A Soft Law Mechanism for Sovereign Debt Restructuring

1024px-UN_General_Assembly_hall

By Martin Guzman and Joseph E. Stiglitz

The ultimate goal of sovereign debt restructuring is to restore the sustainability of public debt with high probability[1]. But this is not happening. Since 1970, more than half of the restructuring episodes with private creditors were followed by another restructuring or default within five years[2] — evidence inconsistent with any sensible definition of “restoration of sustainability of public debt with a high probability.” This evidence suggests that relief for distressed debtors is often insufficient for achieving the main goal of a restructuring, delaying the recovery from recessions or depressions, with large negative social consequences.[3]

The lack of a statutory regime for dealing with distressed sovereign debt makes sovereign debt crises resolution a complex process — marked by inefficiencies and inequities that take multiple forms[4]. The current non-system is characterized by bargaining based on decentralized and non-binding market-based instruments centered on collective action clauses and competing codes of conduct. The IMF often plays the role of the facilitator in this process of bargaining between a distressed debtor and its creditors.[5] But it has not always been successful in ensuring that restructuring needs are addressed in a timely way — indeed, it has often failed; and as we have already noted, even when restructuring processes have ultimately been carried out, they have often not been deep enough.[6]

Overall, the current non-system does not respect priority agreements or resolve inter-creditor inequities, address debtor-in-possession financing, or address adequately such ex-ante concerns as ensuring that creditors have sufficient incentives to lend under the right terms, or borrowers have sufficient incentives for prudential behavior.[7]

The gaps in the legal architecture create perverse incentives for legal arbitrage and work against cooperation. These gaps have led to the emergence and growth of so-called vulture funds, hedge funds whose business model is based on exploiting the deficiencies in the rule of law that they helped shape.[8] They specialize in attacking countries in debt crises. The modus operandi consist in first buying distressed debt at bargain prices in secondary markets, generally issued under New York law, and then suing the issuer claiming full payment — full principal and full interest, including punitive interest[9] and compensation for risks that they did not take. Once they get a favorable ruling, if the country refuses to pay according to the ruling’s terms, they employ tough tactics.[10] This kind of behavior has been on the increase over the past decade: While in the 1980s only about 5 per cent of debt restructurings were accompanied by legal disputes, this figure increased to almost 50 per cent in 2010 (see Schumacher, Trebesch, and Enderlein, 2014).

Outcomes are alarming. The vultures’ strategies are bringing exorbitant returns that result in severe inter-creditor inequities, which in turn aggravate a moral hazard problem that threatens the possibility of finalizing a process of sovereign debt restructuring — as it happened in the recent case of Argentina, for instance. In light of recent events good faith creditors are learning that holdout behavior pays off. In Argentina’s recent saga with the vulture funds in the US courts (where the vultures were led by NML Capital, a subsidiary of the New York based hedge fund Elliott Management), it wasn’t even necessary to be a litigant in order to receive the same treatment the courts awarded to the vultures: the courts ordered the country to treat non-litigant holdout creditors in the same terms obtained by litigant vulture funds. Why, therefore, would good faith creditors be willing to cooperate on a restructuring process with a distressed debtor, which would probably include a large discount, if they could simply follow the lead of a vulture fund and get returns that could be in the order of hundreds or even thousands per cent higher? The main problem with the aggregation of these individually »rational« actions is that, if a sufficiently large number of bondholders follow the same strategy, debt restructuring would become impossible to finalize. The case of Republic of Argentina v. NML Capital intensified an already long-running debate over the need for systemic reforms that involved academics, practitioners, multinational institutions, and civil society.[11]

On the one hand, the International Capital Market Association (ICMA), with the support and endorsement of the IMF, suggested reforms to the sovereign debt contractual language in order to prevent situations like the one Argentina experienced with the vultures. The suggested new terms include a formula for aggregating collective action clauses (see ICMA, 2014; IMF, 2016; Gelpern, Heller, and Setser, 2016). Some countries are already issuing debt using this new language. Although the new terms are a sign of progress, they are unlikely to be sufficient to resolve fundamental problems currently faced in restructuring processes (see Guzman and Stiglitz, 2016a).

On the other hand, the United Nations took the lead in the efforts that aim to create a statutory mechanism for sovereign debt restructuring, as first reflected in the UN GA Resolution 68/304 passed in September 2014 and later in UN GA Resolution 69/319 passed in September 2015. The latter resolution approved a set of nine principles that should serve as the basis for restructuring processes — sovereignty, good faith, transparency, impartiality, equitable treatment of creditors, sovereign immunity, legitimacy, sustainability, and majority restructuring (henceforth the »UN Principles«).

The UN has laid out steps in the right direction. Although in the short term the creation of a multinational statutory framework for debt crises resolution does not seem to be feasible, the UN principles provide a valuable basis for the next stages of the process.

The Road Ahead

The proposals for sovereign debt restructuring should be evaluated in terms of their ability to ensure the recovery of debt sustainability and whether they respect the UN principles. The contractual approach will not, we believe, fully address this concern satisfactorily.[12] The statutory approach could do so, but it seems to be politically unfeasible at the current juncture. This is an unfortunate situation, especially considering that the current state of the global economy puts several countries at risk of debt unsustainability in the short term.[13] The natural question is what can be done to improve matters soon.

A soft law instrument that codifies the UN principles for practical purposes could serve as a guide for domestic legislation. The codification of the principles might remind courts of the big picture in a sovereign debt restructuring process, possibly mitigating biases towards narrower interpretations of debt contracts. The institution hosting the soft law regime could maintain a registry of recalcitrant holdout bondholders and their parent companies. The registry could serve as a guide for domestic and international courts when they have to decide whether bondholders violated the principle of good faith. It could also host a comprehensive, searchable public database of past restructurings, including financial and legal terms, the treatment of public, private, domestic and foreign claims, and any underlying assumptions used for achieving a restructuring plan.

The institution could create its own debt sustainability analysis (DSA) framework, stating general principles for debt sustainability assessments (respecting the UN GA enunciation of the sustainability principle). It would encourage cooperation among the stakeholders involved in order to achieve a level of relief that respects their sustainability assessments and satisfies the other UN principles. In a process of sovereign debt restructuring initiated by the sovereign, the competent institution would first produce a preliminary DSA and transmit it to the government for a response. The government would be required to disclose information and data necessary for the assessment and to respond to the DSA. The preliminary DSA and the government’s response would next be made public to the creditors, other international institutions, and the general public, all of whom would have an opportunity for comment. After a reasonable time period, the institution would publish a final DSA taking into account the government’s response and public comment. The final DSA would give reasons that justify the determination made and would indicate possible disagreement with the government, international institutions, or creditors’ committees.

The statements of the institution would not be enforceable, but could be used as a legitimate guide for the stakeholders involved (especially for domestic courts) on what is sensible practice in a process of debt restructuring. We believe that these reforms can mitigate the deficiencies that are currently leading to inefficient and inequitable restructuring outcomes.

References

Auerbach, Alan and Gorodnichenko, Yuriy (2012a): “Fiscal Multipliers in Recession and Expansion,” in: Fiscal Policy after the Financial Crisis, edited by Alberto Alesina and Francesco Giavazzi (Chicago: University of Chicago Press).

Auerbach, Alan and Gorodnichenko, Yuriy (2012b): “Measuring the Output Responses to Fiscal Policy,” American Economic Journal: Economic Policy 4 (2): 1–27.

Blackman, Jonathan I. and Mukhi, Rahul (2010): “The Evolution of Modern Sovereign Debt Litigation: Vultures, Alter Egos, and Other Legal Fauna.” Law & Contemp. Probs. 73: 47.

Blanchard, Olivier and Leigh, Daniel (2013): “Growth Forecast Errors and Fiscal Multipliers,” IMF Working Paper, Research Department, WP/13/1.

Cruces, Juan Jose and Samples, Tim (2016): “Settling Sovereign Debt’s ›Trial of the Century.‹« Emory International Law Review“.

Gelpern, Anna, Heller, Ben, and Setser, Brad (2016): “Count the Limbs: Designing Robust Aggregation Clauses in Sovereign Bonds.” In: Too Little, Too Late: The Quest to Resolve Sovereign Debt Crises, (Guzman, Ocampo, and Stiglitz, eds.), Chapter 6; Columbia University Press, New York.

Guzman, Martin (2016a): “Reestructuración de Deuda Soberana en una arquitectura financiera-legal con huecos.Revista Jurídica, Universidad de Puerto Rico.

Guzman, Martin (2016b): “An Analysis of Argentina’s 2001 Default Resolution.” Centre for International Governance Innovation Paper.

Guzman, Martin and Heymann, Daniel (2016): »The IMF Debt Sustainability Analysis: Issues and Problems.« Journal of Globalization and Development 6 (2): 387–404.

Guzman, Martin and Stiglitz, Joseph E. (2016a): »Creating a Framework for Sovereign Debt Restructuring that Works.«In: Too Little, Too Late: The Quest to Resolve Sovereign Debt Crises, (Guzman, Ocampo, and Stiglitz, eds.), Chapter 1. Columbia University Press.

Guzman, Martin and Stiglitz, Joseph E. (2016b): “How Hedge Funds Held Argentina for Ransom.” The New York Times, April 1, 2016.

ICMA (2014): “Standard Collective Action and Pari Passu Clauses for the Terms and Conditions of Sovereign Notes“.

Independent Evaluation Office of the IMF (2i016): “The IMF and the Crisis in Greece, Ireland, and Portugal: an Evaluation by the Independent Evaluation Office“.

International Monetary Fund (2016): Strengthening the Contractual Framework to Address Collective Action Problems in Sovereign Debt Restructuring (October).

Miller, Marcus and Stiglitz, J. E. (1999): “Bankruptcy protection against macroeconomic shocks: the case for a ›super chapter 11“, World Bank Conference on Capital Flows, Financial Crises, and Policies (April 15).

Miller, Marcus and Stiglitz, J. E. (2010): “Leverage and Asset Bubbles: Averting Armageddon with Chapter 11?Economic Journal 120 (544) (May): 500–518.

Orszag, Peter and Stiglitz, Joseph E. (2002): “Optimal Fire Departments: Evaluating Public Policy in the Face of Externalities.The Brookings Institution (January 4).

Reinhart, Carmen (2016): “A Year of Sovereign Defaults?“. Project Syndicate (December 31).

Schumacher, Julian, Trebesch, Christoph and Enderlein, Henrik (2014): “Sovereign defaults in court.”

Stiglitz, Joseph E. et al. (2010): “The Stiglitz Report: Reforming the international monetary and financial systems in the wake of the global crisis,” with Members of the Commission of Experts on Reforms of the International Monetary and Financial System appointed by the President of the United Nations General Assembly, New York: The New Press.

 

End notes

[1] Public debt is sustainable with high probability when in most of the possible economic scenarios its repayment does not require a sequence of future borrowings that is unbounded. A sustainable debt path may entail some probability of default (i. e. the debt could only be sustained with unbounded borrowing), reflected, of course, in an interest rate that is higher than the safe rate of return. If there is a very high rate of interest, it would normally reflect that, in the judgment of the market, there is a significant probability of default. On the other hand, an outside expert group might conclude that there is a high probability of default even if the market risk premium is small; markets are sometimes »irrationally exuberant«
[2] See Guzman (2016a), Guzman and Stiglitz (2016b).
[3] In the presence of cross-border spillovers, the delay is also costly for the countries that have economic relations with the distressed debtor. See Orszag and Stiglitz (2002).
[4] Economic theory shows that, in the presence of macroeconomic externalities, markets will not resolve restructuring processes efficiently. See Miller and Stiglitz (1999, 2010).
[5] The bargaining process is itself an indication of the absence of perfect competition. Especially when there is bargaining with imperfect and asymmetric information, both the outcomes and the process may be inefficient.
[6] The IMF Independent Evaluation Office has pointed out serious flaws in the IMF role in the European crisis (IEO of IMF, 2016). The IMF fore- casts of countries in distress are often flawed, overestimating the speed of recoveries of countries in recessions (Guzman and Heymann, 2015), despite the fact that the non-linearities of fiscal multipliers recognized by the literature (Auerbach and Gorodnichencko, 2012; Blanchard and Leigh, 2013) are indications that the programs of fiscal adjustment should be expected to pose difficulties for recovery.
[7] See Guzman and Stiglitz (2016a) for a more extensive analysis.
[8] A prime example is the elimination of the defense of champerty for debt purchases or assignments of a value exceeding 500,000 US dollars by the New York state legislature in 2004. Previously, champerty prohibited purchasing debt in default with the intention of suing the issuer (see Blackman and Mukhi, 2010).
[9] Under New York law, the pre-judgment interest rate is 9 per cent. It was fixed in 1981, when the annual inflation rate in the US was 8.9 per cent, and it has not been modified since despite the significant fall in inflation. Such an interest rate on pre-judgment claims is more punitive than compensatory. Besides, vulture funds that buy defaulted debt may receive interest payments at this rate before there is a sentence even for periods between the default and the purchasing date, a period of time during which they did not hold the bonds. This is what happened in the dispute between Argentina and the vulture funds following the default of 2001 (see Cruces and Samples, 2016; Guzman, 2016b)
[10] In the dispute with Argentina that followed the default of 2001, for instance, they managed to seize an iconic ship belonging to the country, they attempted unsuccessfully to seize deposits of the Central Bank of Argentina in the Federal Reserve Bank of New York, they funded a variety of advertisements intended to put pressure on Argentina’s government to satisfy their demands, and they even supported the creation of a lobbying taskforce (American Task Force Argentina) that hired former high-profile government officials as lobbyists.
[11] The Report of the International Commission of Experts of the International Monetary and Financial System appointed by the president of the General Assembly of the United Nations had pointed out that the approaches to sovereign debt restructuring were flawed, and that improvement was urgently needed to avoid further efficiency losses and inequitable results (Stiglitz et al., 2010).
[12] The key point is that under the contractual approach, there is still scope for a judge not well versed in principles of international law and the economics of sovereign debt restructuring to adopt inappropriate interpretations of key terms in the debt contract — as Judge Griesa made so abundantly clear. Although there is no way to prevent similar rulings within the statutory approach, the fact that the judges in such cases would presumably be familiar at least with the issues of international sovereign debt restructurings would make such rulings less likely. The soft law approach described below provides, in effect, further safeguards.
[13] See Reinhart (2016).

Martin Guzman is a Research Associate at Columbia Business School, an Associate Professor at the University of Buenos Aires, and a Senior Fellow at the Centre for International Governance Innovation.

Joseph Stiglitz is University Professor of Economics at Columbia University, recipient of the 2001 Nobel Memorial Prize for Economic Sciences, and Co-President of Columbia University’s Initiative for Policy Dialogue.

This article is a summary of a more extended paper that has been published as a Friedrich-Ebert-Stiftung New York – International Policy Analysis paper (October 2016). Download the full paper here.

Photo of the UN General Assembly by Patrick Gruban

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