9.8.2011

By Simon Miller

In June, markets managed to take a quick sigh of relief as somehow the need to avoid declaring default overcame political differences in Greece and its parliament voted through both the austerity measures and the means to carry out the measures.

However, Greece is not out of the woods yet. In 2009, the International Monetary Fund gave a 53 per cent probability that the country would default just behind Venezuela with 58 per cent and top of the default probability table.

It is not that the global finance world doesn’t have forms of infrastructure to assist troubled countries. The Paris Club, which comprises of rich-country government lenders, and the London Club (commercial-bank lenders) co-ordinate lending responses and of course there is the European Stability Mechanism and the IMF, among others. However, these bailouts are becoming increasingly criticised over their effectiveness and the political risk to governing parties is becoming greater.

The need for restructure
For indebted nations, one argument is that they should default and restructure their debt. In his paper, The new Vulture Culture: Sovereign debt restructuring and trade and investment treaties, Professor Kevin Gallagher of Boston University, points out that many countries “if not this time then the next time around, may need to reschedule, restructure or even default on their debt”.

Yet a new breed of creditors has emerged in the past decades. In a briefing note issued last month, Sovereign Debt Restructuring and International Investment Agreements, United Nations Conference on Trade and Development (UNCATD) says that “there has been a growing amount of sovereign debt held by numerous creditors dispersed around the globe.

This has created a new class of creditors, making the restructuring process
more complex”.

In his book, Making Foreign Investment Safe: Property Rights and National Sovereignty, Louis Wells comments that this lack of a single international regime to manage all of a country’s foreign obligations in times of crisis stands in contrast to the bankruptcy process available for private debtors in trouble.

He writes: “Domestic bankruptcy regimes can halt the rush of creditors to seize assets before others get them and they determine priorities for various categories of claimants.”

Wells continues: “Also, they can force holdouts to agree to fairly distributed reductions in obligations and try to maximise the benefit available to creditors as a group. Restructuring and reducing obligations allows the bankrupt entity to return to a growth pattern.”

Gallagher points out that although restructuring has been a constant feature of the global economy for centuries, “the fact that there is no comprehensive and uniform regime for governing debt workouts has been seen as one of the most glaring gaps in the international financial architecture” which has accentuated the financial crisis.

Restructuring regimes
It is not that the international community hasn’t tried to install a regime. But with so many bondholders around the world and, of course, the secondary market, it is hard to track them down when trying to initiate a restructure.
In 2001, deputy managing director of the IMF Anne Krueger proposed a Sovereign Debt Restructuring Mechanism which would, essentially, mimic bankruptcy courts for private creditors such as Chapter 11 in the States.
However, the proposal was opposed by private creditors, US government and some creditor nations. According to Gallagher, “some debtors were concerned that they would not receive any more IMF support, and were concerned that they would be scorned by private investors in the market place”.

Instead, the US followed London’s lead and began issuing bonds with collective action clauses (CAC) within their contracts which have taken off to such an extent that they are now found in over 90 per cent of newly issued bonds in the US. CACs allow collective representation, a minimum enforcement component and a majority restructuring component.

Yet, still CACs do not go far enough for some observers. With bondholders globally diverse and the secondary market, it can be hard to call a vote.

Secondly, holdouts – those debt holders that reject haircuts – could purchase a 75 per cent majority and so prevent a restructure vote from being successful.

Indeed, there is one example of a country that demonstrates the lack of a regime for SDR and how holdouts use International Investment Agreements (IIA) to grab a better deal – Argentina.

History lessons
As we have seen, defaults aren’t new. But to get a closer view of how to manage a default, the nearest parallel appears to be Argentina.

In the late 1990s Argentina dived into an economic crisis which resulted
in a full-blown recession between 1999 and 2002.

As a result, Argentina defaulted on part of its external debt in December 2001 leading to an exodus of foreign investment as they fled the country, almost completely ceasing inward capital flows.

To begin combating the crisis, the peso was floated – having previously enjoying a 1-1 fixed parity with the dollar – and the peso devalued leading
to high inflation.

With debt largely unpaid, a restructuring was in order but Argentina faced international criticism over the default with the Italian government leading
the charge.

With no money in the bank, Argentina was effectively shut out of international markets for over four years but, even with an improved economic situation, the debt was still the largest default in history at around $100 billion (£61.3 billion).

In 2005, the country opened an exchange on over $100 billion in principle and interest on a diverse number of bond issuances where the bondholders were to receive a 67 per cent haircut. It managed to restructure some $62 billion.

However, some, including vulture funds, held out and took the legal route with some 158 suits being filed in the US by the end of 2010, according to UNCTAD. The United Nations body pointed out that, for the first time ever, a number of holdouts filed claims under IIAs to the International Centre for the Settlement of Investment Disputes (ICSID). In 2006, around 180,000 bondholders initiated proceedings under the Italy-Argentina BIT for $3.6 billion.

This brings us nearly up to today, with yet another exchange of $18 billion of debt between May and June 2010, offering a 75 per cent haircut. Of bondholders, 66 per cent, totalling $12.1 billion, tendered although $6.2
billion worth of bondholders will continue to litigate either through domestic courts or through ICSID.

IIAs
So defaulting and restructure are necessarily painful but there appears to be increasing concerns over IIAs.

UNCTAD’s briefing note points out that although Argentina is the only nation so far to be subjected to IIA claims related to its sovereign debt and restructure, “today’s situation where numerous countries face the risk of debt crises, suggests that the prospects of holdouts bringing additional investor-State dispute settlement claims cannot be ruled out”.

It adds: “It is therefore important to ensure that IIAs do not prevent debtor nations from negotiating debt restructurings in a manner that facilitates economic recovery and development.”

Indeed, Gallagher argues that CACs do not provide any protection for sovereign debtors in the context of IIAs. Although it seems that CACs would prevent holdouts of sovereign bonds and vulture funds from filing claims under IIA, Gallagher writes that “even if the bondholder of a [particular issuance] voted against litigation through a minority clause, or agreed to the terms of a restructuring under a majority clause, such actions under a CAC would not prevent an investor from filing an arbitral claim”.

In fact, Gallagher cites Michael Waibel who argues that even if a CAC was deployed, holdout bondholders could file a treaty claim arguing that the terms of a treaty have been violated. Waibel argues that “ICSID arbitration could blow a hole in the international community’s collective action policy”.

Indeed, it is these treaties that are the Achilles heel in protecting against holdouts. Despite international trade agreements, many countries also have bilateral investment treaties (BITs) that precede and in some cases supersede international deals.

According to Gallagher, most BITs now include sovereign debt and so are included in IIAs’ jurisdiction. To give some examples of the number of treaties countries hold; Greece has 38 BITs, Portugal 49 and Ireland, one. In comparison, the UK has 124 treaties.

As a result, bondholders may be tempted to ‘treaty shop’ says Wells. Like in libel tourism, where litigants sue in a jurisdiction more likely to reward them higher, this entails filing claims under treaties where it is more likely that they can win jurisdiction.

There are also other clauses in IIAs that affect CACs and restructures. Umbrella clauses place obligations under international law so that even
if the CAC has been appropriately enforced, and a no-25 per cent
minimum vote for litigation had been held, then umbrella clauses could
allow holdouts to resort to investor-state arbitration.

Another way holdouts could instigate action under IIAs would be when a foreign bondholder receives different terms during a restructure. Domestic holders could then trigger a national treatment claim which insists that all bondholders are treated the same no matter which territory they come from.
Gallagher notes that Italian bondholders claimed under the Italy-Argentina BIT for expropriation – in other words wealth deprivation. The difference between the debt and haircut is claimed to have deprived the debt holder and so falls under the IIA.

Mitigating litigation
So if IIAs are bad for sovereign debt, what can be done to mitigate the risk from holdouts and litigation?

Countries have taken steps to exclude sovereign debt from their IIAs. For example, under the Peru-Singapore FTA, any country can engage in a ‘negotiated restructuring’ without being liable for foreign investor losses. However, non-negotiated restructuring can bechallenged subject to a 270-days-cooling-off period.

“The exclusion of sovereign debt from ‘covered’ investments under future treaties would relegate sovereign debt arbitration to national courts and
to international financial bodies,” writes Gallagher.

In addition, bond contracts often have clauses which decree that bond conflicts must be decided in the national court that governs the bond issue.
Gallagher argues that these clauses could be used to steer SDR claims to
other venues.

State security could also be invoked with essential security exceptions covering financial crises and the SDR could be justified as ‘self-judging’ and ‘of necessity’.

Finally, Gallagher and UNCATD point out that State-to-State dispute resolution for SDR may be more prudent as nations attempt to examine the effects of crises while individual firms ‘look out for their own bottom line’.

As Greece talks to members of the Institute of International Finance to deliver cash-flow support to Greece, as well as to lay the basis for a more sustainable debt position, it is important to remember that debt restructuring may not necessarily be the right option for Greece.

For the wider community, it appears necessary that IIAs are brought under greater scrutiny and appropriate actions taken to prevent holdouts and vulture funds from gaining while other bondholders take what may be vital haircuts.

As UNCATD puts it, “it is in countries’ interest to continue considering these issues and to be proactive in preventing outcomes that could hurt their
financial stability”.