Current Legal Issues Affecting Central Banks, Volume V

Chapter 15 The Debt-Rescheduling Process: Pitfalls and Hazards

Robert Effros
Published Date:
May 1998
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The sovereign debt-rescheduling process of the 1980s and early 1990s has never lacked for critics. This chapter is not a contribution to this already rich tradition; rather, its objective is to suggest—from the standpoint of the practicing lawyer advising sovereign debtors in these exercises—a few areas in which future sovereign debt workouts might profitably take a different approach.

The Problem Is Temporary

Nearly everyone involved in the rescheduling process in 1982 and 1983 tried to promote the notion that the external debt problems of the affected countries could be resolved quickly. The problems were pronounced to be temporary liquidity difficulties caused by an unexpected rise in international interest rates and a decline in the price of primary commodity exports of some of the debtor countries.

At the time, there seemed to be good reasons on both sides of the debtor-creditor relationship for nurturing this illusion. The debtors saw their salvation in a speedy return to normal borrowing practices, and a frank assessment of their medium-term debt-servicing capacity would probably not have contributed to early achievement of that objective. For their part, the commercial bank creditors were equally reluctant to acknowledge that their loans were unlikely to be repaid in full any time soon: bank capital ratios were thin, loan loss reserve provisions were small or nonexistent, and stockholders were wholly unprepared for bad news of this magnitude.

In retrospect, this refusal to acknowledge the depth of the problem turned out to be expensive. Faced with what it chose to characterize as a temporary problem, the financial community naturally fashioned temporary solutions. When the debt-rescheduling process began in the early 1980s, only principal maturities falling due during a 12-month to 24-month period were rescheduled at any one time. The payment deferments were relatively brief. The debtors were told that interest had to be paid in full and on time even if this meant borrowing the money needed to pay interest on the old debt from the same banks to which that interest was owed. Above all, the early workout programs assiduously avoided any element of permanent debt relief in the form of a forgiveness of principal or interest. Debt reduction (as opposed to simple debt rescheduling) had to await the final, “Brady Initiative,” stage of the crisis starting in 1990.1

Unfortunately, the capital markets suspected all along that the problem was far more durable than the remedies seemed to suggest. Renewed access to the voluntary capital markets was therefore continually postponed throughout the 1980s, causing the debtor countries to settle into a ten-year financial and economic coma. Without a source of voluntary new funding from private sources, the sovereign borrowers and their commercial bank creditors had no alternative but to repeat, and then repeat again, the same rescheduling techniques. Before the decade was out, the same item of debt may have been rescheduled three or four times.

What is the lesson of this? If the solution is to come from renewed market access, then there is no alternative but to implement remedial measures at an early stage that are, in the eyes of the market, visibly adequate—or at least not visibly inadequate—to restore the country’s medium-term creditworthiness.

The Unanimity Requirement

If no creditor could be forced to join a debt rescheduling at the outset, it seemed to follow that the consent of each creditor would be required before the payment terms of any rescheduled debt could be further amended. This principle was enshrined in clauses of the rescheduling agreements dealing with amendments to the contracts. Except in rare instances,2 those clauses expressly required the unanimous consent of all lenders before any term of the agreement dealing with the amount or the timing of payments could be changed. The proponents of these clauses argued that they were necessary to assuage the concerns of the smaller lenders about joining restructuring syndicates in which larger, money center banks held a predominate position.3

When the initial batch of rescheduled debt fell due and had to be rescheduled in light of the persistence of the crisis, the folly of these unanimity requirements became apparent. Entire rescheduling packages involving tens of billions of dollars were held up because a few lenders with trivial exposures would not agree to sign an amendment to the original rescheduling agreement. For the maverick lender willing to hold its breath as the full bucket of scorn was poured on its head by fellow creditors, the reward was sometimes a quiet buyout of its exposure on preferential terms. In retrospect, it was a serious mistake for the large lenders to have bestowed such leverage on their smaller colleagues through this unanimity requirement.4

Maverick Creditors

The Context

One starts with the premise that a sovereign borrower seeking a generalized debt restructuring cannot pay all of its obligations on their original terms. This is not to say that the sovereign will completely run out of money; there almost always will be some foreign exchange available to the sovereign to cover necessary imports and the servicing of certain types of “preferred” debts, such as credits extended by multilateral institutions. The presumption, however, is that the country has an insufficient supply of foreign exchange with which to service all of its debts. Therefore, certain categories of debtholders are asked to defer or forgive a portion of their claims.

If the majority of those creditors are persuaded of the need for the rescheduling and find the terms acceptable, they may agree to the borrower’s request. The sovereign borrower cannot, however, compel any lender to accede to a proposed rescheduling. Most lenders do so and refrain from exercising their legal rights because they are convinced that the borrower does not have the resources to satisfy all of their claims—even at the sharp end of a court judgment—and the creditor group as a whole is therefore better off negotiating, rather than litigating, its way out of the problem.

What about the creditor who is not prepared to go along with the deal? The benign example of such a creditor is one who simply remains unconvinced about the need for a restructuring or is dissatisfied with the terms on which it is offered. The less benign is one who consciously acquires the debt for the purpose of forcing, by negotiation or by litigation, a settlement of the claim on preferential terms.

As seen by his fellow lenders, the maverick creditor is simply capitalizing on their willingness to grant the borrower a measure of debt relief. It is only by virtue of the indulgence shown by the majority of creditors that the sovereign has the money to pay (or to settle on preferential terms) the claims of the more exacting few. This resentment can be aggravated in circumstances where the maverick purchased its claim on the secondary market at a small fraction of its face value, while the original lenders advanced 100 cents on the dollar as the price of their claims. It is like surrendering your seat on a crowded bus in favor of an elderly woman only to watch a teenager wearing a varsity wrestling jacket jump into it.

This situation quite naturally strikes the majority of creditors as unfair and ungentlemanly. The majority is therefore apt to insist that all, or virtually all, similarly situated creditors must accept the restructuring before any of them are obliged to do so. In some recent Brady-style reschedulings done under English law, the sovereign borrower has been asked to covenant that it will not voluntarily enter into any arrangement with a nonparticipating creditor on terms more favorable than those offered in the Brady deal without those same preferential terms being made available to its other lenders.

The Borrower’s Dilemma

Faced with a maverick creditor, what is a borrower to do? The borrower has the following options:

  • Sweet-talking. For a creditor who is simply feeling unloved and unappreciated, some special attention by the minister of finance or the governor of the central bank may be all that is needed to put things right. Sweet-talking is pointless, however, when the creditor bought the paper with the premeditated objective of staying out of the deal.

  • Defer or cancel the rescheduling deal. This tactic may thwart the maverick, but it also thwarts the country’s chances of economic recovery. This tactic is a little bit like burning down your house to kill the termites.

  • Pay up. There is always the option of paying off the maverick. Apart from the expense and humiliation, this tactic is almost guaranteed to invite a swarm of other mavericks and may jeopardize the main rescheduling program. Moreover, paying off a maverick makes one’s other lenders look pretty silly for having agreed to reschedule their own claims. As noted above, some sovereign borrowers have been asked to accept contractual undertakings that effectively prevent any voluntary settlement of a maverick’s claims.

  • Litigate. The borrower may face one major obstacle if it elects to wage a legal defense against the maverick—the law. The law in most jurisdictions is quite clear that a creditor’s claim to recover money advanced to a borrower is (except in very unusual circumstances) legally enforceable. Moreover, the borrower’s other lenders will have distinctly ambivalent feelings about a vigorous legal defense. Naturally, they will want to see the maverick frustrated in its effort to snatch (as they will see it) their money from the hapless borrower. However, the other creditors will not want the borrower to establish a legal defense that could, down the road, be equally applicable to their own loans.

Why should the position of a sovereign debtor in these circumstances be any more delicate than that of a financially distressed corporate borrower? The answer lies in domestic bankruptcy codes. Those codes may provide a corporate debtor with a shield from hostile creditor actions while its financial affairs are being reorganized.5 Creditors that are reluctant to join a rescheduling program that has been approved by a bankruptcy tribunal may be forced to do so.6 Perhaps most importantly, the mere availability of a bankruptcy option gives the corporate borrower a measure of negotiating leverage with its lenders. Sovereign borrowers do not enjoy the protection of domestic bankruptcy codes. They are thus vulnerable to individual creditor lawsuits, regardless of how many of their other creditors may have agreed to accept a rescheduling package. It is this peculiar legal vulnerability that a maverick creditor intent on litigation seeks to exploit.

The Defenses

The maverick’s legal claim is a straightforward demand for money due but not paid. The sovereign borrower may raise several possible defenses. Among the defenses are the following:

  • Eligible assignee. Many sovereign loan agreements and debt restructuring agreements limit transfers of interests in the loans to “banks or financial institutions,” a phrase that is almost never defined in the agreement. For reputational reasons, well-established banks and financial institutions rarely play the role of the maverick, particularly the litigating maverick. Most mavericks are obscure, special-purpose entities organized in obscure, underregulated jurisdictions. A sovereign defendant may therefore be able to question whether the maverick was ever entitled, under the terms of the underlying agreement, to take an assignment of the debt on which it is suing.

  • Champerty. Under the laws of some jurisdictions, it is illegal to solicit or to take an assignment of a debt obligation for the sole purpose of commencing a lawsuit thereon (a practice known as “champerty”).7 This is not an easy defense to establish, but it may be available in cases where the maverick’s only motivation in taking an assignment of the debt was litigation.

  • Sovereign immunity. This is not usually a promising defense. Most international loan and restructuring agreements contain very broad waivers of sovereign immunity, and, even if they do not, the borrowing of money abroad is regarded as a “commercial activity” for which jurisdictional immunity will not be recognized. Sovereign immunity may be relevant, however, in shielding certain assets of the sovereign borrower from attachment in connection with a lawsuit.8

  • Comity. The U.S. Constitution gives to the executive branch of the government the exclusive power to handle the foreign affairs of the United States.9 Over the years, the judicial branch has shown itself very reluctant to exercise jurisdiction over foreign sovereigns in a way that might embarrass or interfere with the president’s conduct of foreign affairs. Under certain circumstances, U.S. courts will, in the interest of international comity, give effect to foreign governmental actions where such actions are consistent with U.S. law and policy. The availability of a comity defense to a foreign sovereign in a case involving enforcement of external debt obligations turns crucially upon the willingness of the U.S. government to express an interest in the case. The U.S. government has done so only twice since the onset of the debt crisis in 1982, the first time taking the side of the creditor10 and the second time taking the side of the sovereign debtor in connection with a contract interpretation issue.11

Apart from strictly legal defenses, the inclusion of so-called sharing clauses in the underlying loan and restructuring agreements has helped to suppress maverick litigation.12 These clauses can require creditors who obtain preferential recoveries as a result of setoff or litigation to share those recoveries with their fellow lenders under that agreement. The prospect of such sharing tends to cool the litigious ardor of most creditors.

The maverick creditor problem was a nuisance, but no more than a nuisance, in the sovereign reschedulings of the last decade. If debt problems recur in some of these countries, however, the litigation risk to the sovereign debtors will be greater. Much of the debt has now been sold to investors that are not banks or financial institutions. These investors will be far less susceptible to the kind of geopolitical and regulatory pressure that kept the commercial banks in line during the 1980s.

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