Is the world finally ready to restructure sovereign debt? A Q&A with Prof. Schwarcz
On June 16, the U.S. Supreme Court declined to hear Republic of Argentina v. NML Capital, Ltd., a long-standing dispute between Argentina and holders of its Fiscal Agency Agreement bonds, which the country defaulted on in 2001. This left in place a lower-court ruling which stated Argentina could not make payments on bonds that had been restructured unless it also paid bonds held by holdout hedge funds that refused to accept its debt-restructuring plan. The decision helped inspire an unprecedented vote in the United Nations General Assembly on Sept. 9 to begin drafting a multilateral framework, such as a treaty, convention or model law, for sovereign debt restructuring as a means of reforming the global financial system.
Steven L. Schwarcz, the Stanley A. Star Professor of Law & Business at Duke Law, has been arguing for the creation of a multilateral and transnational legal framework approach to sovereign debt restructuring since 2000, originally in a Cornell Law Review article entitled “Sovereign Debt Restructuring: A Bankruptcy Reorganization Approach” and most recently in a 2012 Harvard Business Law Review article, “Sovereign Debt Restructuring Options: An Analytical Comparison.” He sat down with us to discuss the implications of the UN vote for the United States and the global financial system.
Q: Can you provide us with a brief overview of sovereign debt restructuring and your views on it?
A: In general, I believe that a multilateral legal framework is needed to avoid having to choose between bailing out financially troubled nations or allowing them to default. Because a default might trigger systemic consequences, the current absence of a framework virtually assures bailouts, thereby creating moral hazard and taxing the citizens of solvent nations.
More specifically, the problem of sovereign debt restructuring is similar to the problem of all debt restructuring. What is most critical is the so-called “collective action problem.” In a corporate debt context, this problem is addressed by section 1126(c) of the bankruptcy code, which says that when you have a debt restructuring and are changing essential terms that require unanimity, a so-called supermajority vote will be sufficient to override the contractual unanimity requirement.
In the sovereign debt context, attempts have been made to try to solve this problem through collective action clauses—an approach that has long been advocated by our own Prof. Mitu Gulati, among others. These are clauses in loan agreements that say that even essential terms don’t need unanimity but merely a supermajority vote by the creditors of that contract to make the changes. The idea of collective action clauses has been viewed with favor by the U.S. government over the past decade. But the Greek debt restructuring, where only a small percentage of Greek bonds actually had collective action clauses, showed the inadequacy of this approach.
Furthermore, collective action clauses historically do not work across debt issues; rather, they work only on a contract-by-contract basis. You therefore still have a collective action problem among a sovereign’s debt issues. For example, even if all of a country’s debt issues have collective action clauses, creditors of any of those debt issues may act as holdouts by voting no to a debt restructuring. To be effective, you need to have these clauses extend across all debt issues, so that the supermajority voting takes into account creditors of all of those debt issues. There has been a recent attempt to put these broader types of collective action clauses in sovereign debt agreements, but the fact that only a small percentage of Greek bonds had even the more limited collective action clauses indicates that these broader types of clauses are unlikely to solve the problem.
Experience therefore shows that collective action clauses are not sufficient to do a complex sovereign debt restructuring. You need a framework that’s legally binding in which a supermajority vote cuts across all of a sovereign’s debt issues. The only way to really achieve that is a multilateral legal framework, which is what the UN General Assembly overwhelmingly voted in favor of in September. This approach was sponsored by Bolivia, but Argentina, China, and the “Group of 77” developing nations are also big supporters.
Q: Do you think that the philosophical approach to international conventions has changed between 2000 and 2014?
A: At least two things have changed. First, the increased presence of hedge funds has exacerbated the holdout problem. Second, we have had almost 15 years to see if collective action clauses would work and we now know that, at least in practice, they don’t. Debtor countries are recognizing that and they want to be able to get relief.
Also, a collective action clause only purports to solve the collective action problem. A multilateral legal framework could address other concerns with sovereign debt restructuring, including liquidity.
Q: The U.S. opposed the framework on the grounds that it would cause “economic uncertainty.” How have other countries responded to the proposal? If the U.S. refuses to sign on, what would that mean for the framework’s effectiveness?
A: Right now, most sovereign debt is governed either by New York law, English law, or the law of the debtor country. If the U.S. opposes the framework and the U.K. embraces it, most sovereign bonds would likely end up being governed by English, not New York, law. New York law would then lose its status as a major international choice of law in the sovereign debt area. If the U.S. opposes the framework, it is possible that New York State could enact a law that would parallel the framework. That’s an interesting consideration, assuming federal law doesn’t then preempt New York law. Practically, however, if there’s a widely accepted framework, I suspect there will be a lot of pressure for the U.S. to join in.
The U.S. probably also has concerns regarding the kind of relief allocated to the debtor nations – and whether too much will be granted – under the framework. However, I don’t think there’s a real risk of excessive relief. As long as only similarly situated creditors can bind dissenters, a super-majority vote should guarantee that the dissenters’ interests will be protected.
Frankly also, it’s a bit disingenuous for the U.S. government to argue that a multilateral framework would increase economic uncertainty if the approach to solving the collective action problem parallels that of U.S. bankruptcy law.
Q: You’ve mentioned that a multilateral legal framework could address other concerns with sovereign debt restructuring, including liquidity. Can you explain how that would work in practice? What would that look like? Are there risks it may raise the transaction costs of sovereign debt borrowing in general?
A: The same question comes up in U.S. bankruptcy law. You actually have an exact analogy in section 364 of the bankruptcy code, which enables a company in bankruptcy that’s trying to reorganize to borrow on a priority basis, thereby attracting the funds.
My sense is that attracting voluntary funding would increase costs but probably only marginally. Providing funding in order to enable a country to continue in good order and without riots is in everyone’s interest, including the existing creditors. The main concern is whether the country will borrow too much and waste it. In the corporate context, that’s addressed by enabling existing creditors to object to new money funding. I argue there should be a process for that to happen on the international level.
Q: The Supreme Court’s decision would have also encompassed hedge funds, which can purchase original bond at a deep discount but then sue for full payment. What is their impact on sovereign debt discourse?
A: While you had hedge funds in 2000, they are more active and aggressive now. There are probably more transfers of sovereign debt now than there were then. It was all relatively easy when you had the existing creditors hold the claims and work with the debtor. Back in the 1970s and 1980s, most sovereigns borrowed from banks. As a result, bank syndicates would often sit down and negotiate with the country. When you have a lot of transfers of debt, the purchasing parties are often buying sovereign bonds at a discount to make money and will use a very aggressive strategy to force the country to pay. These buyers of bonds – mostly hedge funds – their incentive is to act as a holdout. They will buy for nominal amounts and so can afford to hold those bonds indefinitely. The increased transferability and larger number of bonds held by hedge funds have made it all the more difficult for countries to resolve this absent some legal framework that will bind these holdouts.
– Lauren Sampson ‘15