What features of a legal framework would need to be in place in order to establish adequate incentives for debtors and creditors to agree upon a prompt, orderly, and predictable restructuring of unsustainable debt? As will be seen, although the features of existing domestic legislative models provide important guidance as to how to address collective action problems among creditors in the insolvency context, the applicability of these models is limited by the unique characteristics of a sovereign state.

What features of a legal framework would need to be in place in order to establish adequate incentives for debtors and creditors to agree upon a prompt, orderly, and predictable restructuring of unsustainable debt? As will be seen, although the features of existing domestic legislative models provide important guidance as to how to address collective action problems among creditors in the insolvency context, the applicability of these models is limited by the unique characteristics of a sovereign state.

Existing Rehabilitation Models and Their Limitations

When a financially distressed—but fundamentally viable—company finds that it can no longer service its debt, the company and its diverse creditors cannot generally turn to their domestic authorities for financing as a means of resolving the crisis. Instead, domestic insolvency legislation provides the necessary framework to overcome coordination problems as they work out restructuring terms. A court-administered reorganization chapter of an insolvency law provides the necessary incentives for a debt restructuring agreement (that often involves substantial debt reduction). To the extent that the insolvency system is well-developed, most restructurings take place “in the shadow” of the law, that is, without the need—and expense—of actually commencing formal court-administered proceedings. As is discussed in Box 1 most well-developed corporate rehabilitation laws include the following features:

  • (i) a stay on creditor enforcement during the restructuring negotiations;

  • (ii) measures that protect creditor interests during the period of the stay;

  • (iii) mechanisms that facilitate the provision of new financing during the proceedings; and

  • (iv) a provision that binds all relevant creditors to an agreement that has been accepted by a qualified majority.

All of these features serve to maximize the value of creditor claims by preserving the going concern value of the firm. As will be discussed below, these features are relevant to a discussion of the design of a sovereign debt restructuring mechanism. It should be noted, however, that the applicability of the corporate model to the sovereign context is limited in a number of important respects.

  • First, and perhaps most importantly, corporate reorganization provisions operate within the context of the potential liquidation of the debtor, which could not apply to a sovereign state. In the event that a reorganization plan does not attract adequate support from its creditors and the company continues to be in a state of illiquidity, most laws will provide for the automatic liquidation of the company. Moreover, the potential liquidation of the enterprise also limits the terms of any restructuring proposal. Most modern laws provide that creditors cannot be forced to accept terms under a reorganization plan that would result in their receiving less than what they would have received in a liquidation.

  • Second, since one of the purposes of a reorganization law is to enable creditors to maximize the value of their claims through the going concern value of the enterprise, most modern laws allow for the creditors to commence proceedings unilaterally so as to acquire the company through a reorganization plan that includes a debt-for-equity conversion that, in some cases, may extinguish all ownership interests of the incumbent shareholders. Again, such a feature could not be applied to a sovereign state.

  • Finally, it is difficult to envisage how the constraints that are applied to the activities of a corporate debtor to safeguard the interests of creditors during the proceedings could be made legally binding on a sovereign and enforced, particularly with respect to the exercise of its sovereign powers, including, for example, its fiscal powers. In the sovereign context, we must therefore rely on having the right incentives in place.

Corporate Reorganization Model

Although corporate insolvency laws vary among countries, considerable work has been done to identify “best practices” in core areas.1 The following features of well-developed insolvency laws provide the key incentives for corporate restructuring:

  • First, upon commencement of reorganization proceedings, a stay is imposed on all legal actions by creditors, thereby protecting the debtor from dismemberment. This stay is designed not only to protect the debtor, but also addresses the intercreditor collective action problem. In the absence of a stay, creditors would probably rush to enforce their claims out of a fear that others would do so.

  • Second, during the proceedings, legal constraints are imposed upon the activities of the debtor and a reorganization plan must normally be prepared within a specified time frame. As a means of ensuring that the interests of creditors are protected during the proceedings, the debtor is precluded from entering into transactions that would prejudice creditors generally (for example, transferring assets to insiders or making payments to favored creditors). To ensure compliance, the laws of some countries also provide for a court-appointed administrator to oversee the activities of the debtor during this period.

  • Third, as a means of encouraging new financing, credit provided to the debtor after commencement of the proceeding must be given seniority over prior claims in any reorganization plan. Normally, a creditor that provides financing during the proceedings would have the right to be repaid once the reorganization plan is approved.

  • Fourth, a debt restructuring plan approved by the requisite majority of creditors will be binding on all creditors. The law normally provides for the establishment of a committee of creditors that takes the lead in negotiating the terms of the debt restructuring plan with the debtor. To ensure there is no fraud in the voting process, the court normally oversees the verification of creditors’ claims.

A predictable insolvency system enables corporate restructuring to take place out-of-court but “in the shadow” of the formal insolvency system. Such an out-of-court process generally mimics certain features of the formal process. For example, creditors agree to a voluntary standstill in the knowledge that, if they refuse, the debtor can make a standstill mandatory by commencing formal proceedings. Similarly, potential holdout creditors realize that, if they are inflexible, the debtor and majority creditors can use the law to bind them to the terms of the restructuring agreement. In sum, each party negotiates with a clear understanding of the type of leverage it—and the others—would have if the formal system were to be activated.

1Including by the IMF, World Bank, and United Nations Commission on International Trade Law (UNCITRAL).

In many respects, Chapter 9 of the United States Bankruptcy Code, which applies to municipalities, is of greater relevance in the sovereign context because it applies to an entity that carries out governmental functions. Although it includes a number of the core features of a corporate reorganization law, it differs from the corporate model in a number of respects. For example, only the municipality (not its creditors) may commence proceedings and propose a reorganization plan. Moreover, the bankruptcy court may not interfere with any of the municipality’s political or governmental powers, property or revenue or the municipality’s use or enjoyment of any income-producing property. Finally, a Chapter 9 case cannot be converted into a liquidation case. All of these features could be appropriately integrated into a sovereign debt restructuring mechanism.

There are, however, important differences between a municipality and a sovereign state that would have implications on the design of any sovereign debt restructuring mechanisms. Unlike a sovereign state, a municipality is not independent. Chapter 9 legislation acknowledges—and does not impair—the power of the state within which the municipality exists to continue to control the exercise of the powers of the municipality, including expenditures. This lack of independence of municipalities is one of the reasons why many countries have not adopted insolvency legislation to address problems of financial distress confronted by local governments.

The Sovereign Context

Although the applicability of the above models to the sovereign context is necessarily limited, a number of their features—if appropriately adapted—provide useful guidance when contemplating the design of a sovereign debt restructuring mechanism. Bearing in mind the objective of the mechanism—to provide a framework for the orderly, predictable, and rapid restructuring of debt problems in a manner that preserves value for the benefit of both the debtor and its creditors—the core features of the mechanism could include the following:

  • Majority restructuringThe creation of a mechanism that would enable the affirmative vote of a qualified majority of creditors to bind a dissenting minority to the terms of a restructuring agreement would be the most important element of any new restructuring framework. From the perspective of creditors, such a mechanism would provide confidence that any forbearance exercised by the majority when agreeing to a restructuring would not be abused by free riders who could otherwise press for full payment after an agreement was reached. For the majority of creditors, the disruptive behavior of free riders not only raises intercreditor equity issues, but also reduces the ability of the debtor to service the newly restructured debt. From the perspective of the sovereign, the resolution of these collective action issues will make it more likely that it will be able to reach early agreement with creditors on a debt restructuring. Moreover, it eliminates the threat of disruptive litigation by dissenting creditors after the restructuring takes place.

Majority restructuring provisions form the central element of the collective action clauses that are found in some international sovereign bonds. However, these provisions only bind bondholders within the same issue. They have no effect on bondholders of other issuances, which may in any event be governed by different legal jurisdictions. Moreover, they do not apply to other types of indebtedness, such as bank claims and domestic debt. To address the collective action problems that arise from the very diverse private creditor community that currently exists, such a mechanism would need to apply to all forms of private credit to sovereigns. This feature of a sovereign debt restructuring mechanism would be similar to the majority restructuring provisions of domestic insolvency laws, which aggregate the claims of all eligible creditors (irrespective of the nature of the instrument) when determining whether there is adequate support by a majority to make an agreement binding on all creditors. Aggregation, however, would not result in the equalization of all claims for debt restructuring purposes. For example, as in the case of the domestic insolvency law, safeguards would need to be in place to ensure that the seniority of certain claims is protected.

Ideally, the debtor and its creditors would activate the majority restructuring provision described above prior to a default on the original claims. As borne out by experience, avoiding a default would help minimize economic disruption in the debtor country and preserve asset values, including the secondary market value of creditors’ claims.

  • Stay on creditor enforcementIn the event that an agreement had not been reached prior to a default, a temporary stay on creditor litigation after a suspension of payments but before a restructuring agreement is reached would support the effective operation of the majority restructuring provision. In the context of corporate insolvency, a stay on litigation is intended to enforce collective action by preventing a rush to the courthouse and a “grab race” that could undermine the ability of a company to continue functioning, to the detriment of the debtor and its creditors (the value of whose claims is maximized when the company remains a going concern). The risk of widespread creditor litigation may be less pronounced in the sovereign than in the corporate context, largely on account of the relative scarcity of assets under the jurisdiction of foreign courts that could be seized to satisfy creditors’ claims. Nevertheless, there is a risk that litigation could inhibit progress in the negotiations. This risk could increase if, as a result of the introduction of a majority restructuring provision, the only opportunity to use legal enforcement as a source of leverage is before rather than after the reaching of an agreement. This is one of the reasons why collective action clauses in international sovereign bonds also contain provisions that effectively enable a majority of bondholders to block legal action by a minority before an agreement is reached. But, as in the case of majority restructuring provisions, these provisions only apply to bondholders within the same issuance.

  • Protecting creditor interestsAn SDRM would need to include safeguards that give creditors adequate assurances that their interests were being protected during the period of the stay. These safeguards would have two complementary elements. First, the sovereign debtor would be required not to make payments to nonpriority creditors. This would avoid the dissipation of resources that could be used to service the claims of relevant creditors in general. Second, there would have to be assurances that the debtor would conduct policies in a fashion that preserves asset values. If, throughout the stay, the member was implementing an IMF-supported program or was working closely with the IMF to elaborate policies that could be supported with the use of IMF resources, this would provide many of these assurances. Beyond the fiscal, monetary, and exchange rate policies that lay the basis for the resumption of debt service and a return to sustainability, creditors also have clear interests in other policies, including, for example, the nature and terms of any domestic bank restructuring, the continued operation of the domestic payments system, the country’s bankruptcy regime and the nature of any exchange controls it imposes. Depending on the circumstances, the creditors of the sovereign may have a particular interest in the effective implementation of capital controls to prevent capital flight.

  • Priority financingA majority restructuring mechanism could also usefully be buttressed by a mechanism that would facilitate the provision of new money from private creditors during the period of the stay. It is in the collective interests of private creditors and the sovereign debtor that new money be provided in appropriate amounts. Such financing, when used in the context of good policies, can help limit the degree of economic dislocation and thereby help preserve the member’s capacity to generate the resources for meeting debt-service obligations. In the sovereign context, new money could help cover the sovereign’s need for trade credit and could also finance payments to priority creditors. Under the existing legal framework, however, individual creditors have no incentive to provide new money in such circumstances, as the resulting benefits of a return to debt servicing would be shared among creditors as a group, and there would be no assurance that the new financing would not also get caught up in the restructuring. An SDRM could induce new financing by providing an assurance that any financing in support of the member’s program extended after the introduction of the stay would be senior to all preexisting private indebtedness. This assurance could be provided through a decision of a qualified majority of creditors.

As discussed further below, if this mechanism is to be both equitable and transparent for a broad range of creditors, it will have to be supported by independent arrangements for the verification of creditors’ claims, the resolution of disputes, and the supervision of voting. For example, such arrangements would protect against fraud that may arise through the creation of debt between related parties.

Among the many issues that will need to be addressed is the coverage of offical creditors. Given the special role that the International Monetary Fund and multilateral development banks play in providing finance during crises, their status as preferred creditors has generally been accepted by the international community. These claims would not be subject to the mechanism. However, this leaves the question of how to treat bilateral official debt; debt that is now routinely restructured in the context of the Paris Club. We will need to explore further whether it would be feasible to include bilateral official debt under an SDRM and, if so, how this would be done in a manner that pays due regard to the special features of these claims.

Another set of issues that needs careful consideration concerns the treatment of domestic debt in the context of an SDRM. Sovereigns typically have a wide range of debts to domestic residents. These may include marketable securities (issued under either domestìc or foreign laws), loans from banks, and suppliers’ credits. With the growing integration of international capital markets, and the tendency for residents and nonresidents to hold similar instruments, the distinction between domestic and nondomestic debt has become increasingly blurred.

While the treatment of domestic debt will need to be considered on a case-by-case basis, in practice it may be necessary to include domestic debt within the scope of a restructuring that is intended to bring a sovereign’s debt to a sustainable level. In particular, the magnitude of debt to nonresidents in relation to the scale of the required reduction in the overall debt burden may necessitate the inclusion of domestic debt. Moreover, nonresident investors may only be willing to agree to provide substantial debt reduction if they consider that adequate intercreditor equity has been achieved—they would be unlikely to be willing to provide such relief if it was seen as enabling other private creditors to exit whole.

Nevertheless, the treatment of domestic debt under a restructuring needs to weigh a number of factors that will have a bearing on the prospects for restoring sustainable growth. (These factors would need to be considered by both the debtor in the design of a restructuring proposal and by foreign creditors in their assessment of the adequacy of intercreditor equity.) First and foremost there is a need to ensure that the domestic banking system should remain solvent after a restructuring, in order that it can continue to serve as an intermediary for domestic savings and foreign financing, for example, trade credit. Second, it would be important to take account of the likely impact of a restructuring for the future operation of domestic capital markets, and, in particular, the possible tradeoff between the magnitude of debt reduction obtained through a restructuring, on the one hand, and the prospect that the sovereign will be able to mobilize savings from domestic capital markets in the aftermath of a restructuring—particularly in the period while access to international capital markets will likely remain closed.

In providing a legal basis for the treatment of domestic debt under an SDRM, a number of approaches could be considered. One would have the statutory framework cover a broad range of debt, including domestic debt. This would make the claims of all resident investors subject to the majority restructuring and other features of the mechanism. This need not preclude flexibility in the treatment of domestic debt under individual restructuring proposals, subject to the ability of the sovereign to attract the necessary degree of support from creditors for the overall package. An alternative approach would exclude domestic debt from the scope of the statutory approach and rely instead on the existing governing legal frameworks to facilitate any restructurings of these claims that may be required. Of course, this approach would not reduce the need to achieve an acceptable degree of intercreditor equity in order to garner the necessary support of nonresident creditors. It would also raise practical issues concerning the definition of domestic debt. Would this be based on the residency of investors, or the characteristics of the instruments, possibly the governing law, currency (or location) of debt service payments?

All of the above features, when taken together, would establish a framework within which an orderly and rapid restructuring could take place. Most importantly, the framework would address collective action problems that have, to date, made the cost of restructuring excessively high for debtors and creditors alike. This could help creditors and debtors reach agreement on equitable restructuring terms more rapidly, and thus facilitate the country’s recovery. As noted above, it may facilitate restructurings prior to defaults, thereby protecting asset values for the benefit of debtors and creditors alike. Moreover, if the framework were sufficiently predictable, it would create the incentive for debtors and creditors to reach an agreement without having to rely on its actual use. For example, the voting provisions would encourage early creditor organization, and thus lay the basis for negotiations between the debtor and its creditors. In addition, potential holdouts would realize that, unless they are sufficiently flexible, the debtor and the majority of creditors could use the mechanism to bind them to the terms of an agreement.

More generally, to the extent that the establishment of a sovereign debt restructuring framework serves to create a more structured negotiating framework between creditors and sovereign debtors, it may enhance the value of sovereign debt as an asset class. Over the past several years, a number of dedicated emerging market creditors have complained about the absence of a predictable and equitable process that guides sovereign debt restructuring negotiations. They have argued that this makes it more difficult to attract long-term capital to the emerging market asset class, thereby undermining the stability of the investor base. To provide greater structure to the negotiating process, consideration could be given to designing the mechanism in a manner that gives a creditors’ committee an explicit role in the restructuring process, as is the case in most modern insolvency laws. Creditor committees played a major role during the sovereign debt restructuring process in the 1980s and further efforts could be made to facilitate their formation and operation, taking into consideration the profound changes that have taken place in capital markets over the past twenty years.