Appendix I. Definitions and Roles of Clauses
42. The following is a general description of terms and provisions used in bond contracts.
43. Exit consents (or exit amendments) are legal provisions that allow a simple majority of bondholders to modify the nonpayment terms of old bonds in an exchange to render the old bonds unattractive or illiquid. By stripping away favorable bond features and creditor rights, the old bonds become less attractive, thus inducing bondholders to participate in the exchange into new bonds.
44. Exit consents can be particularly useful for restructuring bonds that do not contain CACs to alter payment terms. Instead of changing the financial characteristics of old bonds via majority restructuring provisions, exit consents can be used to alter nonpayment terms, for example legal features that affect the bond’s liquidity or the holder’s ability to litigate. Most commonly, exit consents include: (i) the de-listing of the outstanding bonds to reduce liquidity; (ii) the removal of cross-default clauses; and (iii) the removal of acceleration clauses. The decision to use exit consents has to occur in agreement with the issuer and often takes place in the context of a bondholder meeting. After the exchange, nonparticipating bondholders will generally not be able to reverse the amendments without the consent of the sovereign issuer. This can considerably reduce the leverage of holdouts, as they may be left with less liquid bonds with unattractive legal features and lower secondary market values.
45. Acceleration clauses are a standardfeature in sovereign debt contracts and entitle creditors to “accelerate” unmatured principal following a default event (see Buchheit and Gultai, 2002). In the case of any missed payments, all principal and accrued interest become immediately due and payable. Typically, the decision to accelerate payments requires a minority vote of at least 25 percent of outstanding principal. This practice follows the general rule for corporate bonds issued in the United States (see Buchheit and Gulati, 2002). Depending on the drafting of terms, an acceleration can also be revoked or vetoed (“de-accelerated”) by a majority of bondholders, provided that the default has been “cured.” One example was the debt exchange in Ecuador 2000, which was made conditional on bondholders revoking the acceleration decision on their old bonds (see Sturzenegger and Zettelmeyer, 2007).
Cross-default and cross-acceleration clauses
46. A cross-default takes place if a default event on one debt contract can trigger a default on another agreement. This implies that a missed payment (including a coupon payment) can trigger a default vis-à-vis the remainder of government’s (bank and bond) obligations. In essence, cross-default clauses can strengthen the principle of inter-creditor equity and act as a deterrent to selective default (i.e., the decision to pick and choose which bondholders or banks to repay). During the 1980s, cross-default clauses in sovereign loan contracts protected banks from selectively defaulting on syndicated loans or parts thereof. Also, Eurobonds and Brady bonds issued since the 1990s typically contain cross-default clauses, Note, however, that many bonds provide for a minimum amount (e.g., 25 percent) to trigger cross-default provisions.
47. Cross-acceleration implies that the acceleration on one debt contract may accelerate other (third party) debt contracts as well. Exit consents are often used to remove this type of clause from the old bond contracts to protect new bondholders from legal remedies by nonparticipating holdouts. Once the cross-default and cross-acceleration clauses are removed, any nonpayments or disputes related to the old bonds will no longer trigger default and acceleration on the new bonds. Cross-acceleration clauses too often require a minimum vote share to be triggered.
48. Often, CACs, exit consents, and other innovations in individual debt contracts are insufficient to deal with the broader problems of collective action problems, as they can only bind bondholders within the same issue without affecting bondholders across other bond issuances or other types of debt (e.g., bank debt and trade credit).
49. Aggregation clauses are provisions that allow the aggregation of creditor claims across all bonds and other debt instruments for voting purposes. Depending on the exact language of the clause, a supermajority of bondholders could then be enabled to amend the payment terms of a multitude of individual bond series at the same time.
50. The use of aggregation clauses in sovereign bonds remains limited. Uruguay introduced them during the 2003 exchange and was followed by Argentina (2005) and several smaller issuers, including Belize and the Dominican Republic. The aggregated CACs in the bonds of Argentina and Uruguay both contain a dual voting threshold structure with two-tiered voting.35 However, aggregation clauses have not been called yet in any sovereign debt workout in recent years.
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This paper was prepared by Udaibir Das, Michael Papaioannou, David Grigorian, and Samar Maziad (all MCMDM).
The paper does not cover developments in the recent European debt crisis.
The list includes 18 debt restructuring cases involving both external and domestic debt and 6 cases aimed at domestic creditors.
A further category of restructurings are debt buybacks, in which outstanding debt instruments are exchanged against cash, often at a discount. However, since the 1950s, with a total of only 26 known cases, debt reduction via buybacks has remained the exception in the debt restructuring context.
It should be noted that different loan agreements may have different definitions of “events of default.”
While most CDS contracts rely on the form ISDA agreement (and, therefore, would rely on ISDA’s determination of a credit event), there exist bilateral contracts that can in some instances be different.
They argue that some debtor countries may be “debt intolerant,” in that they are less able to sustain high levels of debt to GDP without defaulting.
The circumstances of defaults and restructurings that highlight the idiosyncratic nature of those events are examined in further detail in a forthcoming working paper by Das, Papaioannou and Trebesch (2012).
The reported values are computed by averaging the loss across all instruments exchanged. The authors follow the methodology suggested by Sturzenneger and Zettelmeyer (2007), which compares the present value (PV) of new debt instruments in the exchange with the PV of the old outstanding debt (including past due interest) discounted at imputed exit yields.
The number of debt restructuring episodes with face value reduction (nominal debt write-downs) has notably increased since the late 1980s. A reason for the increase in frequency of face value reductions is that bank and bond debt exchanges now often involve a menu of options, which explicitly includes the face value reduction option.
This is consistent with Finger and Mecagni (2007).
The performance of restructured bonds after an exchange differs across countries. Using representative benchmark bond prices in the two years following a debt restructuring for a few recent cases, we observe that average bond prices increase moderately after a restructuring, while volatility tends to be low in the first six months after the event. Also, bond prices performed better after preemptive restructurings compared to post-default restructurings over a two-year horizon.
Indeed, some recent restructuring episodes revealed that nonresidents hold substantial amounts of domestic debt instruments (e.g., Russia, 1998, and Ukraine, 1998). Similarly, residents sometimes hold considerable shares of externally issued bonds (e.g., Pakistan, 1999, and Uruguay, 2003). Therefore, the type of debt instrument issued (i.e., domestic or external) is not necessarily a good predictor of the type of creditors affected by the exchange (i.e., residents vs. nonresidents).
Domestic debt can also be denominated in foreign currency.
Litigation is cumbersome because sovereign debt is typically not backed by any collateral and there are few attachable government assets located outside national borders that could potentially seized.
The authors show that even with dispersed creditors, full participation is the norm as long as neither the haircut nor the probability of successful holding out is too high. They also argue that holdout strategies and litigation are costly and require specialized knowledge.
Enderlein, Schumacher, and Trebesch (2011) provide a new systematic database on litigation cases in the sovereign debt universe based on legal databases of NexisLexis and PACER.
In the case of Dominica, the holdouts were mainly linked to three institutions, while in Argentina they included thousands of investors, including many retail bondholders. The latter were hard to identify and prone to litigate, and asked for special treatment.
Many of the remaining 8 percent holdouts, including distressed debt funds, continue their litigation efforts to this day.
In general, CACs cover the following two broad categories: (i) “majority restructuring” provisions, which allow a qualified majority of bondholders of an issuance to change the bonds’ financial terms and to bind in all other holders of that issuance, either before or after default; and (ii) “majority enforcement” provisions, which can limit the ability of a minority of bondholders to enforce their rights following a default.
On some occasions (e.g., Uruguay and Jamaica), explicit announcement of minimum participation thresholds were used as another mechanism to solve coordination problems.
In addition to the Fund (the role of which in this regard will be discussed in an upcoming joint SPR, MCM, and LEG paper), the official sector (e.g., the Group of Ten (1996, 2002), G7 as well as the U.S. Treasury), had promoted a more widespread use of CACs (Taylor, 2002).
While CACs have gained considerable attention in the EU public debate in recent months, their inclusion in domestic bonds in continental Europe continues to be the exception rather than the rule.
Holders of these bonds were invited to tender their instruments, and at the same time to grant an irrevocable proxy vote to be cast at bondholder meetings. This insured that bondholders who had tendered proxies could not change their minds and reject the proposed amendments at the meetings without incurring substantial civil liability (see IMF, 2001b for details).
CACs were included in two Dominican bonds issued in the late 1990s for which Citibank and RBTT Merchant Bank acted as trustees.
Specifically, these terms included “the deletion of the requirement that all payment defaults must be cured as a condition to any annulment of acceleration, the provision that restricts Ecuador from purchasing any of the Brady bonds while a payment default is continuing, the negative pledge covenant, and the covenant to maintain the listing of the defaulted instruments on the Luxembourg Stock Exchange” (IMF, 2001a, p. 35).
Ultimately, more than 90 percent of participants in the Uruguay exchange approved the use of exit consents. Only one small Brady bond did not reach the minimum approval rate of 50 percent of bonds outstanding necessary to activate the exit consents (see Uruguay “Article IV Consultation and Third Review under the Stand-By Arrangement 2003” available at: http://www.imf.org/external/pubs/ft/scr/2003/cr03247.pdf).
This section reflects the knowledge on the issue prior to the Greek debt exchange of 2012, which is nonetheless important.
In essence, a CDS is a credit derivative contract between two counterparties, which is comparable to an insurance policy on a bond or loan. In a CDS contract, the buyer agrees to pay a quarterly premium to the seller who, in case of a credit event, commits to reimburse the buyer with the value of principal of the bond in exchange for the underlying bond (or its recovery value in cash). While still much smaller than the underlying sovereign bond market, the volume of outstanding contracts has increased sharply in the last five years and there is now a relatively liquid secondary market for sovereign CDS in Europe and the US.
When interpreting these figures, it is important to underline once more that a restructuring can occur many years after the first payment default of a country. In fact, restructuring episodes often mark the end of a crisis and not its beginning (see also Levy-Yeyati and Panizza, 2011).
Reinhart and Rogoff (2008) find that output declines associated with domestic debt default appear to be worse than for external debt crises. On average, the output decline in the year prior to a domestic default is 4 percent, compared to only 1.2 percent in the year before external defaults.
It should be noted that sovereign debt crises are associated with a notable decline in trade and output. The size of output costs largely depends on whether debt crises occur simultaneously with banking and currency crises. “Twin” or “triple crises” are associated with much larger output costs than debt crises alone. Defaults tend to follow, and not precede, output contractions.
The exposure of the banks and nonbank financial institutions to sovereign risk has grown and reached unprecedented levels during the crisis.
Specifically, a modification of terms require an approval by a total of 85 percent of bonds of all affected series (aggregate of at least two bonds) as well as by 66 percent of outstanding bonds of each affected series (issue-by-issue).