreover, consideration would have to be given to the inclusion of domestic liabilities.

A first problem would be the identification of all creditors; difficulties could arise, particularly with respect to the holders of bearer bonds. It would be desirable, therefore, for the facility to establish, with the assistance of the debtor, a registry of all creditors. In addition to the identification of creditors, disputes on the existence and amounts of claims might arise in some cases and would have to be settled.

The second problem would be defining the “eligible debt” that would be subject to adjustment by the facility. The term usually covers the external debt of a government, central bank, or other public sector institutions owed to commercial banks and other private financial institutions (such debt is currently the subject of London Club rescheduling) and to bilateral official creditors (such debt is subject now to Paris Club rescheduling). Debt owed to creditors in the London and Paris Clubs represents a significant portion of the external debt of many highly indebted countries and, as such, should be included in any debt adjustment plan. Such inclusion would not necessarily preclude separate negotiations and conclusion of agreements by these creditors within the framework of a debt adjustment plan established by the facility.

There are, however, a number of other categories of sovereign debt that could raise some problems, depending on their inclusion in, or exclusion from, any debt adjustment process:

  • The first category is debt incurred with domestic creditors and denominated either in foreign or local currency.

  • The second category is debt owed to secured creditors. Under most national laws, secured creditors are included under a reorganization or debt adjustment plan. However, their claims have priority.

  • The third category is debt evidenced by bonds.

  • The fourth category is short-term debt.

  • The fifth and final category of debt is that owed to multilateral financial institutions such as the IMF, the World Bank, and the regional development banks.

The above-noted problems concerning the definition of eligible debt would need to be resolved at the outset because they are fundamental to the establishment and successful operation of the facility.

Operating Procedures

The following procedures may be considered for the operation of the facility in dealing with sovereign debtors:

Qualification for access to facility. The first question to consider with respect to the initiation of the debt adjustment process is what would be the specific situation that triggers or justifies initiation of the process. As in the case of Chapter 9 of the U.S. Bankruptcy Code, recourse to the facility by a sovereign debtor should preferably be based on its actual or prospective inability to service its debts as they become due, that is, illiquidity.

Right to petition the facility. The next question is, Who should have the right to petition the facility for debt adjustment? Most national laws permit the debtor or a group of its creditors to file a petition initiating a proceeding. However, under Chapter 9, only the municipality may file a petition for debt adjustment. In the case of sovereign debtors, the latter voluntary approach would be the preferred and primary method of initiating a debt adjustment procedure. The sovereign debtor is in the best position to know its economic and financial situation and, therefore, also able to foresee any future debt servicing difficulties.

To address the concerns of private creditors, consideration may be given to the possibility of permitting governments of creditor countries (either as creditors in their own right or in the exercise of their diplomatic protection of national creditors) to petition the facility for a sovereign debt adjustment. If this is considered appropriate, the right to petition should be limited to situations where the sovereign debtor’s inability to service its external debt has been evidenced by actual cases of debt service payment default.

Consideration may also be given to the possibility of authorizing the Managing Director of the IMF to notify the facility of a situation in which, in his or her opinion, the sovereign creditor should have filed a petition, in which case the process could be initiated ex officio by the facility. The Managing Director’s initiative would be preceded by appropriate consultations, in particular with the sovereign debtor and the governments of major creditor countries.

Under each of the above three methods of accessing the facility, the final determination as to whether initiation of the debt adjustment process meets the required conditions would be made by the decisionmaking organ of the facility.

Automatic Stay

Sovereign debtors usually own or maintain property and other assets, including bank accounts, in several foreign countries. To ensure a smooth debt adjustment process and the equal treatment of all creditors, it is essential that there be no rush of creditors to courts around the world to obtain judgments against, or to attach the assets of, the sovereign debtor concerned. Therefore, the constituent document establishing the facility (which could be an amendment to the IMF’s Articles or a new treaty) could provide that, once the debt adjustment process has been initiated, an “automatic stay” comes into effect immediately, and this would have the effect of restraining all creditors (secured and unsecured) from commencing or continuing all lawsuits for debt collection or enforcement of liens or judgments. In addition, the constituent document establishing the facility could prohibit the debtor from making payments to particular creditors.

Under many national laws, the filing of a petition results in the suspension of any debt collection action or lien perfection by creditors. This stay of legal actions allows an orderly process of negotiations to take place. Either as a direct effect of the constituent document establishing the facility or through specific enactment, this provision would have to become part of the law of the signatory countries, and domestic courts would thus have to enforce this provision.

The period of time during which an automatic stay continues varies among jurisdictions, but the actual number of days typical in the case of a private sector debtor might not be appropriate for a sovereign debtor, whose affairs are considerably more complex. Given the wide diversity of potential users of the facility and the complexity of their cases, it might be appropriate to make the length of a stay discretionary. Therefore, a limited period of time (up to six months), but subject to a limited number of subsequent extensions (for example, two extensions of up to three months each), might be envisaged.

Interim Financing

The debtor may require additional financing during the period of the automatic stay and while a plan is being developed and approved. In many countries, certain lenders develop a specialization in providing such interim financing to companies in reorganization proceedings. Such lenders are likely to provide financing only if they receive preferential status for their loans, perhaps in the form of a security interest. To facilitate this process, the constituent document establishing the facility could provide that actions to enforce the security interest for such interim financing would be exempt from the application of the automatic stay.

Preparation of a Debt Adjustment Plan

Once the debt adjustment process has been initiated with the facility, a debt-adjustment plan would need to be prepared. Most national laws permit the court to appoint a third party to gather information concerning the financial condition of the company. Many national laws also provide that the court or its appointee prepare the plan, while some provide that it is the debtor that prepares and presents a plan to the creditors. Under Chapter 9, it is exclusively the responsibility of the municipality to do so. In the context of sovereign debt adjustments, it may be more appropriate for the facility first to undertake a study of the debtor country’s financial situation, and then work with the debtor, which will prepare its plan for debt adjustment in consultation with its creditors.

The first step would be to undertake a detailed study and analysis of that particular country’s debt problems, which may vary from severe balance of payments difficulties calling for immediate action to structural, financial, fiscal, and transfer-of-resources problems requiring longer-term adjustment measures. This would involve examination of the domestic economic situation of the country; assessment of the impact of external factors (for example, export performance and prices/markets for major commodities) on the developmental and financial problems of the country; review of the country’s assets, including those of state enterprises, and ownership of natural resources; estimates of short- and long-term capital requirements and likely availability of funds; review of the country’s external debt management policies, projected debt servicing requirements, and measures adopted to avoid debt servicing difficulties; allocation of scarce resources to competing claimants for use of these resources (that is, external debt servicing demands versus demands for funding of domestic programs); and examination of the need for the country to undertake specific adjustment measures.

In preparing its debt adjustment plan under the overall supervision of the facility and with the assistance of the staff assigned to the facility, the debtor would need to consult with its main creditors so as to ensure that the finally negotiated debt adjustment plan will be approved. As is required under most national laws, the debt adjustment plan should provide for fair and equitable treatment of the different classes of creditors, taking into account differences between unsecured and secured (or other preferred) creditors. It would likely propose appropriate concessionary arrangements designed to match the debtor’s capacity to service the debt (for example, extensions of loan maturities, reduction in interest rates, and partial or full write-off of arrears).

The plan could also provide, if necessary, for additional financing from the same or other creditors to tide the sovereign debtor over while the debt adjustment plan is being implemented. There should be no obligation to provide such financing; rather, incentives should be offered, such as adequate security or preferred creditor status.

In terms of staff resources and expertise, the facility is not likely to be equipped to undertake the complex task of studying and analyzing the country’s debt problems. The IMF possesses expert knowledge and understanding of these factors and, with the possible assistance of the World Bank, could undertake such study and analysis as a service to the facility.

Finally, while the debt adjustment plan is being prepared, approved, and implemented, due regard should be paid to the sovereign character of the debtor. For example, Chapter 9 forbids interference by the court (unless the debtor has earlier so agreed in a plan) with any of the municipality’s political or governmental powers, property, or revenues, or use or enjoyment of any income-producing property. It would be wise to include similar restrictions in the constituent document establishing the facility.

Acceptance and Confirmation of a Debt Adjustment Plan

After the sovereign debtor prepares the plan, it would have to be presented to creditors for their approval. National laws differ as to the requirements for determining minimum acceptance by creditors. The constituent document establishing the facility could require, similar to Chapter 9, that creditors be put into classes and that each class of creditors votes on the debt adjustment plan. In Chapter 9 cases, the plan designates the number of classes and which creditors are in each class. The constituent document establishing the facility could provide for a limited number of classes, for example, secured creditors, general unsecured creditors, and subordinated creditors. Following the U.S. approach, it could also provide that, in order for the plan to be confirmed, it would have to be approved by a majority of creditors in each class, representing at least two-thirds of the amount of all claims of such class. It could further provide that, in the event that one or more classes of creditors fails to approve the plan, the facility may deem the plan approved if the plan does not discriminate unfairly and a majority of creditors, representing at least two-thirds of the total amount of debt owed to all creditors, has approved the plan.

Finally, the facility would confirm the debt adjustment plan as accepted by the sovereign debtor and its creditors. Then, the plan could be enforced against all creditors, including creditors who voted against the plan.

Implementation of a Debt Adjustment Plan

Under most national laws, once a plan has been accepted it applies, with certain limited exceptions, to all creditors, even those who dissented. If the facility is established by treaty (either through an amendment to the IMF’s Articles or a separate treaty), the debt adjustment plan could be enforced through domestic law and domestic courts on dissenting creditors. As noted above, the debt adjustment plan could include mechanisms, such as exit bonds, debt equity conversion schemes, and buyback arrangements, so as to permit dissenting creditors to leave the lending syndicate if they so wish.

Monitoring Debtor’s Performance Under a Debt Adjustment Plan

After the debt adjustment plan is confirmed by the facility, the debtor’s compliance with the plan would need to be monitored. Under national laws, the court oversees compliance with the plan. Under Chapter 9 proceedings, the court retains jurisdiction over the case for “such period of time as is necessary for the successful implementation of the plan,”4 but closes the case “when the administration of the case has been completed.”5 The case may be reopened “to administer assets, to accord relief to the debtor, or for other cause.”6 Consequently, if the debtor fails to perform in accordance with the debt adjustment plan, the court may take steps to enforce the terms of the confirmed plan or may consider a proposal to modify the confirmed debt adjustment plan. The facility could be given powers similar to those of a national court.

Under some sovereign loan agreements (through “claw-back” clauses), the creditors have the right to request a modification of the plan if the debtor’s financial condition improves significantly within a specified period of time—for example, one year—from the confirmation of the plan. Similarly, under the facility, the debtor’s performance of the terms of the debt adjustment plan would need to be monitored, and subsequent adjustments in the plan could be envisaged. As suggested above, the task of monitoring the implementation of the plan could be delegated to the IMF. However, the authority to reopen the case and modify the debt adjustment plan would remain with the facility.

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