The IMF’s Way Forward for Sovereign Restructuring

Like consumers who rely on credit cards to pay for their purchases, governments also have to borrow money. But what happens when a government runs into trouble repaying, as has happened in recent years with Argentina and Greece? While a consumer or corporation can seek Bankruptcy court protection under the well-established U.S. Bankruptcy Code, there is no system for sovereign debt restructuring. Instead, nations must rely on arms-length negotiated solutions with creditors, where traditional ‘holdout’ problems can loom large. To combat the inherent limitations of this approach – laid bare by the seizure of an Argentine warship to satisfy creditors – the International Monetary Fund (IMF) has proposed significant changes to the contractual structure of sovereign debt to facilitate restructuring. While the issuing nation sets the terms of its own debt, the IMF’s report carries tremendous influence for the sovereign debt market because of the Fund’s role as one of the largest lenders to sovereign states in financial distress and the perception that the Fund reflects the views of its 188-nation membership. The IMF’s first suggestion is to amend the contractual terms of parri passu clauses in future debt issuances to mitigate the impact of a 2011 New York state court decision in favor of ‘holdout’ creditors from Argentina’s debt restructuring. In corporate insolvency, the parri passu clause simply grants bonds “equal step” in payment relative to the debtor’s other unsecured obligations. However, there is less clarity in the sovereign debt context, leading some courts to conclude that, if a sovereign pays holders of restructured bonds in full, it must also pay holdout creditors. For example, following Argentina’s 2001 default, two restructurings – in 2005 and 2010 – resulted in 93% of creditors accepting newly-created exchange bonds worth roughly 30 cents on the dollar. However, a small group of ‘holdouts’ – deemed ‘vultures’ by Argentina’s president – rejected the deal and chose to litigate for full repayment. Prior to the New York decision, Argentina only paid interest to those who accepted the deal, giving holdouts nothing while the parties’ legal dispute continued. However, the court held that Argentina must pay “all past due principal and interest” to holdouts – roughly $1.6 Billion – if it pays holders of restructured bonds, for whom the court subsequently blocked payments. The Second Circuit upheld the decision in 2013, and despite Argentina’s appeals – buttressed by amicus briefs from Brazil, Mexico, and France, amongst others – the U.S. Supreme Court declined to review the decision. Although the ultimate impact of the ruling is uncertain – and may not be followed by UK courts, whose law governs approximately 40% of sovereign debt – the IMF found that it “may exacerbate collective action problems,” while making the “sovereign debt restructuring process more complicated.” The IMF’s second proposal is to strengthen Collective Action Clauses (CACs) – a legal agreement to overcome ‘holdouts’ by allowing a majority vote of creditors – typically 75% – to modify the terms of previously issued bonds. Although a powerful tool, CACs’ traditional series-by-series operation leaves an opening for creditors to purchase enough of a particular series to prevent a qualified majority from forming – known as a ‘blocking position.’ To nullify this strategy, the IMF has proposed adopting the “single limb” voting procedure – which channels the entire bond restructuring process through a single supermajority vote, binding upon all of the nation’s outstanding bonds. The successful Greek debt restructuring largely followed this template. At the same time, the IMF stressed the need for legal safeguards to protect legitimate creditor’s rights from potential “abuse” inherent in such a potent provision. While a notable shift from its earlier proposal for a more formal sovereign debt restructuring mechanism, the IMF’s report may facilitate “active consideration of the reforms in the contractual framework,” potentially achieving the intended objectives of greater consistency and transparency in sovereign debt restructuring