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Clark, J. (1998), “Fairness in public good provision: an investigation of preference for equality and proportionality,” Canadian Journal of Economics, 708–729.
Couillault, B. and Weber, P. (2003), “Towards a voluntary code of good conduct for sovereign debt restructuring,” Financial Stability Review, Bank of England, 154–162.
Dixon, L. and Wall, D. (2000), “Collective action problems and collective action clauses,” Financial Stability Review, Bank of England, 142–151.
Ghosal, S. and Miller, M. (2003), “Co-ordination failure, moral hazard and sovereign bankruptcy procedures,” Economic Journal, 276–304
IMF (2001), “Involving the Private Sector in the Resolution of Financial Crises—The Treatment of Claims of the Private Sector and Paris Club Creditors,” available via the Internet at www.imf.org/External/NP/psi/2001/eng/062701.pdf.
IMF(2002), “The design of the sovereign debt restructuring mechanism-further consideration,” available via the Internet at www.imf.org/external/np/pdr/sdrm/2002/112702.pdf.
IMF(2003), “Reviewing the Process for Sovereign Debt Restructuring within the Existing Legal Framework,” www.imf.org/external/np/pdr/sdrm/2003/080103.pdf, IMF website
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The paper greatly benefited from comments from Markus Krgier, Carl Lindgren, Steven Phillips, Robert Rennhack, Arnim Schwidrowski, and Roberto Steiner.
Former first deputy managing director of the IMF Stanley Fischer in an address in October 1998 made the following statement about the need to reform the role of the private sector in sovereign debt workouts: “There is great concern about the difficulties the international system has in lending to countries without bailing out private sector participants. We need a system, and we are developing it, for making sure that an appropriate contribution is made by the private sector to the resolution of crises […]”
Financial Times U.S. edition, Comment, p. 15, February 17, 2004.
The credit rating agency, Moody’s, downgraded the Dominican Republic from B3 to Caa1 citing that “it is not clear how negotiations with official bilateral creditors will affect bondholders in the context of “comparability of treatment”, Moody’s press release, rating action, January 30, 2004.
The Swiss investment bank UBS, in a research report of February 27, 2004 (Emerging Markets Daily Comments), wrote “[r]responding to rumors that the PDI payment due February 27 would not be paid until agreement was reached with the Paris Club a senior Central Bank official told us that the authorities are following a clear strategy, under their IMF program, of working with financial/legal advisors in dealing with their request for a Paris Club rescheduling. […] we believe, [that] a default—even if demanded by the Paris Club—would complicate the Dominican government’s relations with the IMF.”
The relevance of intercreditor equity can also be seen in the economic literature with regard to the concepts of fairness and envy. An allocation is said to be equitable if no agent prefers the allocation of any other agent (Pazner and Schmeidler, 1978). Equity does not need to imply the comparison of one agent’s valuation of his allocation with another agent’s valuation of her allocation and affect economic behavior. The economic literature assumes that if agents are indifferent between receiving a fractional allocation and the allocation that he or she actually received, an allocation is still equitable (Brams and Taylor, 1996; Thomson and Varian, 1985). Fairness and envy have been found in empirical studies to have a significant impact on economic behavior: i) “people are willing to sacrifice their own material well-being to help those who are being kind contingent upon perceiving the other as doing his fair share; ii) people will in some situations not only refuse to help others, but will sacrifice to hurt others who are being unfair; and iii) people will not be as willing to sacrifice a great amount of money to maintain fairness as they would be with small amounts of money” (Rabin, 1993).
The notion of fairness and the relationship between fairness and economic behavior suggest that rules to guide intercreditor equity should provide for an outcome that participants themselves consider as satisfactory and where the outcome can be implemented without having to rely on arbitration by an outside party. Equity rules may strengthen the bargaining process among creditors by providing transparent and verifiable guidelines for the debt restructuring process. Satisfaction with the restructuring outcome lies in the perception of equitable participation by creditors which should help to maximize concessions and minimize creditor dissent.
Proposals for a sovereign debt restructuring mechanisms, a factsheet, January 2003; available via the Internet at www.imf.org/external/np/exr/facts/sdrm.htm.
A recent IMF (2003) study concluded that “[d]ifficulties in assessing and achieving intercreditor equity both among private creditors and between private and official creditors can complicate and delay the process of achieving broad participation in an agreement.”
The SDRM addressed explicitly problems of intercreditor group and inter-debt issue equity but did not develop principles for distribution.
The aggregation problem addresses the difficulty of coordinating creditors holding distinct bond issues (Eichengreen and Mody, 2003).
The central bank of France put forward a “code of good conduct” to lay general principles to be adhered to by creditors and debtors (Couillault and Weber, 2003). The code refers to distribution indicating that “proceeds should be distributed pro rata” and that “procedures should ensure comparable treatment among creditors” but does not develop needed valuation principles to provide a practical guide towards the assessment of distribution and comparable treatment.
The Emerging Markets Traders Association (EMTA) attested that “[m]any investors already concerned about the general nature of comparable treatment will argue that private creditors in Russia and Ecuador will, in effect, have ‘bailed out’ the official sector” (EMTA, “Burden-Sharing in 2001: Now it’s time to reform the Paris Club,” February 13, 2001, www.emta.org/emarkets/burden5.pdf).
Given the limited public information about Paris Club obligations, several approximations were made to establish pre- and post-restructuring cash flows.
The Russian commercial debt restructuring assumes equitable treatment between Eurobonds, MinFins, and Prins and IANs as all correspond to unsecured obligations. This does not imply that MinFins or Prins and IANs should not trade at a discount to Eurobonds.
The yields are therefore significantly lower than implied secondary market yields prior to the restructuring agreement.
Data on commercial debt are limited to publicly placed foreign exchange bonds and taken from Bloomberg. As such commercial debt only represents a subset of the actual exposure of commercial creditors and the level of concessions extended is therefore probably overstated. The restructuring terms are taken from the prevailing offering prospectuses distributed at the time of restructuring.
The official debt data and restructuring terms come from the Paris Club website (www.clubdeparis.org). However, as the Paris Club publishes very aggregate data limited to rescheduled flows the calculations are accordingly only gross approximations of actual payment terms. The Paris Club normally only treats so-called pre-cutoff date debt and the data are therefore only a subset of the total exposure of official bilateral creditors. Firm conclusions about changes in the overall exposure of official bilateral creditors cannot therefore be made with the data probably overestimating actual concessions extended by the Paris Club.
A loan with a bullet maturity has an average life equal to the remaining time to maturity; a loan with a sinking fund has an average life shorter than its final maturity, e.g., the Paris Club graduated repayment structure (progressive payments over the life of the debt) implies that the average life of the debt is significantly shorter than its final maturity.
The IMF Sovereign Debt Restructuring Mechanism (SDRM) proposal launched in 2001 attempted to establish international legislation for the treatment of distressed sovereign debt. The SDRM addresses intercreditor equity with regard to the classification of claims (IMF, 2002). The SDRM proposal acknowledges that different loan terms may require different treatment but concludes that for distribution purposes all non-privileged non-official claims should be placed into one class. The SDRM recommends that all creditors within the same class would receive the same restructuring terms. Official bilateral creditors if they were to be covered under the SDRM would constitute a separate class as it should be possible for official creditors to receive different terms than private creditors as long as private creditors consent. The SRDM has not made specific provision for preference avoidance. Considerations to implement the SDRM have been postponed indefinitely by the International Monetary and Financial Committee at the IMF/World Bank spring meetings of April 2003.
The seniority of claims determines the distribution. Under U.S. law, each creditor class is compensated only after classes designated as senior are paid in full (11 USC 1129 (b) (2) (B) (ii)). Under English law, absolute priority is granted for debts that are not of preferential rank (Technical Manuel Chapter 36).
The prohibition of inequitable transfers has its origin in 16th century English law. The focus of English law was not to ensure a mathematical pro-rata distribution of assets but rather to prevent a debtor from administering a distribution based on own and unchecked criteria. The principle of preference followed in the 18th century by advancing a central element of modern preference legislation by distinguishing between transfers as part of the ordinary course of business and transfers detrimental to other creditors. However, only in 1869, a preference provision was drafted into English bankruptcy legislation providing that any payment made within three months of bankruptcy, for the purpose of giving the creditor a preference, was void.
American bankruptcy law introduced preference provisions in the bankruptcy act of 1841. The act defined and prohibited preferences making any transfer illegal if made for the purpose of benefiting a particular creditor. The bankruptcy act of 1898 promulgated an elaborate scheme to ensure ratable distribution. The bankruptcy reform act of 1978 created a specific and technical rule for the definition for preference: Section 547 states that a preference consists of a transfer of the debtor’s property: 1) to or for the benefit of a creditor; 2) for or on account of an antecedent debt owned by the debtor prior to such transfer; 3) made while the debtor was insolvent; 4) made on or within 90 days before the date of the filing of the petition; 5) that enables such creditor to receive more than such creditor would receive if the case were a case under Chapter 7 (liquidation). The debtor’s estate representative has the burden of proving that none of the above provisions are violated to prevent transfers of being voided.
The U.S. bankruptcy code makes specific provisions to allow recovery of a preference against unsecured creditors (section 550). However, the law sets forward defenses a creditor might assert including: 1) a transfer is protected to the extent that the transfer was a contemporaneous exchange for new value (contemporaneous exchange); 2) a transfer is insulated from preference litigation if payments were made in the ordinary course of business (ordinary course transfers); and 3) transfers are exempted to the extent that the creditor gave new value for the benefit of the debtor (enabling loans).
The reorganization plan may place a claim in a particular class “if such claim is substantially similar to the other claims of such class” (11 USC, 1122). The absence of language defining “substantially similar” claims makes classification subject to a wide range of interpretation and arbitrariness. While 11 USC., 1122 bars aggregating dissimilar claims in the same class, it does not explicitly address whether similar claims must be placed in the same class. Case law indicates that “this issue of the permissibility of separate classification of similar types of claims is one that has yet to be addressed, and it remains a “hot topic” both among practitioners and in the academic community” (Aetna v. Chateaugay Corporation, 2nd Cir., 1995). The court may force creditors to accept the plan (cram down) if the plan does not “discriminate unfairly, and is fair and equitable, with respect to each class” (11 USC, 1129 (b)). The U.S. Congress addresses the issue of inter-class equality by demanding that “a class is not to be unfairly discriminated against with respect to equal classes. There is no unfair discrimination as long as the total consideration given all other classes of equal rank does not exceed the amount that would result from an exact aliquot distribution” (U.S. House report 95–595). The guidance provided by case law and the legislative history of the code suggests that equally ranked creditors in different classes should be treated as if they were grouped in one class.
Under U.S. bankruptcy legislation, while accepting the valuation in present value terms, the courts have often been satisfied if the distribution of claims occurs in terms of face value and not if the market value of the new claims is consistent with the terms of the reorganization.
The U.S. Congress also allows for the notion of risk premium to be introduced in the valuation of claims: “Normally, the interest rate used in the plan will be prima facie evidence of the discount rate because the interest rate will reflect an arms length determination of the risk of the security involved […]”(U.S. House report 95–595).
Standard loan documentation often contains other equality provisions, such as, mandatory payment, turnover, and sharing clauses.
Under English law, debt is often issued under trust deeds that may include explicit collective action clauses but typically do not address inter-creditor group distribution issues in detail.
Negative pledge obliges the borrower not to grant security in favor of a subsequent creditor unless obligations under a prevailing loan agreement are equally secured. Cross-default specifies certain events under which a default in respect of any payment obligation by the borrower under any loan agreement other than the loan agreement in question constitutes a default. Acceleration provides in the event of default for the full immediate payment of all outstanding principal normally upon meeting certain specified triggers.
For example the pari passu clause in the Offer to Exchange trade indebtedness of the former Soviet Union (FTO) reads: “2030 Bonds constitute direct, unconditional, unsecured and subordinated obligations of the Russian Federation and rank pari passu without any preference among themselves and at least pari passu in all respects with all other present and future unsecured and unsubordinated obligations of the Russian Federation” (Offering Circular, Russian Federation, Offer to Exchange 2030 Bonds and 2010 Bonds for FTOs, November 2002).
The interpretation of pari passu in the U.S. corporate bankruptcy context is that an obligation is similar in seniority than other indebtedness of the borrower with regard to the priority of payments under liquidation (see above).
A Brussels appeals court in September 2000 ruled in favor of Elliott Associates against Banco de la Nación and the Republic of Peru. Elliott sought full payments from Peru on loans which were not submitted, albeit eligible, to Peru’s Brady exchange that closed in March 1997. In September 2000, Peru attempted to settle interest payments on its Brady bonds within the course of regular coupon payments. Elliott argued that such payments cannot be made in full if Elliott is not paid in full based on its unrestructured loan terms. Elliott litigated on the assertion that Peru was violating the pari passu clause of the underlying loan documentation by paying one group of creditors and not Elliott (Gulati and Klee, 2001; Scott and Jackson, 2002). Elliott argued that pari passu means that all payments must be made on a pro rata basis preventing preferential payments to certain creditors. The Brussels decisions seems to represent the first formal recognition in the sovereign debt context that the pari passu clause gives creditors the right to be paid pro rata with the rest of creditors covered by the clause (Scott and Jackson, 2002).
The Argentine government filed on December 19, 2003 (exactly on the anniversary of the outbreak of the 1994 Mexican crisis) a request with the U.S. Southern District Court of New York to clarify the principle of pari passu in Argentine loan contracts.
The Paris Club, established in 1956, represents a group of major bilateral official creditors to seek coordinated debt restructuring of official claims on distressed sovereign borrowers. There are currently 19 permanent members of the Paris Club: Austria, Australia, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Norway, Russian Federation, Spain, Sweden, Switzerland, United Kingdom, United States.
The Paris Club restructuring terms are guided by the financing needs and the income level of the debtor (Table 4). The Paris Club will only consider payment relief if the debtor is under an IMF-supported program and will provide debt relief consistent with an IMF adjustment program. The Paris Club is guided exclusively by restructuring provisions implicit in the IMF-supported adjustment program. Calls for “two-way comparability”, in which concessions granted by the private sector should be matched by the Paris Club (see EMTA, “Burden-Sharing in 2001: Now it’s time to reform the Paris Club,” February 13, 2001, www.emta.org/emarkets/burden5.pdf), are therefore rejected by the Paris Club. The Paris Club in October 2003 agreed to allow greater flexibility in the restructuring debt of non-HIPC countries (Evian approach).
The London Club has traditionally represented an ad-hoc grouping of commercial banks to lead negotiations to restructure claims on distressed sovereign borrowers. Banks with the greatest exposure to a proposed restructuring form a committee to protect the interests of all banks which have loan agreements with the debtor country (bank advisory committee).
The increasing importance of bondholders in sovereign borrowing has led to the proliferation of bondholder associations. EMTA, established in 1990, represents the emerging markets trading and investment community and seeks to promote the development of efficient and transparent market conditions for emerging markets instruments and provides a forum that enables market participants to identify issues of importance to the trading and investment community, and develop consensus approaches to addressing industry problems and opportunities. EMCA, established in 2000, aims at representing bondholders of emerging markets debt to provide orderly debt restructuring conditions.
Representative private sector associations argued that “inequity in the treatment of private and official bilateral claims allows bilateral creditors to continue to operate in a system that at times afforded them more favorable terms” (EMTA, “Sovereign Debt Restructuring,” December 6, 2002, www.emta.org/ndevelop/SDRM.pdf).
Scott and Jackson (2002) argue, with regard to the outcome of the Elliott Associates ruling (footnote 28), that lack of clarity in key bond contract covenants also suggest that boilerplate provisions that open up the possibility of having another decision contrary to the interest of main creditors should be avoided.
This seems to correspond in spirit to the new Evian approach of the Paris Club that seeks to alleviate previous restrictions on restructuring official bilateral debt.
The chosen discount rate is not aimed at substituting market discount rates and merely acts as an appropriate reference within the equality valuation rules.
The face value of a claim received in distribution would be as good an indicator to determine equitable distribution as the market value of the claims (problem of common denominator). Yet, the level of the discount rate is material when different creditor groups use different discount rates to value their respective shares in distribution and therefore to determine whether equitable distribution has been achieved.
The restructuring of sovereign debt of a debtor in or near default is most often guided by provisions established under an IMF-supported adjustment program and rests on the balance of payments needs established by the IMF to determine the debt relief needed to restore the debtor’s solvency or liquidity. The IMF balance of payments analysis specifies the financing gap that needs to be closed and effectively constitutes the “reorganization plan” in sovereign debt restructuring. The IMF requires the debtor country to implement an adjustment program and obtain sufficient financing through new money, debt relief, or other forms of payment to establish the viability of the economic program supported by the Fund. IMF adjustment programs may include exceptional financing from the Paris Club and other creditors in cases where program-financing needs are large and the debtor’s payment obligations to such creditors are substantial. As such, the IMF-supported reorganization plan may determine the concession floor in sovereign debt restructuring and effectively represents a cram down provision on all creditors albeit without the legal implications normally associated with such provisions.
In a first phase traditional debt relief is provided from bilateral official creditors in the Paris Club providing a reduction of claims based on traditional debt relief (of up to 67 percent (Naples terms)). In a second phase (decision point), upon meeting certain debt ratios after traditional relief, creditors grant an additional reduction of claims of up to 90 percent (Cologne terms) in cumulative terms.